The nexus between stock market and economic activity: an empirical analysis for India

Abstract

PurposeAn understanding on the linkages between financial development and economic growth in general and the stock market with economic activity in particular is imperative in emerging economies. The objective of this paper is to find out the causal linkages between stock market and economic activity in India.Design/methodology/approachThe paper applies recently developed Granger non‐causality tests by Toda‐Yamamota, Dolado and Lutkephol (popularly known as the TYDL model) for an empirical exercise.FindingsThe notable finding of the paper is that both the stock price (BSE Sensex) and economic activity (IIP) are integrated of order one, i.e. I (1). The Johansen‐Juselius co‐integration tests suggest the existence of one co‐integrating vector. This rules out spurious relations and suggests the presence of at least one direction of causality. The TYDL model suggests that there is bi‐directional causality between stock price and economic activity during the post‐liberalization period, implying that a well‐developed stock market could enhance economic activity and vice‐versa.Research limitations/implicationsIn the broader framework of financial markets, the presence and role of the stock market is minuscule in the context of India. Despite this, it could play a considerable role in the process of the economic development of the country. However, to analyze the cause and effect relationship between stock market and economic activity, it is essential to analyze the issue in greater detail and depth. The main limitation of the paper is the use of IIP as a proxy for economic activity, which neglects the agricultural sector, being the primary sector in India and also the service sector. This is of course due to the non‐availability of GDP data on a monthly basis. Further, a detailed study on the issue could be highly appreciable from the perspective of policy implications.Originality/valueThe findings of the paper have some valuable implications. It could give some insight for policy makers about the possible linkages between stock market and the economy. Coming to empirical parts, this is perhaps the first paper in the context of India to apply the TYDL model to examine the relationship between stock price and economic activity.