European Journal of Economics, Finance and Administrative Sciences

ISSN 1450-2275 Issue 16 (2009)

© EuroJournals, Inc. 2009
http://www.eurojournals.com

Economic Forces and the Stock Market in a Developing

Economy: Cointegration Evidence from Ghana

Joseph Magnus Frimpong

Department of Accounting and Finance KNUST School of Business
Kwame Nkrumah University of Science & Technology, Ghana
E-mail: jf_magnus@yahoo.com

Abstract
Finance literature contains considerable number of studies well documented for both major
and developing economies regarding the dynamic linkages between macroeconomic
variables and stock returns. However the few studies available on Ghana provide
inconsistent results which urgently need to be rectified especially at a time when it is
reported that the market suffered a loss of about 50 percent in cedi terms over a 6-month
period ending in June 2009, with offshore investors moving out of the market. Within the
framework of a standard discounted value model the study applies a cointegration analysis
to model the long term relationship between exchange rates, the consumer price index,
money supply, interest rates and stock prices on the Ghana Stock Exchange. With the
exception of exchange rate, the rest of these macroeconomic fundamentals impact
negatively on stock prices. These findings may have important policy implications because
they could be crucial in areas such as the design of stabilization and structural adjustment
programmes.

Keywords: Ghana Stock Exchange, cointegration, market efficiency, developing markets.

1. Introduction
An efficient capital market is one in which security prices adjust rapidly to the arrival of new
information and, therefore, the current prices of securities reflect all information about the security.
What this means, in simple terms, is that no investor should be able to employ readily available
information in order to predict stock price movements quickly enough so as to make a profit through
trading shares.
Championed by Fama (1970), the efficient market hypothesis (EMH), has important
implications for policy-makers and the stock-broking industry alike. Policy makers for example, should
feel free to conduct national macroeconomic policies without the fear of influencing capital formation
and the stock trade process. The EMH suggests that competition among the 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 profit through prediction of the future stock market movements. Hence
Maysami et al (2004) argue that there should be no stock broking industry, if one were to believe the
conclusions of the EMH.
For the past three decades evidence that key macroeconomic variables help predict the time
series of stock returns has accumulated in direct contradiction to the conclusions drawn by the EMH.
The onslaught against the conclusions drawn from the EMH includes early studies by Fama and
124 European Journal of Economics, Finance and Administrative Sciences - Issue 16 (2009)

Schwert (1977), Nelson (1976), and Jaffe and Mandelker (1976), all affirming that macroeconomic
variables influence stock returns. Again Chen, Roll and Ross (1986), having first illustrated that
economic forces affect discount rates, the ability of firms to generate cash flows, and future dividend
payouts, provided the basis for the belief that a long-term equilibrium existed between stock prices and
macroeconomic variables.
More recently, Granger (1986) and Johansen and Juselius (1990) proposed to determine the
existence of long-term equilibrium among selected variables through cointegration analysis, paving the
way for a (by now) preferred approach to examining the economic variables-stock markets
relationship. A set of time-series variables are cointegrated if they are integrated of the same order and
a linear combination of them is stationary. Such linear combinations would then point to the existence
of a long-term relationship between the variables. An advantage of cointegration analysis is that
through building an error-correction model (ECM), the dynamic co-movement among variables and
the adjustment process toward long-term equilibrium can be examined, Maysami et al (2004).
This methodology has been employed by a growing literature to show strong influence of
macroeconomic variables and stock markets, mostly for industrialized countries (see, for example,
Hondroyiannis and Papapetrou, 2001; Muradoglu et al. 2001; Fifield et al. 2000; Lovatt and Ashok
2000; and Nasseh and Strauss 2000). Additionally, researchers have begun to turn their attention to
examining similar relationships in countries of emerging markets (for example, Maysami and Sims
2002, Maysami and Koh 2000).
Despite the importance of previous studies, until now the majority of research considers
developed countries financial markets, which are efficient enough and do not suffer from the
inefficiency problems in less developed countries. Considering this matter, the subject of financial
markets in developing countries still needs lengthy analysis and more research attention. Therefore, the
importance of this study stems from it being an empirical attempt in this direction. The study selects
four macroeconomic variables based on their hypothesized effect on stock market performance proxied
by Ghana Stock Exchange (GSE) All-Share Index. The GSE is also a well-established, small,
developing open equity market, thus, providing a showcase for other developing markets in the world.
From another perspective we notice that substantial economic literature, dating back to
Schumpeter (1912), has placed much importance on the positive contributions of financial systems to
economic growth. However, the direction of causality between the increasing growth in financial sector
and a country’s economic growth rate has been regarded as unimportant in small economies like Ghana
(Lucas, 1988). This study presents the findings for Ghana’s case in the counter argument above.
The rest of this paper is organized as follows. Section 2 provides a review of the relevant
literature on the relationship between macroeconomic variables and the stock market movement.
Section 3 presents the theoretical model, discusses the data as well as the econometric methodology.
The results and discussions are presented in section 4 and section 5 concludes the paper.

2. Previous Research
A major contributor to the fact that a long-term equilibrium relationship exists between stock prices
and relevant macroeconomic variables is attributable to Chen, Roll and Ross (1986). They found that
asset prices react sensitively to economic news, especially to unanticipated news. Hamao (1988)
replicated the Chen, Roll and Ross (1986) study in the multi-factor APT framework. He put on view
that the Japanese stock returns are significantly influenced by the changes in expected inflation, and the
unexpected changes in both the risk premium and the slope of the term structure of interest rates.
Darrat and Mukherjee (1987) used a Vector Autoregression (VAR) model along with Akaike’s
final prediction-error on the Indian data over 1948-84, and demonstrated that a significant causal
relationship exists between stock returns and certain macroeconomic variables. Brown and Otsuki
(1990) found that money supply, production index, crude oil price, exchange rate, call money rate and
a residual market error are associated with risk premia and affect the Japanese stock market.
125 European Journal of Economics, Finance and Administrative Sciences - Issue 16 (2009)

Mukherjee and Naka (1995) test the dynamic relationship between six macroeconomic
variables and the Japanese stock market, by employing a vector error correction to a model of seven
equations. They find that a long-term equilibrium relationship exists between the Japanese stock
market and the six macroeconomic variables such as exchange rate, money supply, inflation, industrial
production, long-term government bond rate and call money rate.
Another early study to provide an assessment of stock market behavior and various multiple
macroeconomic variables for an emerging financial market was conducted by Kwon, Shin, and Bacon
(1997) for the South Korean stock market between January 1980 and December 1992. The independent
variables consisted of a production index, inflation and expected inflation, risk premium, term
structure, dividend yield, trade balance, foreign exchange rate, oil price, and money supply that were
time-series regressed on monthly returns of the value-weighted Korea Composite Stock Price Index
(KOSPI). Their results showed that the Korean stock market was more sensitive to real economic and
international trading activities, measured in terms of foreign exchange rates, trade balance, the money
supply, and the production index, than that of the U.S. and Japanese stock indexes.
One of the most comprehensive researches into the linkage of stock prices and macroeconomic
factors was conducted by Wongbangpo and Sharma (2002). They explored the relationship between
the stock returns for the ASEAN-5 countries of Indonesia, Malaysia, the Philippines, Singapore, and
Thailand and five macroeconomic variables. By observing both short and long run relationships
between respective stock indexes and the macroeconomic variables of gross national product (GNP),
the consumer price index (CPI), the money supply, the interest rate, and exchange rate they found that
in the long-run all five stock price indexes were positively related to growth in output and negatively to
the aggregate price level. But a negative long-run relationship between stock prices and interest rates
was noted for the Philippines, Singapore, and Thailand, and was found to be positive for Indonesia and
Malaysia. In the end, causality tests detected an overall relationship between macroeconomic variables
and stock prices for all five ASEAN equity markets.
Emerging stock markets (and especially markets of poor developing economies like Ghana)
have been identified as being at least partially segmented from global capital markets. For this reason,
it has been argued that local risk factors rather than world risk factors are the primary source of equity
return variation in these markets. Accordingly, Bilson, Brailsford, and Hooper (1999) aimed to address
the question of whether macroeconomic variables may proxy for local risk sources. They found
moderate evidence to support this hypothesis.
Ibrahim (1999) investigated the dynamic interactions between the Kuala Lumpur Stock
Exchange (KLSE) Composite Index, and seven macroeconomic variables (industrial production index,
money supply M1 and M2, consumer price index, foreign reserves, credit aggregates and exchange
rate). He concluded that Malaysian stock market was informationally inefficient after observing that
macroeconomic variables led the Malaysian stock indices.
Vuyyuri (2005) investigated the cointegrating relationship and the causality between the
financial and the real sectors of the Indian economy using monthly observations from 1992 through
December 2002. The financial variables used were interest rates, inflation rate, exchange rate, stock
return, and real sector was proxied by industrial productivity. Johansen (1988) multivariate
cointegration test supported the long-run equilibrium relationship between the financial sector and the
real sector, and the Granger test showed unidirectional Granger causality between the financial sector
and real sector of the economy.
One of the studies on Africa is that of Omran (2003) who focused on examining the impact of
real interest rates as a key factor in the performance of the Egyptian stock market, both in terms of
market activity and liquidity. The cointegration analysis through error correction mechanisms (ECM)
indicated significant long-run and short-run relationships between the variables, implying that real
interest rates had an impact upon stock market performance.
As far as Ghana is concerned two of the most recent studies in the literature regarding this topic
are that of Osei (2006) and Kyereboah-Coleman and Agyire-Tettey (2008) but their findings do not
utterly confirm each other. Contrary to the former study that finds a positive relationship between
126 European Journal of Economics, Finance and Administrative Sciences - Issue 16 (2009)

interest rates and stock prices, the latter concludes with a negative relationship between the two
variables. As a matter of fact, the findings of this study are important for the literature, at least, to have
a clear idea about such crucial economic relationships for the Ghana case especially when the twin
most worrying economic indicators in recent times are possibly trends in inflation and interest rates.
The current study builds upon and extends the literature through the employment of three steps
in modeling the relationship between relevant macroeconomic indicators and stock market
performance in Ghana as follows: First, using the Phillips-Perron (PP), (1988) and Elliot-Rothenberg-
Stock(ERS), (1996) tests to check the stationarity properties of the data; second, using Johansen and
Juselius (1990), Johansen (1991, 1995) maximum likelihood multivariate approach to test for the
existence of a stable long-run cointegration relationship; and thirdly obtaining final estimates for
analysis using the long-run and the associated error-correction models. The choice of macroeconomic
variables and the hypothesized relations with the sector indices are discussed in subsequent sections.

3. Data and Methodology

3.1. Data - Sources and Description
The study utilizes monthly time series data spanning the period 1990:11 through to 2006:12 (a total of
194 observations) obtained from the Ghana Stock Exchange and Bank of Ghana. The data is seasonally
adjusted using the Census X12 (Version 0.2.9) prior to using the data for analysis.
The study uses the GSE All-Share Index as a measure of stock market performance. It is a
composite index reflecting the average price movements in all the equities listed on the stock market.
The interest rate equivalent of the 91-day Treasury bill is used as the proxy for interest rate. M2+ is
used as a measure of money supply defined as M2 plus foreign currency deposits where M2 comprises
M1 plus savings and time deposits. M1 is defined as currency outside banks plus demand deposits.
Inflation is proxied by the year-on-year inflation rate in percentage. Nominal exchange rate used is the
nominal monthly average cedi/dollar rate. All variables used are transformed into natural logs to allow
a partial elasticity analysis. Logged values of the nominal stock index, exchange rate, inflation, interest
rate and money supply are denoted as lnGSE, lnEXR, lnINFL, lnINTR and lnM2 respectively.

3.2. Model Specification

3.2.1. Theoretical Model of Asset Valuation
According to the basic discounted cash flows model, the price of a financial asset is equal to the
discounted value of the future cash flows to be derived from the asset:
n
CFt
P=∑ t
t =1 (1 + RRR ) (1)
Any change in an asset's cash flows (CF) should have a direct impact on its price. Thus, the
asset’s expected growth rates which influence its predicted cash flows will affect its price in the same
direction. Conversely, any change in the required rate of return (RRR) should inversely affect the
asset's price. The required rate of return has two basic components - the nominal risk free rate and the
premium commensurate with the asset’s risk. The nominal risk-free rate in addition is comprised of the
real rate of interest and the anticipated inflation rate.
A country’s stock index therefore is affected by factors that influence its economic growth or
bring about changes in its real rate of interest, expected rate of inflation, and risk premium. Based on
intuitive financial theory (Chen et al. 1986; Fama 1981) coupled with the results of previous studies,
this article hypothesizes that nominal interest rates, inflation, exchange rate and the money stock will
affect the variables implicit in the above model and therefore should influence the Ghana Stock
Exchange index.
The study hypothesizes a negative relationship between interest rates and stock prices. The
interest rate directly changes the discount rate in the valuation model and being a denominator in the
127 European Journal of Economics, Finance and Administrative Sciences - Issue 16 (2009)

model equation its effect on stock price is obviously negative. Moreover, as substantial amount of
stocks are purchased with borrowed money, an increase in interest rates would make stock transactions
more costly. Investors will require a higher rate of return before investing. This will reduce demand
and lead to a price depreciation.
The results of studies by Fama and Schwert (1977), Chen, Roll and Ross (1986) and many
others pointed to a negative relation between inflation and stock prices. The study hypothesizes
similarly: an increase in the rate of inflation is likely to lead to economic tightening policies, which in
turn increases the nominal risk-free rate and hence raises the discount rate in the valuation model
explained above. The effect of a higher discount rate would not necessarily be neutralized by an
increase in cash flows resulting from inflation, primarily because cash flows do not generally grow at
the same rate as inflation. DeFina (1991) attributes this to nominal contracts that disallow the
immediate adjustment of the firm’s revenues and costs. Cash flows would probably decrease initially if
the cost of inputs adjusts faster to rising inflation than output prices. (Maysami et al, 2004)
A positive relation between the exchange rate and stock prices is conjectured. Persistent
depreciation of the Ghana cedi lures people to rather invest in strong international currencies usually by
keeping them as idle balances. Thus resources that could be invested on the stock exchange are
diverted into non-functioning assets usually comprised of dollars and pound sterling. In addition, real
exchange depreciation more often than not results in capital flight which deprives the economy of its
much needed financial resources that could otherwise have nurtured the underdeveloped bourse.
In the opinion of Mukherjee and Naka (1995), the effect of money supply on stock prices is an
empirical question. An increase in money supply would lead to inflation, and may increase discount
rate and reduce stock prices (Fama, 1981). However, the negative effects might be countered by the
economic stimulus provided by money growth, also known as the corporate earnings effect, which may
increase future cash flows and stock prices. Maysami and Koh (2000), who found a positive
relationship between money supply changes and stock returns in Singapore, further support this
hypothesis
Based on both theoretical and empirical literature reviewed, the present study posits the
following implicit functional model of stock market performance for Ghana assumed to take a Cobb-
Douglas form.
GSE = f ( EXR, INFL, INTR, M 2 ) (2)
where GSE is the GSE All-share index (serving here as proxy for stock market performance); EXR is
the exchange rate; INFL is inflation rate; INTR is the interest rate and M2 is a measure of money
supply.
Log-linearizing equation (2) yields the following static long-run model:
ln GSE = β 0 + β1 ln EXR + β 2 ln INFL + β3 ln INTR + β 4 ln M 2 + ε t (3)
where all variables are already defined except
ε t representing the error term and ln is natural logarithm
β β , β , β , β and β 4 are long-run parameter
operator. 0 represents the constant term in the model and 1 2 3 4
estimates. Equation (3) is modeled using the Johansen (1991, 1995) and Johansen and Juselius (1990)
cointegration methods.

3.2.3. Econometric Methodology

Unlike traditional econometric methodology, time-series econometrics methodology requires an
analysis of the time-series properties of the economic variables in a regression equation before
estimation in order to avoid any spurious relationship between them. If the time-series properties of the
variables are fulfilled, then a possible long-run (co-integration) relationship between them can be
investigated. As suggested by Engle and Granger (1987), a possible long-run relationship between the
economic variables can be examined by identifying their time-series paths. The long-run relationship
between the economic variables exists if the variables are stationary in their level or differenced forms.
128 European Journal of Economics, Finance and Administrative Sciences - Issue 16 (2009)

The economic variables in question should be integrated in the same order, that is, they should be
stationary in their level or in their first differences denoted as I(0) and I(1), respectively.

The study follows three econometric steps in modeling the relationship between
macroeconomic indicators and stock market performance in Ghana. The first step involves the use of
Phillips-Perron (PP), (1988) and Elliot-Rothenberg-Stock ((ERS), 1996) tests to check the stationarity
properties of the data. These tests are chosen over the traditional Augmented Dickey-Fuller because it
provides an alternative (nonparametric) method of controlling for serial correlation and structural
breaks when testing for a unit root and detrending of the data prior to the estimation of the unit root
equation. ERS (1996) propose a simple modification of the ADF tests in which the data are detrended
so that explanatory variables are “taken out” of the data prior to running the test regression (Dickey-
Fuller Test with GLS Detrending (DF-GLS)).The test for the existence of a stable long-run
cointegration relationship using the Johansen and Juselius (1990), Johansen (1991, 1995) maximum
likelihood multivariate approach follows the unit root tests in the second step. The final step involves
the estimation of the long-run and the associated error-correction models through cointegration
analysis.
The Johansen–Juselius estimation method is based on the error correction representation of the
Vector Auto Regression (VAR) model with Gaussian errors. The VAR method is also related closely
to co-integration. Following Engle and Granger (1987), a cointegrated time series system has an
equivalent vector error correction (VEC) representation. A general VECM model with the lag length,
p, can be expressed in vector format as follows:
∆Xt =Θ0 +Θ∆1 Xt −1 +Θ2∆Xt −2 +L+Θp−1∆Xt − p+1 +π Xt − p + vt (4)
v
where X t represents m × 1 vector of I(1) variables, Θs are unknown parameters and t is vector of error
terms. The π matrix conveys the long-run information contained in the data and can be written as π= α
β’. The Johansen methodology determines the number (or vector) r of cointegrating relation-ships, 0 <
vector (X) = r < N, as well as their long-run relationship. β(p * r) and α(p * r) represent the long-run
coefficients and error-correction estimates, respectively. The VECM is a VAR that builds in
cointegration by incorporating error correction terms that account more fully for short-run dynamics
and thus, if the long run equilibrium condition is valid and cointegration exists, it explains short-run
fluctuations in the dependant variable. The hypothesis that π has a reduced rank r < m is tested using
the trace and the maximum eigenvalues test statistics.
In this study, the vector error-correction model (VECM) with a lag order p is specifically
modeled as:
p p p p p
∆lnGSEt =α0 +α1t ∑∆lnGSEt−i +α2t ∑∆lnEXRt−i +α3t ∑∆lnINFLt−i +α4t ∑∆lnINTRt−i +α5t ∑∆lnM2t−i +ψεt−1 +ϑ1t (5)
t=1 i=1 i=1 i=1 i=1

where all variables are as previously defined, α1 , α 2 , α 3 , α 4 and α 5 represent short-run elasticities, εt−1
is the error correction term with its coefficient,ψ , denoting the speed of adjustment to long-run
equilibrium after a shock to the system. The lag length of the VECM is determined using the Akaike
information criterion (AIC), Schwarz information criterion (SIC), Hannan-Quinn information criterion
(HQ) and the Final prediction error (FPE) information criteria.
129 European Journal of Economics, Finance and Administrative Sciences - Issue 16 (2009)

4. Empirical Results and Discussions

4.1. Unit Root and Stationarity Tests
Prior to performing the unit root tests, a visual examination of the time series plots of the data over the
study period 1990:11-2006:12 was undertaken.

Table 1: Results of Unit Root Tests

PP DF-GLS
Levels
No Trend Trend No Trend Trend I(d)
lnGSE -0.575573 -2.384899 1.309963 -2.222569 I(1)
lnEXR -1.883498 -0.229678 0.539282 -1.501968 I(1)
lnINFL -2.328469 -2.438403 -0.830573 -1.955812 I(1)
lnINTR -0.752429 -1.637747 -0.669938 -1.043676 I(1)
lnM2 -0.349992 -3.199086* 1.937805 -2.266568 I(1)
First Difference
∆lnGSE -11.42287*** -11.39595*** -2.706601*** -5.918974*** I(0)
∆lnEXR -7.056664*** -7.471568*** -2.661460*** -2.931634* I(0)
∆lnINFL -9.174897*** -9.151741*** -6.293522** -6.519086*** I(0)
∆lnINTR -10.31589*** -10.39164*** -1.320134 -3.008115** I(0)
∆lnM2 -20.07848*** -20.03530*** -3.4088885*** -18.65348*** I(0)
Note: ***, **, * indicates significance at the 1%, 5% and 10% levels respectively. Schwarz Information Criterion (SIC)
was used to select optimal lag length for DF-GLS while Bandwidth was based on Newey-West using Bartlett
Kernel for PP. ∆ is first difference operator. Critical values obtained from MacKinnon (1996) and Elliot-
Rothenberg-Stock (1996, Table 1). I(d) implies order of integration.

Figure 1 (see appendix) show the graphical plots of the variables. The log of GSE, EXR, and
M2+ show relatively upward trends with significant volatility compared to the INFL and INTR. The
plots suggest that all variables are non-stationary in the levels as changing means and variances could
so be observed. The results of the unit root tests are presented in Table 1. Both PP and DF-GLS tests
indicate that all the variables were non-stationary at the levels except M2 which was found to be
weakly stationary at the 10% level when a trend was included in the PP equation. However, all the
series achieved stationary status after taking their first differences. Therefore, all variables can be said
to be integrated of order one (i.e. I(1)) and thus contain unit root, a necessary pre-condition for
cointegration analysis.

4.2. Results of Cointegration Test

Table 2 provides the test statistics for cointegrating vectors and critical values at the 5% significance
level using the Johansen (1991) test. Nine lags are selected in the cointegration test since this yielded
more robust results where both trace and maximum-eigenvalue tests confirmed cointegration. Results
of the λ m a x and λ t r a c e tests suggest a unique cointegrating relationship since their test statistics
are greater than the critical values for each test at the 5% level enabling us to reject the null hypothesis
of no cointegration (r = 0) in favour of one cointegrating equation (r = 1). Thus our selected
macroeconomic fundamentals of exchange rate, inflation, interest rate and money supply are all ‘long-
run forcing’ variables that explain directional movements in the Ghana Stock Exchange index.
130 European Journal of Economics, Finance and Administrative Sciences - Issue 16 (2009)
Table 2: Results of Johansen Cointegration Test

λ 95% Critical Value λ t r a c e Statistic 95% Critical Value

No. of CE(s) [H0] m ax Statistic [Max.] [Trace]
r=0* 38.54960 33.87687 78.42830 69.81889
r≤1 18.79707 27.58434 39.87870 47.85613
r≤2 13.79156 21.13162 21.08163 29.79707
r≤3 4.368458 14.26460 7.290068 15.49471
r≤4 2.921610 3.841466 2.921610 3.841466
Note: Maximum Eigen and Trace tests indicates 1 cointegrating eqn(s) at the 0.05 level * denotes rejection of the
hypothesis at the 0.05 level

4.3. Long Run Results

The long-run results shown in Table 3 indicate that with the exception of exchange rate, the rest of the
macroeconomic fundamentals impact negatively on stock prices.

Table 3: Long-run Cointegrating Model

Regressor Coefficient Std. Error t-statistic

Constant -1.128752 - -
lnEXR 0.917312 0.36362 2.5227215**
lnINFL -0.897601 0.15991 -5.6131637***
lnINTR -0.035737 0.27909 -0.1280483
lnM2 -1.753062 0.31302 -5.6004792***
Note: ***, ** denotes statistical significance at the 1% and 5% levels respectively. Dependent variable: lnGSE

The study supports the hypothesis of a positive relationship between exchange rate and the
Ghana stock market performance. A stronger domestic currency lowers the cost of imported inputs and
allows local producers to be more competitive internationally thereby creating a favourable news
perception on the stock market thus generating positive returns on stocks. This relationship is
significant at the 5% level.
Consistent with theory, inflation has a significant negative impact on the Ghanaian bourse.
There have been several instances where the Ghanaian economy has been punctuated by defiant
inflationary trends making it impossible for investors to forecast into the future. In reaction to such a
situation, investors choose to either invest in physical assets or shift their investment portfolios toward
short term instruments. Consequent upon this, the stock market which thrives strictly on long term
investment funds loses out considerably on performance. From another perspective, an increase in the
rate of inflation is likely to lead to economic tightening policies to curtail soaring prices in the
economy. Then also actual inflation will be positively correlated with unanticipated inflation, and will
ceteris paribus move asset prices in the opposite direction.
The negative relationship between interest rate and stock prices is expected because Treasury
bill acts as the rate of return offered by the risk-free asset. The shifting of funds between risky equity
and risk-free assets by portfolio managers is expected in consequence. When T-bill rate is high,
rational investors would tend to invest in less risky assets with high returns. This was the case in Ghana
especially between 1995 and 1999 which considerably affected the performance of the exchange.
However, the relationship is not statistically significant in the long-run.
Increasing money supply in the economy significantly reduces the returns on stocks in the long-
run. This result is consistent with Fama’s (1981) assertion that increases in money supply increases
inflation and the discount rate thus reducing stock prices which in this case has a sizeable magnitude to
overcome the economic stimulus effect of money supply increases.
131 European Journal of Economics, Finance and Administrative Sciences - Issue 16 (2009)

4.4. Short Run Results

The existence of a unique cointegrating vector among the variables implies that an error correction
model can be estimated to investigate the short-run dynamic relationship. On the basis of the AIC, SIC,
HQ, and FPE, an optimal lag of two (2) was selected for the vector error correction model (VECM) as
shown in Table 4. Thus all variables entering the short-run equation are expressed using two lags.

Table 4: VECM Lag Order Selection Criteria

Lag FPE AIC SIC HQ

0 8.51e-05 4.817811 4.905833 4.853494
1 1.84e-13 -15.13469 -14.60656 -14.92059
2 8.97e-14* -15.85354* -14.88530* -15.46103*
3 9.03e-14 -15.84811 -14.43975 -15.27718
* indicates lag order selected by the criterion

Table 5 reports the error correction model. The sign and magnitude of the error correction
coefficient indicates the direction and speed of adjustment towards the long-run equilibrium path. It
should be negative and significant, which is the case here at the 5 per cent level. The negative sign
implies that, in the absence of variation in the independent variables, the model’s deviation from the
long run relation is corrected by increase in the dependant variable. It confirms the existence of a long–
run relationship. The size of the coefficient of the ECT term implies that about 3% of the
disequilibrium in the long-run model is corrected every month. The results also show that all the
variables significantly explain the variation in the performance of the GSE All-Share Index.
The short-run results indicate that lags of the GSE All-Share Index have significant effects on
current stock prices. In addition, exchange rate maintained its positive and significant impact in the
second lag of the short-run whilst interest rate significantly and negatively impacts stock prices. Even
though inflation maintained its negative relationship, it is not significant. Money supply has the right
theoretical sign in the short-run but loses its statistical significance.

Table 5: Vector Error Correction Model

Regressor Coefficient Std. Error t-statistic

Constant -0.004123 0.00952 -0.43303
∆lnGSEt-1 0.165504 0.07137 2.31887**
∆lnGSEt-2 0.172546 0.07049 2.44775**
∆lnEXRt-1 -0.235623 0.27925 -0.84376
∆lnEXRt-2 0.818118 0.27611 2.96299***
∆lnINFLt-1 -0.042153 0.05516 -0.76414
∆lnINFLt-2 -0.023971 0.05483 -0.43720
∆lnINTRt-1 -0.017444 0.09781 -0.17835
∆lnINTRt-2 -0.271634 0.09984 -2.72079***
∆lnM2t-1 0.222025 0.15488 1.43357
∆lnM2t-2 0.076943 0.15349 0.50128
ECTt-1 -0.029121 0.01214 -2.39802**
2
R 2 = 0.17972 R = 0.12931 SSR = 0.922921 S.E. equation = 0.071805 F-statistic = 3.565191*** S.D. dep. = 0.076953
LogL = 238.2350
AIC = -2.368953 SIC = -2.164622 Mean dependent = 0.022462
Note: ***, ** denotes statistical significance at the 1% and 5% levels respectively. Dependent variable: ∆lnGSEt
132 European Journal of Economics, Finance and Administrative Sciences - Issue 16 (2009)

5. Conclusion
This paper examined the relation between key macroeconomic variables and the stock market
performance represented by the GSE All-Share Index using Johansen’s VECM, a full information
maximum likelihood estimation model. The paper arrived at the conclusion that the Ghana stock
market All-Share Index formed significant relationships with all macroeconomic variables identified.
One major deduction from the empirical results is that the conclusions of the efficient market
hypothesis (EMH) are, as expected, thrown in doubt. This claim is consequent upon the presence of a
cointegrating relationship found to exist between macroeconomic variables and stock prices. Primarily
then, the behaviour of stock market may indeed be predicted, contrary to the EMH conclusions. For
this reason policy-makers may need to re-examine their economic policy if affecting the stock market
is not something they wish for.
Monetary and exchange rate policies might need more circumspect analysis before
implementation to avoid unwanted dribbling effects that could be worse than the actual problem
targeted for solution. Policy-makers need to be careful whenever they try to influence the economy
through changes in these key macroeconomic variables comprising the exchange rate, interest rate and
money supply. Even as different governments aim at correcting macroeconomic ills such as inflation or
unemployment, they may inadvertently depress the stock market, and inhibit capital formation which
itself would lead to further deceleration of the economy. These findings may have important policy
implications because they could be crucial in areas such as the design of stabilization and structural
adjustment programmes.

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Appendix
Figure 1: Graphical Representation of Data in Levels and First Differences

9 .6
lnGSE DlnGSE

8 .4

7 .2

6 .0

5 -.2

4 -.4
1992 1994 1996 1998 2000 2002 2004 2006 1992 1994 1996 1998 2000 2002 2004 2006

10 .16
lnEXR DlnEXR

9 .12

8 .08

7 .04

6 .00

5 -.04
1992 1994 1996 1998 2000 2002 2004 2006 1992 1994 1996 1998 2000 2002 2004 2006
135 European Journal of Economics, Finance and Administrative Sciences - Issue 16 (2009)

0.0 .8
lnINFL DlnINFL
-0.5
.4
-1.0

-1.5 .0

-2.0
-.4
-2.5

-3.0 -.8
1992 1994 1996 1998 2000 2002 2004 2006 1992 1994 1996 1998 2000 2002 2004 2006

-0.4 .3
lnINTR DlnINTR
.2
-0.8
.1
-1.2
.0

-1.6 -.1

-.2
-2.0
-.3

-2.4 -.4
1992 1994 1996 1998 2000 2002 2004 2006 1992 1994 1996 1998 2000 2002 2004 2006

11 .4
lnM2_ DlnM2_
10 .3

.2
9
.1
8
.0
7
-.1

6 -.2

5 -.3
1992 1994 1996 1998 2000 2002 2004 2006 1992 1994 1996 1998 2000 2002 2004 2006