CAUSAL RELATIONSHIP BETWEEN STOCK MARKET AND EXCHANGE RATE, FOREIGN EXCHANGE RESERVES AND VALUE OF TRADE BALANCE: A CASE STUDY FOR INDIA

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1 CAUSAL RELATIONSHIP BETWEEN STOCK MARKET AND EXCHANGE RATE, FOREIGN EXCHANGE RESERVES AND VALUE OF TRADE BALANCE: A CASE STUDY FOR INDIA BASABI BHATTACHARYA & JAYDEEP MUKHERJEE Reader, Deparmen of Economics, Jadavpur Universiy, Kolkaa , India. Phone: (033) (R), (033) (O), (033) (Fax O) Res. Address: Fla 5 B, 63/114 B, Prince Anwar Shah Road, RHINE VIEW, Kolkaa Junior Research Fellow, Deparmen of Economics, Jadavpur Universiy, Kolkaa , India Phone: (033) (R), (033) (O), (033) (Fax O) Res. Address: Praima Aparmen, Fla 3B, 45, Jessore Road (N), Anandapuri, P.O. Barasa, Pin: INDIA. basabi54@yahoo.com jaydeep7@vsnl.ne jaydeep_mukherjee@homail.com

2 CAUSAL RELATIONSHIP BETWEEN STOCK MARKET AND EXCHANGE RATE, FOREIGN EXCHANGE RESERVES AND VALUE OF TRADE BALANCE: A CASE STUDY FOR INDIA Absrac: This paper invesigaes he naure of he causal relaionship beween sock prices and macroeconomic aggregaes in he foreign secor in India. By applying he echniques of uni roo ess, coinegraion and he long run Granger non causaliy es recenly proposed by Toda and Yamamoo (1995), we es he causal relaionships beween he BSE Sensiive Index and he hree macroeconomic variables, viz., exchange rae, foreign exchange reserves and value of rade balance using monhly daa for he period o The resuls sugges ha here is no causal linkage beween sock prices and he hree variables under consideraion. JEL classificaion: G1, E4 Keywords: Macroeconomic Aggregaes, Sock Price Index, Granger Causaliy and Efficien Marke Hypohesis. 2

3 Inroducion: Globalisaion and financial secor reforms in India have ushered in a sea change in he financial archiecure of he economy. In he conemporary scenario, he aciviies in he financial markes and heir relaionships wih he real secor have assumed significan imporance. Since he incepion of he financial secor reforms in he beginning of 1990 s, he implemenaion of various reform measures including a number of srucural and insiuional changes in he differen segmens of he financial markes, paricularly since 1997, have brough in a dramaic change in he funcioning of he financial secor of he economy. Alogeher, he whole gamu of insiuional reforms concomian o globalisaion programme, inroducion of new insrumens, change in procedures, widening of nework of paricipans call for a reexaminaion of he relaionship beween he sock marke and he foreign secor of India. Correspondingly, researches are also being conduced o undersand he curren working of he economic and he financial sysem in he new scenario. Ineresing resuls are emerging paricularly for he developing counries where he markes are experiencing new relaionships which are no perceived earlier. The analysis on sock markes has come o he fore since his is he mos sensiive segmen of he economy and i is hrough his segmen ha he counry s exposure o he ouer world is mos readily fel. The presen sudy is an endeavour in his direcion. I analyses he relaionship beween sock prices and foreign secor macroeconomic variables in India wih implicaions on efficiency of Indian sock marke. Along wih he newer relaionships operaing in he markes, newer economeric echniques are also being inroduced and applied. This paper makes use of he laes available economeric echniques and examines efficiency of Indian sock marke in erms of he relaionships menioned above. 3

4 The informaional efficiency of major sock markes has been exensively examined hrough he sudy of causal relaions beween sock price indices and macroeconomic aggregaes. The findings of hese sudies are imporan since informaional inefficiency in sock marke implies on he one hand, ha marke paricipans are able o develop profiable rading rules and hereby can consisenly earn more han average marke reurns, and on he oher hand, ha he sock marke is no likely o play an effecive role in channeling financial resources o he mos producive secors of he economy. The Efficien Markes Hypohesis (EMH), in is srong form, assumes ha everyone has perfec knowledge of all informaion available in he marke. Therefore, he curren price of an individual sock (and he marke as a whole) porrays all informaion available a ime. Accordingly, if real economic aciviy affecs sock prices, hen an efficien sock marke insananeously digess and incorporaes all available informaion abou economic variables. The raional behaviour of marke paricipans ensures ha pas and curren informaion is fully refleced in curren sock prices. As such, invesors are no able o develop rading rules and, hus may no consisenly earn higher han normal reurns. Therefore, i can be concluded ha, in an informaionally efficien marke, pas (curren) levels of economic aciviy are no useful in predicing curren (fuure) sock prices. Saed in Granger jargon, informaional efficiency exiss if a uni-direcional lagged causal relaionship from a macroeconomic variable o sock prices could no be deeced. While finding causaliy from lagged values of sock prices o an economic aggregae does no violae informaional efficiency, his finding is equivalen o he 4

5 exisence of causaliy from curren values of sock prices o fuure levels of he economic variable. This would sugges ha sock prices lead he economic variable and ha he sock marke makes raional forecass of he real secor. If, however, lagged changes in some economic variables cause variaions in sock prices and pas flucuaions in sock prices cause variaions in he economic variable, hen bi-direcional causaliy is implied beween he wo series. This behaviour indicaes sock marke inefficiency. In conras, if changes in he economic variable neiher influence nor are influenced by sock price flucuaions, hen he wo series are independen of each oher and he marke is informaionally efficien. The purpose of he presen sudy is o invesigae he empirical relaionship persising in India beween foreign secor macroeconomic aggregaes, namely exchange rae, foreign exchange reserves and rade balance, and sock prices in he Bombay Sock Exchange (BSE) using monhly daa ha span from o Specifically, in his sudy we es for marke informaional efficiency in BSE, by esing he exisence of a long run causal relaionship beween macroeconomic aggregaes and sock prices using Granger non causaliy es recenly proposed by Toda and Yamamoo (1995). Among he hree forms of marke efficiency, namely he weakly efficien, semi-srong and srongly efficien, we consider he semi-srong form relevan o he Indian conex. The hypohesis saes ha all publicly available informaion is refleced in sock prices. The res of he paper is organized as follows. A survey of he exising lieraure including empirical evidences on he naure of he causal relaionship beween macroeconomic aggregaes and sock prices is conduced in Secion II. Secion III discusses he 5

6 mehodology o be employed and presens he variables and daa descripions. Secion IV repors he empirical resuls followed by conclusion in Secion V. The Presen Sae of he Ar: Sudies on he relaionship beween macroeconomic variables and naional sock marke have been he cornersone of mos economic lieraure for quie some ime. During he las decade and a half, i has been recognized ha exernal secor indicaors like exchange rae, foreign exchange reserves and value of rade balance can have an impac on sock prices. Early sudies (Aggarwal, 1981; Soenen and Hennigar, 1988) in he area of exchange raes sock prices considered only he correlaion beween he wo variables. Theory explained ha a change in he exchange raes would affec a firm s foreign operaion and overall profis. This would, in urn, affec is sock prices. The naure of he change in sock prices would depend on he mulinaional characerisics of he firm. Conversely, a general downward movemen of he sock marke will moivae invesors o seek for beer reurns elsewhere. This decreases he demand for money, pushing ineres raes down, causing furher ouflow of funds and hence depreciaing he currency. While he heoreical explanaion was clear, empirical evidence was mixed. Aggarwal (1981) found a significan posiive correlaion beween he US dollar and US sock prices while Soenen and Hennigan (1988) repored a significan negaive relaionship. Soenen and Aggarwal (1989) found mixed resuls among indusrial counries. Ma and Kao (1990) aribued he differences in resuls o he naure of he counries i.e. wheher he counries were expor or impor dominan. Morley and Penecos (2000), in heir sudy on G-7 counries, argue ha he reason for he lack of 6

7 srong relaionship beween exchange raes and sock prices may be due o he exchange conrols ha were in effec in he 1980s. Bahmani-Oskooee and Sohrabian (1992) were among he firs o use coinegraion and Granger causaliy o explain he direcion of movemen beween exchange raes and sock prices. Since hen various oher papers analyzing hese aspecs and using his echnique have appeared covering boh indusrial and developing counries (for example, Granger e.al. [2000]; Ajayi e.al. [1998]; Ibrahim [2000]). The direcion of causaliy, similar o earlier correlaion sudies, appears mixed. For Hong Kong, Mok (1993) found ha he relaionship beween sock reurns and exchange raes are bidirecional in naure. For he Unied Saes, Bahmani-Oskooee and Sohrabian (1992) poin ou ha here is a wo-way relaionship beween he U.S. sock marke and he exchange raes. However, Abdalla and Murinde (1997) found ou ha he resuls for India, Korea and Pakisan sugges ha exchange raes Granger cause sock prices, which is consisen wih earlier sudy by Aggarwal (1981). Bu, for he Philippines, Abdalla and Murinde found ou ha he sock prices lead he exchange raes. This is consisen wih Smih s (1992) finding ha sock reurns have a significan influence on exchange rae in Germany, Japan and he Unied Saes. For he Indian Economy, work in his area has no progressed much. Abhay Pehe and Aji Karnik (2000) has invesigaed he iner relaionships beween sock prices and imporan macroeconomic variables, viz., exchange rae of rupee vis - a - vis he dollar, prime lending rae, narrow money supply, and index of indusrial producion. The analysis and discussion are siuaed in he conex of macroeconomic changes, especially in he financial secor, ha have been aking place in India since he 7

8 early 1990s. There are some oher relaed sudies hough no specifically focused o his aspec. The main purpose of he presen sudy is o complemen he exising lieraure on he sock marke macroeconomic nexus in wo respecs. Firs, is o deermine wheher sock reurns are a leading indicaor for fuure economic aciviy. In India, cerain quarers of he populaion believe ha he improvemen in he performance of he sock markes will resul in an improvemen in he economy measured by he posiive growh in he gross naional produc. However, wheher sock markes lead or lag real economic aciviy is an empirical quesion. The empirical evidence provided by he sudies menioned above showed ha macroeconomic variables have srong effecs on he sock marke. In oher words, naional sock markes are said o informaionally inefficien wih respec o mos macroeconomic variables. If marke is inefficien wih respec o informaion, hen i has imporan implicaions boh a micro and macro levels. A he micro level, his implies ha he individual invesor can earn considerably higher normal rae of reurns from he sock marke. A he macro level, i raises serious doubs on he abiliy of he marke o perform is fundamenal role of channeling funds o he mos producive secors of he economy. Secondly, he more recen developmens in economerics on he properies of ime series has enabled researchers o invesigae he relaionship beween inegraed economic variables wih ease and can provide precise esimaes, in he sense ha spurious regression problems can be avoided. I has been noed ha he radiional Granger (1969) causaliy es for inferring leads and lags among inegraed variables will end up in spurious regression resuls, and he F es is no valid unless he variables in levels are 8

9 coinegraed. Several ess for a uni roo(s) in a single ime series have been proposed (for example, Dickey and Fuller, 1979; Phillips and Perron, 1988). Unforunaely, however, he power of hese ess is known o be very low agains he alernaive hypohesis of (rend) saionariy. Tess for coinegraion and coinegraing ranks have also been developed, viz., error correcion model due o Engle and Granger (1987) and he vecor auoregression error correcion model due o Johansen and Jesulius (1990). Unforunaely, hese ess are cumbersome and sensiive o he values of he nuisance parameers in finie samples and herefore heir resuls are unreliable (poined ou by Toda and Yamamoo, 1995 and Zapaa and Rambaldi, 1997). Toda and Yamamoo (1995) proposed a simple procedure requiring he esimaion of an augmened VAR, even when here is coinegraion of differen orders, which guaranees he asympoic disribuion of he MWALD saisic. This mehod is applicable wheher he VAR s may be saionary (around a deerminisic rend), inegraed of an arbirary order, or coinegraed of an arbirary order (Toda and Yamamoo: Journal of Economerics 66, 1995, pp. 227). The mehodology ha we have applied o examine he naure of he causal relaionship beween macroeconomic aggregaes and sock prices is discussed in he nex secion. Mehodology and Daa Sources: Tradiionally o es for he causal relaionship beween wo variables, he sandard Granger (1969) es has been employed in he relevan lieraure. This es saes ha, if pas values of a variable Y significanly conribue o forecas he value of anoher variable X +1 hen Y is said o Granger cause X and vice versa. The es is based on he following regressions: 9

10 M N = 0 + β ky k + α l X l k = 1 l= 1 Y β + u (1) M N = 0 + γ k X k + δ ly l k = 1 l= 1 X γ + v (2) where Y and X are he variables o be esed, and u and v are muually uncorrelaed whie noise errors, and denoes he ime period and k an l are number of lags. The null hypohesis is α ι = δ ι = 0 for all l s versus he alernaive hypohesis ha α ι 0 and δ ι 0 for a leas some l s. If he coefficien α i s are saisically significan bu δ ι s are no, hen X causes Y and vice versa. Bu if boh α ι and δ ι are significan hen causaliy runs boh ways. Recen developmens in he ime series analysis have suggesed some improvemens in he sandard Granger es. The firs sep is o check for he saionariy of he original variables and hen es coinegraion beween hem. According o Granger (1986), he es is valid if he variables are no coinegraed. Second, he resuls of Granger causaliy are very sensiive o he selecion of lag lengh. If he chosen lag lengh is less han he rue lag lengh, he omission of relevan lags can cause bias. If he chosen lag lengh is more, he irrelevan lags in he equaion cause he esimaes o be inefficien. To deal wih his problem Hsiao (1981) has developed a sysemaic auoregressive mehod for choosing opimal lag lengh for each variable in an equaion. This mehod combines Granger causaliy and Akaike s Final Predicion Error (FPE), defined as he (asympoic) mean square predicion error. Uni Roo Tes and Coinegraion: 10

11 Empirical sudies (for example, Engle and Granger, 1987) have shown ha many ime series variables are non-saionary or inegraed of order 1 (i.e., heir changes are saionary). The ime series variables considered in his paper are he sock prices and hree macroeconomic variables, namely, exchange rae, foreign exchange reserves and value of rade balance. In order o avoid a spurious regression siuaion he variables in a regression model mus be saionary or coinegraed. Therefore, in he firs sep, we perform uni roo ess on hese six ime series o invesigae wheher hey are saionary or no. The Augmened Dickey-Fuller (ADF) uni roo es is used for his purpose. The ADF regression equaions are: Y P 1 Y 1 + γ j Y j ε.. (3) j= 1 = α + Y P = α + α Y + γ Y + ε.. (4) j= 1 j j Y 1 P = α 0 + α1y + α 2 + γ Y + ε. (5) j= 1 j j where ε τ is whie noise. The addiional lagged erms are included o ensure ha he errors are uncorrelaed. The ess are based on he null hypohesis (H 0 ): Y is no I (0). If he calculaed DF and ADF saisics are less han heir criical values from Fuller s able, hen he null hypohesis (H 0 ) is acceped and he series are non-saionary or no inegraed of order zero. In he second sep we esimae coinegraion regression using variables having he same order of inegraion. The coinegraion equaion esimaed by he OLS mehod is given as: Y a a X + Z = (6) 11

12 In he hird sep residuals (Z ) from he coinegraion regression are subjec o he saionariy es based on he following equaions: (DF) Z = α + Z + V. (7) β 0 1 (ADF) Z k 1 + i Z i + i= 1 = α + β 0 Z β V....(8) where, Z is he residual from equaion (6). The null hypohesis of non-saionariy is rejeced if β is negaive and he calculaed DF or ADF saisics is less han he criical value from Fuller s able. Tha means here is a long run sable relaionship beween he wo variables and causaliy beween hem is esed by he error correlaion model. On he oher hand, if he null hypohesis of non-saionariy is rejeced and he variables are no coinegraed hen he sandard Granger causaliy es is appropriae. Hsiao s Opimum Lag Lengh: More recenly many sudies like Thornon and Baen (1985), Hwang e. al. (1991) and Chang and Lai (1997) have found Hsiao s Granger Causaliy es provides more robus resuls over boh arbirary lag lengh selecion and oher sysemaic mehods for deermining lag lengh. Hsiao s procedure involves wo seps. The firs sep follows a series of auoregressive regressions on he dependen variables. The independen variable appearing in he firs regression is he dependen variable lagged once. In each following regression, one more lag on he dependen variable is added. The m regressions we esimaed are of he form: m Y = α + β iy i + ε1 i= 1 (9) 12

13 where, he choice of lag lengh is based on he sample size and underlying economic process. I is beer o selec m as large as possible (for example, we may se m=10). Then we compued he FPE for each regression in he following way: T+m+1 FPE (m) = RSS (m) / T. (10) T-m-1 where T is sample size and FPE and RSS are he final predicion error and he residual sum of squares respecively. The opimal lag lengh, m*, is he lag lengh which produces he lowes FPE. In he second sep, once m* has been deermined, regressions are esimaed wih he lags on he oher variable added sequenially in he same manner used o deermine m*. Thus we esimae en regressions of he form: m* n Y = α + β iy i + γ j X j + ε 2 i= 1 j= 1.. (11) We hen compue FPE for each regression as: T+ m*+1 FPE (m*, n) =. RSS (m*, n) /T (12) T-m*-1 We choose he opimal lag lengh for X, n* as he lag lengh which produces he lowes FPE. Toda and Yamamoo Version of Granger Causaliy: I has been noed ha he radiional Granger (1969) causaliy es for inferring leads and lags among inegraed variables will end up in spurious regression resuls, and he F-es is no valid unless he variables in levels are coinegraed. New developmens in economeric offers he error correcion model (due o Engle and Granger (1987)) and he vecor auo regression error-correcion model (due o Johansen and Jesulius, 1990) as 13

14 alernaives for he esing of non-causaliy beween economic ime series. Unforunaely, hese ess are cumbersome and sensiive o he values of he nuisance parameers in finie samples and herefore heir resuls are unreliable (see Toda and Yamamoo, 1995; Zapaa and Rambaldi, 1997). Toda and Yamamoo (1995) proposed a simple procedure requiring he esimaion of an augmened VAR, even when here is coinegraion, which guaranees he asympoic disribuion of he MWald saisic. Therefore, he Toda-Yamamoo causaliy procedure has been labeled as he long-run causaliy ess. All one needs o do is o deermine he maximal order of inegraion d max, which we expec o occur in he model and consruc a VAR in heir levels wih a oal of (k + d max ) lags. Toda and Yamamoo poin ou ha, for d=1, he lag selecion procedure is always valid, a leas asympoically, since k > =1=d. If d=2, hen he procedure is valid unless k=1. Moreover, according o Toda and Yamamoo, he MWald saisic is valid regardless wheher a series is I (0), I (1) or I (2), non-coinegraed or coinegraed of an arbirary order. In order o clarify he principle, le us consider he simple example of a bivariae model, wih one lag (k=1). Tha is, x A A x + e = (13) or more fully, x x 1 2 α = α α + α (1) 11 (1) 21 α α (1) 12 (1) 22 x x 1, 1 2, 1 e + e (14) e e 1 / where E ( e ) = E = and E( e e ) =

15 (1) To es ha x 2 does no Granger cause x 1, we will es he parameer resricion α 12 =0. If now we assume ha x 1 and x 2 are I (1), a sandard -es is no valid. Following Dolado (1) and Lukepohl (1996), we es α 12 =0 by consrucing he usual Wald es based on leas squares esimaes in he augmened model: x x 1 2 α = α α + α (1) 11 (1) 21 α α (1) 12 (1) 22 x x 1, 1 2, 1 α + α (2) 11 (2) 21 α α (2) 12 (2) 22 x x 1, 2 2, 2 e + e (15) The Wald saisic will be asympoically disribued as a Chi Square, wih degrees of freedom equal o he number of "zero resricions", irrespecive of wheher x 1 and x 2 are I (0), I (1) or I (2), non-coinegraed or coinegraed of an arbirary order. In his sudy, we used monhly daa series for four variables for he period April 1990 o March For sock price we use he monhly averages of BSE Sensiive Index (base: =100). The key macroeconomic variables included are he indices of Real Effecive Exchange Rae (REER) of he Indian Rupee (36-counry bilaeral weigh wih base 1985=100), he foreign exchange reserves (in rupees crores) and he value of rade balance (in rupees crores). The daa has been compiled from Handbook of Saisics on Indian Economy (2001) published by Reserve Bank of India and various issues of RBI Bullein. Empirical Resuls: As our firs sep, we have deermined he order of inegraion for each of he four variables used in he analysis. Using he sandard Augmened Dickey Fuller uni roo es 15

16 analysed in he earlier secion, we have esed on boh he levels and he firs differences of he series. The resuls are abulaed in Table 1 and Table2. Table 1: Resuls for he Dickey Fuller uni roo es for he sock price index and hree macroeconomic variables in levels Variables Consan, No rend Consan, Wih rend Sock Price Exchange Rae Foreign Exchange Reserves Value of Trade balance Table 2: Resuls for he Dickey Fuller uni roo es for he sock price index and hree macroeconomic variables in firs differences Variables Consan, No rend Consan, Wih rend Sock Price ** ** Exchange Rae ** ** Foreign Exchange Reserves ** ** Value of Trade Balance ** ** 16

17 Noe: Aserisk (**) denoes saisically significan a 5% level Clearly he resuls sugges ha none of he variables are saionary, ha is, inegraed of order 0. However, hey are all characerised as inegraed of order 1, ha is, firs differencing will render hese series saionary. Having deermined ha d max =1, we hen proceed in esimaing he lag srucure of a sysem of VAR in levels and our resuls indicae ha he opimal lag lengh based on Akaike s FPE (using Hsiao s opimal lag echnique discussed in he previous secion) is 2, ha is, k=2. We hen esimae a sysem of VAR in levels wih a oal of (d max +k=3) lags. SP SP 1 SP 2 SP 3 e1 REER REER 1 + REER 2 = + + REER 3 + e2 A 0 A1 A2 A (16) FR FR 1 FR 2 FR 3 e3 NX NX 1 NX 2 NX 3 e4 where, SP = Sock price, REER = Real Effecive Exchange Rae, FR = Foreign Exchange Reserves NX = Value of Trade Balance The sysem of equaions is joinly esimaed as a Seemingly Unrelaed Regression Equaions (SURE) model by Maximum Likelihood and compues he MWALD es saisic. The MWALD saisic will be asympoically disribued as a Chi Square, wih degrees of freedom equal o he number of "zero resricions", irrespecive of wheher x 1 and x 2 are I (0), I (1) or I (2), non-coinegraed or coinegraed of an arbirary order. The resuls of he MWALD es saisic as well as is p-values are presened in able 3. 17

18 Table 3: Resuls of long run Causaliy due o Toda-Yamamoo (1995) Null Hypohesis MWALD saisics Sock price versus exchange rae (REER) Sock price does no Granger cause REER REER does no Granger cause sock price Sock price versus foreign exchange reserves (FR) Sock price does no Granger cause FR FR does no Granger cause sock price Sock price versus value of rade balance (NX) Sock price does no Granger cause NX NX does no Granger cause sock price p-values The es resuls in able 3 sugges ha we fail o rejec he null hypohesis of Granger non-causaliy from sock price o exchange rae, foreign exchange reserves and value of rade balance as well as he null hypohesis of Granger non-causaliy from exchange rae, foreign exchange reserves and value of rade balance o sock price a 5% 18

19 level of significance. The resuls sugges ha he BSE Sensiive Index neiher leads hese hree variables nor hey lead he BSE Sensiive Index. This implies ha he sock marke canno be used as a leading indicaor for fuure growh in exchange rae, foreign exchange reserves and value of rade balance in India. Conclusion: The efficien marke hypohesis (EMH) was formalized by Fama (1970). The hypohesis suggess ha changes in he macroeconomic variables in he canno be used as a rading rule by invesors o earn consisenly abnormal profis in he sock marke. In an efficien marke, curren as well as pas informaion on he growh of hese variables are fully refleced in asse prices so ha invesors are unable o formulae some profiable rading rule using he available informaion. The main objecive of he presen paper is o deermine he lead and lag relaionships beween he Indian sock marke and hree key macroeconomic variables relaing o he foreign secor. We endeavor o invesigae he quesion: Can he Indian sock marke ac as a baromeer for he Indian economy? This is of course an empirical quesion. To es his hypohesis, we employ he mehodology of Granger non-causaliy recenly proposed by Toda and Yamamoo (1995) for he sample period April 1990o March In his sudy, he BSE Sensiive Index was used as a proxy for he Indian sock marke. The hree imporan macroeconomic variables included in he sudy are real effecive exchange rae, foreign exchange reserves and rade balance. The resuls sugges ha here is no causal linkage beween sock prices and he hree variables under consideraion. The Sensiive Index of he Bombay Sock Exchange has already 19

20 incorporaed all pas informaion on exchange rae, foreign exchange reserves and rade balance. The analysis reveals ineresing resuls in he conex of he Indian sock marke, paricularly wih respec o exchange rae, foreign exchange reserves and rade balance. These resuls mus be explained in he ligh of he following developmens. Firs, mos of he earlier sudies ha analysed he naure of he causal relaionship beween macroeconomic aggregaes and sock prices have employed he radiional Granger causaliy es. Since i is now recognized ha he convenional procedure may be inadequae, conclusions based on such an approach may yield misleading inferences. So we have employed he recenly developed long run Granger non causaliy es proposed by Toda and Yamamoo (1995) in our sudy. Secondly, alhough our daa se is from April 1990, he full fledged financial secor reforms in India have come o operae only afer Furher, for a sufficien period of ime he financial secor in India has remained dominaed by he banking secor hrough which he changes in foreign exchange primarily operae. In his conex, he relaionship beween exchange rae and sock prices ha we obained in our resul is no very surprising. Las bu no he leas, sock marke in India is sill in a ransiory phase. If his resul is also arrived a for subsequen periods, hen i may be concluded ha Indian sock marke is approaching owards informaional efficiency a leas wih respec o hree macroeconomic variables, viz. exchange rae, foreign exchange reserves and rade balance. References: 20

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