**2. Literature Review**

The Smithsonian Agreement formulated in 1971 necessitated that developed nations should peg their currencies to the US dollar. The Nixon Shock caused the collapse of the Bretton Woods system of fixed exchange rates among developed nations. To stimulate economic growth by stabilising the real exchange rate (RER), developing economies subsequently adopted crawling pegs and managed floating regimes. In this regard, a major concern for economies engaged in trade is RER misalignment, which has economic growth implications. Misalignment is a common occurrence by which the RER deviates from the ideal or the equilibrium exchange rate. Fixed exchange rate regimes like Botswana are generally associated with exchange rate misalignment (Chowdhury and Wheeler 2015; Dubas 2009; Ghosh et al. 2015). Pesaran et al. (2001) define exchange rate misalignment as the percentage gap between the observed exchange rate and the equilibrium real exchange rate (ERER). Deviations of the RER from the equilibrium instigated major currency crises in developing nations, such as the 1994 Mexican currency crisis, the 1997 Asian currency crises and the 1999 Brazilian financial crisis. Currencies of Asian economies were significantly misaligned before the currency crisis (Chinn 2000; Coudert et al. 2013; El-Shagi et al. 2016; Jeong et al. 2010; Kinkyo 2008).

The literature posits that overvaluation of the RER was the cause of capital flight in Latin America (Cuddington 1986). The Latin American debt crisis was a financial crisis accompanied by significant capital flight. The debate as to whether capital flight initiated the debt crisis or foreign debt caused capital flight in Latin America is ongoing. Capital flight occurs when monetary assets flow out of a country rapidly as a response to economic and political changes. It leads to loss of wealth and depreciation of the local currency. Erbe (1985) defines capital flight as total private capital outflows from developing nations. Dooley (1986) and Lessard and Williamson (1987) sugges<sup>t</sup> that capital flight should be distinguished by its motivations rather than economic consequences. A challenge facing research on capital flight is its measurements, which do not capture the actual value of capital flight because capital flight can occur illegally. Illegal capital outflow is large in developing economies since they have ine ffective, or no capital controls to stimulate foreign direct investment (FDI) inflows. Capital flight has significant adverse e ffects on economic growth, particularly in developing economies, because it reduces private and public investment. As capital leaves the domestic economy, governmen<sup>t</sup> tax revenue declines, which reduces funding for public investments. Therefore, the governmen<sup>t</sup> must borrow from foreign bodies at high costs. The interest rate for an investor taking assets abroad is fixed. However, the loan interest incurred by the governmen<sup>t</sup> increases with the magnitude of the loan. Hence, capital flight creates major debt obligations, particularly in developing economies (Cuddington 1986).

According to Hermes et al. (2004), capital flight occurs owing to macroeconomic instability and manifests in multiple ways, such as budget deficits, current account deficits, overvaluation of the currency and high inflation. Overvaluation of the domestic currency is an important underlying determinant of capital flight. Expectations of depreciation are high when the currency is overvalued. Since investors aim to maximize returns and avoid welfare losses, domestic investors would be inclined to send their monetary assets abroad. The literature on exchange rate misalignment argues the Botswana pula is overvalued because of mining revenue (Limi 2006; Pegg 2010). Hence, this study aims to identify the impact of exchange rate misalignment on capital flight from Botswana as an attempt to promote FDI inflows, economic diversification and sustainable growth.

Few studies investigate the e ffects of exchange rate misalignment on capital flight. To determine these e ffects, we have to reflect on the exchange rate expectations theory developed by Hermes et al. (2004). The theory posits that an overvalued currency leads to increasing expectations of depreciation in the future. As a result, economic agents will demand more foreign goods than domestic goods, leading to inflationary pressures and loss of real income. Under such circumstances, economic agents will prefer to hold their assets abroad to avoid welfare losses, leading to capital flight. Gouider and Nouira (2014) examine the role of exchange rate misalignment on capital flight for a sample of 52 developing economies using data on the 1980–2010 period. Their results show that strong undervaluation of the domestic currency restricts capital flight, while strong overvaluation stimulates it (Gouider and Nouira 2014). Further, Sohrabji (2011) examines the link between capital flows and REER overvaluation. The author uses Edwards' (1989) model, cointegration tests and an error-correction model. The results show that capital inflows significantly contribute to exchange rate misalignment.

Botswana has no exchange rate restrictions, since it aims to boost domestic business e fficiency and FDI inflows. The country attracted significant capital flows in the mining sector with moderate portfolio investments (Bank of Botswana 2016). FDI in Botswana is required for investment capital, economic diversification and promotion of inclusive growth. In 2017, Botswana experienced loss of foreign exchange reserves due to appreciation of the pula, which increases its exposure to a financial crisis (Agénor et al. 1992; Coudert et al. 2013; El-Shagi et al. 2016; Jeong et al. 2010; Kaminsky et al. 1998; Kinkyo 2008; Krugman 1979). Following Hermes et al. (2004) and Cuddington (1986), overvaluation of the pula may create expectations of depreciation thereby increasing capital outflows. The central bank conducted portfolio-rebalancing operations in 2017 to counter persistent capital outflows. As regards the literature on this issue, although capital inflow is vital to Botswana's economy, previous studies have not evaluated the impact of exchange rate misalignment on capital flight from Botswana.
