Free Press Journal

Impact of Macroeconomic indicators on India capital markets

Vinod Nair

Analysis of past data suggests that macroeconomic variables and the stock market index are related and, hence, a long-run equilibrium relationship exists between them. Stock prices positively relate to the money supply and industrial production but negatively relate to inflation.

Are stock prices influenced by macroeconomic indicators in an economy? This is an issue of interest both to the academics as well as the practitioners all over the world. This is what researchers refer to as the macroeconomic approach. It is a method of using factor analysis technique to determine the factors affecting asset returns.

Many scholars have used macroeconomic factors to explain stock return and found that changes in some macroeconomic variables are associated with risk premium. They interpreted the observations to be a reflection of the finding that changes in the rate of inflation are fully reflected in interest rates. The focus of the macroeconomic approach is to examine how sensitive are stock prices to changes in macroeconomic variables. This approach maintains that the performance of stock is influenced by changes in factors like money supply, interest rate, inflation rate, exchange rate, international crude oil prices, external debt, and external reserve.

Several attempts have been made to identify or study the factors that affect stock prices. Some researchers have also tried to determine the correlation between selected factors (internal and external, market and non-market factors, economic and non-economic factors) and stock prices. The outcomes of the studies vary depending on the scope of the study, the assets and factors examined. The Capital Asset Pricing Model (CAPM) assumes that asset price depends only on market factor. Hence, it is tagged a one factor model.

On the other hand the Arbitrage Pricing Technique/Model (APT) which could be taken as a protest of CAPM believes that the asset price is influenced by both the market and non-market factors such as foreign exchange, inflation and unemployment rates.

Let us examine the relationships between the Indian stock market index (BSE Sensex) and some key macroeconomic variables.

Analysis of past data analysis that macroeconomic variables and the stock market index are co-integrated and, hence, a long-run equilibrium relationship exists between them. It is observed that the stock prices positively relate to the money supply and industrial production but negatively relate to inflation. The exchange rate and the short-term interest rate are found to be insignificant in determining stock prices.

Industrial Production

Index of Industrial Production (IIP) denotes the total production activity that happens in the country during a particular period as compared to a reference period. It helps us to understand the general level of industrial activity in the economy. The products included for calculation of IIP can be segregated into 3 major sectors – Manufacturing (79.36%), Mining & Quarrying (10.47%) and Electricity (10.17%). Another way of categorising the items used in the calculation of IIP is a ‘Use based classification’ with categories like basic goods, capital goods, intermediate goods, consumer durable and non-consumer durable. Now, that we know what IIP is, why is it so important?

The chart given above shows the movement of SENSEX and IIP over a four year period. It is quite evident that the IIP and Sensex movement is closely related. The IIP data is not as volatile as the Sensex but even a 2-3% change in IIP can lead to a lot of swing in stock market movement. There are many other factors that impact the stock market, but IIP gives a very good indication of where it is headed. Consider for example the period from January 2010 to April 2010. The rise in IIP during this period has been reflected in the upward movement, which saw Sensex touching 20,000 in September that year. Thus, IIP can drive the stock market up or down.

Gross Domestic Product

This is perhaps the most important indicator since it shows the economic progress made by the country. Higher the GDP growth, higher would be the capital inflow into the stock markets. The year 2007, saw FII investing huge money into the Indian markets since the GDP growth was 9.2% while the 2008 saw huge outflow since the GDP was only 6.3% even though it was far better then the world, which grew only at 1% in 2008 during the global financial crisis.

Inflation: Two edged sword

Higher Inflation results into the higher interest rates in the economy, which makes the economy less attractive. This results that FII sells the shares since the cost of debt goes up ad the corporate profitability will also come down. The stock market takes the higher inflation and higher interest rates as negative indicator and market goes down. Until recently the RBI has increased the repo rate from 3.25% to 8.25%, which had increased the cost of funds from the corporate viewpoint. This has made the economy unattractive and stock markets displayed a negative outlook.

Fiscal Deficit

Higher fiscal deficit is also viewed as negative data from the capital market perspective and the FII generally withdraw money from the stock markets. Higher the fiscal deficit, greater will be the negative impact on the stock markets.

Foreign Institutional Investor Inflows

In the recent past, investments made in the Indian equity market have seen a huge surge. Predominantly, foreign investments in India are rising. Among the investments from foreign nations, FIIs plays a vital role in the Indian equity market as they are the main source of foreign investments in India.

Studies of the FII flows to India and their relationship with other economic variables have arrived at the following major conclusions:

  • While the flows are highly correlated with equity returns in India, they are more likely to be the effect than the cause of these returns;
  • The FIIs do not seem to be at an informational disadvantage in India compared to the local investors;
  • The Asian Crisis marked a regime shift in the determinants of FII flows to India with the domestic equity returns becoming the sole driver of these flows since the crisis. Given the thinness of the Indian market and its susceptibility to manipulations, FII flows can aggravate the equity market bubbles, though they do not actually start them.


The function of stock markets in the economy is not only to raise capital but also to channel funds to the most profitable opportunities and to ensure that those funds are well utilised. Research has shown that inflation and foreign remittances are negatively related with stock prices indicating the fact that additional funds flow through inflation and foreign remittances increase the supply side through additional funds flow in the stock market while demand side remains unaffected.

Static condition in the demand side in the security market puts downward pressure in the stock price. On the other hand positive relationship is found between stock price and the remaining independent variables i.e. industrial production index, market price/earnings and monthly average growth rate of market capitalisation. In general sense, growth of industrial productive activity, market p/e and growth of market capitalisation all bear positive and favorable information content which induce the demand side and ultimately gives positive pressure in stock price.

The author is Head-Academics & Product Development, BSE Institute Ltd.