Do macroeconomic variables play any role in the stock market movement in

Ghana?
By
Anokye Mohammed Adam
School of Management, University of Leicester, UK
E-mail: [email protected] or [email protected]

And

George Tweneboah
School of Management, University of Leicester, UK
E-mail: [email protected] or [email protected]

Abstract
This study examines the role of macroeconomic variables on stock prices movement in Ghana. We use

the Databank stock index to represent Ghana stock market and (a) inward foreign direct investments,

(b) the treasury bill rate (as a measure of interest rates), (c) the consumer price index (as a measure of

inflation), and (d) the exchange rate as macroeconomic variables. We analyze both long-run and short-

run dynamic relationships between the stock market index and the economic variable with quarterly

data for the above variables from 1991.1 to 2006.4 using Johansen's multivariate cointegration test and

innovation accounting techniques. We established that there is cointegration between macroeconomic

variables identified and Stock prices in Ghana indicating long run relationship. Results of IRF and

FEVD indicate that interest rate is the key determinant of the share price movements in Ghana.

Keywords: Cointegration, Innovation Accounting, Partial derivative

JEL Classification: C22, E44, G10

1
1.0 Introduction

The relationship between macro economic growth and stock market development has dominated both

academician's and practitioner’s literature in recent times. This has been necessitated by the general

perception, that macroeconomic fundamentals such as inflation and interest rate influence economic

activities especially stock returns. “A significant research has been done to investigate the relationship

between stock market returns and a range of macroeconomic variables, across a number of different

stock market and over a range of different time horizon” (Humpe and Macmillan, 2007). For example,

Modigliani and Cohn (1979) reported in their study of the interaction between stock return and

inflation that expected stock returns should equal the current earnings yield on stocks (defined as

earnings over price) plus an inflation premium. Using cointegration analysis and Causality, Ho (1983)

findings showed that there is unidirectional causal flow running from measures of monetary supplies

(M1 and M2) for Japan and Philippines; and Australia, Thailand and Hong Kong exhibits

unidirectional causal flow running from M1 only. Mayasami and Koh (2000) applied Johansen

cointegration approach and vector error-correction model to examine dynamic relationship among

stock prices and macroeconomic variables and report the sensitivity of Singapore stock market to

interest rate and exchange rate. Similarly, Humpe and Macmillan (2007) examine the influence of a

number of macroeconomic variables on stock prices in two countries, the US and Japan using

cointegration analysis. They report evidence of positive influence of industrial production on both

stock markets and US stock market negatively influence by inflation and long interest rate.

It is regrettable that most of these studies have focused on the developed economies and emerging

market of Asia. This is due to under developed nature of most of the stock markets. The size,

institutional and regulatory framework, political and economic instability have marred the

development of stock markets in Africa. Ghana and for that matter Africa has seen little and the few

who have captured Africa focus on the continent’s supper powers in terms stock market development

such as South Africa, Egypt, morocco and Nigeria. The recent financial and monetary stability policies

2
aimed at boosting investors’ confidence in Africa are yielding positive results especially for Ghana.

Ghana is seen as the most politically stable country in sub-Sahara after conducting four consecutive

successful elections. Ghana is increasingly becoming investment destination for most foreign investors

following recent sound macroeconomic policies, stock market reforms, privatization and financial

liberalization. The study of Ghana stock market is therefore important for investment decision. There is

therefore a need to research into the dynamic relationship among Ghana stock market and

macroeconomic variables for better investment decision.

Our study is unique for number of reasons. Firstly, we systematical justified our variables selection

through critical analysis of Dividend Discount Model, open it up (mimicking Risk Factor Model to

capture other potential variables that influence return of security and support it with empirical

evidence. Secondly, the importance of the FDI inflow to developing and emerging Markets can not be

overlooked yet no one has examined the role of net FDI inflow on the stock market development in

Ghana.

The present study employs Johansen multivariate cointegration test and Innovation Accounting

techniques from Vector Error Correction Model (VECM) to study the effect of macroeconomic

variables identified on the movement of Ghana stock market proxy by Databank stock Index (DSI) .

Our result indicate that equity prices in Ghana is consistently influenced by changes macroeconomic

variables as found in both developed and emerging markets like the US, Japan, UK, Malaysia, New

Zealand and Korea

The rest of the study is organised as follows: we justify our variable selection in section 2. The data and

methodology is covered in section 3. Section 4 examines the empirical results and discussion. The

conclusion is presented in section 5.

3
2.0 Variables selection Justification

Miller and Modigliani (1961) Dividend Discount Model (DDM) provides a simple but useful

framework for understanding the relationship between stock prices. Number of studies has used this

model as bases for their variables selection (see Oyama, 1997; Gan, Lee, Young and Zhang, 2006;

Humpe and Mcmillan, 2007; Leibowitz, Sorensen, Arnott and Hansen, 1989; and Tessaromatis, 2003)

for the study of stock market and macro economy. We consider the same model with variation. In

DDM, the stock market price is set equal to the stream of forecast dividend, D, discounted at the

required rate of return, r:

D1 D2 D3 Dn
P0 = + + + .... + 2.1
(1 + r ) 1
(1 + r ) 2
(1 + r ) 3
(1 + r ) n

where Po = current price

Di= expected dividend in period I

r= required rate of return on the asset j.

This becomes

Dt
r− g , as n → ∞
Pt= 2.2

Where, Dt = dividend at time t

r = required rate of return

g = constant growth rate

Th expected rate of return can be written as function of risk free interest rate I, an expected inflation

component Π and risk premium, τ such that r = Ι + τ + Π and growth rate as a function of interest

rate ,I, expected inflation, Π and non -interest rate related growth Φ such that g = β Ι + λΠ + Φ

4
,Where

β captures the sensitivity of growth to interest rates and λ the sensitivity of growth to inflationary

expectations.

From the two functions we write

dr = dΙ + dΠ + dτ 2.3

and

dg = β dΙ + λdΠ + dΦ 2.4

Defining the total differential of share price p (Leibowitz, Sorensen, Arnott and Hansen ,1989) as

∂p ∂p 2.5
dP = dr + dg
∂r ∂g

We can write the rate of changes in prices, dp / p using equations 2.3 , 2.4 and 2.5 as

dp / p = −αdΙ + −γdΠ − ϕdτ + ρdΦ 2.6

Where α , γ , ϕ and ρ represent the sensitivity of the return to changes in respective factors. It is

believed that any factor that influences any of the variables influence price movement.

We can infer from the the above expression that changes in expected inflation and interest rate affect

stock market returns. This is consistent with empirical evidence from Fama and Gibbon(1982);

Mundell(1963); Bulmash and Trivoli (1991) and Geske and Roll(1983).

(Humpe and Macmillan, 2007) argues that policy makers are likely to embark tight monetary policy

when inflation is high. This slows money supply growth and increase interest rates which influence

discount rate and cost of capital, hence the negative impact. An increase in interest would force

investors to require high rate of return due to the rise in opportunity cost of investing in shares.

According to Alagidede (2008), the risk perceptions remains obstacle to increased access to capital

markets in Africa; and are set apart from stock market from other regions due to the small size and highly

5
illiquid nature. These negative effects that marred emerging stock market are likely to reduce if open to

foreign investors. For example, large investment inflows to SEE supported the economic growth rates and

pushed up stock prices at the major equity markets in the region (SEE Investment Guide, (2006)).

Oyama (1997) pointed out that the risk premium for Venezuela stock market, Jordan and Pakistan

declined sharply between 1990 and 1992 following liberalization of stock investment by foreigners in

1990; and increase of the amount of home currency and foreign exchange that could betaken abroad by

residents and non-residents .

The risk of foreign exchange exposure continues to hinder emerging markets' effort to attract foreign

investors. The exchange rate exposure does not only threat their cash flows but also reduce their

competitive advantage in the market. According to Adler and Dumas (1984) exchange risk affect all

firms whose input and output prices are influenced by currency movement. Some argue that stock

prices should increase with depreciation of home currency because of expected increase in export.

Such impact will be determined by the relative dominance of import and export sectors of the economy

.This has not been supported by the available empirical study (see Luetherman, (1991),Solnik (1987)).

It is therefore right to ague that foreign investment inflow and exchange rate influence the risk factor

of stock market in diverse ways, hence the inclusion.

We hypothesized negative relationship between share prices and inflation, interest rate and exchange

rate; and positive relationship with net FDI inflow.

6
3.0 Data and Methodology

3.1 Data Description

The data for the study are quarterly from 1991.1 to 2006.4. All the macroeconomic data except

Inward FDI were extracted from IFS statistics, June 2008. The data on Inward FDI were extracted

from UNCTAD while the data DSI were obtained from Databank Group Research. . The FDI data

were obtained in annually form and interpolated by the method proposed by Goldstein and Khan

(1976). The brief description for each variable used is presented in Table below

Table 1: Description and source of data

Variable Concept Description Units Source

LDSI Log of Databank Databank stock 30 Nov. 1990= Databank Group

Stock Index Index 79.83 Research
LFDI Log of net Foreign Volume of foreign Millions of US UNCTAD
Direct Investment capital invested in Dollar Database
Inflow the economy

LPR Log of exchange Principal Index number IFS statistics

rate rate(USD per
National
Currency)
LCPI Log of inflation Consumer Price Percentage Per IFS statistics
Index annum (200=100)
LTB Log of Interest 91-day Treasury Percentage per IFS statistics
rate bill rate Annum

3.2 Methodology

Cointegration tests look for linear combinations of I(d) time series that are stationary and the linear

combination of I(d) which is stationary is called the cointegrating equation and may be interpreted as a

long-run equilibrium relationship between the variables as captured in Granger (1987). We employ the

Johansen (1991, 1995) maximum likelihood procedure, which is based on a vector error correction

model (VECM) and is represented in VECM form:

7
 p
∆X t = µ + ∑ Γ∆X t −i + Π X t − p + ΦDt + ξ t 3.1
i =1

where ∆ is the first difference lag operator, X t is a (kx1) random vector of time series

variables with order of integration equal to one, I(1), µ is a (kx1) vector of constants, Γi are (k x k)

matrices of parameters, ξ t is a sequence of zero-mean p- dimensional white noise vectors, and Π is a

(k x k) matrix of parameters, the rank of which contains information about long-run relationships

among the variables. If the Π -matrix has reduced rank, implying that Π =αβ', the variables are

cointegrated, with β as the cointegrating vector. If the variables were stationary in levels, Π would

have full rank.

Johansen's multivariate approach has number of advantages; testing and estimating multiple long-run

equilibrium relationships is possible.. Also, Johansen's estimation method allows for testing of various

economic hypotheses via linear restrictions in the cointegration space (see Johansen and Juselius, 1990).

In estimating the cointegration we first consider whether each of the series is integrated ( the order of

difference before stationarity is achieved) of the same order, to do this we consider the standard

Augmented Dickey-Fuller test, phillips- Perrons and Alkaike Information Criterion as leading indicator

for lag selection. The number cointegration rank(r) in this study is tested with the maximum

eigenvalue and trace test. The Maximum eigenvalue statistics test the null hypothesis that there are r

cointegrating vectors against the alternative of r+1 cointegrating vectors. The trace statistics tests the

null hypothesis of no cointegrating vector against the alternative of at least one cointegrating vector.

The asymptotic critical values are given in Johansen (1990) and MacKinnon-Haug-Michelis (1999).

From the above theoretical, intuitive, and empirical discussion, we postulate the relationship between

stock prices and selected macro economic variables as

LDSI t = β 0 + β 1 LCPI t + β 2 LPRt + β 3 LTBt + β 4 LFDt I + ξ t 3.2

Where LDSI is databank stock index, LCPI is consumer price index, LPR is USD/GHS exchange rate,

8
LTB is 91-day treasury -bill rate and LFDI is inward foreign direct investment

β1 ,..................................................... , β 4 are the sensitivity of each of the macroeconomic variables to stock prices.

β 0 is a constant and ξt is error correction term.

The coefficients of LPR and LFDI are expected to be positive while LCPI and LTB are expected to be

negative

4. 0 Empirical Results and Discussion

4.1 Descriptive Statistics

Table 2 presents a summary of descriptive statistics of the variable. Sample mean, standard deviation,

skewness and kurtosis, and the Jacque-Bera statistic and p-value have been reported. The high standard

deviation of LDSI with respect to the mean is an indication the high volatility in the stock market.

From the p-values, the null hypothesis that LDSI LCPI and LPR are normally distributed at 1% level

of significance can not be rejected. All the variables are positively skewed except LCPI and LFDI.

9
 LDSI LT B
4.0 2.2

2.0
3.5

1.8
3.0
1.6
2.5
1.4

2.0
1.2

1.5 1.0
92 94 96 98 00 02 04 06 92 94 96 98 00 02 04 06

LFDI LCPI
8.5 2.50

2.25
8.0

2.00
7.5
1.75
7.0
1.50

6.5
1.25

6.0 1.00
92 94 96 98 00 02 04 06 92 94 96 98 00 02 04 06

LPR
1.50

1.25

1.00

0.75

0.50

0.25

0.00
92 94 96 98 00 02 04 06

Figure 1: Logarithms of Variables

Table 2:Summary Statistics of the Variable: 1991:1 to 2006 :4

LDSI LPR LCPI LTB LFDI
Mean 2.898272 0.583210 1.828133 1.492419 7.431932
Median 2.970082 0.630309 1.871399 1.492569 7.513199
Maximum 3.918558 1.455078 2.455180 2.069864 8.080350
Minimum 1.879650 0.035374 1.064903 1.091783 6.145196
Std. Dev. .613817 0.488242 0.453579 0.203617 0.374028
Skewness 0.011984 0.333226 -0.302435 0.960284 -1.147513
Kurtosis 2.154169 1.739727 1.778526 4.855756 4.691274

Jarque-Bera 1.909346 5.419858 4.954311 19.01977 21.67348

Probability 0.384938 0.066542 0.083982 0.000074 0.000020

10
Table 3: ADF and PP unit Root Test
Variables ADF Unit Root Test PP Unit Root Test
Levels First Difference Levels First Difference
LDSI -1.124073 -4.604914** -0.755972 -4.604914**
LPR -1.767030 3.187248** -1.835472 -3.277407**
LFDI -2.548019 -4.099517** -1.988769 -4.259959**
LCPI -1.877965 -2.981643** -1.835472 -3.277407**

LTB -1.943722 -7.682588** -2.220418 -7.682616**

[Note: ** denote significance at 5% , critical values are from Mackinnon (1999)]

4.2 Unit Root Test

Table 3 shows unit root test conducted to determine the stationarity of the variable. Augmented

Dickey-Fuller (ADF) and Phillips- Perron test were used. Both results indicate that all the data are

non-stationary at levels but first differences are stationary at 5% significant level. We conclude that all

the variables are I(1). The results are consistent with figure 1.

4.3 Cointegration Test

The next step involves estimating the model and determining the rank, r to find the number

of cointegrating relations in our model. The model lag length selection was determined by both Schwarz

(SIC) and Akaike (AIC) Information Criterion using 5 lags in the general VAR model. The aim is to choose

the number of parameters, which minimizes the value of the information criteria. The SIC has the tendency

to underestimate the lag order, while adding more lags increases the penalty for the loss of degrees of

freedom. To make sure that there is no remaining autocorrelation in the VAR model, AIC is selected as the

leading indicator. The model lag length is reporting in table 4. indicates appropriate lag length as 4.

We proceed to estimate the cointegration equation using Johansen's approach having selected

appropriate lag length. An intercept and no trend are specified for the cointegrating equation. The result of

the cointegration test is presented in table 5. The trace statistic suggests three cointegrating vector, and

the maximum eigenvalue statistic one cointegrating vector at the 5% significance level. Given the

evidence in favour of at least one cointegrating vector, we normalise the cointegrating vector on the

11
log of stock price (LDSI). The normalized cointegrating coefficient for LDSI is shown in table 6. We

can therefore write our cointegrating relationship as

LDSIt = -1.742364-1.06094871LTBt+1.645557LCPIt + 0.393549LFDIt + 0.609393LPRt.

The coefficients of LTB, LPR and LFDI are correctly sign; contrary to our expectation, LCPI has

positive signs. The negative relationship between LTB and LDSI is expected.

Table 4: VAR Lag Order Selection Criteria

Lag AIC SC
0 -2.393699 -2.217637
1 -15.09075 -14.03438
2 -15.97967 -14.04298*
3 -15.79505 -12.97805
4 -16.30743* -12.61012
5 -16.14994 -11.57231
* indicates lag order selected by the criterion

Table 5: Multivariate Johansen cointegration Test

Trace test Maximum Eigenvalue Test
Trace 0.05 Critical Max-Eigen 0.05 Prob**
Rank r Prob**
Statistics Values statistics Critical values

r=o 76.97277* 109.5383 0.0000 53.29040* 34.80587 0.0001

r=1 54.07904 * 56.24792 0.0316 20.61372 28.58808 0.3666
r=2 35.19275* 35.63421 0.0448 18.65031 22.29962 0.2560
r=3 20.26184 16.98390 0.1331 10.94409 15.89210 0.2560
r=4 9.164546 6.039804 0.1876 6.039804 9.164546 0.1876

* denotes rejection of the hypothesis at the 0.05 level

**MacKinnon-Haug-Michelis (1999) p-values

Table 6: Normalized cointegrating coefficients (standard error in parentheses)

LDSI LCPI LTB LPR LFDI C
1.000000 -1.645557 1.064871 -0.609393 -0.393549 1.742364
(0.11875) (0.06071) (0.10301) (0.02829) (0.28315)

12
This is because investing in Treasury bill was more lucrative than stock market in the late 90's due to

high T-bill rate. This affected the performance of the Ghana stock market. The opening of the market

to non-resident Ghanaians and foreigners in June 1993 was a big boost to the development of the

market. Exchange Control permission was given to foreigners and non-resident Ghanaians to invest

through the Exchange without prior approval. This has attracted a number of top-rated foreign

institutional buyers, thus positive relationship between LFDI and LDSI. A positive relation LCPI and

LDSI is not expected. This is probably in support of Fisher (1930) hypothesis. It is argue that in stock

returns, Fisher hypothesis implies a positive one-to -one relationship between stock returns and inflation.

The positive relationship implies investors are compensated for inflationary increase.

The positive relationship between LDSI and LPR can be explained by the following factors: appreciation

of the Ghana Cedi (GHS) would attract more investors to invest in the Ghana stock market. The other

possible explanation to this long run positive relationship is that the cost of imported goods becomes cheap

to producers. Ghana is import dominated economy and that appreciation of the GHS is boosting to the

economy, hence the positive relation.

The coefficients can be interpreted as the elasticity of the changes in stock prices with respect to

corresponding changes in the macroeconomic variables since we used logarithms. This means that 1%

increase in LTB leads to 106% decrease in LDSI and 1% increase in CPI increases stock prices by 164%.

This suggests that Ghana stock market provide a hedge perfectly against inflation. Similarly 1% increase in

net LFDI and LPR lead to 39.3% and 60.9% increase in LDSI respectively.

4.4 Innovation Accounting

The cointegration analysis only captures the long-run relationship among the variables, it does not provide

information on responds of variables in the system to shocks or innovations in other variables To find how the

Stock market in Ghana responds to shocks or innovation in the macroeconomic variables we evaluate

13
Innovation Accounting such as impulse response function and Variance decomposition base on Vector Error

Correction Model (VECM) . Figure 2 shows impulse responds Function while the Variance decomposition is

presented in table 6.

From figure 2 we observe that LCPI seems not to have immediate effect on LDSI, negative responses

after the second quarter, but positive long-run association with one standard deviation innovation in

LCPI. The result implies that the market efficiently allocate resources by adjusting to general increase

price levels in the long run.

Th response of LDSI to LPR and LTB is in line with findings by other researcher in both advanced and

emerging markets. A shock in LTB leads to a sharp reduction in LDSI, this explains the strong inverse

relation between the t-bill and stock market investment in Ghana. The positive impact of the shock in

exchange supports the cointegration results.

From figure 2, we can also observe that a shock in LFDI increase LDSI, peaked after seven quarters,

decline till end of 13 quarter and pick up again. This support the Oyama (1997) claim that increase in

foreign investors increase the liquidity of the stock market and reduce the risk premium. The decline

may due to hikes in interest rate.

We observe from table 6 that the variations in LDSI are mainly attributing to its own variations after 4

quarters accounting for over 60 percent with LPR and LFDI explaining 16% and 14% respectively. After 8

quarters, quiet sizable proportion of the variations in LDSI is explained by LFDI, LTB and LPR accounting

for 28%, 15% and 20% respectively. The fraction that is accounted for by CPI however remain less than

5% . The variations in the LDSI due to shocks/innovations in LFDI and LPR reduced after 12 quarter

through to end of 16 quarter while that of inflation and interest rate continues to increase. The LTB prove to

be the most significant factor that explain the movement in stock prices accounting for 34% and 50% at

the end of 12 quarters and 16 quarters respectively. The Ghana equity market seems to respond less to the

shocks in real activities than to monetary shocks.

14
Figure 2: Impulse Response Function of LDSI to Shocks in System Macroeconomic Variables.

Response to Generalized One S.D. Innovations

Response of LDSI to LDSI Response of LDSI to LCPI
.12 .12

.08 .08

.04 .04

.00 .00

- .04 - .04

- .08 - .08

- .12 - .12

- .16 - .16
2 4 6 8 10 12 14 16 2 4 6 8 10 12 14 16

Response of LDSI to LFDI Response of LDSI to LTB

.12 .12

.08 .08

.04 .04

.00 .00

- .04 - .04

- .08 - .08

- .12 - .12

- .16 - .16
2 4 6 8 10 12 14 16 2 4 6 8 10 12 14 16

Response of LDSI to LPR

.12

.08

.04

.00

- .04

- .08

- .12

- .16
2 4 6 8 10 12 14 16

15
 Table 7: Variance Decomposition
Variance Decomposition of LDSI due to innovations in
Period LDSI LCPI LPR LFDI LTB

4 60.74373 0.386244 16.04913 14.89349 7.927410

8 34.71359 1.075746 20.16964 28.75001 15.29101
12 23.08379 2.000862 15.47862 24.83220 34.60452
16 16.61807 3.137028 11.74128 18.22213 50.28150
Cholesky Ordering: LCPI LPR LFDI LTB LDSI

5.0 Conclusion

In this study we examine the role of macroeconomic variables in stock market movement during the

period of January 1991 to December 2006. We employed Databank Stock Index (DSI), interest rate,

inflation, net foreign direct investment and exchange rate. We examined the long run relationship

between share prices and group of macroeconomic variables using Johansen's multivariate

cointegration tests. Short run dynamics were traced using impulse response function and forecast error

variance decomposition analysis.

Cointegration analyses provide evidence in support of long run relationship between share prices and

macroeconomic variables identified over the time horizon in this study. Contrary to our hypothesis,

inflation positively correlates with share prices. This implies that the stock market provide partly or

full hedge against inflation. Our finding is consistent with Firth (1979); Anari and Kolari (2001); Luintel

and Paudyal (2006); and Gultekin (1983).

The FEVD test results indicate inflation explain small proportion of the variation of the share prices

compared to interest rate , net FDI inflow and exchange rate. Our suggestion base on the result is that

potential investors should pay more attention to interest rate followed by net FDI inflow and exchange

rate rather than inflation rate index (CPI).

Ghana being developing nation and net oil importing country, investment decision might be sensitive

16
to world oil prices and government financial policy. Future studies can therefore extend this study to

include these areas.

17
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