EFFECT OF FISCAL POLICY ON THE PERFORMANCE OF THE NAIROBI

SECURITIES EXCHANGE

MAUREEN VIOLA MUTULIS

HD 335-040-1178/2016

A proposal submitted in partial fulfillment for the Masters in Financial Economics in the
School of Open, Distance and e-learning at Jomo Kenyatta University of Agriculture and
Technology

2018
ABSTRACT

Fiscal policy involves the use of government taxation and spending to influence the economy in
terms of stabilizing national output, economic growth, employment and inflation. Through fiscal
policy, a government is able to determine spending and revenue levels and by increasing or
decreasing the levels of revenue and expenditure, representing taxes and spending respectively,
a government can influence inflation, employment, and the flow of money within an economy .
Fiscal policy could therefore affect stock market performance by potentially driving stock prices
lower through the crowding out of private sector activity and consequently affecting the entire
economy (Chatziantoniou, Duffy, & Filis, 2013). Reilly & Norton (1999), posit that changes in
fiscal instruments (like government spending, taxes and other revenue items) can change market
interest rates instantaneously and force investors to revalue their stock holdings.

The purpose of this study therefore is to investigate the extent to which fiscal policy affects the
performance of the Nairobi Securities Exchange. The study will investigate the variables
associated with fiscal policy; Government expenditure, Government Tax Revenue and Domestic
debt and establish their individual effects on performance of the Nairobi Securities Exchange.
The Broad Money supply will be used as a control variable so as not to ignore the fact that fiscal
and monetary policies always interact to affect stock market performance.

The study is motivated by the recent declining performance of the NSE 20 share index and the
dire effects it has on the economy in general as well as to individual investors.Additionally,
empirical studies have indicated conflicting results on how fiscal policy affects stock market
performance and this study aims to put the issue to rest.

The study will be of a diagnostic design and will use secondary time series data to investigate
the problem where stock market performance, the dependent variable will be measured by the
NSE 20 share index and the variable of Government Expenditure, Revenue and Debt will be
measured as percentages of GDP. The study will also use cointergration tests to detect the
existence of long-run relationship between stock index and macroeconomic variables and
Vector Error Correction Model (VECM) to test for short-run relationships among the variables.
Multivariate analyses will be employed and the study will test for correlation using multiple
correlation and regression analyses.

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TABLE OF CONTENTS

DECLARATION..........................................................................................................................................ii

ABSTRACT...............................................................................................................................................iii

ACRONYMS/ABBREVIATIONS..........................................................................................................vii

DEFINITION OF TERMS.......................................................................................................................ix

CHAPTER 1................................................................................................................................................1

1.1Background..........................................................................................................................................1

1.12 The Stock Market.......................................................................................................................5

1.2Statement of the Problem.....................................................................................................................7

1.3 Objectives of the Study.......................................................................................................................9

1.4Research Questions............................................................................................................................10

1.5 Significance of the Study..................................................................................................................10

1.6 Scope of the Study............................................................................................................................10

1.7 Research Methodology.....................................................................................................................11

CHAPTER 2..............................................................................................................................................12

2.0 Literature Review.............................................................................................................................12

2.1Theoretical Literature........................................................................................................................12

2.2 Empirical Literature..........................................................................................................................15

2.21 Fiscal Policy and its Impact on Stock Market Performance......................................................15

2.22 Effect of government public expenditure on performance of the Nairobi Securities Exchange 17

2.23 Effect of domestic debt, on performance of the Nairobi Securities Exchange..........................19

2.24 Relationship between government revenue and stock market performance..............................21

2.25 Fiscal and Monetary Policy Interactions...................................................................................22

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 2.3 Conceptual Framework.....................................................................................................................23

2.4 Critique.............................................................................................................................................24

2.5 Summary of findings........................................................................................................................24

2.6 Research Gaps..................................................................................................................................25

CHAPTER 3..........................................................................................................................................26

3.0 Methodology.....................................................................................................................................26

3.1Introduction........................................................................................................................................26

3.2Research design.................................................................................................................................26

3.3 Population.........................................................................................................................................26

3.4Sampling frame..................................................................................................................................26

3.5 Sample and sampling technique.......................................................................................................26

3.6 Data collection procedure.................................................................................................................27

References..................................................................................................................................................30

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ACRONYMS/ABBREVIATIONS
ADF Augmented Dickey Fuller

A-I-A Appropriation in Aid

ARDL Autoregressive Distributed Lag

ASI All Share Index

BF Budget Deficit

BT Balance of Trade

CBK Central Bank of Kenya

CEX Capital Expenditure

CPI Consumer Price Index

CSE Colombo Stock Exchange

DBT Domestic Debt Outstanding

DOLS Dynamic Ordinary Least Squares

DR Deposit Rate

ECM Error Correction Model

EMH Efficient Market Hypothesis

EX Exchange Rate

GARCH Generalized Autoregressive Conditional Heteroskedascticity

IBR Inter Bank Rate

IF Inflation

IMF International Monetary Fund

INT Lending Interest Rates

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IP Industrial Production

KNBS Kenya National Bureau of Statistics

KSH Kenya Shilling

LR Liquidity Ratio

MB Monetary Base

MC Market Capitalization

MPR Monetary Policy Rate

NASI Nairobi All Share Index

NSE Nairobi Securities Exchange

OBB Open Buy Back

OP Real Output

REX Recurrent Expenditure

REV Government Revenue

SP Standard and Poor’s Index

SPG Stock Market Index in Germany

SPUS Stock Market Index in the US

SVAR Structural Vector Auto regression

TB Treasury Bill

TBR Treasury Bill Rate

UN Unemployment Rate

US United States

XGR Exchange Rate

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DEFINITION OF TERMS

Capital account: shows the net financial flows of stocks, bonds, loans, foreign direct
investment (FDI), and reserves for a particular country (Perry, 2011).

Capital Expenditure : refers to the amount spent in the acquisition of fixed (productive) assets
(whose useful life extends beyond the accounting or fiscal year), as well as expenditure incurred
in the upgrade/improvement of existing fixed assets such as lands , building, roads, machines
and equipment, etc., including intangible assets.(Aigheyisi, 2013).

Crowding Out: The reduction in the availability of private capital resulting from government
borrowing to finance budget deficits (Perry, 2011).

Current account: consists of the trade deficit or surplus (exports minus imports), factor income
(earnings on foreign investments minus payments made to foreign investors), and cash transfers
(Perry 2011).

Fiscal Policy: The use of government taxation and spending to influence the economy in terms
of stabilizing national output, economic growth, employment and inflation (Chatziantoniou,
Duffy, & Filis, 2013).

GDP: one of the primary indicators used to gauge the health of a country's economy. It
represents the total dollar value of all goods and services produced over a specific time.

Government debt: Total amount borrowed and owed by the government .Debt issued by a
government through bonds and other instruments (Gerleman 2012).

Government Expenditure: refers to the expenses incurred by the government for the
maintenance of itself and provision of public goods, services and works needed to promote
economic growth and improve people’s welfare in the society (Aigheyisi, 2013).

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NSE 20 share Index: a price weight index. The members are selected based on a weighted
market performance for a 12-month period as follows: Market Capitalization
40%, Shares Traded 30%, Number of deals 20%, and Turnover 10%. (www.nse.co.ke).

NSE All Share Index: a market cap weighted index consisting of all the securities on the NSE.
Prices are based on last trade information from NSE's Automated Trading System.
(www.nse.co.ke).

Recurrent Expenditure: refers to purchase of goods and services, wages and salaries,
operations as well as current grants and subsidies (Aigheyisi, 2013).

Stock Exchange: regulated market where the public can purchase and sell listed securities in
line with well-documented rules and regulations .

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 CHAPTER 1

1.1 Background
1.11 Fiscal Policy and its influence on Stock Market Performance

Fiscal policy is a major factor that influences the economic performance in a country .Through
fiscal policy, a government can determine spending and revenue levels . According to John
Maynard Keynes, by increasing or decreasing the levels of revenue and expenditure,
representing taxes and spending, respectively, a government can influence inflation,
employment, and the flow of money within an economy . Fiscal policy therefore involves the
use of government taxation and spending to influence the economy in terms of stabilizing
national output, economic growth, employment and inflation. In addition, fiscal policy can
support aggregate demand, boosting the economy and potentially driving stock prices higher
(Chatziantoniou, Duffy, & Filis, 2013). Fiscal policy that increases aggregate demand directly
through an increase in government spending, is referred to as expansionary while fiscal policy is
often considered contractionary if it reduces demand via lower spending (Horton & El-Ganainy,
2009).

The fiscal policy objectives vary, with the short-term objectives focusing mainly on
macroeconomic stabilization through stimulating an ailing economy, combating rising inflation
or helping reduce external vulnerabilities. The long-term objectives of fiscal policy focus mainly
on sustainable economic growth,poverty reduction through investment in infrastructure or
education (Horton & El-Ganainy, 2009).The country circumstances however play a major role
in determining the priorities of these fiscal policy objectives.While lower income countries
would spend on improvement of primary health care so as to reduce poverty levels, oil rich
countries may aim at moderating procyclical spending for bursts when oil prices rise and for
cuts when oil prices drop (Horton & El-Ganainy, 2009).

Fiscal policy can facilitate macroeconomic stability by sustaining demand and incomes from the
private sector in the course of economic downturns, in addition to regulating economic activity
in times of strong economic growth. A key stabilizing factor of fiscal policy acts in the form of
the ‘automatic fiscal stabilizers,’ which act through the effects of fluctuations in the economy on
government budget, and may not require any short-term intervention from policy makers . For
instance, the scale of tax collection and transfer payments, are influenced directly by the state of
an economy, and adjust in a manner that facilitates the stabilization of private sector incomes
1
and aggregate demand. This ‘automatic’ feature enables timely responses, with agents being
able to assess investments with confidence .

For investors, large budgetary deficits negatively impact stocks and bond prices due to increase
in interest rates.The government is usually a large borrower and would require large amount of
funds which would have otherwise been channelled to the private sector hence driving up the
interest rates.Increased interest rates consequently reduce capital expenditure for businesses thus
hampering real economic activity. In the end, the asset prices in the financial markets will be
significantly reduced complicating further the cost of borrowing (Laopodis, 2009) If
government spending is kept constant while taxes are increased, the expected asset prices would
be lowered and this would discourage investors from investing further in the stock market.
Additionally, an increase in government borrowing raises the short-term interest rate, which in
turn, lowers the discounted cash flow value from an asset like a share and thus signals a
reduction in stock market activity.

Governments could also deliberately adjust taxes or spending in response to fluctuations in

economic activity. However, discretionary fiscal policies are hardly appropriate from demand
management, since they could undermine healthy budgetary positions, and governments are
more likely to decrease taxes than increase spending following slumps in growth. Discretionary
fiscal policy tends to increase public debt and the tax burden consistently, with potentially
adverse effects, since a high tax environment reduces the incentives for investment, work, and
innovation .

Government expenditure could influence developments in stock market through the effects on
decisions and activities of private firms and households . Firms enjoying government patronage
could have boosted turnover, translating into profits and impressive dividends for shareholders,
based on the firms’ expenses and dividend policies. Enhanced profitability and attractive
dividends would draw positive attention on the trading floor for a listed firm, driving up
demand. Stock prices would increase, as well as the firm in question’s market capitalization, and
in turn, the entire stock market’s market capitalization. If the market is efficient, the value of
transactions would also rise .

Government expenditure could also influence stock market activity via the effect on income,
particularly government employees. Depending on the outlook of a market, prospects of return
on investment, as well as prospects of returns on alternative investments, government employees
2
may deposit part of their income in the stock market . In such a case, salaries constitute
government recurrent expenditure, and if government employees regard the stock market as a
favorable investment option, there would be an increase in the number of transactions at the
stock market by virtue of their expectations of high returns .

The Kenya economic report (2016) highlights the key fiscal indicators for fiscal performance as
revenue performance, government expenditure, fiscal deficit and its financing and overall public
debt. The total cumulative revenue (including A-I-A) over the first half of 2015/16 amounted to
581.1 Billion Kenyan Shillings against a target of 678 Billion Kenyan Shillings, compared to
1081.2 Billion Kenyan Shillings in 2014/15 against a target of Ksh 1,170.5 Billion. Thus, total
revenue over the first half of 2015/16 was below target by Ksh 96.9 Billion. Ordinary revenue
amounted to Ksh 544.2 Billion in the first half of 2015/16, against a target of Ksh 591.8 Billion.
Thus, total revenue fell below the target by 17.0 per cent, while ordinary revenue also fell below
target by 8.7 per cent (Kenya Economic Report, 2016).

Total government expenditure and net lending for the first half of 2015/16 amounted to Ksh
727.4 billion compared to Ksh 1,616 billion in 2014/15 and Ksh 1,297.8 billion in 2013/14.
Recurrent expenditure accounted for 58.0 per cent of total expenditure in 2014/15 and first half
of 2015/16, respectively. Development expenditure, accounted for 31.0 per cent and 28.0 per
cent of total expenditure in 2014/15 and first half of 2015/16, respectively. Wages and salaries
accounted for 18.0 per cent and 20.0 per cent of recurrent expenditure in 2015/15 and the first
half of 2015/16, respectively. Operations and Maintenance accounted for 21.0 per cent and 20.5
per cent of total expenditure in 2015/15 and first half of 2015/16, respectively (Kenya Economic
Report, 2016).

In 2014/15, the overall fiscal balance on commitment basis (including grants) amounted to Ksh
506.7 Billion, which was 8.9% of GDP against a target of Ksh 584.9 Billion, a 10.2% of GDP.
For half of 2015/16, the overall fiscal balance on commitment basis amounted to Ksh 146.2
Billion against an annual target of Ksh 319.2 Billion. Overall fiscal deficit, including grants, on
a cash basis amounted to Ksh 471.9 billion (8.3% of GDP) compared to a target of Ksh 584.9
billion (10.2% of GDP). For half of 2015/16, the overall fiscal balance cash basis (including
grants) amounted to Ksh 165.3 Billion against an annual target of Ksh 319.2 Billion. In 2014/15,
deficit financing was largely from domestic sources, amounting to Ksh 251.1 billion compared
to the first half of 2015/16 where deficit financing was mainly foreign, amounting to Ksh 136.8

3
billion (83% of the deficit financing over the same period). This represented domestic financing
and external financing of 0.43 per cent and 2.12 per cent of GDP in the first half of 2015/16,
respectively, as compared to domestic financing of 4.4 per cent of GDP and external financing
of 3.81 per cent in 2014/15 (Kenya Economic Report, 2016).

Kenya’s total public debt was Ksh 2,844 Billion (about 49.7% of GDP) at the end of December
2015 compared to Ksh 2,276 Billion at the end of December 2014. The total external debt stock,
including the International Sovereign Bond, stood at Ksh 1,615 Billion at the period ending
December 2015, accounting for 51 per cent of total gross public debt. The external debt stock
comprised of multilateral debt (47%), bilateral debt (30%), export credit debt (1%) and
commercial banks’ debt (23% including the International Sovereign Bond). Most of Kenya’s
external debt remains on concessional terms, although its commercial component has increased.
The stock of domestic debt increased from Ksh 1,308 Billion in December 2014 to Ksh 1,540
billion in December 2015, accounting for 49 per cent of total gross public debt. The total
cumulative debt service payments to external creditors amounted to Ksh 33.8 billion by
December 2015, which comprised Ksh 16.4 Billion principal repayments and Ksh 17.4 Billion
interest payment (Kenya Economic Report, 2016).

Statistics on central government’s debt show that total debt more than quadrupled between 2000
and 2014. Thus, the issue of debt sustainability should be a concern given the increasing debt
levels and their effect on stability of key macroeconomic variables such as inflation, interest
rates and exchange rate on private sector participation in the economy. The relationship between
central government debt and expenditure over time is the determinant of debt sustainability.
Debt is sustainable if government revenue and expenditure move in a similar manner, implying
that the government is able to finance its expenditure from its own revenues. The analysis of
growth in total revenue and total expenditure indicates that the growth in expenditure over the
years reflects the growth in revenue, except for increased expenditure during election years and
after 2012 where total expenditure increased at a higher rate than total revenue while total
revenue declined. In 2015, total revenue grew at a faster rate than total expenditure. Even
though previous analysis by the International Monetary Fund (IMF, 2013) showed that Kenya
faced a low risk of external debt distress as all external public debt indicators were found to be
below the relevant country-specific debt burden thresholds (for Kenya, a threshold of 40% of
GDP and 150% of exports), persistence in recent trends could signal fiscal distress.

4
The biggest risks to Kenya’s fiscal position are: fluctuations in the exchange rate; less favorable
terms of payment on new loans; slower economic growth rate; and widening current account
deficit. The maintenance of a favorable debt position requires slower increases in fiscal and
current account deficits; faster growth, at the long-term projected rate of 6 per cent; stability in
macroeconomic fundamentals, especially inflation; and growth in exports beyond the medium
term projection of 7 per cent.

1.12 The Stock Market

A stock exchange or a securities market is a regulated market where the public can trade listed
securities in line with well-documented rules and regulations . It provides an opportunity to
stockbrokers to trade in stocks, bonds, among other securities. Securities markets also offer
facilities for the issue and redemption of securities and other financial instruments. They also
offer avenues for capital events such as paying income and dividends .

The stock market has an important role in a country’s macroeconomic development (Zakaria &
Shamsuddin, 2012). Studies have shown that proper functioning financial systems result in
economic growth and stock markets lie at the heart of these financial systems. The stock
markets facilitate growth of companies by mergers, acquisition or fusion, are instrumental in
mobilizing savings for investment, create investment opportunities for small investors, promote
corporate governance, help governments raise capital for development and are indicators of the
economy (Kaur,2014). They serve as a means of transforming savings into financing for
different sectors of the economy.Efficient stock markets have been shown to make corporations
compete on an equal basis for funds thus making investment more efficient (El-Wassal,2013).

Financial markets are critical for the development of an economy. They facilitate capital
creation and allocation in an economy, offering infrastructure for firms and governments to raise
long-term capital that can either finance new projects or expand existing operations . The
institutional infrastructures in the form of stock markets provide avenues for mobilizing funds
from the public and channel the same to productive investments. Stock markets also offer
capital at relatively lower costs, since capital is obtained directly from the public, while
accelerating economic growth . In addition, stock markets facilitate wider ownership and the
distribution of risks among investors. They are crucial for an economy since they generate
savings for investment. In the case of investors, stock markets offer an opportunity to make
informed investment choices .

5
Globally, the major stock exchanges like the New York Stock Exchange, Tokyo Stock
Exchange, London Stock Exchange, Hong Kong and NASDAQ have grown in structure over
the last few decades due to macroeconomic stability, higher economic growth and specific
policy changes like capital account linearization and domestic capital reforms. The development
in the global economies has been the main factor that contributed to the establishment of stock
markets in African countries in the last few decades (Yartey & Adjasi 2007). The authors argue
that the development of the stock market in Sub-Saharan Africa has been central to the domestic
financial liberalization programs of most Africa countries and insist that any program of
financial liberalization in Africa cannot be complete without the development and establishment
of stock markets.

Ngugi, (2003) explores the evolutionary process of the stock market in Kenya historically and
identifies the institutional and policy changes that have shaped its development patterns. The
developments occurred in the regulatory system, trading system, market membership,
composition of market investors and taxation policy. The stock market development evolved in
three phases. In the initial stages in the 1920s, there were no formal rules and foreign players
dominated the Nairobi Stock Exchange. Afterwards, the post-independence government pursued
formalization in a self-regulatory environment, while encouraging local investors to get
onboard. The third stage has been characterized by numerous institutional and policy reforms
with a view of facilitating growth with the market.

The political environment in East Africa and the macroeconomic environment have both
influenced the development of the Nairobi Stock Exchange, influencing the composition of
participants and supporting local funds mobilization for long-term economic development,
respectively. By 2003, stock brokerage firms had increased from six (6) to twenty (20) and
numerous stock dealers and investment banks had been licensed indicating expansion in the
stock brokerage industry. There have also been concerted efforts in mass education on stock
market operations.

To increase market depth, novel instruments were applied over the years. A punitive tax policy
for share investors in the initial stages has since been replaced with an incentive-based policy
that promoted competitiveness and did away with barriers to listing. The initial non-formal
system was gradually replaced with a self-regulatory and a statutory regulatory system.
Additionally, the introduction of a Central Depository System and the automation of the trading

6
cycle focused on increasing efficiency in price discovery and liquidity. The trajectory above is
similar to those witnessed in developed and emerging economies. The Performance of the
Securities Exchange in Nairobi is measured by the NSE All Share Index (NASI) and the NSE 20
share index.The NSE 20 share Index is a long standing benchmark index introduced in 1964 and
represents the geometric mean of the Share prices of the NSE’s top 20 stocks.The NASI,
introduced in February 2008 after criticisms of the NSE 20 share Index, was aimed at capturing
market capitalizations of all NSE’s Listed equities traded in a day. Research has however shown
that there are no significant differences between the two indices (Osoro & Jagongo, 2013) .

According to The Nairobi Securities Exchange, press release (2016),the 20 companies in the
NSE 20 Share Index are selected based on a weighted average performance in the period under
review with adherence to the following criteria: trading activities measures that are made up of,
market capitalization,shares traded, deals, liquidity and turnover weighed in the ratio 4:2:3:1
respectively;free float of at least 20%; minimum market capitalization of at least Ksh 20
million;and a company should ideally be blue chip with superior profitability and dividend
record. Currently, the companies listed in the NSE 20 Share Index are Sasini Ltd in the
Agricultural Sector;Nation Media Group and Scangroup Limited in the Commercial and
Services Sector;Kenya Commercial Bank,The Cooperative Bank of Kenya,Diamond Trust
Bank Limited,Barclays Bank Limited,Equity Bank Limited,CFC Stanbic Holdings Limited in
the Banking Sector;East African Breweries Limited,British American Tobacco Kenya
Limited,Athi River Mining,Bamburi Cement in the Manufacturing and Allied Sector;Kenol
Kobil Limited,Kenya Power and Lighting Limited,Kengen Limited in the Energy and Petroleum
Sector;Britiah American Investments Company(Kenya) Limited and CIC Insurance Group in
the Insurance Sector ;Safaricom Limited in the Telecommunications and Technology Sector and
lastly, Centum Investment Limited in the Investment Sector. Historically, the NSE 20 share
index reached an all time high in January 2007 at 5774.27 and the lowest at 1043.38 in August
2002 (Investing.com).

1.2 Statement of the Problem

The performance of the Nairobi Securities Exchange has been on a decline. Despite posting a
profit before tax of Ksh 233.1 Million in 2016, it was still a 39% decrease from Ksh. 381.5
Million in 2015. The profit before tax of Ksh 381.5 Million posted in 2015 was also a 13.6%
decrease from Ksh. 441.8 million posted in 2014. The decline was because of the compounding
macroeconomic effects in the economy and a decline in equity turnover. The NSE 20 Share
7
Index recorded a decline of 20.9% from 5113 points on close of December 2014 to close at 4041
points at the close of trading in December 2015 and a further decline of 21.15% from 4,041
points at the close of December 2015 to close at 3,186.21 points at the close of trading day in
December 2016. Statistics indicate that equity turnover decreased by 3 per cent from 215 Billion
Kenyan Shillings in 2014 to 209 Billion Kenya Shillings in 2015 to 147 Billion Kenyan
Shillings in 2016 (NSE 2015 & 2016 Annual Reports). In 2016, the Nairobi Securities
Exchange emerged as the worst performing in the world. Nigerian Stock Exchange previously
held this position, in 2015. The NSE closed the second week of trading in January 13 2017 at
2971.10, a 10-year low, last witnessed in 2009. The poor performance of the NSE affects other
regional stock exchanges where Kenyan companies are cross-listed like the Uganda Securities
Exchange, which has eight cross-listed firms, Dar-es-Salaam Stock Exchange, which has six and
the Rwanda Securities Exchange, which has four. The investors in the NSE as well as the
regional stock exchanges also lose millions of dollars because of decline in market
capitalization.

Mankiw (2003) argues that stock prices reflect the expectations of companies’ future
profitability and therefore stock indices are indicators of economic conditions. Pardy (1992)
notes that sound, efficient securities market can contribute to economic growth in the long run
while in the short run they play an important role in financial liberalization and deepening.
Pardy (1992) also insists on the importance of a conducive macroeconomic and fiscal
environment as prerequisites for the development of security markets among other factors like
legal, regulatory and institutional infrastructure, certainity about property rights, transparent
trading and other procedures, protection against unfair practices by insiders and public
disclosure by companies of all information relevant to the value of their securities. Additionally,
the absence of a well-developed and efficient stock market leads to an unattractive capital
markets, which in turn hinders its ability to play the role of channeling funds from surplus units
to deficit units (Aigheyisi & Edore, 2014). The surplus units may seek alternative investment
options to channel their funds, severely crippling the capital markets, a source of long term and
short-term funds for both government and non-government borrowers who use the funds for
infrastructural development and business expansion

Aigheyisi and Edore(2014) pointed out the factors affecting the performance of the stock
exchange as financial development, stock market liquidity, income, savings rate, consumer price
index, external debt,political risk, bureaucratic quality and government expenditure; a clear
8
indication that instruments of fiscal policy have a role to play in the performance of stock
exchange. Various public expenditure and taxation components of fiscal policy have been seen
to have an effect on growth. A distortionary tax regime retards investment and growth while
excessive public expenditure on consumption at the expense of investment has also been seen
to deter growth (M'Amanja & Morrissey, 2005). Fiscal policy could potentially drive stock
prices lower through the crowding out of private sector activity thus affecting the performance
of the entire economy (Chatziantoniou, Duffy, & Filis, 2013). Reilly & Norton ( 1999) posit
that changes in fiscal instruments like government spending, taxes and other revenue items can
change market interest rates instantaneously and force investors to revalue their stock holdings.
As such, the value of investors’ wealth derived by the summation of the discounted value of
future cash flows could be affected by an easing or tightening of fiscal policy.

Despite the fact that the relationship between fiscal policy and stock market performance has
been well documented in the developing world and generally in West African Countries like
Nigeria and Ghana, the number of empirical researches in Kenya, an emerging economy, is
quite few. Also notably, very few studies have focused on how fiscal and monetary policies
interact to affect the performance of the stock market. Existing literature only looks at how
fiscal policy and monetary policy affect stock market performance in isolation. The complex
interaction involving direct and indirect channels for example through the impact of inter-
temporal budget constraint on monetary policy or through the effect of fiscal policy on monetary
variables like interest rates, inflation and exchange rates, have not been explored
(Chatziantoniou, Duffy, & Filis, 2013).This research aimed to fill that gap

1.3 Objectives of the Study

The main objective of this study was to establish how fiscal policy affects the performance of
the Nairobi Securities Exchange. The specific objectives were:
1. To determine the effect of government expenditure on performance of the Nairobi
Securities Exchange
2. To determine the effect of domestic debt, on performance of the Nairobi Securities
Exchange
3. To investigate the relationship between government revenue and stock market performance

9
1.4 Research Questions
1. What is the effect of government expenditure on performance of the Nairobi Securities
Exchange?
2. What is the effect of domestic debt, on performance of the Nairobi Securities Exchange?
3. What is the relationship between government revenue and stock market performance?

1.5 Significance of the Study

This study will be instrumental for policy makers in better understanding the role fiscal policy
plays in the performance of the NSE. In addition, since the study considers money supply as a
control variable to cater for monetary policy and the fact that its interactions with fiscal policy
have to be considered, it will be important for policy makers to ensure that monetary policy is
deeply entrenched into the financial sector. This will result in real economic growth through
proper mechanisms that ensure monetary policy is transmitted into the macro-economy through
various channels like the interest rate, credit and price level (Osuagwu, 2009). The role of
capital markets on government policies decision making is multi-dimensional. They are a
reflection of economic development and can be easily adopted by authorities tasked with
formulating fiscal policies for decision-making. (Anghelache, Jakova, & Oanea, 2016).

The study will also be paramount to investors. In this regard, capital market performance not
only responds to fiscal and monetary policy decisions and affects the economy, but also
provides feedback to private sector's expectations about the future course of key macroeconomic
variables. This will aid in investment decision making.
Additionally, the Capital markets Authority and other regulators would benefit from the wealth
of information. This study will also be significant for academia concerning adding to their
resource of knowledge on determinants of stock market performance in addition to offering
areas for further research

1.6 Scope of the Study

This study will cover Kenya’s Fiscal policy between the year 2002:Q1 and 2016:Q4 a fifteen
year period and incorporate Money Supply M3 as a control variable. The Fiscal instruments
under study will be public expenditure as a percentage of GDP, Domestic debt as a percentage
of GDP and government revenue as a percentage of GDP. The stock market performance will
consider the NSE 20 share index as a measure of stock market performance because it is a better

10
market measurement index than the NSE All share Index (Waithaka, 2014). The period
between 2002-2016 was characterised by quadrupling of the public debt, the financial crisis of
2008-2009, and increased expenditure during election years (2002, 2007 and 2013) and after
2012 where total expenditure increased at a higher rate than total revenue while total revenue
declined and in 2015, where total revenue grew at a faster rate than total expenditure

1.7 Research Methodology

The study intends to use the descriptive research. Two sets of Empirical data are involved. The
20 Share Index will represent the performance of Nairobi Securities Exchange and form the
dependent variable. Data on fiscal policy instruments from the Central Bank of Kenya, the
Kenya Revenue Authority and the Kenya National Bureau of Statistics official documents forms
the other set that will encompass the independent variables of public expenditure, debt, revenue
and money supply as the control variable. Analysis and examination of these sets of data will
investigate the relationship between fiscal policy and the performance of NSE by establishing
correlation coefficients between the NSE 20-share index and the fiscal policy variables.

11
 CHAPTER 2

2.0 Literature Review

2.1Theoretical Literature
Keynes, (1936) on his General Theory of Employment interest and Money proposed active
government management of the economy through fiscal policy.The theory published in 1936
during the great depression advocated for fiscal stimulus and proposed that government, and not
the private sector could create employment.The Keynesians believed that if the private sector
was not investing enough to increase employment and output, then a fiscal stimulus,
characterised by use of governmnet fiscal policy to increase demand would be instrumental.
Increased government spending through the fiscal stimulus would provide more income to
private individuals and would allow them to spend more through consumption thus increasing
demand and encouraging the private companies to begin to spend more for output to meet the
demand. The increased output from private companies would mean the hiring of more
employees who would then spend more themselves creating more demand and more output
produced to meet the demand. The fiscal stimulus according to the Keynesians is created by
deficit spending, i.e a government spending more than it generates in taxes and other reveue
sources.Governments can enact fiscal stimulus through spending on government programs while
keeping taxes the same, through tax reductions while keeping spending the same or by a
combined reduction in taxes and an increase in government spending. According to this theory,
a decrease in government spending would lead to decreased employment which would result
into lower consumer demand and a decrease in production by firms reulting in even further job
losses which would translate to poor performing stocks.

Critics of the Keynesian General Theory of Employment, Interest and Money argue that
political reality does not allow it to work in practice as proposed in theory.Despite government
undertaking fiscal stimulus to boost economic activity in the short term and create demand
temporarily so as to boost the private sector, evidence suggests that once increased government
spending has been executed, government deficit spending does not decrease as expected.Thus,
critics propose that the private sector and not government can best create long term productivity
increases.In addition, implementation of fiscal policy, and in this case the fiscal stimulus has
been shown to exhibit lags making it nearly impossibel for government to implement.

12
Tas (1991) summarised the theoretical aspects of budget deficits by analysing the standard view,
the Ricardian view , the Neoclassical view and the Keynesian view of budget deficits. The
standard model assumes that the substitution of a budget deficit for current taxation results in an
expanded aggregate consumer demand. This means that desired private savings rise by less than
the tax cuts so that the desired national saving declines.For a closed economy, the expected real
interest rate would have to rise to restore equality between desired national saving and
investment demand. The higher real interest rate would consquently crowd out investment
which would show up in the long run as a smaller stock of productive capital.For an open
economy, the budget deficits for a small country would have negligible effects on the real
interest rates in international capital markets. Therefore, the decision to substitute a budget
deficit for current taxes in the standard view leads mainly to increased borrowing from abroad
instead of a higher real interest rates and expected interest rates rise for the home country only if
it is large enough to influence world markets. The alternative is that budget deficits would lead
to current account deficits. Critics like Kormendi (1983) put forward strong evidence that in
contrast to the standard view, consumption is not reduced by taxes but by government
expenditure.

The Ricardian view stipulates that a deficit financed cut in current taxes for a determined
direction of government spending would lead to higher future taxes with the same present value
as the initial tax cuts. This theory puts forward the fact that government spending must be paid
for now or later with the total present value of receipts fixed by the total present value of
expenditure. Barro (1989), explored the Ricardian approach to Budget Deficits and developed a
simple theory of optimal public finance by identifiying factors that would influence the choice
between taxes and debt issue. He also raised theoretical objections to the Ricardian view
summarised as; finite horizons, imperfect loan markets, uncertainity about future taxes and
income,the timing of taxes, full employment and keynesian views. The objections stated that
people do not live forever and thus don’t care about taxes levied after their death and would
rather capitalize on taxes they expect to face while alive. The Ricardian equivalence also failed
due to imperfect credit markets and the fact that the government implicitly guarantees the
repayment of loans through its tax collections and debt repayments.The uncertainty about
individual’s future taxes and the complexities associated with estimating them implies that there
would be a high rate of discount in capitalising them as future liabilities.The objection on the
timing of taxes argued that if taxes were not lumpsum, budget deficits change their timing for

13
example in the case of income taxes thereby affecting people’s incentive to work and produce at
different periods.Lastly, the Ricardian view depends on full employment which fails to hold in
the Keynesian view. Barro (1974) posits that shifts between debt and tax finance for a given
amount of public expenditure would have no first order effect on the real interest rate and
volume of private investment.

The Neoclassical view on budget deficits has three central features that are critical in the
determination of the impact of budget deficits.First, the consumption of each individual is
determined as the solution to the inter-temporal optimization problem where both lending and
borrowing are permitted at the market interest rate. Secondly,individuals have finite lifespans
and the lifespans of successive generations overlap.This generally differentiates the Neoclassical
and Ricardian framework.Thirdly, market clearing is generally assumed in all periods, the
primary distinction between Neoclassical and Keynesian views.

Lastly, the Keynesian view according to Tas (1992) stipulates that increasing the budget deficit
causes output to expand by the inverse of the marginal propensity to save. Based on standard IS-
LM analysis, expansion of output raises demand for money. A fixed money supply based on the
assumption that deficits are financed by bonds would lead to a rise in interest rates thus
crowding out private investments.

Tobin ( 1969) in his ‘ general equilibrium approach to monetary theory’ uses models to explain
the approaches with regards to the capital account,the accounting framework, the analytical
framework, the money-capital economy, the equilibria in the money capital model and a money
securities capital model. He highlights the role of stock returns as a linkage between the real and
the financial sectors of the economy showing how the growth of money and budget deficits can
have an impact on stock market returns.In his explanation of the Long-run equilibrium in the
money capital model and the money securities capital model, he stipulates that the supply of
money is identical with government debt and therefore its not possible to increase money by a
dollar without simultaneously increasing private wealth by the same. This means that an
increase in the nominal money stock is a monetary consequence of fiscal policy rather than
monetary policy in the usual sense.This further emphasises the interaction of the two policies
and the importance of further exploring their interactions rather than looking at them in
isolation.

14
The Efficient Market hypothesis(EMH) theory stipulates that the stock markets prices reflect all
available information and it is therefore impossible to beat the market. This means that the EMH
strongly advocates that the stocks always trade at their fair value thus making it impossible for
investors to either purchase undervalued stocks or sell stock at infalted prices. Darrat (1988)
tested the validity of the EMH hypothesis by investigating empirically the relationship
betweeen aggregate quaterly stock returns and a number of important macrovariables including
monetary and fiscal policy actions in Canada. Using available information on interest rates,
lagged monetary and fiscal policy actions and other macrovariables the study established that
past monetary actions had an insignificant effect on stock market returns.

2.2 Empirical Literature

2.21 Fiscal Policy and its Impact on Stock Market Performance

Mbanga & Darrat, (2016) explored the short run and long run effects of fiscal and monetary
policy on the U.S Stock market and tested market efficiency. The authors’ motivation was the
fact that most studies had focused on the role of monetary policy on stock market performance
while largely ignoring the role of fiscal policy. The study primarily focused on whether US
Stock prices fully reflected available information on fiscal and monetary policy moves. The
authors measured fiscal policy actions by changes in real high employment federal budget
deficits (BF) and measured stock returns in by changes in the Standard and Poor’s 500 index
(SP). The effects on stock prices from monetary policy actions represented by the Monetary
base (MB) are controlled to avoid potential estimation biases. The study also factored in other
factors that could influence stock returns based on other empirical literature. These factors
accounted for were inflation (IF) ,measured by changes in the Consumer Price Index (CPI),
output measured by the Industrial Production average (IP) and the required rate of return
measured by the three month Treasury-Bill Rate (TB). To avoid spurious regression, the data
was tested for stationarity using the Augmented Dickey Fuller Test (ADF) and the Phillip-
Perron (PP) Unit root Test

Results from ADF and PP tests indicated that all the variables SP,BF,MB,TB,IF and IP were
non stationary in levels and became stationary in first difference i.e. SP,BF,TB,IP and MB and
IF achieve stationarity in second differencing indicating the inexistence of any long term
relationship between Monetary Policy (MB) and Stock Market (SP). Since Fiscal policy
integrated in the same order as stock prices, there was an indication that it could have long run

15
cointergrating relationship with stock prices. Further tests on short run effects of past policy
actions on stock returns indicated that the US stock market seemed inefficient with respect to
available information on fiscal policy moves but efficient with respect to information available
on monetary policy moves. Further tests to establish if anticipated fiscal policy actions
influenced stock returns by testing the variables CPI,TB,MB,IP, Balance of Trade
(BT),Unemployment Rate (UN) and exchange rate (EX) showed that the US stock market was
sensitive to changes in inflation and balance of trade.

Darrat (1988) investigated how fiscal policy affected stock market performance in Canada and
found that fiscal policy plays an importat role in determining stock returns even when the path
through interest rates is excluded.The study also established the presence of a significant lagged
relationship between fiscal measures and current stock returns,after controlling for the effects of
fiscal policy on required return to capital. Further tests showed that fiscal policy actions
anticipated from an ex-ante equation have significant lagged effects on current stock returns.

Bekhet and Othman(2012) examined the role of fiscal policy in the Malaysian Stock market by
analyzing the relationship between stock index and macroeconomic policies using quaterly data
for Malaysia for 1999:Q1-2011:Q4. The change in stock index was used as proxy for financial
performance.The study used cointergration tests to detect the existence of long-run relationship
between stock index and macroeconomic variables and Vector Error Correction Model
(VECM) to test for short-run relationships among the variables.The variables for study were
Stock index (S), Government Operating Expenditure (GO), Government Development
Expenditure (GD), Tax Revenue (T), Interest Rate (r), and Money supply (M). All variables
were presented in logarithmic form to help induce stationarities and obtain elasticities with log
of government expenditure being the summation of operating expenditure and development
expenditure.To ensure non violation of normality, homogenity, linearity and multicollinearity,
preliminary tests were conducted using E-views package 7.1

The study applied a double log model to explore the connection between the dependent (S) and
the independent variables and assess the sensitivity.

The coefficients of the logs represented the level of sensitivity of stock index towards changes
in independent variables with greater values for the same indicating higher sensitivity. The
negative values for the coefficients of tax and interest rates were because of the expectation that
tax and interest rate had a negative relationship with stock index. Empirical findings for the
16
study indicated that fiscal and monetary tools had a long-run relationship with stock market
performance indicating that the policies played an important role in accelerating financial
performance in Malaysia.The study found that while interest rates could influence stock market
performance in the short and long-run the other fiscal variables could only influence stock
market performance in the long-run.

Ngigi (2000) studied the effect of fiscal and monetary policies on stock market performance and
established that anticipated fiscal policy does not in the long run affect stock market
performance.

2.22 Effect of government public expenditure on performance of the Nairobi Securities

Exchange
Government expenditure has been seen to affect the development of the stock exchange through
its effects on activities and decisions of private sector firms and households . Firms tend to
experience boosts, which indicate high profitability and dividends for shareholders whenever
there is government’s influence with all factors kept constant. High profitability and high
dividends add to the firms’ attractiveness thus driving up demand for their stocks, which results
in even higher stock prices and market capitalizations of these firms and the entire stock
exchange. Additionally, government expenditure can affect stock prices through its effect on
income on individuals, in this case government employees. Perception of the market,
expectations of returns on investment and the rate of return on alternative investment are factors,
which drive government employees to invest their income which constitute part of government
recurrent expenditure. A favorable market perception of high expectation leads to increased
participation in the market thus increased market transactions

Ogbulu, Torbira, & Chizoba (2015), with an objective to invetigate the nature and behavior of
the relationship between fiscal policy and stock market returns in Nigeria, carried out a study for
the period 1985-2012 using OLS, cointergration, error correction mechanism (ECM), Granger
Causality, impulse response and variance decomposition techniques. The stock market
performance was measured using the All share index while fiscal policy measures were captured
using Government Total public Expenditure (PEX) in millions of Nairas obtained from the
sum of Capital expenditure (CEX) and Recurrent Expenditure (REX); Non-oil Revenue (NOR)
in millions of Nairas, Domestic Debt Outstanding (DBT) in millions of Nairas. The study also
used broad money supply (MS) in millions of Nairas as a control variable, to account for the
17
monetary policy transmission path as demonstrated by empirical studies that showed fiscal
policy interacts with monetary policy to affect stock prices.

The results indicated that there was a significant but negative relationship between Public
Expenditure and Stock performance, the Domestic Debt Outstanding had a positive and
significant relationship with stock prices, non-oil revenue had a significant and positive
relationship with stock prices.The relationship beween current broad money supply (MS) and
ASI was found to be positive but insignificant while the two period and three period lagged
values of MS were significant indicating Money Supply had a lagged effect on stock prices.

Namini & Nasab (2015) also investigated the interactions of monetary and fiscal policy and
their effects on the stock market in Iran for the period 1991-2010.The study used GDP target, oil
revenue, the general price levels and government expenditure as variables for fiscal policy and
used money supply for monetary policy while the performance of the stock exchange was
measured using the stock market index. Data was analsed using Structural Vector
Autoregression model (SVAR), Impulse response functions and variance decomposition were
used to investigate the impact of shocks.The findings for the study were that monetary and fiscal
policies had a positive but little impact on the changes in the stock market index and that both
policies affect the stock market, with the interactions affecting stock market development
directly while fiscal policy was shown to have no impact on stock market development. The
study established that the stock markets responded negatively to an increase in government
expenditure.

Muyanga, (2014) carried out a study aimed at determining the relationship between fiscal
policy and performance of the Nairobi Secutities exchange using the NSE 20 share index that
was regressed against fiscal policy instruments such as government expenditure,government tax
revenue and government debt expressed as a percentage of the GDP.The scope was 10 years
between January 2004 to December 2013

The study established that government expenditure and government revenue had positive effect
on stock market performance.Government debt had low positive effect on stock market
performance with a negative cumulative effect due to its risk on inflation as a result on interest
on debt.

18
2.23 Effect of domestic debt, on performance of the Nairobi Securities Exchange
Kimathi & Muturi, (2016) explored the Relationship between Government Domestic Debt and
Stock Market Performance in Kenya for the period January 2009 to December 2015. The
study’s main objective was to determine the effect of treasury bills, treasury bonds, commercial
bank advances to government and central overdraft on performance of the NSE 20 share index.
The author was motivated by the fact that establishing the relationship would be significant in
predicting optimum government debt to gross domestic ratio where any debt changes do not
have a negative impact on stock market performance.The data was analysed quantitatively using
multiple regression performed by STATA version 12.

The dependent variable analysed was NSE 20 share index at time t,(NSEIDX) while the
independent variable were, Treasury bonds at time t (TBD t), Treasury Bills at time t (TBL t ),
Central Bank Overdraft at time t (CBOt) and Commercial Bank Advance at time t (CBA t ) The
results of the study indicated that treasury bills and treasury bonds had negative but insignificant
influence on stock market performance while the central bank overdraft to the government and
commercial bank advance to the government has positive and significant influence on stock
market performance.

Gerleman, (2012) also studied the impact of government debt changes on stock market
movements for three different European countries of Germany, Portugal and Sweden.The study
focused on quaterly government debt changes as a percentage of GDP and quaterly stock market
changes over the time period 2000:Q2-2011:Q2.It’s main objective was to put the Efficient
Market Hypothesis (EMH) to test to establish whether stock prices fully reflect all relevant
information for example government debt changes as soon as they occur without delays. The
study applied OLS and Granger Causality test for each respective country. The stock index was
the dependent variable with independent variables represented by lagged values of debt as a
percentage of GDP, Interest rates and unemployment.The results in the case of Sweden and
Portugal proved to be inconclusive thus the inability to reject or accept the EMH with respect to
government debt changes while results from Germany indicated a correlation between the two
variables.

Hsing, (2013) examined the potential impacts of fiscal and monetary policy on stock market
performance in Poland for the period between 1999:Q2-2012:Q4. The study examined the stock
market index in Poland as a function of fiscal policy, interest rate, money supply, real output,

19
the nominal effective exchange rate, inflation rate, the stock market in Germany and the stock
market in the US. Using GARCH to estimate the regression parameters, results indicated that
Fiscal policy as represented by the ratio of government deficit spending to GDP had an
insignificant positive coefficient, suggesting that more government deficits as a percent of GDP
would not cause Poland’s stock index to decline.

Aigheyisi & Edore ( 2014) studied the effect of government expenditure and governmnet debt
on the value of transactions on the trading floors of the Nigerian Stock Exchange. The study
used annual time series data for the year 1981-2012 sourced from the Central Bank of Nigeria
Statistics Bulletin and was motivated mainly by the fact that the literature for government debt
and stock market development was still quite lean. Using the methodology of cointergration and
ECM justified by the need to investigate the short run and the long run effects of the variables
on stock market development,:the study developed the model to be estimated first in its basic
functional form and developed it to a more robust and inclusive form. The values of transactions
on the trading floors of the Nigerian stock exchange were used as proxy for stock market
development
Initially, the dependent variable which was the value traded as percentage of GDP was
expressed as a function government debt as a percentage of GDP and Government expenditure
as a percentage of GDP. Further, Government debt was then disaggregated into domestic debt
(DDT) and external debt (EXDT); while government expenditure disaggregate into recurrent
expenditure (REC) and capital expenditure (CAP)

Other variables already identified in literature as determinants of stock market development

were then incorporated to make the model more robust, and to avoid the problem of omitted
variables. The variables incorporated were lending interest rate, exchange rate and trade
openness.

The empirical evidence indicated that the short-run and long-run effects of federal government
recurrent expenditure, domestic debt and external debt on value of transactions on the Nigerian
Stock Exchange were statistically insignificant thus, the stock market development was
unaffected by these variables. Government capital expenditure was observed to have had
significant negative short-run and long run effects on value of transactions on the stock market.

20
Muyanga (2014) while exploring government debt as a variable in fiscal policy found that it
had a low positive effect on stock market performance with a negative cumulative effect as its
long term use poses risk to inflation owing to interest on debt.

2.24 Relationship between government revenue and stock market performance

Foresti & Napolitano (2016), conducted a panel analysis to investigate the effects of government
expenditure and stock market indices in 11 member of the Eurozone for the period 1999:Q1-
2012:Q1.The study was motivated by the fact that a significant number of studies in the
Eurozone had focused on monetary policy and therefore little was known on the sign and
stability of the stock markets’ reaction to taxation and public expenditure.The study employed
the panel Dynamic Ordinary Least Square (DOLS) estimator as proposed by another empirical
study by Mark and Sul (2003) of a homogenous cointergration vector for a balanced panel of N
individuals observed over T time periods.The DOLS estimation was used for longrun regression
augmented by lead and lag differences of the variables in order to control for serial correlation
and endogenity of the regressors.

One lead and one lag of first differences of explanatory variables were used as instruments with
lnS being the logarithm of the stock market index, lnG and lnT representing public
expenditures and revenues respectively, lnY being the GDP growth rate, lnM3 measuring
money supply and R the long-term interest rate. The results indicated that fiscal maneuvers
influenced stock markets and an increase in public deficits would result in stock markets
dropping and vice-versa. It was also noted that stock markets performed poorly with an increase
in public expenditure or reduction in public revenue and the study recommended that
governments should take into account the consequences of their fiscal maneuvers in terms of
stock markets’ reaction

Jakova, (2016) analysed the response of stock markets in Eastern and Central Europe to a
deviation in fiscal policy using Vectro Autoregressive Model (VAR). The study employed
quaterly data for the period 2004:Q1-2015:Q4 and analysed markets in Bulgaria,Czech
Republic, Slovakia, Poland and Romania.

The dependent variable was represented by the return market for each quarter for country i, year
t, and quarter q while the independent variables were measured by the variables by government
revenue as a percentage of GDP for country i, year t and quarter q and government expenditure
as a percentage of GDP for country i, year t and quarter q. The indices samples were expressed
21
in Euros using official exchange rates from European Central Bank. Results indicated the
existence of an inverse relationship between stock market performance and government
expenditure and a positive relationship between stock market performance and government
revenue for Bulgaria and Slovakia. For Czech Republic, Hungary an Poland, there was a
negative impact of public revenue to stock market performance explained by increased taxation
that affected revenues. Results for Romania indicated that both public revenue and expenditure
affected the stock market performance negatively.

Amporfu, Sakyi, & Ofori-Abebrese, (2016) used Autoregressive Distributed Lag (ADRL)
technique to investigate the impact of macroeconomic policy on the development of the Ghana
stock exchange for the period 1991-2011.Motivated by the fact that most studies had failed to
capture the entire macroeconomic aspect.

The variables under study were Market Capitalisation as a proxy for stock market
development,expressed as a function of General Expenditure(GE) and Government tax Revenue
(GR) as proxies for fiscal policy, broad money supply (M2), interest on domestic bonds (INTR)
and Real Exchange Rates (RER).All the variables were expressed in log-linear function. The
study carried out cointergration using ADRL bound test technique and the Error Correction
Model justified by their appropriateness for small sample studies and for variables intergrated
for strictly order zero or one or a mixture of both.The study established that government
revenue had a negative impact on stock market development while government expenditure had
a positive though insignificant impact on stock market performance.

2.25 Fiscal and Monetary Policy Interactions

Nyamongo, Misati, & Ngare, (2014) emphasised the need to consider the monetary-fiscal mix
bearing in mind that both policies have an impact on key macroeconomic variables despite their
differences in use of policy instruments.The authors highlighted three channels in which fiscal
policy could influence the short term environment for Monetary policy in Kenya.The channels
are:discretionary fiscal policy stabilizations, operations of automatic stabilizers can contribute to
reducing short term volatility,specific instruments at the disposal of the government that have a
quick effect on prices such as Value added Tax (VAT). In the long-term, the effect of fiscal
policy on monetary policy occurs via its impact on sustainability of public finances and on
potential growth.

22
 Money volume changes play a significant role in achieving a country’s economic goals, growth
and development of the capital market (Namini and Nasab 2015). Increased liquidity could lead
to an increase in asset demand. Information on expansionary monetary policy has positive
psychological effects on formation of expectations and propensity to invest indicating a positive
relationship between stock market index and money volume. Namini and Nasab (2015) found
that money supply shocks had a positive impact on stock market performance. This is because
money supply was looked at as an important factor as a macroeconomic variable and because it
is significant as an asset in the investor’s portfolio.

2.3 Conceptual Framework

Independent Variables Control Variable Dependent Variable

Government Domestic debt to

GDP (DBT/GDP)

Monetary Supply (M3) to Stock Market Performance

Government Revenue to
GDP (NSE 20 share index)
GDP (GR/GDP)

Government Expenditure to
GDP (PEX)

Figure

NSE= The 20 share index yearly averages obtained from monthly averages of respective years
specified in the study.

PEX =Government Total public Expenditure in millions of Shillings obtained from the sum of
Capital expenditure (CEX) and Recurrent Expenditure (REX); as percentage of GDP

DBT= Domestic Debt Outstanding in millions of Kenya Shillings as percentage of GDP

GR = Government Revenue in millions of Kenya shillings,as percentage of GDP

MS =broad money supply in millions of Kenya shillings as a control variable, to account for the
monetary policy transmission path as demonstrated by empirical studies that showed fiscal
policy interacts with monetary policy to affect stock prices.

23
2.4 Critique
While Mbaga and Darrat (2016) established a long-run cointergrating relationship between
fiscal policy, interest rates and industrial production on stock prices the study fails to indicate
the level of significance and the direction of the relationship. While the study is cognizant to the
fact that other factors could influence stock returns apart from monetary policy actions, it factors
inflation, output and short-term interest rates whereby inflation and monetary base end up being
stationary at different levels from the other variables thus failing to be cointergrated with the
rest of the variables. The study could have limited the number of control variables.

Ogbulu, Torbira & Chizoba (2015) used the Nigerian All share Index to measure performance
of the Nigerian Stock Exchange meaning that they sampled the entire population in the market.
This means that some counters, which were very illiquid, were included yet they would not
make much difference in improving the performance.

All the empirical literature relied on secondary data whose validity would be difficult to verify
and even though they indicate the type of data analysis procedure used, they do not give reason
for preference.

2.5 Summary of findings

The empirical literature has exhibited convergent and divergent views in their findings. While
Mbaga and Darrat (2016) reported that fiscal policy had long-run cointergrating relationship
with stock prices, Namani &Nasab (2015) reported the contrary; fiscal policy had no impact on
stock market performance. Muyanga (2014),established that government expenditure had a
positive effect on stock market performance , Amporfu, Sakyi & Ofori-Abebrese(2016) noted a
positive but insignificant relationship, while Ogbulu, Torbira and Chizoba(2015) established the
contrary; the existence of a negative relationship between public expenditure and stock market
performance. This was similar to findings by Namini and Nasab (2015), and Foresti and
Napolitano (2016) who noted that the stock markets responded negatively to an increase in
government expenditure.
Government revenue was found to have a significant and positive relationship with the stock
prices in Nigeria (Ogbulu, Torbira & Chizoba 2015), which were similar findings to Muyanga
(2014) in Kenya and Foresti and Napolitano (2016). On the contrary, Amporfu, Sakyi and

24
Ofori-Abebrese (2016) reported that government revenue had a negative impact on stock market
performance in Ghana

The impact of government debt changes to stock market performance also reported conflicting
findings. Gerleman (2012), established inconclusive results. Kimathi & Muturi, (2016) indicated
that treasury bills and treasury bonds have negative but insignificant influence on stock market
performance while the central bank overdraft to the government and commercial bank advance
to the government has positive and significant influence on stock market performance. Hsing,
(2013) established that fiscal policy as represented by the ratio of government deficit spending
to GDP had an insignificant positive coefficient, suggesting that more government deficits as a
percent of GDP would not cause Poland’s stock index to decline. Muyanga (2014) reported that
government debt had low positive effect on stock market performance similar to Ogbulu,
Torbira & Chizoba (2015) who reported a positive and significant relationship, while Aigheyisi
& Edore (2014) determined that the short-run and long run effects of federal government
domestic debt and external debt were statistically insignificant to the stock market performance.

2.6 Research Gaps

The determining factors of fiscal policy; government expenditure, revenue and debt seem not to
have been exhausted in the Kenyan context and even though empirical studies have attempted to
address it, few have taken into consideration the interaction of fiscal and monetary policy.
Existing literature tends to focus more on impact of fiscal policy on economic growth yet the
stock market is one of the main indicators of economic performance. It is also commendable
that scholars from West Africa seem to understand the importance of the stock market and that
its performance is critical and have therefore carried out studies in the recent past on it.

The fact that Kenya’s debt has quadrupled in the past ten years should create interest among
scholars on the effect it might have on our stocks bearing in mind that it is headed to
unsustainable levels according to the World Bank. This has not been addressed by the studies.

25
 CHAPTER 3

3.0 Methodology

3.1 Introduction
This chapter outlines how the researcher intends to carry out the research from the preliminary
stages to its completion. It intricately describes the research design that will be adopted, the data
sources, how the population will effectively be sampled, the techniques and instruments that wll
be used for data collection and the procedure that will be used to measure the variables.

3.2 Research design

Kothari ( 2004) defines research design as the arrangement of conditions for collection and
analysis of data in a manner that aims to combine relevance to the research purpose with
economy in procedure. In other words, research is conducted within the conceptual structure. It
constitutes the blueprint for the collection, measurement and analysis of data. The research
design adopted for this study will be diagnostic. It will attempt to determine the extent to which
fiscal policy affects the performance of the Nairobi Securities exchange. A diagnostic research
design will be the most appropriate for this study because the study clearly defines the
population, and the researcher will be aiming to get complete and accurate information.

3.3 Population

The target population will be the Nairobi Securities Exchange. The study will sample the NSE
20 share index that consist of 20 companies listed in the NSE and the indices will be from the
first quarter of 2002 to the last quarter of 2016.
3.4Sampling frame;

3.5 Sample and sampling technique

The sampling design will be non-probability or purposive sampling because the researcher
intends to use indices as exhibited by the NSE 20 share Index and not any other Instruments,
which is a deliberate decision. The NSE 20 share index, which has been in existence longer than
the NSE All Share index is a sufficient indicator of market performance as previously seen in
empirical studies by Nyamongo (2015) and Waithaka (2014)

26
3.6 Data collection procedure

The data analyzed was secondary and the researcher collected the NSE 20 share index from the
Nairobi Securities Exchange historical Data. Data on Public debt, public expenditure and
revenue were sourced from the Central Bank of Kenya Published Statistics.Data on broad
money supply(M3) was sourced from the Kenya National Bureu of Statistcs yearly economic
surveys..
The NSE 20-share index was chosen as a proxy for the stock market because it is able to
measure price movements in selected, relatively stable and best performing 20 listed companies
at the bourse. It is based on a geometric mean of average prices of the constituent companies
that are equally weighted, and reviewed periodically to ensure that it reflects an accurate picture
of market performance (Olweny and Kimani 2011). Secondary data offers the advantages of
convenience, cost and time which were very crucial given the time anticipated to carry out the
data collection and analysis.

3.7 Data Processing, analysis and model

Data processing implies the editing, coding, classification and tabulation of collected data to
ensure they are amenable to analysis (Kothari 2004).
Preliminary analysis will be performed to ensure no violation of assumption of normality,
homogeneity, stationarity, linearity, Heteroskedascticity, autocorrelation and Multicollinearity
using E-views software package. Since time series data was involved in this study, the first
preliminary step was to test for stationarity among all dependent and independent variables, and
if found not stationary, convert them into stationary form. The Durbin-Watson test tested for
stationarity with values obtained indicating either a positive or a negative autocorrelation in the
error term. The Augmented Dickey Fuller Test will be applied for unit root tests of the same
order or integration and ARDL technique will be applied if the variables are observed to be of
mixed order of integration.
To check the existence of Multicollinearity, the Variance Inflation Factor will indicate the extent
to which the variances of the parameters are inflated by the presence of Multicollinearity. If
Multicollinearity will be found to exist, the study will either drop one of the collinear
explanatory variables or increase the sample size bearing in mind that the variables are already
represented as ratios.

27
Heteroskedascticity indicates that the assumption of the error terms having a constant variance
is violated and this would mean the inability to test for significance of the parameters. The
Golfeld-Quandt test or the White test will be used to test for Heteroskedascticity. If found to
exist, the study will convert the data either into log form or to reciprocals.
Additionally, other specification errors like omission of important explanatory variables,
inclusion of unimportant explanatory variables not supported by theory or specification of a
wrong model will be considered. For this research, the Ramsey test will be conducted to
establish whether the model estimated has been specified correctly. The model will also be
tested for stability. To ensure that the error terms have a normal distribution, the Jarque –Bera
test will be performed and introduction of dummy variables will follow if there will be any
indication of non-normality.
The study will also use cointergration tests to detect the existence of long-run relationship
between stock index and macroeconomic variables and Vector Error Correction Model
(VECM) to test for short-run relationships among the variables. Multivariate analyses will be
employed and the study will test for correlation using multiple correlation and regression
analyses.

The model of analysis will follow a linear combination of explanatory time series variables that
will denote fiscal policy, and monetary policy as a control variable, and the dependent variable,
which will be an estimate of stock market performance. The model will be adopted from
Muyanga (2014) and Bekhet and Othman (2012). All variables will be presented in logarithmic
form to help induce stationarities, avoid heteroskedascticity, multicollinearity and obtain
elasticities.

Log NSEit= ao + a1 logPEXit + a2 log DBTit + a3 log GRit + a4 logMSPit +Ut

Where:

NSE= The 20 share index yearly averages obtained from monthly averages of respective years
specified in the study.

PEX =Government Total public Expenditure in millions of Shillings obtained from the sum of
Capital expenditure (CEX) and Recurrent Expenditure (REX); as percentage of GDP

DBT= Domestic Debt Outstanding in millions of Kenya Shillings as percentage of GDP

28
GR = Government Revenue in millions of Kenya shillings,as percentage of GDP

MS =broad money supply in millions of Kenya shillings as a control variable, to account for the
monetary policy transmission path as demonstrated by empirical studies that showed fiscal
policy interacts with monetary policy to affect stock prices.

ao,= constant coefficients

a1,a2, a3, a4 = partial coefficients for independent variables

Ut= residual error term

29
 CHAPTER 4

RESEARCH FINDINGS AND DISCUSSION

i) Style of presentation – presentation of raw data followed by discussion

ii) Should be guided by the methodology. Unit of analysis should be based on the
research questions or objectives and should capture the independent variables.
iii) Tables should have no vertical lines (use simple formatting)
iv) Table titles should be at the top of the tables.
v) Tables copied from elsewhere should have source below them.
vi) Any table generated by the researcher should not have the source quote.
vii) Figure titles should be at the bottom of the figures.
viii) Figures can have different shadings.
ix) Discussion should follow the results.

30
x)

CHAPTER 5

SUMMARY, CONCLUSIONS AND RECOMMENDATIONS

5.1 INTRODUCTION-A brief on the chapter

5.2 SUMMARY- This is an extended abstract
5.3 CONCLUSIONS- Must be derived from the summary
5.4 RECOMMENDATIONS- Should be derived from the conclusions

31
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