Are exchange rates and international trade responsive to the nonlinear shocks of investor sentiments?

Abstract

Purpose The increase in international trade has given credence to the exchange rate. In emerging economies, instability in exchange rates often exposes the economy’s weaknesses and causes financial and economic hardships. In this study, we examined how exchange rates (EXR) and imports (IMGS) respond to the nonlinear shocks of investor sentiment underscored by the economic complex theory. Design/methodology/approach Using the principal component analysis (PCA), we first created an investor sentiment index (ISI) and controlled for some macroeconomic indicators. Then, we employed the nonlinear autoregressive distributed lag (NARDL) model to an annual dataset from 1990 to 2022. Findings The analysed data shows that the domestic currency appreciates as sentiment decreases but is indifferent as sentiment increases and imports increase on a marginal scale regardless of the direction of sentiment. However, the effect of ISI on EXR was stronger than that of IMGS. Besides, both EXR and IMGS affect each other, but the influence of IMGS on EXR is intense. We also confirmed that both EXR and IMGS are affected by interest rates, inflation and real GDP. Originality/value Literature acknowledges that creating ISI presents a challenge, and linear estimates bias results. Hence, we chronicled and created an ISI and applied a nonlinear model that yields better results to extend the literature on the nexus of exchange rate, import and investor sentiment in behavioural and international finance.