Research Proposal 2010“Macroeconomic Factors and Mauritian Stock Market:Impact Analysis through Co integration Approach”

Name: BAZERQUE Sebastien

Programme: Finance with law (Level 2)

Student ID: 0810195

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Abstract

The relationship between macroeconomic variables and stock market returns is, by now,

well-documented in the literature. The study will investigate whether current economic

activities in Mauritius can explain stock market return in the long run by using a co

integration test and in short run dynamic adjustment from a vector error correction model.

The study will also test for the causality of economic variables and stock returns. The

cointegration test and the vector error correction model will illustrate whether or not

stock price indices are cointegrated with a set of macroeconomic variables such as

inflation, consumer price index, productivity index, interest rates, money supply and

economic growth. It is generally argued by authors that stock market should react with

fluctuations in macroeconomic variables; otherwise investors will not be likely to switch

from stock market to money market or other places where the opportunity cost for them

will be higher. The outcome of the study can probably be that there will be no

cointegration between growth of stock market returns and fundamental macroeconomic

factors; the reason being that the stock exchange of Mauritius if fairly new compared to

other countries. Implication of the study and suggestion for the improvement of the study

will also be provided.

Key words: Stock market returns, Cointegration, Granger Causality, Macroeconomic

variables, Vector Error Correction Model.

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1.0 INTRODUCTION

Over the few decades, the interaction of share returns and macroeconomic variables has

been subject of interest among academics and practitioners. It is often argued that stock

returns are generally determined by macroeconomic variables such as interest rates,

exchange rates and inflation. Evidence from financial press indicates that investors

generally believe that monetary policy and macroeconomic events have a large influence

on the volatility of the stock price. This implies that macroeconomic variables can

influence investors’ investment decision and motivates many researchers to investigate

the relationships between share returns and macroeconomic variables. Several studies

have attempted to capture the effect of economic forces on stock returns in different

countries. For example, using, the Arbitrage Pricing Theory (APT), developed by Ross

(1976), Chen et al. (1986) used some macroeconomic variables to explain stock returns in

the US stock markets. Their findings showed that industrial production and changes in

risk premium were positively related to stock prices whereas expected and unanticipated

information about inflation were negatively related to stock prices.

The development of cointegration analysis provided another approach to examine the

relationships between the macroeconomic variables and stock returns. For example,

Mukherjee and Naka (1995) employed the Johansen cointegration test in the Vector Error

Correction Model (VECM) and found that the Japanese stock market is cointegrated with

six macroeconomic variables namely, exchange rate, money supply, inflation rate,

industrial production, long term government bond rate and the short term call money rate.

The results of the long-term coefficients of the macroeconomic variables are consistent

with the hypothesized equilibrium relationships. Kwon and Shin (1999) applied Engle-

Granger cointegration and the Granger-causality tests from the Vector Error Correction

Model (VECM) and found that the Korean stock market is cointegrated with a set of

macroeconomic variables. However, using the Granger-causality test on macroeconomic

variables and the Korean stock index, the authors found that the Korean stock index is not

a leading indicator for economic variables.

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1.1 Objectives

The aim of the study is to investigate the relationship between the market returns

of the stock market of Mauritius with macroeconomic variables.

Attempts to determine whether there exists any long run relationship and a short

run dynamics between the stock market of Mauritius and real economic activity in

Mauritius.

Tests whether major macro-economic variables in Mauritius can explain stock

returns by using a co-integration test and vector error correction model.

Stock Market

With mounting economic gloom and heightened risk aversion in international markets,

the local stock market lost considerable ground in the second half of 2008. The SEMDEX

and the SEM-7 fell by 35 per cent and 41 per cent, respectively, reaching lows of

1,112.17 and 245.90 on 24 November 2008. With the focus on the economic weakness of

major export markets and the potential impact on export oriented enterprises amid the

revised domestic economic outlook, share prices of blue chip companies dipped

following aggressive selling by both local and foreign investors. Foreign investors

disinvested significantly from the local stock market. Net sales by foreign investors in the

second half of 2008, which mostly occurred in the last quarter of 2008, stood at Rs308

million as against inflows of Rs1, 091 million in the first half of the year. The decline

was mainly driven by sales of banking and hotels stocks.

InflationDespite the recent monetary loosening, inflationary pressures have

eased since the reversal of last year’s global food and commodity price

shock and the slowdown of the domestic economy and portfolio

inflows. Since 2006, the BoM calculates measures of core inflation

which are used as complementary indicators of the trend component

of inflation. Core inflation volatility has also significantly declined,

confirming that relative price adjustment (from administered prices)

has an impact on inflation.

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GrowthLooser monetary stance is not always associated with stronger growth.

Despite periods of lower policy rates and high growth there does not

appear to be a strong relationship between short-term interest rates

and real output. Perhaps this is due to the fact that lower interest rates

are associated with monetary expansions of 2000-06 and 2007-08 and

have contributed to the private sector credit growth in 2003-2004 and

2007-08, while at the same time private sector credit growth was high

under high interest rate environments of 2004-2006. In addition,

growth developments in Mauritius depend heavily on the global

economy (particularly the EU which is Mauritius’ main market for

exports and tourism).

Exchange rateMauritius’ exchange rate regime has been reclassified from a managed

float to a free float in the Fund’s AREAR classification. Foreign

exchange intervention by the BoM is in principle limited to smoothing

operations. This allows the Mauritian monetary and exchange rate

regime to combine the flexibility of a floating exchange rate with some

of the discipline of a less flexible regime. Recently, within the floating

regime, the BoM accumulated reserves through mid-2008 then allowed

them to decline as capital inflows eased late last summer. This trend

continued when, in step with international developments, monetary

policy was eased in November and again in early December. The BoM

has since refrained from interventions, and the floating exchange has

depreciated in nominal effective terms by about 4 percent since

January 2009, while remaining relatively stable against the U.S. dollar.

Overall, monetary policy easing tends to be followed by a depreciation

of the rupee. With the exception of a short period in the mid 2000s,

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movements of the nominal effective exchange rate (NEER) have

followed the short-term interest rate (perhaps with a lag).

1.2 Outline

The layout of the study is as follows: section two deals with the review of literature and

section three presents methodology with model specification. (Methodology will include

unit root test, which is testing for stationarity of all the variables, Engel and Granger two

step approach of cointegration, The Johansen Cointegration Method, the vector error

correction model, the granger causality test and the impulse response). Moreover, the

data and the methods used to obtain them will also be specified in section three. It is to be

noted that in this section, all the variables and proxies used in the study will be explained.

Section 3.3 will elaborate on the expected outcomes and what kind of statistical analysis

will be performed. Section four will consist of a Gantt chart which will provide details

about the tasks and respective dates that is intended to be followed for the dissertation.

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2.0 Literature Review

2.1 Theoretical Review

Economic theory suggests that stock prices should reflect anticipations about future

corporate performance and the corporate profits generally reflect the level of economic

activity. If this was the case, then stock prices should be employed as crucial indicators of

future economic activities. Probably the relationship between stock prices and

macroeconomic variables is well illustrated by the Dividend Discounted Model (DDM)

proposed by Miller and Modigliani than other theoretical stock valuation model.

According to the model, the current price of an equity share equals the present value of

all future cash flows of the share. Thus the determinants of share prices are the required

rate of return and the expected cash flows suggesting that economic factors which

influence those two affect the share price. According to the DDM, the required rate of

return and share price are inversely related.

By using the multi-factor Arbitrage Pricing Theory, Hamao (1988) showed that the

Japanese stock returns were significantly affected by inflation. Fama (1981) carried out

investigations of the relationship between stock prices and real economic activity,

inflation and money supply. He found a strong positive correlation common stock returns

and real variables. Next, the exchange rate which also involves the movement of currency

affects stock prices in a way similar to inflation variable. In the event the local currency

depreciates, import becomes more expensive than export leading to increased production

cost of import companies. Owing to the fact that all cost cannot be passed on to the

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consumer due to competitiveness of the market, corporate earnings, which are

determinants of stock prices according to the DDM, will fall.

Theoretically, the money supply has a negative impact on stock prices because, as money

growth rate increases, the inflation rate is also expected to increase; consequently the

stock price should decrease. However, an increase in the money supply would also

stimulate the economy and corporate earnings would increase. This would result in an

increase in future cash flows and stock prices.

2.2 Empirical Review

Studies on whether current economic activities in Turkey have explanatory power over

stock returns have been conducted by Karamustafa O and Kucukkale Y (2003). They

considered monthly data of stock price indexes of Istanbul Stock Exchange and a set of

macroeconomic variables, including money supply, exchange rate of US Dollar, trade

balance, and the industrial production index. Engel-Granger and Johansen- Juselius

cointegration tests and Granger Causality test were used in the study to explain the long-

run relations among variables questioned. Obtained results illustrate that stock return is

co-integrated with a set of macroeconomic variables by providing a direct long-run

equilibrium relation. However, the macroeconomic variables are not the leading

indicators for the stock returns, because any causal relation from macroeconomic

variables to the stock returns cannot be determined in sample period. In contrast, stock

return is the leading indicator for the macroeconomic performance for the Turkish case.

Using cointegration techniques, Chowdhury A.R. (1995) explains the lack of efficiency

in the emerging stock markets by investigating the issue of informational efficiency in the

Dhaka Stock Exchange in Bangladesh. He argued that in an efficient market the prices of

the securities fully reflect all available information i.e. stock market participants

incorporate the information contained in money supply changes into stock prices. Initially

he tested the bivariate relationship between stock prices and money supply changes.

Results from bivariate models suggest independence between the stock price and

monetary aggregates. In other words Dhaka stock market is informationally inefficient.

However, it is well known that bivariate models fail to address the obvious possibility

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that the relationship may be driven by another variable acting on both stock price and

money supply. Hence multivariate models were estimated which shows the presence of a

unidirectional causality from the money (both narrow and broad) to stock price. But the

findings are insensitive to the functional form of the variables employed. Thus the stock

prices do not immediately reflect changes in monetary policy and the market in

inefficient. One important limitation of this study is that the cointegrating test was

conducted only for bivariate model. No such test was conducted for multivariate model.

Homa and Jaffe (1971) estimated the relationship between the supply of money and an

index of common stock prices, seeking a forecasting tool in the implementation of

investment strategies. Their findings indicated that the price of any common stock is

determined by three variables: the level and growth rate of dividends, the risk-free rate of

interest, and the risk premium. The risk-free rate of interest being a function of money

supply, they concluded that the average level of stock prices is positively related to the

money supply.

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3.0 Data and Methodology

3.1 Data Selection Justification and Hypothesis

In this section, the selection of the variables used for the analysis in this study will be

justified.

Variable Definition

Share Price Index Official published index of the market-weighted value of closing price for 40 shares listed on the Stock Exchange of Mauritius

Inflation Rate (INF) Quarterly

Exchange Rate (EX) End of month price of domestic currency rate in terms of trade weighted index

Gross Domestic Product (GDP) Real production based gross domestic product at constant level.

Money Supply (M1) Narrowly defined money supply in Mauritius

3.2 Data Sources

The data used for the analysis in this study include selected macroeconomic variables and

stock price index. Monthly data series for the period of July 1997 to June 2005

(96 monthly observations) will be considered. The data will be obtained from the Central

Statistic Office. For stock price the data used are the monthly general share price index of

the Stock Exchange of Mauritius. It is the closing index prices of the last trading day in

each month. The macroeconomic variables used are monthly data for the same time

period as the stock market data (July 1997 to June 2005).

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3.3 Research Methods

For the purpose of the study, the relationship between stock market returns and some

selected macroeconomic variables will be examined. The share price index will be used

as a proxy to represent stock market return and macroeconomic variables namely

inflation, interest rates, economic growth and money supply. A series of tests such as unit

roots, cointegration, vector error correction (VECEM) will be carried out. Granger

causality will also be conducted to test for causality. These tests will examine both long

run and short run relationships between stock market index and the economic variables

used. The VECM analyses provide some support for the argument that the lagged values

of macroeconomic variables have a significant influence on the stock market.

From the above theoretical, intuitive, and empirical discussion, we postulate the

relationship between stock prices and selected macroeconomic variables as described

above as follows:

3.1.1 Unit root test

Many studies have shown that most macroeconomic time series are not stationary, rather

non-stationary with a deterministic trend. This creates a problem since in the conditions

of non-stationary data the normal properties of Durbin-Watson (DW) and t statistics and

measure such as R2 break down. Running regression with such data produces

questionable, invalid and spurious results. To eliminate this problem, stationarity test

must be performed for each of the variables. There have been a variety of proposed

methods for implementing stationarity tests (for example, Dickey and Fuller, 1979;

Sargan and Bhargava, 1983; Phillips and Perron, 1988 among the others) and each has

been widely used in the applied economics literature. In the study, Augmented Dickey-

Fuller (ADF) test procedure will be employed for implementing stationarity tests.

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3.1.2 Johansen Cointegration Method

The Johansen method applies the maximum likelihood procedure to determine the

presence of cointegrating vectors in non-stationary time series as a vector autoregressive

(VAR). Consider a VAR of order p.

Y t =A1Yt-1+A2Yt-2+……………………………..+ A pY t-p + BX t+ U t

where Yt is a k-vector of non-stationary I(1) variables, Xt is a d vector of deterministic

variables, and εt is a vector of innovations. We can rewrite the VAR as:

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