Stock market and macro economic behavior in India

Sangeeta Chakravarty Institute of Economic Growth University Enclave Delhi-110007

sangeeta@iegindia.org

Stock Market and macro economic behavior in India

Abstract This paper reexamines the relationship between stock price and some key macro economic variables in India for the period 1991-2005 using monthly time series data. The study uses Granger non causality test procedure developed by Toda and Yamamoto(1995). The results of the study indicate that index of industrial production and inflation Granger cause stock price but stock price does not cause either of the two so the causation is unidirectional. The causal relation between stock price and money supply is unidirectional as stock price Granger cause money supply but money supply does not. On the other hand there is no causal relation between stock price and exchange rate. Similarly there is no causal linkage between gold price and stock price.

Introduction: A significant amount of literature now exists that examines the relationship between stock market returns and a range of macro economic and financial variables over a number of different stock markets and time periods. Now a days financial economics provide a number of models that helps to examine the relationship The return on stocks is highly sensitive to both fundamentals and expectations. The latter in turn is influenced by the fundamentals which may be based on either rational or adaptive expectation models, as well as by many subjective factors which are unpredictable and also non quantifiable. Empirical studies indicate that once the financial deregulation takes place, the stock market becomes more sensitive to both domestic and external factors. The domestic fundamentals, in principles, are related to domestic macro economic conditions. However there may be a lot of divergence between the overall state of the economy and individual stock return. The external factors influencing the stock return would be stock prices in global economy, the interest rate and the exchange rate. The early survey on the behaviour of stock return was done by Famma(1970). The Famma Theory of efficient market hypothesis suggests that stock markets are efficient because they reflect the fundamental macro economic behavior. The term efficiency implies that a financial market incorporates all relevant information(including macro economic fundamentals) in the market, in which case the outcome is the best possible under the circumstances . Many empirical studies have been conducted to examine the relationship between stock price and macro economic variables and findings are generally mixed. Famma and French (1989) and Poterba and Summers (1988) have shown that the U.S. stock returns have a mean reverting tendency and can be predictable to some extent .Similar results have been found by MacDonald and Power (1991) that U.K. stock returns have a mean reverting-tendency and so can be predicted. Subsequent studies like Famma(1981), Famma and Gibbons(1982) Summers(1986) and Chen(1991) verified that the efficient market hypothesis holds in US market, and there was significant linkage between US stock market on one hand and real economic variables, such as, GDP, industrial production, inflation and unemployment on the other hand. Naj and

Rahman(1991) studied the relationship between volatility of stock return and of macroeconomic variables in four developed countries and confirmed the relationships Fang and Lee(1990) studied the long term relationships between stock return on the one hand and GNP, inflation and money supply on the other in Taiwan and concluded that the efficient market hypothesis is not valid for an emerging market. Fang and Loo (1995) studied the relationship between stock return volatility and international trade for four Asian countries. They however, found evidence in favor of the efficient hypothesis. Their empirical market

results based on vector autoregressive model(VAR)

suggested that the stock return volatility in the four markets respond to information on trade. The behavior of stock price (BSE) in relation to some key macro economic variables in India during the scam period 1992 was studied by Bhattacharya and Chakravarty (1994). Their dynamic forecasts indicate that the behavior of stock price is unrelated to key macro variables. Mukherjee and Naka(1995) explored the relationship between exchange rate, inflation , money supply, real economic activity, long term government bond rate and call money rate with the Japanese stock market. Their empirical result suggested that cointegration relation existed and positive relationship was found between the Japanese industrial

production and stock return. Chaudhuri and Koo(2001) investigated the volatility of stock returns in some Asian emerging markets in terms of the volatility of domestic and external factors, found that both domestic macroeconomic variables and international variables have significant impact on stock return volatility. Their empirical results suggest the presence of a significant contagion effect and integration of capital market in this region. The results also suggested the role of government in terms of fiscal and monetary policy in smooth functioning of the stock market is crucial in this region. In Indian context , Bhattacharya and Mukherjee (2002) studied the nature of the causal relationship between stock prices and macro aggregates in India by using the methodology proposed by Toda and Yamamoto for the period of 1992-93 to 20002001.Their results show that there is no causal relationship between stock price and macro economic variables like money supply, national income and interest rate but there exists a two way causation between stock price and rate of inflation. According to them index of industrial production lead the stock price.

They further investigated the causal linkage between stock prices and macro economic aggregates in the foreign sector in India like exchange rate, foreign exchange reserves and value of trade balance by applying the technique of co integration and long run Granger non causality test developed by T&Y(1995). Their results suggested that there is no causal linkage between stock price and the three variables. Thus BSE sensitive index neither leads these three variables nor they lead the BSE sensitive index. They also added that if this type of results hold for subsequent periods then it can be said that Indian stock market is approaching towards informational efficiency with the three variables, ie exchange rate ,foreign exchange reserves and trade balance. Mishra (2004) examined the relationship between stock market and foreign exchange markets using Granger causality test and Vector Auto Regression technique .They used monthly data for stock return exchange rate, interest rate and demand for money for the period 1992 to 2002. The study found that there exists a unidirectional causality between the exchange rate and interest rate and also between the exchange rate return and demand for money. The study also suggested that there is no Granger causality between the exchange rate return and stock return . The BSE sensex is about to cross the five digit points mark and will be major index in the Asian market so it compel us to think whether the market is expected to remain bullish in the long run or not? Is there any macro economic variables which causes this bullish behavior of stock price in India? In reference to the above statements this paper attempts to examine whether the macro economic variables causes the recent bull phase of stock price in India . The study uses Granger non causality test by Toda and Yamamoto(1995)( T&Y) for the period of April 1991 to December2005.The causal relationship tested between the BSE index and macro economic variables such as money supply, index of industrial

production, inflation rate, exchange rate . Gold price is included in the model as an additional variable, to examine whether gold price contain any additional significant information about price movements. Since gold is an important saving instrument in India and is very often used as a hedge against inflation, it is expected that gold may be looked upon as alternative asset for those holding idle money, for speculative purposes. This paper is organized as follows:

Section-2 describes the macro economic variables and data used in the study. Methodology is presented in Section-3. Section 4 reports the empirical results and conclusion is contained in Section 5. .

The Data and Variables This paper study the impact of domestic macro economic fundamentals on the

stock price in India using monthly data from April 1991 to December2005.This period is not only the economic reform period but also depicted a great deal of volatility. The data are from RBI weekly and monthly bulletins. The study examines relationships between stock price in India and the macro-economic variables like money supply (M3),

exchange rate (ER), index of industrial production (IIP) , inflation (INF) and gold price(G). While a number of macroeconomic variables may affect stock prices directly or indirectly ,in this paper only the most proximate macroeconomic determinants are chosen.

3 .Methodology

The long

run relationships among variables

can be found out by applying

Johansens(1988) and Johansen and Juselius(1990) multiple cointegration test. . Giles and Mirza(1999) have pointed out that the pre testing for non stationarity and cointegration before the Granger causality test can lead to over rejection of a non causal null ,i.e. pre testing for nonstationarity can lead to the wrong conclusion of causality. Toda and Yamamoto(1995)and Dalado and Lutkepohl (1996) suggested to test Granger concept of causality on an augmented VAR in levels even if the series are integrated or cointegrated of an arbitrary order , but this procedure does not replace the conventional hypothesis testing of unit roots and cointegration ranks. To establish the causal relationship between stock price and macro economic variable in India this paper uses Granger non causality test suggested by Toda and Yamamoto (1995) (T&Y).

According to recent literature (T&Y) method is simple and able to overcome many drawbacks of alternative econometric methods. The cointegration technique by Johansen and Juselius(1990) model(ECM) and transforms the suggested relationship into an Error correction identify the parameters associated with the causality. The co

integration methodology basically characterizes the existence of long run relationship. The method suggested by T&Y is to overcome problem of invalid asymptotic critical values when the causality tests are performed in the presence of nonstationary series. In the method developed by T&Y(1995) a modified WALD test is used for restrictions on the parameters of a VAR(k), where k is the lag length in the system .According to them even if the series are non stationary, a level vector autoregressive (VAR) model can be estimated and a WALD test can be applied. This method essentially suggests the determination of the maximum order of integration of the series in the models dmax , such that VAR is of order p=k + dmax, where k is the optimal lag order. The choice of lag length in the causality test has been discussed in some studies but very few have considered the sensitivity of the test results under different lag. There is a need to obtain consistent causality result for some consecutive lag structures along with the optimal choice of the lag using some criterion. T&Y(1995) method utilizes a modified WALD(MWALD) test for restrictions on the parameters of a VAR .This test has an asymptotic 2 distribution with the degrees of

freedom equal to the number of zero restrictions ,when VAR(k +dmax) is estimated. The MWALD method for testing Granger no causality can be computationally simple by using a seemingly unrelated regression (SUR) which was proved by Rambaldi and Doran(1996). In the present study consider six variable VAR system in a SUR form, the system of equations are jointly estimated as SURE model and MWALD test statistic is calculated. The advantage of this method is that there is no need of the knowledge of cointegration properties of the system. It has a normal standard limiting 2 distribution with degrees of freedom equal to the number of zero restrictions. According to T&Y(1995) VAR can be estimated using data in the levels even if the process is integrated or co integrated of an arbitrary order and also the general restrictions can be tested. The six variable VAR system in SUR form is written as follows

Xt = A0 + Ai Xt-k +et
i =1

p 1

(3.1)

Where Xt

is a(nx1) column vector of p variables,A0 an nx1 vector of constant term and

Ai i =1, 2 , p-1 represent coefficient matrices, k denotes the lag length , et is a error term To examine the first causality (from M3 to stock price) one should test whether M3t-k appears in the first equation of the system (3.1) .The hypothesis that is to be tested for first causality is H0 :a1(1) = a(2)==a(n) =0 ,where a1(l) are the coefficients of M3 for 1,2.3, .,n lags

in the first equation of the system. Rejecting the null hypothesis, the causality from M3 to stock can be established through MWALD statistic. The MWALD statistic will be asymptotically distributed as 2 ,with degrees of freedom equal to the number of zero restrictions. If the hypothesis is rejected then M3 does Granger cause stock price. Similarly for second causality (from stock price to M3),the null hypothesis to be tested is H0 : a2(1) = a
(2) (n)

= ..=a

=0 , where a2(l) are the coefficients of stock price for

1,2, .,n lags in the second equation of the system (3.1)

4.Empirical Results . Prior to testing for non causality , it is necessary to establish the order of

integration .For that Augmented Dickey-Fuller test(ADF) was conducted on the time series in the levels and differenced forms.

TABLE 1.Results of Unit root test for five macro variables in levels. variables Intercept with trend -.9323 Intercept with out trend .7611 5.895* -1.0934 -2.3786 -.3695

Stock price Money .5347 supply Exchange -1.1323 rate Rate of -2.8295 inflation -5.0256* Index of industrial production *significant at 5% level

The unit root results show that some variables are non stationary at levels but stationary after first difference. From Table 1.the results clearly suggest that money supply(M3)(intercept and without trend) is significant at 5% level of significance variables but not significant with intercept and trend. Similarly index of industrial production(IIP) is significant at 5% level of significance with intercept and linear trend. Thus the result suggest that these two variables IIP and M3 are integrated of order 0 so they are I(0) variables. But stock price, rate of inflation exchange rate are integrated of order1 they are I(1) variables .These series will be stationary after first differencing, therefore dmax=1.Next step is to estimate the lag with system of VAR in levels. The optimum lag length based on the AIC and BIC information criteria indicate that optimal lag length is3.Therefore k=3.Then estimate a system of VAR in levels with total of lag length(dmax+3=4). The model is estimated using several lag structure,( dmax =1 and for k>3) so that the results are not sensitive to the choice of lag length. TABLE 2 indicates that results are consistent with each other for different lags and thus the results are robust.

TABLE 2.Granger no causality test results Lag structure MWALD Statistics VAR order BSE does not 2 (3) 6.283** Granger cause 3 (4) 8.467** 4 (5) money supply(M3) 8.450** 9.391** 5 (6) 2 (3) M3 does not Granger 3.586 3 (4) 4.363 cause BSE 4 (5) 6.395 6.233 5 (6) BSE does not Granger cause ER
2 3 4 5 2 3 4 5 2 3 4 5 (3) (4) (5) (6) (3) (4) (5) (6) (3) (4) (5) (6) (3) (4) (5) (6) (3) (4) (5) (6)

Null hypothesis H0

ER does not Granger cause BSE

BSE does not Granger cause IIP

1.647 4.384 4.323 4.215 4.542 5.018 8.848 8.725 4.951 6.038 9.682 4.329 7.659** 7.982** 10.211** 11.481** .366 .743 1.0823 1.254

IIP does not Granger cause BSE

2 3 4 5 2 3 4 5

BSE does not Granger cause INF

INF does not Granger cause BSE

2 3 4 5

(3) (4) (5) (6) (3) (4) (5) (6)

9.045* 11.507* 11.971* 12.987* 1.325 1.623 1.989 2.035

BSE does not Granger cause G

2 3 4 5

10 Gold does not Granger cause BSE

3.321 3.538 4 (5) 3.986 4.056 5 (6) *and **Significant at 5% and 10% level
3 (4)

(3)

VAR order =k +dmax ,where: k is the lag length used in the system; dmax the maximum order of integration in the system and is equal to 1.

is

The results in Table 2 suggest that the null hypothesis Granger causes M3 is rejected at 10% level but the

that BSE does not

hypothesis M3 does not Granger

causes BSE is accepted at both 5% and 10% thus the causation is unidirectional. There is no causal relation between BSE and ER as the null hypothesis of Granger non causality from both variables are accepted . The results suggest that BSE does not granger causes IIP but the null

hypothesis IIP does not Granger cause

BSE is rejected at10% level. Similarly the

hypothesis BSE does not Granger causes inflation is accepted but the hypothesis that inflation does not Granger cause BSE is rejected at 5% level thus the causality is unidirectional. The gold price does not show any causal linkage with stock price.

5.

Conclusion This paper made an attempt to study the causal relationship between

macroeconomic variables and stock price of India for the period of April 1991 to December 2005 using Granger no causality test developed by Toda and Yamamto(1995) Although the choice of optimum lag in causality test has been noted in some studies but very few have considered the problem of the sensitivity of the causality test under different lag structure. This paper obtain consistent causality results for some Akaike

consecutive lag structures along with the optimal choice of the lag using information criteria(AIC) and Schwartz criterion(SC) ,so the results are robust. In the earlier literature there are few studies

suggested that there is a relation ship

between exchange rate market and stock market in India but some suggested that there was no Granger causality between the stock return and exchange rate return .However

our empirical results suggest that exchange rate does not Granger cause stock price nor stock price Granger cause exchange rate. The empirical results further suggest that the index of industrial production and rate of inflation Granger cause BSE but BSE does not Granger cause index of industrial production and inflation, so the causation is unidirectional. Thus it can be said that good performance by the industrial sector, rise in the farm sector out put along with low inflation rate could be the reason of bull run of sensex. The causal relation between BSE and M3 is unidirectional as BSE cause M3 but M3 does not cause BSE. Gold price included in the model does not show any causal relationship with stock price.

In past most studies have proved that sensex is neither a good barometer of economic fundamentals nor it is an indicator of future growth prospects of the economy. In India all past stock market volatilities were associated with irregularities and manipulation so with all those past experiences market manipulation can not be ruled out but on the other hand the Indian economy experiences robust exports and good

economic growth which attracts foreign investors to invest in Indian stock market, they are expecting good healthy returns from the market. The index will cross 10,000 points mark in the next three to four months time may be due to foreign institutional

investors(FII).Stock price ,being sensitive to speculation ,is bound to show periodic change. The recent bull run of sensex is a mater of concern for the market, especially in an emerging economy like India. Therefore some periodic econometric and policy analysis is therefore necessary.

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