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MACROECONOMIC DETERMINANTS OF STOCK MARKET PERFORMANCE IN SRI LANKA

AN ECONOMETRIC ANALYSIS
N.P.Ravindra Deyshappriya
ravipdn@yahoo.com
ravindra@uwu.ac.lk
Lecturer in Economics
Faculty of Management
Uva Wellassa University
Badulla


Abstract
Stock markets have been becoming very crucial instrument in global economies, which can be used to reflect the
stability of financial system and rapid the economic growth. Therefore, empirical research works based on stock
market performance are quite common in the recent literature. In the context of Sri Lanka, the stock market has
reported a remarkable improvement during the past few years, giving considerable contribution to Sri Lanka
economic growth. Hence, it is timely important to examine the dated factors which promote the stock market
performance in order to ensure both financial and economic stability. Consequently, this paper attempts to identify
the macroeconomic determinants of stock market performance in Sri Lanka using quantitative tools. Basically, the
current study is based on time series data during the period of 1990 to 2009. After testing the order of integrated of
the variables with ADF test, the Vector Auto Regression (VAR) model has been employed to identify short run
dynamics of the stock market performance along with the Impulse Response Function, Variance Decomposition and
Granger Causality Test.
Market capitalization was used as a proxy for stock market performance and according to the results, a positive
shock of following variables such as balance of payment, growth rate of real GDP, openness, growth rate of FDI and
investment caused to sustain a positive effect on market capitalization while real interest rate is negative. According
to the variance decomposition, the variance of market capitalization is mainly explained by its own variable, balance
of payments and FDI. Further, Granger causality test captured that both FDI and real GDP significantly affect to the
market capitalization. Moreover, the higher level of economic growth, attraction of FDI and domestic investment
and stable BOP situation will account for higher level of stock market performance.
Keywords: Market capitalization, VAR model, Openness, FDI, Granger causality test

1. INTRODUTION
1.1 BACKGROUND OF THE STUDY

Stock market is the place where the shares are issued to fulfill the capital requirements of public companies and
make opportunities for investors to get benefits from their investments. In Sri Lanka, these transactions occur
through Colombo Stock Exchange (CSE). Considering the Share trading in Sri Lanka; it was originated in the 19th
century, when British planters needed funds to set up tea plantations in Sri Lanka. In fact, CSE has come a long
journey nearly for a century contributing to Sri Lanka economy immensely. According to the current situation of
CSE; it is the best performing stock market through the 52 markets beating to the Mongolia and Bangladesh
markets. At present, 235 companies are listed on the CSE, representing twenty business sectors with a market
capitalization of Rs. 2190 billion as in October 2010. All Share Price Index closed at 7,147, topping the 7,000 mark,
and increased by 150.56 points while the more liquid Milanka Price Index closed at 7,829.05 and increased by 3.66
percent. Colombo stocks rose 120 percent in 2009, ending the year as the world's second best performing market and

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Colombo Stock Exchange showing 110.9% development considering to the year 2009. Earlier Bloomberg ranked
CSE name as the second best performing stock market in the world, in the year 2010 CSE was already named as
the second best performing stock market globally in the year 2009. Therefore, most of the analyzers recognized the
CSE is now emerging as the 'wonder of Asia'.
Undoubtedly, the above evidence justifies the essentialness of the stock market for Sri Lanka economy in order to
achieve the expected level of growth and development during the planed time. However, the past experience
suggested that the performances of stock market tremendously depend on the political satiability and
macroeconomic condition of the country.
Figure 01 Behavior of the Market Capitalization

Sources: Colombo Stock Exchange
According to the behavior of market capitalization, it is apparent that the behavior of market capitalization is mainly
depending on the political satiability and economic stability as well. After finishing the civil war situation of the
country; especially after 2009, it has increased dramatically showing the highest value. Examining the existing
empirical works on this regards, Mohammad et al (2006) have used Pakistan data from 1971-2006 and found that
there is a direct relationship in between economic growth and stock market development. Not only by Mohammad et
al (2006) but Valeriano et al (1999) have also justified the same relationship by using a panel data analysis of fifteen
countries over the period from 1980-1995. According to the results of the co integration analysis, Adam et al (2008)
suggested that FDIs have a long run positive impact on stock market in Ghana. Cherif et al (2010) has contributed to
the literature by providing new evidence from the macroeconomic environment and institutional quality on stock
market development, using data from 14 MENA countries over the period of 1990-2007. The findings of this study
emphasized that, savings rate, financial intermediary, stock market liquidity, interest rate and income are the
important determinants of stock market development. Furthermore, Yartey C.A. (2008), he investigated the
macroeconomic and institutional determinants of stock market development in emerging economies using a panel
dataset of 42 countries for the period 1990 to 2004. The empirical analysis has found four results. First, income
level, domestic investment, banking sector development, private capital flows, and stock market liquidity are
important determinants of stock market development in emerging markets. Second, the relationship between
banking sector development and stock market development in emerging countries to be non-monotonic. This finding
suggests that at early stages of its development, the banking sector is a compliment to the stock market in financing
investment.
Even though the empirical works are much common for other countries, the researches based on CSE are rare in the
literature. In fact, it is worth to observe the mentioned relationships in the context of Sri Lanka to sustain and
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Behavior of Market Capitalization
MARKET
CAPITALIZATION

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enhance the CSE performances. Therefore, the current study mainly focuses on the identification of macroeconomic
determinants of stock market performances in terms of Sri Lanka.
1.2 PROBLEM STATEMENT
As mentioned in the earlier section, the central research problem of this study is What are the macroeconomic
variables that can influence the performances of Sri Lanka stock market? In fact, there are several empirical studies
have been taken place to examine the concerned matter here. However, the current study is quite different from the
existing empirical works since I have employed the VAR methodology to capture the short run dynamics of the
variables.
1.3 OBJECTIVES OF THE STUDY
Stock markets in all developed and developing countries are highly sensitive to the economic condition and the
information. It can be identified by examining the behavior of price indices and market capitalization of all
countries. In the context of Sri Lanka, even though stock market performances had dramatically been affected by the
unstable economic and political situation, currently it is performing quite well exhibiting the stability of economic
condition. It implies that, the stock market behavior in Sri Lanka also heavily depends on the macroeconomic
variables that rule the countrys economic performances. Therefore, the objective of this study is to identify the
macroeconomic variables that influence the stock market performances in Sri Lanka.
In the next section of this paper, the methodological choices have been motioned including data collection. Just after
that both results and discussion can be observed followed by conclusion policy implication of the study. Finally, the
bibliography and important appendices will be seen.

2. METHODOLOGY

2.1 DATA
Since this study mainly based on time series data during the period of 1990- 2009, the data set was collected by the
various issues of Central Bank annual reports. In addition to that, stock market data were collected from the CD
issued by the Colombo Stock Exchange and several issues of Socio Economic Statistics published by the Central
Bank of Sri Lanka also were considered. Moreover, the variable called Openness was collected from the Penn
world table that has been published by the University of Pennsylvania.

2.2 THEORITICAL METHODOLOGY
The methodology that is used here is the key pathway to accomplish the objectives of the study. Since we need to
capture the short run dynamics of the stock market performance, I intended to employ the Vector Auto regression
(VAR) model together with the several other techniques. However, the employment of any model probably depends
on the nature of the data series and therefore, the unit root test was applied in advance.

2.2.1 UNIT ROOT TEST
This research basically depends on the time series data. Therefore, it is wise to check data for stationarity in order to
avoid the spurious regression in time series data. Therefore, unit root test was done since; the unit root test that
captures the order of integration of the time series can be utilized to examine the stationarity. The unit root tests are

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carried out for all the variables in the model by using the Augmented Dickey-Fuller (ADF) test. The ADF test for
one unit root is based on the following regression
t
n
i
i t i t t
X t X X

=

+ A + + + = A
1
1
u o o
Where, Xt can be real any variable in the model, t represents time, t is the random error term, and n is the number
of lag, selected in terms of Schwarz Criterion (SC). The null hypothesis is = 0. If this null hypothesis is not
rejected, the corresponding time series will be non-stationary; otherwise, the time series will be regarded as
stationary and said to be integrated of order zero, denoted as I (0). Unless the null hypothesis is rejected, one should
correct the variables by taking their appropriate log transformation or differences.

2.2.2 VAR MODEL

In this effort to identify the determinants of stock market performance, basically I had intended to use Vector Auto
Regression (VAR) model to identify the short run dynamics of the market capitalization based on the integratedness
of the variables. Based on the following theoretical VAR model, the model has been estimated by considering the all
explanatory variables. Here, I just consider only bi-variants model to explain the theoretical base of VAR.
y2t q - 2t 2q 1 - 2t 21 q - 1t 1q 1 - 1t 11 2t
y1t q - 2t 2q 1 - 2t 21 q - 1t q 1 1 - 1t 11 1t
e y c y c y c y c y
e y b y b y b y b y
+ + . + + + . + + =
+ + . + + + . + + =

o


Since the interpretation of coefficients of the VAR model is quite complex and meaningless thing, in accordance
with the econometrics theories I used Impulse Response Function, Variance Decomposition and Granger Casualty
Test to evaluate the outcome of the VAR model. Based on those econometric techniques, the determinants of stock
market performance have been observed in the next few sections.

3. RESULTS AND DISCUSSION
3.1 UNIT ROOT TEST
The results of the unit root test that is based on the ADF test can be illustrated as follows.

Table -01: Results of Unit Root Test




Series Prob. Lag Max Lag Obs
BOP 0.0257** 0 3 18
GRMCAP 0.0123** 0 3 18
GRFDI 0.0225** 1 3 17
GRRGDP 0.0153** 0 3 18
INTER_R 0.0136** 0 3 18
OPEN 0.0001*** 1 3 17
INVEST 0.0295** 1 3 17



** - 5% significance level
*** - 10% Significance level

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According to the results, it is obvious that all the time series are stationary at their level form. It implies that the
variables in this analysis are I(0) that is probably needed for the VAR model. Consequently, the VAR model could
be utilized to accomplish the specified objectives.
3.2 VAR MODEL
As I mentioned in the methodology section, the interpretation of the coefficients of VAR output is quite meaningless
and very complex. In that sense, mainly three instruments; impulse response function, variance decomposition and
granger causality test are considered to analyze the results of the VAR model.

3.2.1 IMPULSE RESPONSE FUNTION (IRF)

Figure 02: Impulse Response Functions

IRFs trace out the expected responses of current and future values of each variable to a shock in one of the VAR
equations. In this regards, shocks can be defined or measured in different ways. The shock may be equal to the one
-100
-50
0
50
100
1 2 3 4 5 6 7 8 9 10
Response of GRMCAP to BOP
-100
-50
0
50
100
1 2 3 4 5 6 7 8 9 10
Response of GRMCAP to GRMCAP
-100
-50
0
50
100
1 2 3 4 5 6 7 8 9 10
Response of GRMCAP to GRFDI
-100
-50
0
50
100
1 2 3 4 5 6 7 8 9 10
Response of GRMCAP to GRRGDP
-100
-50
0
50
100
1 2 3 4 5 6 7 8 9 10
Response of GRMCAP to INTER_R
-100
-50
0
50
100
1 2 3 4 5 6 7 8 9 10
Response of GRMCAP to OPEN
-100
-50
0
50
100
1 2 3 4 5 6 7 8 9 10
Response of GRMCAP to INVEST
Response to Generalized One S.D. Innovations 2 S.E.

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standard deviation or one unit of the residual; otherwise one can follow the generalized impulse method depending
on the statistical package which they are using. In this study, I gave shock to the residual of each endogenous
variable which is equal to the one standard deviation and the following graphs illustrate the possible outcomes of
these shocks.
According to the illustration of the IRF below, any positive shock to the BOP will immediately increase the market
capitalization and it will continue increasing trend through the first and second time period. However, after second
time period the effect of BOP on market capitalization gradually declines and it will be dying out after 9
th
time
period. In fact, the surplus in BOP displays the stability of the economy that significantly enhances the stock market
performances through enriching the positive expectation in investors mind about future of the economy. Apart from
that, the second graph of the first panel visualizes that; any shock to FDI also will make a similar effect on market
capitalization as BOP. It is obvious that FDI directly increases the stock market performances, because some of the
FDIs are coming through the stock market. Otherwise once they established in the country, they used to issue the
shares to the public through the stock market. The first graph of the second panel indicates the effect of the real GDP
on market capitalization. Any positive shock in real GDP causes to increase the stock market performances, since it
provides positive signals about the forthcoming economy that really needs to flourish the performance of the stock
market. Moreover, the capital needed to boom the economy in real terms is most probably collected from the stock
market transactions. In that sense also the mentioned relationship can be justified. However, when a positive shock
is given to the real interest rate, it has an immediate negative effect on market capitalization. In fact, savings are
highly motivated when the real interest rates are increasing; consequently people who are willing to save more than
that, they are investing on the stock market since it involves in built risk. Despite, the effect of real interest rate will
be becoming a positive effect after the third time period and gradually dying out. The last two graphs illustrate the
effects of both openness and domestic investment on the market capitalization. As the graphs indicate both openness
and domestic investments create a positive impact on stock market performances since openness of the economy
attracts the foreign investors while domestic investments are boosting the stock market through demanding for
capital.
3.2.2 VARIENCE DECOMPOSITION
Variance decomposition decomposes the variance in an endogenous variable in to the component shocks to the
endogenous variables in the VAR. The variance decomposition gives the information about the relative importance
of each random innovation in the VAR. The column S.E. in the below Variance Decomposition table is the forecast
error of the variable for each forecast horizon. The source of this forecast error is the variation in current and future
values of the innovations to each endogenous variable in the VAR.
Table -02: Variance Decomposition


Period S.E. BOP GRMCAP GRFDI GRRGDP INTER_R OPEN INVEST


1 0.794086 6.990793 93.00921 0.000000 0.000000 0.000000 0.000000 0.000000
2 1.261128 20.33344 57.58427 11.86517 3.439550 4.511606 2.219295 0.046669
3 1.305084 17.39553 50.78294 21.00620 3.222043 4.295733 3.034853 0.262709
4 1.382247 24.59236 44.66843 19.13577 2.705930 4.553658 4.093230 0.250623
5 1.406474 24.70915 45.05361 18.71378 2.654816 4.444836 4.172469 0.251333
6 1.436899 24.85867 43.14997 17.64103 3.536650 5.510017 5.065901 0.237761
7 1.441983 24.74776 42.19394 18.52982 3.820166 5.457142 4.987670 0.263500
8 1.458211 25.31959 41.90659 18.25177 3.763512 5.476357 5.023096 0.259081
9 1.460959 25.30924 41.92601 18.26472 3.753390 5.471384 5.014718 0.260549
10 1.463314 25.25481 41.82507 18.20624 3.820569 5.542070 5.091544 0.259700

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According to the above table, the majority of the variance in the market capitalization is explained by its own
variable followed by the BOP and growth rate of FDI. Then all other variables such as real interest rate, real GDP,
openness and domestic investment account for the rest of variance of the market capitalization respectively.
However, the variance decomposition summarizes that all the variables considered in this study are important to
explain the variance in the market capitalization though some magnitudes are really low. Therefore, variables such
as BOP, FDI, and real GDP may have higher significance in policy formulations.
3.2.3 GRANGER CAUSILITY TEST
Basically, Granger Causality Test can be employed in order to examine the direction of the causality among the
variables. Granger-causality requires that lagged values of particular variable are related to subsequent values in
another variable, keeping constant the lagged values of secondly mentioned variable and any other explanatory
variables. The results of the Granger Causality test can be summarized as follows.
Table 02: Granger Causality Test
Null Hypothesis Observations F Statistic Probabilities
of F stat.
GRMCAP does not Granger Cause BOP 17 0.99358 0.3988
BOP does not Granger Cause GRMCAP 17 0.22433 0.8023
GRFDI does not Granger Cause GRMCAP 17 9.87437 0.0029**
GRMCAP does not Granger Cause GRFDI 17 0.67107 0.5293
GRRGDP does not Granger Cause GRMCAP 17 1.02433 0.0384**
GRMCAP does not Granger Cause GRRGDP 17 3.48919 0.0639
INTER_R does not Granger Cause GRMCAP 17 1.26193 0.3181
GRMCAP does not Granger Cause INTER_R 17 0.10426 0.9018
OPEN does not Granger Cause GRMCAP 17 0.78303 0.4790
GRMCAP does not Granger Cause OPEN 17 0.32804 0.7266
INVEST does not Granger Cause GRMCAP 17 2.49187 0.1244
GRMCAP does not Granger Cause INVEST 17 0.93896 0.4180

According to the results, both growth rates of FDI and GDP cause to the higher level of market capitalization by
indicating the performance of the stock market. Further, these results are statistically significant at 5% level.
However, all other determinants have not reflected statistically significant causality with the market capitalization,
despite the VAR model exhibits. The fact that, VAR model captures all the short run dynamic relationships among
the variables while the Granger Causality Test takes only the static relationships in to account. Therefore, Granger
Causality Test stresses only the direct relationship between two variables, not the dynamic relationships among the
variables.
4. CONCLUSION
In accordance with the findings of the study, balance of payment, growth rate of real GDP, openness of the
economy, growth rate of FDI AND investment positively related to the market capitalization. According to the
impulse response function, the stock market performances can be flourished by shocking the above mentioned
variables. In fact, those findings are fairly parallel with the findings of other empirical works. Especially,
Mohammed et al (2006) and Valeriano et al (1999) have revealed the same findings as the current study. Moreover,

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Adam et al (2008) has emphasized the positive relationship between growth rate of FDI and stock market
performance, reflecting the validity of the current study. Similarly, real interest rate showed a negative impact on
market capitalization during the considered period. This relationship has also been suggested by Cherif et al (2010).
According to Granger Causality Test, both the growth rate of real GDP and FDI granger cause to performances of
the stock market. The policy implications involve in this study, strongly recommend that the maintaining of
economic stability by managing the mentioned economic variables will account for a higher performance in stock
market. Therefore, it is quite essential to adopt appropriate policy changes in order to establish well developed stock
market that ensures the countrys economic growth as well.

5. BIBLIOGRAPHY
Adam, A. M. and George, T.(2008), Foreign Direct Investment (FDI) and Stock market Development: Ghana
Evidence, Munich Personal RePEc Archive
Atje, Raymond, and Boyan Jovanovic. (1993). Stock Markets and Development, European Economic Review 37
(2/3), pp. 632-40.

Bencivenga, Valerie R. , Bruce D. Smith, and Ross M. Starr. (1996). Equity Markets, Transactions Costs, and
Capital Accumulation: An Illustration The World Bank Economic Review 10 (2).

Berthelemy, Jean-Claude, and Aristomene Varoudakis. 1996. Financial Development Policy and Growth, OECD
Development Center.

Boyd, John and Bruce Smith. (1996). The Coevolution of the Real and Financial Sectors in the Growth Process
The World Bank Economic Review 10 (2).

Campbell, J. Y., (2003), Consumption-Based Asset Pricing,.in Constantinides, Handbook of the Economics of
Finance (Volume 1B, chapter 13), 803-887.

Carr, P. and D. Madan, (2001), Optimal Positioning in Derivative Securities, Quantitative Finance 1, 19-37.

Carr, P. and L.Wu, (2004), Variance Risk Premia,.Working Paper, Bloomberg L.P. and Courant Institute.

Cherif M and Gazadar K.,(2010), Macroeconomic and institutional determinants of stock market development in
MENA region: new results from a panel data analysis, International Journal of Banking and Finance, Vol. 7, 8


Mohammad, M.R and Mohammad, S., (2006), The determinants of economic growth in Pakistan: Does stock
market development play a major role?

Roeder, P.G. (2001). Ethnolinguistic Fractionalization (ELF) Indices, 1961 and1985. Retrieved from
http//:weber.ucsd.edu\~proeder\elf.htm

Valeriano F. Garcia and Lin liu,(1999), Macroeconomic determinants of stock market development, Journal of
Applied Economics, Vol. II, No. 1 (May 1999), 29-59

Yartey, C. A. (2008). The determinants of stock market development in emerging economies: Is South Africa
different? IMF Working Paper No.08/32.

Zoli, E. (2007). Financial development in emerging Europe: The un_ nished agenda. IMF Working Paper No.
07/245 .

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APPENDICES
VAR output
(0.16460) (15.1504) (0.95933) (0.26562) (0.41512) (1.97315) (0.05114)
[-2.06438] [-0.86747] [ 0.46545] [-1.83675] [-0.47080] [-0.37487] [-2.16722]

INTER_R(-1) -0.116454 -6.347707 -0.723230 -0.142466 0.250292 0.393916 -0.006638
(0.07029) (6.46930) (0.40964) (0.11342) (0.17726) (0.84255) (0.02184)
[-1.65685] [-0.98120] [-1.76554] [-1.25609] [ 1.41201] [ 0.46753] [-0.30398]

OPEN(-1) 0.058994 3.091904 0.346846 -0.019744 -0.134713 -0.734875 0.003694
(0.02280) (2.09885) (0.13290) (0.03680) (0.05751) (0.27335) (0.00708)
[ 2.58710] [ 1.47314] [ 2.60984] [-0.53658] [-2.34249] [-2.68841] [ 0.52143]

INVEST(-1) 0.320434 15.67056 -2.576070 0.285403 0.263925 -0.979453 1.048028
(0.16010) (14.7358) (0.93308) (0.25835) (0.40376) (1.91916) (0.04974)
[ 2.00147] [ 1.06343] [-2.76083] [ 1.10472] [ 0.65366] [-0.51035] [ 21.0691]

C -21.05558 -627.7321 47.75726 4.382741 -2.039173 48.23274 -0.331973
(5.06407) (466.107) (29.5140) (8.17177) (12.7713) (60.7046) (1.57339)
[-4.15784] [-1.34676] [ 1.61812] [ 0.53633] [-0.15967] [ 0.79455] [-0.21099]

@TREND 0.063947 -3.615535 0.389497 0.023733 -0.346616 0.397068 -0.017391
(0.04238) (3.90094) (0.24701) (0.06839) (0.10689) (0.50805) (0.01317)
[ 1.50883] [-0.92684] [ 1.57686] [ 0.34702] [-3.24286] [ 0.78155] [-1.32069]


R-squared 0.772913 0.695176 0.803430 0.777518 0.772633 0.577648 0.993475
Adj. R-squared 0.571058 0.424222 0.628701 0.579757 0.570530 0.202223 0.987675
Sum sq. resids 5.675152 48078.29 192.7676 14.77785 36.09537 815.4968 0.547840
S.E. equation 0.794086 73.08921 4.628025 1.281399 2.002647 9.518968 0.246721
F-statistic 3.829053 2.565660 4.598151 3.931595 3.822956 1.538652 171.2885
Log likelihood -15.15242 -96.55282 -46.88091 -23.76572 -31.80303 -59.86173 5.888399
Akaike AIC 2.683603 11.72809 6.208990 3.640635 4.533670 7.651303 0.345733
Schwarz SC 3.128788 12.17328 6.654176 4.085821 4.978856 8.096489 0.790919
Mean dependent -7.922222 -22.49598 1.610643 5.138889 0.863889 0.344444 25.30000
S.D. dependent 1.212463 96.32207 7.595106 1.976669 3.055891 10.65735 2.222346


Determinant resid covariance (dof adj.) 11159.92
Determinant resid covariance 87.18688
Log likelihood -218.9987
Akaike information criterion 31.33319
Schwarz criterion 34.44949