Effects of Interest and Exchange Rates on GSE Returns

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This article is a thesis writing/review on the topic, “An Analysis of The Effects of Interest Rate and Exchange Rate Changes on Stock Market Returns: Empirical Evidence of Ghana Stock Exchange (GSE).”

Researcher: R.C.E.

Introduction

After almost a decade of reasonably solid economic performance, with real gross domestic product (GDP) expanding at an annual rate of approximately 6% on average over the prior five years, there was increased concern regarding Ghana's economic development prospects in early 2009. Unsurprisingly, economic growth dropped to a two-decade low of 4.7 percent in 2009, after reaching a two-decade high of 7.3 percent in 2008. Economic growth is forecast to moderate somewhat to 6.4 percent in 2010 then accelerate to 8.3 percent in 2011 as a result of global recovery, unprecedented governmental investment in the growing oil industry, and earnings from anticipated fresh oil finds (African economic outlook, 2010).

The establishment of the Ghana Stock Exchange (GSE) was one of the proposals made during the 1980s economic reforms aimed at generating sustainable economic growth and development. As Boateng (2004) notes, following many years of experimentation with heavy state intervention in the economy, a consensus emerged that achieving more dynamic economic growth required a greater role for the private sector and stock market, as they are effective levers for increasing private sector access to finance.

Interest rate and foreign exchange rate risks are two key economic and financial variables that impact the value of the common stock. The stock market is thought to be critical to the economy because it mobilises domestic resources and directs them toward productive ventures. However, in order to fulfil this duty, it must have a strong connection to the economy.

Numerous macroeconomic and financial factors influencing the stock market have been reported in recent empirical research without agreement on their suitability as regressors (Lane 2002; Campbell and Yogo, 2003, Jansen and Moreira, 2004, Donaldson and Maddaloni, 2005). The most often discussed macroeconomic indicators include GDP, price level, interest rate, exchange rate, balance of payments, unemployment rate, fiscal balance, and inflation. Only a few studies have been undertaken to far on the direct influence of some of the aforementioned factors on Ghana's stock exchange. This empirical article focuses on the dynamic implications of changes in IR and EXR on Ghana's total stock market results.

The link between interest rates and stock market returns is fundamentally based on the fact that stock prices and interest rates are negatively connected. Increased interest rates as a consequence of monetary policy tightening often have a negative influence on stock market performance. This is because a higher interest rate diminishes the value of equities, as the dividend discount model indicates, and hence makes fixed income instruments more appealing as a substitute for stocks. As a consequence, this may diminish investors' willingness to borrow and invest in stocks, as well as increase the cost of conducting business, eroding profit margins. On the other side, the stock market benefits from reduced interest rates as a consequence of expansionary monetary policy.

Additionally, as Hashemzadeh and Taylor (1988) observed, a drop in interest rates increases the current value of future dividends. As a consequence of changes in foreign investments, there are interactions between stock market returns and the exchange rate. Returns on international investments in equities are translated between currencies using fluctuating spot exchange rates.

When rates of return in a declining currency are converted to rates of return in an appreciating currency, the adjusted rates of return fall. When rates of return in an appreciating currency are converted to rates of return in a falling currency, adjusted rates of return rise. Foreign portfolio investors place a premium on the timing of their return conversions in relation to expected currency fluctuation.

Additionally, increased foreign investment in a country's stock market results in an appreciation of the local currency relative to the relevant foreign currency due to increased foreign currency inflows. On the other hand, foreign investors' sales of a country's shares result in foreign capital outflows. As a result of this depreciation of the local currency versus a corresponding foreign currency, portrayals of such interactions between the stock and foreign currency markets are likely to contain bidirectional causation. International fund managers are expected to rebalance their stock market investments when currency devaluation and uncertainty have a negative effect on stock returns.

Ghana's rapid development has occurred in the context of a solid macroeconomic environment. Prudence in fiscal and monetary policy has aided in the easing of inflationary pressures as interest rates have declined. The private sector has reacted favourably to the government's development initiatives and better business climate. Bank lending and capital inflows are growing, implying an increase in investor confidence. Ghana's new alliances with rising countries such as China and South Korea are bringing more funding and development experience (African Economic Outlook, 2011).

Statement of the Issue

Ghana's stock market, which is now classified as an emerging market, was created in July 1989 as a private company limited by guarantee under the Companies Code of 1963 (Act 179) and began trading on 12 November 1990 to promote private investment in Ghana. However, in April 1994, the firm's status was changed to that of a public company limited by guarantee according to the Company's Code. The Securities and Exchange Commission regulates the GSE according to the Securities Industry Law, PNDCL 333, 1993, as modified. The GSE, on the other hand, has made great strides, with 35 firms presently listed on the market.

The government has undertaken a variety of initiatives and policies with the goal of fostering a more favourable macroeconomic climate conducive to private investment. The current administration, under its "Better Ghana" agenda, views macroeconomic stability as important for private investment. Additionally, their current tenure has witnessed a decline in inflation and interest rates, as well as a stability of the cedi on the foreign currency market. The worries are scientific evidence of a link between stock prices and macroeconomic indicators, which would reassure investors that the current age is truly a better time to invest in Ghana, particularly in the stock market.

Since GSE's founding, the exchange has fared well, as seen by the GSE All-Share Index, which evaluates the exchange's overall performance. Using year-end values, the GSE All-share index grew 11.42 percent in 2001 over 2000. In 2002, the growth was 45.90 percent; in 2003, it was 154.67 percent; and in 2004, it was 91.33 percent. However, the GSE All share index declined 29.85 percent in 2005 compared to 2004. According to many observers, 2005 was the year when stock prices started to settle after a sustained bull run. The GSE All-Share Index increased from 4,769.00 points at the end of 2005 to 10,431.60 points at the end of December 2008, before falling to 5,572.34 points at the close of 2009. Although year-on-year performance has been inconsistent, long-term investors have earned large returns, averaging roughly 3.60 percent over the last five years (2005 and 2009).

2009 was a very challenging year for the stock market, especially when compared to 2008, which was one of the market's finest years. The market had a hard patch in 2009 as a consequence of the global financial crisis, which started in the fourth quarter of 2008, and the Exchange's successful transition from paper certification to electronic book entry securities under the new automated Trading System in 2009. Naturally, this procedure takes time, since investors needed to be encouraged to join. The increase in the local interest rate, which made money market instruments more appealing, was also a factor.

With a 46.58 percent decline in the GSE All-Share index (GASI), the Ghana Stock Exchange concluded 2009 as Africa's worst performing market. In 2008, the GSE All-Share Index gained 58 percent, putting Ghana top of all African markets. It's worth noting that Tunisia dominated African markets in 2009, with a 46.60 percent return on index. Due to GSE's constant progress, it was named the most innovative African stock exchange in 2010 at the African Investor (Ai) renowned annual index series awards held at the New York Stock Exchange.

The growing importance of the African economy as a result of increased market openness, continuing development of strong trade relationships with the rest of the world, rising foreign investment, expanding GDP growth rate, and sustained expansion of export-oriented industry and services necessitates an examination of certain macroeconomic factors and their relationship to the stock market.

The openness of a country's economy is recognised as a factor in the market's volatility. Ghana is a textbook example of an open economy that participates in foreign commerce. Additionally, as a consequence of globalisation, emerging countries are becoming increasingly connected with developed economies, as seen by increased import and export flows. Ghana is not an exception to this rule. A brief analysis of Ghana's foreign exchange and interest rate history reveals a significant degree of unpredictability.

As such, it would be fascinating to investigate the influence of foreign currency and interest rate fluctuations on the country's stock market. Again, little research has been conducted on the impact of exchange rate and interest rate fluctuations in developing countries such as Ghana. Thus, the research will examine the influence of foreign currency and interest rate fluctuations on Ghana's stock market returns.

Objectives

The purpose of this research is to determine how firms listed on the GSE perform in the face of a more volatile exchange rate and interest rate environment, taking into account investors' sensitivity to movements in both markets.
 

Significant Findings

Interest rates were found to be favourably connected to GASI in the short run, whereas exchange rates were found to be adversely related to GASI in the short run, which is similar with Banerjee and Adhikary (2009) and Adjasi et al (2008) findings on exchange rates and stock market returns.

Additionally, it was shown that the variables have a long-run equilibrium connection and that a unidirectional causal flow goes from changes in the interest rate and exchange rate to GASI. Nevertheless, given the very low numerical value of the modified R2, the variables demonstrated near independence from one another. Contrary to predictions, changes in the IR demonstrate relatively little short-term net positive feedback effects on stock market performance. This link may be explained by the fact that the 91-day Treasury bill rate has been positive for the most of the period with considerable consistency, although on a smaller scale, as well as by the fact that the rate fell from 10.81 percent to 12.89 percent in the first half of 2010.

The exchange rate investigation demonstrates a short-term net negative feedback from the exchange rate to the GASI, with negligible t-values associated with the coefficients of the existent and delayed variables. This presupposes that the exchange rate and GASI are substantially independent of one another, a conclusion reinforced by the corrected R-squared and F-statistic values. This is likely due to the limited foreign portfolio investment in Ghana's stock market and the cedi's devaluation against the dollar. The Ghana cedi, for example, declined modestly by 0.7 percent versus the US dollar in the interbank market during the second quarter of 2010.

As a result, it may be inferred that the GSE market, the Treasury bill rate, and the USD's foreign exchange rate seem to move separately, but there is some evidence of a long-run equilibrium link between the variables.

The research investigated the impacts of many macroeconomic variables on stock prices in Ghana, established their link with stock prices, and maybe used them to forecast future changes in stock prices as a consequence of these macroeconomic variables changing.

The well-known cointegration methodology was used to examine the relationship between the Ghana Stock Exchange All-Share Index and the corresponding macroeconomic variables from January 2000 to December 2010 in order to ascertain the extent to which these macroeconomic variables affect stock market returns.

The analysis demonstrated a long-run equilibrium and causal link between the dependent variable, the GSE All-share index (GASI), and the two independent variables, interest rates and currency exchange rates. Additionally, it was established that the impacts of interest rate and currency rate volatility on the Ghana Stock Exchange are essentially fictitious in the short run.

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Some References

Abdalla, I.S.A., and Murinde, V. (1997). “Exchange Rate and Stock Price Interaction in Emerging Financial Markets: Evidence on India, Korea, Pakistan and Philippines”, Applied Financial Economics, 7, 25-35.

Adam, A.M., and Tweneboah, G. (2008). “Macroeconomic Factors & Stock Market Movement: Evidences from Ghana”, MPRA Paper112556, University library of Munich, Germany.

Adebiyi, M.A., Adenuga, A.O., Abeng, M.O., and Omanukwue, P.N. (2009). “Oil Price Shocks, Exchange Rate and Stock Market Behavior: Empirical Evidence from Nigeria”. A Paper Presented at the 15th Annual African Econometric Society (AES) Conference on Econometric Modeling for Africa Held in Abuja from July 07-09.

Adjasi, C., Harvey, S.K., and Agyapong, D. (2008). “Effect of Exchange Rate Volatility on the Ghana Stock Exchange”, African Journal of Accounting, Economics, Finance and Banking Research Vol.3.No.3.

Adjasi, C.K.D., and Biekpe, B.N. (2005), “Stock Market Returns and Exchange Rate Dynamics in Selected African Countries: A bivariate analysis”, The African Finance Journal, July, Cape Town, South Africa.