Relationship between Selected Macroeconomic Factors and the Stock Market Prices: Evidence from Colombo Stock Exchange, Sri Lanka

Abstract

The stock market plays a vital role in all economies. In 2010, the Colombo Stock Exchange became the second-highest performing stock market in the world as many domestic and foreign investors invested in the Sri Lankan stock market with the end of the war. However, it has created a market bubble and no significant improvements reported since mid-2011. Further, the determinants of share market performance remain unclear. It is generally apparent that macroeconomic factors cause a sound impact on stock market performance. Thus, this study attempts to identify the causal relationship between share prices and the four major macroeconomic factors in the Sri Lankan economy. The dependent variable was the All Share Price Index (ASPI). Real gross domestic product (RGDP), Money supply (M2b), Balance of trade (BOT) and Net foreign investment (NFI) were the independent variables. Monthly data was used for 10 years spanning from January 2009 to December 2018 for all variables. Monthly bulletins of the Central Bank of Sri Lanka and the Colombo Stock Exchange data library were used to get data. Stata13, the statistical software was utilized to analyze the data. Descriptive analysis, correlation analysis, regression analysis, Johansen co-integration test and Vector Error Correction Model (VECM) were employed to identify how macroeconomic factors impact share prices. There was a co-integration between the dependent and independent variables. The study revealed that there was a long-run causality between the performance of the capital equity market and macroeconomic variables and the long-run equilibrium could be reached at a speed of 13.90%. Empirical results disclose that M2b and BOT had a positive impact on the ASPI. However, NFI had a negative influence on the ASPI. All variables significantly impacted ASPI except RGDP. The results of the study may help policymakers, investors, and other professionals to make proper decisions.