International Review of Business Research Papers

Vol. 3 No.5 November 2007 Pp.21-35

Macroeconomic Factors and Bangladesh Stock Market:

Impact Analysis through Co integration Approach

Md. Nehal Ahmed* and Mahmood Osman Imam**

The paper investigates whether current economic activities in

Bangladesh can explain stock market returns in long-run horizon
by using co integration test and in short-run dynamic adjustment
from a vector error correction model. In addition, this paper tests
causality of economic variables on stock returns and vice-versa.
This paper finds that the Bangladesh stock market does not reflect
macroeconomic effect on stock price indices. The co integration
test and the vector error correction model illustrate that stock price
indices are not co integrated with a set of macroeconomic
variables like industrial production index, broad money supply and
GDP growth. Findings of no co-integration between the growth of
stock market return and fundamental macroeconomic factors may
be the outcome of a small and shallow emerging stock market of
Bangladesh. But interest rate change or T-bill growth rate may
have some influence on the market return. It is argued by the
authors with the explanation that the stock market should react
with these changes otherwise investor is likely to switch from
stock market to money market or other places where opportunity
cost for them is likely to be higher. However, the findings that
change of interest rate Granger causes stock market returns
unidirectionally implies that stock market index is not a leading
indicator for the economic variable of the change in interest rate,
which shows the evidence of informationally inefficient market.

Keywords: Cointegration, Macroeconomic variables, Stock market

returns, Granger causality
Field of Research: Securities Market and Market Efficiency

1. Introduction

The paper aims at investigating the relationship between stock market and different
macroeconomic variables in a developing country like Bangladesh. The paper
attempts to determine whether there exists any long run equilibrium relationship and
a short-run dynamics between stock markets and real economic activity empirically
in Bangladesh and to explain the direction of causality between changes in stock
prices and that of the economic activity.
___________________________
*Assistant Professor, Bangladesh Institute of Bank Management (BIBM), Mirpur-2, Dhaka-1216,
Bangladesh. E-mail: [email protected]
**Professor, Department of Finance, Faculty of Business Studies, University of Dhaka, Dhaka-1000,
Bangladesh. E-mail: [email protected], [email protected]

# Both the authors have equal contribution

 Ahmed & Imam 22

Stock market plays an important role in any economy. A mature and sizeable stock
market is perceived across the globe as an indicator of the economic health and
prospect of a country as well as an index of the confidence of domestic and global
investors. A significant correlation does exist between the development of stock
markets and economic growth, which has also been documented in a number of
recent studies. A well meaning equity market is characterized by its informational
efficiency in the sense that the prices of securities traded in the market act as though
they fully reflected all available information and react instantaneously and in an
unbiased fashion to new information [Fama (1970), Strong & Walker (1987)].
Therefore, current price of the stock portrays all information available at time t.
Accordingly, if macroeconomic activity affects stock prices then an efficient stock
market instantaneously incorporates all available information about economic
variables. In the absence of informational efficiency, participants in the stock market
would be able to develop profitable trading rule and can earn above average market
return.

According to Chen, Roll and Ross (1986), macroeconomic movements affect

country’s stock index. A number of studies find an economically meaningful positive
relationship between macroeconomic variables and stock market returns for
developed economies. However, these studies have not considered the emerging
market of South Asian countries, generally. This paper extends this presumed
relation to the emerging markets by considering Bangladesh case.

The main purpose of the paper is to test whether major macro-economic variables in
Bangladesh can explain stock returns by using a co-integration test and vector error
correction model. In addition, this paper proposes to test causality of economic
variables on stock returns and vice-versa. The paper is organized as follows. Section
two deals with the review of literature and section three presents methodology with
model specification. Section four analyzes the empirical results followed by the
discussion of findings and conclusion in section five and six respectively.

2. Review of Literature

The relationship between stock market returns and fundamental economic activities
in the developed countries are well documented [Fama (1970, 1990, 1991)]. In
recent years, numerous studies [Fama (1981), Huang and Kracaw (1984), Chen,
Roll, and Ross (1986), Pearce and Roley (1988), Fung and Lie (1990), Chen (1991),
and Wei and Wong (1992)] modeled the relation between asset prices and real
economic activities in terms of production rates, productivity, growth rate of GDP,
unemployment, yield spread, interest rates, inflation, dividend yields, etc. However,
the economic role of the stock markets in relatively less developed Asian countries
(e.g. Korea, Taiwan, Singapore, Hong Kong, Malaysia, China, etc.) is less clear.

In an informationally efficient market, stock prices immediately reflect changes in

monetary policy and correctly anticipate future monetary growth. Cornelius (1994)
examined the relationship between money supply changes and stock prices in six of
the most active emerging markets – India, Korea, Malaysia, Mexico, Taiwan and
Thailand. However, findings are not uniform across countries. Results from Granger-
 Ahmed & Imam 23

causality tests suggest that at least four of these markets – India, Korea, Malaysia,
and Mexico appear informationally inefficient.
Naka A., Mukherjee T. and Tufte D. (1998) explained the relationships among
selected macroeconomic variables and the Indian stock market. By employing a
vector error correction model, they find that three long-term equilibrium relationships
exist among these variables. Results suggest that domestic inflation is the most
severe deterrent to Indian stock market performance, and domestic output growth is
its predominant driving force. After accounting for macroeconomic factors, the Indian
market still appears to be drawn downward by a residual negative trend.

Karamustafa O and Kucukkale Y (2003) investigated whether current economic

activities in Turkey have explanatory power over stock returns, or not. They
considered monthly data of stock price indexes of Istanbul Stock Exchange and a set
of macroeconomic variables, including money supply, exchange rate of US Dollar,
trade balance, and the industrial production index. Engel-Granger and Johansen-
Juselius cointegration tests and Granger Causality test were used in the study to
explain the long-run relations among variables questioned. Obtained results illustrate
that stock return is co-integrated with a set of macroeconomic variables by providing
a direct long-run equilibrium relation. However, the macroeconomic variables are not
the leading indicators for the stock returns, because any causal relation from
macroeconomic variables to the stock returns cannot be determined in sample
period. In contrast, stock return is the leading indicator for the macroeconomic
performance for the Turkish case.

Hardouvelis (1987), Keim (1985), Litzenberger and Ramaswamy (1982) empirically

investigated whether the main economic indicators (e.g., inflation, interest rates,
treasury bond’s returns, trade balance, dividend returns, exchange rates, money
supply, and crude oil prices) are effective to explain the share returns. If there were a
co-integration relation between macroeconomic indicators and share returns, there
would be a causal relation between these variables, too. Otherwise, share returns
cannot be explained by main macroeconomic variables.

Using cointegration techniques, Chowdhury A.R. (1995) explains the lack of

efficiency in the emerging stock markets by investigating the issue of informational
efficiency in the Dhaka Stock Exchange in Bangladesh. He argued that in an efficient
market the prices of the securities fully reflect all available information i.e. stock
market participants incorporate the information contained in money supply changes
into stock prices. Initially he tested the bivariate relationship between stock prices
and money supply changes. Results from bivariate models suggest independence
between the stock price and monetary aggregates. In other words Dhaka stock
market is informationally inefficient. However, it is well known that bivariate models
fail to address the obvious possibility that the relationship may be driven by another
variable acting on both stock price and money supply. Hence multivariate models
were estimated which shows the presence of a unidirectional causality from the
money (both narrow and broad) to stock price. But the findings are insensitive to the
functional form of the variables employed. Thus the stock prices do not immediately
reflect changes in monetary policy and the market in inefficient. One important
limitation of this study is that the cointegrating test was conducted only for bivariate
model. No such test was conducted for multivariate model.
 Ahmed & Imam 24

It is an empirical question whether principal economic indicators such as industrial

production, interest rates, yield of T-bill, GDP and money supply are significant
explanatory factors of Bangladesh stock market. The conclusion that
macroeconomic performance affects share prices exposed the necessity of
investigating relationship between stock market return and a number of
macroeconomic variables taking into consideration of the Bangladesh stock market,
which is an emerging one.

3. Methodology

3.1 Research Methods

In this paper the relationship between stock market and selected macroeconomic
variables has been examined. We use share price index to represent the stock
market and several macroeconomic variables namely broad money supply, treasury
bill rate, interest rate, GDP, industrial production index etc. A series of tests such as
unit roots, cointegration, vector error correction models (VECM) have been carried
out. Granger causality test was also conducted to test the causality. 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 have a significant
influence on the stock market.

3.1.1 Unit Root Test

Many studies have shown that most macroeconomic time series are not stationary,
rather non-stationary with a deterministic trend. This creates a problem since in the
conditions of non-stationary data the normal properties of Durbin-Watson (DW) and t
statistics and measure such as R2 break down. Running regression with such data
produces questionable, invalid and spurious results. To eliminate this problem,
stationarity test must be performed for each of the variables. There have been a
variety of proposed methods for implementing stationarity tests (for example, Dickey
and Fuller, 1979; Sargan and Bhargava, 1983; Phillips and Perron, 1988 among the
others) and each has been widely used in the applied economics literature. In this
study, Augmented Dickey-Fuller (ADF) test procedure was employed for
implementing stationarity tests.

3.1.2 Johansen Cointegration Method

The Johansen method applies the maximum likelihood procedure to determine the
presence of cointegrating vectors in non-stationary time series as a vector
autoregressive (VAR). Consider a VAR of order p
Yt = A 1 Yt −1 + A 2 Yt − 2 + LLL + A p Yt − p + BX t + ε t

where Yt is a k-vector of non-stationary I(1) variables, Xt is a d vector of deterministic

variables, and εt is a vector of innovations. We can rewrite the VAR as:
p −1
∆Yt = ΠZ t −1 + ∑ Γi ∆Yt −i + BX t + ε t
i =1
 Ahmed & Imam 25

p p
where Π = ∑ A i − I and Γi = − ∑ A j
i =1 j=i +1

Here Yt is a vector of nonstationary variables. The information on the coefficient

matrix between the levels of the series Π is decomposed as Π = αβ′ where the
relevant elements of the α matrix are adjustment coefficients and the β matrix
contains the cointegrating vectors. Johansen and Juselius (1990) specify two
likelihood ratio test statistics to test for the number of cointegrating vectors. The first
likelihood ratio statistics for the null of exactly r cointegrating vectors against the
alternative of r+1 vectors is the maximum eigenvalue statistic. The second statistic
for the hypothesis of at most r cointegrating vectors against the alternative is the
trace statistic. Critical values for both test statistics are tabulated in Johansen and
Juselius (1990). The number of lags applied in the cointegration tests is based on
the information provided by the multivariate generalization of the AIC.

3.1.3 Vector Error Correction (VEC) Model

A vector error correction (VEC) model is a restricted VAR that has cointegration
restrictions built into the specification, so that it is designed for use with non-
stationary series that are known to be cointegrated. The VEC specification restricts
the long-run behavior of the endogenous variables to converge to their cointegrating
relationships while allowing a wide range of short-run dynamics. The cointegration
term is known as the error correction term since the deviation from long-run
equilibrium is corrected gradually through a series of partial short-run adjustments. If
the two endogenous variables Y1t and Y2t have no trend and the cointegrating
equations have an intercept, the VEC has the form

∆Y1t = γ 1 (Y2, t −1 − µ − βY1, t −1 ) + ε1,t

∆Y2 t = γ 2 (Y2,t −1 − µ − βY1, t −1 ) + ε 2,t

3.1.4 Granger Causality Test

The causality relationships among the variables in this study are determined by
using the methodology based on Granger (1988). The Granger tests involve the
estimation of the following equations.
k m
X t = α 0 + ∑ α1s X t −s + ∑ α 2i Yt − m + ε1t
s =1 i =1
n p
Yt = β 0 + ∑ β1 j Yt − j + ∑ β 2 h X t − h + ε 2 t
j=1 h =1

where ε1t and ε2t are assumed to be uncorrelated and E(ε1t ε1s) = 0 = E(ε2t ε2s) for all
s≠t.

These equations can be used to show the unidirectional causality from stock price
index and macroeconomic variable. If the estimated coefficients α2i are statistically
significant i.e. α2i ≠ 0, then Y Granger-causes X. Similarly, X is the “Cause Variable”
for Y if β2h is statistically significant i.e. β2h ≠ 0. If both α2i and β2h are significant, it
would provide evidence of a mutual dependency between these two variables.
 Ahmed & Imam 26

Finally, if both α2i and β2h are statistically not different from zero, then X and Y will be
independent.
According to this approach, a stock market is said to be informationally inefficient if Y
Granger-causes X (considering X represents stock market variable and Y represents
macroeconomic variable). Mathematically, α2i ≠ 0 and β2h = 0. The stock market will
be informationally efficient if the direction of causality runs from lagged X value to
current Y value i.e. α2i = 0 and β2h ≠ 0. This means relationship between lagged
stock prices and current value of macroeconomic variable imply a stock market with
a forward-looking propensity where changes in the macroeconomic variables are
correctly anticipated.

3.2 Data and Data Sources

The data used for the analysis in this study include selected macroeconomic
variables and stock price index. Monthly data series for the period of July 1997 to
June 2005 (96 monthly observations) was considered. The data has been compiled
from Economic Trend published by Bangladesh Bank and International Financial
Statistics. For stock price the data used are the monthly general share price index of
Dhaka Stock Exchange (DSE). It is the closing index prices of the last trading day in
each month. The macroeconomic variables used are monthly data for the same time
period as the stock market data (July 1997 to June 2005). This study selects
macroeconomic variables namely Money Supply (M2), Treasury Bill Rate (91-day
weighted average rate), Interest Rate, Gross Domestic Product, Industrial Production
Index.

3.3 Model Specification

This study examines both long run and short-run relationship among the stock price
index and the macroeconomic variables. Here three different models have been
considered to test the relationships taking multicollinearity problems into account. In
the model, stock price index (SPINDEX) is considered as dependent variable and
Industrial production index (IIP), Money supply (M2), Gross Domestic Product
(GDP), Interest rate (Intr), 91-day T-bill rate (TB91R) as independent variable. All
variables except interest rate are transformed into natural logs. We expect that there
will be long-run cointegrating relationships between the variables consistent with
macroeconomic fundamentals. Further, there should be short run relationships
between these variables. The forms of these variables in the model are in the order
of co-integration one – I(1), which is explained in table-2 and 3. So the models are as
follows
ln DSpindexch t = α1 + β11 ln DIIPt + β12 ln M 2 t + β13 ln GDPch t + e1t (1)
ln DSpindexch t = α 2 + β 21 ln DIIPt + β 22 ln M 2 t + β 23 ln GDPch t + β 24 DIntrch t + e 2 t (2)
ln DSpindexch t = α 3 + β 31 ln DIIPt + β 32 ln M 2 t + β 33 ln GDPch t + β 34 ln Tb91rch t + e 3 t (3)
 Ahmed & Imam 27

4. Empirical Results
4.1 Summary Statistics

Table-1 represents the summary statistics of the variables under study. The average
monthly index is 841 during the study period (July 1997-June 2005) with a high
standard deviation implying a volatile stock market. The average index of industrial
production is 234 with a maximum of 310 and minimum of 178. The trend is
increasing which indicates slow but steady growth over time. Velocity of money and
real activity increases as the money supply significantly increased within the study
period. Gross Domestic Product (GDP) doubled recently over the 8 years period of
time having a nominal growth of 8.8 percent per annum on an average. The average
interest rate is 8.05 percent during the period with 1.4 percent deviation. But trend is
declining as government has undertaken the necessary steps to reduce the interest
rate in order to encourage the investor for investing in the stock market. Interest rate
shows the investors expectation of return if they wish to invest in money market and
ensure the fund to be secured. Hence the variable represents opportunity costs of
investors fund when to invest in capital market. Also 91-day weighted average T-bill
rate per month is 6.98 percent, which is the average risk free rate during the period.
This is the rate at which banks used to employ their excess liquidity for very short
period of time in order to tap the opportunity cost of the idle fund.

Table-1: Summary Statistics

Name of the
Observations Mean Std. Dev. Maximum Minimum
Variables
Stock Price Index 96 841.44 371.39 1971.31 478.4
Industrial Production
96 234.55 33.17 310 178
Index
Money Supply (M2)
96 89084.6 29812.98 151561.8 17470.7
(Tk. in Crore)
GDP (Tk. in Crore) 96 262280.8 51857.41 368476 182249

Interest Rate (%) 96 8.05 1.40 9.98 5.09

91-day T-bill Rate
96 6.98 1.53 9.12 4.85
(%)

4.2 Test for Stationarity

Table-2 summarizes the ADF test results. The third column summarizes the ADF
test statistics of the variables under study considering for both with and without trend
(with constant). All the variables are non-stationary in levels. Some of them are non-
stationary in first difference. The fourth column represents the p-value of the trend.
Based on the existence of the trend, the data are de-trended in some cases and
ADF test for these de-trended variables are considered. Then variables are
transformed into natural logs except interest rates. The fifth column describes the
order of cointegration of the concerned variables.
 Ahmed & Imam 28

Table-2: Unit Root Test

Variables Test for unit root in ADF Test Statistic Trend Order of
Without With trend (p-value) cointeg-
trend ration
M2 Level (1) [12] 2.3612 -1.2993 0.1124
lnM2 Level (1) [12] -0.0362 -2.6208 - I(1)
1st Difference (1) [12] -4.0434* -4.0253* -
IIP Level (3) [12] 1.7855 -1.6103 0.0513
lnDIIP Level (12) [12] -2.2409 -2.3786 - I(1)
1st Difference (11) [12] -3.2924* -3.6569* -
GDP Level (1) [12] 1.9497 -0.6588 0.2911
lnGDP Level (1) [12] 1.7535 -1.7002 - I(2)
1st Difference (12) [12] -2.0355 -2.4229 -
2nd Difference (9) [12] -3.1011* -3.5776* -
Intr Level (9) [12] -0.3232 -2.4043 0.0132
DIntr Level (9) [12] -2.0250 -2.1693 I(2)
1st Difference (11) [12] -2.1341 -1.9448 -
2nd Difference (1) [12] -2.8998* -3.9303* -
Tb91r Level (2) [12] -2.0525 -2.4293 0.1416
lnTb91r Level (3) [12] -1.9951 -2.5672 - I(2)
1st Difference (6) [12] -2.8947 -2.9007 -
2nd Difference (1) [12] -3.1970* -3.2264* -
Spindex Level (3) [12] -0.1118 -1.5445 0.0122
lnDSpindex Level (5) [12] -0.5745 -2.6498 - I(2)
1st Difference (12) [12] -2.3379 -2.7238 -
2nd Difference (3) [12] -3.4574* -3.4913* -
Note: * indicates significant at 5% level. Figures within the first bracket of the 2nd column represent the
significant lag length and that of within the third bracket represents the total lag lengths that are
considered in this analysis.

Table-3 represents the order of co-integration of the selected variables. Some of

them are co-integrated of order one and some are of order two. So changed data
series are considered for those series that are integrated of order two to make them
order one. Because if the series are integrated of order one and are non-stationary,
then the series may be said to be co-integrated and there can be a long-run
equilibrium relationship among the series.

Table-3: Selected Variables for Cointegration Test

Variable Order of Selected Variable Order of
Cointegration Cointegration
lnM2 I (1) lnM2 I (1)
lnDIIP I (1) lnDIIP I (1)
lnGDP I (2) lnGDPch I (1)
Intr I (2) DIntrch I (1)
lnTb91r I (2) lnTb91rch I (1)
lnDSpindex I (2) lnDSpindexch I (1)

4.3 Cointegration Results and Long-run Equilibrium Relationship

The cointegration procedure developed in Johansen (1991) and Johansen &

Juselius (1990) is employed to test the long run equilibrium relationship between the
stock price index and macroeconomic variables. Johansen method uses likelihood
 Ahmed & Imam 29

ratio test to determine the number of cointegrating relationships, which may exist
between the variables. If the hypothesis of no cointegration is rejected, then a stable
long run relationship between stock index and related variable does exist.

While performing cointegration and the subsequent estimation, two tests (1)
Intercept & No trend in CE and (2) Intercept & Trend in CE are conducted throughout
the analysis. However, only the results of first one will be discussed here. As the
findings of the second test, i.e., Intercept & Trend in CE are almost similar with that
of the first one so the result for that is not reported.

Table-4: Johansen Cointegration Test

Variables Eigenvalue Likelihood 5% critical Null Alternative
Ratio value
LNDSPINDEXCH, 0.2066 43.1996 47.2100 k=0 k=1
Model-1

LNDIIP, LNM2, 0.1361 22.8339 29.6800 k <= 1 k=2

LNGDPCH 0.1013 9.9608 15.4100 k <= 2 k=3
0.0064 0.5610 3.7600 k <= 3 k=4
LNDSPINDEXCH, 0.3171 74.6747* 68.52 k=0 k=1
Model-2

LNDIIP, LNM2, 0.1642 41.1075 47.21 k <= 1 k=2

LNGDPCH, 0.1588 25.3131 29.68 k <= 2 k=3
DINTRCH 0.1013 10.0943 15.41 k <= 3 k=4
0.0078 0.6892 3.76 k <= 4 k=5
LNDSPINDEXCH, 0.3013 71.9218* 68.52 k=0 k=1
Model-3

LNDIIP, LNM2, 0.1999 40.3730 47.21 k <= 1 k=2

LNGDPCH, 0.1166 20.7485 29.68 k <= 2 k=3
LNTB91RCH 0.0978 9.8428 15.41 k <= 3 k=4
0.0089 0.7850 3.76 k <= 4 k=5
Note: *(**) denotes rejection of the hypothesis at 5% (1%) significance level. Likelihood ratio rejects
any cointegration for model-1, one cointegrating equation(s) at 5% significance level for model-2,
model-3, model-4 and one cointegrating equation(s) at 1% significance level for model-5.

Table-4 provides the test statistics for cointegration vectors and critical values at 5
percent significance level. The result shown in the table is obtained by considering
six lags and without any trend term. The test result indicates that there is no
relationship between lnDSpindexch, lnDIIP, lnM2 and lnGDPch. However existence
of such relationship does emerge, when additional variables are added with the
model-1 such as DIntrch, lnTb91rch.

As the objective of the study is to find the long run relationship between the stock
index and macroeconomic variables, table-5 provides the estimates of these
relationships. From the analysis it can be concluded that for model-2, change of
stock price index is influenced positively by industrial production index, change of
GDP and change of interest rate. But the result is insignificant for industrial
production index. On the other hand money supply (M2) affects the stock index
positively and significantly. In model-3 when T-bill rate is considered instead of
interest rate, the result obtained is almost same as observed in the previous model
except one exception. The change of T-bill rate also positively affects the stock price
index.
 Ahmed & Imam 30

Table-5: Normalized Cointegrating Coefficients

LNDSPIN
LNDIIP LNM2 LNGDPCH DINTRCH C
Model-2 DEXCH
Coefficients 1.00 0.4149 -0.0661 12.0233 3.3903 0.6716
S.E. - 0.3486 0.0241 5.6957 1.0688 -
t-statistics - 1.1901 -2.7350*** 2.1109** 3.1720*** -
Log 1145.49
Likelihood
LNDSPIN
LNDIIP LNM2 LNGDPCH LNTB91RCH C
DEXCH
Model-3

Coefficients 1.00 0.5575 -0.1561 12.4603 -0.7135 1.6893

S.E. - 0.3944 0.0313 6.0520 0.3511 -
t-statistics - 1.4136 -4.9945*** 2.0588** -2.0321** -
Log 1068.88
Likelihood
Note: (**)(***) significant at 5% and 1% significant level respectively

4.4 Short-run Dynamic Adjustment using VECM

The Vector Error Correction Model (VECM) allows us to make inferences on the
long-run impacts of the variables in levels to those in differences. The variables'
responses to themselves are significant and negative, indicating positive
autocorrelation. If the variables of the model-2 are cointegrated, then there exists an
error correction model that may take the following form
p r s
∆ ln DSpindex 1t = γ 10 + ∑ γ 11 j ∆ ln DSpindex t −i + ∑ φ12i ∆ ln M 2 t − k + ∑ φ13i ln GDPch t −l
i =1 k =1 l =1
t p

∑φ
m =1
14 i DIntrch t − m + ∑ φ15i ln DIIPt − j + ρ1µ1, t −1 + e1t
j=1

where ∆ denotes first difference operator, µ1, t-1 is the correction term, e1t is the
random disturbance terms. The error correction term µ1, t-1 which is the residual
series of the cointegrating vectors normalized for the lnDSpindexcht, lnDIIPt, lnM2t,
lnGDPcht and Dintrcht measure the deviations of the series from the long run
equilibrium relations. Similarly, error correction model for equation 3 can be formed.
Table-6 contains the significant part of the estimated error correction for the model-2
and model-3.

The error correction term has a correct negative sign and is significant at 10 percent
only for model-2. This implies that stock price index adjusts to long run equilibrium.
The estimated value of the coefficients of the error correction term shows that the
system corrects its previous period’s level of disequilibrium by 100ρ percent per
month. So from the analysis of model-2 results, it can be concluded that the stock
price index is adjusting towards equilibrium at a rate of 43.82 percent per month
implying that it requires around two and a half months to reach equilibrium from
disequilibrium state. However, the result for coefficient of error correction term of
model-3 is not significant.
 Ahmed & Imam 31

Table-6: Vector Error Correction Estimate

Model-2 Model-3
Error Correction
∆lnDSpindexch ∆lnDSpindexch
CointEq1 -0.4382* (-1.7842) -0.1137 (-0.4088)
∆lnDSpindexcht-1 -0.5502** (-2.1876) -1.0123*** (-3.0757)
∆lnDSpindexcht-2 -0.5655** (-2.1748) -0.9297** (-2.4569)
∆lnDSpindexcht-3 -0.3332 (-1.2150) -0.7761** (-1.9806)
∆lnDSpindexcht-4 -0.1057 (-0.4103) -0.5177 (-1.4273)
∆lnDSpindexcht-5 0.0371 (0.1797) -0.1547 (-0.5488)
∆lnDSpindexcht-6 0.2007 (1.4544) 0.0083 (0.0497)
∆lnGDPcht-1 -51.9631 (-1.4127) 10.0768 (0.2512)
∆lnGDPcht-2 23.5816 (0.6863) 4.6175 (0.1212)
∆lnGDPcht-3 -26.0032 (-0.8145) -22.1425 (-0.5830)
∆lnGDPcht-4 62.2149* (1.9309) 48.3656 (1.2300)
∆lnGDPcht-5 -45.9235 (-1.4437) -31.2059 (-0.8043)
∆lnGDPcht-6 5.8467 (0.1851) -8.3725 (-0.2189)
∆DIntrcht-1 1.9376*** (2.5823)
∆DIntrcht-2 1.1471* (1.7018)
∆DIntrcht-3 1.9401*** (3.1018)
∆DIntrcht-4 1.7801*** (3.1293)
∆DIntrcht-5 1.1195** (2.082)
∆DIntrcht-6 0.4210 (1.0948)
C 0.0057 (0.6334) 0.0093 (0.8827)
Diagnostics Test Result
R-squared 0.7448 0.6531
Adj. R-squared 0.6036 0.4610
S.E. equation 0.0764 0.0892
F-statistic 5.2739 3.4004
Log likelihood 121.2582 107.7348
Akaike AIC -2.0286 -1.7212
Schwarz SC -1.1277 -0.8204
Note: (*)(**)(***) represents level of significance at 10%, 5% and 1%.
Values in parenthesis denote t-values.

4.5 Outcome of Granger Causality

Granger causality enables us to identify leading, lagging and coincident

macroeconomic factors for the stock market performance. In analyzing Granger-
causality the profound affect of lag values of macroeconomic variables upon the
growth of the stock market return has been investigated while controlling for lag
values of the growth of the stock market return.
 Ahmed & Imam 32

Table-7: Tests for Granger causality between Stock Price Index

and Macroeconomic Variable
Direction of Causality F-Statistic Probability
LNDIIP ∼ LNDSPINDEXCH 0.5088 0.7998
LNDSPINDEXCH ∼ LNDIIP 1.2512 0.2901
LNM2 ∼ LNDSPINDEXCH 0.7185 0.6358
LNDSPINDEXCH ∼ LNM2 0.6951 0.6542
LNGDPCH ∼ LNDSPINDEXCH 0.7214 0.6336
LNDSPINDEXCH ∼ LNGDPCH 0.5033 0.8039
DINTRCH → LNDSPINDEXCH 2.0573 0.0681*
LNDSPINDEXCH ∼ DINTRCH 1.2429 0.2941
LNTB91RCH ∼ LNDSPINDEXCH 0.4859 0.8169
LNDSPINDEXCH ∼ LNTB91RCH 0.6691 0.6748
Note: * significant at 10% level. (∼) implies lack of any causal relationship. (→) shows the direction
causal relationship

The causal relationship between the stock price index and the macroeconomic
variables are reported in table-7. As seen from the Granger causality test it is
suggested that there exists no Granger causality between change of stock index and
industrial production, money supply, Change of GDP, change of T-bill rate. But
unidirectional causality is observed in case of change of interest rate and stock
market index is not a leading indicator for the economic variable of the change in
interest rate, which shows the evidence of informationally inefficient market.

5. Discussion of Findings

This paper analyzes long-term equilibrium relationships as well as short-run dynamic

adjustment of such relationships between a group of macroeconomic variables and
the stock price index. The macroeconomic variables are represented by the
industrial production index, broad money supply, interest rate, T-bill rate and GDP.

Three different multivariate models were used to identify the relationship among the
endogenous variables taking multicollinearity into account. Among them no
cointegration was found in the first model, which considers the relationship between
growth of stock market return with industrial production index, money supply and
GDP growth. So there exists no long run relationship between stock market and
these fundamental macroeconomic factors. When one additional variable – change
of interest rate is added with the previous model, existence of significant long run
relationship was observed with money supply, GDP growth and interest rate change.
So inclusion of one variable makes significant result for three variables. Though the
result provides the evidence of long run relationship between stock market and
macroeconomic factors but this may be partly attributable to the effect of interest rate
upon the three fundamental macroeconomic variables, especially money supply
change, which makes them significant on the growth of stock market return. Instead
of interest rate when T-bill rate is considered, the model provides the same result as
discussed earlier.
 Ahmed & Imam 33

From the Vector Error Correction model, which estimates the short run adjustment
for the long run relationship between stock market and macroeconomic factors, there
exists no strong argument in favor of the adjustments. That means no such type of
adjustments, which makes the stock market return converged to the long run
equilibrium, is absent. This observation corroborates the findings of a study by Imam
and Amin (2004) that volatility of DSE return series increases over time.

Granger causality test was used to analyze the causal relationship between stock
market and macroeconomic variables. Results from the test show the presence of a
unidirectional causality from interest rate change to the stock market return. Thus
stock prices do not immediately reflect changes of the macroeconomic factors and
also fail to anticipate future changes.

6. Conclusion and Policy Implications

The purpose of this study was to investigate whether real economic activities in
Bangladesh can explain stock market returns in long run horizon by using a
cointegration test and a Granger causality test and in short run dynamics from a
vector error correction model. Generally there exists no long run relationship
between stock market index and macroeconomic variables. But interest rate change
or T-bill growth rate may have some influence on the market return. The explanation
is straightforward. The stock market should react with these changes otherwise
investor is likely to switch from stock market to money market or other places where
opportunity cost for them is likely to be higher. Findings of no cointegration between
the growth of stock market return and fundamental macroeconomic factors may be
the outcome of a small and shallow emerging stock market because Dhaka Stock
Market is characterized by a thin market having small market capitalization, low level
of liquidity and depth [Imam (2000)].

One of the important characteristics of a well functioning equity market is its

informational efficiency in the sense that the prices of the securities traded in the
market fully reflect all available information. In an efficient market, macroeconomic
factors cannot have a systematically lagged effect on the stock market. The result of
Granger causality test provides the notion of informational inefficiency for the Dhaka
Stock Exchange (DSE), which cannot ensure the fair price, established for the stocks
being traded in DSE and deters the role of DSE in allocating resources efficiently.
The implication of the finding suggests that a rational investor can earn above
average abnormal return constantly in Dhaka Stock Market.
 Ahmed & Imam 34

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