Determinants of Stock Market Performance in Pakistan

Determinants of Stock Market Performance in Pakistan Mehwish Zafar Sr. Lecturer Bahria University, Karachi campus Abstract Stock market performance, economic and political condition of a country is interrelated and has been an important debating issue. Many studies directly or indirectly have been dealing with the macro and institutional factors and their correlation with the stock market performance at both theoretical and empirical levels. Keeping in mind the Pakistani perspective, many studies cannot be traced into literature. Therefore, macro-economic determinants of stock market performance in Pakistan can be examined using a time series data for the period 1988-2008. We take only macroeconomic determinants due to unavailability of accurate information on institutional variables. Whereas, institutional variables are reflected in macroeconomic factors, such as, investment and trading rules are highly correlated with stock market liquidity and can be measured through Value Traded, while, stock market liquidity is one of the determinants used for this research. The set of macroeconomic determinants are; foreign direct investment as percentage of GDP, real interest rate, domestic credit provided by banking sector and value traded as percentage of GDP, whereas stock market performance is measured by market capitalization as percentage of GDP. Data is analyzed in a quantitatively through regression analysis in E-views. Hypothesis testing is used to measure the significance of the study. The paper highlights the findings, that foreign direct investment and value traded have positive impact on stock market performance. It also highlights that there is a negative relationship between real interest rate and stock market performance, whereas the banking sector development has no significant impact on stock market performance. Key Words: Stock market, Financial Crisis, GDP, Value traded, Real Interest Rate, Foreign Direct Investment, Market capitalization. 1. Introduction Financial sector of any country plays very vital role in the country s economic growth. Stock market is financial sector s key institution which provides a platform, where borrower and lender can easily fulfill their financial needs. Stock market performance is factual reflection of country s economic performance. Many researchers like Demirguc-Kunt and Levine (1996a), Singh (1997), and Levine and Zervos (1998) found in their research that stock market development plays an important role in economic growth. The World Bank Economic Review also contributes in its May 1996 issue to the role of the stock markets in economic growth. There are numerous factors having impact on the performance of stock markets, such as, expansion in the country s economic activities, strength in the exchange rate, decrease in lending interest rates and improvement in recovery of outstanding loans, rescheduling and payment of foreign debts, large scale mergers and acquisitions, better relationship with the neighbor countries, investor friendly policies and strong regulatory framework (Imran Ali, 2009). In Pakistan stock markets performance is also affected by legal, economic and political factors. The Karachi Stock Exchange (KSE) is Pakistan s first and one of the oldest stock exchanges in emerging markets of South Asia. KSE was established in 18 th September, 1947, just two months after Pakistan became an independent state. KSE is the Pakistan s largest stock exchange. The other exchanges in Pakistan, the Lahore Stock Exchange (LSE) and the Islamabad Stock Exchange (ISE), were established in 1974 and 1997 respectively. Stock market performance, economical and political condition of a country is interrelated and has been a significant debating issue. Many studies directly or indirectly have been dealing with the macroeconomic and institutional factors and their correlation with the stock market performance at both theoretical and empirical levels. Charles Amo Yarty (2008) found that macroeconomic factors such as income level, gross domestic investment, banking sector development, private capital flows, stock market liquidity and institutional determinants such as political risk, law and order, and bureaucratic quality are important determinants of stock market development in COPY RIGHT 2013 Institute of Interdisciplinary Business Research 1017

emerging markets. He used number of listed companies, market capitalization % of GDP, value traded % of GDP, turnover ratio %, and GDP per capita($) as indicators of stock market development. Valeriano F. Garcia (1999) also examined the determinants of stock market development in emerging markets. He found that real income, saving rate, financial intermediary development and stock market liquidity are important determinants of stock market capitalization, macroeconomic volatility does not prove significant and stock market development and banking sector development are complements. In this paper, we study only the macroeconomic determinants of stock market performance, due to data limitation we have to ignore the institutional determinants of stock market performance. We use Market Capitalization ratio as a measure for stock market performance, which is defined as the value of domestic equities traded on the stock exchange relative to GDP. Market Capitalization ratio is used to measure the size of stock exchange. We examine the affect of real interest rate, domestic credit provided by banking sector and foreign direct investment as percentage of GDP. We also use Total Value Traded as a percentage of GDP, to measure the activity of stock markets in Pakistan, which gives the value of stock market transactions relative to the size of the economy. Total Value Traded used to measure market liquidity (Levine and Zervos, 1998). Demirguc-Kunt and Levine (1996) have found that in developed countries stock market performance is highly correlated with financial intermediary performance. We intend to investigate positive relationship between financial intermediary performance and stock market performance. Two research questions are essential to this study: 1. Is stock exchange performance affected by macroeconomic factors? 2. Does banking sector development have significant role in stock market performance? Macroeconomic and institutional, both factors have significant impact on stock market performance. Pagano (1993) shows that rules & regulation and law & order situation of any country have significant impact on stock market performance. For example, disclosure requirements and investor s interest protective regulations increase the investor s confidence and encourage them to invest and trade in the stock markets. We are taking only macroeconomic determinants due to unavailability of accurate information on institutional variables, directly reflected in macroeconomic factors. For example, investment and trading rules are highly correlated with stock market liquidity measured by Value Traded, while stock market liquidity is one of the determinants used in this research. Boyd and Smith (1996) and Demirguc-Kunt and Levine (1996) found that stock markets development and banking sector development are complements rather than substitute. In this paper, banking sector performance is measured by domestic credit provided by banking system to the private sector as percentage of GDP. Private credit is the most inclusive indicator of the activity of commercial banks. It limits the amount of funds transferred from banking sector to private firms. Domestic credit provided by banking sector as percentage of GDP, measures the role of banks in the creation of funds available to private firms (Valeriano F. Garcia, 1999). Liquid securities can easily be converted into cash at a reasonable price. Stock market liquidity is important from investor s point of view, more liquid the stock market, the larger the amount of saving channeled to stock market. Hence, to measure the stock market performance we use value traded as a percentage of GDP as one of the determinants. Value traded as a percentage of GDP shows stock market liquidity. This determinant does not directly measure how easily investors can buy and sell shares at posted prices. However, it measures the degree of trading relative to the size of the economy (Levine and Zervos, 1998). Volatility in economic situation has significant impact on stock market performance in Pakistan. We experienced that greater volatility in the economic situation which created less incentive available for firms and savers to participate in the stock market. In addition, the profitability of corporations also effected due to unexpected changes in economic policies such as monetary policy, fiscal policy, exchange rate policy and trade policy. Macro-economic stability has significant impact on stock market performance, to measure the macro-economic stability we use real interest rate, as the previous studies also highlighted its importance (Garcia and Liu, 1999). From last decade, foreign investors have shown interest in emerging stock markets. Foreign investment is associated with country s political and economic situation, Law and order situation, quality of legal law and policy enforcement and fair trading practices. The increase in informational and operational efficiency is expected to inspire greater confidence in domestic markets. This increase the investor s base and participation and leads to more capital flows (Charles Amo Yartey, 2008). Private capital flows is expected to have positive impact on stock market performance that s why we use foreign direct investment as a percentage of GDP. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 1018

2. Theoretical Framework In this paper the model which we have selected first to show the impact of macroeconomic factors on stock market performance in Pakistan. MC = βo + β1fdi - β2rir + β3vt + β4dcpbs But results were insignificant that s why after dropping DCPBS variable, we get this estimated model for forecasting purpose: MC = βo + β1fdi - β2rir + β3vt Where, MC= market capitalization as a percentage of GDP, FDI= foreign direct investment as a percentage of GDP, RIR= real interest rate as a percentage of GDP, VT= value traded as a percentage of GDP, DCPBS= domestic credit provide by banking sector as a percentage of GDP. Theory Intuition and Expected Signs Variable Theory intuition Expected sign Stock market liquidity Stock market liquidity measure + by value traded relative to the size of the economy. Market liquidity has positive impact on market performance. Financial Development Increase in credit provided to + private sector by banks encourages the investment in stock market. Real interest Rate Real interest rate and investment - in stocks have inverse relationship. Foreign Direct Investment Market performance is expected to be influenced positively by FDI. Annual data of all variables have been collected from different sources; Aggregate market capitalization from Handbook of Statistics on Pakistan Economy 5.2, GDP factor cost from hand book of statistics on Pakistan economy 1.1, CPI % from Handbook of Statistics on Pakistan Economy 2.9, Domestic credit provided by banking sector (% of GDP) from data. worldbank.org, total value of stocks traded as a %of GDP from data.worldbank.org and FDI AS % GDP from Handbook of Statistics on Pakistan Economy 7.12. Data is analyzed in a quantitatively through regression analysis in E-views. Hypo testing is used to measure the significance of the study. HYPOTHESIS TESTING: H0: There is no relationship between FDI, VT, RIR and MC HA: There is a relationship between FDI, VT, RIR and MC 3. Empirical Results Descriptive statistics and correlation matrix of the variables of our selected model are expressed in table 1 and 2 respectively. Table 2 Correlation matrix shows the correlation between depended variable; market capitalization as percentage of GDP with different in-depended variables. The relationship between market capitalization as percentage to GDP and domestic credit provided by banking sector divide by GDP have weak positive relationship. Market capitalization and foreign direct investment have strong positive relationship. In market capitalization and real interest rate, strong negative relationship does exist. Value traded and market capitalization has strong positive relationship. DCPBS and VT have moderate relationship. RIR and FDI also have moderate relationship. Figure 2 shows the combine pattern of study variables over time 1988 to 2008 + COPY RIGHT 2013 Institute of Interdisciplinary Business Research 1019

Since 2001 to 2005 Pakistan s stock market performed very well and was focus of the global fund managers, many investment firms such as Morgan Stanley, Merrill Lynch, Goldman Sachs, etc, have entered the markets with local fund managers. After 2005 there is a deceasing trend in value traded. In 2005 and as well as in 2006, stock market sharply declined. After 2002 real interest rate shows decline trend, at that time State Bank of Pakistan used easy monetary policy. Negative real interest rate shows high inflation rate. Market capitalization increased since 2002 to 2006 due to easy monetary policy and negative real interest rate. Rising market capitalization indicates that in terms of the size, market has been improving faster than the economic growth. Debt and equity securities are substitutes. If the interest rate on debt instrument increases, investment in equity instrument decreases. Due to political unsteadiness, FDI as percentage of GDP is quite low since 1988 to 2008. Domestic Credit provided by banking sector (DCPBS), shows smooth pattern throughout the period. 3.1 Regression result Present study attempts to study the relationship between stock market performance and macroeconomic variables in Pakistan, we use E-views to estimate whether a statistically significant relationship exists between stock market performance and its determinants or not. Regression analysis is used to assess the relationship between dependent variable and independent variable. There are two types of regression coefficients; un-standardized coefficients and standardized coefficients. The un-standardized coefficients used in the equation as coefficients of different independent variables along with constant term to predict the value of dependent variable. Table 3: model summary gives us R values for assessing the overall fit of the model. The adjusted R square value in this case is 0.815. This tells us that four independent variables (DCPBS, VT, RIR, and FDI) in our model account for 82% variance in the dependent variable (stock market performance). Clearly this is a very good model as there are factors which should be used to predict a stock market performance (MC). Table 3 also gives the regression coefficients and their significance. These regression coefficients can be used to construct an Ordinary Least Square (OLS) equation and also test the hypothesis on each of the Independent variables. Under this model the OLS equation for predicting stock market performance as: MC = (-18.979) + (6.751) FDI (.766) RIR + (.134) VT (.477) DCPBS The test result gives the t-statistics of DCPBS and RIR as insignificant. P-value of DCPBS is 0.1332 and RIR is 0.1503 also shows these variables are insignificant. After dropping one variable; domestic credit provided by banking sector; real interest rate become significant and value traded and foreign investment still significant, these results are shown in table 4. MC = (4.384) + (6.782) FDI (1.218) RIR + (0.084) VT We drop DCPBS variable in the model because model is suffering from multi-co linearity problem because there is a correlation between VT and DCPBS; VT and FDI; RIR and FDI shown in Table 2. In Pakistan, banking sector does not has significant impact on stock market performance because result shows there is weak positive relationship( 7% only)that's why after dropping DCPBS Adj. R square decrease by only 2%. Table 4 On the basis of p-value, all independent variables are a significant therefore, we reject null hypothesis. The F-test use to test overall significance of model. The result shows overall model is significant. There is a significant relationship between FDI, VT, RIR and MC. 4. Conclusion Our finding suggests that there exist significant positive strong relationship(0.83) between stock market performance and foreign direct investment, if FDI as percentage GDP increases by 1 % MC as percentage of GDP increases by 6.78 %; Negative moderate relationship(-0.69) between real interest rate and stock market capitalization, if RIR as percentage GDP increases by 1 % MC as percentage of GDP decreases by 1.218 %;and there is a positive moderate relationship(0.60) between value traded as percentage of GDP and MC as percentage of GDP; while stock market has weak positive relationship(0.07) with financial intermediary development in Pakistan. The results are consistent with academic predictions. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 1020

5. Implications Economic factors play an important role in the performance of stock market. Policy makers in Pakistan may initiate policies to foster economic growth. Improving stock market liquidity is another approach of promoting stock market performance. This study emphasizes on the role of government to reduce political risk and improve law and order enforcement to attract foreign investors which will enhance market capitalization and foreign direct investment as well. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 1021

References Monther Cherif and Kaothar Gazdar(2010). Macroeconomic and institutional determinants of stock market development in MENA region: new results from a panel data analysis, the International Journal of Banking and Finance, Vol.7. Imran Ali (2009). Causal relationship between macroeconomic indicators and stock exchange prices in Pakistan, The African Journal of Business Management Vol. 4. M. Mafizur Rehman and M. Salahuddin, the determinants of economic growth in Pakistan: Does stock market development play a major role? Valeriano F. Garcia(1999), Macroeconomic determinants of stock market development, Journal of Applied Economics, mayo, vol.2. Charles Amo Yartey(2008), the determinants of stock market development in emerging economies: Is South Africa different? IMF working paper. Hand book of Statistics of on Pakistan Economy Data.Worldbank.org COPY RIGHT 2013 Institute of Interdisciplinary Business Research 1022

Annexure Year mc % gdp DCPBS REAL IR FDI%GDP value traded% GDP Y MC DCPBS RIR FDI VT 1988 6.348 53.1 1.37 0.53 0.5 1989 6.431 51.3-2.45 0.54 0.5 1990 6.399 50.9 2.23 0.54 0.6 1991 7.534 51.2-6.70 0.69 1.4 1992 20.257 55.9-4.22 0.6 2 1993 17.867 54.9-3.71 0.68 3.6 1994 28.635 51.6-5.13 0.73 6.2 1995 17.544 51-6.75 1.74 5.3 1996 19.080 54.4-4.38 1.1 9.6 1997 21.090 52.1-5.00 0.97 18.4 1998 10.451 51.5-0.99 0.75 14.5 1999 10.461 49.1 0.79 0.77 33.4 2000 11.001 41.6 1.87 0.55 44.6 2001 8.647 38.1 0.87 0.82 17.2 2002 9.832 37.2 0.11 1.17 36 2003 16.462 37.9-1.49 0.98 80 2004 25.854 43-3.65 0.97 75.4 2005 32.882 46.5-7.93 1.39 128.6 2006 38.645 45.5-5.94 2.94 99.3 2007 48.339 48.4-5.20 3.78 70.2 2008 37.737 53.2-7.87 3.41 33.2 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 FDI 4 2 0-2 -4-6 -8-10 RIR COPY RIGHT 2013 Institute of Interdisciplinary Business Research 1023

60 56 52 48 44 40 36 DCPBS 140 120 100 80 60 40 20 0 VT 50 40 30 20 10 0 MC Figure 1: Graph of the Study Variables over Time COPY RIGHT 2013 Institute of Interdisciplinary Business Research 1024

140 120 100 80 60 40 20 0-20 DCPBS FDI MC RIR VT Figure 2: The combine graph of Study Variables over time 1988 to 2008 Table 1: Descriptive statistics DCPBS FDI MC RIR VT Mean 48.49524 1.221429 19.11886-3.05571 32.40476 Median 51 0.82 17.544-3.71 17.2 Maximum 55.9 3.78 48.339 2.23 128.6 Minimum 37.2 0.53 6.348-7.93 0.5 Std. Dev. 5.796247 0.960132 12.15592 3.30039 37.34052 Skewness -0.797307 1.74869 0.886601 0.192577 1.172949 Kurtosis 2.381506 4.69252 2.819201 1.737461 3.329773 Jarque-Bera 2.559661 13.20926 2.779814 1.524555 4.91049 Probability 0.278084 0.001354 0.249098 0.466603 0.085842 Sum 1018.4 25.65 401.496-64.17 680.5 Sum Sq. Dev. 671.9295 18.43706 2955.33 217.8515 27886.29 Observations 21 21 21 21 21 Table 2: Correlation matrix DCPBS FDI MC RIR VT DCPBS 1.00-0.02 0.07-0.36-0.53 FDI -0.02 1.00 0.83-0.54 0.47 MC 0.07 0.83 1.00-0.69 0.60 RIR -0.36-0.54-0.69 1.00-0.27 VT -0.53 0.47 0.60-0.27 1.00 COPY RIGHT 2013 Institute of Interdisciplinary Business Research 1025

Table 3: With Domestic Credit provided by Banking Sector (DCPBS) Dependent Variable: MC Variable Coefficient Std. Error t-statistic Prob. C -18.97979 14.89291-1.274418 0.2207 DCPBS 0.477328 0.301686 1.582199 0.1332 RIR -0.7668 0.507517-1.510887 0.1503 FDI 6.751451 1.569429 4.301852 0.0005 VT 0.134578 0.047606 2.826939 0.0121 R-squared 0.852607 Mean dependent var 19.11886 Adjusted R-squared 0.815759 S.D. dependent var 12.15592 S.E. of regression 5.21773 Akaike info criterion 6.346259 Sum squared resid 435.5953 Schwarz criterion 6.594955 Log likelihood -61.63572 F-statistic 23.1383 Durbin-Watson stat 2.320663 Prob(F-statistic) 0.000002 Table 4: Without Domestic Credit provided by Banking Sector (DCPBS) Dependent Variable: MC Variable Coefficient Std. Error t-statistic Prob. C 4.38448 2.016407 2.174402 0.0441 FDI 6.782758 1.637223 4.142842 0.0007 RIR -1.218722 0.437667-2.78459 0.0127 VT 0.084113 0.03687 2.281327 0.0357 R-squared 0.829546 Mean dependent var 19.11886 Adjusted R- squared 0.799466 S.D. dependent var 12.15592 S.E. of regression 5.443552 Akaike info criterion 6.396384 Sum squared resid 503.7484 Schwarz criterion 6.595341 Log likelihood -63.16203 F-statistic 27.57784 Durbin-Watson stat 2.451601 Prob(F-statistic) 0.000001 COPY RIGHT 2013 Institute of Interdisciplinary Business Research 1026