Stock market reaction to macroeconomic events

Abstract

The primary role of capital markets is allocation of capital among competing sectors of the economy. As a result of economic liberalization and reforms in the financial sector, Indian capital markets are expected to play an important role in mobilizing savings and channelizing the same to productive sectors of the economy. The changes in laws concerning the financial sector during the '80s and the economic reforms introduced after June 1991 have contributed to the growth of Indian capital markets significantly. One of the main objectives of liberalization of industrial policy and financial sector reforms is to ensure an efficient allocation of scarce resources by encouraging competition (internal and external, entrepreneurial initiative and innovation. This efficient allocation of capital is sought to be achieved through abolition of various controls, industrial policy reforms, 'trade policy reforms, etc., thus allowing a free play of market forces. Evidence of stock market reaction to inflation and money supply announcements, reforms in tax policy, changes in policy of regulation, and announcements of macroeconomic aggregates has been reported from the United States and other developed countries of the West. Researchers in India have studied the impact of inflation and money supply announcements, and firm-specific events such as announcements of rights and bonus issues, dividend and earnings announcements on the stock market But the response of share prices to various macroeconomic policy pronouncements had not been explored. The study examined the response of stock prices quoted on the Bombay Stock Exchange (BSE) to fiscal and monetary policy pronouncements (e.g, deregulation of interest rates), changes in industrial policy (e.g., delicensing of an industry), changes in administered price policy (e.g, decontrol of steel prices), changes in exchange rate policies (e.g., devaluation), and amendments to Foreign Exchange Regulation Act (FERA). These events will affect the entire economy and the market as a whole and/or profitability of a particular industry or a group of firms (e.g, export-oriented firms, FERA companies), and hence, the returns on the securities of the firms which constitute the same. The major findings were: 1. Federal Budgets were associated with increases in volatility whereas half-yearly credit policy announcements by the Reserve Bank of India (RBI) had no impact on the market. 2. of all the events, changes in administered prices seemed to have the maximum impact on the market. This was due to the large gap between demand for and supply of the commodity and the consequent expectations of a rise in their prices resulting in windfall gains to the firms in that industry. 3. Exporting firms experienced 27% abnormal returns while firms with net import expenditure experienced negative abnormal returns following devaluation of the rupee in July, 1991. However, the market took about four days to discount the expected benefits. Changes in industrial policy (delicensing) and Foreign Exchange Regulation Act (FERA) did not seem to enthuse the market participants whereas regulatory action by Monopolies and Restricted Trade Practices Commission (MRTPC) was associated with negative abnormal returns. (5) Prominent scrips in the portfolio did not have a decisive influence on the response of the market. The study has implications for: (a) policymakers ~ as they can anticipate the likely response of the stock market to the policy pronouncements. Also, market reaction serves as a feedback for judging the effectiveness of policy changes. (b) fund managers-as they can design and implement appropriate trading strategies if they have prior knowledge of the likely response of the market.