Macroeconomic Influence on the Stock Market: Evidence from an Emerging Market in South Asia

Abstract

This study examines the influence of macroeconomic variables on stock market equity values in Sri Lanka. We use the Colombo all share price index to represent the stock market and (a) the money supply, (b) the treasury bill rate (as a measure of interest rates), (c) the consumer price index (as a measure of inflation), and (d) the exchange rate as macroeconomic variables. We analyse monthly data for the above variables for the 17-year period from January 1985 to December 2001 employing a battery of tests, which include unit roots, cointegration, vector error correction models (VECM), impulse response functions (IRFs) and variance decompositions (VDCs). These tests examine both long-run and short-run relationships between the stock market index and the economic variables. The VECM analyses provide some support for the argument that the lagged values of macroeconomic variables such as the consumer price index, the money supply and the treasury bill rate have a significant influence on the stock market. The treasury bill rate demonstrates the strongest influence on price changes compared to other variables. However, the share price index does not have any influence on macroeconomic variables except for the treasury bill rate. Both VDC and IRF analyses revealed that shocks to economic variables explained only a minority of the forecast variance error of the market index; these effects did not persist for very long.