2013-15

Relationship between Indian Stock markets with interest rates since liberalization

Financial Markets and Institutions

Submitted by

Sahil Sanghvi - 048

Ashish Menon - 134

Sagar Sanghani - 144

Ankit Singhal - 156

Introduction

The economic liberalization and financial sector reforms which started in the late 1980s brought

about a big change in the financial architecture of the Indian economy making it more market

oriented and increasing private and foreign investment. It also had a positive impact on the

Indian stock market which has provided tremendous returns in the long run since the past three

decades. Across the globe, the stock market level is perceived to be the indicator of the economic

health and prospect of a country. It also denotes the domestic and global investor confidence.

Rampant investment in the country also gets reflected in the stock market resulting in an overall

positive outlook being projected about the economy.

Interest rate is one of the important macroeconomic variables, which is directly related to

economic growth. Interest rates in the country have also witnessed a big transition since

liberalization depicting the growth in the economy. Interest rate refers to the cost of borrowing or

lending funds and applies to both the companies as well as the retail investors. Interest rate can

also be considered as the cost of capital, i.e. the price paid for the use of money for a period of

time. For a borrower, interest rate is the cost of borrowing money whereas for a lender it is the

fee charged for lending money.

The Indian stock markets and the interest rates can be said to have a correlation among each

other due to a number of reasons. Any increase in the interest rates has an impact on the

company’s profits especially if the company has a high debt, which affects the stock prices

owing to a negative sentiment regarding the stock and the company’s future performance. This

scenario affects smaller companies the most. Also when the interest rates are high, people who

are risk averse tend to put their money more into fixed deposits and other low risk avenues

thereby reducing retail participation in the stock market.

If the lending rate of a bank is high it also means that it has to charge an even greater interest

from its loans which thereby increases the burden on loan takers like corporates, SMEs, etc.

which impact their profits and discouraging borrowing resulting in their stock prices coming

down. Sectors which have a high debt percentage like the capital intensive industries also get

affected. Increasing interest rates also has a negative impact on the economy, leading it into a

recessionary mode.

Lowering the interest rates would result in increasing borrowing from the banks by the

companies for expansion projects, acquisitions, etc. would result in a huge inflow of cash into the

market. However with more amount of disposable income, people would save less and consume

more resulting in demand exceeding supply which would in turn give rise to inflation. This

makes it important to strike a balance as far as the interest rate is concerned.

A lower interest rate thus simulates the economy and increases the value of the stock whereas a

higher interest rate results in slowing down of the economy resulting in a reduction in the stock

process. Thus theoretically there is an inverse relationship between stock market and interest

rates.

Stock Market after Liberalization in 1991:

The economic barriers were reduced and developed technology helped in the integration

of stock market

Although SEBI was established in 1988, it became more active post 1991 and enhances

market regulation

Many systems including electronic trading, demat, rolling settlement etc

Foreign investors were allowed to enter Indian markets through FDI and FII routes

Indian investors could invest global markets through global depository receipts (GDR),

American depository receipts (ADR) and foreign currency convertible bonds (FCCB)

The number of investors and share trading volume rose dramatically.

Impact on Monetary Policy and Interest Rates Post 1991:

Separation of monetary and fiscal policy which relieved RBI from financing fiscal deficit

CRR and SLR were reduced allowing more liquidity for the banks

Banking sector was allowed more autonomy enabling them to assess funds as per their

own methods

The interest rates were liberalized and became more market oriented

External factors such as reduced import controls and lower tariffs facilitated influx of

foreign exchange

Directed credit via introduction on priority sector in banking system

Literature Review:

Many researchers have studied this topic to find out some relationship or correlation between

the leading economic indicator interest rate and the Indian stock market returns. As their period

of study differs, so do their conclusion on the relationship. The empirical investigations of Zhou

in 1996 state that the interest rates have an important implication on stock market returns

especially over a longer horizon. Many of the research papers used the Granger causality test to

understand the relationship between these two parameters. Other tests like the Co-integration test

clearly define a long-run relation (between Singapore stock prices and their interest and money

supply). However, this long-run relation could not be observed on the same parameters of the

US. Similar phenomenon was observed when Harasty and Roulet in 2000 observed a relation

between the stock prices, their dividends and interest rates which did not apply in the Italian

market.

Another researcher Bren et al. in 1989 had an interesting observation stating that interest rates

can be used in predicting the sign and variance of the excess returns of stocks. Arango et al.

discovered evidence of non-linear and inverse relationship among the Bogota stock market

returns and the short-term interbank loan interest rate.

Alam and Uddin in 2009 empirically discovered that interest rates have a negative relation with

the share prices applicable for all the 15 developed and developing countries they studied. Their

period of study was from January 1998 to March 2003. This inverse relationship between stock

market and interest rates was also observed by Hsing in 2004. There was another empirically

study of the impact of monetary policy on asset prices which was performed by Rigobon and

Sack in2004. They also concluded that with the increase in short term rates the stock prices

decreased. Campbell in 1987 also concluded the negative association between nominal T- bill

yield (one month) and future stock prices. This same thesis was again proved by Shanken in

1990. Another researcher Leon also examined a negative association between conditional market

returns and interest rates. His period of study was approx. 9 months from 31 st January to 16th

October 1998. Another research by Lee in 1997 shows that the relation between these two

variables is inconsistent over time.

All these studies described above prove that there have been discoveries of negative

correlation between the stock market returns and interest rates. But concluding a relationship

which can globally apply to all emerging and developed economies and also prove consistent

over time is difficult. The study that follows will add to the research made so far and will be a

benchmark for comparison for future research because not many research papers have studies the

effects of lending rates on the returns of the Indian stock market.

Quantitative and Qualitative analysis

To perform the quantitative analysis and to find out the relationship between interest rates and

stock markets, we gathered the following data:

Stock market: we considered the yearly closing prices of BSE sensex since liberalization

i.e. from 1991 to 2014. The data was obtained from the BSE website: www.bseindia.com.

We considered the absolute values of the index and not the returns to get a more accurate

idea of the stock prices.

Interest rates: we considered the annual lending rates of SBI as it is not only a national

bank but also has a huge market capitalization. Also, the lending rates of SBI are

followed by the other commercial banks. We also considered the yields of 10 year

government securities as it determines the risk free rate in our economy. Both these interest

rates were obtained from the RBI website: www.rbi.org.in.

The graph shows the relationship between stock markets and the above mentioned interest rates.

1990-91

1992-93

1994-95

1996-97

1998-99

2000-01

2002-03

2004-05

2006-07

2008-09

2010-11

2012-13 0

2

4

6

8

10

12

14

16

18

0

5000

10000

15000

20000

25000

30000

Chart Title

Lending Rate G-Sec Yield BSE

Rate

of I

nter

est

BSE

Observations:

The BSE Sensex is seen rising gradually from 1991 since liberalization.

The interest rates are seen moving downwards mirroring the moment of stock markets in

opposite direction

The BSE Sensex closed at around 20,000 points during the end of year 2006.

The government security yields dropped below 6 percent during 2004 while lending rates

maintained its gradual downward slope

After 2007, the markets were affected by recession because of which the index dropped

below 10,000 points.

in the period following recession, the index depicted volatile price moment till 2009-10

However, both lending rate and government yield had shown similar movement during

the entire period. Also spread between government security yields and lending rates is

more or less maintained.

Explanation:

It is clear from the graph that the BSE has the negative correlation with lending rate and g-sec

yield, barring few ups and downs. The graph clearly explains the fact that lending rates have

fallen since 1991 and at the same time the stock market in India has risen. It is interesting to note

that the both the rates have very high correlation and moving in the same direction. The

exceptions in the graph can be explained from the events that took place in the respective years.

In the year 2008, the subprime crisis wreaked havoc on the world economy and the Indian

economy was also not insulated from this event. And this resulted in crash of stock markets

across globe and Sensex in India crashed like a falling peck of cards. Then again in the year

2011, the world economy was hit by Euro-zone sovereign debt crisis.

Methodology:

To determine the relationship between stock market and interest rates, we used

correlation matrix as well as regression analysis.

Year BSE Lending Rate G-Sec Yield

2013-14 27085.93 12.6 8.48

2012-13 21170.68 12.6 8.36

2011-12 19426.71 11.4 8.52

2010-11 15454.92 10.5 7.92

2009-10 20509.09 11.5 7.23

2008-09 17464.81 12.3 7.69

2007-08 9647.31 11.9 8.12

2006-07 20286.99 12 7.89

2005-06 13786.91 12.6 7.34

2004-05 9397.93 13.2 6.11

2003-04 6602.69 13.3 5.71

2002-03 5838.96 13.7 7.34

2001-02 3377.28 14.1 9.44

2000-01 3262.33 14.8 10.95

1999-00 3972.12 15.4 11.77

1998-99 5005.82 16.2 11.86

1997-98 3055.41 16.9 12.01

1996-97 3658.98 17.1 13.69

1995-96 3085.2 16 13.75

1994-95 3110.49 16.5 11.9

1993-94 3926.9 17 12.63

1992-93 3346.06 16.8 12.46

1991-92 2615.37 16.8 11.78

1990-91 1908.85 16.8 11.41

Data obtained from RBI and BSE India.

Correlation Matrix:

Explanation:

Using Data analysis, we obtained the correlation matrix. From the result it was observed that the

correlation between the BSE Sensex and the lending rate is below -0.8, which implies that there

exists a negative correlation between the two factors. This negative correlation explains that the

movement of these two parameters is in opposite direction. It was also observed that the

correlation factor between BSE Sensex and 10 year G-sec yield is below -0.6, which is again

negatively correlated. It is important to observe that the Lending rates and 10 year G-sec have

the correlation factor of 0.86, which implies that the both these rates move in same direction.

Explanation:

R square value of 0.67 implies that 67 per cent movement in the stock market can be explained

from the interest rate movement. Whereas adjusted R square value represents adjustment in the R

square value on account of multiple independent variables. P value of 0.000008 is quite

significant which implies the confidence level of the output. It is interesting to note that the 100

basis points change in the lending rate will result in the negative change of 3642.41 points in BSE

index and 100 basis points change in the G-sec yield will see the positive change of 800 points in BSE

index. These results are in accordance with our theory which states that the increase in G-sec yield always

results in positive sentiments in the economy and increase in lending rate is a dent to an expansionary

economy and leads to negative sentiments in the economy.

Conclusion

Since the year 1991, the interest rates have fallen from as high as 17 per cent to 12.5 per cent,

which implies that the cost of borrowing funds have decreased so as the interest component in

the balance sheet of companies, resulting in higher PAT. The improved bottom-line numbers

have reflected in the stock market, surging to new highs and improved sentiments in the market.

Other rationale which explains this behavior is that the lower is the lending rate, more will be the

liquidity in the market. And the more capital can be employed in the expansion of the business,

and hence the macro-level economic development of the economy, which results in the improved

sentiments and the soaring stock market. This also explains the stock market as the lead indicator

of an economy.

References

Rahman, M., & Mustafa, M. (1997). Dynamic linkages and Granger causality between short-

term US corporate bond and stock markets. Applied Economic Letters, 4, 89-91.

Hatemi-J, A., & Roca, E.D. (2008). Estimating banks’ equity duration: a panel co-integration

approach. Applied Financial Economics, 18, 1173-1180.

Campbell, J.Y. (1987). Stock returns and the Term Structure. Journal of Financial Economics,

18, 373-399.

Alam, Md. Mahmudul, & Uddin, Md. Gazi Salah (2009). Relationship between interest rate and

stock price: Empirical evidence from developed and developing countries. International Journal

of Business and Management, 4.

Leon, N’dri. Konan (2008). The effects of interest rates Volatility on stock returns and volatility:

Evidence from Korea. International Research Journal of Finance and Economics, ISSN 1450-

2887.

Arango, L., Gonzalez, A., Posada, C., 2002. “Returns and interest rate: A nonlinear relationship

in the Bogota stock market,” Applied Financial Economics, Vol.12, No11, pp.835-42.

Hsing, Yu. 2004. “Impacts of fiscal policy, monetary policy, and exchange rate policy on real

GDP in Brazil: A VAR model,” Brazilian Electronic Journal of Economics, Vol.6, No1.

Zhou, C., 1996. stock market fluctuations and the term structure. Board of Governors of the

Federal Reserve System, Finance and Economics Discussion Series: 96/03.

Harasty, H. and Roulet, J. (2000). Modeling Stock Market Returns. Journal of Portfolio

Management, 26 (2), 33.

Interest Rate statistics database link:

http://dbie.rbi.org.in/DBIE/dbie.rbi?site=statistics, as viewed on Sep 1, 2014.

BSE Sensex data:

http://www.bseindia.com/indices/IndexArchiveData.aspx?expandable=1, as viewed on Sep 3,

2014.