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IMPACT OF FOREIGN RESERVES ON KARACHI STOCK EXCHANGE MARKET OF PAKISTAN

Posted on | February 26, 2011 | No Comments

Abstract This paper explains the relationship between foreign exchange reserves of Pakistan and KSE market capitalization on the basis of quarterly gathered data from fiscal year 2001 to 2009. Both of the variables under consideration are very important because foreign exchange reserve is one out of the major supports to stable the value of home currency against foreign currencies and market capitalization shows the overall investment in stock market. This study uses easy linear regression model to measure the relationship between these two important variables. Results of this study show that there is positive (not significant positive) relationship between variables. The results show that foreign exchange reserves of Pakistan have a positive impact on KSE Stock Market that is the principal stock market of Pakistan. Introduction This research is carried out to find the impact of foreign exchange reserves held by the Say Bank of Pakistan on the investment and performance of stock markets of Pakistan. There are three stock exchanges (Karachi Stock Exchange, metropolis Stock Exchange and Islam-Abad Stock Exchange) operating in Pakistan. metropolis Stock Exchange (KSE) is premier, biggest and the most favourite stock market of the country, so it is used as representative of all stock exchanges of Pakistan. About KSE KSE is hub of capital formation in Pakistan, established on September 18, 1947. KSE started with 5 companies with a paid up capital of Rs. 37 million. The first index was the 50 index and trading was done through open-out-cry system. In spite of political issues, social, financial and other problems, it played a key role in the economy of Pakistan. KSE 100index showed a return of 40.19% and became the sixth ideal performer among the emerging markets in the calendar year 2007. It reached a major milestone by touching of KSE-100 Index psychological level of 15,000 for the first time in its history and peaked 15,737.32 on 20 April, 2008. Moreover, the increase of 7.4 per cent in 2008 prefabricated it the ideal performer among major emerging markets (Gulf News, 2008). It was declared the Best Performing Stock Market of the World for the year 2002 as declared by the international entrepot Business Week Similarly, the US newspaper USA Today declared metropolis Stock Exchange as one of the ideal performing stock exchange in the world. As at June 1, 2009 there were 651 companies listed at KSE with market capitalization of US $ 26.48 billion having listed capital of US $ 9.65 billion. Exchange was owned by 200 member/brokers through electronic trading system. (Karachi Stock Exchange, 2009) Foreign Exchange Reserves Foreign exchange is the currency of other countries and Foreign Reserves mean deposits of international currencies held by a central bank. Foreign reserves grant governments to keep their currencies stable, reserves are used as a tool of exchange rate and monetary policy, it assist for the payment of external debt and liabilities, it act as a defense against unexpected emergencies and economic shocks. To know about the relationship of foreign reserves with stock market is important because of above reasons and because international reserves accumulation has been the preferred policy recently adopted by developing economies to achieve financial stability. The aim of this policy is to increase liquidity and thus reduce the risk of suffering a speculative attack. (Cruz & Walters, June 2008). Foreign reserves can be enhanced by storing more and more international currency and this can be done through three ways, by increasing exports, by foreign remittance and by taking official allows or loans. If foreign reserves are increasing

due to exports and remittances then the growth of reserves is positive but if it is increasing with the help of loans then growth will be negative. This research is not concerned with the positive or negative growth, this research examines only the foreign reserves held by central bank and their impact on stock market capitalization. Market Capitalization Market capitalization represents the aggregate value of a company or stock. It is obtained by multiplying the number of shares outstanding by their current price per share then by adding all the values, we get aggregate market capitalization. For example, if XYZ company has 200,000 shares outstanding with a share price of per share then the market capitalization is 200,000 x = ,000,000. KSE market capitalization represents the aggregate value of whole market, in this way by measuring KSE-All shares market capitalization we can measure the overall performance of metropolis stock exchange. Objective The purpose of this research is to know about the impact of foreign exchange reserves of Pakistan on KSE market capitalization on the basis of previous behavior of both variables with apiece other. Problem Statement The main focus of this study is to link the foreign exchange reserves of Pakistan with its Stock Markets to see a clear picture about them as it affects many other variables. Significance Significance of this research work is to wage the considered necessary information that will guide the stock brokers, agents, planners, government policy makers to make decision about the stocks and stock markets of Pakistan especially about KSE by looking at the trend of foreign exchange reserves of Pakistan. The research will also try to add value for executives, directors, researchers and other students to know about the foreign reserves and stock markets of Pakistan. Literature Review In the following there are some studies related to this topic that has been conducted prior by other researchers. Hussain et al. (2009) examined the Impact of Macroeconomics Variables on Stock Prices: Empirical Evidence in Case of KSE they think about the quarterly data of several economic variables such as foreign exchange rate, foreign exchange reserve, industrial production index, whole understanding price index, gross fixed capital formation, and broad money M2 , these variables are obtain from 1986 to 2008 period. The results shows that after the reforms in 1991 the influence of foreign exchange rate and reserve effects significantly to stock market whiles other variables like IIP and GFCF are not effects significantly to stock prices. This result also shows that internal factors of firms like increase production and capital formation not effects significantly while external factors like exchange rate and reserve are effects significantly the stock prices. Nishat and Shaheen analyze long-term equilibrium relationships between a group of macroeconomic variables and the metropolis Stock Exchange Index. The macroeconomic variables are represented by the industrial production index, the consumer price index, M1, and the value of an investment earning the money market rate. They used vector error correction model to explore such relationships during 1973 to 2004. Their results indicate a causal relationship between the stock market and the economy and show that industrial production is the largest positive determinant of Pakistani stock prices, while inflation is the largest negative determinant of stock prices in Pakistan. They found that macroeconomic variables Granger-caused stock price movements, the reverse causality was observed in case of industrial production and stock prices. Furthermore, he found that statistically significant holdup lengths between fluctuations in the stock market and changes in the real economy are relatively short (Nishat & Shaheen, 2004). Bhattacharya et al. conduct a case study to analyze Causal Relationship between Stock Market and Exchange Rate, Foreign Exchange Reserves and Value of Trade Balance. They used methodology of Granger non-causality recently proposed by Toda and Yamamoto (1995) for the sample period April 1990 to March 2001. In this study, the Bombay BSE Sensitive Index was used as a agent for the Indian stock market. The three important macroeconomic variables included in the study are real effective exchange rate, foreign exchange reserves and trade balance. The analysis reveals interesting results in the context of the Indian stock market, particularly with respect to exchange rate, foreign exchange reserves and

trade balance. The results recommend that there is no causal linkage between stock prices and the three variables under consideration (Bhattacharya & Mukherjee, 2001) . Dimitrova examined the relationship between stock prices and exchange rates using multivariate model. He focuses on the stock markets of United Says and the United Kingdom over the period Jan 1990 through August 2004. This study developed the hypothesis that there is a link between the foreign exchange and stock markets. The researcher asserted that relationship is positive when stock prices are the lead variable and likely to negative when exchange rates are the lead variable (Dimitrova, August 2005). Sohail et al. conducted a research on LSE, the intention of this study was to analyze long-run and short-run relationships between metropolis Stock Exchange and macroeconomic variables in Pakistan. Monthly data from December 2002 to June 2008 was used in this study. The results revealed that there was a negative impact of consumer price index on stock returns, while, industrial production index, real effective exchange rate, money supply had a significant positive effect on the stock returns in the long-run (Sohail & Hussain, winter 2009). Robert Gay conducted study to investigate the time-series relationship between stock market index prices and the macroeconomic variables of exchange rate and oil price for Brazil, Russia, India, and China (BRIC) using the Box-Jenkins ARIMA model. But no significant relationship was found between respective exchange rate and oil price on the stock market index prices of either BRIC country and also there was no significant relationship found between present and past stock market returns (Gay, March 2008). Data explanation and Methodology Dependent Variable KSE Market capitalization is dependent variable in this study and simply picked up from the Economic Surveys of Pakistan and from the reports of Say Bank of Pakistan at the end of quarter month from the fiscal year 2001 to 2009. Independent Variable A foreign exchange reserve of Pakistan is independent variable in this research and calculated by following equation. R = SDR + Fc + Nostro + TLR Where: R = Foreign exchange reserves SDR= Special drawing rights held by SBP Fc = Foreign Currency held by SBP Nostro = Accounts of SBP in foreign countries in foreign currencies. TLR = Total liquid reserves Methodology To analyze the relationship between the foreign reserves and KSE market capitalization following easy linear regression model has been tested. Y = ?0 + ?1 X1 + Where: Y = KSE market capitalization in billion Rs. ?0 = Y intercept ?1= Slope of the line X1 = Foreign Exchange Reserves in million US $ = Error variable Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate 1 .680 .463 .440 903.87372 Anova Model Sum of Squares df Mean Square F Sig. Regression 1.687E7 1 1.687E7 20.651 .000

Residual 1.961E7 24 816987.693 Total 3.648E7 25 Note. The data are adapted from the SPSS software output After analysis results show that the value of co-efficient of correlation (R) is equal to 0.680 which shows that there is positive (not significant positive) relationship between market capitalization and foreign exchange reserves, as it is looking in the following graph. This graph shows that an increase in foreign reserves also reflecting in KSE market capitalization but not too much. The results show that the value of co-efficient of determination (R2) is equal to 0.463 which shows that 46.3% of the variation in the KSE market capitalization is explained by the variation in the foreign exchange reserves. The remaining 53.7% is unexplained. The value of Anova plateau is significant (.000) which shows that the model is overall good fit. The value of Regression constant or intercept is -1227.56 this is the average market capitalization without independent variable. Here it shows that the average value of market capitalization is negative (below the X-axis line) with the value of 1227.56 billion Rs. when foreign exchange reserves are zero. The value of Regression co-efficient or slope is equal to 0.303 which shows that the KSE market capitalization will increase by 0.303 billion Rs. for an increase of one million $ increase in foreign exchange reserves of Pakistan. Conclusion Results of this study show that there is positive (not significant) relationship between the foreign exchange reserves and KSE market capitalization. The results show that 46.3% of the variation in the KSE market capitalization is explained by the variation in the foreign exchange reserves. The results of this study also match with the result of other researchers like Suliaman et al. conduct study to measure the impact of macroeconomic variables on stock prices and write that there is positive relation between foreign reserves and stock prices in Pakistan. In other countries there are different results like in India there is no relation between these variables as showed by one researcher, but this study shows the facts about the stock market of Pakistan