Academic journal article IUP Journal of Applied Economics

Do Stock Returns in India Follow a Random Walk?

Academic journal article IUP Journal of Applied Economics

Do Stock Returns in India Follow a Random Walk?

Article excerpt

The study re-examines the McKinnon-Shaw financial liberalization hypothesis, which posits simply that high real deposit interest rates increase financial savings, which in turn lead to increase in the quantity and quality of domestic investment. More specifically, the study investigates the impact of interest rate deregulation on investment in Ghana and the transmission mechanism through which this could happen. Utilizing cointegration and error correction model techniques with data for the period 1970-2005, the study's findings are as follows. While the study finds a statistically significant and positive relationship between real deposit interest rate and financial savings as well as between bank credit and financial savings, the net effect of a real deposit rate on investment is found to be negative. In other words, holding all other variables constant, a higher real deposit rate which leads to a higher increase in financial savings and then bank credit, is offset by a higher cost of lending, thus making the net effect on investment negative. In this regard, the findings do not seem to provide support for the McKinnon-Shaw financial liberalization hypothesis. Other variables found to be important in explaining investment in Ghana are the financial deepening, macroeconomic volatility that is proxied by inflation differential and the lagged change in GDP, affirming the accelerator model principle. The findings therefore have important policy implications for the on-going financial sector reforms.

(ProQuest: ... denotes formulae omitted.)

Introduction

There has been a paradigm shiftin the choice of factors influencing a country's investment and economic growth. While the emphasis during the 1950s and 1960s was on the nexus between capital accumulation and economic growth to the extent of almost neglecting the financial factors, it is now well acknowledged that an efficient and relatively stable financial system is vital for investment and growth. Prior to the early 1970s, the policy stance of many countries was overwhelmingly in favor of low interest rates because it was believed to facilitate capital accumulation or promote investment spending. Subsequently, many governments in the developing countries generally adopted low interest rate policies, whether for doctrinal or other reasons (Hussain et al., 2002).

McKinnon (1973) and Shaw (1973), however, disputed this idea by arguing that financial repression associated with negative real interest rates often leads to the withdrawal of funds from the banking sector as well as is a saving disincentive. In effect, it reduces the availability of bank credit which lowers investment and growth. The policy recommendation was therefore to liberalize the financial sector. Such liberalization, as suggested by McKinnon and Shaw, includes eliminating undue reserve requirements, interest rate ceilings and mandated credit allocations, while at the same time using appropriate macroeconomic measures to stabilize price levels. The expected outcome is increased savings and investment and a reduction in dispersion in the profitability of investing in different sectors of the economy. According to the McKinnon-Shaw hypothesis (hereinafter referred to as M-S hypothesis), deregulating the financial system raises interest rates, which then encourages more people to demand financial savings. These in turn lead to increase in the quantity and the quality of domestic investments. However, this hypothesis is radically different from the neoclassical and Keynesian positions. Neo-Keynesians argue that financial liberalization is deleterious to investment and growth. They stress the fundamental Keynesian message that it is investment that determines saving, not the other way round; and that high interest rate, by stifling investment, may reduce saving. Furthermore, high interest rates may lead to cost-push inflation via the financing of working capital with borrowed funds. To them what is important is the prospect of profit and an ample and elastic supply of credit to the private sector but not prior saving (Warman and Thirlwall, 1994). …

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