International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 49 (2010)

© EuroJournals Publishing, Inc. 2010
http://www.eurojournals.com/finance.htm

The Relationship between Stock Market Volatility and

Macroeconomic Volatility: Evidence from China

Xiufang Wang
School of Economics, Osaka Prefecture University
1-1 Gakuen-cho, Nakaku, Sakai, Osaka 599-8531, JAPAN
E-mail: wangxiufang0622@hotmail.co.jp
Tel: +81-72-252-1161; Fax: +81-72-293-7626

Abstract

The relationship between stock prices and macroeconomic variables is well

documented for the United States and other major developed economies, but the
relationship between stock prices and economic activity in China is not well documented.
This study investigates the time-series relationship between stock market volatility and
macroeconomic variable volatility for China using exponential generalized autoregressive
conditional heteroskedasticity (EGARCH) and lag-augmented VAR (LA-VAR) models.
We found evidence that there is a bilateral relationship between inflation and stock prices,
while a unidirectional relationship exists between the interest rate and stock prices, with the
direction from stock prices to the interest rate. However, a significant relationship between
stock prices and real GDP was not found. Our results suggest that China’s stock market is
likely to be less efficient than those in the U.S. and other developed countries and is
somewhat separated from the real economy of China.

Keywords: China, Stock market volatility, EGARCH model, LA-VAR model, Granger
causality

1. Introduction
Investors have a great interest in discovering variables that may help forecast stock prices. They can
more appropriately manage their positions and portfolios (increase returns and/or lower risk) if they
can use macroeconomic news releases as reliable indicators for where the stock market is headed.
Meanwhile, policymakers pay attention to the situation of the stock market that can be regarded as a
leading indicator of future macroeconomic activity. They can better control the direction and stability
of an economy by adjusting macroeconomic variables if the relationship between stock returns and
economic activity has predictive power.
The relationship between the stock market and macroeconomic variables has long been a
subject of economic research. Throughout modern history, the stock market is recognized to have
played a prominent role in shaping a country’s economic and political development. The collapse of
the stock market always tends to trigger a financial crisis and push the economy into recession.
Recently, the U.S.-triggered financial crisis in 2008 stemming from the bankruptcy of Lehman
Brothers is a further testimony to the importance of the stock market. Most of the major stock markets
in the world were greatly affected by this global financial crisis. Many industrialized economies
suffered a significant decline in economic activity because of this crisis, and one can safely say that the
International Research Journal of Finance and Economics - Issue 49 (2010) 150

volatility of stock markets is the most important factor in the economic growth in not only developed
economies but also emerging economies.
The Chinese stock market began developing in the early 1990s, with the creation of two stock
exchanges in Shanghai and Shenzhen. Within a decade, China had one of the largest stock markets in
terms of market capitalization (over $500 billion in 2004) in Asia. Since China reopened its stock
market at the end of 1990, its economy has grown continuously at an astonishing rate of 10% per year
on average. China is expected to become the second largest economy in the world by the end of 2010.
Therefore, it would be interesting to investigate whether a relationship exists between China’s stock
market and its economic development. We here attempt to provide empirical evidence demonstrating
the relationship between stock market volatility and macroeconomic variable volatility in China.
Theoretical evidence of such a relationship can be found through a simple discount model,
which shows that the fundamental value of a corporate stock equals the present value of expected
future dividends. The future dividend must ultimately reflect real economic activity. If all currently
available information is taken into account, there should be a close relationship between stock prices
and expected future economic activity. To the extent that the stock prices react quickly to
macroeconomic information, it should be a leading indicator of real economic activity. For the U.S.
and some European countries, there is substantial evidence for stock prices being a leading indicator of
real economic activity. Similarly, the volatility of stock prices depends on the volatility of expected
future cash flows and future discount rates. If discount rates are constant over time, the volatility of
stock prices is proportional to that of expected future cash flows. Since the value of corporate equity at
the aggregate level should depend on the state of the economy, it is plausible that a change in the level
of uncertainty about future macroeconomic conditions would produce a change in stock return
volatility.

2. Selected Literature Review

Not surprisingly, a large body of literature is devoted to the study of the stock market and its effects on
macroeconomic variables.
Schwert (1989) analyzed the relationships between macroeconomic volatility and financial
asset volatility using monthly data for the U.S. over the period from 1857 to 1987, finding strong
evidence that financial asset volatility helped to predict future macroeconomic volatility. Fama (1990)
showed that the stock return highly correlates with future production growth rates for the period 1953-
1987 in the U.S. Lee (1992) investigated causal relationships and dynamic interactions among asset
returns, real economic activity, and inflation in the postwar US using a VAR approach. He found that
stock returns help explain real economic activity; however, stock returns explain little about the
variation in inflation. Dropsy and Nazarian-Ibrahimi (1994) analyzed the influence of underlying
macroeconomic policies on stock returns using monthly data from 1970 to 1990 for 11 industrialized
countries, concluding that anticipated macroeconomic policies did not help to predict stock returns.
Park and Ratti (2000) investigated the dynamic interdependencies among real economic activity,
inflation, stock returns, and monetary policy, using a VAR model. They used monthly U.S. data from
1955 to 1998 and found that shocks due to monetary tightening generated statistically significant
movements in inflation and expected real stock returns, and that these movements are not found in
opposite directions.
In recent years, emerging markets have attracted increasing attention in the global integrated
stock market. Vigorous research into the relationship between stock market behavior and various
multiple macroeconomic variables for emerging countries has been conducted in the past decade.
Kwon, Shin, and Bacon (1997) analyzed the relationship between the stock market and various
multiple macroeconomic variables using monthly data for South Korea from 1980 to 1992. Their
results showed that the Korean stock market was more sensitive to real economic and international
trading activities than that of the U.S. and Japanese stock indexes. Aylward and Glen (2000)
empirically examined the extent to which stock market prices predicted future economic growth using
151 International Research Journal of Finance and Economics - Issue 49 (2010)

annual data for 23 countries, including 15 developing countries, between 1951 and 1993. They found
that stock prices generally have some predictive power, the magnitude of which may vary substantially
across countries, with the stronger results for the G-7 countries than for the emerging markets.
Wongbangpo and Sharma (2002) explored the relationship between the stock returns for the ASEAN-5
countries and five macroeconomic variables. They found that in the long term all five stock price
indexes were related positively to growth in output and negatively to the aggregate price level.
Mukhopadhyay and Sarkar (2003) conducted a systematic analysis of Indian stock market returns prior
to and after market liberalization and the influence of macroeconomic factors on returns. The result
suggests for the post-liberalization period (since 1995), real economic activity, inflation, money supply
growth, foreign direct investment, and the NASDAQ index were significant in explaining variations in
Indian stock returns.
In summary, the relationships between stock markets and macroeconomic variables have been
examined in several developed and developing countries. In this study, we focus on whether these
causal relationships exist in China. We analyze the relationships between stock market volatility and
macroeconomic variable volatility based on the data of China during 1992:1-2008:12. Furthermore, we
use an EGARCH model to estimate the volatility of the stock market and of macroeconomic variables.
Moreover, the lag-augmented VAR (LA-VAR) approach is applied to investigate the causal
relationships between stock market volatility and macroeconomic variable volatility.
This paper is organized as follows. Section 3 provides a description of the data used. Section 4
outlines the methodology of the EGARCH model and reveals the results of the estimation of the stock
market volatility and macroeconomic variable volatility of China. In Section 5, we analyze the causal
relationship between stock market volatility and macroeconomic variables volatility using LA-VAR
model. Finally, in Section 6, we present the conclusions.

3. Data
To represent the stock market index of China, we chose the Shanghai composite index of the Shanghai
stock market. Since China established its stock market only about twenty years ago, the sample size of
the stock price index is limited. We used the monthly reports of the stock price index from January
1992 to December 2008 with data from the China Economic Information Network. The choice of the
macroeconomic variables was difficult but important. Based on Fama’s (1981) hypothesis, the measure
of economic activity and inflation is important for the analysis of stock market activity. So we selected
the gross domestic production (GDP) and consumer price index (CPI) as the measures of domestic
macroeconomic activity in China. We also considered the short-term interest rates, which may
influence economic activity and the stock market. Since only the quarterly or yearly GDP data of
China are available, we used the monthly value added by industry as the weight, and the quarterly GDP
was adjusted to monthly data. The GDP and CPI data were adjusted using the Census X12 method to
eliminate the influence of seasonal fluctuations. Considering the inflation factor, we chose the real
GDP but not the nominal ones. The real GDP is the value of the nominal GDP deflated by China’s
CPI. With regard to short-term interest rates, we selected the one-year loan rate as a proxy variable.
GDP and CPI data came from the National Bureau of Statistics of China. Interest rate data came from
the People’s Bank of China.
In our analysis, all variables were taken in logarithmic form. Real stock returns (RSR) were
defined as the difference between the log difference in return on the stock price (SP) and that in the
CPI of China. (Note 1) The real growth rate of the GDP was calculated by taking the first log
difference of real GDP. (Note 2) The inflation rate was calculated by taking the first log difference of
the CPI. (Note 3) As the interest rates (IR) were in percentages, we define them as log (1+IR/100).
Based on the data described above, we performed a two-step procedure to examine the
relationship between stock market volatility and macroeconomic variable volatility of China. The first
step was to estimate the volatility of each variable using the AR-EGARCH model. In the second step,
International Research Journal of Finance and Economics - Issue 49 (2010) 152

the causal relationships between the volatility of the stock market and that of selected macroeconomic
variables were analyzed using a LA-VAR model.

4. Estimation of Volatility Using EGARCH Model

4.1. Model Specification
In empirical analysis, heterosecdasticity is often associated with cross-sectional data, whereas time
series are usually studied in the context of homoscedastic processes. However, in the analyses of
macroeconomic data, Engle (1982) found evidence that for some kinds of data, the disturbance
variances in time-series models were less stable than usually assumed. For instance, the uncertainty of
stock market returns, which are measured using variance and covariance, changes over time. Thus, we
should pay more attention to the heteroskedasticity when performing the time series analysis. For this
problem, it is necessary to specify the variance dynamics (volatility).
Engle (1982) suggested the ARCH (autoregressive conditional heteroskedasticity) model as an
alternative to the standard time series treatments. It is well known that a period of high volatility
continues for a while after a period of increased volatility, a phenomenon called volatility clustering.
The ARCH model takes the high persistence of volatility into consideration and so has become one of
the most common tools for characterizing changing variance and volatility. This observation led
Bollerslev (1986) to extend the ARCH model into the generalized ARCH (GARCH) model. The virtue
of this approach is that a GARCH model with a small number of terms appears to perform as well as or
better than an ARCH model with many terms. It is commonly thought that volatility is likely to rise
during periods of falling growth and likely to fall during periods of increasing growth. However,
neither the ARCH nor the GARCH model can capture this asymmetry. The exponential GARCH
(EGARCH) model developed by Nelson (1991) can demonstrate the existence of asymmetry in
volatility with respect to the direction of real growth. The EGARCH (p, q) model is given by
p q
log σ = ω + ∑ (α i z t −i + γ i z t −i ) + ∑ β i log σ t2−i ,
t
2
(1)
i =1 i =1

where z t = ε t / σ t and ε t is the error term. Note that the left-hand side of equation (1) is the
logarithm of the conditional variance. The logarithmic form of the EGARCH (p, q) model ensures the
non-negativity of the conditional variance without the need to constrain the model’s coefficients. The
asymmetric effect of positive and negative shocks is represented by inclusion of the term z t − i . If
γ i > 0 ( < 0 ) volatility tends to rise (fall) when the lagged standardized shock, zt −i = ε t −i / σ t −i is
positive (negative). The persistence of shocks to the conditional variance is given by ∑ iq=1 β i . As a
special case, the EGARCH (1, 1) model is given as follows:
log σ t2 = ω + α z t −1 + γ z t −1 + β 1 log σ t2−1
. (2)
For a positive shock ( z t − 1 > 0 ), equation (2) becomes
log σ t2 = ω + (α + γ ) z t −1 + β 1 log σ t2−1 , (3)
whereas for a negative shock ( z t − 1 < 0 ), equation (2) becomes
log σ t2 = ω + (α − γ ) zt −1 + β log σ t2−1 . (4)
Thus, the presence of a leverage effect can be tested by the hypothesis that γ i = 0 . The
impact is asymmetric if γ i ≠ 0 . Furthermore, the parameter β governs the persistence of volatility
shocks for the EGARCH (1, 1) model. There are several benefits to using the EGARCH model. First,
since the log value of volatility is used as an explained variable, there is no need to impose non-
negative constraint on the parameters of variance dynamics. Second, the EGARCH model can take into
consideration the asymmetric effect of the volatility. Third, only the coefficients of the GARCH term
govern the persistence of volatility shocks. Considering its benefits, it is useful to estimate the
153 International Research Journal of Finance and Economics - Issue 49 (2010)

volatility of the stock market and of macroeconomic variables by applying the EGARCH approach. It
is hoped that this analysis can provide empirical evidence regarding the relationships between the
volatility in the stock market and macroeconomic variables.

4.2. Empirical Results

In this study, we estimate a series of univariate time-series models to allow for time variation in both
the conditional mean and conditional variance. The AR (k)-EGARCH (p, q) is used to model the
dynamics of the GDP, CPI, interest rate and stock returns in China. The conditional mean and
conditional variance are respectively specified as follows: autoregressive process of order
k
yt = π 0 + ∑ π i y t−i + ε t , E t (ε t ) = 0 , E t −1 ( ε t2 ) = σ t2 , (5)
i =1
p q
log σ t
2
=ω + ∑ (α i z t−i + γ i z t−i ) + ∑ β i log σ t2− i . (6)
i =1 i =1

Equation (5), the conditional mean equation, is specified as an autoregressive process of order k
(AR (k)). Here π 0 is the constant, k is the lag length, ε t is the heteroskedastic error term with its
conditional variance σ t2 . Equation (6), the conditional variance equation, is specified as the EGARCH
(p, q) model. Here p is the number of ARCH terms, and q is the number of GARCH terms. Also, ω is
the constant, z t is i.i.d. with zero mean and unit variance. z t and σ t are statistically independent,
and z t = ε t / σ t .
These models are applied to estimate the volatility of real growth rates of the GDP, inflation
rate, interest rate, and stock returns in China. Each model is estimated by the maximum likelihood
method. The Schwarz Baysian information criterion (SBIC) and the Ljung-Box test are used to specify
the model. The SBIC is often used for model selection, with a preference for smaller SBIC values. The
Ljun-Box test is used to check whether there is serial correlation in residuals. The choice of the lag
length k in the AR model, ARCH term p, and GARCH term q in the EGARCH model is carried out
among k = 1, 2,…, 12, p = 1, 2 and q = 1, 2, using the SBIC and residual diagnostics. The following
models are thus selected: the AR(2)-EGARCH(2,2) model for real GDP growth (GDP), the AR(7)-
EGARCH(2,1) model for the inflation rate (CPI), the AR(4)-EGARCH(1,2) model for interest rate
growth (IR), and the AR(2)-EGARCH(1,1) model for stock returns (SR).
Table 1 reports the parameter estimates and their corresponding p-value, showing that the
coefficient of the GARCH term ( β ) is estimated to be 1.332 and -0.573 for the GDP, 0.933 for the
CPI, 1.485 and -0.978 for the interest rate, and 0.937 for the stock return. Each is statistically
significant at the 1% level. The coefficient of the ARCH term ( α ) is estimated to be 0.637 and -0.671
for the GDP, 0.627 and -0.759 for the CPI, 0.178 for the interest rate, and 0.382 for the stock returns.
Each is statistically significant at the 1% level. The asymmetric parameter ( γ ) is estimated to be 0.225
and -0.591 for the GDP, 0.213 and -0.090 for the CPI, 0.711 for the interest rate, and -0.066 for the
stock returns. Note that this asymmetric parameter is not statistically significant for the CPI and stock
returns.
Table 1 also shows the diagnostics of the empirical results of the AR-EGARCH model. The
Ljung-Box test statistic Q(s), developed by Ljung and Box, is defined as follows:
s
ρˆ ( i ) 2 , (7)
Q ( s ) = T (T + 2 ) ∑
i =1 T − i
where ρˆ ( i ) is the ith sample autocorrelation and T is the number of observations. The Ljung-Box test
statistic at lag s, Q(s), is a test statistic for the null hypothesis of no autocorrelation up to order s for
standardized residuals. Q(s) is asymptotically distributed as χ 2 with degrees of freedom equal to the
number of autocorrelations less the number of parameters. As the table clearly shows, Q(20) (p-value)
is 26.632 (0.146) for the GDP, 24.539 (0.220) for the CPI, 13.806 (0.840) for the interest rate, and
International Research Journal of Finance and Economics - Issue 49 (2010) 154

24.174(0.235) for the stock returns. Thus, the null hypothesis of no autocorrelation up to order 20 for
standardized residuals is accepted for all variables. Table 3 also indicates the Q 2 (s) statistic and its
associated p-value. Q 2 (s) is a test statistic for the null hypothesis of no autocorrelation up to order s for
standardized residuals squared. Q 2 (20) (p-value) here is 11.065 (0.945) for the GDP, 25.853 (0.171)
for the CPI, 4.893 (1.000) for the interest rate, and 10.489(0.958) for the stock market returns. Thus,
the null hypothesis of no autocorrelation up to order 20 for standardized residuals squared is accepted
for all variables. In addition, LM, the Lagrange multiplier test statistic for ARCH in residuals, is
distributed as chi-square. It is clear from the table that the null hypothesis of no further ARCH effect in
residuals is accepted for each variable. These results suggest that the selected model specification of
the AR-EGARCH model explains the data well.

Table 1: Empirical results of AR-EGARCH model

GDP CPI IR SR
AR (2)- AR (7)- AR (4)- AR (2)-
Model
EGARCH (2,2) EGARCH (2,1) EGARCH (1,2) EGARCH (1,1)
Mean equation
π0 0.013 (0.000)** 0.0001 (0.613) 2.93E-05 (0.000)** －0.0008 (0.894)
π1 －0.312 (0.002)** 0.293 (0.004)** 0.163 (0.000)** －0.011 (0.881)
π2 －0.041 (0.441) －0.006 (0.932) 0.079 (0.000)** 0.075 (0.317)
π3 0.167 (0.000)** 0.256 (0.001)**
π4 0.105 (0.077) －0.0004 (0.818)
π5 0.133 (0.112)
π6 0.042 (0.551)
π7 0.125 (0.046)*
Variance equation
ω －1.660 (0.000)** －0.671 (0.000)** －6.216 (0.000)** －0.585 (0.000)**
α1 0.637 (0.000)** 0.627 (0.001)** 0.178 (0.000)** 0.382 (0.000)**
γ1 0.225 (0.003)** 0.213 (0.072) 0.711 (0.000)** －0.066 (0.146)
α2 －0.671 (0.000)** －0.759 (0.000)**
γ2 －0.519 (0.000)** －0.090 (0.488)
β1 1.332 (0.000)** 0.933 (0.000)** 1.485 (0.000)** 0.937 (0.000)**
β2 －0.573 (0.000)** －0.980 (0.000)**
Diagnostic
Q ( 20 ) 26.632 (0.146) 24.539 (0.220) 13.806 (0.840) 24.174 (0.235)
2
Q (20) 11.065 (0.945) 25.853 (0.171) 4.893 (1.000) 10.489 (0.958)
LM 0.126(0.723) 0.142(0.707) 1.715 (0.192) 0.646 (0.422)
SBIC － 3.765 － 7.902 － 9.478 － 1.488
Note: 1. The numbers in parentheses are the p-value.
2. ** (*) shows the statistical significance at the 1% (5%) level.
3. Q(20) is a test statistic for the null hypothesis that there is no autocorrelation up to order 20 for standardized residuals.
4. Q2 (20) is a test statistic for the null hypothesis that there is no autocorrelation up to order 20 for standardized residuals
squared.

Based on the parameters estimated according to the AR-EGARCH model in Table 1, the
volatility of China’s GDP, CPI, interest rate, and stock returns can be calculated. Table 2 reports the
descriptive statistics for the volatility of each variable. It gives the mean, standard deviation (Std.
Dev.), skewness, kurtosis, Jarque-Bera test statistics, and its corresponding p-value. From Table 2, one
155 International Research Journal of Finance and Economics - Issue 49 (2010)

can clearly observe that the mean and standard deviation of stock returns volatility is relatively high
compared to those of the other variables. The table also indicates that the volatility for either the stock
returns or the macroeconomics variables exhibits strong positive skewness and high levels of kurtosis.
Moreover, it is obvious from the Jarque-Bera statistics and corresponding p-values that the null
hypothesis of normal distribution is rejected at the 1% significance level for all of the variables. These
results strongly indicate that China’s stock prices are much more volatile than the major
macroeconomic variables.

Table 2: Summary statistics of volatility

GDP CPI IR SR
Mean 0.002 2.04E-05 0.0003 0.019
Std. Dev. 0.004 2.63E-05 0.002 0.030
Skewness 5.944 3.821926 8.208 3.634
Kurtosis 41.046 19.73571 78.248 18.589
Jarque-Bera 13305.920 2764.519 49184.130 2477.857
p-value 0.000 0.000 0.000 0.000

In the next section, we will use a LA-VAR model to examine the interdependence between the
volatility of the stock market and that of macroeconomic variables.

5. Causal Relationship between Stock Market Volatility and Macroeconomic

Volatility
5.1. Model Specification
In this section, we investigate the causal relationship between China’s stock market volatility and
macroeconomic variable volatility using the lag-augmented VAR (LA-VAR) model developed by
Toda and Yamamoto (1995).
The LA-VAR approach is applicable to the Granger-causality test in the VAR framework. The
most significant benefit to using LA-VAR model is as avoiding biases by paying little attention to the
integration and cointegration properties of the data-generating process. The standard VAR or VECM
(vector error correction model) relied on the prior test of integration or cointegration order, which
subjects coefficient restrictions test based on the VAR or VECM to pretest biases if there were flaws in
these conclusions. The LA-VAR method avoids these biases by elaborating the Granger causality test
and other tests of coefficient restriction. Therefore, using the LA-VAR technique, we can cope with
pretest biases that give rise to problems in statistical inference and execute the Granger-causality test in
a level VAR model when the variables are of unknown integration or cointegration order.
The method proceeds, briefly, as follows. Let the following equation generate {yt }, the n-
dimensional vector constituting the levels of the variables in the study:
yt=g0+g1 t+J1 yt-1+J 2 yt- 2+...Jk yt-k+ε t , (8)
where t is the time trend, k is the lag length, ε t is an i.i.d. sequence of n-dimensional random vectors
with mean zero and variance covariance matrix Σ ε ; and g 0 , g 1 , J 1 ,... J k are the vectors or matrices of
coefficients.
The null hypothesis that the jth variable does not Granger-cause the ith variable is formulated
as
H 0 : J ij (1) = J ij ( 2 ) = ⋅ ⋅ ⋅ J ij ( k ) = 0
(9)
where J ij (h) is the (i, j) element of the matrix J h (h = 1,2,...,k ) . To test this hypothesis, we estimate a
VAR formulated in levels by ordinary least squares (OLS) as follows:
International Research Journal of Finance and Economics - Issue 49 (2010) 156

yt=γˆ0+γˆ1 t+Jˆ1 yt-1+Jˆ 2 yt- 2+...Jˆ p yt-p+εˆt (10)

where a circumflex (^) indicates an estimation by OLS and p = k + dmax represents the true lag length k
augmented by a suspected maximum integration order dmax(k ≥ dmax) . γˆ 0 , γˆ1 , Jˆ 1 ,... Jˆ P are vectors
(matrices) of parameter estimates. Considering that the true values of d max are zero, those parameters
are not included in restriction (9). Toda and Yamomoto (1995) established that the Wald statistic
asymptotically has a chi-square distribution with degrees of freedom equal to the number of excluded
lagged variables regardless of the integration order of the process or the existence of a cointegrating
relationship.

5.2. Empirical Results

Following the LA-VAR model introduced above, we execute a Granger causality test to investigate the
interdependence between the stock market volatility and the macroeconomic variables volatility of
China. Before performing the empirical analysis, the true lag length (k) of the VAR model and the
possible maximum integration order should be determined. The optimal lag length in each regression is
determined by minimizing the SBIC, which indicates that the true lag is one (k = 1) for the model. The
analysis was conducted using dmax =1 based on the restriction dmax(k ≥ dmax). Thus, the total lag length for
our LA-VAR estimation is two. The model includes a constant, and a deterministic time trend now
enables us to analyze the causal relationships among variables associated with the estimated LA-VAR
model.
For empirical analysis we use the volatility of the GDP, CPI, interest rate, and stock returns
estimated in section 4. The results of the Granger causality test from the LA-VAR procedure are shown
in Table 3. The null hypothesis is that there is no causality among the variables, and the Wald test
statistic and the corresponding p-value are presented the second and third columns.

Table 3: Causality results of LA-VAR model

Null Hypothesis Wald Statistics p-value

GDP Volatility does not Granger Cause Stock Market Volatility 0.729 0.695
Stock Market Volatility does not Granger Cause GDP Volatility 1.279 0.528
CPI Volatility does not Granger Cause Stock Market Volatility 8.404* 0.015
Stock Market Volatility does not Granger Cause CPI Volatility 15.350** 0.000
Interest Rate Volatility does not Granger Cause Stock market volatility 0.827 0.661
Stock market volatility does not Granger Cause Interest Rate Volatility 9.060** 0.011
Note: ** (*) shows the statistical significance at the 1% (5%) level.

First, we can observe that the p-value of the test for the null hypothesis that GDP volatility does
not cause stock market volatility is 0.695, while the p-value of the test for the null hypothesis that stock
market volatility does not cause GDP volatility is 0.528. These results suggest that there is no causal
relationship between GDP volatility and stock returns volatility in China. The results also imply that
China’s stock market is not fundamentally linked to its economic growth, and the two variables move
independently of each other between 1992 and 2008. This finding suggests that the Shanghai stock
market index is not a leading indicator of China’s future economic activity, nor is it likely that any
change in China’s future economy could provide valuable information to the Shanghai stock market.
The interpretation of this result will be discussed in the next subsection.
Second, for the relationship between the volatility in the CPI and the stock market, the null
hypothesis that CPI volatility does not cause stock market volatility is rejected at the 5% level of
significance. Reciprocally, the null hypothesis that stock market volatility does not cause CPI volatility
is rejected at 1% level of significance. These results clearly indicate that there is a bilateral causal
relationship between inflation volatility and stock market volatility, confirming the feedback
phenomenon of two-way causation between these two variables in China. These results can be
157 International Research Journal of Finance and Economics - Issue 49 (2010)

understood in China’s high rates of inflation increasing the cost of living and shifting consumers’
resources from investment to consumption. This leads to a fall in the demand for the domestic market
and subsequently leads to a reduction in the volume of stock traded. On the other hand, higher stock
prices boost household wealth, which encourages consumers to spend more and increases general price
inflation. Our results suggest there is a close relationship between China’s inflation rate and stock
market.
Finally, the result of the causality test suggests that there is a unidirectional causal relationship
between interest rate volatility and stock market volatility with direction from the stock market to the
interest rate. Table 3 demonstrates that stock market volatility tends to Granger-cause interest rate
volatility at the 5% level of significance. Our results suggest the Chinese stock market is not efficient
in the sense that it responds insensitively to the change of the interest rate.

5.3. Discussion
It is generally recognized that higher stock prices boost household wealth, which encourages
consumers to spend more. A rise in stock prices also makes it cheaper for firms to raise funds and thus
invest more. Meanwhile, the rise in the value of collateral, such as real estate, increases banks’
willingness to lend. All these factors can swell domestic demand and help increase real GDP growth.
Thus, if stock prices accurately reflect the underlying fundamentals, then the stock prices should be
used as leading indicators of future economic activity. Similarly, since the value of corporate equity at
the aggregated level should depend on the state of the economy, it is plausible that a change in the level
of uncertainty about future economic growth would produce a change in the stock market. However,
the result of our empirical analysis suggests that there exists no causal relationship between volatility
of China’s stock market and that of its real GDP. There could be many possible explanations of this
seemingly abnormal evidence.
First, a unique characteristic of China’s stock market is the relatively high percentage of non-
tradable shares held by the central government, local governments and state-owned enterprises. Yao Y.
and Yueh L. (2009) noted that approximately 69% of all shares in the 1,400 listed companies on the
Shanghai and Shenzhen exchanges were non-tradable, so their value was prescribed rather than market
determined. One feature of this system is the transfer of risk to the individual stock investors, causing
price aberrations in the stock market. Smaller trades get run over by the larger, market-moving
government orders. The result is that small investors are more interested in short-term gains and ignore
long-term investment opportunities. This makes China’s stocks more volatile than those in mature
markets like the U.S. and Europe and less correlated to longer-term company performance and
economic growth. Therefore, the stock market performance of the listed companies in China can hardly
reflect their real economic competence. In fact, the Chinese stock market is somewhat separated from
the real economy, and the stock indexes do not reflect the actual situation of the economy.
Second, as we can see from the data observed in well-developed market economy countries,
financing provided by banks and by the stock market are nearly equal. However, most Chinese
financing is supported by commercial bank loans, and even less financing relies on the stock market. In
China, commercial bank financing relies to a significant extent on the “big four” state-owned
commercial banks (Note 4); thus, the credit of commercial banks is to some extent supported by the
government. This indicates that the Chinese banking industry is not self sufficient. As a result, the
dominant commercial banking industry has weakened the role played by the stock market and left the
financial risks undiversified. Therefore, this unbalanced financial structure could explain at the least
partly why China’s stock market is not playing an important role in the country’s real economic
growth.
International Research Journal of Finance and Economics - Issue 49 (2010) 158

6. Conclusions
In this study, we have examined the relationship between the volatility of China’s stock market and
that of macroeconomic variables such as the real GDP, inflation, and interest rate. This research was
performed in a two steps. The first step involved the estimation of the volatility for each variable using
the AR (k)-EGARCH (p, q) model. The second step investigated the causal relationship between the
volatility of the stock prices and the macroeconomic variables by using a LA-VAR model.
The results of our investigations produced the following findings. First, our result suggests that
there was no causal relationship between stock market volatility and real GDP volatility. This finding
implies that the stock prices were not significant in explaining the real GDP, and vice versa. Second,
we found that there is a bilateral causal relationship between inflation volatility and stock market
volatility, confirming the existence of a feedback phenomenon between China’s CPI and stock prices.
Third, the result of the causality test suggests that there is a unidirectional causal relationship between
stock market volatility and interest rate volatility, with the direction from stock prices to the interest
rate. It is generally believed that stock prices should reflect expectations about future corporate
performance. Corporate profits, conversely, generally may reflect the level of country’s economic
activities. Thus, if stock prices accurately reflect the underlying fundamentals, then the stock prices
should be used as leading indicators of future economic activity. However, our findings indicate that,
except for the inflation rate, the Chinese stock market does not reflect the changes of macroeconomic
variables like the real GDP and interest rate.
In sum, China’s stock market is only one-twentieth the age of its two-century-old U.S.
counterpart and has only roughly one-fifth the market capitalization. Although China is the world’s
third-largest national economy, its stock market is still at that of the level of a developing country, and
its financial system is relatively weak. Unlike those of well-developed countries, China’s stock market
index could not be considered a leading indicator of future economic activity. In the future, it is
necessary for the Chinese government to improve the efficiency of the stock market and reform the
financial system. However, because an extreme reform of the stock market and financial system would
cause more hot money flow and speculation, the reform process should occur in a proactive,
controllable, and gradual manner.

Notes
Note 1. The real stock return is defined by ∆1(ln SPt ) − ∆1(ln CPI t ) ,
where ∆1(ln SPt ) = ln( SPt ) − ln( SPt −1 ) and ∆1(ln CPI t ) = ln(CPI t ) − ln(CPI t −1 ) .
Note 2. The real GDP growth rate is defined by ln(GDPt ) − ln(GDPt −1 ) .
Note 3. The inflation rate is defined by ln(CPI t ) − ln(CPI t −1 ) .
Note 4. The “big four” state-owned commercial banks are the Bank of China, Industrial &
Commercial Bank of China, China Construction Bank, and Agricultural Bank of China.

Acknowledgement
I would like to express my sincere gratitude to Prof. Shigeru Matsukawa, Osaka Prefecture University,
who provided me with many helpful suggestions and important advice. Special thanks are due to Prof.
Katsuhiro Miyamoto, School of Accountancy, Kansai University, for his kindness and affection, and
for never letting me feel that I am away from my parents and country. Special Gratitude goes to
Lecturer Jin Guo, Setsunan University, who made many valuable suggestions and gave constructive
advice.
159 International Research Journal of Finance and Economics - Issue 49 (2010)

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