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Emerging Stock Market Performance

and Economic Growth
Seyyed Ali Paytakhti Oskooe
American Journal of Applied Sciences

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American Journal of Applied Sciences 7 (2): 265-269, 2010
ISSN 1546-9239
© 2010 Science Publications

Emerging Stock Market Performance and Economic Growth

Seyyed Ali Paytakhti Oskooe

School of Economics, Kingston University,
Kt1 2EE, Kingston upon Thames, London, United Kingdom

Abstract: Problem statement: In spite of significant development in Iran stock market as a emerging
stock market, there has been not specific research on the causality between the stock prices and
economic growth. This study represented a systematic investigation of the relationship between stock
market performance and economic growth in Iran by conducting causality tests within the Vector Error
Correction Model (VECM) framework. Approach: To achieve this objective unit root tests are
fulfilled for all time series data in their levels and their first differences. Johansen co-integration
analysis is used to investigate whether the variables are co-integrated of the same order taking into
account the maximum eigenvalues and trace statistics tests. A vector error correction model is applied
to examine the long-run relationship between stock market performance and economic growth. Finally,
Granger causality test is applied in order to find the direction of causality between the examined
variables of the estimated model. Results: Findings imply the causality link between economic growth
and stock price fluctuations in the long run, as well as bilateral causality running between share prices
and economic growth in the short run. Conclusion: Therefore, it can be inferred that the level of real
economic activity is the main factor in the movement of stock prices in the long run and stock market
plays a role as a leading economic indicator of future economic growth in Iran in the short run.

Key words: Stock market development, causality test, economic growth

INTRODUCTION On the other hand, other studies have examined the

impact of stock prices on macroeconomics indicators.
The role of stock market as part of financial markets According to the results of these investigations share
in economic development process is emphasized by prices fluctuations play a role in directing economic
growth theories. The interaction between stock prices activities in the medium and long term. Stock prices
movements and real economic activities has been a reflect the expectation of public towards the future
debated issue in majority of economic studies. In this economic activity. In other words, the stock market is
connection, two crucial questions have become the main forward-looking and stock prices reflect anticipations
focus of attention. First, are stock prices or share price about future economic activity. If a recession is
movements influenced by economic change or are they expected, for example, then stock prices reflect this by
determined on the basis of speculative bubbles? Second, decreasing in value whereas large increase in stock
to what extent does the stock market performance as a prices may reflect the expectation towards future
macroeconomic indicator affect the prospects for economic growth (Jefferis and Okeahalam, 2000;
economic growth? Nasseh and Strauss, 2000; Mauro, 2000; Shirai, 2004;
There are a lot of studies about the connection Adajaski and Biekpe, 2005; Mun et al., 2008).
between stock prices fluctuations and economic growth In the light of the mixed empirical results in the
as well as other economic variables which have literature, we are motivated to examine the empirical
detected that changes in stock prices reflect real support for the causality link between stock price
economic situation. Economic growth through the fluctuations and economic growth in a developing
changes in levels of real economic activities affects country, in particular Iran, as opposed to the advanced
profitability and activity of firms. As a result, with industrialized countries. In spite of significant
changes in profitability prospects, expected earnings development in Iran stock market in recent years, there
and dividends of shares, stock prices fluctuate (Fama, has been not specific research on the causality between
1990; Ferson and Harvey, 1993; Cheung and Ng, 1998; the stock prices movements and economic growth
Mauro, 2003; Ritter, 2005; Liu and Sinclair, 2008; performance. The aim of this study is to investigate the
Shahbaz et al., 2008). short run dynamics and long term equilibrium
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relationship between changes of real GDP as an The Error-Correction (EC) coefficients ai(i = 1, 2)
economic growth indicator and stock prices fluctuations capture the adjustments process towards long-run
for the emerging Iran stock market. equilibrium, while the Aij(i, j = 1, 2) reflect the short-
There are several reasons why investigating the run dynamics of the model. The formulation of Eq. 1
causality between stock market and economic growth in provides investigation of the causal relationship
Iran is particularly important. First, the study can between variables both in the short run and long run.
provide evidence as to whether theories relevant to role The data analyzed in this study consists of
of stock market in economic growth and the findings economic and financial time series of Iran there are real
from developed and developing countries can be Gross Domestic Product (GDP) and Iran stock market
applied to Iran economy. Second, from a policy point of index (BPI).Quarterly GDP at constant prices and stock
view, analyzing the relationship between stock market Price Indices (BPI) for Iran are taken from the Central
performance and economic growth is important in Bank of Iran and Iran stock market web sites. The data
designing economic development programmes. set of the study consists of 45 observations covering the
This study has two objectives: period from 1997:3-2008:3.
The graphs of quarterly Iran stock prices index
• To examine the long run relationship among stock (Fig. 1) offer visual support for the possibility of a break
market performance and economic growth in Iran in trend behavior around 2005:Q1, when the political
• To apply granger causality test based on a vector challenge about Iranian nuclear programme started.
error correction model in order to examine the Following these reasons, the two dummy variables for a
causal relationships between the stock prices and break in the level (or intercept) and break in the slope (or
GDP growth taking into account Johansen co- the rate of growth) are considered.
integration analysis When data are collected quarterly, the data are very
likely to be seasonal. Figure 2 shows the existence of
The remainder of this study is organized as seasonality in Iran GDP data trend. Therefore, the
follows: Initially the data and the specification of the moving average methods are applied to remove
multivariate VAR model are described. After that seasonality from the GDP series. Therefore, the
stationarity test and Johansen co-integration analysis seasonally adjusting series are used in econometrics
are fulfilled taking into account the estimation of vector analysis.
error correction model. On the other hand, Granger
causality test is applied in order to find the direction of Unit root test: The variables used in this study are used
causality between the examined variables of the in the logarithms form, so that the first differences of
estimated model. Then the empirical results and some GDP and stock prices represent the economic growth
discussion issues are presented. Finally the conclusions rate and changes in stock prices, respectively. The
are summarized relatively. results from ADF tests are summarized in Table 1. The
lag length is chosen by downward search and the t
MATERIALS AND METHODS statistics reported are from the longest significant lag.
The null hypothesis of a unit root is not rejected for any
Data and specification model: When the time series of the two variables. However, each of the series is
are nonstationary and cointegrated, the causality test stationary in first differences, so all the variables are
can be performed according to the following equations: integrated of order one (I (1)).

⎛ ΔX t ⎞ ⎛ a1 ⎞ ⎛ A11 (L) A12 (L) ⎞ ⎛ ΔX t −1 ⎞

⎜ ⎟=⎜ ⎟+⎜ ⎟+⎜ ⎟+
⎝ ΔYt ⎠ ⎝ a 2 ⎠ ⎝ A 21 (L) A 22 (L) ⎠ ⎝ ΔYt −1 ⎠
(1)
⎛ a x u t −1 ⎞ ⎛ e xt ⎞
⎜⎜ ⎟⎟ + ⎜⎜ ⎟⎟
⎝ a y u t −1 ⎠ ⎝ e yt ⎠

Where:
(L) = A lag operator
ut = The residual term from the long-run equilibrium
relation such as:

X t = β1 y t + u t , u t ∼ (0, σ2 ) (2) Fig. 1: Time plot of quartely Iran stock market index
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 Am. J. Applied Sci., 7 (2): 265-269, 2010

Table 1: The unit root test Table 2: Johansen cointegration test

Variables ADF at level ADF at first difference Null λmax 95% CV Trace test 95% CV
LGDP 0.018532 (1) -9.423447*** r=0 14.2287 14.8800 16.8815 17.8600
LBPI -1.108720 (1) -4.287041** r=1 2.6528** 8.0700 2.6528** 8.0700
Note: ** and ***: Denote significance at the 5 and 1% levels, Note: **: Denotes significance at the 5% level
respectively; Figures in parentheses are the number of lags used
Table 3: Causality test
Independent variable
Dependent ------------------------------------
variable LGDP LBPI Inference
LGDP 9.5783*** 11.8434*** BPI→GDP
LBPI (0.003) (0.008) GDP→BPI
Note: ***: Denotes significance at the 1% level

This means that the changes in real GDP is significant

in predicting movements in stock prices and stock price
changes is basically connected to real economic
activities in the long run in Iranian economy. The
possible reason is that an increase in GDP raises
expected future cash flow, firm’s economic
Fig. 2: Time plot of quartely Iran GDP
opportunities, corporate profitability and thereby, stock
Testing for cointegration: For testing cointegrating prices increase. The result is consistent with the
relationships, the general to specific approach is taken findings from previous researches in the cases of EU
to search for a suitable lag length. The selection and emerging economies (Wongbangpo and Sharma,
criterion is a combination of Akaike’s information 2002; Vazakidis and Adamopoulos, 2009).
criteria and diagnostic tests. A model with two lags, a Regarding to empirical results which presented in
constant and dummies constrained to lie in the Table 3, the null hypothesis that the stock prices do not
cointegration space is chosen. The number of Granger cause economic growth is rejected at the 1%
cointegration vectors is tested by applying the significance level and confirm the existence of causal
maximum likelihood based on λmax and λtrace statistics link running from stock price movements to economic
introduced by Johansen and Juselious (1990). growth in the short run. In the meantime, the null
hypothesis that the economic growth does not Granger
Testing for causality: According to the Granger (1969) cause stock prices is b at the 5% significance level. As a
causality approach, a variable for example real GDP, is result bilateral causality relationship between stock
caused by BPI (stock prices index) if GDP can price fluctuations and economic growth in Iranian
predicted better from past values of GDP and BPI than economy is confirmed.
from past values of GDP alone. For a simple bivariate The causal link from GDP growth to stock prices
model, we can test the causality between stock market movements persists on the role of improving of
growth and economic growth. economic activities in development of stock market.
The causal link from stock prices to GDP growth
RESULTS AND DISCUSSION implies that stock prices, which are generally the
discounted present value of future dividends, can be
The results from cointegrating tests for the VAR used to anticipate future economic growth. The study’s
system presented in Table 2 indicate that there is one finding confirms the notion that the forward-looking
cointegration vector. Applying VECM approach after nature of stock prices performs as a leading indicator of
normalizing the coefficients of stock price indices to economic growth in Iranian economy.
one, the cointegrating relationship between stock prices Another possible explanation for why stock prices
and GDP for Iran can be expressed as: “Granger cause” economic activity is the wealth effect.
According to this concept, fluctuations in stock prices
LBPI = C+6.8537 LGDP + Dum (3) through the change in wealth level, give rise to change
in aggregate consumption and aggregate demand. As a
Equation 3 indicates that the long-run level of stock result, economic activities level is affected by
prices is positively affected by the level of real GDP. fluctuations in the stock market.
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 Am. J. Applied Sci., 7 (2): 265-269, 2010

Hence, from economic policymaking view, it can Fama, E.F., 1990. Stock returns, expected returns and
be noted that Iran government should improve the stock real activity. J. Finance, XLV: 1089-1108.
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