Qual Quant

DOI 10.1007/s11135-012-9774-4

Foreign capital inflows, economic growth and stock

market capitalization in Asian countries: an ARDL
bound testing approach

Syed Ali Raza · Syed Tehseen Jawaid

© Springer Science+Business Media B.V. 2012

Abstract This study investigates the effects of foreign capital inflows and economic growth
on stock market capitalization in 18 Asian countries by using the panel data from the period
of 2000–2010. The ARDL bound testing cointegration approach confirms the valid long run
relationship between the considered variables. Results indicate that foreign direct investment
has significant negative and economic growth has significant positive relationship with the
stock market capitalization, whereas, the results of workers’ remittances is found insignifi-
cant in long run. The error correction model confirms the significant positive relationship of
economic growth and workers’ remittances while, FDI has negative and significant impact
on stock market capitalization in short run. Results of causality test based on Toda and
Yamamoto (J Econom 66: 225–250, 1995) show the bidirectional causal relationship of for-
eign direct investment and economic growth with stock market capitalization. However, no
causal relationship is found in between workers’ remittances and stock market capitaliza-
tion. It is suggested that investor should not idealize the inflow of workers’ remittances to
invest in Asian stock markets in long run. Simultaneously, size of the economy is a better
leading indicator for Asian stock markets. On the other hand, inflows of FDI may mislead
the investor to invest. Investor should keep on eye whether FDI come in the competition of
domestic market or not? If this happens so investor should not invest in the stock market of
host country.

Keywords Remittances · Foreign direct investment · Economic growth ·

Market capitalization

S. A. Raza (B) · S. T. Jawaid

IQRA University, Karachi 75300, Pakistan
e-mail: [email protected]
S. T. Jawaid
e-mail: [email protected]

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 S. A. Raza, S. T. Jawaid

1 Introduction

In recent years, strong financial systems recognized as a main determinant of economic sta-
bility and growth. Stock market is an integral part of the financial system of the economy.
It plays an important part to lead the economic growth, saving and investment in the coun-
try. Empirical results show the significant positive impact of stock market development on
economic growth of specific economies.1 Modigliani (1971) argues that an increase in the
stock prices leads to increase in the individual wealth holdings simultaneously which leads
to higher consumption or savings. The continuous development and stability of stock market
is very essential for economic growth and cannot be ignored in any economy.
Prediction of stock market performance through macroeconomic variables is a serious
concern of both academicians and professionals. Some scholars have used single risk factor
to predict the stock returns.2 Many scholars have used the different macroeconomic vari-
ables to explain the stock returns [Aggarwal (1981); Soenen and Hennigar (1988); Chatrath
et al. (1997); Farooq and Keung (2004); Aquino (2004); Ratanapakorn and Sharma (2007)].
The main focus of the macroeconomic approach is to examine the sensitiveness of stock
prices to changes in economic variables. Economic growth plays an important part in the
development of stock markets in developing or developed countries. Rapid or sustainable
economic growth builds the confidence of investment in domestic or international investors.
Duca (2007) argues that the countries doing well in terms of economic growth, having better
domestic stock market performance.
Foreign direct investment and workers’ remittances are proved to be an important source of
capital inflow in developing countries In most of the developing countries, FDI contributing
by fulfilling the gaps of technology, capital formation, human capital formation, managerial
skills and provide more competitive environment for domestic producers.3 On the other hand,
it is also found that the more focus and dependence on FDI may discourage the domestic
industry. Entrance of foreign companies in the imperfect competitive markets may leads
to reduce market share of domestic producers. Capabilities of economies of scale also suf-
fer in domestic producers because of lost of market share, which has a negative impact on
productivity.4
Workers’ remittances play an important role to increase the disposable income. Workers’
remittances have become an increasingly important source of income for the economic growth
of countries. For last two decades, the workers’ remittances have grown rapidly in positive
direction. In last 5 years, foreign direct investment have fall sharply due to economic reces-
sion in many developing countries whereas, workers’ remittances are continuously increas-
ing. Even in some developing countries the workers’ remittances are more than their foreign
direct investment.
Stock market plays a role of mediator between savers and borrowers. Stock market col-
lects the savings from the large pool of small savers and channelizes these funds into fruitful

1 Fama (1981), Levine and Zervos (1996), Beck and Levine (2002), Antonios (2010), Petros (2012),
Modigliani (1971).
2 Lau et al. (1974), Jagganath and Wang (1993), Dowen (1988), Raza et al. (2011).
3 Feder (1982), Helpman and Kruman (1985), Lucas (1988), Edwards (1992), Kueh (1992), Chen et al. (1995),
Akbar and Naqvi (2000).
4 Adams (2009).

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An ARDL bound testing approach

investments.5 Workers’ remittances play an important part in the development of stock mar-
ket of developing economies. Workers’ remittances provide external source of income and
play a part to increase in the minimum wages level in developing countries, which leads to
increase in private savings. Increase in private saving may leads to more investment in stock
market by small investors.
The main objective of this study is to examine the relationship between foreign capital
inflows, economic growth and stock market capitalization by using 10 years annual data of 18
Asian countries from 2000 to 2010 and applying more rigorous technique. The rest of paper
is organized as follow: Sect. 2 reviews the empirical literature on the relationship of foreign
capital inflows, economic growth and stock market capitalization. Section 3 discusses the
modeling framework; Sect. 4 shows estimations and results, Sect. 5 analyze the causal rela-
tionship between considered variables and the final section conclude the study and provide
some policy implications.

2 Literature review

In this section, some selected literature has been reviewed on the relationship between foreign
capital inflows, economic growth and stock market capitalization.
Duca (2007) investigates the causal relationship between stock market capitalization and
economic growth in top 5 stock markets of the world in terms of stock market capitalization
namely, United States, Japan, United Kingdom, France and Germany. Granger causality test
results indicate the unidirectional causality exist run from stock market capitalization to eco-
nomic growth in all countries except Germany, while, no causal relationship has been found
in Germany. It is suggested that researchers can used stock market capitalization to better
predict the economic growth.
Shahbaz et al. (2007) investigate the relationship between workers’ remittances and finan-
cial sector development in Pakistan by using the annual time series data from the period of
1971–2001. Auto regressive distributed lag (ARDL) and Johansen cointegration techniques
have been used. Results indicate the positive and significant impact of workers’ remittances
on financial sector development in long run.
Billmeier and Massa (2007) investigate the impact of workers’ remittances on stock mar-
ket capitalization of 17 Middle East and Central Asian countries. Regression results suggest
the positive and significant effects of workers’ remittances on stock market capitalization.
They conclude that the stock market capitalization is mainly driven by the oil price in Asian
markets.
Adam and Tweneboah (2009) investigate the relationship between foreign direct invest-
ment and stock market capitalization in Ghana by using the quarterly time series data from
the first quarter of 1991 to fourth quarter of 2006. Cointegration, and Variance Decomposi-
tion method have been used. Results indicate the positive relationship between foreign direct
investment and stock market development. Results suggest the unidirectional causality exist
runs from foreign direct investment to market capitalization.
Kaleem and Shahbaz (2009) empirically identify the relationship between foreign direct
investment and stock market capitalization in Pakistan by using the annual time series data
from the period of 1971–2006. ARDL bound testing approach and error correction method
have been used for long run and short run estimations respectively. Results indicate the
positive and significant impact of foreign direct investment on stock market capitalization

5 Sohail and Hussain (2009).

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 S. A. Raza, S. T. Jawaid

in long run as well as in short run. Daferighe and Aje (2009) investigate the relationship
between stock market performance and gross domestic product in Nigeria by using data from
the period of 1997–2006. Regression results indicate the positive and significant impact of
gross domestic product on stock market performance.
Sohail and Hussain (2009) investigate the impact of macroeconomic variables on stock
returns in both long and short run by employing monthly data of Lahore stock exchange
(Pakistan) from December 2002 to June 2008. Johansen and Juselius cointegration and vector
error correction models (VECM) have been used. Results indicate the negative relationship
between consumer price index and stock returns, while, positive impact of real effective
exchange rate, industrial production index and money supply on stock returns are found in
long run. Results of VECM indicate that the error term were significant and also having
negative sign. The coefficient of error correction term showed high speed of adjustment.
Kuwornu and Nantwi (2011) investigate the impact of macroeconomic variables on stock
market returns in Ghana by using the monthly data from the period of January 1992–Decem-
ber 2008. Full information maximum likelihood estimations procedure has been used. Results
indicate the positive and significant impact of consumer price index on stock returns, while,
stock market returns is having negative and significant relationship with exchange rate and
interest rate. Results also indicate the insignificant relationship between oil prices and stock
returns.
Adaramola (2011) investigates the relationship between macroeconomic variables and
stock prices in Nigeria by using the quarterly data from the first quarter of 1985 to fourth
quarter of 2009. Results indicate the significant positive impact of exchange rate, oil prices
and gross domestic production on stock prices, while, negative and significant relationship
is found between interest rate and stock prices. The results of money supply and inflation are
found insignificant.
Oke et al. (2011) investigate the relationship between workers’ remittances and financial
development in Nigeria by using the annual data from the period of 1977–2009. Generalized
method of moments has been used. Results indicate the positive and significant impact of
workers’ remittances on financial development. They recommend that workers’ remittances
should be encouraged through proper formulation and implications of favorable policies.
Motelle (2011) investigate the relationship between workers’ remittances and financial sec-
tor development in Lesotho. Johansen–Juselius cointegration results indicate the positive
and significant impact of workers’ remittances on financial sector development. Granger
causality test confirms the unidirectional causality runs from financial development to remit-
tances.
Sahu and Dhiman (2011) investigate the causal relationship between stock market devel-
opment and economic growth in India by using the time series data from the period of
1980–2006. Results of Granger causality test indicate the no causal relationship between
Bombay stock exchange and economic growth. They conclude that development in Bombay
stock exchange cannot be called as an indicator of economic growth of India. Hsing (2011)
investigate the relationship between market capitalization and economic growth in Hungry
by using the quarterly time series data from the period of 2000 Q1–2010 Q2. Regression
results indicate the positive and significant impact of gross domestic production on stock
market performance.
Yahyazadehfar and Babie (2012) empirically identify the relationship between macroeco-
nomic variables and stock prices in Iran by using the monthly data from the period of March
2001–April 2011. Johansen–Juselius cointegration techniques have been used. Results indi-
cate the positive impact of house prices on stock price while negative impact is found of
nominal interest rate and gold prices with stock prices.

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An ARDL bound testing approach

3 Empirical framework

In this study, 10 years annual panel data of 18 Asian countries6 have been used from 2000 to
2010. All data are acquired from official websites of World Bank and stock markets of Asian
countries. All variables are in logarithm form.

3.1 Panel unit root test

Im, Pesaran and Shin, and Levin, Lin and Chu panel unit root test have been used to analyze
the stationary properties of variables. Common unit root process is the assumption of Levin,
Lin and Chu test. The Levin, Lin and Chu test considers the following fundamental ADF
specifications:

pi
yit = αyi,t−1 + βi,j yi,t _1 + Xit δ + it
j=1

where yit is the corresponding panel data series in differenced term, α = q−1, q is the lag
order for yit that may fall and rise for cross section and X it is the exogenous variable in
the model. Individual unit root procedure is allowed in Im, Pesaran, and Shin panel unit root
test. This unit root test combines the individual unit root test to derive a panel specific result.

3.2 ARDL bound testing approach

The ARDL method of cointegration developed by Pesaran and Pesaran (1997), Pesaran and
Shin (1999), Pesaran et al. (2000, 2001) has been used with the help of unrestricted vec-
tor error correction model to investigate the long run relationship between foreign capital
inflows, economic growth and stock market capitalization. The ARDL approach has several
advantages upon other cointegraion methods. ARDL approach may applies irrespective of
the of whether underlying variables are purely I (0), I (1) or mutually co-integrated.7 ARDL
approach has estimated better small sample properties.8 In ARDL procedure the estimations
of results is even possible if the explanatory variable are endogenous.9 The ARDL model is
developed for estimations as follow:

p

p

p
MKCit = ψ0 + ψ1 MKCi,t−i + ψ2 FDIi,t−i + ψ3 REMi,t−i
i=1 i=1 i=1

p
+ψ4 GDPi,t−i + γ1 MKCit−1 + γ2 FDIit−1 + γ3 REMit−1
i=1
+γ4 GDPit − 1 + μit
where ψ0 is constant and μit is white noise error term, the error correction dynamics is
denoted by summation sign while the second part of the equation corresponds to long run
relationship. Schwarz Bayesian Criteria (SBC) has been used to identify the optimum lag
of model and each series. In ARDL model we first estimate the F-statistics value by using

6 These countries are Bangladesh, India, Nepal, Pakistan, Sri Lanka, Iran, Israel, Oman, Kazakhstan, Russian
Federation, China, Hong Kong, Indonesia, Japan, Korea Republic, Malaysia, Philippine and Thailand.
7 Pesaran and Shin (1999).
8 Haug (2002).
9 Pesaran and Shin (1999) and Pesaran et al. (2001).

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 S. A. Raza, S. T. Jawaid

the appropriate ARDL models. Secondly, the Wald (F-statistics) test is used to investigate
the long run relationship among the series. The null hypothesis of the cointegration is that
(H0 = γ1 = γ2 = γ3 = γ4 = 0). The null hypothesis of no cointegration is rejected if the
calculated F-test statistics exceeds the upper critical bound value. The results are said to be
inconclusive if the F-test statistics falls between the upper and lower critical bound. Lastly,
the null hypothesis of no cointegration is accepted if the F-statistics is below the lower crit-
ical bound. If long run relationship between foreign capital inflows, economic growth and
stock market capitalization is found then we estimate the long run coefficients. The following
model will be use to estimate the long run coefficients:

p

p

p

p
MKCit =ζ0 + ζ1 MKCi,t−i + ζ2 FDIi,t−i + ζ3 REMi,t−i + ζ4 GDPi,t−i +μit
i=1 i=1 i=1 i=1

If we find evidence of long run relationship between foreign capital inflows, economic growth
and stock market capitalization then we estimate the short run coefficients by employing the
following model:

p

p

p
MKCit = ϕ0 + ϕ1 MKCi,t−i + ϕ2 FDIi,t−i + ϕ3 GDPi,t−i
i=1 i=1 i=1

p
+ϕ4 REMi,t−i + nECit + μt
i=1

The error correction model shows the speed of adjustment needed to restore the long run
equilibrium following a short run shock. The n is the coefficient of error correction term in
the model that indicates the speed of adjustment.

4 Estimations and results

To check the stationary properties we use Levin, Lin and Chu, and Im, Pesaran and Shin unit
root tests. Table 1 represents the results of stationary tests. First, these tests are applied on
level of variables then on their first difference.
Results of Table 1 show that all variables are stationary and integrated at first difference.
This implies that the series of variables may exhibit a valid long run relationship.

Table 1 Stationary test results

Variables Im, Pesaran and Shin Levin, Lin and Chu

I(0) I(1) I(0) I(1)

C C&T C C&T C C&T C C&T

MKC 1.071 −0.108 −2.586* −2.044** −0.787 −0.253 −1.644** −2.218**

FDI 0.975 0.193 −2.297** −1.547*** −0.020 1.090 −7.660* −5.408*
GDP 1.374 −0.885 −4.178* −3.298* 0.384 1.320 −7.929* −8.844*
REM 0.340 0.991 −3.394* −2.317** 0.541 1.214 −9.839* −10.063*
*, **, *** Indicates significance level respectively at 1, 5 and 10 %.
Source Authors’ estimation

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An ARDL bound testing approach

Table 2 Lag length selection and

Lags order AIC HQ SBC F-test statistics
bound testing for cointegration
0 33.556 33.601 33.666 4.686*
1 9.433 9.746 10.204* 2.453*
2 9.057∗ 9.639∗ 10.491 1.273
* 5 % level of significant

Table 3 Lags defined through

Lag 0 1 2 Selected lags
VAR of variables
SBC SBC SBC SBC

MKC 17.374 15.519∗ 15.543 1

GDP 16.943 10.376∗ 10.421 1
FDI 9.495 7.758 7.612∗ 2
REM 7.469 3.731∗ 3.799 1
* Indicate minimum SBC values

Autoregressive distributed lag method for cointegration is used to estimate the long run
relationship between foreign capital inflows, economic growth and stock market capitaliza-
tion. The first step is to determine the optimal lag length of the variables. The order of optimal
lag length is decided by using the SBC. Table 2 shows the results of ARDL cointegration
method.
The ARDL results suggest the rejection of null hypothesis of no cointegration in model
because the value of the F-statistics is greater than upper bound critical value at 5 % level
of significance in favor of alternative hypothesis that the valid long run relationship is exist
between foreign capital inflows, economic growth and stock market capitalization.
Now we estimate the lag length order of the all variables through unrestricted vector auto
regression method. The decision criterion is based on minimum value of SBC.
Table 3 represents the results of lag length order of all variables. Results of SBC indicate
that the foreign direct investment should be include in model at 2nd lag while all other three
variables should be include in model at 1st lag. After having the valid evidence of long run
relationship between foreign capital inflows, economic growth and stock market capitaliza-
tion now we applied the ARDL method to estimate the long run and short run coefficients.
The model for long run coefficients as follow:

p

p

p

p
MKCit = ζ0 + ζ1 MKCi,t−1 + ζ2 FDIi,t + ζ3 FDIi,t−1 + ζ4 FDIi,t−2
i=1 i=1 i=1 i=1

p

p

p

p
+ζ5 REMi,t +ζ6 REMi,t−1 + ζ7 GDPi,t + ζ8 GDPi,t−1 + μit
i=1 i=1 i=1 i=1

Table 4 shows the results of long run ARDL estimations. Results indicate the negative and
significant impact of foreign direct investment on stock market capitalization. The coefficient
of FDI indicates that in long run 1 % increase in FDI causes the decrease in the stock market
capitalization by 0.30 %. When FDI come to the host country in the competition of domestic
producers, so market share of domestic producers decreases which leads to decrease their
productivity and performance which results in decrease in their stock prices. The economic
growth is positive and significantly associated with stock market capitalization. The one
percent increases in economic growth increases the stock market capitalization by 0.57 %.

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 S. A. Raza, S. T. Jawaid

Table 4 Long run results using

Variables Coeff. t-stats Prob.
ARDL approach
C −0.661 −1.411 0.160
MKC (-1) 0.625 10.601 0.000
FDI −0.303 −2.996 0.003
FDI (-1) 0.567 2.406 0.017
FDI (-2) 0.779 1.989 0.048
GDP 0.569 4.829 0.000
GDP (-1) −0.244 −4.374 0.000
REM 0.154 0.330 0.742
REM (-1) −0.555 −0.224 0.823
Adj. R2 0.911
F-stats (prob.) 191.431 (0.000)
Source Authors’ estimations

The results of workers’ remittances show positive but an insignificant impact on stock mar-
ket capitalization that’s mean workers’ remittances is completely ineffective to effect market
capitalization in long run.
Following model is used to check the short run relationship among the considered variables
with the different lag length.


p

p

p
MKCit = ϕ0 + ϕ1 MKCi,t−i + ϕ2 FDIi,t +ϕ3 FDIi,t−1
i=1 i=1 i=1

p

p

p

p
+ϕ4 FDIi,t−2 +ϕ5 REMi,t + ϕ6 REMi,t−1 + ϕ7 GDPi,t
i=1 i=1 i=1 i=1
p
+ϕ8 GDPi,t−1 + nECit + μt
i=1

Table 5 represents the short run relationship between foreign capital inflows, economic
growth and market capitalization. Results indicate the lagged error correction term for the
estimated market capitalization equation is both negative and statistically significant. This
confirms a valid cointegration between foreign capital inflows, economic growth and market
capitalization. The coefficient of error term is −0.599 suggest that about 60 % of disequilib-
rium is corrected in the current year. Results indicate the positive and significant impact of
workers’ remittances and economic growth on stock market capitalization while significant
negative relationship is exist between foreign direct investment and stock market capitaliza-
tion.

5 Causality analysis

The direction of causality between dependent and independent variables is analyzed by using
the causality test based on Toda and Yamamoto (1995) procedure. This test use a modified
Wald test which can be applies irrespective of the of whether underlying variables are purely
I (0), I (1) or mutually co-integrated. Toda and Yamamoto (1995) augmented Granger cau-

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An ARDL bound testing approach

Table 5 Short run results using

Variables Panel
ARDL approach
Coeff. t -stats Prob.

C −0.829 −0.205 0.838

D (MKC (-1)) −0.023 −0.132 0.895
D (FDI) −0.237 1.969 0.049
D (FDI (-1)) 0.617 1.583 0.116
D (FDI (-2)) 0.208 5.855 0.000
D (GDP) 0.257 5.276 0.000
D (GDP (-1)) 0.263 1.006 0.316
D (REM) 0.896 3.354 0.001
D (REM (-1)) −0.572 −0.376 0.707
ECM (-1) −0.599 −3.300 0.001
Adj. R2 0.848

Source Authors’ estimation F-stats (prob.) 27.675 (0.000)

Table 6 Causality test results

Dependent Variable Modified Wald-Statistics

MKC FDI GDP REM

MKC _ 25.482 41.062 0.066

(0.000) (0.000) (0.935)
FDI 20.520 _ 7.755 0.044
(0.000) (0.028) (0.956)
GDP 25.612 20.943 _ 0.107
Note The lag length for SP is 3,
FDI is 3, GDP is 2 and REM is 1 (0.000) (0.000) (0.898)
as per Schwartz-Bayesian REM 0.029 0.019 0.148 _
Criteria (SBC) (0.998) (0.999) (0.930)
Source Author’s estimations

sality test uses the seemingly unrelated regression (SUR) technique through estimating a
two equation system. The Wald test improves efficiency when SUR models are used in the
estimation. So, the model can be specified as follows:

k+d 
k+d
Yt = α1 + γ1i Yt−i + γ2i X t−i + ε yt
i=1 t−i


k+d 
k+d
X t = α2 + δ1i Yt−i + δ2i X t−i + εxt
i=1 t−i

where k is the optimal lag order, d is the maximum order of integration of the series in the
system, and ε yt and εxt are error terms that are assumed to be white noise. Usual Wald tests
are then applied to the first k coefficient matrices using the standard χ 2 -statistics. The main
hypothesis can be drawn as follows:
(a) X t “Granger causes” Yt if Y2i  = 0
(b) Yt “Granger causes” X t if δ2i  = 0

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 S. A. Raza, S. T. Jawaid

The results of Toda and Yamamoto (1995) based causality test are reported in Table 6.
Results indicate the bidirectional causality between foreign direct investment and economic
growth with stock market capitalization. However, no causal relationship is found in between
workers’ remittances and stock market capitalization.

6 Conclusion and recommendations

This study investigates the impact of foreign capital inflows and economic growth on stock
market capitalization in 18 Asian countries by using the panel data from the period of 2000–
2010. The ARDL bound testing cointegration approach confirms the valid long run rela-
tionship between considered variables. Results indicate that foreign direct investment has
significant negative and economic growth has significant positive relationship with the stock
market capitalization, whereas, the results of workers’ remittances is found insignificant in
long run. The error correction model confirms the significant positive relationship of eco-
nomic growth and workers’ remittances while, FDI has negative and significant impact on
stock market capitalization in short run. Results of causality test based on Toda and Yamamoto
(1995) show the bidirectional causal relationship of foreign direct investment and economic
growth with stock market capitalization. However, no causal relationship is found in between
workers’ remittances and stock market capitalization. It is suggested that investor should not
idealize the inflow of workers’ remittances to invest in Asian stock markets in long run.
Simultaneously, size of the economy is a better leading indicator for Asian stock markets.
On the other hand, inflows of FDI may mislead the investor to invest. Investor should keep
on eye whether FDI come in the competition of domestic market or not? If this happens so
investor should not invest in the stock market of host country.

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