A Monthly Data Analysis of the Impact of Inflation and Exchange Rate on NSE Index

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1 Vol. 3, No. 2, 2014, A Monthly Data Analysis of the Impact of Inflation and Exchange Rate on NSE Index Michael Segun Ogunmuyiwa 1, Babatunde A. Okuneye 2 Abstract This research study investigates the impact of inflation and exchange rates on the performance of the stock market in Nigeria. Using Consumer Price Index (CPI) to proxy inflation and the parallel exchange rate of the naira to the dollar to measure exchange rate, various econometric techniques like the Augmented Dickey Fuller (ADF) test, the Phillips Perron (PP) test and the Box Jenkins O.L.S technique were employed on monthly time series data from 2011:6 to 2013:3. Empirical findings revealed that the stock market does not provide a hedge against inflation in Nigeria. Also, inflation and exchange rates are crucial macroeconomic variables determining the movement of stock returns and the overall performance of the Nigerian Stock Market Index. JEL Classification: E31, E44, G10, C40 Keywords: inflation rate, exchange rate, NSE index, box jenkins 1. Introduction The rate of inflation and a country s exchange rate are critical macroeconomic variables determining movements of the stock price. The effect of both inflation and exchange rate are intertwined as far as movement in the share price is concerned. Inflation is a persistent and incessant rise in the price level without a matching increase in the quantity of goods and services in the economy over a period of time. An increase in the general price level leads to a fall in the value of the domestic currency. That is, each unit of the country s currency buys fewer goods and services reflecting erosion in the purchasing power of money and subsequently a loss of real value in the internal medium of exchange and unit of account in the economy, as well as reducing the external worth of the country s currency among other baskets of currencies. Thus, the inflation process if unabated could lead to a fall in the value of the domestic currency. No doubt, money loses its function as a standard for deferred payment and store of value during the period of inflation. Borrowers gain during the inflationary period and lenders lose thereby making lending unattractive and this consequently affects the capital formation process and the country s economic growth. However, the stock market performs the function of financial intermediation and promotes economic growth by channelling funds from surplus to the deficit units in the economy. Equity markets create a forum for trading in financial assets whereby business firms are able to obtain investments funds through the issuance of shares and thus facilitating them to meet their investment objectives. The role of the stock market in promoting economic growth through financial intermediation could be hampered by incessant inflation and exchange rate fluctuations as their performance greatly influence the prices of financial assets. Persistent inflation affects the prices of stock and the eventual returns and dwindling exchange rate inhibits not only stock prices and returns but also the overall performance of other stock market indices. In Nigeria, the movements in inflation rate measured by Consumer Price Index (CPI), exchange rate and the NSE index as shown in the figure (1) below revealed that percentage change in the 1 Department of Economics, Olabisi Onabanjo University P.M..B 2002, Ago-Iwoye, Nigeria 2 Department of Economics, Olabisi Onabanjo University P.M..B 2002, Ago-Iwoye, Nigeria 2014 Research Academy of Social Sciences 56

2 NSE Index are higher than percentage changes in both inflation and exchange rate for the period under review. Negative percentage change of the NSE index from the 2 nd quarter of 2011 to 2 nd quarter of 2012 is indicative of the fall in share indices occasioned by the global economic meltdown. By the 3 rd quarter of 2012 through 1 st quarter of 2013, the economic variables particular the NSE index have manageably recovered from the effect of the financial crisis, albeit inflation continued on a negative trend II III IV I II III IV I % Change CPI % Change ER % Change NSE Fig 1: Percentage Multiple Bar Chart of CPI, ER and NSE (2011:6-2013:3) Also, imported inflation occasioned by contagion effects from the country s trading partners and external shocks arising from global economic recession also inhibits the performance of macroeconomic variables such as inflation, interest rate and exchange rate in the domestic economy and these consequently affect the performance of stock market variables. It is the direct/internal and indirect/external impacts of inflation and exchange rates that this study hopes to investigate. 2. Review of Empirical Studies Several studies abound on the relationship between macroeconomic variables and stock market performance in general and inflation and exchange rate in relation to stock market performance in particular. Inflation rate has both positive and negative effect on the corporate sector as some industries benefit while others suffer (Chandra 2004). It also has negative effect on consumer price index (CPI), (Fama and Schwert, 1977), and share prices as investors under- value equity (Amadi and Ddubo (2002). Tanggaard (2002) study finds a moderately positive relationship between expected stock returns and expected inflation in the U.S. Also, Sharfe (2002) suggests that rise in expected inflation reduces equity prices in the U.S. The negative relationship between inflation and stock returns has been established by Najandand and Noronhal (1988) in Japan, Zhao (1999) in China and Crossby (2001) in Australia. Contrary to the above, Samarakoon (1996) found that nominal stocks are positively related to expected inflation in a one-to-one correspondence in Sri Lanka. For the Ghanian economy, Kyereboah-Coleman and Agyire-Tettey (2008) concluded in their study of the impact of macroeconomic indicators on Ghana stock market that lending rates from deposit money banks have adverse effect on stock market performance. The study also found inflation to be negatively related to stock market performance and this effect takes time because of the presence of a lag period. Onwusu-Nantwi and Kuwornu (2011) investigates the relationship between macroeconomic variables and stock market returns using monthly data spanning from January 1992 to December, The OLS model in the context of Box-Jenkins methodology was used in analyzing the impact of macroeconomic variables on stock market returns in Ghana. Their empirical findings reveal that there is a significant 57

3 M. S. Ogunmuyiwa & B. A. Okuneye relationship between stock returns and consumer price index used as a proxy for inflation. The study conducted by Kimani and Mutuku (2013) on the Kenyan economy using quarterly data from 1998 to 2010 revealed a negative relationship between inflation and stock market performance in Kenya. The study conducted by Omotor (2010) on the relationship between inflation and stock market returns in Nigeria and the findings revealed that stock market returns may provide and edge against inflation in Nigeria. Amadasu (2011) and Osamwonyi (2003) noted that since the exchange rate is the price of a unit of domestic currency in terms of a foreign currency. A rise in it negatively affects the performance and profitability of industries relying on imports, external trade, Balance of Payments and the level of external reserves influence the exchange rate. Bahmani and Sohrabian (1992) found a bi-directional causality between stock prices measured by the Standard & Poor's 500 index and the effective exchange rate of the dollar, at least in the short run. However, the co-integration analysis revealed no long run relationship between the two variables. Similarly, Abdalla and Murinde (1996) investigated the interactions between exchange rates and stock prices in the emerging financial markets of India, Korea, Pakistan and the Philippines. The results of the granger causality tests results show unidirectional causality from exchange rates to stock prices in all the sample countries, except the Philippines. Ajayi and Mougoue (1996), using daily data for eight countries, show significant interactions between foreign exchange and stock markets. Aggarwal (1981) examined the relationship between US stock market indexes and a trade weighted value of the dollar for the period and finds that the stock prices and exchange rates are positively related. Negating Aggarwal s (1981) study is the work of Soenen and Hernigar (1988) using monthly data which found a strong negative relation between US stock indexes and fifteen currency weighted value of the dollar for the period Amadasu (2012) analyzed the impact of interest rate, inflation and exchange rate on stock market index in Nigeria using co-integration on annual data between 1975 and The findings revealed that some relationships exist among the variables, albeit not significant. Singh et al (2012) conducted a study on the influence of exchange rate and inflation on the performance of Bombay Stock Exchange (BSE) sensex. The study employed regression analysis on monthly time series data from April, 2007 to March, The results revealed that inflation and exchange rate significantly affect the performance of BSE sensex. 3. Methodology and Empirical Findings The shortcomings of the Capital Asset Pricing Model (CAPM) has led to the development and testing of various alternative asset pricing specifications such as the Arbitrage Pricing Theory (APT) and the Present Value Model (PVM). This study employs the Arbitrage Pricing Theory (APT) since in the context of macro dynamics of stock returns, the APT assumes that returns are generated by a number of macroeconomic factors. It allows multiple risk factors to generate asset returns. The APT is expressed as follows: E(R j ) = R j + (β 1 F 1 + β 2 F 2 + β 3 F β n F n ) +UR s... (1) Where E(Ri) is expected predictable return, β 1 is firm s (j) factor one beta, β 2 is factor two beta etc. F represents surprise in factors and UR is unanticipated return. Model Formulation To investigate the impact of inflation and exchange rate on NSE Index, we posit the following behavioural relationship in line with the aforementioned APT model. The model is stated in semi-log or loglin model form as follows: 58

4 We proxy inflation with Consumer Price Index (CPI) for all goods and services, parallel exchange rate is used to represent the exchange rate and the NSE Index is used to represent the stock market performance. All the data are on monthly basis from June 2011 to March 2013 sourced from Central Bank of Nigeria (CBN) bulletin and the NSE publications various issues. Unit Root Test priori terms, Most time series data are trended over time and regressions with trended series may produce significant parameters with high R 2, but may be spurious and meaningless. To make time series data with unit roots stationary, an evaluation of each of the variables for the presence of unit root using both the Augmented Dickey Fuller (ADF) and Phillips Perron (PP) tests. The regression equations for both levels and first difference are formulated below: Where y is the variable whose stationarity is being examined, M is the number of lags and (t) represents time. The rule is that M should not be too large to prevent the presence of autocorrelation. In this case M=1. 4. Empirical Results and Discussion of Findings Table 1: ADF and PP Test Results (2011:6-2013:3) Augmented Dickey Fuller (ADF) Test Results (2011:6-2013:3) LEVEL ( Intercept only) 1 st Difference (Intercept only) Lags Vars ADF P-Value ADF P-Value 1 NSE CPI Order of Integration I(1) I(2) 1 ER Phjllips Perron (PP) Test Results (2011:6-2013:3) Lags Vars PP P-Value PP P-Value Nil NSE Nil CPI I(0) Order of Integration I(1) I(2) Nil ER I(0) 59

5 M. S. Ogunmuyiwa & B. A. Okuneye The ADF and PP test were conducted with intercepts only to compare the results of both tests. From table 1, it is observed that both ADF and PP regressions generated similar results and only ER was found to be stationary at levels. NSE and CPI were found to contain unit roots and therefore not stationary at levels. After applying 1 st difference on the variables, NSE was found to be stationary and CPI with repeated lags up till the 4 th lag was not stationary. Therefore, the 2 nd difference was performed on CPI and that made it an I(2) series. Since, the series are not of the same order of integration, the conventional co-integration and parsimonious error correction specification becomes inappropriate. To find the short run interactions between these variables, equation (2) is reformulated in 1 st difference form in the context of Box Jenkins methodology Box and Jenkins (1976). Where FDNSE= is the 1 st difference of NSE index, FDCPI= the 1 st difference of consumer price index and FDER = the 1 st difference of exchange rate. Table 2: Box Jenkins O.L.S Results (2011:6-2013:3) Dependent Variable: FDInNSE Variables Coeff Std Error t-value Prob C FDCPI FDER AR(1) R-squared = f-statistic= Prob(f-stat) = Adjusted R-squared = Durbin-Watson = From table 2, it is evident that exchange rate is correctly signed while inflation rate proxied by consumer price index fails to conform with a-priori expectation. That is, a fall in the exchange rate of /$ improves performance of the stock market. So, also a rise in the inflation rate also portends increase in stock returns. The standard error of both FDCPI and FDER are insignificant. The t-statistics for FDCPI and FDER are also found to be insignificant. The adjusted R 2 of only explains 90 percent variation in stock index movements being responsible for by both inflation and exchange rate. The significance of the f- statistics confirms that the regression is of good fit. Figure (2) shows that the residual is stationary around 0 i.e mean reverting. 6) 36,000 32,000 28,000 3,000 2,000 1, ,000 20,000 16,000-1,000-2,000-3,000 III IV I II III IV I Residual Actual Fitted Figure 2: Residual, actual and fitted plots of NSE Index 60

6 The regression without the autoregressive term gave a D.W statistics of which shows some serious problem of autocorrelation. However, with the introduction of the autoregressive term AR(1), the Durbin Watson improved to as well as the R 2 and its adjusted value. Regression with log differenced component failed to improve the performance of the parameter estimates and therefore not made use of. 5. Conclusion and Policy Implication This paper investigates the impacts of both inflation and exchange rate on the performance of the Nigerian stock market. Macroeconomic variables employed are consumer price index as a proxy for inflation, parallel exchange rate as a measure of exchange rate and the Nigerian stock exchange index as a measure of the stock market performance. Econometric analysis via the ADF and PP tests for stationarity showed that inflation is I(2), NSE index is I(1) and exchange rate is I(0). Consequent upon the above, the Box Jekins methodology of employing the differenced series into the regression model becomes appropriate and was made use of. The results however revealed that inflation is positively related but not significant to stock market performance while exchange rate of the /$ is found to be negatively and also insignificantly related to the NSE index. The policy implication is that the positive relationship between FDCPI and NSE index implies that the Nigerian stock market does not provide a hedge against inflation. That is, in Nigeria stocks cannot be used as a hedge against inflation. As inflation rises the return on stocks is expected to increase. This empirical outcome in the Nigerian case is in agreement with previous studies such as Choudhry (2001), Maysami et al (2004) and Onwusu-Nantwi and Kuwornu (2011). The negative relationship between exchange rate and NSE index.also sjgnals that a fall in the exchange rate of /$ improves stock returns at the Nigerian stock exchange market. Hence, exchange rate and inflation are important variables determining stock market returns and investors must be mindful of these variables as continuous increase inflation may be counterproductive for stock returns in the long run. Policy makers also need to guide the exchange rate of the naira against other currencies to encourage and protect investors in the Nigerian stock market. References Abdalla, I. S. A. and V. Murinde (1996). Exchange rate and stock prices interactions in Emerging financial markets: Evidence on India, Korea, Pakistan and Philippines. Applied Financial Economics, Vol 7, Aggarwal, R (1981). Exchange Rate and Stock Prices: A Study of US Capital Markets Under Floating Exchange Rates. Akron Business and Economic Review. Vol 12, No 2, pp Ajayi, R. A. and M. Mougoue (1996), On the Dynamic Relation between Stock Prices and Exchange Rates, Journal of Financial Research Vol 19, Amadsu D.E (2012). Interest Rate, Inflation Rate and Exchange Rate Influence on the Nigerian Stock Market Index. An International Journal of Arts and Humanities, Vol 1, No 3, pp Bahmani-Oskooee, M. and A. Sohrabian (1992). Stock Prices and the Effective Exchange Rate of the Dollar, Applied Economics, 24, 4, Chandra, P. (2004). Investment Analysis and Portfolio Management, McGraw-Hill, New Delhi. Choudhry, T (2001). Inflation and Rates of Return on Stocks:Evidence from High Inflation Countries. Journal of International Financial Markets, Institutions and Money. Vol 11, No 1, pp Crossby, M (2000). Stock Returns and Inflation. Australian Economic Papers. Vol 40, pp

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