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Stock Market: Evidence from Jakarta Composite Index, Indonesia

Cardiff Metropolitan University, UK.

Badan Standardisasi Nasional, Indonesia.

ABSTRACT

The significant growth experienced in the World stock market has been attributed to the development of emerging

markets. This paper investigates the short and long-run equilibrium relationship between macroeconomic

variables, namely; interest rates, inflation, economic growth, exchange rates and Jakarta composite index using

cointegration, vector error correction models and variance decomposition. The paper identifies cointegrating

relationships between selected macroeconomic variables and stock price index. It depicts that these

macroeconomic variables influence the major stock price index in Indonesia in the long-run. The vector error

correction model indicates that selected macroeconomic variables have no significant short-run impact on Jakarta

composite index.

Keywords:Macroeconomic Variables; Stock Market; Emerging Economy; Cointegration Model; Vector Error

Correction Model.

*Corresponding author.

1. INTRODUCTION

The stock market, as part of the financial system, is very vital to economic development. The stock market

functions as a mediator between savers and borrowers, these lenders and borrowers' preferences are harmonized

through the operation of the market (Nadeem & Zakir, 2009). Financial and economic theories have been

developed over the years; they argue that stock markets are influenced by movement in macroeconomic factors

(Ahmad & Ghazi, 2014). The argument has intensified in the past few years because the stock market is a good

reflection of the domestic economic conditions. Stock market is an important part of the economy as it is the source

for raising large funds from domestic and international investors in the primary market. From an investor's

viewpoint, the existence of the stock market gives the opportunity of entry and exit. When investors are in dire

need of funds or when they decide to diversify their portfolios, the secondary market is readily available for them

to trade investments. Advanced economies have fully explored the benefit of stock markets while emerging

economies are yet to fully usurp the benefits that are derived from sourcing of capital through the stock market

(Asaolu & Ogunmuyiwa, 2011). The significant growth experienced in the World stock market has been attributed

to the development of emerging markets which has increased the attention of academics, individuals and

institutions in emerging stock market.

Indonesia is an emerging economy that is a member of the G-20 and the Next-11 emerging economies. It is the

largest economy in South East Asia that contributes up to 2.3% of global economic output (Jakarta, 2012). The

relationship between stock market and various macroeconomic factors in emerging economies has been featured

in several studies; however, Indonesia despite its investment potentials has received a minimal attention in this

type of study. Theoretically, stock market is said to be influenced by some fundamental macroeconomic variables.

When trend of a stock market is known, it will be of great benefit to fund managers and potential investors in the

market who seek for an insight of the future corporate earnings and how much to expect in terms of interests and

dividend. It also helps them to understand how the market functions to implement portfolio diversification

strategies when considering investing in an emerging stock market like Indonesia. The understanding of the

interaction between stock market and major macroeconomic variables may be helpful to predict future economic

conditions.

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Exchange rates is one of those; currencies are often included in investment funds portfolio as an asset, therefore,

an accurate estimate of the impact of the variability in exchange rate is, therefore, needed for a given portfolio

(Dimitrova, 2005). Some policy makers' advocate for weak currency, as it is said to boost export sector, this type

of study would shed more light to policy makers and create an awareness of what policy direction they should take

to propel their economies. An economy with a positive net export benefits from depreciating currency while one

with a negative net export will prefer a stronger domestic currency. Interest rate is a tool used by the government

to give the economy a boost. It is raised to slow the economy down and attract foreign investors from stronger

economies and lowered to promote economic growth by increasing the money in circulation. Interest rate is an

important factor and investors must monitor its level and growth in various sectors of the economy to be able to

evaluate the impact on profitability and performance of firms (Osamwonyi & Osagie, 2012). Inflation is an

important factor in an economy and it is of great importance to investors. Funds tend to flow out of an economy

that is experiencing inflation; people are also less likely to hold cash during inflation due to loss in monetary value.

When inflation is not well managed in an economy, it may result in the collapse of value of stocks in the market

(Geetha et al.,, 2011).

Share prices increase because of expectation of higher profits from healthy business environment. Investors

therefore have more confidence in an economy that is striving well; therefore, a positive linkage is expected

between economic growth and stock prices (Osamwonyi & Osagie, 2012). The relationship between

macroeconomic factors such as exchange rates, interest rates, inflation and economic growth is of paramount

interest to investors, fund managers as well as economic planners. This paper, therefore, is aimed at investigating

the short and long-run relationship between the following macroeconomic variables: interest rates, inflation,

economic growth, exchange rates; and the stock market in Indonesia. The result of the findings will be useful to

these interest groups for investment and policy decisions. This investigation will lead to the achievement of the

following objectives:

- Identification of the trend and pattern of macroeconomic variables and stock market in Indonesia.

- Expression of the short and long-run relationship between macroeconomic factors and stock market using

cointegration and vector error correction model techniques.

- Presentation of the visualization and numeric impact of the shock of each macroeconomic variable on the stock

market in Indonesia using impulse response function and variance decomposition.

- Identification of which of the macroeconomic variables have the greatest impacts on the stock market.

2. THEORETICAL BACKGROUND

Empirical evidences on the linkage between macroeconomic factors and stock market in emerging economies had

been numerous especially in this era where investors are considering investing in emerging economies due to high

growth in returns on investments. The evidences provided by various researchers had not followed a pattern.

Godfrey (2013) suggested that capital allocation variation and institutional differences within and between

countries has made findings in an emerging country not to be generalized thus, the increasing need for country

specific studies. Evidence from literature show a number of statistical methods employed such as; Vector error

correction model (VECM), Vector autoregressive model (VAR), Ordinary least square method (OLS), Granger

causality, Cointegration, Impulse response function, Variance decomposition, Box-Jenkins autoregressive

integrated moving average (ARIMA) and Generalized autoregressive conditional heteroskedasticity (GARCH).

All these methods are unique as they measure various ways in which variables can be linked together. Arbitrage

pricing theory (APT) is the theory that identifies that stock market returns are affected by various macroeconomic

factors but the theory has its shortcoming by not being able to specify these macroeconomic factors. Chen et al.,

(1986), therefore, proposed a set of relevant variables which are industrial production, inflation, risk premium,

term structure, market indices, and consumption as well as oil prices.

The impacts of these variables were tested in the New York stock exchange market and result confirmed that stock

returns are exposed to systemic economic news. However, researchers have also added and deducted from these

variables as some of the variables are not available for emerging or pre-emerging countries. Some empirical

evidences from these researchers are:

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Geetha et al., (2011) examined the relationship between stock returns and inflation in Malaysia, United States and

China. Inflation was expressed using two different variables which are expected and unexpected inflation. Using

monthly data from 2000 to 2009 and employing cointegration and error correction model technique, the study

revealed a long run relationship for the three countries but no short run for Malaysia and US. Guneratne (2006)

investigated the relationship among macroeconomic variables and stock prices in Sri-Lanka, an emerging market.

Six macroeconomic variables (Consumer price index, money supply, gross domestic product, three-month fixed

deposit rate, exchange rate and US stock market index) were examined in monthly frequency ranging from 1985

to 2004. Cointegration, error correction models, variance decomposition and impulse response function were used

to analyse the data. Results showed the evidence of both short and long run relationships between macroeconomic

variables and stock prices in Sri-Lanka.

Adam and Tweneboah (2008) examined how macroeconomic variables impacts stock price movement in Ghana.

Four basic macroeconomic variables were used which are; foreign direct investment (inflow), interest rates,

consumer price index and exchange rate. Innovation accounting technique and cointegration test were used to

analyse quarterly data from 1991 to 2006 and the findings showed cointegration between stock market and

macroeconomic variables indicating a long run relationship. The results also showed that interest rates and foreign

direct investment are the key determinants of stock price movement in Ghana. Omondi and Tobias (2011)

investigated the effect of foreign exchange rate, interest rate and inflation on stock return volatility in Nairobi stock

exchange. Monthly time series data from 2001 to 2010 was analysed using exponential generalized autoregressive

conditional heteroskedasticity (EGARCH) and threshold generalised autoregressive conditional heteroskedasticity

(TGARCH). The findings showed that interest rate, inflation and exchange rate impacts stock market volatility in

Kenya. Naik and Padhi (2012) examined the relationship between India stock market index and five

macroeconomic variables (industrial production, whole sale price index, money supply, Treasury bill rates and

exchange rate).

Monthly data ranging from 1994 to 2011 was analysed using Johansen cointegration and vector error correction

model to study the short and long run equilibrium relationship between the stock market and macroeconomic

variables. Results showed a long run equilibrium relationship and positive impact of money supply and industrial

production but negative impact of inflation rates on stock market. Short term interest rate and exchange rates were

not statistically significant in determining stock prices in India. Our research employs cointegration and vector

error correction model on monthly time series data ranging from 1990 month 1 to 2014 month 12 to investigate

the possible short and long-run relationship between the following macroeconomic variables; interest rates,

inflation, economic growth, exchange rates; and the stock market in Indonesia. Other necessary statistical tests

including Impulse response function (IRF) for VECM and variance decomposition has been employed as detailed

in the methodology section. To our knowledge this research is the first study of its kind in terms of the country,

macroeconomic variables used, time horizon and the statistical method employed.

3. METHODOLOGY

This part defines and details the techniques and procedures employed in this research; this includes data collection,

justification for choice of variables, model specifications and required analysis. The discussion of the reasoning

for the choice of the variables gives the rationale behind the selection of the four major macroeconomic variables

and their possible linkage with stock prices. This research uses quantifiable observations to represent each of the

variables so that tests can be conducted using statistical analysis. Tests undertaken and the decision rules for the

tests are outlined and clearly detailed in subsequent sections.

Data is retrieved from reliable sources and the strategy for the collection of data is archival. Data is collected

repeatedly over a long period which is a type of longitudinal time horizon. In this research, data selection is based

on studying part of a population which is known as sample. The type of sampling used in this research is the

purposive sampling because the researchers have deliberately selected the sample period. The reason being that

stock market of most developing nations started to gain international recognition in the 1990s and this allowed

foreign investors to purchase and sell securities in the market. Data are sourced for stock prices from Trading

Economics and Federal Reserve Economic Data (FRED). Data collected from these sources is for a period of 25

years (1990 - 2014) which gives a total number of 300 observations per variable. Since stock prices change daily,

it would have been ideal to use daily frequency data but most macroeconomic data are recorded on monthly,

quarterly and yearly basis. It is therefore admissible to use monthly frequency as stock prices would not have

deviated too much within the space of one month. Data used in this research is studied over time, therefore, a time

series analysis is utilised.

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Choice of variables in this type of research has been a thing of concern as previous studies suggest various

macroeconomic factors; the researchers have, therefore, created a sampling table so as to be able to identify which

variables have been mostly used by researchers.

(Olukayode & Atanda, 2010)

(Khan & Senhadji, 2000)

(Daferighe & Aje, 2009)

(Tursoy, et al.,, 2009)

(Olorunleke, 2014)

(Adaramola, 2011)

Names and Variables

(Osuagwu, 2009)

(Kadir, 2008)

(Kutty, 2010)

Industrial Production (x) (x) (x) (x)

Inflation rate (x) (x) (x) (x) (x) (x) (x) (x) (x) (x) (x)

Interest rate (x) (x) (x) (x) (x) (x) (x) (x) (x) (x) (x)

Gross Domestic Product (x) (x) (x) (x)

Money supply (x) (x) (x) (x) (x) (x) (x) (x) (x) (x) (x)

Exchange rate (x) (x) (x) (x) (x) (x) (x) (x) (x) (x)

Consumer Price Index (x) (x)

Treasury bills (x)

Risk premium (x)

Foreign reserve (x)

Fiscal deposit (x)

Note: (x) Indicate the inclusion of a variable in the study.

The table above shows names of researchers as well as the variables that were included in their studies. The most

commonly used variables based on this sampling table are inflation/consumer price index, exchange rates, interest

rates, gross domestic product/industrial production (a measure of economic growth) and money supply. This

research is set to give an equal level of measurement to all variables, therefore, the daily swift changes of stock

price had been considered and the researchers have decided to examine variables that are available on monthly

basis as quarterly or annual frequency would not capture the variations in the movement of stock prices. Gross

domestic product and inflation rates of countries like Indonesia are not available in monthly frequencies, therefore,

industrial production and consumer price indexes are used as proxies respectively for these two variables. Money

supply which is the measure of the total amount of currency in circulation is also a variable that researchers in this

field are interested in because of its impact on inflation, value of domestic currency and business cycle.

The quantity theory of money suggests that money supply hasa direct relationship with general price level. This

simply implies that an increase in money supply causes prices of goods to go up which indicates inflation in an

economy. Kryzonowski et al., (1994) warned financial economists to be careful while selecting variables to avoid

the problem of multicollinearity. To guard against this sort of problem, the researchers have avoided using money

supply as one of the macroeconomic variables; this is because, consumer price index which is selected shows the

growth or decline of money supply and the demand for money in a nation is a function of interest rate which is

also one of the variables selected. Table 2 shows the variables chosen for this research, their description and source.

A further explanation of the rationale behind the choice of these variables is given in subsequent sub section to

espouse the conceptual and theoretical underpinning.

This is the major stock market index in Indonesia and it accounts for the performance of all companies listed on

the Indonesia stock exchange. It is a modified capitalization-weighted index with a base value of 100. JCI is a

general indicator of all stocks listed on Jakarta stock exchange market. It comprises of more than 400 companies

that are listed on the stock exchange. Although JCI was influenced by the Asia financial crisis in 1997, it however,

recovered and grew more than seven times of its original level in early 2000.

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JCI has experienced a stable growth just after the global meltdown in the late 2000s. A significant growth of up to

19% was experienced in 2011 with 4978 index point and has since 2012 to date have index points ranging from

4000 to 6000.

Indonesia Jakarta Composite index The main index in Indonesia Trading

stock exchange market economics

Industrial production Measure of overall economic FRED

activity

Consumer price index monthly consumer price FRED

index

Indonesian rupiah/US 1 Rupiah per US dollar FRED

Dollar

Discount rate/borrowing Borrowing rate FRED

rate

Interest rate (IR) according to Alam and Uddin (2009) is the cost of capital and they gave two definitions of interest

rate from a lender and a borrower’s point view. To a borrower, IR is the fee that is paid for using money over a

period (borrowing rate) and to a lender, IR is the amount that is charged for using money over a period (lending

rate). They examined the relationship between interest rate and stock prices and found a negative one. Interest

rates influences profits made by firms which in turn influences investor’s expectation of higher dividend payments.

The high capital requirement that is needed in setting up businesses leads to companies taking the option of debt

financing which gives them the opportunity to purchase inventories and equipment, an increase in borrowing rate,

therefore, results to higher cost of borrowing which negatively influences the future expected return of the firm.

On the other hand, a reduction in borrowing rate decreases the costs of borrowing which serve as incentives for

firms to expand and increase their profitability thus a positive effect is, thereby, expected on the firm’s output.

The consumer price index is a variable that is used as a proxy for inflation rate. It is a variable that is used to

measure the general price level of consumer goods and services that are purchased by households. It is the weighted

average of prices of a basket of consumer goods and services such as transportation, food and medicare. It is

calculated by taking price changes for each item in the predetermined basket goods and averaging them. Goods

are weighted according to their importance. The findings of Chen et al., (1986), who were the first set of researchers

to examine the relationship between inflation and stock prices, pointed towards a negative relationship between

the two variables. Inflation could have a negative as well as positive impact on stock prices based on past

researchers. Osamwonyi and Osagie (2012) mentioned that during inflation, investors undervalue stocks due to

failure in considering capital gains and that stock prices are determined using earning price ratio which tend

towards nominal interest rate rather than real interest rate. Inflation in a nation is usually an increase in price level

of commodities and this often influences purchasing power of the nation’s currency. Countries with pegged

currencies especially those with currency pegged to US dollars have a limited experience of inflation but could

suffer from speculative attacks.

Stock holders during inflation have the opportunity of holding on to their stocks when prices are going up, and at

the time they are willing to sell, investors must pay more to acquire them which enriches the pocket of stock

holders. This is the positive influence inflation can have on stock prices. On the other hand, firms’ experiences

increase in expenses during inflation which influences profitability and this extends the impact to share prices.

This is the rate at which one currency is exchanged for another. It is also the value of a country’s currency in terms

of another. Exchange rate is a product of a nation’s external trade and it is also directly related to the balance of

payments of the country. Balance of payment and external trade influences the exchange rate. Depreciation of a

nation’s currency leads to an increase in demand for the country’s export products which increases cash inflow in

the country. Firms of a nation pay attention to the variation in the currency to be able to manage foreign contracts

or importation of raw materials. Ito and Yuko (2004) explained the relationship between exchange rate and stock

prices by suggesting that the relationship between the two variables contributed to the spread of the Asia financial

crisis in 1997. The depreciation of Thai baht had a great impact on the nation and its environs and it led to stock

market crash at the time.

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Alternatively, if a nation’s currency is expected to appreciate, investors will be willing to invest in such a nation

and increase in demand causes stock market returns and prices to go up. This instance suggests a positive impact

of exchange rate on stock prices. Moreover, exchange rate impact may equally depend largely on the level of trade

balance and international trade. Therefore, the impact of the variable on the Indonesia stock prices is determined

by dominance of import and export of the economy.

Industrial production is used as a proxy for economic growth. It is used to measure changes in the price-adjusted

output of industry, it also measures the real production output of industries such as mining, manufacturing and

utilities. It measures production output and highlights structural development in the economy. It is used to explore

production variation in short term period and it is used to calculate macroeconomic indicators like gross domestic

product. Industrial production (IP) is a measure of real economic activity of Indonesia studied in this research. It

measures the output of industries such as manufacturing and mining. IP is well known for its response to the state

of the economy. It rises during economic boom and declines during recessions which show its procyclical nature.

IP reflects growth in relevant industries of the economy. Firm growth is usually influenced by environmental

factors especially growth in the economy. When industries in a nation are doing well, firms generate more cash

flow as a result and there will be increase in productivity and profitability which would trigger share prices to go

up.

The research seeks to investigate how Indonesia stock exchange market responds to changes in some set of

macroeconomic variables in the short and long run. Using statistical techniques, the following hypothesis are

therefore subjected to tests;

Macroeconomic variables do not have significant long-run relationship with the stock market in Indonesia

Macroeconomic variables have significant long-run relationship with the stock market in Indonesia

Macroeconomic variables do not have significant short-run relationship with the stock market in

Indonesia

Macroeconomic variables have significant short-run relationship with the stock market in Indonesia

Inflation and interest rates have negative relationship with the stock market in Indonesia

Inflation and interest rates have positive relationship with the stock market in Indonesia

Exchange rates and economic growth have positive relationship with the stock market in Indonesia

Exchange rates and economic growth have negative relationship with the stock market in Indonesia

The null and alternative hypothesis will be tested and analysed and rejection or acceptance of null or alternative

hypothesis is justified using cointegration and vector error correction model techniques. Method used in this

research begins with a process of a regression analysis and the following equation shows a representation of the

dependent and intervening variables.

The equation above represents the intercept which is usually a constant and it is the expected mean value of the

dependent variable LJCI (log of Jakarta composite index) when all intervening variables LCPI (log of consumer

price index), LIP (log of industrial production index), LER (log of exchange rate) and LIR (log of interest rate) are

equal to zero, represents the sensitivity of each of the chosen macroeconomic variables in relation to stock prices

in Indonesia. (?) is the error term which stands for all other factors that influences stock prices while L indicates

that variables are in their natural logarithm form. The base t shows that variables are studied over time. To

understand the data movement, variables are plotted in a graph and a table is presented to show the results of the

sample mean, skewness, kurtosis, standard deviation, p-value and Jacque-Berra statistics. The results derived from

these are explained in the analysis section. The standard deviation results indicate the level of volatility of each of

the variables and the normal distribution of the intervening variables is tested using the skewness and Kurtosis.

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Most macroeconomic variables are close substitutes, therefore, there is a tendency of correlations of high

magnitude among the intervening variables selected in this study, this has prompted the need to do a

multicollinearity test to be able to detect the correlation among intervening variables as results derived from a

model with multicollinearity problem are said to be biased.

As mentioned earlier, this test is necessary to be sure that multiple correlation of sufficient magnitude does not

exist among intervening variables as this would influence the regression estimates. Multicollinearity problem leads

to the following; non-significant result, predictor beta moving in a non-sensible direction and large standard errors.

To identify this problem, variance inflation factor (VIF) is employed on the intervening variables. VIF values of

9 or less are often the criteria to validate that intervening variables does not have multiple correlations while values

of 10 or more shows correlations among the intervening variables. This test is of great importance due to the

suggestion made by Kryzonowski et al., (1994) who emphasized on multicollinearity problem in the issue of factor

selection. There are ways to correct the problem of multicollinearity that should the researchers identify one. The

following solutions are suggested: exclude the redundant variable in the model; increase the sample size to add

more stability to the data; apply first differenced transformation technique and lastly, check if two variables are

duplicates to replace one with another variable.

The preferred way to correct multicollinearity is the third point mentioned which is to use first differenced data.

This is because Granger and Newbold (1974) recommended the use of differenced form of variable before running

regression. Since all our tests are done through the process of regression, it is the best way to correct

multicollinearity. Before this is achievable, it is ideal to check for stationarity of data which is done through the

unit root test, however, it is important to first identify the number of lag lengths that must be included in the

estimation of our model, therefore, a lag selection test is conducted.

Appropriate lag length is very important as it helps to avoid inconsistency in Vector autoregressive model. The

two ways to approach this are through information criteria restriction or cross-equation restrictions. This study

uses the information criteria restriction; the method focuses on residual sum of squares. The aim of this is to choose

appropriate number of lags that can reduce information criterion values. Lag lengths would be justified using three

tests which are; Akaike’s information criteria (AIC), Schwarz’s Information criteria and Hannan-Quinn

information criteria. All these three will be put into consideration in selecting a suitable lag length for the model.

After multicollinearity problem is checked, the research would proceed to checking for stationarity of the variables

employed. Most economic and financial time series data are not usually stationary in their level form and non-

stationary data cannot be used to estimate parameters or run cointegration tests as it could lead to arriving at

misleading results which is also known as spurious regression. Spurious result is a form of Type II error which

could be in form of high R squared, inflated t-ratios and small standard errors in the models estimated. Stationarity

in time series occur when mean and variance of the data is constant over time. In an equation like this;

(2)

Where Y is the choice variable, is the intercept, is the coefficient of the intervening variable X, is the error term

and t denotes time i.e. t = 1,2,3….n. Applying differencing operation gives results of observations such as;

X level

There are two basic types of unit root tests that are common to researchers which are employed in this research;

they are augmented Dickey-Fuller (ADF) and Phillips-Perron unit root tests.

Augmented Dickey-Fuller (ADF) test is developed by Dickey and Fuller (1979) where they examined data using

trend and intercepts. ADF regression decide whether to include constant, trend, drift or lag lengths for the

differences that augment the regular Dickey-Fuller regression. If time series must be differenced for it to become

stationary, it is said to be integrated of order d, I (d);

I – refers to integrated and d denotes the number of times the data is differenced.

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International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Gujarati and Porter (2009) modelled unit root and expressed time series variables as follows;

∆ ∑ ∆ (3)

α represents i 1 and 2 ε is the stationary stochastic process, P is the number of lagged terms .

The decision rule for the ADF test statistics is based on a null and alternative hypothesis,

The decision rule for the ADF test statistics is based on a null and alternative hypothesis. The output of the tests

gives McKinnon’s critical values and ADF value, the null hypothesis of presence of unit root is rejected when the

ADF value is higher than McKinnon’s critical value, and when McKinnon’s critical value is higher than ADF

value, we fail to reject null of hypothesis of unit root. Stationarity of time series data confirms the suitability of

the data for model estimation. ADF is a test that helps to determine whether economic time series is trend stationary

or difference stationary.

Phillips-Perron (PP) test is developed by Phillips and Perron (1988) and it differs from the ADF test, unlike the

ADF test that includes serial correlation of error term with lagged difference; PP ignores serial correlation and

replaces it with non-parametric statistical method with exclusion of lagged difference terms, this helps to correct

heteroskedasticity and serial correlation in the errors. PP takes variables in their first differenced log form to

eliminate the possibility of non-stationarity of data as financial and economic variables are likely to be stationary

in their first differenced form.

Cointegration test is the concept of Granger (1981) and was fully developed by Johansen (1988), and it is useful

in determining long run relationship among variables. Let’s assume non-stationary after first differencing I (1)

then the linear combin LIR ation

(4)

will also be non-stationary of the same order. Cointegration means that variables move in the same direction which

indicates that they share common stochastic trend. To test for cointegration in a model, stationarity test is first

performed on the error term, and this is observed using least square residuals of error term (). If the residuals are

stationary based on the test conducted, then Y and X are cointegrated. Existing literature has employed the

cointegration test developed by Johansen (1988) to investigate cointegration among variables. There are two

different forms of Johansen’s cointegration tests which are bivariate and multivariate cointegration tests. The

bivariate test is useful when the relationship between stock prices and a macroeconomic variable is examined while

multivariate cointegration test considers the relationship between all macroeconomic variables selected as one

entity on the dependent variable which is stock prices. Johansen test therefore assumes a null hypothesis of no

cointegration among variables at 5% level of significance. In examining this, trace and maximum Eigen statistics

methods are applied. The equations for these tests are as follows;

∑ ln 1 (5)

, 1 ln 1 (6)

in Equation (5) is the ordered Eigen values, r is the cointegrating vectors and n is the number of variables. The

output of the results derived is reported under analysis section using a table which specifies the values for (r=0, 1,

2, 3...n-1). The null and alternative hypothesis is as follows;

: 0

: 0

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When trace value is greater than the critical value in absolute terms then one should reject the null hypothesis of

no cointegration and when trace value is less than critical value, then you fail to reject the null hypothesis of no

cointegration which indicate no long run relationships among the variables. Equation (6) is the formula

representing the maximum Eigen method of cointegration. It assumes a given r under the null hypothesis against

the alternative of r+1 cointegrating equations. The hypothesis for the maximum Eigen test is;

1 1,2,3 …

This test considers critical values at 5% level of significance when making decisions. When maximum statistics is

greater than critical value, then null hypothesis is rejected and when maximum statistics is less than critical value

in absolute terms, then you fail to reject null hypothesis.

After the cointegration test is performed, the VECM model is a restricted vector autoregressive (VAR) where the

dependent variable is not covariance stationary in its level form but in first difference form. According to Granger’s

representation theorem, VECM is just a representation of cointegrated VAR. The VECM helps to investigate the

short run relationship amongst the variables. Short run dynamics are measured by the speed it takes the dependent

variable to deviate and go back to its point of equilibrium. The VECM explains the time it takes the dependent

variable to change because of influences from intervening variables. The VECM structure is specified as the

equation below;

∆ ∆ (7)

ECT in the equation above is the value attached to the speed at which deviations from equilibrium is corrected.

The error correction term in the equation for all X variables (intervening variables) would help to determine the

short run effect of intervening variables on the dependent variable. The advantages of the VECM are; the resulting

VAR from VECM representation has more efficient coefficient estimate, it restricts the long-run behaviour of the

endogenous variables to converge to their cointegrating relationship while allowing a wide range of short run

dynamics and VECM makes the concept of cointegrationuseful for modelling and inference for macroeconomic

time series.

Impulse Response Function (IRF) is a tool used for interpreting vector autoregressive model (VAR). It is used to

measure the reaction of variables to shocks emanating from another variable. It shows the vanishing rate, size and

magnitude of the effect of shocks. IRF from stationary VAR model is said to die out over time while IRF from

VECM does not usually die out over time. This is because stationary VAR model is time-variant variance which

makes it possible for the effect of shocks to die out to enable variables go back to its mean. Moreover, variables

that are stationary in their differenced form in VECM are not mean-reverting which supports the assumption of

the effect of shocks not being able to die out over time. The terminology given to shocks that dies over time is

transitory shocks while a shock that does not die out over time is referred to as permanent shocks. The result of

test would be presented in a graph and the interpretation of the graphs is given based on the guidelines stipulated.

The variance decomposition shows the proportion of the forecast error of a variable due to another variable. It

helps to determine the importance of each intervening variable in creating fluctuations in the dependent variable

(Ratanapakorn & Sharma, 2007).

The output of each of the tests conducted is presented was obtained by Eviews 7.1, a statistical software that is

used in finance and economics.

Descriptive statistics is a way of quantitatively explaining the patterns and trends of dataset and giving a summary

of the data in numerical value. Table 3 presents the summary of all the variables that is used in this study. Using

300 observations, first we examined the measure of variability exhibited by each of the variables, variability

indicates how spread out the data is and the standard deviation provides an index of variability in the distribution.

The negative skewness observed in ER indicates that ER data falls close to the tail on the left of the probability

density in a bell-shaped curve while the positive skewness observed in JCI, IR, IP and CPI indicates that the data

of these variables fall to the right side of the curve. IP and CPI exhibit nearly normal distribution which is in line

with the suggestion of the measure of central tendency (mean and median).

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Mean 58.25158 7145.332 84.26891 13.07043 1467.213

Median 54.71642 8925.500 84.33125 11.04500 617.2750

Maximum 130.7391 13962.50 127.5327 70.81000 5226.940

Minimum 12.08572 1804.850 47.45341 5.750000 226.6840

Std. Dev. 36.21316 3542.771 17.44668 9.663603 1468.135

Skewness 0.284526 -0.527032 0.087921 3.681830 1.228532

Kurtosis 1.733584 1.687354 2.674528 19.26104 3.081037

Probability 0.000006 0.000000 0.425143 0.000000 0.000000

Sum Sq. Dev. 392106.4 3.75E+09 91011.56 27922.18 6.44E+08

CPI- Consumer price index, ER- Exchange rate, IP- Industrial production, IR- Interest rate, JCI-Jakarta composite index

When mean is greater than median, there is a positive skewness in place and when mean is less than median, there

is a negative skewness in place. The maximum and minimum gives the range of the data and a small range suggests

that data are close together but if they are large, it means data is more spread out.The mean of JCI is 1467.2 while

the maximum price is 5226.9. The standard deviation is 1468.1 which indicates a very high variability in Jakarta

composite index. IP exhibits moderate variability with a mean of 84.27 and standard deviation of 17.44. For a

standard deviation that is almost half of the value of the mean like the case of CPI and ER, there is a possibility

that variables have high but moderate variability. Table 4 is presenting the results of Multicollinearity Test.

CPI 10.13 0.0987

IP 5.1 0.1962

ER 4.1 0.227

IR 1.75 0.5728

Mean VIF 5.34

VIF- Variance Inflation Factor

The VIF is a quantifiable measure of how much the variance is inflated in the model we are about to estimate. The

variance in this concept means standard errors. To calculate VIF, Where represents the proportion of the

variance of independent variable i that is related with the other independent variable in the model estimated. VIF

measures how much variance of the estimated regression coefficient is inflated as compared to when the predictor

variables are not linearly related. VIF of 5.3 implies that the standard errors are larger by a factor of 5.3 than would

otherwise be the case. A value of 10 according to Hair et al., (1995) and Kennedy (1992) is recommended as the

maximum level accepted. Therefore, our set of variables is clear of multicollinearity problem.

All variables are taken in natural logarithm form and presented in Figure 1. Stationarity in series enhances the

reliability and accuracy of model estimated and it helps the researchers to draw a meaningful inference in a time

series analysis. Non- stationarity data often leads to biased or spurious result in analysis. Pattern and trend are the

common characteristics of a non-stationary data and can be visualised in a graphical representation of data. The

five series plotted in Figure 1 exhibit various patterns and trends. LJCI, LIP and LCPI are seen to exhibit upward

trend and are also noticed to be wandering or better still fluctuating around a trend while LIR is fluctuating around

a constant. LER seems to be wandering around a constant and a trend. In all, all variables exhibit a sign of non-

stationarity graphically but this cannot be limited to a mere visual inspection. Therefore, a formal test for

stationarity is suggested so as to have a concrete conclusion of whether variables are stationary or not.

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Figure 1.

Graphical Illustration of Each of the Variables

The table below shows the number of lag lengths suggested by AIC, SC, HQ and FPE.

0 2.88e-06 1.431409 1.493746 1.456367

1 3.53e-14 -16.78655 -16.41253 -16.63680

2 1.36e-14 -17.74271 -17.05700* -17.46816

3 1.18e-14* -17.88473* -16.88734 -17.48540*

Final prediction error (FPE), AIC and HQ criteria suggest maximum of 3 lags while Schwarz’s information criteria

suggest maximum of 2 lags. This model will stick to 3 lags as suggested by 3 different information criteria for

model estimation.

Fuller Test statistics statistics

(H0: Unit root /Non- (H0: Unit root/Non-

stationary) stationary)

Variables Level First Difference Level First Difference

LJCI -0.1344 -12.0259* -0.0838 -13.8608*

LIP -1.4912 -10.4805* -2.0217 -37.479*

LER -1.445 -5.7891* -1.3969 -13.1669*

LCPI -1.0925 -4.3296* -1.35 -8.4141*

LIR -2.2717 -6.5114* -1.9527 -9.6047*

Test critical

values

5% Critical -2.8712

values

10% critical -2.572

values

* indicates that variables are significant at 5% critical level

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Table 6 shows the variables in level as well as the first difference state. All variables exhibit non-stationarity in

level but stationary after first differencing. This implies that variables are integrated of Order I (1). The null

hypothesis of unit root is accepted for all variables in level form but rejected for all variables in first difference

form which indicates that variables are stationary after first differencing. In order to be accurate in unit root testing,

Phillips-Perron unit root test is also employed to confirm the stationarity of variables. The table shows the ADF

and PP values of each of the variables and shows the McKinnon’s critical value at the tail end of the table. The

null hypothesis of presence of unit root is rejected when ADF or PP value is greater than McKinnon’s critical

value.

The ADF and PP values are less than critical values in level form indicate that all variables are non-stationary

while the first difference shows that ADF and PP values are greater than both 5% and 10% critical values which

suggest the rejection of the null hypothesis of presence of unit root. Both tests show that variables are not integrated

of Order I (0) but of Order I (1). All variables are therefore difference stationary of the same order. The finding is

not uncommon (Nadeem & Zakir, 2009). The first difference data can be visualized in the illustration below:

Figure 2.

First Difference State Graphical Representation

It can be seen that all variables do not exhibit upward or downward trend but are stationary over time. The

stationarity of all variables in same Order I(1), therefore leads to Johansen multivariate cointegration test. This

helps to examine the long –run impact of ER,IP,IR,CPI and JCI.

Using lag length 3, the Johansen cointegration test results output for trace and maximum Eigen statistics. Trace

and maximum statistics are reported in tables 7 and 8 respectively. Table 7 indicates that for none (0) and at most

1 cointegrating equations, trace statistic value is greater than 0.05 critical value while for at most 2 cointegrating

equations, trace statistic (22.8977) is less than 0.05 critical value (29.797) which from all indication suggests that

we do not reject null hypothesis of at most 2 cointegrating equation in the model.

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No. of CE(s) Eigen-value Statistic Critical Value Prob.**

None * 0.121781 90.69698 69.81889 0.0005

At most 1 * 0.095134 52.38848 47.85613 0.0177

At most 2 0.047209 22.89776 29.79707 0.2511

At most 3 0.020545 8.631781 15.49471 0.4005

At most 4 0.008465 2.507793 3.841466 0.1133

*Indicate rejection of null hypothesis at 5% significant level

The Maximum Eigen statistic helps to confirm the trace statistic result. Using the same guideline with trace statistic

method, the maximum Eigen statistic (Table 8) is greater than 0.05 critical values when we have null hypothesis

of none (0) and at most 1 while maximum Eigen value (14.266) is less than 0.05 critical value (21.13) which

suggests that we should fail to reject the null hypothesis of at most 2 cointegrating equations. Both trace and

maximum Eigen statistic suggest that the model has at most 2 cointegrating vectors therefore, the study proceeds

to using 2 cointegrating equations to establish the long-run equilibrium relationships among the variables in the

model.

No. of CE(s) Eigen-value Statistic Critical Value Prob.**

None * 0.121781 38.30850 33.87687 0.0138

At most 1 * 0.095134 29.49072 27.58434 0.0281

At most 2 0.047209 14.26598 21.13162 0.3436

At most 3 0.020545 6.123988 14.26460 0.5973

At most 4 0.008465 2.507793 3.841466 0.1133

*indicates rejection of null hypothesis at 5% significant level

Johansen cointegration test indicates at most 2 cointegrating equating relations which show the existence of a long-

run relationship between the selected macroeconomic variables and stock prices. The long run output equation is

expressed below;

, , , , (8)

The equation above indicates a significant negative long-run relationship between LJCI, LCPI and LIR; and a

positive long-run relationship between LJCI, LIP and LER. This implies that one percent increase in interest rate

would result in approximately 2.0% fall in Jakarta composite index. This is in line with the suggestion of Huang

et al., (1996) that interest rate is used to discount future cash flows which eventually influences share prices and

concludes that increase in interest rate leads to decrease in stock prices. The result is also conversant with Naik

and Padhi (2012). In the long run, the result also suggests that a one percent increase in consumer price index

reduces stock prices by 4.59%. Consumer price index (a measure of inflation) having negative relationship with

Jakarta stock prices shows that the market does not provide hedge against inflation. This also indicates that

Indonesia currency is not pegged as countries with pegged currency experience limited impact of inflation. A

negative long-run relationship was also found between inflation and stock prices.

A one percent increase in exchange rate (depreciation of rupiah) results in 3.06% increase in stock prices. The

reaction of stock price movement to exchange rate depends solely on level of trade balance i.e. the difference

between export and import in the nation. A positive impact therefore suggests that depreciation of Indonesia rupiah

would lead to increasing demand for country’s production. It means Jakarta composite has more export-oriented

firms, therefore, a positive impact is expected to reflect on firm’s cash flow which leads to increase in return and

ultimately resulting in increase in share prices. In Nigeria, a negative relationship runs from exchange rate to stock

price. The obvious reason is that, the country is import dependent unlike Indonesia. A one percent increase in

industrial production results in 0.99% increase in stock prices in the long-run.

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This implies that when industries in Indonesia are doing well, firms generate more cash flow which increases

productivity and profitability and causes hike in stock prices. This finding is common in the literature (Naik &

Padhi, 2012).

1.000000 0.000000 1.778 2.870 -4.014

[2.654] [9.669] [-10.584]

t- Statistics are in parenthesis []

Results from Table 9 are just slightly different from the long run equation stated in Equation (1). The result shows

that industrial production index and exchange rate positively impacts stock prices while consumer price index on

the other hand has a negative impact.

1 0.224* -0.072 0.121 0.141 -0.647 -0.0291***

[3.73] [-0.87] [1.84] [1.49] [-1.12] [-1.829]

2 -0.077 0.189 -0.030 0.111 0.302

[-1.19] [-0.189] [-0.25] [1.12] [0.49]

3 0.042 -0.094 0.083 -0.087 0.570

[0.661] [-1.23] [0.84] [-0.92] [1.028]

0.115279

*, **, *** denotes at 1%, 5% and 10% significant level respectively. T-statistics in []

The VECM result presented in Table 10 above shows that about 11.53% of the variation in the first difference of

LJCI, i.e. D (LJCI) is explained by variations in the selected macroeconomic variables. The result also suggests

that lag difference of interest rate, industrial production index, exchange rate and consumer price index have no

significant impact on D (JCI) in the short-run. Our result reveals that, in the short run, only the first lag difference

of LJCI has a positive and significant impact on its first difference. The error correction term result is negative and

significant at 10% level. The result suggests that about 2.9% of the previous period’s disequilibrium in Jakarta

stock prices is corrected every month. The implication of this is that following a shock to the stock market in the

short-run, stock prices adjusts by 2.9% in one month to the long-run equilibrium. The result also shows that it will

take approximately (1/0.0291=34.36) 34 months to eliminate the disequilibrium in JCI before it returns fully to its

long-run equilibrium.

Cointegration and vector error correction model has shown the long-run relationship between Jakarta composite

index and selected macroeconomic variables where deviation from a systemic shock in the short-run is corrected.

However, the VECM and cointegration analysis does not specify whether the shock is from LJCI, LIR, LIP, LER

or LCPI. It is therefore important to employ the impulse response function and variance decomposition so as to

analyse and identify the various shocks. The impulse response function shows the response of JCI to shocks in

each macroeconomic variable while the variance decomposition shows the proportion of JCI which is due to

shocks from macroeconomic variables as well as its own. Although there are different types of impulse response

function, the generalized impulse is employed in this study because it is independent on ordering of the variables.

Figure 3 and Table 11 show impulse response and variance decomposition of LJCI:

The graph above shows that, a shock in interest rate results in an immediate negative or downward impact on stock

prices after first month. Although the impact does not deepen, it lingers for 12 months and probably beyond. The

response of stock prices to a shock in industrial production is positive but very close to 0. After the first 3 months,

it dies off but picks up again and dies off before the 10th month. The behaviour of stock prices to exchange rate

and consumer price index is mixed. It varies in the first 3 months, positive to a shock from exchange rate and

negative to a shock form consumer price index. However, the behaviour changes after the first quarter to negative

and positive response to shocks from exchange rate and consumer price index respectively.

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Figure 3.

Impulse Response Function Graphs

Results from Table 11 reveals that changes in stock prices are driven majorly by its own variation in the first period

where it accounts for 100% of its variation and by the end of 30th and 35th period, about 79.23% and 78.87% are

respectively accounted for by its own variation. By the end of 10th month, LIR and LIP accounts for less than 1%

of the variation in LJCI while LER and LCPI accounts for 4.35% and 1.95% respectively.

1 0.08 100.00 0.00 0.00 0.00 0.00

5 0.20 98.64 0.43 0.06 0.65 0.22

10 0.29 93.08 0.60 0.05 4.31 1.95

15 0.35 86.88 0.45 0.12 7.41 5.12

20 0.41 82.62 0.34 0.19 8.91 7.94

25 0.45 80.29 0.30 0.25 9.35 9.80

30 0.50 79.23 0.31 0.28 9.29 10.88

35 0.54 78.87 0.32 0.31 9.04 11.46

Cholesky Ordering: LJCI LIR LIP LER LCPI. (S.E-Standard error)

In the 35Th period, LIR and LIP does not jointly account for up to 1% variation in LJCI but LER and LCPI

accounts for 9.04% and 11.46% respectively. Another observation of the results shows that the proportion of the

variation in Jakarta composite index explained by the LER and LCPI macroeconomic variables jointly increases

in subsequent periods, ranging from 0.87% in period 5 to 12.53% in period 15, 19.15% in period 25 and 20.5% in

period 35. From period 25 onwards, it should be noted consumer price index has a slightly higher impact on LJCI

than LER whereas before these periods the reverse was the case. It should also be noted that jointly interest rate

and industrial production accounts for a very small proportion of variation in Jakarta composite index with less

than 1% in each period.

5. CONCLUSION

This study has investigated the short and long-run relationship between four macroeconomic factors namely;

interest rates, inflation, economic growth, exchange rates and Indonesia stock market from January 1990 to

December 2014 for Indonesia.

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The macroeconomic time series data employed included monthly observations of the Jakarta composite index,

indices of industrial production, interest rate, exchange rate and inflation. The finding in the study has established

that there exists a relationship between the selected macroeconomic variables and Jakarta composite index. The

multicollinearity test indicated that the chosen macroeconomic variables does not have magnitude correlation,

therefore the model estimation in this study is reliable. All variables are not stationary in level form but stationary

after first difference conversion according to the ADF and PP unit root tests. This is represented visually in Figures

1 and 2 respectively. The Johansen test under trace and maximum Eigen statistics suggested a long-run relationship

between Jakarta composite index and the macroeconomic variables.

The long-run estimation showed a negative long-run relationship between variables such as interest rate and

consumer price index and Jakarta composite index, however, a positive relationship has been found between

variables like exchange rate and industrial production and Jakarta composite index. A negative impact of inflation

means that when demand for firm’s produce is high and inflation rises, net income and firm’s sales declines and

thus its stock price. Inflation in the economy also puts pressure on the cost of raw materials for firms, which

increases expenses and decreases cash inflow, thus putting a downward pressure on firm’s share prices. Interest

rate exhibits a negative and significant impact on stock prices; this shows that increase in cost of borrowing

(especially companies with high debt ratio) reduces net income which eventually causes decline in share prices.

These findings corroborated the results of Abduh and Surur (2013) and Oktavia (2007) where they found negative

significant impact of consumer price index and interest rates on Jakarta composite index respectively. A positive

impact of industrial production on stock price means that a stable economy encourages investors as most investors

prefer to invest in a business environment that is conducive. Building of investor’s confidence is very important

as factors like political instability, terrorism and social unrest pushes investors out of the market. Exchange rate

according to the finding impacts stock prices positively. It is not surprising since Indonesia is an export oriented

country; also 60% of the free-floating shares are owned by foreign investors. This means that depreciation in rupiah

helps to boost the export sector and this eventually increases share prices in the stock market. A similar occurrence

happened in the US between November 2003 and February 2004. Stock market in the US moved in an upward

direction at the time the US dollar depreciates against major currency (Dimitrova, 2005).

The findings are conversant with that of Oktavia (2007) where exchange rate showed a positive significant impact

on Jakarta composite index but differed from Abduh and Surur (2013) where exchange rate negatively influences

Jakarta composite index. In the short-run, interest rate and inflation also show a negative relationship while

economic growth and exchange rate show positive relationship. However, the short-run estimation for all

macroeconomic variables are not significant at 1%, 5% and 10% level of significance therefore, we can ascertain

that there is no short-run relationship between stock market and macroeconomic variables tested. Therefore, this

study can, reject the first null hypothesis which states that macroeconomic variables do not have significant long-

run relationship with stock market in Indonesia and accept the alternative hypothesis that macroeconomic variables

have significant long-run relationship with stock market in Indonesia. This study fail to reject the second null

hypothesis that macroeconomic variables do not have significant short-run relationship with stock market in

Indonesia. We also fail to reject the third null hypothesis that interest rate and inflation have negative relationship

with stock market in Indonesia.

For the forth hypothesis, the null hypothesis that exchange rate and industrial production have positive relationship

with stock market in Indonesia fail to reject. Our investigation of whether one standard deviation shock given to

each macroeconomic variable generates any response from stock prices in the short horizon using impulse response

function is interesting. This study also found that stock prices respond largely positively to its own shock and stock

prices underwent a certain degree of volatility in shorter horizons except for shocks given to interest rate which

stock prices responded to negatively and a positive but near 0 responses to shock given to industrial production.

The variance decomposition shows that exchange rate and consumer price index are the leading macroeconomic

variables that influence stock prices.

The implication of this finding is that investors can devise methods to predict stock prices in Indonesia from

macroeconomic factors. It is significant for policy makers as it would help them improve market efficiency in the

market thereby making the market more attractive to existing and potential investors. The result showed that

information about exchange rate, inflation, interest rate and economic growth can be utilized to forecast stock

market movement in Indonesia. Since inflation and exchange rates are the two leading variables that influence

stock market, successful stabilization of inflation rate in Indonesia would help reduce mispricing of assets by

investors who are subject to inflation illusion; this would contribute immensely to the efficiency of the market.

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To policy makers, advocating for currency depreciation can be an option when the country wants to correct the

balance of payment. This study has shown that such policy would not depress the stock market.

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