DEDICATIONS
This dissertation is dedicated to my late father, and my mother for their enduring moral and financial support.
Thank you, uncle, Dorcas and Ruvimbo
ACKNOWLEDGEMENTS
I wish to acknowledge my profound gratitude to the many people who contributed in various ways to make this project a reality. The preparation of this document would not have been possible without the invaluable and unequal support received from these people in their different capacities.
Most of all I would like to thank the Lord for the guidance. In addition I would like to thank my supervisor, Mr. Mandishekwa for his tremendous efforts and guidance that really helped me in completion of this project. I would also like to thank my econometrics lecturer, Mr.Dzingirai who made me know this module, that I can do a project on it. I would like to thank the entire Economics department as a whole for guidance.
I would also want to acknowledge the tremendous support received from my family and friends. To Sylvia Musekiwa and Sikelela Ncube thank so much for your machine-you saved
ABSTRACT
This study examines the dynamic interactions between the stock market and inflation, 90-day Treasury bill rate and exchange rate in Zimbabwe for the period 1995:01 to 2007:03. The study uses tests for Granger causality. The stock market has been on an upward trend for most of the period under study. The depreciation of the currency on the parallel market and the changes in inflation can explain the recent rapid increase in stock prices. Granger causality tests using the Sims approach reveal uni-directional causality between inflation and industrial share index and bi-directional between exchange rate and the industrial share index and bi-directional causality from industrial share index to interest rates
TABLE OF CONTENTS
DEDICATIONS
ACKNOWLEDGEMENTS
ABSTRACT
TABLE OF CONTENTS
1.0Introduction
1.3 Objectives of the Study
1.4 Significance of the Study
1.5 Research Hypothesis
1.6 Research Questions
1.7 Assumptions
1.9 Organization of the Study
CHAPTER 2
LITERATURE REVIEW
2.0 Introduction
2.1 Theoretical Review
2.2 Empirical Review
2.3 Conclusion
METHODOLOGY
3.0Introduction
3.1 Model Specification
3.2 Diagnostic Tests
3.2.1 Unit Roots Tests
3.2.2 Integration and Cointegration Tests
3.2.3 Causality Tests
3.3 Justification of Variables
3.3.1 Exchange Rates
3.3.2 Consumer Price Index (As a Measure of Inflation)
3.3.3 Interest Rates
3.3.4 The Stochastic Error Term (The Disturbance Term)
3.4 Data Characteristics
3.5 Strengths and Weaknesses of the Model
3.5 Conclusion
CHAPTER FOUR
DATA PRESENTATION
4.0 Introduction
4.1 Unit Roots Tests and Cointegration Results
4.2 Interpretation of Results
4.3 Conclusion
CHAPTER FIVE
RECOMMENDATIONS and CONCLUSIONS
5.0 Introduction
5.1 Policy Recommendations
5.2 Suggestions for Future Research
5.3 Conclusions
REFERENCES
APPENDIX
List of Tables
Table one-optimal lag length……………………………………………………...... 21
Table two-results of unit roots tests……………………………………………...... 22
Table 3-causality results…………………………………………………………...... 23
Table four-direction of causality...... 24
List Of Figures
Figure one: Trend in the industrial index…………………………………2
Figure two: Trend of the inflationary pressure……………………………3
List of appendix
Appendix A: data set……………………………………………………34
Appendix B unit roots tests……………………………………………..36
Appendix C causality tests………………………………………………40
1
CHAPTER ONE
INTRODUCTION
1.0Introduction
Since stock markets are vital for any well defined financial system of a country, this researchwill explore the linkages and the relationships between the Zimbabwe Stock Exchange (ZSE) industrialindex and the highlighted macroeconomic variables of consumer price index (CPI), short term nominal interest rates(90-day TB-rate) and exchange rates(ZWD/USD). TheZimbabwe stock exchange acts as a secondary market giving a platform for companies to raise capital through ‘issues’ to theinvesting public. This chapter encompasses: the background of the study, statement of the problem, objectives,significance of the study, research questions,research hypothesis, limitation/delimitations, assumptions andorganization of the study.
1.1Background of the Study
The Zimbabwe stock exchange is a small dynamic stock exchange. It was open to investors since 1993.It formalized its operations following passing of the Stock Exchange Act which was implemented in 1974 by then it was the Rhodesian Stock Exchange (RSE).Since then the Zimbabwe stock exchange has grown immensely to become one of the most important equities exchange in Africa and a provider of servicesthat ease the increasing of capital and the dealings of shares. In Africa the Zimbabwe stock exchange boast as the third largest bourse after the JohannesburgStock Exchange(JSE) of South Africa and CasablancaStock Exchange of Morocco. According to its website ( more than seventy five (75) local and international companies are now listed with the local bourse.
The Zimbabwe stock exchange reports on trading prices daily .Basically there are two weighted indices;the industrial index and the mining index .The industrial index uses data from various industrial counters listed with the Zimbabwe stock exchange and it cuts across all the sectors of the economy. The mining index on the other hand uses strictly data from the mining sectorof the economy (ZSE website).
According to Adept solutions (1999), developments in the Zimbabwe Stock Exchange have been largely influenced by the prevailing unstable macroeconomic conditions, characterized by low interest rates, dual interest rates, exchange control, shortage of foreign currency and hyperinflation as well as the unstable political situation, land reforms and decline in foreign participation.
Over the years 1995 to 2005 the trend between the ZimbabweStock exchange and the selected macroeconomic variables of interestrates, exchange rates and consumer price index was rather positive. The industrial index was fluctuating below the inflation rate (represented by the CPI in this case) and the interest rates from the beginning of the period under study but later caught up with inflation rate as from 2006.Besides the soaring interest rates and ever increasing inflation rate as well as persistent depreciation in the Zimbabwean dollar against major currencies such as the united states dollar, the ZSE sustained an upward trend (2006 monetary policy statement). The trend in the ZSE index is shown in the figure below.
Figure One: Trend In Industrial Index
Source Zimbabwe Stock Exchange
It is due to the above mentioned background that The African Stock Exchange Association (ASEA) rated the ZSE as thebest performing bourse on the African continent for the year 2005.. This rise was well above of the Casablanca Stock Exchange one of its closest rivals.
One of the major challenges to the economy at the inception of reforms was high inflation. This high level of inflation resulted in reduced operations and company closures because of cash flow mismatches. The inflation level for the year 2007 was very high compared to SADC partners thus eroding the economy’s export competitiveness. It was fuelled by high budget deficit, high interest rates, deteriorating terms of trade, electricity and fuel shortages. (RBZpublications) The graph below illustrates the trend of the inflationary pressures that affected the economy.
Figure two: Trend Of The Inflationary Pressure
Source: Reserve Bank Of Zimbabwe
The trend of the consumer price index indicates that there was an upward path of the inflation between 1995 and 2004. This upward trend in inflation continued even up to 2007. These inflationary trends are expected to have depressed stock market activity by lowering business activity. Because it is the main signal for business in market driven economies, an increase in inflation raises the country’s economic risk and thus can scare off foreign investors.
When reforms were introduced the local currency had to be devalued to promote exports. The local currency was then pegged at about Z$38/US$ from 1998 until it was devalued again by 44.4% in August 2000 to Z$55/US$(RBZ 1997). The influence that the devaluation of the Zimbabwean dollar could have had on the performance of the ZSE is not clear. It depends on the net benefits to both exporters and importers.
Interest rates were relatively high because of limited competition in the banking system. In October 1995, the RBZ redefined the rediscount rate to reflect its medium term view on inflation and thus maintained it at 29.5% when inflation was above 22 %.( RBZ 1996). High inflation resulted in the minimum bank lending rates being raised negatively impacting on equity investment. Positive real rates of interest were maintained in the money market.
The impact the Treasury bill rate could have had on the stock market is obviously negative because an increase in the Treasury bill rate is expected to have to channel funds from the stock market to the money market.
1.2 Statement of the Problem
Basically according to theoretical and economic postulations, a good stock market performance is due to good macroeconomic performance, Smithet al(1994). However in the case of Zimbabwe, the country was experiencing the worst melt down during most of the period under review but the stock market has sustained an upward trend. According to the ZSEwebsite, it was rated as the as the best performing stock exchange in the world rising capital markets in 2007.
The researcher therefore intends to investigate why the ZSE under those unfortunate circumstances has managed to defy the odds and emerge as the best performing stock exchange among the world emerging capital markets by looking at the relationship between the ZSE’s industrial index and the selected macroeconomic variables.
1.3 Objectives of the Study
In carrying out this research, the researcher intends to fulfill the following objectives:
- To establish whether the selected macroeconomic variables are crucial in explaining the behavior of the stock market.
- Scrutinize the long run relationship between the performance of ZSE and the selected macroeconomic variables(interest rates, exchange rate and consumer price index)
- To contribute to the international debate regarding the relationship between these variables. In so doing the researcher will avail some new literature on the sophisticated relationship among the selected macroeconomic variables and the stock market industrial index.
1.4 Significance of the Study
In tackling this topic, the researcher will get an informed perspective between the ZSE industrial index, interest rates, exchange rates and consumer price index. Theinstitution, MidlandsState University is going to harness this work as one of the foundations for further research to the related areas as well as teaching aids. The information from this research can also be lead to effective policy implementation by policy makers. To the investor it aids investment decision in different economic climate.
Although research in the area has been well documented and well covered in both the developed and developing worlds including Zimbabwe-for example Oyama (1997) investigated the relationship between the stock market and macroeconomic variables in Zimbabwe using the Revised Discount Model,ECM and Multifactor Return Model, Sadosky(2001) studied the interaction between the stock market and economic activity in the US and Kurihara(2006) investigated the relationship between macroeconomic variables and daily stock prices in Japan the period covered by the researcher is of great interest to many stakeholders who have questioned the ability of macroeconomic fundamentals in explainingZSE given the illicit dealings that caused speculative behavior on the local bourse.
In addition, given the fact that the year 2007 was almost the dusk of the hyperinflationary environment and the use of the Zimbabwean dollar as legal tender in Zimbabwe the researcher is likely to close the curtain in the Zimbabwean dollar era.
1.5 Research Hypothesis
H0:macroeconomic variables does not Granger cause ZSE index
H1: macroeconomic variables Granger cause ZSE index
1.6 Research Questions
In tackling this research, the researcher should answer the following questions:
- Which of the selected macroeconomic variables has greatest influence on the performance of the Zimbabwe stock exchange?
- Is there any causal relationship between the selected macroeconomic variables and the ZSE industrial index?
- If there is any causality what is the direction of the causality?
1.7 Assumptions
In carrying out this research the researcher assumed the following:
- All the information about the variables in question is authentic and satisfactorily reliable. Therefore all the data sources used (CSO, RBZ and IMARA) are reliable in collecting their data.
- The econometric package (E-views student’s 3.1 versions) used correctly computes the relationship between the variables under consideration.
- The causal ordering is unknown. It is unknown which variable is a cause and which one is a result of the relation.
1.9 Organization of the Study
This research will be conducted in a systematic way as follows:
Chapter two offers both the theoretical and empirical literature. Chapter three considers the methodology employed by the researcher in the study. It also highlights the data used. More so, it justifies the inclusion of certain variables in the study. Chapters four presents and analyze the findings from chapter three (results will obtained using E-views student’s 3.1 version).Chapter five summarizes the research findings and also proposing policy recommendations drawn directly from this study.
CHAPTER 2
LITERATURE REVIEW
2.0 Introduction
Sir Isaac Newton once said, “It is by standing on the shoulders of giants that you can manage to see more than others.” The researcher therefore exploits the ideas put forth by different individuals about the particular issues in this chapter in order to add value to his research.
This chapter reviews both theoretical and experimental underpinnings of this study. Literature on the various studies on stock market performance is examined to give lessons to the current study. Theoretical review analyses the theoretical premises of this while empirical assess past researches for both developing and developed economies that are relevant to this study. There are various opinions reflecting wide views towards the impact of real interest rates, exchange rates and consumer price index on stock market performance. The behavior of the world’s stock market performances exhibit diverse responses to the various macroeconomic variables in question.
2.1Theoretical Review
Irving Fisher (1930) found that real interest rates were equal to nominal interest rates minus expected inflation. This macroeconomic relationship is known as the Fisher Effect. The Fisher Effect is unique in that it incorporates expected inflation as opposed to actual inflation rates into the analysis. This is crucial to this study because it allows the use of rational expectations model.
The Fisher Effect is primarily an alternative way of measuring real interest rates and is used as a means of relating interest rates and inflation expectations to stock prices. To fully understand the relationship between the Fisher Effect and stock prices, it is necessary to understand the individual relationships between inflation expectations, interest rates, and the stock market.
An Efficient Market is market in which the values of securities at any instant in time fully reflect all available information resulting in the market value and the intrinsic value being the same. Propounded by Fama (1970) EMH also states that the prices of shares will immediately adjust to new information. There are three different types of efficiency in an efficient market. These are weak form, semi strong form and strong form.
The weak form fully incorporates information about past stock prices. Stock prices are said to follow a random walk as the information on stock comes in a random manner. Attempts to use technical analysis are futile in predicting future prices. In the semi strong form, prices incorporate all publicly available information including published accounting statements as well as historical price movements. Thus any information that can be extracted is already reflected in the price.
In the strong-form all information public or private is incorporated. It makes the most stringent demand on information since it says that even the information available only to those closely concerned with the firms has already been taken up and incorporated in the price.The main fundamental implication of EMH is that if the markets are efficient then it is impossible for investors to exploit information in order to earn excess returns over a sustained period of time (Howells and Bain 2002).
As for the effect of macroeconomic variables on the stock market EMH suggests that competition among profit maximizing investors in an efficient market will ensure that all the relevant information currently known about changes in macroeconomic variables are fully reflected in current stock prices so that investors will not be able to earn abnormal profits through prediction of future prices, Chong and Goh (2003).
The Capital Asset Pricing Model (CAPM) was developed by Sharpe and Litner in 1964. It is an equation that equates the expected rate of return on a stock to the risk free rate and the risk premium for the stock’s systematic risk, Martin and Scot jnr (1996). Basically, the CAPM illustrates the relationship between expected return on an individual security and the beta of the security. The beta according to Hull (1997) is a parameter that shows the relationship between the return on a portfolio of stocks and the return on the market.
In all, the model argues that the investor requires excess returns to compensate for any risk that is correlated to the risk in the return from the stock market but requires no excess return for other risks. The Arbitrage Pricing Model (APM) was developed by Ross (1976). According to the APM returns vary from their expected amounts because of unanticipated changes in a number of basic economic forces such as industrial production, inflation rates, term structure of interest rates and the difference in interest rates between high and low risk bonds, Martin and Scot jnr (1996). It suggests that the risk of a security is reflected in its sensitivity to unexpected changes in important economic forces.
The Classical case of investment and savings theory strongly argue that the savings are invested as a result of interest mechanism. They propel that in an economy where demand and supply forces are at play, savings and investments are equated in the economy. They suggest that both investments and savings are functions of interest rates. Savings are positively related to the rate of interest. As interest rates rise, people are induced to save more and the convex is typically true. If on the other hand, the interest rates decline, depositors are discouraged to save and they transfer their money from the money market to equity market and the stock market will start to perform well (Arnold, 1998).