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Dynamic analysis of the relationship between stock prices and

macroeconomic variables: An empirical study of Pakistan stock exchange

Article · September 2019

DOI: 10.1108/SAJBS-06-2018-0062

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Stock prices
Dynamic analysis of the and
relationship between stock prices macroeconomic
variables
and macroeconomic variables
An empirical study of Pakistan stock exchange
Bisharat Hussain Chang Received 1 June 2018
Revised 15 September 2018
Department of Management Sciences, SZABIST Larkana, Larkana, Pakistan 19 January 2019
10 May 2019
Muhammad Saeed Meo Accepted 17 May 2019
Department of Management Sciences,
The Superior College Lahore, Lahore, Pakistan, and
Qasim Raza Syed and Zahida Abro
Department of Management Sciences, SZABIST Larkana, Larkana, Pakistan

Abstract
Purpose – The purpose of this paper is of twofold: first, to empirically examine the short-run and long-run
impact of macroeconomic variables such as industrial production, foreign direct investment (FDI), trade
balance (TB), exchange rate, interest rate (IR) and consumer price index (CPI) on stock prices (SP) of KSE-100
index; and second, to examine whether this relationship changes as a result of the financial crisis.
Design/methodology/approach – This study uses an autoregressive distributed lag model by using the full
sample period data from 1997Q3 to 2018Q2 and the post-crisis period data from 2008Q3 to 2018Q2. Moreover, it
uses variance decomposition analysis to examine the importance of each variable in explaining SP.
Findings – The findings of the full sample period indicate that in the long run, TB, exchange rate and IR
negatively affect SP whereas CPI and industrial production positively affect SP. However, the post-crisis
period data indicate that only CPI positively affects the SP in the long run. Finally, variance decomposition
analysis indicates 30 percent variance in SP is explained by its own shock.
Practical implications – The study findings suggest that macroeconomic variables have a significant role
and can be considered important for taking investment and/or policy decisions. Especially, Governments and
other regulators may need to take measures to increase the TB since it can help to increase the performance of
the Pakistani stock market. Furthermore, investors may consider that findings change when the financial
crisis has been taken into consideration.
Originality/value – This study uses two additional variables, namely FDI and TB by using the robust
technique in the context of emerging countries like Pakistan. Furthermore, it takes into account the impact of
the financial crisis on the underlying variables.
Keywords Stock prices, Financial crisis, ARDL model, Macroeconomic variables
Paper type Research paper

1. Introduction
Arbitrage pricing theory (APT) proposed by Ross (1976) suggests that there are multiple
factors, including macroeconomic variables, which affect stock prices (SP). Fama (1981, 1990)
test the APT model and find the significant relationship between SP and macroeconomic
variables such as risk premium, yield curve, interest rate (IR), inflation and industrial
production. In addition, the present value model (PVM) or a discounted cash flow model also
links macroeconomic variables with SP. PVM relates to SP with future expected cash flows
and a discount rate of future expected cash flows. Hence, all those macroeconomic variables
that affect future cash flows or discount rate affect the SP as well.
There are a number of studies that consider the relationship between macroeconomic
variables and SP (Ajaz et al., 2017; Fernandez-Perez et al., 2014; Humpe and Macmillan, 2009; South Asian Journal of Business
Studies
Hussain, 2011; Kuosmanen et al., 2015; Maio and Philip, 2015; Rahman et al., 2009; Yang et al., © Emerald Publishing Limited
2398-628X
2014). These studies, however, revolved around developed economies, and the finding revealed DOI 10.1108/SAJBS-06-2018-0062
SAJBS that macroeconomic variables significantly affect the SP. Conversely, there is a dearth in
available literature in relation to the context of developing economies to examine the relationship
between SP and macroeconomic indicators. Chang, Ahmed, Ghumro and Rehman (2018), and
Yusof and Majid (2007), however, stated that emerging markets features are different from those
of developed markets. As the economic and political structures of developing economies are
different from those of developed economies, furthermore, risk and return profiles also vary.
Different studies conclude that risk and returns are usually higher in developing economies
(Harvey, 1995). Therefore, there is a need to focus on developing economy, like Pakistan, as the
characteristics of developing economies are different from those of developed economies.
In addition, another limitation of the existing studies is that they provide mixed evidence.
Some of the above studies confirm a positive relationship between SP and macro variables,
e.g., inflation, IR and exchange rate, whereas other studies show the negative relationship
between these variables. For example, Ibrahim and Aziz (2003) find the positive effect of
inflation on SP, whereas Mukherjee and Naka (1995), including others, find the negative
effect of inflation on SP. In the case of IR, Mukherjee and Naka (1995), including others find
the positive relationship, whereas Fernandez-Perez et al. (2014) and Maysami and Koh (2000)
find the negative relationship. Due to these conflicting results, it can be difficult for investors
and policymakers to make the right decisions.
Thus, this study aims to examine the short-run and long-run equilibrium relationship
between macroeconomic variables, i.e., foreign direct investment (FDI), trade balance (TB),
consumer price index (CPI), IR, exchange rate (REER), industrial production index (IPI) and the
SP of KSE-100 index. The major reason for taking FDI as a major determinant of SP is that
Pakistan is one of the consumption-oriented economies[1]. The FDI helps in boosting technology,
education, skilled labor and knowledge which ultimately leads to the efficient industry. In spite
of the huge importance of FDI, Pakistan faced a 55 percent decrease in FDI[2] in October 2018.
Therefore, it is dire need to examine either FDI enhances the stock market performance of
Pakistan or not. The TB is also one of the major factors of stock market performance specifically
in the context of Pakistan because Pakistan is being ranked at eighth[3] number in 2017 in the
trade deficit. If a country imports more than exports for a long time period, investors do not
invest in such countries which ultimately affect stock market performance. Keeping in view the
significant role of FDI and TB in the context of Pakistan, this study further examines the
additional contribution of the underlying variables to add value to the existing literature.
Since the South Asian stock markets are integrated with the international stock markets
(Kumar and Dhankar, 2017), the international financial crisis may affect developing
economies through finance and trade (Ali and Afzal, 2012). In addition due to the financial
crisis, net capital inflow from advanced economies dramatically reduced in developing
economies. Iqbal (2010) finds that as a result of the financial crisis, FDI, portfolio investment
and trade of developing economies highly reduced. This is evident in the context of Pakistan
from the reflection of the financial crisis of 2008 that pushed the economy backward. The
GDP growth of Pakistan was 5 percent in 2007 which was dropped to 0.40 percent in 2008
(PES, 2007–2008[4]). Furthermore, various research studies indicate that the world financial
crisis tends to change the direction of the relationship between the macroeconomic variables
and SP (Fratzscher, 2009; Melvin and Taylor, 2009). This study, therefore, has also taken
under consideration the effect of the global financial crisis on the relationship between
macroeconomic variables and SP.
In light of the above context, the study objectives are as follows:
(1) to examine the short-run dynamics and long-run equilibrium relationship between
macroeconomic variables and SP;
(2) to analyze the extent of each macroeconomic variables in explaining SP of KSE-100
index in the long run; and
 (3) to evaluate whether the global financial crises change the relationship between Stock prices
macroeconomic variables and SP. and
In brief, the present study contributes to the existing literature in various ways. First, in macroeconomic
order to substantiate the previous findings, this study focuses on the Pakistani stock market variables
due to its highly volatile nature (Sohail and Hussain, 2009). Second, the present study
incorporates two additional variables such as FDI and TB. The prime objective of including
these factors as major determinants of the stock market is that these factors play a vital role
in the stock market of Pakistan. In addition, very limited studies are available on these
variables. Third, this study contributes to the existing literature by taking into account the
impact of the global financial crisis on the relationship between macroeconomic variables
and SP. In order to fulfill the objectives of the study following research questions have been
addressed in this study:
RQ1. Is there any short-run dynamics and long-run equilibrium relationship between
macroeconomic variables and SP?
RQ2. Up to what extent each of the macroeconomic variables explains variation in SP of
KSE-100 index in the long run?
RQ3. Whether the global financial crisis changes the relationship between
macroeconomic variables and SP.
Figure 1 provides time series trends of macroeconomic variables and SP. These plots
indicate a negative relationship between SP and some of the macro variables such as IR and
TB, whereas a positive relationship exists between SP and macro variables, such as IPI and
CPI. Furthermore, the relationship of SP with the exchange rate and FDI is ambiguous. In
the pre-crisis period, a negative relationship has been found between exchange rate and SP,
whereas the relationship turns positive in the post-crisis period. On the contrary, a positive
relationship can be seen between FDI and SP before the crisis period; however, it becomes
negative after the crisis period. Furthermore, the gray area indicates abrupt changes during
the crisis period which further leads to examine the impact of the global financial crisis on
the relationship between macroeconomic variables and SP.
The remaining part of this paper is organized as follows. Section 2 discusses the
literature and development of hypothesis; Section 3 discusses the data and its sources;
Section 4 reviews the model specification and estimation techniques; Section 5 discusses the
results and Section 6 concludes the paper and gives directions for future research.

2. Literature review
There is a vast literature available that discusses the association between macroeconomic
variables and SP. The literature provides different theoretical frameworks such as APT
(Ross, 1976) and the efficient market hypothesis (Fama, 1970) to examine the relationship
between macroeconomic variables and SP. Following these theoretical frameworks,
various studies have been conducted to examine the effect of macroeconomic variables on
SP (see e.g. Rahman and Uddin, 2009; Yang et al., 2014; Kuosmanen et al., 2015; Peiró, 2016).
Following subsections discuss some of the major studies related to the variables used in
this study.

2.1 Interest rate and stock prices

The IR plays a vital role in the fluctuations of SP; most of the previous studies find the
negative relationship between these variables. However, a few studies indicate a positive
relationship between the two variables. As per Fisher’s effect (Fisher, 1930), expected
inflation and nominal IR should move together in the same direction. Therefore, the IR is
SAJBS Stock prices vs exchange rate
130
Stock prices vs interest rate
16

120 12
50,000

110 8
40,000
50,000
4
100
30,000 40,000
0
90 30,000
20,000
20,000
80
10,000
10,000

0 0
98 00 02 04 06 08 10 12 14 16 18 98 00 02 04 06 08 10 12 14 16 18

SP REER SP IR

Stock prices vs trade balance Stock prices vs foreign direct investment

10 0.8
0
–10 0.6

–20 0.4
–30
–40 0.2
50,000 –50 50,000
0.0
40,000 40,000
30,000 30,000
20,000 20,000
10,000 10,000
0 0
98 00 02 04 06 08 10 12 14 16 18 98 00 02 04 06 08 10 12 14 16 18

SP TB SP FDI

Stock prices vs industrial production index Stock prices vs consumer price index
160 200
140
160
50,000
50,000 120
120
100 40,000
40,000
80 80
30,000
30,000
60
40
20,000 20,000
40
0
10,000 10,000

Figure 1. 0 0
Plots for stock prices 98 00 02 04 06 08 10 12 14 16 18 98 00 02 04 06 08 10 12 14 16 18

and macroeconomic SP IPI SP CPI

variables
Note: The shaded areas include the financial crisis period

expected to be negatively related to SP through inflationary effect. Moreover, according to

Ratanapakorn and Sharma (2007), financing costs increase as a result of an increase in IR
which decreases corporate profitability and SP. Some of the recent empirical studies also
examine the relationship between the IR and SP (see e.g. Andrieș et al., 2014; Huang et al.,
2016; Peiró, 2016). These recent studies also indicate that IR and SP are linked with
each other:
H1. There is a significant impact of IR on stock market prices.

2.2 Inflation and stock prices

The relationship between inflation and SP is not consistent. For example, Mukherjee and
Naka (1995) and Fama (1981) find the negative relationship between these variables. This
negative relationship exists because an increase in inflation creates inflation uncertainty
and as a result investors demand more risk premium, which results in a decrease in SP
(Malkiel, 1979). The negative relationship could also be due to the fact that an increase in
inflation raises the cost of production, and lowers firms’ cash flows which result in a
decrease in SP. On the contrary, Nasseh and Strauss (2000) find the positive co-integration Stock prices
between SP and inflation in six European countries, e.g., Germany, the UK, Switzerland, The and
Netherlands, Italy and France. Ibrahim (2003) and Ibrahim and Aziz (2003) also find similar macroeconomic
results in the Malaysian equity market. There are some other empirical studies which
examine the relationship between inflation and SP (see e.g. Kaul, 1987; Rapach, 2002; variables
Bjørnland and Leitemo, 2009; Valcarcel, 2012; Bjørnland and Jacobsen, 2013). Knif et al.
(2008) find that inflation significantly affects stock returns (SR) but this effect depends upon
the economic state and perception of investors that either they take inflation as good news
or bad news. Recently, Delgado et al. (2018) also investigate the relationship between
inflation and SP and find that inflation negatively affects SP. Chang and Rajput (2018) find a
significant association between IPI and SP:
H2. There is a significant impact of inflation on stock market prices.

2.3 Industrial production index and stock prices

There are numerous studies, such as Abdullah and Hayworth (1993), Mukherjee and Naka
(1995), Fama (1990), including others, which find the positive relationship between SP and
IPI. The authors find a positive relationship between these variables since the level of output
affects the profitability of a firm which ultimately affects SP. In other words, the increase in
output enhances cash flows of firms which boosts SP. Humpe and Macmillan (2009) examine
the relationship between macroeconomic variables and SP and find the positive impact of
industrial production on SP. Singh (2010) conducts a study in the context of India and finds
a bidirectional causal relationship between industrial production and SP. Singh (2014) also
finds a significant association between SP and industrial production in the context of India.
Peiró (2016) examines the relationship in the context of France, Germany and the UK and
find that industrial production affects SP. Chang and Rajput (2018) find a significant
association between IPI and SP:
H3. There is a significant impact of IPI on stock market prices.

2.4 Exchange rate and stock prices

Including others, Mukherjee and Naka (1995) and Soenen and Hennigar (1988) indicate that
changes in exchange rates affect the performance of the stock market. Mukherjee and Naka
(1995) discuss that depreciation in currency can increase the performance of the domestic
stock market. When the local currency depreciates, domestic products become more
competitive in the world market that results in a boom in export volume and further
increases firms’ cash flows, prices and SP of local companies. In addition, as a result of an
increase in the exchange rate, foreign portfolio investment increases as well, which boosts
the domestic economy. Rahman and Uddin (2009) conduct a study in the context of
Bangladesh, India and Pakistan by using Johansen’s (1991) co-integration and Granger’s
causality test by using monthly data from 2003 to 2008. Findings indicate that there is
neither a long-run relationship nor any causal relationship between exchange rate and SP.
Yang et al. (2014) conduct a study in the context of Japan, Korea, Indonesia, Malaysia, India,
Thailand, Philippine, Taiwan and Singapore. The authors use Granger causality test on the
daily data from 1997 to 2010 by using different quantiles. Findings indicate a feedback
relationship between exchange rate and SP. Recently, Ajaz et al. (2017), Roubaud and Arouri
(2018) and Delgado et al. (2018) also investigate the relationship between exchange and SP
and find the significant association between these variables. For example, Delgado et al.
(2018) indicate that exchange rate negatively and significantly affects the SP in the context
of Mexico which suggests that SP increase as a result of the appreciation of the currency.
Likewise, Roubaud and Arouri (2018) also investigate the relationship between these
SAJBS variables by using a vector autoregressive (VAR) and multivariate Markov switching
VAR models. Their findings indicate a nonlinear relationship between these variables.
Akbar et al. (2019) also found a significant relationship between exchange rate and SP:
H4. There is a significant impact of exchange rate on stock market prices.

2.5 Foreign direct investment and stock prices

There are a few studies available in the context of developing countries having a
relationship between FDI and SP. Malik and Amjad (2013) conduct the study in the context
of Pakistan and find that FDI has a positive impact on stock market prices. Inward FDI can
increase jobs, technology transfers and can boost overall economic growth. In addition, host
countries’ export capacity can also be increased as net FDI increases. Shahbaz et al. (2013)
also suggest that FDI is an important factor in the development of the Pakistani stock
market, while Usman and Siddiqui (2019) also find similar results that FDI positively
affects SP:
H5. There is a significant impact of FDI on stock market prices.

2.6 Trade balance and stock prices

There are also limited studies available that examine the relationship between TB and SP.
Abdullah and Hayworth (1993) find the negative relationship between the trade deficit and
SP. According to economic theory, the increase in TB increases corporate profits and that
results in SP increase. Recently, Gay (2016) investigate the effect of macroeconomic
variables on stock market indexes of emerging economies such as Brazil, Russia, India and
China. The findings of their study suggest the insignificant effect of macroeconomic
variables, such as oil price and exchange rate on stock market indexes. The study
recommends to include other international macroeconomic variables such as TB. Hence, this
study considered TB as one of the dimensions influencing SP:
H6. There is a significant impact of the TB on stock market prices.
Overall, the above literature generates mixed evidence. Moreover, there is a dearth in
literature in the context of emerging economies like Pakistan. Nevertheless, the current
study paid vivid attention in relation to the study context; as discussed by Yusof and
Majid (2007) risk and returns profiles of developing countries are different from those of
developed countries. Harvey (1995) indicates that risk and returns are higher in
developing economies. This study, therefore, extends previous studies in the context of
Pakistan for examining the impact of macroeconomic variables on SP by using robust
techniques such as the ARDL model which previous studies have failed to use in the
context of Pakistan.

3. Data sources and measurement

The present research considers KSE-100 index SP as a dependent variable and six
independent macroeconomic variables such as CPI, IR, IPI, real effective exchange rate
(REER), the TB, and FDI. In this study, we use quarterly data where the full sample period
covers the data from 1997Q3 to 2018Q2, whereas the post-crisis period data cover the period
from 2008Q2 to 2018Q2. Data for SP (KSE-100 index) are collected from the Pakistan stock
exchange (PSX) website, where SP are adjusted with stock splits and dividends. KSE-100
index is a capital weighted index, which includes 100 companies and represents 90 percent
market capitalization of PSX. Data for CPI and IPI are taken from international financial
statistics (IFS), an IMF database, where the base year is 2010. Following Adeel-Farooq et al.
(2017) and Belloumi (2014) we use FDI and measure it as net inflows of FDI as a percentage
of GDP and measure TB as a percentage of total trade. Data for a net inflow of FDI are taken Stock prices
from State Bank of Pakistan, whereas the data for GDP, exports and imports are taken from and
IFS. REER is the value of Pakistani currency against the basket of foreign currencies and is macroeconomic
measured in such a way that an increase in REER indicates the appreciation of
Pakistani rupee. Finally, three months T-bill is used to measure IR. Data for REER and IR variables
are also taken from IFS. In estimating the ARDL model, we have used the natural log of all
the variables.
Table I gives the descriptive statistics of all the variables under consideration. In the
descriptive statistics, SR are used which are calculated from the SP (SR ¼ 100×(SP−SP
(−1))/SP). Moreover, the normality of the series is being checked using the Jarque–Bera test,
where the null hypothesis is that the data are normally distributed. In this case, the null
hypothesis is rejected for SPR, REER, FDI and CPI, which indicates that these variables are
not normally distributed, whereas TB, IPI and IR are normally distributed.

4. Model specification and estimation techniques

Most of the previous studies consider the techniques of Johansen (1991) and of Engle and
Granger (1987) to investigate the co-integration between macroeconomic variables and SP.
However, these techniques require stationary data as a prerequisite before advance analysis
and all variables must have the same order of integration. Pesaran et al. (2001) propose
another model titled as ARDL bounds testing approach, which is in many ways better than
previous co-integration techniques. At first, this technique is generally considered than
Engle and Granger (1987) and Johansen (1991) when the sample size is small (Ghatak and
Siddiki, 2001), whereas the Johansen’s (1991) co-integration technique requires large sample
data. Second, this technique can be applied whether the variables are integrated of order I (0)
or I (1) (Chang et al., 2019; Anjum et al., 2017; Bhutto and Chang, 2019; Chang and Rajput,
2018; Chang, Rajput and Ghumro, 2018; Ghumro and Karim, 2017; Ghumro and Memon,
2015). On the contrary other techniques such as VECM and VAR require that all variables
should be integrated of the same order (Pesaran et al., 2001). Third, an ARDL model can also
help us to examine a sufficient number of lags in getting better results. Fourth, the ARDL
model can be helpful to derive the dynamic error correction model (ECM) (Banerjee et al.,
1993) where this ECM integrates the short-run relationship with the long-run equilibrium
relationship. Finally, this ARDL model is gaining more popularity in recent years
( Jayaraman and Choong, 2009). Keeping in view the various advantages, an ARDL bound
testing approach has been selected in this study.
Besides these advantages, an ARDL model has one limitation that none of the variables
should be integrated of order 2. It means that the variables should be stationary at either
level or at first difference. So before proceeding with ARDL, an ADF, KPSS and Zivot
Andrews Breakpoint test statistics have been used in order to find out the order of
integration of the variables. The null hypothesis under the ADF test is that data have a unit

SPR TB REER FDI CPI IPI IR

Mean 4.68 −23.13 103.78 0.13 87.14 93.16 8.35

Maximum 31.63 1.94 127.99 0.74 163.59 156.72 15.10
Minimum −40.97 −46.64 90.13 0.02 38.11 45.53 1.05
SD 12.67 12.93 9.86 0.14 43.05 25.89 3.13
Jarque–Bera 11.07* 3.80 10.98* 136.57* 9.37* 1.57 0.82
Probability 0.003 0.14 0.004 0.000 0.009 0.45 0.66
Notes: The null hypothesis for Jarque–Bera is that series is normally distributed. *indicates the rejection of Table I.
null hypothesis at 1 percent significance level Descriptive statistics
SAJBS root whereas the null hypothesis under KPSS test statistics states that data are stationary.
Once these statistics confirm that all variables are either integrated of order 0 or 1 then the
following ARDL model is estimated:
X
n1 X
n2 X
n3 X
n4
DLnSP t ¼ a0 þ bi DLnSP ti þ ci DLnTBti þ di DLnFDI ti þ ei DLnREERti
i¼1 i¼0 i¼0 i¼0

X
n5 X
n6 X
n7
þ f i DLnI PI ti þ g i DLnCPI ti þ hi DLnI Rti þa1 LnSP t1 þa2 LnTBt1
i¼0 i¼0 i¼0

þa3 LnFDI t1 þa4 LnREERt1 þ a5 LnI Rt1 þa6 LnI PI t1 þa7 LnCPI t1 þ et : (1)
The differenced variables with the summation signs show the error correction dynamics,
and variables with αs show the long-run relationship. Ln with each variable indicates that
all the variables are used in the natural logarithm. After estimating the lag length,
the long-run relationship is examined with the help of a test named ARDL bounds
test. In the above-given model, the null hypothesis for the bounds test is H0:
α1 ¼ α2 ¼ α3 ¼ α4 ¼ α5 ¼ α6 ¼ α7 ¼ 0, which indicates that there exists no
co-integration. Rejection of the null hypothesis, in this case, indicates that macroeconomic
variables are co-integrated with SP. Once the results confirm that there is co-integration, the
short-run analysis is conducted by the following ECM:
X
n1 X
n2 X
n3 X
n4
DLnSP t ¼ a0 þ bi DLnSP ti þ ci DLnTBti þ di DLnFDI ti þ ei DLnREERti
i¼1 i¼0 i¼0 i¼0

X
n5 X
n6 X
n7
þ f i DLnI PI ti þ g i DLnCPI ti þ hi DLnI Rti þZECM t1 þ et ; (2)
i¼0 i¼0 i¼0

where n1, n2, n3, n4, n5, n6 and n7 are the lag lengths which are selected by using the AIC
criteria. ECM indicates the speed of adjustment of short-run adjustments toward the long-
run equilibrium relationship.
Thereafter, variance decomposition analysis technique is used in order to examine the
variance in SP that is explained by its own shock and shocks in macroeconomic variables.
Finally, diagnostic test statistics have been applied in this study. Ramsey reset is applied for
model specification, LM test for serial correlation and adjusted R2 is used for examining the
goodness of the fit of the model. CUSUM and CUSUMQ test statistics have also been applied
for checking the stability of the models.

5. Results analysis and discussion

5.1 Unit root test
This study uses ADF and KPSS unit roots statistics to find out the stationarity of the data.
Table II provides the results at a level, whereas Table III provides the results when the data
are used at the first difference. These test statistics are used with intercept, with trend and
intercept and without trend and intercept. In all cases, the null hypothesis is not rejected
under ADF test statistics whereas it is rejected under KPSS test statistics when the data are
used at the level. It, therefore, indicates that all variables are not stationary at level. On the
contrary, the null hypothesis is rejected under ADF test statistics whereas it is not rejected
under KPSS test statistics when the data are used at the first difference. These test statistics
indicate that all the variables are integrated of order 1, I(1). In addition, the global financial
crisis (2008) caused structural breaks in the data. ADF and KPSS test statistics can provide
spurious results in case of structural breaks. Therefore following Lahiani (2018) we also
employ Zivot and Andrews (1992) unit root test which considers structural breaks to avoid Stock prices
misleading inference. The findings of Zivot and Andrews (1992) unit root test confirm that and
all the variables are integrated of order 0, I(0), which confirm the requirement of the ARDL macroeconomic
model that none of the variables should be integrated of order 2, I(2). This study, therefore,
proceeds further with the ARDL model (Table IV ). variables
In order to find out the long-run relationship of joint macroeconomic variables with SP, it
is necessary that F-statistic obtained through bounds test must exceed the upper bounds
critical value of Pesaran et al.’s (2001) table. It means co-integration must exist before
proceeding further steps. F-statistic values for ARDL bounds test are given in Table V for
the full sample and post-crisis periods. The calculated F-test values of the full sample and
post-crisis are greater than the upper bounds values, which strongly support the rejection of
the null hypothesis of no co-integration at 5 percent level of significance. Since the results of
Table V indicate that there is co-integration between macroeconomic variables and SP, so
both long-run and short-run results are estimated.

Variables ADF intercept ADF int. and trend ADF KPSS intercept KPSS trend and intercept

LnSP −0.56 −2.39 1.93 1.06* 0.12

InTB −0.54 −2.60 0.79 1.07* 0.09
LnREER −1.30 −2.29 −0.09 0.56 0.27*
LnFDI −2.52 −2.50 −0.75 0.20 0.19
LnCPI 0.11 −1.69 3.72 1.13* 0.17
LnIPI −1.15 −1.27 3.23 1.21* 0.25* Table II.
LnIR −2.15 −2.21 −0.87 0.15 0.12 ADF and KPSS tests
Note: *Significant at 1 percent critical level at the level

Variables ADF intercept ADF int. and trend ADF KPSS intercept KPSS trend and intercept

ΔLnSP −7.04* −6.99* −6.62* 0.08 0.08

ΔLnTB −13.00* −12.98* −12.91* 0.43 0.33*
ΔLnREER −7.35* −7.69* −7.41* 0.26 0.09
ΔLnFDI −15.37* −15.27* −15.46* 0.50 0.50*
ΔLnCPI −4.79* −4.79* −1.49 0.27 0.25*
ΔLnIPI −5.59* −5.64* −2.78* 0.16 0.06 Table III.
ΔLnIR −6.53* −6.49* −6.55* 0.06 0.07 ADF and KPSS tests
Note: *Significant at 1 percent critical level at first difference

Stationarity at level
Variables t-Statistic Prob. Break year

LnSP −4.32 0.001* 2008Q2

InTB −2.89 0.034* 2003Q4
LnREER −4.16 0.000* 2008Q2
LnFDI −4.16 0.011* 2008Q4
LnCPI −4.70 0.000* 2008Q2
LnIPI −3.84 0.003* 2008Q1 Table IV.
LnIR −3.61 0.001* 2003Q2 Zivot and Andrews
Note: *Refers to the rejection of the null hypothesis of a unit root at 5 percent level of significance (1992) unit root test
SAJBS Panel A in Table VI shows the results of a long-run and the short-run relationship among
proposed variables. The findings show that in the long-run TB, exchange rate and IR
negatively and significantly affect the SP. The coefficients of these variables indicate that a
1 percent increase in the TB, exchange rate and IR decrease the SP by 0.32, 5.05 and 0.41 percent,
respectively. The negative relationship between exchange rate and SP is also confirmed by
Aggarwal (2003) and Agrawal et al. (2010). The negative relationship between exchange rate and
SP is true for those countries which are import based since the decrease in currency leads to an
increase in the cost of production which ultimately reduces production and sale. The negative
effect of IR on SP could be due to the fact that an increase in IR increases the cost production,
lowers firms’ revenues and decrease SP. Following various previous studies, such as Mukherjee
and Naka (1995), Fama (1990), including others, a positive relationship is hypothesized between
industrial production and SP. The results of this study also indicate that the IPI positively affects
SP by 1.41 percent. Furthermore, CPI and SP have also a positive relationship with 1.36 percent
coefficient. There are various studies which confirmed the positive relationship between inflation
and SP in Asian stock markets. The positive relationship between inflation and the stock market
can be possible because the rise in inflation can raise equity of the firms if firms are a net debtor.
However, FDI does not affect SP significantly in the Pakistani context. Malik and Amjad (2013)
also found an insignificant relationship between FDI and SP. The major reason for FDI not
significantly affecting the stock market is that Pakistan faces many issues like political
uncertainty, governance, etc. However, in the short run exchange positively and significantly
affects SP, while inflation negatively and significantly affects SP. Moreover, the rest of the
variables do not affect SP in the short run.

Model F-test Lower bound Upper bound Conclusion

Full sample period

LnSP/(LnTB, LnREER, LnFDI, LnCPI, LnIPI, LnIR) 7.37* 2.431 3.518 Co-integration

Table V. Post-crisis period

Co-integration using LnSP/(LnTB, LnREER, LnFDI, LnCPI, LnIPI, LnIR) 6.52* 2.618 3.863 Co-integration
bounds testing Note: *refers to the rejection of the null hypothesis of absence of co-integration at 5 percent level
approach of significance

Panel A: long-run and short-run analysis

Long run Coefficient p-value Short run Coefficient p-value
LnTB −0.32 0.090* ΔLnREER 0.27 0.607
LnREER −5.05 0.009*** ΔLnREER(-1) 0.68 0.179
LnFDI 0.08 0.519 ΔLnREER(-2) 0.49 0.355
LnCPI 1.36 0.002*** ΔLnREER(-3) 1.01 0.069*
LnIPI 1.41 0.045** ΔLnCPI −1.87 0.091*
LnIR −0.41 0.007*** ΔLnCPI(−1) −1.35 0.253
C 21.49 0.04** ΔLnCPI(−2) −3.29 0.006***
ECT −0.54 0.000***
Panel B: diagnostics
RESET 1.77
LM 0.83
2
Adj. R 0.35
Table VI. Notes: Initially, a maximum of four lags are selected for the short-run coefficients. Then the AIC criterion is
ARDL estimation: full used to select the optimal model. Short-run coefficients for TB, FDI, IPI and IR have been dropped for
sample period selecting the optimal model. and *,**,*** indicate the significance at 10, 5 and 1 percent level, respectively
This study further estimates the error correction representations. The coefficient sign of error Stock prices
correction term is negative and significant at 1 percent significance level which further and
supports the earlier findings of this paper obtained through bounds test that overall macroeconomic
macroeconomic variables are co-integrated with SP. Further, the coefficient of the error
correction term indicates the speed of adjustment toward long-run equilibrium. This value is variables
almost 54 percent indicating that any disequilibrium in the previous quarter is almost
corrected by 54 percent in the following quarter or in simple words dependent variable will
return to its equilibrium with the speed of 54 percent in each quarter.
Next, the ARDL model is re-estimated by taking into consideration the impact of the
financial crisis. For this purpose, we use the post-crisis period data from 2008Q2 to 20182.
Findings, in Table VII, suggest that during the post-crisis period only inflation positively
and significantly affects the SP in the long run. The prime reason for this asymmetric
association among the underlying variables during pre- and post-crisis is that investors
change their portfolio considering economic recession (Kumar, 2018). Finally, this study
provides the diagnostic test statistics such as adjusted R2, Ramsey reset the test and serial
correlation LM test. Panel B of Tables VI and VII presents the results of these diagnostic
tests. These diagnostics, respectively, indicate that models enjoy a good fit, correctly
specified, and there is no problem of serial correlation. CUSUM and CUSUMQ plots, given in
Figure 2, also indicate that models are stable.
The co-integration in the above results indicates that the arbitrage opportunities are
available for investors and other stakeholders. It means, up to some extent, fluctuations in
SP can be predicted by using macroeconomic available information. Based on these results,
investors and policymakers are therefore advised to consider macroeconomic variables
before taking any suitable investment decisions.
Thereafter, this study applies variance decomposition analysis through VAR to account
for the proportion of the forecast error of each variable that is accounted for by each of the
other variables. Therefore, variance decomposition helps to examine how much each
variable is important in explaining variations in other variables. This study specifically
focuses on the importance of macro variables and past SP that help to explain the variation
in the SP. Table VIII indicates that almost 30 percent variance in SP is explained by its own
shock even after 24 quarters (six years). The findings of the study are not surprising since
previous studies also found that Pakistani SP have an obvious trend that can predict future
prices (Haque et al., 2011).

Panel A: long-run and short-run analysis

Long run Coefficient p-value Short run Coefficient p-value
LnTB 0.03 0.867 ΔLnREER −1.01 0.090
LnREER −2.77 0.421 ΔLnREER(-1) 1.11 0.037
LnFDI −0.12 0.613 ΔLnIPI −0.31 0.138
LnCPI 3.37 0.041** ΔLnIPI(-1) 0.80 0.002
LnIPI −7.85 0.382 ΔLnIR −0.08 0.652
LnIR −3.15 0.249 ECT −0.56 0.000***
C 50.44 0.345
Panel B: diagnostics
RESET 2.01
LM 0.11
2
Adj. R 0.62
Notes: Initially, a maximum of four lags are selected for the short-run coefficients. Then AIC criterion is used Table VII.
to select the optimal model. Short-run coefficients for TB, FDI, and CPI have been dropped for selecting the ARDL estimation:
optimal model. **,***indicate the significance at 5 and 1 percent level, respectively post-crisis period
SAJBS (a)
30 1.2

1.0
20

0.8
10
0.6
0
0.4
–10
0.2

–20 0.0

–30 –0.2
02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18

CUSUM 5% Significance CUSUM of Squares 5% Significance

(b)
15 1.4

1.2
10
1.0

5 0.8

0.6
0
0.4

–5 0.2

0.0
–10
–0.2

–15 –0.4
IV I II III IV I II III IV I II III IV I II III IV I II III IV I II IV I II III IV I II III IV I II III IV I II III IV I II III IV I II

Figure 2. 2012 2013 2014 2015 2016 2017 2018 2012 2013 2014 2015 2016 2017 2018

CUSUM and CUSUM 5% Significance CUSUM of Squares 5% Significance

CUSUMQ Graphs
Notes: (a) Full sample period; (b) post crisis period

6. Conclusion and policy implications

There are various studies that examine the relationship between macroeconomic variables
and SP. The literature provides different theoretical frameworks such as APT (Ross, 1976)
and the efficient market hypothesis (Fama, 1970) to examine the relationship between
macroeconomic variables and SP. Following the theoretical literature, various empirical
studies have also been conducted; however, this literature provides mixed evidence. Keeping
in view the limitations of the existing literature, this study aims to examine the short-run
and long-run impact of macroeconomic variables such as CPI, IR, exchange rate, industrial
production, TB and FDI on the KSE-100 index.
We contribute to the existing literature in various ways. First, we focus on the Pakistani
stock market due to its highly volatile nature (Sohail and Hussain, 2009). Second, the present
study incorporates two additional variables such as FDI and TB. Third, this
study contributes to the existing literature by taking into account the impact of the
global financial crisis.
The study concludes that overall macroeconomic variables are co-integrated with SP.
The findings of the study confirmed a negative and significant impact of the TB, exchange
rate and the IR on SP in the long run. However, CPI and IPI positively affect SP in the long
run. Furthermore, FDI does not affect SP in the long run. Interestingly, post-crisis period
data analysis exhibited that only CPI has a significant effect on SP.
The study results are significant for policymakers and Government of developing/
emerging countries to focus upon the macroeconomic indicators in relation to SP. Moreover,
this study is a strong referral for academic researchers who are interested to conduct similar
research in the highly volatile nature of capital markets. More specifically, Governments and
 Percentage of forecast error variance explained by innovation
Stock prices
VDC of quarter LnSP LnTB LnREER LnFDI LnCPI LnIPI LnIR and
macroeconomic
LnSP 1 100.00 0.00 0.00 0.00 0.00 0.00 0.00
6 42.37 5.64 6.86 14.76 6.88 10.41 13.06 variables
12 33.75 5.50 8.91 22.02 6.41 9.79 13.60
24 30.68 6.03 9.59 21.04 10.31 9.57 12.77
LnTB 1 0.07 99.93 0.00 0.00 0.00 0.00 0.00
6 1.58 81.16 4.84 2.54 5.93 2.18 1.76
12 6.14 48.83 19.54 9.54 8.37 5.81 1.76
24 7.29 43.72 20.01 13.27 7.62 6.36 1.72
LnREER 1 10.91 3.66 85.41 0.00 0.00 0.00 0.00
6 10.89 7.27 64.77 8.81 0.93 5.89 1.43
12 11.49 19.85 43.34 15.01 1.75 7.32 1.22
24 11.44 19.32 41.60 15.28 3.49 7.72 1.15
lnFDI 1 3.67 12.50 0.75 83.07 0.00 0.00 0.00
6 4.93 12.14 14.19 39.87 18.79 8.07 2.01
12 8.92 13.06 22.97 30.27 14.64 8.93 1.21
24 9.25 15.50 22.52 28.95 13.56 9.03 1.19
lnCPI 1 0.04 9.22 0.06 0.14 90.53 0.00 0.00
6 7.06 1.92 12.89 0.72 62.64 7.86 6.89
12 11.59 4.85 14.38 0.71 51.91 10.99 5.55
24 11.97 5.57 12.32 0.85 52.65 10.71 6.91
LnIPI 1 1.93 8.25 9.12 0.69 9.99 70.00 0.00
6 5.24 18.73 7.91 7.52 4.72 54.18 1.69
12 6.07 15.67 11.19 9.71 4.08 51.71 1.55
24 6.35 15.87 11.32 10.35 4.13 50.34 1.64
LnIR 1 0.01 0.62 0.09 11.86 13.93 3.69 69.78
6 4.13 0.41 28.14 18.78 25.72 6.05 16.77 Table VIII.
12 9.18 9.01 30.92 19.93 14.37 7.99 8.59 Variance
24 9.23 12.09 29.54 20.19 13.57 7.89 7.47 decompositions

other regulators may need to take corrective measures to reduce the trade deficit since it can
help to increase the performance of Pakistani stock market. Since CPI and IPI positively
affect the SP, investors should increase their level of investment when there is an increasing
trend in the price level as well as when the income level of the country is increasing. On the
contrary, investors may reduce the level of investment when there are stable prices and the
economy is not growing well. Moreover, since the exchange rate negatively affects the SP it
indicates a positive signal for the investors when the currency is depreciating.
In the international literature on the stock market, most researchers use macroeconomic
variables as a major determinant of SP. However, in the future, natural resources can be
used as determinants of SP. Moreover, traditional econometric co-integration based models
force variables to be linear. Therefore, in the future, nonlinear models such as quantile
regression and the NARDL model can be used to examine the nature of the relationship
between macroeconomic variables and SP.

Notes
1. www.finance.gov.pk/survey/chapters_13/HGHLIGHTS%202013.pdf
2. https://tribune.com.pk/story/1847306/2-foreign-direct-investment-continues-fall-pakistan/
3. https://tribune.com.pk/story/1836177/2-pakistan-ranked-8th-size-trade-deficit/
4. www.finance.gov.pk/survey/chapters/Oveview%20of%20the%20economy08.pdf
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Corresponding author
Bisharat Hussain Chang can be contacted at: [email protected]

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