Relations between macroeconomic variables and the stock market index : evidence from Sri Lanka

Abstract

This study examines whether the performance of Colombo Stock Exchange(CSE), as measured by the All Share Price Index (ASPI), is affected by a set of macroeconomic variables namely, Interest rate, Broad money supply, Index ofIndustrial Production and Inflation by using quarterly data obtained from Central Bank of Sri Lanka from 2004:QI to 20I6:Q3. The Vector. Autoregressive (VAR) framework was adopted by initially looking at the long run and short run relationship between stock market and the macroeconomic variables via the Johansen cointegration technique. To further explore the dynamic co-movement among the variables and the adjustment process towards the long run equilibrium, vector error-correction model (VECM) was used. Finally, Impulse Response Function (IRF) and Variance Decomposition (VDC) are employed in order to illustrate the importance of each macroeconomic variable to the stock market movement when a shock is imposed to the system. The analysis reveals that macroeconomic variables and the stock market index are co-integrated and, hence, a long-run equilibrium relationship exists between them. It is observed that the stock prices positively relate to the industrial production but negatively relate to inflation. The interest rate and money supply are found to be insignificant in determining stock prices in the long run. The results showed that both inflation and money supply significantly and inversely affect stock return in the short run. The results ofGranger causality test further indicate that there exists unidirectional causality from inflation to stock return. Furthermore, based on the results of impulse response function and variance decomposition analysis, it is confirmed that that stock market index has stronger dynamic relationship with industrial production index and inflation as compared to money supply and interest rate. Therefore Central Bank of Sri Lanka must undertake pragmatic policies aimed at controlling inflation within acceptable limits, since inflation is seen to inversely affect stock return.