Time Series Analysis of the Impact of Real Interest Rates on Stock Market Activity and Liquidity in Egypt: Co-Integration and Error Correction Model Approach

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ABSTRACT

Since 1991 Egypt has witnessed major and radical changes in its economic climate as a result of the government's adoption of a program of economic reform aimed at increasing the growth rate of the economy. Arguably, this objective can be assisted through creating a strong stock market. This paper focuses on examining the impact of real interest rates as a key factor in the program on the performance of the Egyptian stock market, both in terms of market activity and liquidity. By applying Engle and Granger's two-stage procedure, results from co-integration analysis through error correction mechanisms (ECM) indicate significant long-run and short-run relationships between the variables, implying that real interest rates have an impact upon stock market performance.

JEL: C12, C22, E44, G10, 023

Keywords: Real interest rates; Stock market; Egypt; Co-integration; Error correction mechanism

I. INTRODUCTION

Numerous scholars have performed extensive empirical investigation of the impact of several macro-economic variables on the stock market performance, concentrating on investors' perspectives by looking at stock prices and returns. However, little attention has been paid to real interest rates, which might be considered an important factor. Yet, there are other important issues concerning the extent to which real interest rates may affect the smooth functioning of stock markets, in terms of the extent of trading, capital issues and the dominance of major companies. Such issues require investigation. It can be argued that for emerging markets these examples can be especially critical in terms of success in economic reform. An emerging stock market can indeed be seen as an important vehicle in a country's strategy to facilitate the flow of investment into the business sector in order to accelerate economic growth and reduce external debt (Ploeg, 1996).

As an example, Egypt has been particularly successful in its program of economic reform and is chosen here as the focus of this study as to the impact of real interest rates upon these functional aspects of stock market performance.

With regard to real interest rates as an important variable, it has been argued that it has a positive relationship with economic growth (Pill, 1997) (1). In fact, this means that an economic reform program, in terms of financial liberalization, permits real interest rates to rise to modestly positive, equilibrium levels. Through a variety of mechanisms, higher real interest rates prompt financial activities, and in turn economic development and growth (see, Landi and Saracoglu, 1983; Gelb, 1989; and Pill, 1997).

As mentioned previously, many studies (Mukherjee and Naka, 1995; Masih and Masih, 1996; Kwon, Shin, and Bacon, 1997; Cheung and Ng, 1998; and Nasseh and Strauss, 2000) examine the impact of several macroeconomic variables (including nominal interest rates and inflation) on stock markets in both developed and emerging economies. Most studies find that these macroeconomic variables have significant influence on the stock market and/or the existence of a long-run relationship between these macroeconomic variables and stock prices/returns. Additionally, the work of Omran and Pointon (2001) investigates the impact of the inflation rate on the performance of the Egyptian stock market and concludes that there is a long-run relationship between inflation rate and stock market performance. On the other hand, real interest rates seem to be a neglected variable in the literature. Among the very few studies, Spiro (1990) examines the relationship between real interest rates and stock market performance in developed economies and documents a negative relationship between real interest rates and stock prices. The argument is that people may prefer to invest in banks rather than stock markets when real interest rates go up; hence, higher real interest rates may affect stock markets negatively. …