15

CHAPTER II

REVIEW OF LITERATURE

2.1. Financial Markets and Economic Growth

There are mainly five strands of literature exploring various aspects of the link

between finance and economic development. The first among them pertains to the

relationship between financial structure and economic development pioneered by

Goldsmith (1969). Such studies evaluated the relative merits of bank-based and

market-based financial systems and their impact upon economic development. Second

strand of research attempted to study the role of financial markets, including stock

market, from a functional point of view. Researchers in this school investigated the

contribution of financial markets in the provision of liquidity, amelioration of risks

and informational symmetry, mobilisation of resources and corporate governance. A

large body of cross-country and country level studies are made in this line following

the seminal works by King and Levine (1990, 1995,1996); and most of them

concluded that financial markets in general and stock markets in particular positively

contributes to economic growth through the provision of these services.

Another prominent line of researchers investigated the impact of financial

market development on the capital structure decisions and growth rate of firms. They

have found that well developed and efficient financial markets ease the constraints that

firms face to growing faster (Demirg-Kunt and Maksimovic 1995, 2000). Fourth

strand of literature focused on the nexus between legal environment in which banks

and stock markets work and overall economic development (La Porta et al 2000).
 16

Subsequent studies in this line rejected the view that financial structure influences

economic development. Instead they concluded that it is the legal system that strongly

influences the level of financial development which in turn influences firm

performance, creation of new firms, and national growth rates. Another area where

there has been recent empirical work is the impact of financial development on income

distribution and poverty. Studies on financial access and income distribution (Haber

1997), financial development and its impact on the growth rate of Gini Coefficient of

income distribution (Beck, Demirg-Kunt and Levine 2004) show that financial

development exerts a positive impact on the poor and reduce income inequality.

2.1.1. Financial Structure and Economic Growth

Demirg-Kunt and Levine (1996) made a pioneering study using data from

both industrial and developing countries. Their study supports the Gurley and Shaw

(1955) view that at low levels of development commercial banks are the dominant

financial institutions. As economies grow, specialised financial intermediaries and

equity markets develop and prosper, which will reduce the share of banking finance in

the overall financial system. They also studied the interaction between development of

financial intermediaries and stock market development. Their results suggest that

across countries the level of stock market development is positively correlated with

the development of financial intermediaries.

Boyd and Smith (1996) studied the co-evolution of the real and financial

sectors of the economy as it develops. They argued that financial innovation is a

dynamic process that both influences and is influenced by the real sector. As an

economy develops, the aggregate ratio of debt to equity generally falls; yet, debt and

equity markets function as complements rather than substitutes in financing real

 17

development of the economy. They found that the development of equity markets

occur relatively late in the economic development process because of the frictions in

the financial market. As these frictions become less severe overtime, the economy gets

the benefits of a more efficiently functioning set of capital markets.

Fase and Abma (2003) examined the empirical relationship between financial

development and economic growth in South- East Asia using data for twenty five

years. They found that financial development matters for economic growth and that

causality runs from financial structure to economic development. The results

suggested that in developing countries a policy of financial reforms could improve

economic growth.

2.1.2. Financial Development and Economic Growth

Harvey (1989) analysed the forecasting capacity of stock and bond prices for

GNP growth rate. He found that information about economic growth can be drawn

from both bond market and stock market variables. However, the bond market delivers

more information about future economic growth than the stock market. He found that

the bond market forecasts also compare favourably with the forecasts from leading

econometric models, whereas forecasts from stock market models do not perform well

in this regard.

Levine (1991) studied the impact of stock markets on economic activity

through the creation of liquidity. The study revealed strong link between stock market

liquidity and economic growth even after controlling for other economic, social,

political, and policy factors that affect economic growth. Stock market liquidity is

proved to be a good predictor of future long-term growth. However, other measures of

 18

stock market development such as stock market size and volatility do not significantly

affect economic growth.

Berthelemy and Varovdakis (1994) made a novel attempt to find out the

reciprocal interactions between financial and real sectors in the economy in the

context of multiple steady state equilibrium. They found that depending on the nature

of the initial steady state, there may exist either a poverty trap in which the financial

sector disappears and the economy stagnates or a positive endogenous growth which is

followed by a natural development of financial intermediation. They concluded that

financial development policies might have very different consequences depending on

the initial context of the economy.

Obstfeld (1994) examined the impact of risk diversification through

internationally integrated stock markets on economic growth. He found that, since

high-return projects also tend to be comparatively risky, stock markets that facilitate

risk diversification encourage a shift to higher return projects. Thus, better

functioning, more internationally integrated stock markets boost economic growth by

shifting societys savings into higher return projects.

Bencivenga, et al (1995) studied the impact of the efficiency of an economys

equity markets-as measured by the cost of transacting in them, affects the economys

efficiency in producing physical capital and through these channel final goods. They

found that as the efficiency of an economys capital markets increases, it cause agents

to make longer-term and hence more transaction-intensive investments, resulting in a

positive change in the composition of savings and investment.

 19

Levine and Zervos (1996) in their pioneering study empirically evaluated the

relationship between stock market development and long-run economic growth

through cross-country growth regressions. Their results suggest that there is a positive

and robust association between the two. Moreover, there is a strong connection

between the pre-determined component of stock market development and economic

growth in the long run.

A comprehensive study by Mishkin (1996) concluded that adverse selection

and moral hazard problems arising from asymmetric information in investor-firm

relationship creates disruption in financial markets, leading to inefficient allocation of

funds. His study revealed that banks and financial intermediaries are more efficient

than stock markets in this regard.

Nagraj (1996) made a comprehensive work on the impact of stock market

activity on aggregate savings and investment, and found that in India, the huge

increase in stock market activity is not associated with either a rise in aggregate gross

domestic saving or with an increase in the proportion of financial saving. He found no

statistically valid association between capital market resource mobilisation and growth

in corporate fixed investment or growth in net value added. Stock markets role is

limited to financial intermediation with little effect on aggregate saving rate, corporate

investment and output growth rates.

Harris (1997) made a comparative study of the relationship between stock

market activity and economic growth on different samples of both developed and less-

developed countries. He found no hard evidence for the models that suggest a positive

association between the level of stock market activity and growth in per-capita output.
 20

Further, for the less developed countries sample, the stock market effect, as with the

full sample, was very weak. For the developed countries, however, stock market

activity exhibited some explanatory power.

Shah and Thomas (1997) studied the relative efficiency of banking system and

stock market in terms of quality of information processing and reduction of transaction

cost. They found that in India the stock market is more efficient than banking system

in both dimensions. Efficient stock market contributes to long run growth through

efficient allocation of scarce savings. They also found that foreign capital flows have a

positive impact on the real economy via lowering the cost of capital.

Singh (1997) examined the impact of rapid growth of market capitalisation in

developing countries after financial liberalisation. He found that stock markets, by

making the financial system more fragile, are not likely to enhance growth in

developing countries. Singh (1998) after examining the implications of stock market

development for economic growth, recommend that less developed countries should

promote bank-based system, and influence the scale and composition of capital flows

and prevent a market for corporate control from emerging.

Levine and Zervos (1998) studied the empirical relationship between various

measures of stock market development, banking development and long-term economic

growth. They found that even after controlling for other factors associated with

growth, stock market liquidity and banking development are both positively and

robustly correlated with contemporaneous and future rates of economic growth, capital

accumulation and productivity growth. They found no evidence for theories that
 21

suggest more liquid and more internationally integrated capital markets hinder saving

and growth rates.

According to Filer and Campos (1999) stock markets, especially in more

developed countries, incorporate expected future growth in to current prices. Their

study also revealed a strong relationship between stock market activity and future

economic growth for the low and middle income countries but not in higher income

countries with more developed alternative financial mechanism. They argued for the

establishment of proper institutional framework for stock market since it is found that

stock market activity fails to contribute to economic growth in countries which with

inefficient institutional system.

In a comprehensive work in the Indian context, Nagaishi (1999) studied the

role of stock markets in domestic resource mobilisation, the impact of foreign

portfolio investment on the domestic economy, and the possibility of complementary

development of stock market with financial intermediaries. The study revealed that

Indian stock market development from the 1980s onwards has not played any

prominent role in domestic savings mobilisation. Similarly the impact of foreign

portfolio investment on economic growth is insignificant when compared to other

Asian countries. He also found that Indian stock market and financial intermediaries

have shown hand-in-hand development during the period under study.

Agarwal (2000) investigated the relationship between stock markets and

financial intermediaries development and the link between stock market development

and long-term growth in India. The study suggests that well-developed stock markets

offer different types of financial services than those of the banking system and
 22

therefore provide an extra impetus to economic activity. Hence, banking sector and

capital markets are complementary and not substitutes. He also found that various

parameters of stock market development such as size and liquidity are statistically

significant in explaining economic activity.

Henry (2000) studied the impact of stock market liberalisation on private

investment in a sample of eleven developing countries. He found that after

liberalisation most of the countries experienced higher private investment growth rates

than their pre-liberalisation period. The evidence stands in sharp contrast to recent

works that suggest capital account liberalisation has no effect on investment.

Arestis, et al (2001) examined the relationship between stock market

development and economic growth in five developed countries after controlling for the

effects of banking system and stock market volatility. The results support the view

that, although both banks and stock markets are able to promote growth, the effect of

the former is more powerful. They also suggested that the contribution of stock

markets to economic growth has been exaggerated by studies that use cross -country

growth regressions.

Beck and Levine (2001) examined the link between financial development and

growth and the independent impact of banks and stock markets on long-term growth.

Their findings are consistent with the models that suggest that well-functioning

financial systems ease information and transaction costs, and thereby, enhance

resource allocation and economic growth. They found that the measures of banking

development and stock market development both frequently enter the growth
 23

regression significantly, which suggests that both banks and stock markets

independently boost economic growth.

Biswal and Kamaiah (2001) evaluated the behaviour of stock market

development indicators, viz. market size, liquidity and volatility and examined the

presence of trend break in these indicators since liberalisation in India. The findings of

the study suggested that stock market has become larger and more liquid in the post-

liberalisation period. In respect of volatility, however, there was no significant change.

Durham (2002) tested the relevance of stock market development for lower

income countries. The study showed that stock market development has a more

positive impact on growth for greater levels of per capita GDP, lower levels of country

credit risk and high levels of legal development. Similarly, equity price appreciation

seemed to boost private investment growth in the short run, but only in rich countries.

According to Laurenceson (2002) the impact of stock market on economic

development is limited in China. Especially, the corporate governance effect has been

ineffectual and stock markets are insignificant sources of financing for non-state

owned firms. Besides, on a macro level, their impact on the overall level of savings

mobilisation and allocation efficiency of capital also has found to be negligible.

Caporale, et al (2003) tested the hypothesis that financial development causes

higher growth through its influence on the level of investment and productivity. The

results reiterated that investment productivity is the channel through which stock

market development enhance growth rate in the long run. The study supported the
 24

endogenous growth proposition that economic policies intended to promote financial

institutions will lead to higher rate of growth in the long run.

Sharia and Junankar (2003) analysed the impact of stock markets on

economic growth in Arab countries using panel estimation techniques. They found

that the level of stock market activity is related to economic growth in the Arab

countries. Of the various stock market development measures used, the turn over ratio

shows significant impact on growth when compared to market capitalisation and value

traded in the stock market.

Bayer, et al (2004) examined the connection between the creation of stock

exchanges and economic growth. They found that economic growth increased relative

to the rest of the world after a stock exchange opened. Evidence indicated that

increased growth of productivity is the primary way through which a stock exchange

increases the growth rate of output, rather than an increase in the growth rate of

physical capital. They also found that financial deepening is rapid before the creation

of a stock exchange and slower subsequently.

Binswanger (2004) investigated the traditionally strong relation between the

stock return and subsequent growth rates of real activity in the U.S. and also in the

other G-7 countries. He found a breakdown in the positive relation between stock

return and growth rate of real economic activity in the U.S. and Japan. Temporary

breakdown occurred in Canada and Germany, while the evidence supported the

traditional link in the U.K. The results for France and Italy were inconclusive.
 25

The growth impact of stock markets in Nigeria was investigated by Osinubi

(2004). The results indicate that there exists a positive relationship between growth

and the various stock market development variables, such as stock market size,

liquidity, and concentration. However, these relationships are statistically

insignificant, indicating that the effect of stock market on economic growth is weak

and insignificant.

Handroyiannis, et al (2005) studied the impact of the development banking

system and stock markets on the economic performance of Greece. The results suggest

that there exist a bi-directional causality between finance and growth in the long run.

Both bank and stock market promote growth in the long run, although their effect is

small. Further, the contribution of stock market finance to economic growth appears to

be substantially smaller compared to bank finance.

According to Beckaert, et al (2005), stock market liberalisation, on an average,

leads to a one per cent increase in annual real economic growth. Their study with

alternate definitions of liberalisation revealed that in countries with high quality

institutions the growth response to stock market liberalisation was more significant.

The effect also remained in tact when an exogenous measure of growth is included in

the regression.

2.1.3. Financial Markets and Corporate Finance

Demirg-Kunt and Maksimovic (1996) analysed the effects of stock market

development on firms financing choices using data on both developing and industrial

countries. The results suggest that initial improvements in the functioning of

developing stock markets produce a higher debt-equity ratio for firms and thus create
 26

more business for banks. In stock markets that are already developed, further

development leads to a substitution of equity for debt financing. In developing stock

markets, large firms become more benefited as the stock markets develops, whereas

small firms do not appear to be significantly affected by stock market development.

Their study also shows that firms in countries with better functioning stock markets

and banks grow faster than predicted by individual firm characteristics.

Samuel (1996) made a comparative study of the importance of stock market as

a source of finance to Indian and U.S. firms. He found that internal finance plays a

lesser role for Indian firms than for U.S. firms. Indian firms rely more on external debt

as a source of finance. By generalising the results for other developing countries, he

concluded that stock market development is unlikely to spur corporate growth in

developing countries.

Rajan and Zingales (1998) investigated the link between financial sector

development and industrial growth. They found that financial sector development

reduces the cost of external cost of finance for firms. Industrial sectors that are

relatively more in need of external finance develop disproportionately faster in

countries with more developed financial and stock markets.

Oshikoya and Ogabu (2000) studied the impact of African stock market

activity on long-term growth in the context of the continents structural adjustment

programme and financial sector liberalisation. The study showed that the development

of stock market helped to strengthen the corporate sector because of the requirements

for the development of international accounting standards and disclosure of reliable

 27

information. However, the African stock markets suffer from high volatility and focus

on short-term financial return rather than on long-term economic return.

Gupta and Yuan (2004) investigated the effect of stock market liberalisations

on industrial growth in emerging markets. Their results suggest that liberalisations

disproportionately benefit particular type of industries. Firms more dependent on

external sources of finance, and industries that experience global demand shocks grow

significantly faster following liberalisation. They also found that the increase in

growth occurred primarily through an expansion in the size of existing firms, rather

than through the creation of new firms.

Michelacci and Suarez (2004) studied the role of stock markets in creating new

business. They found that stock markets encourage business creation, innovation and

growth by allowing sufficiently mature companies to go public and monitors to

redirect their resources towards new ventures.

Demirg-Kunt and Maksimovic (2005) on the basis of firm level survey data

studied the link between finance development and corporate growth. They found that

financial development eases the obstacles that firms face while growing faster. This

effect was found to be particularly stronger for smaller firms.

2.1.4. Legal Framework and Financial Development

Based on a large sample of countries, La Porta et al (1999) studied the link

between law, finance and economic growth and found that stronger legal protection of

investors is associated with more efficient financial institutions and better outcomes on

overall economic growth. They found that countries with English common-law origin
 28

provide the strongest legal protection to both shareholders and creditors, while

countries with French civil law origin provide the weakest.

Beck, Thorsten, et al (2000) explored the relationship between financial

structure - the degree to which a financial system is market or bank-based, and

economic development. They applied three different methodologies using cross

country data, industry level data and firm level data. They concluded that financial

structure is not analytically important to explain differences in the growth rate of

countries, industries and firms. It is the overall level of financial development and the

legal environments in which financial institutions are working that critically influence

economic development.

Allen, et al (2004) demonstrated that China provides a counter example for the

findings in the law, finance, and growth literature. Despite its poor legal and financial

systems and autocratic government, China has one of the fastest growing economies.

They have pointed out that alternative financing channels and informal governance

mechanisms have substituted for formal channels and mechanisms to support

corporate as well as overall economic growth in China.

Allen, Franklin et al (2006) studied the legal aspects of Indian financial

system and its impact on corporate financing pattern and growth. They found that

despite English-common law, Britishstyle judicial system and democratic

government, corruption within the legal system and government weakens the legal

protection to investors in practice. Alternate financing channels such as internal

financing and trade deficits provide the most important source of funds to Indian

firms. It is also found that entrepreneurs and investors rely more on informal
 29

governance mechanism such as those based on reputation, trust to resolve disputes,

overcome corruption and finance growth. They concluded that the weakness of the

legal system inhibits the growth of stock markets as an important provider of external

finance.

2.1.5. Financial Development and Income Inequality

Greenwood and Jovanovic (1990) studied the impact of accessibility to credit

and income distribution in a cross section of countries. They found that if access to

credit improves with economic growth and more people can afford to participate in the

formal financial system, it will reduce income inequalities. However this relationship

is non-linear in the sense that there are adverse effects during the early stages which

gets fade away in the long run and ultimately creates a positive impact.

Using cross country growth regressions Beck, et al (2000) investigated how

financial development influences the growth rates of Gini coefficient of income

inequality, the growth rate of the income of the poorest section of the society. The

results indicate that finance exerts a disproportionately large, positive impact upon the

poor and hence reduces income inequality.

Haber (1997) showed that financial access, especially access to credit, only

benefits the rich and the connected, particularly during the early stages of

development. It cannot be precisely stated that when it will create a positive impact on

other sections of the society. Hence, he concluded that though financial development

promotes economic growth, its impact on income distribution is not clear.

The result of these studies shows that the impact of stock market on economic

growth is mixed. Though a large body of studies found positive association between
 30

the two, many of them admit that the relationship is weak (Handroyiannis et al 2005,

Osinubi 2004, Arestis, et al 2001). The observation by Berthelemy and Varovdakis

(1996) that the policy impact of stock market reforms differs in accordance with the

initial condition is noteworthy. It calls for the need for conducting separate research

studies in different types of economies before suggesting policy prescriptions.

Besides, it emphasises that uniform policy prescription on the basis of the success

stories of developed nations may not produce the desirable results. The finding that

banks and stock markets act as complementary institutions in providing finance is also

important from the view point of policy formulation (Beck and Levine 2001, Agarwal

2000). The importance of stock market development for developing countries is

doubted by many researchers (Sharia and Junankar 2003, Durham 2002, Laurenceson

2002, Harris 1997). Recent studies point towards the need for setting up of efficient

and competent legal framework so as to make stock markets formal institutions of

resource mobilisation and vehicles of economic growth (Beckaert, et al (2005),

Durham 2002, Fase and Abma 2003, Beck, Thorsten, et al 2000, Filer and Campos

1999, Shah and Thomas 1997, Bencivenga, et al 1996).

2.2. Stock Prices and Macro Economic Variables

Kraft and Kraft (1977) studied the causal relationship between stock prices,

money supply and rate of change in money supply. They found that the monetary

variables under study significantly affect the behaviour of common stock prices.

However they found no causal relationship between the money supply and common

stock prices.

Rao and Bhole (1990) examined the relation between return on equity and

contemporaneous inflation in India, They found that the real return on equity is
 31

negatively related to inflation, especially to high and extraordinary rates of inflation.

However, in the long run this relationship becomes weak. The study revealed that

nominal return on equities in India increased during inflation, but not in proportion to

the rate of inflation.

Jenson and Jeffery (1996) analysed the role of monetary environment on U.S.

stock and bonds and found that the Federal Reserves monetary stance, indicated by

periods of expansionary monetary policy and measured in terms of the directional

change of the discount rate, affect the variations in stock prices and stock returns.

Lee, Unro (1997) investigated whether stock markets of the Pacific Basin

countries of Hong Kong, Taiwan, South Korea and Singapore are informationally

efficient with respect to macro economic policies. He used Granger causality test and

Vector Error Correction Model to test the relationship between aggregate stock prices

and fiscal and monetary policies. The findings indicated that stock prices of all four

countries are not efficient with respect to both policies and hence rejected the efficient

market hypothesis.

Choi, et al (1999) examined the relationship between industrial production

growth rates and real stock prices and lagged real stock returns for the G-7 countries.

The tests showed a long run equilibrium relationship between the log levels of

industrial production and real stock prices. The study also indicated a correlation

between growths of industrial production and lagged real stock returns for all

countries except Italy.

According to Kwan and Shin (1999) the Korean stock market indices reflect

macro economic variables like production index, exchange rate, trade balance and
 32

money supply. They observed a direct long-run equilibrium relation with each stock

price index. However, the stock price index is not a leading indicator for macro

economic variables, which is inconsistent with the previous findings that stock market

rationally signals changes in real activities

Morley (2000) investigated the relationship between money and stock prices in

developed countries and whether deregulation during the 1980s and 1990s have

affected it. He used cointegration and Granger causality tests to determine whether a

long run equilibrium relationship exists between stock prices and various macro

economic variables in both stock markets based and bank based economies. The

results suggested that there is strong bi-directional causality between money and stock

prices in both types of economies. It is also found that the causality runs

predominantly from stock prices to money, supporting the view that stock prices are

an important determinant of both narrow and broad definitions of money (Friedman

1988). Overall, the results suggested that it is the nature of the financial system rather

than the extent of deregulation that determines the relationship between stock prices

and money supply.

Pethe and Karnik (2000) studied the interrelationship between stock prices

and important macro-economic variables. They found that the link between macro

variables and stock indices are not very conclusive, and there exist no stable long-run

relationship between stock prices and exchange rate, prime lending rate, narrow

money supply, broad money supply and index of industrial production.

Bilson, et al (2001) studied whether local macro variables have explanatory

power over stock returns in emerging markets, and the identical sensitivity of stocks to
 33

a common set of extracted factors. They found moderate evidence for the inter-linkage

between local macro variables and stock returns. Little evidence is found regarding

common sensitiveness when emerging markets are taken collectively. However,

considerable causality is found at the regional level.

According to Mc Millan (2001) there exist co-integration between both S&P

500 and DJIA indices and macro economic activity variables. The relationship is

positive and significant for industrial production and inflation, negative and significant

for long-term interest rates, and negative but insignificant for money supply and short-

term interest rates. The study also showed that long-term rates of these variables

explain a substantial amount of variability in stock prices, while short-term rates of

industrial production and inflation also have some explanatory power.

Omran and Pointon (2001) studied the impact of the inflation rate on the

performance of the Egyptian stock market. They studied the effects of the rates of

inflation on various stock market performance variables indicating market activity and

market liquidity. They found significant long run and short run relationship between

the variables, implying that the inflation rate has had an impact upon the Egyptian

stock market performance generally.

Panda and Kamaiah (2001) investigated the causal relations and dynamic

interactions among monetary policy, inflation, real activity and stock returns in the

post-liberalisation period. They found that monetary policy, expected inflation and

real activity affect stock returns. However, monetary policy loses its explanatory

power for stock returns when expected inflation and real activity are put in the system.

Moreover, the relationship between monetary policy, expected inflation and real
 34

activity with stock returns lack consistency. Their observation is inconsistent with the

view that stock market rationally signals changes in real activity.

Rapach (2001) examined the effects of money supply, aggregate spending and

aggregate supply shocks on real stock prices in the US. The study showed that each

macro shock has important effects on real stock prices. It also confirmed the well-

known negative correlation between real stock returns and inflation.

Bhattacharya and Mukherjee (2002) tested the causal relationship between the

BSE Sensex and five macroeconomic variables. They found that there are no causal

linkages between stock prices and money supply, national income and interest rate,

while the index of industrial production leads the stock prices and there exists a two-

way causation between stock price and rate of inflation.

Fang and Miller (2002) investigated the effects of daily currency depreciation

on Korean stock market returns during the Korean financial turmoil of the late 1990s.

The study found that there exist a bi-directional causality between Korean foreign

exchange market and Korean stock market. Currency depreciation had statistically

significant effects on stock market returns through three channels. First, the level of

exchange rate depreciation negatively affects stock market returns. Second, exchange

rate depreciation positively affects stock returns and third, stock market return

volatility responds to exchange rate depreciation positively.

Glen (2002) examined the effect of currency devaluation on stock returns in

emerging stock markets. He found that stock returns preceding the devaluation are

significantly below normal and returns following devaluation are normal. At the

country level both aggregate economic activity and the size of the devaluation are
 35

important in explaining stock return behaviour. Even though returns appear to

anticipate devaluation, they are not statistically significant at predicting the size of the

devaluation.

Morana and Beltratti (2002) investigated the effects of the convergence of

European economies and introduction of the euro on European stock markets. The

study showed that introduction of the euro, after an initial bust of volatility common to

all European stock markets, has indeed stabilised the Spanish and Italian stock

markets.

Muhammad (2002) examined the long run and short run association between

stock prices and exchange rates for four South Asian countries including India. He

found no long run or short run equilibrium relationship between stock prices and

exchange rates.

Thomas and Shaw (2002) explored the interplay between the Union Budget

and stock market, especially in the efficient market framework. The study found that

stock market in India appears to be fairly efficient at information processing about the

Union Budget. The Union Budget added 10 percent to the stock index on an average

and yield elevated volatility starting from the budget date for the following thirty

trading days.

Wongbangpo and Sharma (2002) investigated the role of select macro

economic variables, i.e. GNP, the consumer price index, the money supply, the

interest rate and the exchange rate on the stock prices in five ASEAN countries. They

found long and short term relationships between these macro economic variables.
 36

Moreover, macro-economic variables in these countries affect and being affected by

stock prices in the Granger sense.

Baily, et al (2003) studied the impact of switching between silver, gold and

paper money standards on stock returns. They found that the paper currency regime is

often associated with higher stock market volatility and higher correlation between

markets, Indicators of global economic activity and export commodity prices typically

explain a greater fraction of stock market behaviour than currency related factors.

They observed little evidence that abandonment of the traditional currency has

affected stock return volatility and cross- market correlation.

Boon and Hook (2003) studied the impact of volatility in the Malaysian

financial system during the Asian financial crisis on the performance of the Kuala

Lumpur Stock Exchange. They found that the volatility of the exchange rate and

interest rate had increased significantly during the crisis period and it affected the

stock prices significantly. Exchange rate volatility exhibited more explanatory power

on stock prices than interest rate volatility during this period.

Nath and Samanta (2003) examined the extent of integration between foreign

exchange and stock markets in India during the liberalization era, employing two

different methodologies. The results of the study are not robust on the choice of

methodology. While, the results in VAR framework indicate poor causal link between

returns in foreign exchange and stock markets in most of the financial years, the

Gewekes feedback measures detect strong causal relationship in each financial year.

They later extended the study to the post-liberalisation period and found that there is

no significant causal relationship between exchange rate and stock price movements

except for some random years, during which unidirectional causal influence from
 37

stock index return to foreign exchange market is detected and very mild causal

influence in reverse direction is also found in 1997 and 2002.

Binswanger (2004) analysed the inter-linkages between growth rates of

industrial production and stock prices in the US, Japan and Europe. He found that real

activity shocks only explain a small fraction of the variability in real stock prices since

the early 1980s. However, they explain a substantial portion of the stock price

variability over the 1960s and 1970s in all these countries.

Cassola and Morana (2004) studied the role of stock market in the transmission

mechanism in the euro area and evaluated whether price stability and financial

stability are mutually consistent and complementary objectives. They found that stock

price, more generally relative asset prices, play an important role in the transmission

mechanism in the euro area. Stock prices are mostly driven by permanent productivity

shock in the long run. They also found that a monetary policy focused on maintaining

price stability in the long run can contribute to stock market stability.

Ray, et al (2004) studied the relationship between the real economic variables

and the capital market in India in the post reform period. They found that while macro

economic variables like the interest rate, output, money supply, inflation rate and the

exchange rate significantly affects the stock market movement, some other variables

like fiscal deficit and foreign institutional investment have very negligible impact on

the stock market.

Chi and Cook (2005) studied the dynamic inter-linkages between stock market

liquidity and the macro economy in Japan. They found that liquidity shocks affected

the equity returns of firms during major cyclical fluctuations. Stock market liquidity
 38

seemed to be strongly associated with short-term interest rate. Similarly, liquidity

shocks showed a persistent negative effect on the demand for real money balances.

Verma and Ozuna (2005) examined the response of Latin American stock

markets to movements in cross country Latin American macro economic variables.

They found little evidence that Latin American stock markets are responsive to these

changes. However, Mexicos stock market affects other Latin American stock

markets, but not vice versa. The exchange rate of a Latin American country affects its

own stock market, suggesting that currency risk is an important source of risk in Latin

America. They concluded that cross-country macro economic variables are not very

useful for forecasting Latin American stock market movements.

Wong, Khan and Du (2005) examined the long run and short run relationship

between stock market indices and selected macro economic variables of Singapore and

the United States. The cointegration results suggested that Singapores stock prices

generally display a long run equilibrium relationship with interest rate and money

supply (M1), but a similar relationship does not hold for the United States. However,

this relationship gradually weakened after the East Asian crisis of 1997. The study

concluded that stock price dynamics might be used as a good gauge for monetary

policy adjustment.

Vikramasinghe (2006) examined the causal relationship among stock prices

and macro economic variables in the Colombo Stock Exchange using Cointegration

and Error Correction Models. The study showed that there are both short run and long

run relationship among stock prices and macro economic variables in Sri Lanka. It is

also found that stock prices can be predicted from some macro economic variables and

hence violate the validity of the semi strong version of the capital market.
 39

There is a vast body of literature that supports the traditional view that stock

market rationally signals changes in real economic activities (Omran and Pointon 2001

(Binswanger 2004, Ray, et al 2004, Wongbangpo and Sharma 2002, ). Macro

variables, especially monetary variables do possess obvious relationship with stock

prices. Studies in the efficient market framework indicate that well developed stock

market efficiently absorbs information regarding macro economic variables. However

there are variations in results depending on the time period and specific economic

conditions. The use of stock prices as transmission mechanism in the monetary policy

stance indicates the relevance of the barometric role of stock markets (Cassola and

Morana 2004, Jenson and Jeffery 1996). The analysis of various studies clearly shows

the dearth of comprehensive studies in the Indian context. This is particularly true in

the post liberalisation era. The present study tries to bridge this gap.