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The Stock Market and the Economy in Pakistan

Husain, Fazal and Mahmood, Tariq (2001): The Stock Market and the Economy in Pakistan. Published in: The Pakistan Development Review , Vol. 40, No. 2 (2001): pp. 107-114.

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This paper re-examines the causal relationship between stock prices and macro variables like consumption expenditure, investment spending, and economic activity (measured by GDP) in Pakistan. Using annual data from 1959-60 to 1998-99 and applying cointegration and error correction analysis, the paper indicates the presence of long-run relationship between stock prices and macro variables. Regarding the cause and effect relationship, the analysis indicates a one-way causation from macro variables to stock prices, implying that in Pakistan fluctuations in macro variables cause changes in stock prices. The findings suggest that the stock market in Pakistan is not that developed to play its due role in influencing aggregate demand. A disturbing feature of the stock market in Pakistan is that it cannot be characterised as the leading indicator of economic activity. In the absence of other strong indicators, shooting up of stock prices may indicate a speculative bubble. I. INTRODUCTION The stock market plays an important role in the economy by mobilising domestic resources and channelling them to productive investment. This implies that it must have a significant relationship with the economy. The relationship can be seen, in general, in two ways. The first relationship views the stock market as the leading indicator of the economic activity in the country, whereas the second focuses on the possible impact the stock market may have on aggregate demand, particularly through aggregate consumption and investment. In other words, whether changes in stock market cause fluctuations in macroeconomic variables, like Consumption Expenditures, Investment Spending, Gross Domestic Product (GDP), Index of Industrial Production (IIP), etc., or are caused by these variables is an interesting issue to be examined. The former case implies that stock market leads economic activity, whereas the latter suggests that it lags economic activity. The knowledge of the relationship between stock prices and macro variables is now becoming more important in the case of developing countries in view of the various economic reforms taking place there. From the beginning of the 1990s, a number of Fazal Husain and Tariq Mahmood are Senior Research Economist and Research Economist, respectively, at the Pakistan Institute of Development Economics, Islamabad. Authors’ Note: We are grateful to Dr Abdul Qayyum, Dr A. R. Kemal, and Dr Faiz Bilquees for their valuable comments and suggestions on an earlier draft of the paper.

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