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
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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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.

Inflation
Despite 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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Growth
Looser 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 rate
Mauritius’ 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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1.0 Literature Review
1.1 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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2.0 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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