THE INFLUENCE OF MONETARY POLICY ON THE NIGERIAN STOCK MARKET
CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Monetary policy connotes interest rate, exchange rate, credit allocations and other financial policy intervention programmes that promote economic growth. Monetary policy can act as growth catalyst by creating an enabling environment with appropriate incentives to empower innovative entrepreneurs to drive inclusive growth. Extant economic literature has identified five main monetary transmission channels (interest rates, asset prices, exchange rates, credit and expectations) through which monetary policy can affect real economy and promote growth. Changes in monetary policy tend to influence aggregate demand, growth, and inflation through various transmission channels and induce changes in employment as a result. However, monetary policy actions such as changes in the Central Bank monetary policy rate have at best an indirect effect on these variables and considerable lags are involved in the policy transmission mechanism. For example, the stock market, government and corporate bond markets, mortgage markets, foreign exchange markets, are quick to incorporate new information. Therefore, a more direct and immediate effect of changes in the monetary policy instruments may be identified using capital market data. Identifying the link between monetary policy and stock market prices in Nigeria is highly important to gain a better insight in the transmission mechanism of monetary policy, since changes in stock market prices play a key role in several channels.
Stock prices are among the most closely monitored asset prices in the economy and are commonly regarded as being highly sensitive to economic conditions. In the context of the transmission mechanism through the stock market, monetary policy actions affect stock prices, which themselves are linked to the real economy through their influence on consumption spending; wealth effect channel, investment spending and balance sheet channel (Goodhart and Hofmann, 2010). As Bernanke and Kuttner (2015) pointed out, some observers view the stock market as an independent source of macroeconomic volatility to which policymakers may wish to respond. Stock prices often exhibit pronounced volatility and boom–bust cycles leading to concerns about sustained deviations from their ‘fundamental’ values that, once corrected, may have significant adverse consequences for the broader economy. Hence, establishing quantitatively the link between monetary policy and stock market prices in Nigeria will not only be germane to the study of stock market but will also contribute to a deeper understanding of the conduct of monetary policy and of the potential economic impact of policy actions or inactions.
Theoretically, the present value or discounted cash flow model offers useful insights on the stock market effects of monetary policy changes. According to the discounted cash flow model, stock prices are equal to the present value of expected future net cash flows. Monetary policy should then play an important role in determining equity returns either by altering the discount rate used by market participants or by influencing market participants’ expectations of future economic activity. These channels of influence are interlinked since more restrictive monetary policy usually implies both higher discount rates and lower future cash flows (Thorbecke, 2017). Thus, monetary policy tightening should be associated with lower stock prices given the higher discount rate for the expected stream of cash flows and/or lower future economic activity. In contrast, an expansive monetary environment is commonly viewed as good news as these periods are usually associated with low interest rates, increases in economic activity and higher earnings for the firms in the economy. Consequently, stock market participants pay close attention to strategies based on the stance of the monetary authority as inferred by changes in indicators of Central Bank policy. Also, the financial press often interprets asset price movements as reaction to monetary policy shifts, attributing for instance increases in stock markets to low interest rates (Patelis, 2012). It is against this theoretical background that financial economists have sought to establish if and/or to what extent does monetary policy influences stock market prices.
1.2 Statement of the Problem
Previous empirical evidence broadly supports the notion that restrictive (expansive) monetary policy decreases (increases) contemporaneous stock returns, as well as expected stock returns (Patelis, 2012). Majority of these studies typically relate stock returns to measures of monetary policy stringency in the context of single equation specifications and/or multivariate Vector Autoregressions (VAR’s). However, various literatures showed that VAR models suffer from over-parameterization, and many different approaches have been proposed in order to obtain more efficient estimates. It is therefore germane to employ appropriate estimators in order to overcome this problem. In the present study, the Dynamic Ordinary Least Squares (DOLS) estimator, engineered by Stock and Watson (2013) and the Fully Modified Ordinary Least Squares (FMOLS), originally developed by (Phillips and Hansen, 1990) were adopted. Both the DOLS and FMOLS approach introduces dynamics in the model specified while allowing for simultaneity bias. Thus, this study added to the literature by varying on the period covered, methodology adopted, variables used, and frequency of data among other factors to examine the empirical linkage between monetary policy and stock market prices in Nigeria. This helps to validate past findings or bring forth new issues on the subject for further research.
1.3 Objectives of the Study
The main objective of this study is to determine the influence of monetary policy on stock market in Nigeria. Specific objectives include:
1. To examine the effect of monetary policy on stock market prices.
2. To determine the effect of interest rate on stock market performance.
3. To examine the relationship between monetary policy and stock market prices.
1.4 Research Questions
i. What is the effect of monetary policy on stock market performance?
ii. What is the effect of interest rate on stock market performance?
iii. Is there a relationship between monetary policy and stock market prices?
1.5 Research Hypotheses
Hypothesis I
H0: Monetary policy has no significant effect on stock market price movement.
Hi: Monetary policy has significant effect on stock market price movement.
Hypothesis II
H0: There is no significant relationship between monetary policy and stock market prices.
Hi: There is a significant relationship between monetary policy and stock market prices
1.6 Significance of the Study
The significance of monetary policy on stock market prices throughout the whole countries of the world and its immense contributions in economic development cannot be undermined. This study will be of benefit to the following groups:
Academia: The intensified urge to develop stock market has resulted in many researchers on the stock market development as well as growth determinants and the likes. This study however will add to existing literatures on this topic as well as a research material for future studies.
Policy markers: Government policy makers and regulatory institutions such as Securities and Exchange Commission (SEC) and Nigerian Stock Exchange (NSE) will benefit heavily. It is expected that this study will complement the efforts of the government and policy makers in reviving the Nigerian stock market and restoring confidence of shareholders and other participants in the market especially now that investors and shareholders confidence seems to be eroding. It will also assist government in knowing the measures and policies to undertake to encourage stock market development, having known what determines its growth and the economic variables which if given serious attention, will improve stock market development and hence economic growth. It will assist market regulators to take appropriate measures to improve trading system by eliminating the identified problems hindering the development of the exchange. This will increase the ease with which investors buy and sell shares.
Investors: It is the desire of investors, borrowers, lenders, especially corporate institutions, to know that there is a market that can serve their various financial needs. To individual investors, it serves as an avenue to make quick and genuine fund which can easily turn them to a millionaire just by investing in stock and shares with a good return. Corporate institutions can raise long-term capital fund for expansion through the issue of debt or equity instruments. The whole mechanism brings borrowers and lenders desirous to invest their surplus funds, interact directly or through financial intermediaries with those who wish to procure funds for their businesses. Ologunde, et. al., (2013) opined that in the Nigerian context, participants include Nigerian stock exchange, discount houses, development banks, investment banks, building societies, stock broking firms, insurance and pension organizations, quoted companies, the government, individuals and the Nigerian stock exchange commission..
1.7 Scope of the Study
The study made use of monthly macroeconomic data in Nigeria to cover the period between December 2013 and February 2019 (a period of seventy-five (75) months). This period is considered long enough to minimize the chances of committing either type I or type II errors while using the VAR model to achieve the targeted objectives. Monetary policy rate (MPR), introduced in December 2013 (which is the reason that informed the choice of December 2013 as the leading period/month) will be used as a proxy to capture monetary policy in Nigeria. More so, for the long term interest rate, we used prime lending rate and the nominal effective exchange rate (NEER) figures were used to capture exchange rate while the headline inflation figures from National Bureau of Statistics was used for inflation in the research study.
1.8 Limitations of the study
One of the major limitations of the study is the use of MPR as a proxy to capture monetary in Nigeria. In practice, CBN uses other instruments like OMO, Liquidity ratio and Cash reserve Requirement to compliment variation in MPR in achieving Price Stability. The use of prime lending rate (excluding the maximum lending rate) for interest rate could also be a challenge toward producing the accurate and most reliable outcome. In a nutshell, there is likelihood that the research model has omitted some important explanatory variables.
Furthermore, the accuracy and the reliability of the data produced by NBS, CBN etc. used in this study cannot be guaranteed. Finally, the study might be seen as restrictive because any development (in the variables examined) before December, 2013 and after February, 2019 is considered to be beyond the scope of this study
1.9 Definition of Terms
Monetary Policy: Monetary policy is the policy adopted by the monetary authority of a country that controls either the interest rate payable on very short-term borrowing or the money supply, often targeting inflation or the interest rate to ensure price stability and general trust in the currency.
Stock Market: A stock market, equity market or share market is the aggregation of buyers and sellers of stocks (also called shares), which represent ownership claims on businesses; these may include securities listed on a public stock exchange, as well as stock that is only traded privately, such as shares of private companies which are sold to investors through equity crowdfunding platforms. Investment in the stock market is most often done via stockbrokerages and electronic trading platforms. Investment is usually made with an investment strategy in mind.