THE IMPACT OF INFLATION ON STOCK MARKET PERFORMANCE AT THE NIGERIAN STOCK EXCHANGE 1986-2006

Abstract

The study examined specifically the impact of inflation on stock market performance at the Nigerian Stock Exchange. The study used time series data for 21 year period; 1986-2006, to fill this important research gap. The least square regression approach was used to estimate the necessary models. The regression results showed that coefficient of inflation rate does not have significant negative impact in explaining the long run performance of the stock market performance indicators tested. The result as well showed that the coefficient of inflation rate was negative, implying that, though theoretically inflation did not have significant negative impact on stock market performance indicators on the surface, but intrinsically considering the time value of money, inflation actually depreciated the real worth of the market indicators. In view of the above the following recommendations were made towards measures that can be used by the government for achievement of low and predictable inflation in Nigeria. The measures are as follows: Adoption of    balanced budget by the government; Import substitution and encouragement of domestic production; Enhancement of food production through extension of credit facilities to agricultural sector as well as construction of silos for storage of excess produce in order to avoid hoarding or scarcity of food items; Prevention of sharp practices through sound management of the exchange rate of the naira; Implementation of measures to mope up excess liquidity in the system that result from upward  review of workers salary; Earnest pursuance of stable macro-economic environment devoid of political turbulence and instability; Granting of total autonomy to the Central Bank in the formulation and implementation of monetary policies; and encouragement of massive industrialization for improved industrial output in order to facilitate appreciation of the naira in the international market.

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND TO THE STUDY

Inflation as a concept is intrinsically linked to money as captured by the often heard maxim ” inflation is too much money chasing after few goods”. Inflation also has been widely described as an economic situation where the increase in money supply is “faster” than the new production of goods and services in the same economy [Hamilton 2001]. Usually economists try to distinquish inflation from an economic phenomenon of a one time increase in prices or when there are price increases in a narrow group of economic goods or services [Piana 2001]. Thus the term inflation describes a general and persistent increase in the prices of goods and services in an economy [Ojo 2000, Melberg 1992].

High rate of inflation is a problem that has faced the Nigerian economy for over a long period. The country registered low rates of inflation in the years immediately after independence. Available information indicates that the country experienced a double digit rate of inflation in

1970; this was attributed to the outcome of the civil war. Other periods of high inflation were

1974-1979, when the wage freeze was discontinued, as was recommended by the Udoji salary review commission of 1974.  The rate of inflation rose to 20.9% in 1981; 23.2% in 1983; 39.6% in 1984; 10.2% in 1987; 38.3% in 1988 and 40.9% in 1989. In 1990, inflation rate reduced to a

single digit, only to rise again at a tremendous pace from 1991-1994, climaxing to 72.6% in

1995. But from 1996, remarkable reductions were witnessed; but double digit was still recorded, except in 2006 that recorded 8.2% [National Bureau of Statistic 2007]. Rates of inflation further reduced to 5.4% in 2007 but rose to 11.5%, 13.9%, 10.8%, and 12.7% from 2008-2012 respectively. The current rates of inflation in Nigeria as

at January-May 2013 were 12.75%, 12.44%, 11.70%, 11.00%, and 10.70% respectively (National Bureau of Statistical News May 2013). The above data still placed Nigeria in the category of high inflated region as her inflation rate still recorded above 5%. Normal inflation is between 1-5%. Any rate below zero % amounts to deflation (Vegh, 1992 and Piana, 2001).

There are three dominant schools of thought on the causes of inflation in recent times; the neo- classical/monetarist, neo-keynesian and structuralist. The neo-classical/monetarist is of the view, that inflation is driven mainly by growth in the quantum of money supply. However, practical experiences of the Federal Reserve in the United State [US] have shown that this may not be entirely correct. For instance the US money supply growth rates increases faster than prices itself [Hamilton 2001, Colander 1995]. This has been traced to the increased demand for the US dollar as a global trade currency.

The neo-Keynesians attributes inflation to diminishing returns of production. This occurs when there is an increase in the velocity of money and an excess of current consumption over investment. The structuralist attributes the cause of inflation to structural factors and underlying characteristics of an economy [Adamson 2000]. For instance in developing countries, particularly those with a strong underground economy, prevalent with hoarding or hedging, individuals expect future prices to increase above current prices, hence demand for goods and services are not only transactionary, but also precautionary. This creates artificial shortages of goods and reinforces inflationary pressures.

Factors that affect the level of inflation can be grouped into institutional, fiscal, monetary and balance of payments. Several studies [Melberg 1992; Cukierman,Webb and Neyapti 1992; Grilli, Masciandaro and Tabellini 1991; Alesina and summers 1993; Posen 1993; Polland 1993; and Debelle and Fischer,1995] have shown that the level of independence [legal administrative instrument] of monetary authority is an important institutional factor that affects inflation, especially in industrialised countries, while the rates of turnover of central bank governors in

developing countries was seen as an important factor influencing inflation. However, caution should be exercised in the interpretation of these findings, giving the difficulty in measuring the actual level of independence of the central bank.

The fiscal factors relates to the financing of budget deficits, largely through money creation process. Under this view, inflation is said to be caused by large fiscal in-balances, arising from inefficient revenue collection procedures and limited development of the financial markets, which tends to increase the reliance on seigniorage as a source of deficit financing [Agenor and Hoffmaster 1997; Essien 2005]. The monetary factors or demand side determinants include inncreases in the level of domestic demand, monetization of oil receipts, interest rates, real income and exchange rate [Moser 1995]. Prudent monetary management was also found to aid the reduction in the level and variability in inflation [Alesina and Summers 1993].

The balance of payments or supply side factors relate to the effects of exchange rate movements on the price level. For instance, exchange rate devaluation or depreciation induces higher import prices, external shocks and accentuates inflationary expectations [Melberg 1992; Odusola and Akinlo 2001; Essien 2005].

Amongst the various debates in economics has been the relationship between inflation and the performance of the stock market. A stock market is where equities and bonds are issued and traded, either through exchange or over the counter market. The trading of securities such as stocks and bonds are conducted in stock exchanges, which are grouped under the general term stock market. The stock market is a collection of financial institutions set up for the mobilization and allocation of long –term funds for developing the-long-term end of the financial system [Ologunge, Elumilade and Asaolu 2006]. In this market, lenders [investors] provide long-term funds in exchange for long term financial assets offered by borrowers. The market is an important institution for capitalist countries because it encourages investment in corporate securities, providing capital for new business and income for investors.

It is one of the most vital areas of the economy as it provides company access to capital and investors with a slice of ownership in the company and the potential of gains based on the company’s future performance [Finance and Investment Dictionary 2000]. Okafor [1983] categorized the market in three ways; on the basis of securities exchanged [bond and equity stock market]; on basis of market organisation [securites exchange and over-the counter market]. On

the  basis  of  age:  [primary  and  secondary  market].  He  further  sub-divided  the  market  into corprate bond market, the muncipal bond market for government bonds. The market is generally classified into two main sections, the primary and secondary market. The primary market is where new issues are first offered, with any subsequent trading going on in the secondary markets. The instruments tradeable in the stock market are bonds, government development stocks, industrial loans, preference stocks  and  equities [Nigeria Stock  Exchange Fact Book

2005]. The stock market is unique in a country’s financial system because of its role in the economy. Levine [1991] defined these roles as raising capital for business, mobilizing savings for investment, facilitating company’s growth, redistribution of wealth, corporate governance, creating investment opportunities for small investors, government capital raising avenue for development projects and barometer of the economy.

The relationship between inflation and stock market performance indicators has received a great deal of attention throughout the modern history of economics[ see Summers,1981a; Feldstein,

1980b,1982;  Fama,1981;  Gultekin,1983;  Pindyck,  1984;    Benderly and  Zwick,  1985;  Kaul,

1987; Chen and Jordan,1993; Boudoukh and Richardson,1993; Chen and Jordan,1993, Omran and Pointon,2001; Saryal, 2007; Eromosele, 2009 et cetera]. Theoretically, it is expected that, since inflation means an increase in general level of prices, and as common stocks can be considered as capital goods, then the stock prices should move with the general level of prices. So when there is a general increase in inflation, cost of common stock should also rise to compensate investors for the decrease in the value of money. In this framework, it is expected that there is a positive relationship between inflation and stock prices [Omran and Pointon,

2001]. However, early empirical studies demonstrated a negative relationship between the inflation and stock returns [see Lintner 1975, Zvie Bodie 1976, Charles Nelson 1976, Eugene Fama and William Schwart 1977, Jaffe and Mandelker 1976, Bulent Gultekin 1983, Gautam Kaul 1987]. The inverse relationship between a higher inflation rate and a lower common stock prices according to Feildstein [1980a], results from basic features of the United States of American (US) tax laws, particularly historic cost depreciation and taxation of nominal capital gains. This, is also reinforced by other studies [see Feildstein and Summers 1979, Fieldstein

1980b, 1982; Summers 1981a, b; Pindyck 1984, Fama 1981]. Dokko and Edelstein [1987] examined  this  relationship  in  the  US  market  by  using  the  mundel  [1963]  wealth-effect hypothesis, and the Darby [1975] tax-effect hypothesis. The results of their study indicated

negative relationship exist between the level of expected inflation and the expected real stock market returns.

Chen, N., R. Roll and S.A. Ross [1986] used monthly data for the period 1958-1984 to test the impact of inflation rate on stock prices. They defined three variables related to the inflation rate; expected inflation; the change in expected inflation; and unanticipated inflation and found a significantly negative relationship between the inflation variables and stock prices. Similarly, Chen and Jordan [1993] found the same result for same variables.

Benderly and Zwick [1989], however, suggested that there exist a structural relationship between the inflation rate and stock returns arising from the real balance effect pertaining only to a period of adjustment rather than to a long-run equilibrium.

1. 2.   STATEMENT OF RESEARCH PROBLEM

Nigeria presents a good case of one of the emerging stock market in Africa. Despite the surge by firms and investors in the market within 2006-2008, it is quite overwhelming to note that there has not been much empirical work on the impact of inflation on the stock market performance indicators.

Empirical study on America by Boudoukh and Richardson [1993], demonstrated a negative relationship between inflation and stock returns on the short run, but in the long-horizon, the relationship tended to be positive. In contrast to this finding, an earlier study by   Bottazzil and corradi [1991], when investigating the variability of the risk premium in the stock market over the period 1978-1989, found that the acceleration of inflation rate is negatively related to stock prices.

Asprem [1989], in his study explored the relationship between macroeconomic variables, and stock prices and asset portfolios in European countries. He found a negative relationship between inflation and stock prices. But Najand and Rahman [1991] argued that the volatility of inflation increases the volatility of stock prices.

It is important to note that these empirical studies have concentrated mainly on stock prices and returns as indicators of stock market performance variables. It can be argued that the changes in the rates of inflation can also affect other aspects of stock market performance indicators, such as: value of shares, market turnover, volume of trade, and market capitalization. This neglect has constituted a research gap, which this work intends to bridge.

1.3 OBJECTIVES OF THE STUDY

The  objectives  of  the  study  are  to  evaluate  empirically  the  long-run  relationship  between inflation and stock market performance indicators using data from Nigeria. Accordingly the study set out the following objectives:

1.   To determine the long-run impact of inflation on the values of shares.

2.    To determine the long-run impact of inflation on market turnover.

3.     To determine the long-run impact of inflation the volume of trade.

4.     To determine the long-run impact of inflation on the market capitalization.

1.4   RESEARCH QUESTIONS

This study will be tailored in such a way that it will answer the following questions:

1.   What is the long-run relationship between inflation and value of stock traded in the

Nigerian stock market.

2.   What is the long-run relationship between inflation and market turnover in the Nigerian stock market.

3.   What is the long-run relationship between inflation and the volume of trade in the

Nigerian stock market.

4.   What  is the long-run relationship  between  inflation  and  market  capitalization in  the

Nigerian stock market.

1.5       RESEARCH HYPOTHESES

To achieve the above objectives, the following hypotheses were formulated for this research study:

HYPOTHESIS 1

Ho1. There is a significant negative long-run relationship between inflation and value of shares traded in the stock market.

HYPOTHESIS 11

Ho2      There is a significant negative long-run relationship between inflation and  market turnover.

HYPOTHESIS 111

Ho3     There is a significant negative long-run relationship between inflation and the volume of trade.

HYPOTHESIS 1V

Ho 4. There is a significant negative long-run relationship between inflation and market capitalization.

1.6     SIGNIFICANCE OF THE STUDY

The relationship between inflation and stock market performance has been studied in different developed countries like United Kingdom and United State of America. This study will fill the research gap in Nigeria and will lend support, to financial intermediation literature. This study will have immense benefit to the following:

A.        The Government

The outcome of this study is expected to benefit policy makers, such as government and her agencies, in understanding the relationship between inflation and stock market performance indicators. This will help in formulation of policies, on how to promote stock market through achievement of stable rate of inflation.

B.         Stock Market Regulators

This study will be of immense benefit to the Security and Exchange  Commission and the Nigerian Stock Exchange. Understanding the relationship between inflation and the stock market performance indicators will help in designing appropriate policies to guide operations in the market.

C           The Body of Academic

This study will serve as a spring -board for further researches in this area of study with regards to

Nigeria as one of the emerging markets in Africa.

1.7     SCOPE OF THE STUDY

The scope of this study is on the relationship between inflation and stock market performance indicators (value of shares, market turnover, volume of trade and market capitalization). This study will focus frontally on Nigeria and will use annual data on rates of inflation and stock market performance indicators.

The stock market data are reported by regulatory agencies like Central Bank of Nigeria (CBN), the Nigerian Stock Exchange and Securities and Exchange Commission. Based on this, the determinants of stock market performance variables and rates of inflation on annual basis for the period  1986-2006  will  be  collated  from  CBN  Statistical  Bulletin  and  the  Nigerian  Stock Exchange Annual Reports and Statements of Account. Note that, the upper limit 2006 was allowed for this work in 2013, because the research started in 2007 and the proposal of the work was done in 2009.

1.8    LIMITATIONS OF THE STUDY

This work was limited by many factors, amongst which are:

1.   Financial constraint.

2.   Difficulty in acquisition of required materials.

1.9   Operational Definition of Terms

Deflation: This is a decline in the general level of prices of prices in the economy.

Market capitalization: This is the total value of stock at the stock exchange during a particular period at the end of a trading date. It is expressed in monetary terms.

Market turnover: This refers to the quantity of shares sold in the stock market at any given period. It is expressed in monetary terms.

Performance Indicators: Refers to variables that show the result of how effective or ineffective the stock market works in a particular period.

Seigniorage: The profit that results from the difference in the cost of printing money and the surface value of that money.

Stock Market:  Refers to where stocks and shares of corporate entities are traded.

Values of shares: This is the cumulative amount of the offer prices, of individual shares multiplied by the number of shares offered for the period concerned. It is expressed in monetary terms Volume of trade: Refers to the amount of trade transacted in the stock market in a particular period. It could be daily, weekly, monthly or yearly. It is expressed in monetary terms.

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