The connection between macroeconomic variables and stock price - Free Essay Example

Over the past few decades, the connection between macroeconomic variables and the movement of stock prices has been a subject of interest among academics and researchers. It is often argued that stock prices are determined by some fundamental macroeconomic variables such as interest rate (Base Lending Rate, BRL), exchange rate, inflation (Consumer Price Index, CPI), industrial production index and money supply (M2). In fact, investors generally believe that macroeconomic events have a large influence on the volatility of the stock prices, which in turn motivates researchers to explore the relationship between macroeconomic variables and stock prices. 1.1 Research Background The relationship between stock prices and macroeconomic variables has been widely investigated in scientific literature. Sohail and Hussain (2009) claimed that the stock market plays an important role as it mobilizes domestic resources and channels them to productive investment, which leads to economic growth in a country. It acts as a mechanism that facilitates flow of funds from saver to borrower. A well-organized stock market makes an attractive feature of issuing and investing in stocks. From the corporations perspective, the stock market allows it to raise funds by selling additional shares of ownership. On the other hand, it also provides liquidity to investors. In other words, investors are able to quickly and easily convert their securities to cash. A companys stock price is determined by the perception of investors on true value of the stock. Stock prices are also affected by all forms of company and market news. According to Asmy, Rohilina, Hassama, and Fouad (2009) as well as Maysami, Lee, and Hamzah (2004), the efficient market hypothesis suggests that efficient market is where new information about changes in macroeconomic variable is quickly incorporated into the price so that the current market price reflects all available information. Therefore, no one can outperform the market or earn abnormal profit consistently in the market. However, some evidences are against this theory and shown that abnormally higher return can be earned. The stock price is the primary indicator of a countrys economic strength and development (Shahbaz, Ahmed, and Ali, 2008). This means that when stock prices move up or down, due to demand and supply of stock prices, it can be used to predict the economic condition in the future. A rise in stock prices always associate with increased business investment which improves the economy of a country and vice versa. Stock prices have some impacts on economy as revealed by Enisan and Olufisayo (2009). Firstly, stocks ar e one of the types of people assets, thus changes in stock prices will affect the wealth of investors. A fall in the stock price, for instance, will lead to loss of money on stocks that investors are holding. They become more hesitant to spend money and this contributes to a fall in consumer spending which then prohibit the economic growth. Other than this, stock prices can affect the investor confidence. As known that stock prices movement always reflect the condition of the economy, a fall in stock prices, for instance, discourage investors from investing in stock market which can lead to stagnant of economy. Moreover, stock prices are also play an important role in affecting the investment in a country. A fall in the stock prices, for instance, makes the ability to raise funds become more difficult. Thus, this discourages those firms from expanding their businesses and making investment. As a consequent, economy of a country will not be improved. Most countries in Asia were si gnificantly affected by the Asian Financial Crisis during year 1997, and Malaysia has been no exception. The crisis which originated from Thailand had great impact on Asia countries especially in aspect of currency value. Before the crisis, Malaysian currency was pegged to U.S. dollar. At that time, as U.S. dollar was operating under floating exchange rate, therefore, the pegged currency of Malaysian was floating as well. Thus, the currency of Malaysia was greatly affected by the crisis (Daniel, n.d.). At the beginning of 1997, the Malaysian currency is trading at 2.49 and KLSE composite index was 1216. After the emergence of the crisis, KLSE composite index continuously dropping around 75% and this phenomenon last until August 1998 which reached 303. While for currency, the Malaysian currency kept depreciating and reached its peak of 4.545 in January 1998. Besides, for industrial production index, was also declining in the beginning of 1998 due to fall of production in various d ivision including electricity and electronic, manufacturing and wood products. On the other hand, using year 1999 as the base year, the inflation rate increased from the initial 92.68 in the end of year 1997 to 97.59 in the end of year 1998. In response to the crisis, various defensive measures were introduced. One of them was fixing of the ringgit peg to the US dollar at 3.80 that imposed by the premier, Dr. Mahathir Mohammad (Dori, 1998). In order to fight against the depreciation of currency and rising of inflation, Malaysian government decided to temporarily raise interest rates. Therefore, the interest rate increased from initial 9.58% in July 1997 to 12.07% in July 1998. This led to higher return on Malaysian investment and attracted more foreign capital as a strategy to inflate the effect of depreciation. For inflation, rises in the interest rate encouraged people to save instead of spend that helped to reduce inflation. In this globalized era, the financial systems in different countries around the world are integrated. Again, Malaysia is suffering due to the global financial crisis that was originated from United States in year 2007. However, Malaysia may not witness sharp downturn as compared to Asian Financial Crisis in 1998 (Asmy et al., 2009). This might due to Malaysia stock market has little linkage with the subprime loan in United States. The negative shock from United States was transmitted to Malaysia in the fourth quarter of 2008. Malaysian government de-pegging of the Ringgit from the US dollar in 2005, the Malaysian currency had depreciated from initial 3.4575 in September 2008 to 3.6085 in January 2009. On the other hand, the industrial production index declined as well started from the end of year 2008. Among those divisions that were significantly affected were electrical and electronic, textiles wearing apparel and footwear, rubber, wood as well as paper products. 1.1.1 Malaysian Stock Market Bursa Malaysia is an exchange holding company approved under Section 15 of the Capital Markets and Services Act 2007. It operates a fully-integrated exchange, offering the complete range of exchange-related services including trading, clearing, settlement and depository services. The wholly-owned subsidiaries of Bursa Malaysia own and operate the various businesses. Today, Bursa Malaysia is one of the largest bourses in Asia with just under 1,000 listed companies providing a wide range of investment choices to the world (Bursa Malaysia, 2010). In 1930, the first formal securities business organisation introduced in Malaysia was the Singapore Stockbrokers Association. It was later re-registered as the Malayan Stockbrokers Association in 1937. The Malayan Stock Exchange was established in 1960 and the public trading of shares commenced in the clearing house of Bank Negara Malaysia. Due to the termination of currency interchange ability between Malaysia and Singapore, the Stock Exc hange of Malaysia and Singapore was divided into the Kuala Lumpur Stock Exchange Berhad (KLSE) and the Stock Exchange of Singapore (SES) in 1973 (Bursa Malaysia, 2010). On 14 April 2004, Kuala Lumpur Stock Exchange Berhad changed their name to Bursa Malaysia Berhad. Besides, they employ demutualization in order to enhance the competitive position and to respond to global trends in the exchange sector, leading to become more customer-driven and market-oriented. On 18 March 2005, Bursa Malaysia was listed on the Main Board of Bursa Malaysia Securities Berhad. In Dec 2008, Bursa Malaysia launched a new trading platform called Bursa Trade Securities, enabling faster processing and execution of orders and providing wider trading functions and features (Bursa Malaysia, 2010). As part of Bursa Malaysias strategic initiative, the Kuala Lumpur Composite Index (KLCI) was enhanced to ensure that it remains robust in measuring the national economy with growing linkage to the global econom y. Bursa Malaysia together with FTSE, its index partner, had integrated the KLCI with internationally accepted index calculation methodology to provide a more investable, tradable and transparently managed index. The enhanced KLCI, whilst remaining representative of the Malaysian stock market, provided a platform for a wider range of investable and appealing opportunities. The KLCI is now known as the FTSE Bursa Malaysia KLCI and the enhancements were implemented on 6 July 2009 (Bursa Malaysia, 2010). There are six main advantages for implementing FTSE Bursa Malaysia KLCI, which are the followings (Bursa Malaysia, 2010): The KLCI is known as FTSE Bursa Malaysia KLCI to provide global relevance, recognition and reach. The new index complies with the international accepted calculation method, enabling a comparison among other countries stock index that makes it more relevant with the global financial condition. A market barometer made up of primary market movers will more apt ly define market activities while remaining representative of the Malaysian stock market. Stocks that are not marketable or without a good rating should be eliminated out of the index because it will only drag the value of the average market index. Thus, the new index only consists of 30 most rated and marketable stocks from various sectors. The FTSE Bursa Malaysia index calculation methodology emphasises free float and liquidity screens for a clearer representation of the market. Unlike previous KLCI index which consists of 100 companies, the new index only focus on the 30 stocks which are always liquid and marketable in order to give a true picture of the market. A smaller basket of 30 stocks makes it easier to manage and more appealing for the creation of Index Linked products to promote market liquidity. The greater the stocks contained in the index, the higher of difficulties in calculating the index. Smaller basket of stocks therefore can make the calculations of index t o be easier and save efforts on monitoring and managing all these stocks. Besides, unsystematic risks can also be reduced because fewer companies are involved into the index. Increasing the frequency of index calculation from every 60 seconds to every 15 seconds tracks the market pulse closely and more efficiently. The new index provides a better accuracy of market values because it monitors the share price more frequently. Hence, it can reduce price misleading with the faster reflection of overall market share prices of index. The continuity of the KLCI index value preserves the historical movements of the Malaysian stock market. Rather than to start with a new value, the new index continues with the previous value to pertain the trends of the Malaysia market for market survey and statistical researches. On 3 August 2009, Bursa Malaysia effectively implemented a merging procedure where main board and second board merged into a single main market while Mesdaq revamped into ACE market. When the second board was established in November 1988, it was to complement the main board by providing smaller companies with firm growth potential, particularly small and medium enterprises (SMEs), with an avenue to raise funds in the equity market. The following year, only two companies were floated on the second board. The population grew to 14 in 1990 and to 160 five years later. Owing to the stock market boom over the next several years, the lightweight listings surged, keeping the ratio of main board companies to second board companies at about 5:3. The number of second board counters peaked in 2000 with 297 companies. The board began the decade with 292 companies but now has 219. The steady decline was partly the result of delisting by the exchange because the companies had failed to rescue themselves from financial woes. To create a well-defined board structure that caters efficiently to the different risk appetites of investors was the prime objective of the unification and the transformation of the Mesdaq Market into the ACE Market. The ACE Market is designed to offer emerging companies early access to equity funding. The Main Market will be for established companies, and will have uniform listing requirements and comprehensive market-based regulation. Another benefit of the merger is that it eliminates the problem of poor sentiment on Mesdaq and second board counters spilling into the main board (Second Board, 2009). Furthermore, this new framework for listings and equity fund-raisings is aimed at allowing efficient access to capital and investments, as well as making Bursa Malaysia a more attractive platform for Malaysian and foreign companies. There is a significant shift in the regulatory approach with regards to listings and equity fund-raisings. This shift to a more market-based regulatory approach is to ensure greater efficiency and competitiveness without compromising on investor protection. Enabling blocks have been pu t in place to enhance the standards of due diligence, disclosures and corporate governance. 1.2 Problem Statement Some of the fundamental macroeconomic variables such as inflation rate, interest rate, exchange rate, money supply and industrial production are generally believed that they are the determinants of the stock price. In general, a number of studies have been issued on the relationship between macroeconomic variables and stock prices in other countries such as the US, Singapore, and Japan. Different studies have provided different results. The result of previous studies have changed according to the macroeconomic variable used and the research methodology employed. This paper extends the literature by examining the effect on stock price due to the different macroeconomic variables by using different methodology approaches including descriptive statistics, unit root test, cointegration test, vector error correction model (VECM) . Besides, in this study, we tend to examine on the relationship between the macroeconomic variable and stock prices in Malaysia. This is due to the previous studies (Gan, Lee, Au Yong Zhang, 2006; Maysami et al., 2004) focus mainly on developed countries such as New Zealand and Singapore. However, developing countries such as Malaysia are less explored by the researcher because most of the people lack of knowledge in this field of study. Therefore, in this paper, we tend to focus this study in our developing country, Malaysia. In previous paper, there is no research investigating those five variables simultaneously with the stock prices in Malaysia. Therefore, we have chosen five macroeconomic variables including inflation rate, interest rate, exchange rate, money supply and industrial production index to examine the variables with the stock prices. Indeed, there are other variables that affect stock prices but we limit our discussion on these variables because of efficiency in modeling as incorporating many variables result in loss of degree of freedom. In our paper, five of the macroeconomic variables are assumed to be signifi cant to the stock prices. For example, we assume that exchange rate has a significant relationship with the stock prices. However, Ahmed and Mustafa (n.d.), Gan et al. (2006), Fama (1981) and Humpe and Macmillan (2009) do not include exchange rate in their research because it seems to be insignificant variable to them. Nevertheless, exchange rate is assumed to be extremely significant variable to the stock price because nowadays is global village where the linkage between local stock market and global stock market becomes tightened. It is due to the fact that fluctuation in exchange rate will affect the foreign investor decision in investing in our country. Home currency depreciation relative to the host country will intensify the demand for the domestic assets because it is relatively cheaper for them to hold. Hence, foreign investors will purchase domestic assets when the home currency is depreciate and sell when the home currency is appreciate in order the gain from the currency differences. For some macroeconomic variables, findings of prior studies are found to differ from our hypotheses since they examine using annually data, instead of monthly or daily data which could provide a better view of fluctuation in macroeconomic activities. Against this background, we reinvestigate the impact of the macroeconomic variable on stock prices based on monthly data. This is because monthly data can reflect a better vision of the fluctuation in the macroeconomic activities compare to the annually data (Rahman, Sidek Tafri, 2009). Therefore, for our research, we used up-to-date time series monthly data from year 1999 to year 2008 to explore the relationship between macroeconomic variables and the stock prices in Malaysia. Using obsolete data to derive the relationship between macroeconomic variables and stock price, it may mislead the current situation in the economy, which in turn brings the information futile. In contrast, using up-to-date data may reflect the current situation in the economy which guides the policy makers to propose an appropriate policy based on our economy situation. We hope this paper can help to shed some useful light for government in stabilizing the stock price in Malaysia. 1.3 Research Objectives 1.3.1 General Objective The objective of this study is to gather information and examine the relationship between macroeconomic variable and the stock prices in Malaysia by using time series data from year 1999 to year 2008. 1.3.2 Specific Objectives To examine the relationship between interest rate and stock prices. To investigate the effect on exchange rate with the stock prices. To explore the interaction between the inflation rate and stock prices. To estimate the result of the relationship between money supply and stock prices. To identify the effect of industrial production on the stock prices. To estimate which macroeconomic variables are better policy instrument in order to stabilize the stock prices. 1.4 Research Questions Two research questions are central to this study: Examine the relationship between macroeconomic variables and stock prices in Malaysia. Determine the macroeconomic variables that can be used to predict stock prices in Malaysia. 1.5 Hypotheses of the Study In order to achieve the objectives of the study, we will hypothesize certain relationships between exchange rate, industrial production index, inflation rate, interest rate and money supply with the Kuala Lumpur Composite Index (KLCI). The following hypotheses are developed. Interest Rate A reduction in interest rates reduces the costs of borrowing and consequently serves as an incentive for expansion, as companies often finance their capital equipment and inventories through borrowings. This will have a positive effect on future expected returns for the firm. Thus, stock prices react negatively to the interest rate and consistent with the findings of Menike (2006), Maysami et al. (2004) as well as Pilinkus and Boguslauskas (2009). We hypothesize the same, saying that an inverse relationship between interest rate and stock prices. H0: Interest rate is negatively related to KLCI H1: Interest rate is positively related to KLCI Our null hypothesis describes that interest rate is negatively related to KLCI, while alternative hypothesis states that interest rate is positively related to KLCI. We assume our null hypothesis is true, in which we do not reject it. Inflation Rate A rise in inflation generates a level of uncertainty, which in turn decreases the economic activity and lowers the expected output in future that finally results a decline on the stock prices. Hence, it is concluded that inflation rate is inversely related to stock prices. The suggestion is consistent with Chatrath, Ramchander and Song (1997) study which provided an evidence of a negative relationship between market returns and inflationary trends in India. We hypothesize similarly, signifying that there is a negative relationship between inflation rate and KLCI. H0: Inflation rate is negatively related to KLCI H1: Inflation rate is positively related to KLCI Our null hypothesis is that inflation rate is negatively related to KLCI, and alternative hypothesis defines the opposite if null hypothesis is not true. We do believe that our results will not allow us to reject the null hypothesis. Exchange Rate Parallel to the empirical studies, we expect that exchange rate is directly correlated to KLCI. This is because assuming that Malaysia is an import-depending country, a depreciation of the ringgit Malaysia will lead to a rise in the cost of imports and consequently reduces the firms profits (Asmy et al., 2009). This decline in firms profits will be reflected in the value of stocks, suggesting a positive relationship between exchange rate and stock prices. The finding is consistent with Menike (2006) as well as Mohammad, Hussain and Ali (2009), who established positive relationship between the exchange rate and stock prices in Sri Lanka and Pakistan respectively. H0: Exchange rate is positively related to KLCI H1: Exchange rate is negatively related to KLCI Our null hypothesis states that exchange rate is positively related to KLCI, while the alternative hypothesis describes that the exchange rate is negatively related to KLCI. Parallel to the empirical studies, we expect t hat we do not reject H0, indicating that exchange rate is positively correlated to the stock prices. Money Supply 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, and consequently the stock price should decrease. On the other hand, an increase in money supply growth would also indicate excess liquidity available for buying securities, resulting in higher security prices as well as stimulating the economy. So we have found ambiguous effects. Assuming that effects of a rise in inflation rate are minor, we hypothesize a direct relationship between money supply and stock prices, supported by Bilson, Brailsford and Hooper (2001), Menike (2006) and Gan et al. (2006). H0: Money supply is positively related to KLCI H1: Money supply is negatively related to KLCI Our null hypothesis is that money supply is positively correlated to KLCI, while alternative hypothesis demonstrates that money supply is negatively correlated to KLCI. We expect that we do not reject the null hypothesis. Industrial Production Index Industrial production is typically used as a proxy for the level of real economic activity, that is, a rise in industrial production index would signal economic growth. Maysami et al. (2004) hypothesized a similar positive relationship through the effects of industrial production index on expected future cash flows. We hypothesize likewise, saying that industrial production index is positively related to the stock prices in Malaysia. In other words, an increase in industrial production index would lead to a rise in stock exchange prices. Rahman et al. (2009), who found a positive relationship between industrial production index and stock prices in Malaysia, further support this hypothesis. H0: Industrial production is positively related to KLCI H1: Industrial production is negatively related to KLCI Null hypothesis demonstrates that industrial production index is positively associated to KLCI, while alternative hypothesis is that industrial production index is negatively a ssociated to KLCI. We expect that we do not reject the null hypothesis. 1.6 Significance of the Study It is important to know the relationship between macroeconomic variables and the stock prices in Malaysia. This study aims to observe how the determinants will affect the stock prices in Malaysia. It is believed that government fiscal and monetary policies have large influence on the economy including the stock market. Thus, this motivates financial economists, policy makers and investors to have long attempted to understand the dynamic interactions among macroeconomic variables such as exchange rate, interest rate, inflation rate, industrial production index and money supply towards the stock prices in Malaysia (Mansor and Sulaiman, 2001). This study aims to provide a better understanding or meaningful insight for the financial economists, policy makers or governments and investors. It is helpful for them to have a better intuition of the stock market behavior (Rahman et al., 2009). Thus, they will be able to make the adjustments accordingly and eventually move towards achievin g the desired goals. For instance, inflation is a sustained deterioration in the purchasing power of money (EconomyWatch, 2008). Inflation is resulted from various shocks to the economy and will cause changes in the stock prices. Thus, the governments can know when is the need to control high level of unpredictable inflation since it can severely disrupt the economy, and cause uncertainty in financial decisions. By using the monetary policy (increase or decrease the money supply) or fiscal policy (change the amount of taxes and government spending) to control the economic growth in the market, this can prevent fluctuation in the stock prices (GetObject, 2004). On the other hand, the financial economists are interested to know whether the changes in stock prices may influence variations in economic activities and act as a channel of monetary transmission mechanisms. The monetary transmission mechanism requires monetary authorities to take caution in implementing monetary policies especially if they are used to affect movements in the stock prices. This is because the monetary policies can move the stock prices as desired such as implementing expansionary monetary policy to support stock prices (Mansor and Sulaiman, 2001). If the financial economists find that the supply of money is lowered, implying that the government has tightened the monetary policy, which in turn causing interest rate to rise (The Financial Pipeline, n.d.). Thus, they will be cautious about the changes of money supply in order to make proper and adequate adjustments to their policy making process. In addition, by knowing which macroeconomic variables will affect stock prices the most, both the individual and corporate investors would be able to manage their investment decision making wisely according to the changes of the monetary policy (Rahman et al., 2009). Therefore, they will do some research or a study on the economic situation or financial anomalies before they enhance the inve stment decisions. Besides, if they know that the domestic stock prices is increasing which means that the domestic financial assets have become more attractive, the individual or corporate investors will adjust their domestic and foreign portfolios by demanding more domestic assets. As a result, this will lead to an appreciation of the domestic currency. Other macroeconomic variables may also be affected due to these adjustments (Mansor and Sulaiman, 2001). In the nutshells, investors will concern the investment decisions based on the economic condition such as inflation. When there is inflation in Malaysia, individual and corporate investors will attempt to preserve the value of their money by opting for investments that generate yields higher than the rate of inflation (EconomyWatch, 2008). From this scenario, they can have an idea when is the suitable time for them to make investment in order to acquire the opportunity of gaining higher profit. For example, if the investors ex pect there is a rise in inflation in the future, they are likely to invest in the stock market today. Therefore, investors will make the investment decisions wisely. For the academic perspectives, students will likely to know more about which macroeconomic variables might have the strongest effect on the stock prices in developing countries like Malaysia (Rahman et al., 2009). This study can provide them about the linkage of academic theories with the macroeconomic variables, where students will have a better understanding of the usages of the theories learnt. Generally, students are restricted in the paper theory rather than practices because they just study and learn from whatever from the books. Through this study, they can understand the real example on how the macroeconomic variables influence the movement of stock prices in Malaysia, giving a firm evidence to prove the validity of all those theories studied from the books. Besides that, they can know if the financial crisis occurs, what will be the effects to the stock prices, macroeconomic variables as well as economy. 1.7 Chapter Layout The remaining of the paper proceeds as follows. Chapter 2 reviews previous literature and elaborates on the theoretical frameworks. Chapter 3 discusses data used and empirical model to be estimated. Chapter 4 presents the findings and econometric results. Lastly, Chapter 5 provides a summary and concludes the study. 1.8 Conclusion This study aims at examining the role of macroeconomic variables in explaining Malaysian stock prices in order to derive an appropriate policy instrument. By covering time period spans from January 1999 to December 2008, this study employs some fundamental macroeconomic variables including exchange rate, industrial production index, inflation rate, interest rate and money supply. Based on the hypotheses developed, we assume that industrial production index, exchange rate and money supply are positively correlated to KLCI, while inflation rate and interest rate are inversely associated to KLCI. Empirical findings suggest that all of the independent variables appear to significantly influence the stock prices in Malaysia.