Establishing Causality and Cointegration between Inflation and Stock Returns for India and China

Abstract

Stock returns have been long considered as hedge against inflation. However, a large amount of evidence favors a negative relationship between inflation and stock returns. This paper investigates the dynamics of Inflation Risk in the Indian and Chinese stock market. The period for the study has been divided into pre-crisis and crisis period owing to the United States sub-prime crisis. Johansen Cointegration test has been used to ascertain the presence of long run relationship between consumer price index values and stock prices. We find that the results support the hedge hypothesis in the Indian context, where inflation and stock returns have been found to move in cohesion in the long run for the entire period of study. However, results do not verify the hedge hypothesis for China, i.e., China’s stock market does not provide hedge against inflation. Further, long run Granger Causality test of precedence supports the hedge hypothesis for India in pre-crisis period, the evidence disappearing in the crisis period. Reverse causality hypothesis has been verified in the Indian context in both pre-crisis as well as crisis period by means of short run Granger Causality test. The findings of the study have important implications for policy makers, regulators, academicians and investors at large. While as, inflation is considered as an important variable affecting stock market performance, the same does not seem to be true in the context of the Chinese market.