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JES
30,1

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Macroeconomic variables and

the Malaysian equity market
A view through rolling subsamples
Mansor H. Ibrahim and Hassanuddeen Aziz
Kulliyyah of Economics and Management Sciences, International Islamic
University Malaysia, Kuala Lumpur, Malaysia
Keywords Stock prices, Macroeconomics, Variable costs, Malaysia
Abstract Analyzes dynamic linkages between stock prices and four macroeconomic variables for
the case of Malaysia using standard and well-accepted methods of cointegration and vector
autoregression. Empirical results suggest the presence of a long-run relationship between these
variables and the stock prices and substantial short-run interactions among them. In particular,
documents positive short-run and long-run relationships between the stock prices and two
macroeconomic variables. The exchange rate, however, is negatively associated with the stock
prices. For the money supply, documents immediate positive liquidity effects and negative long-run
effects of money supply expansion on the stock prices. Also notes the predictive role of the stock
prices for the macroeconomic variables. However, there seems to be irregularity in the data when
observations from the recent crisis are included. Finally, documents the disappearance of the
immediate positive liquidity effects of the money supply shocks and unstable interactions between
the stock prices and the exchange rate over time.

Introduction
Finance literature contains considerable number of studies that examine stock
price behavior. Perhaps, one important subject that has received increasing
attention from economists, financial investors and policy makers is on dynamic
linkages between macroeconomic variables and stock returns. Based on the
stock valuation model, macroeconomic forces may have systematic influences
on stock prices via their influences on expected discounted future cash flows.
Alternatively, the relations between them may be motivated using the
arbitrage pricing theory (APT) model developed by Ross (1976). Moreover, the
standard aggregate demand and aggregate supply (AD/AS) framework also
allows for the roles of equity markets especially in the specification of money
demand (Friedman, 1988) and in monetary transmission mechanisms (Mishkin,
1998). These models provide a basis for the long-run relationship and short-run
dynamic interactions among macroeconomic variables and stock prices. The
main emphases have generally been on asset pricing, return predictability,
stock market efficiency and equity price channel of monetary transmission
mechanisms.
Journal of Economic Studies
Vol. 30 No. 1, 2003
pp. 6-27
q MCB UP Limited
0144-3585
DOI 10.1108/01443580310455241

The authors would like to thank two anonymous referees for helpful comments on the paper. All
remaining omissions and errors, however, are the authors responsibility. The authors would
also like to acknowledge the financial support from the Research Center, International Islamic
University under the short-term research grant.

While a predominant number of empirical studies focus on industrialized Malaysian equity

economies, some recent studies have extended the analysis to the cases of
market
developing economies. An illustrative list of studies for developed economies
includes Fama (1981, 1990); Chen et al. (1986); Hamao (1988); Asprem (1989);
Chen (1991); Thornton (1993); Kaneko and Lee (1995); Cheung and Ng (1998);
Darrat and Dickens (1999). These studies identify such factors as industrial
7
production, risk premiums, slope of the yield curve, inflation, interest rate,
money supply and so forth as being important in explaining stock returns. The
few notable studies for developing economies include Mookerjee and Yu (1997)
and Maysami and Koh (2000) for Singapore, Kwon et al. (1997) and Kwon and
Shin (1999) for South Korea, and Habibullah and Baharumshah (1996) and
Ibrahim (1999) for Malaysia. Using bivariate cointegration and causality tests,
Mookerjee and Yu (1997) note significant interactions between M2 money
supply and foreign exchange reserves and stock prices for the case of
Singapore. However, Maysami and Koh (2000) document significant
contribution of interest rate and exchange rate in the long-run relationship
between Singapores stock prices and various macroeconomic variables.
Evaluating the Korean equity market, Kwon et al. (1997) provide evidence for
the exchange rate, dividend yield, oil price and money supply as being
significant macroeconomic factors. In a similar vein, Kwon and Shin (1999)
establish a long-run relationship between stock prices and four macroeconomic
variables industrial production index, exchange rate, trade balance and
money supply for Korea.
In the Malaysian context, the studies by Habibullah and Baharumshah
(1996) and Ibrahim (1999) are notable. Habibullah and Baharumshah (1996)
employ cointegration analyses to evaluate the informational efficiency of the
Malaysian stock market index and sectoral indices using monthly data from
January 1978 to September 1992. Considering real output and money supply
(M1 and M2) in the cointegrating relation, they find no evidence for
cointegration between them. Accordingly, they conclude that the Malaysian
stock market is informationally efficient in the long run. However, using a
wider range of macroeconomic variables and longer data sample, Ibrahim
(1999) concludes to the contrary. Specifically, the bivariate analysis suggests
cointegration between the Malaysian stock prices and three macroeconomic
variables the price level, credit aggregates and official reserves. Moreover,
the results from bivariate error correction models suggest that the stock prices
react to deviations from the cointegrating relationship. The multivariate
cointegration and causality analyses further suggest the significant role of the
exchange rates in influencing short-run movements of the market prices.
The purpose of the present paper is to contribute further to the literature on
stock market macroeconomic variable linkages for developing economies
and, specifically, for the case of Malaysia. The specific issues that we attempt
to address are stock return predictability or efficiency, monetary transmission

JES
30,1

mechanism via stock price channel and temporal stability of their interactions.
To this end, the analysis contains the following features. First, we analyze the
issue in a multivariate setting. The variables included are stock prices, industrial
production as a measure of real activity, money supply, consumer price index
and bilateral exchange rate vis-a`-vis the US dollar. Habibullah and Baharumshah
(1996) consider only real output and money supply in their analysis of the
informational efficiency of the Malaysian equity market. Moreover, Ibrahim
(1999) has a focus mainly on bivariate interactions. Our analysis, thus, may
further enrich our understanding of the Malaysian stock market behavior and its
interactions with various relevant macroeconomic variables.
Second, we employ standard procedures of cointegration and vector
autoregressions (VARs). In the analysis, we go beyond existing analyses on the
issue that end at reporting cointegration results and/or causality tests from
final models by evaluating variance decompositions and impulse response
functions. The procedures capture both direct and indirect effects of
innovations in variables of interest on other variables. The variance
decompositions indicate the percentage of a variables forecast error variance
attributable to innovations in all variables considered. From these, we may
evaluate the percentage of equity returns forecast error variance attributable to
macroeconomic shocks and vice versa. In addition, the impulse-response
functions capture the direction of response of a variable to a one standard
deviation shock in another variable. Accordingly, the dynamics that exist
among these variables may be fully addressed.
Finally, in addition to the whole sample that spans about 22 years, we also
apply rolling regression technique normally used in the money-income link
literature (see, for instance, Thoma, 1994; Swanson, 1998) to evaluate the
changing interactions among the variables. Given the rapid development of the
market, it is generally contended that it becomes more efficient in digesting all
relevant macroeconomic information. Additionally, various works have noted
the increasing integration of national stock markets, especially after the stock
market crash of October 1987 (Lee and Kim, 1993; Arshanapalli and Doukas,
1993; Meric and Meric, 1997). Accordingly, the ways that the market responds
to external factors such as the exchange rate as well as to domestic variables
may have changed over time. We attempt to address this issue by estimating
the interactions over rolling subsamples.
The rest of the paper is structured as follows. We first describe the data and
evaluate their stochastic properties. Then, in the next two sections, we present
estimation results on the interactions among the variables for the whole
samples and rolling sub-samples. Finally, we provide concluding remarks and
some discussion on the findings.
Data and their temporal properties
The analysis considers the interactions between the Malaysian equity market
and four macroeconomic variables including real output, price level, money

supply and exchange rate. The data are monthly for the period from January Malaysian equity
1977 to August 1998. We begin our sample in January 1977 due to the
market
availability of the stock price index from 1977 onwards. Then, the sample ends
in August 1998 due to capital controls and fixed exchange rate imposed by the
government on 2 September 1998. Note that our sample includes several
observations during the 1997/1998 Asian crisis[1], which started in July 1997.
9
We believe that whether this crisis affects the results would be reflected in the
rolling regressions. The data on macroeconomic variables are obtained from
the IFS-CD ROM while the stock price data are from Lian (1993); Investors
Digest (various issues).
To measure stock prices, we use end-of-the-month values of the Kuala Lumpur
Composite Index (KLCI). The index, which is normally used to reflect the
Malaysian equity market performance, is based on a sample of 100 component
stocks and is value-weighted. Real output is measured by real industrial
production index (IP). We employ the consumer price index (CPI), an oft-quoted
index for computing inflation, as a measure of the aggregate price level.
Meanwhile, the money supply is represented by M2 monetary aggregate (M2).
With the shift in emphasis of the Bank Negara (i.e. Malaysias Central Bank)
towards broader monetary aggregates during the mid-1980s, a broader monetary
aggregate seems to play a more important role in the conduct of monetary policy.
Moreover, the broader monetary aggregate such as M2 that we employ satisfies
both wealth and substitution effects of monetary holdings and, accordingly,
makes it more appropriate for the present analysis[2]. Finally, we use the bilateral
Ringgit exchange rate vis-a`-vis the US dollar as a measure of the exchange rates
(EXC). While we attempt to maximize the time span of the sample, the use of the
bilateral Ringgit-US dollar rate is justified based on its importance to Malaysian
international transactions and economy. Elsewhere, compared to other measures
of exchange rates such as effective exchange rates, Ibrahim (2000) provides
evidence for the relevant role of the Ringgit-US dollar rate.
As a pre-requisite for subsequent analyses, we first evaluate the integration
properties of the variables under consideration. Table I reports the ADF and PP
unit root tests for all the series, where the tests are implemented without and
with a time trend. With the exception of IP, the ADF and PP tests with and
without the time trend for the variables in levels indicate that they are nonstationary. The PP test with the time trend, however, suggests the possibility
that IP is stationary. When first differenced, we find evidence that the variables
are stationary. Namely, the PP tests suggest stationarity in all variables
considered. The ADF tests further substantiate the stationarity of KLCI, IP,
and M2 when expressed in first differences. They, however, indicate the
presence of two unit roots in CPI and EXC. Since the results tend to suggest
non-stationarity in levels of the variables but stationarity in their first
differences, we proceed by contending that the variables belong to the I(1)
process.

JES
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10

Table I.
Integration tests

ADF
Variables
Levels
KLCI
IP
M2
CPI
EXC

No trend
2 2.1246
2 0.2165
2 0.8819
2 0.7824
0.6455

PP
Trend

No trend

Trend

2 2.3359
2 2.4023
2 2.1968
2 2.4388
2 0.8774

2 2.1211
2 0.6557
2 0.7200
2 1.5089
0.9843

22.4363
25.0827*
21.4419
21.6485
20.5743

First differences
KLCI
2 4.1392*
2 4.2467*
2 14.560*
214.608*
IP
2 3.2605**
2 3.1487***
2 28.410*
228.355*
M2
2 2.7967***
2 2.7986
2 15.505*
215.478*
CPI
2 2.2907
2 2.2113
2 13.576*
213.641*
EXC
2 1.7098
2 2.0731
2 14.999*
215.227*
Note: *, ** and *** denote significance at 1 percent, 5 percent and 10 percent respectively

Estimation results: whole sample

Cointegration
Since the five variables are noted to be I(1), there exists the possibility that they
share a long-run equilibrium relationship. To test this, we apply multivariate
cointegration tests of Johansen (1988); Johansen and Juselius (1990) and report
the trace statistics and maximal eigenvalue statistics from these tests at
various lag lengths, namely, 3, 6, 9 and 12 in Table II[3]. As may be noted from
the table, in most cases, the results suggest the presence of cointegration
among the variables. However, when we set the lag length to 6, we find no
evidence of cointegration. These contradicting results for different lag
specifications are not unexpected as the JJ tests are noted to be sensitive to lag
length selection (Hall, 1991). However, in selecting the lag length, the minimum
Null hypothesis
r0
r # 1
r # 2
r # 3
r # 4

Table II.
Johansen-Juselius
cointegration tests

Trace

Max. eigenvalue

Trace

Lags 3
83.845*
48.535*
19.386
9.498
0.953

35.310*
29.149*
9.888
8.545
0.953

Lags 6
64.781
38.279
18.147
7.913
0.150

Max. eigenvalue
26.502
20.132
10.234
7.763
0.150

Lags 9
Lags 12
r0
74.378*
35.947*
81.861*
31.296**
r # 1
40.431
19.316
50.564*
23.759
r # 2
21.115
12.902
26.805
17.637
r # 3
8.213
7.893
9.168
8.420
r # 4
0.320
0.320
0.748
0.748
Note: ** and *** denote significance at 5 percent and 10 percent levels respectively

requirement is that the error terms for all equations in the system must be Malaysian equity
serially uncorrelated. Accordingly, we use Ljung-Box-Pierce Q statistics to test
market
the null hypothesis of serially uncorrelated errors up to lag orders of 24. The
results (not reported here) indicate the absence of autocorrelation when the lag
length is set to 12. Accordingly, our further analysis will be based on the lag
length of 12 for the vector error correction model (VECM) or, equivalently, of 13
11
for VAR representation.
At lag length equals 12, the trace statistics indicate the presence of two
cointegrating vectors. Meanwhile, the maximal eigenvalue statistics indicates a
unique cointegrating vector. In the case of more than one cointegrating vector,
the vector that corresponds to the maximum eigenvalue is the most useful
(Johansen and Juselius, 1990). Moreover, for the long-run relationship to be
meaningful for our analysis, the stock price index needs to contribute
significantly to the long-run relationship. The LR test confirms the importance
of the stock price in the cointegrating relationship. Assuming one cointegrating
vector, the test statistics is 184.6, which is significant at 1 percent level. The
cointegrating vector representing the long-run relationship is (normalized on
the price level):
KLCI 0:2476IP 4:5197CPI
0:3957M 2
1:5787EXC
9:0716:

These estimated long-run coefficients may be interpreted as elasticity measures

since the variables are expressed in natural logarithms.
The long-run relationship between stock prices and industrial production is
positive, similar to results obtained for the USA (Fama, 1990), Japan
(Mukherjee and Naka, 1995), South Korea (Kwon and Shin, 1999), and
Singapore (Maysami and Koh, 2000). The result is expected since, representing
real economic activity, the real industrial production directly influences firms
expected future cash flows. The result we obtained also indicates a positive
relationship between CPI and KLCI in the long run, which is consistent with the
work of Khil and Lee (2000). Examining whether the common stocks can be a
good hedge against inflation for ten Pacific-rim countries, Khil and Lee (2000)
find a negative relationship between stock returns and inflation for all
countries except Malaysia. That is, Malaysia is the only country in the sample
that exhibits a positive association.
Interestingly, we find a negative long-run association between stock prices
and M2 money supply. While Mukherjee and Naka (1995) and Maysami and
Koh (2000) document positive long-run relation for respectively Japan and
Singapore, Kwon and Shin (1999) note a negative relation. Moreover,
examining five industrialized countries (Canada, Germany, Italy, Japan and the
USA), Cheung and Ng (1998) find ambiguous relation between the two
variables. Namely, while the money supply-stock price relation is positive for
Canada, it is negative for Japan and the USA. For Italy and Germany, the
relation is ambiguous since there are more than one cointegrating vector and

JES
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12

their relation depends on which cointegrating vector is used. Theoretically, the

relation between the two variables can be positive or negative. The
expansionary effect of money supply on real economic activity suggests a
positive relation (Mukherjee and Naka, 1995). Changes in money supply may
also be positively related to stock prices through portfolio substitution (Dhakal
et al., 1993; Cheung and Ng, 1998). However, if the increase in money supply
generates inflation as well as contributes to inflation uncertainty, then it might
exert a negative influence on the stock prices. A related point is that the
(unexpected) increase in money supply may generate risk premium, causing
equity prices to fall (Cornell, 1983). Lastly, Bulmash and Trivoli (1991) argue
that the continued increase in money supply may exert a negative effect on the
stock prices due to increasing inflationary pressures and subsequent policy
orientation to contain the pressure. Our negative long-run coefficient seems to
indicate the dominance of these negative channels.
However, a surprising aspect that arises from the forgoing discussion is that
money supply is negatively related to stock prices while consumer prices are
positively related to stock prices. While it is generally noted that monetary
expansion is inflationary for the case of Malaysia and therefore a positive
money supply-stock price relation should be expected, it needs to be noted that
the relation between money supply and stock prices is not only accounted by
inflationary pressures from monetary expansion. Inflation uncertainty and
expectations of future contractions may also accompany changes in money
supply and generate risk premium for holding shares. Moreover, since the
coefficient captures the long-run relation, Bulmash and Trivolis (1991) views
on differential short- and long-run effects of monetary expansion may apply.
In the context of the Malaysian economy, the Malaysian Central Bank has
been highly active in achieving multiple objectives of stable price level, stable
exchange rate, sustainable output growth and low unemployment.
Accordingly, since at times certain objectives take priority, the Central Bank
has to shift policy stance. For example, the contractionary effects of oil price
shocks prompted easy monetary policy in 1973, which was then reversed to
tight monetary policy in 1974 to contain inflationary pressures. Similarly, the
Central Bank shifted to stabilizing the exchange rate in 1986 and allowed the
interest rate to increase despite its expansionary stance in 1985 to cope with the
recession. This active participation may have intended effects in the short run
but generates risk premiums and uncertainty in the long term, prompting a
negative relation between money supply and stock prices.
Finally, we find a negative association between stock returns and the
Ringgit exchange rate, which is in line with the results reported for South
Korea (Kwon and Shin, 1999) and Singapore (Maysami and Koh, 2000). A
common feature of these economies is that they are highly dependent on
international trade, i.e. on exports and imports of capital and intermediate
goods. While currency depreciation encourages exports, it increases costs of

production through increasing domestic prices of imported capital and Malaysian equity
intermediate goods. The latter effect of currency depreciation on real output
market
and accordingly expected cash flows of the firms seems more dominant.
Moreover, the result is also consistent with recent observations during the
Asian crisis that both stock prices and exchange rates substantially decreased
in value.
13
It needs to be reiterated that the above estimated coefficients relate only to
the long run relationship. That is, the estimated coefficients can be viewed as
describing some trend relationship linking the variables concerned. They,
however, do not tell us about short-run dynamics among the variables, the
nature of which may be different from the ones described. Accordingly, we
proceed to evaluate variance decompositions and impulse-response functions
based on the VAR specification to capture the dynamic interactions among the
variables.
Variance decompositions and impulse-response functions
In this section, we specify a dynamic model using VAR framework and
generate variance decompositions and impulse response functions to examine
short-run dynamic interactions among the variables. Generally, there are two
different ways of specifying a VAR when the time series under study are
cointegrated an unrestricted VAR in levels or a VECM. Which specification
is more appropriate remains debatable. While the VECM conveniently
combines the long-run behavior of the variables and their short-run relations
and thus can better reflect the relationship among the variables, there is no
guarantee that imposing restriction of cointegration can be a reliable basis for
making structural inferences (Faust and Leeper, 1997). Moreover, current
finding is still unclear on whether the VECM outperforms the unrestricted VAR
at all forecasting horizons. Naka and Tufte (1997) found that the two methods
have comparable performance at short horizons. The support for the use of the
unrestricted VAR can also be found in Clements and Hendry (1995), Engle and
Yoo (1987) and Hoffman and Rasche (1996). Accordingly, with low
computational burden required by the VAR in levels, we implement the
VAR using the variables in levels.
Compactly, the VAR model can be expressed as follows:
ALzt ut

where A(L) is a matrix of polynomials in the lag operators and z is a vector

consisting of the five variables considered. Orthogonalized innovations in each
of the variables and the dynamic responses to such innovations are identified
from the Cholesky decomposition of the variance-covariance matrix. For our
analysis, the variables making up z are entered in the following order: z (IP,
CPI, M2, EXC, KLCI). This ordering is consistent with various works that order
the variables representing the goods market (IP and CPI) first and the variables

JES
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14

from the asset markets (EXC and KLCI) last (Koray and McMillin, 1999; Park
and Ratti, 2000). This means that the good markets are affected with lags by
the variables higher in the ordering. However, they contemporaneously
influence the monetary variable (M2) and asset price variables. Similarly, from
the ordering, monetary innovations affect asset prices contemporaneously and
are affected by asset price innovations with lags. We set the lag length of the
above VAR to 13, since we verified that the equations in the VECM are serially
uncorrelated at 12 lags.
Table III provides variance decompositions while Figure 1 plots impulse
response functions generated from the VAR. From Table III, while much of
the variations in KLCI can be attributed to its own variations, we may note
an important role of macroeconomic variables in forecasting variance of
stock prices. These results seem to be in line with those found for Korea
(Kwon and Shin, 1999). Using Granger causality tests, Kwon and Shin
(1999) found the significance of such variables as industrial production,
money supply, exchange rate and trade balance in explaining changes in
stock prices. Similarly, Nasseh and Strauss (2000) note substantial fraction
of stock price variance explained by real economic activity for six OECD
countries. However, while Nasseh and Strauss (2000) documented minor
role for nominal factors, our results seem to indicate dominant roles of
monetary variables such as money supply, price level and exchange rate in
explaining variations in stock prices. In particular, after a period of 24

VDs

Periods

KLCI

IP

Innovations in
M2

CPI

EXC

KLCI

1
6
12
24
1
6
12
24
1
6
12
24
1
6
12
24
1
6
12
24

92.62
76.16
58.85
48.48
0.00
2.30
5.24
8.26
0.00
0.32
1.15
6.25
0.00
7.90
6.47
13.13
0.00
1.22
4.58
9.53

0.66
0.20
3.89
6.64
100.00
82.63
66.62
64.41
0.03
1.25
7.45
14.63
3.41
1.76
2.06
2.28
0.22
0.69
2.65
3.24

2.77
8.26
22.33
26.57
0.00
7.72
7.48
9.16
99.97
95.70
67.52
33.69
0.00
10.87
13.60
21.55
0.53
1.49
8.23
12.88

3.78
7.73
8.23
9.47
0.00
2.91
3.74
3.19
0.00
1.51
5.87
6.69
96.59
73.75
61.36
45.67
0.003
0.16
0.34
1.57

0.17
7.64
6.69
8.85
0.00
4.44
16.91
14.97
0.00
1.21
18.00
38.74
0.00
5.73
16.51
17.37
99.25
96.43
84.21
72.79

IP

M2

CPI

EXC
Table III.
Variance
decompositions

Malaysian equity
market

15

Figure 1.
Impulse-response
functions

JES
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16

Figure 1.

months, innovations in M2 account for more than a quarter of the variation Malaysian equity
in KLCI. Note also that IP shocks appear to have delayed effects on the
market
stock prices, i.e. after 21 months.
Substantiating the evidence from the variance decompositions, the stock
prices respond to innovations in the macroeconomic variables (Figure 1).
Interestingly, a one standard deviation shock in the money supply results in
17
positive equity price response, which peaks around seven to eight months after
the shock and then subsides gradually afterward. Coupled with the negative
long-run coefficient estimated earlier, the results seem consistent with the
argument made by Bulmash and Trivoli (1991) that the money supply has
immediate positive liquidity effects and possible long-run negative effects. Note
again that, in line with variance decomposition results, there seems to be
positive lagged responses of the stock prices to the industrial production
innovations. Gjerde and Sttem (1999) also document similar lagged responses
of the stock prices to real activity in a small open, but developed, market of
Norway. Finally, the stock prices respond negatively to Ringgit depreciation
shocks. This may stem from the fact that the Malaysian economy is highly
dependent on the imported capitals. Moreover, the depreciation shocks may
generate risk in the market that reverses the inflows of portfolio investments,
as observed during the recent crisis.
Our results also seem consistent with the contention that stock prices contain
information on future variations in macroeconomic variables. From Figure 1, we
may note that money supply seems to be accommodative to the stock price
shocks, responding positively over the entire horizons. The stock price
innovations also have a total positive influence on the price level, which seems
to be in line with the accommodative nature of the monetary policy. However,
they result in negative responses from the exchange rates. Accordingly, the
pattern of the stock prices exchange rates interactions seems to be
destabilizing in the sense that once shocks in one variable take place, the other
variable responds such that the shock variable reacts and amplifies itself. For
instance, depreciation shocks decrease the stock prices, which result in further
depreciation. For the case of the industrial production, its responses to the stock
prices are first negative and then turn positive after five months.
Apart from these stock prices-macroeconomic interactions, the substantial
role of the exchange rate to the Malaysian economy deserves highlighting,
which is consistent with Malaysia being open and highly dependent on
international trade, in accounting for variations in other macroeconomic
variables. We may note particularly that M2 seems to respond more to EXC
shocks than to IP and CPI shocks. From the impulse-response functions, we
note that money supply has a negative response to depreciation shocks. Thus,
money supply seems to be contractionary to contain the decreasing value in the
Ringgit and expansionary in the face of currency appreciation, suggesting the
monetary policy process stabilizes the exchange rate. According to Siregar
(1999), the policy to stabilize the exchange rate to keep the rate competitive is

JES
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normally inflationary. As we may note, we indeed document the inflationary

effects of currency depreciation in our case. Currency depreciation is also found
to be contractionary. However, its effect lasts only for about 18 months, where
it peaks at 12-month horizons and reduces to zero afterward.

18

Rolling regression results

In this section, we implement rolling regressions of the VAR model to gain
further insights on the dynamic linkages among the stock prices and the
macroeconomic variables. The rolling regression technique is generally applied
in the money-income link literature to evaluate possible diminishing predictive
role of monetary aggregates and is recently used by Park and Ratti (2000) for
the stock market macroeconomic variable linkages. We follow a similar
empirical approach for our case. Over the past years, Malaysia has witnessed
rapid developments in its financial scene characterized by liberalization of
interest rates, financial innovations, removal of trade barriers and rapid growth
of equity market. This has made the Malaysian equity market more integrated
to the international financial markets[4]. Accordingly, it is interesting to see
whether there is an evolving pattern in dynamic interactions among stock
prices and macroeconomic variables under Malaysian changing financial
environments. Moreover, as our sample includes some observations from the
recent 1997/1998 Asian crisis[5], the results that we obtained previously may
be the artifacts of the crisis. By using the rolling regression method, we may
possibly discern the influences of the recent crisis on the interactions.
In running the rolling regressions, we need to set the size of the rolling
window. To the best of our knowledge, there is no statistical method to set the
optimal window size. In existing works, the choice of the window size seems
arbitrary. With the luxury of more than 42 years of data, Park and Ratti (2000)
employ 20-year window size (i.e. 240 observations). In our case, we have only
about 22 years of observations. From the related literature that we have
reviewed in the introduction, the shortest sample that is used is about eight
years (Maysami and Koh, 2000). Accordingly, we settle with 13-year
observations (i.e. 156 observations) as our effective window size (after the
adjustment of lags) to exclude first the period of rapid stock market
developments of the 1990s (exclusive of the 1990 observations). In what
follows, we focus only on the interactions between the Malaysian market on
one end and the macroeconomic variables on the other end.
Our first rolling sample spans from January 1977 to December 1990. Then, we
add one observation at a time and drop an initial observation such that the
window size remains fixed. From these regressions, we obtain impulse-responses
functions for three-month, six-month, 12-month and 24-month horizons.
Figures 2-5 plot the rolling responses of KLCI to innovations in the four
macroeconomic variables IP, M2, CPI and EXC. Meanwhile, Figures 6-9
represent the responses of the four macroeconomic variables to innovations in
KLCI.

Malaysian equity
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19

Figure 2.
Impulse responses of the
KLCI to IP shocks
rolling regression

Figure 3.
Impulse responses of the
KLCI to M2 shocks
rolling regression

A noted feature from these plots is the irregularity in the responses among the
variables once observations from the recent financial crisis are included in the
samples. Indeed, for the case of the KLCI-EXC interactions, the responses of
KLCI to EXC innovations and vice versa are both erratic and substantial. Since
the inclusion of these observations seems to mask their dynamic interactions
for early years, we report only the results up to June 1997 for the two cases, i.e.
Figure 5 and Figure 9. Note that, excluding the observations from the recent

JES
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20

Figure 4.
Impulse responses of the
KLCI to CPI shocks
rolling regression

Figure 5.
Impulse responses of the
KLCI to EXC shocks
rolling regression

crisis, the interactions between stock prices and macroeconomic variables seem
generally to be in line with those from the whole sample. In other words, in the
case of long data set, the effects of including the crisis (which is a part of the
whole sample) may have not influenced the general conclusion of the
estimation. However, due to irregularity that the crisis generates, it should be
omitted from any empirical analysis that requires the understanding of the
data regularity especially for the case of small sample sizes.

Malaysian equity
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21

Figure 6.
Impulse responses of the
IP to KCLI shocks
rolling regression

Figure 7.
Impulse responses of the
M2 to KCLI shocks
rolling regression

In the case of KLCI-IP dynamic interactions, the results for all rolling subsamples concur well with the estimation using the whole sample. Namely, they
suggest lagged responses of KLCI to IP shocks and, similarly, lagged responses
of IP to KLCI shocks. Likewise, conforming to the results from the whole
sample, KLCI-CPI dynamic responses to each others innovations, plotted in
Figure 4 and Figure 8, exhibit a consistent pattern over all rolling samples
except the samples that include the recent crisis. In line with existing works for
Malaysia and our earlier results, there seems to be a positive association
between the stock market movement and CPI.

JES
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22

Figure 8.
Impulse responses of the
CPI to KCLI shocks
rolling regression

Figure 9.
Impulse responses of the
EXC to KCLI shocks
rolling regression

One interesting pattern that emerges from these rolling regressions is that the
responses to money supply shocks by KLCI seem to shift over the rolling
samples, as indicated by Figure 3. As in the whole sample, we observe positive
responses of the stock prices to money shocks at horizons from three to 12
months. The responses seem to be higher at three- and six-month horizons.
However, these positive responses seem to diminish as we move the window
toward the recent observations. Again, including the samples from the recent
crisis, the responses become erratic with negative responses at the short

horizon and positive at longer horizons. As may be noted from the Malaysian equity
figure, the 24-horizon responses of KLCI seem to shift substantially over the
market
rolling samples. First, KLCI exhibits positive responses and then negative
responses for the samples that end around late 1992 and 1993. Interestingly, the
Malaysian economy witnessed a drastic increase of the portfolio investment
inflows in 1993. Then, KLCI responses turn positive and reduce gradually
23
afterwards. For the samples that end around the crisis years, the 24-month
period responses turn erratic again. These results, we believe, can be taken as
construing the positive liquidity effects of money supply in the short run but
the uncertain and negative effects in the intermediate or long run, as explained
earlier. Again, from these rolling sub-samples, we note the accommodative
nature of money to stock price innovations (Figure 7).
Finally, there seems to be fluctuations in the responses to EXC innovations
by the stock market. In some samples, the responses are positive. Meanwhile, in
other samples, the responses are positive. Moreover, the direction of responses
for a given horizon keeps changing over the rolling samples. Take six-month
horizon as an example, the responses are first positive, then negative. Next,
they turn negative and again positive. Only at 12-month horizon, the responses
seem to be consistently positive. The instability of the KLCI responses to the
exchange rate shocks may suggest the danger of the shocks to the Malaysian
equity market performance. From Figure 7, while EXC appreciates at threemonth horizon, it depreciates at 12-month horizon. However, its responses to
the stock market shocks seem to be zero at six- and 24-month horizons. This
pattern of responses seems to suggest overshooting in the EXC.
Discussion and conclusions
This study examines causal relations and dynamic linkages between the
Malaysian stock market and four macroeconomic variables, namely, the
industrial production, the money supply, the price level and the bilateral
exchange rate vis-a`-vis the US dollar. The analysis relies on standard and wellaccepted techniques of cointegration and VARs to uncover the long-run
relationship and short-run interactions among the variables using the data that
span for about 22 years. From the VAR, we compute variance decompositions
and simulate impulse response functions to trace the strength of the Grangercausal links among them and the responses of a variable to innovations in other
variables. We also investigate the possible changing patterns in the
interactions by simulating impulse-response functions based on rolling
regressions with a fixed window size of 13 years.
Empirical results we obtained bear various implications on the issues of
equity market efficiency, monetary transmission mechanism, and temporal
stability of dynamic linkages between macroeconomic variables and stock
prices. The presence of cointegration between stock prices and macroeconomic
variables indicate long-run predictability of the Malaysian equity prices. In

JES
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24

other words, at least in the long run, movements in the Malaysian equity
market are tied to its economic fundamentals. Moreover, the dynamic
responses of the stock prices to changes in macroeconomic variables especially
its lagged responses to real economic activity spell inefficiency in the
Malaysian equity market. With the exception of its diminishing responses to
money supply, the inefficiency of the market seems to persist over time.
Accordingly, investors may gain by exploiting information contained in
macroeconomic variables for investment decisions.
Given that shocks in stock prices anticipate future variations in output and
price level, the stock prices may be used as an indicator variable for the conduct
of stabilization policies. However, our results raise caution or, to some extent,
question on the implementation of monetary policies for the stability of the
financial market. Although the role of money supply in the dynamic behavior
of equity prices seems to decline over time, at times, its relation to equity prices
is uncertain and in the long run is negative. This means that shocks in money
supply may feed into the economy inflation instability, expectations of
contractions and risk elements and, accordingly, result in adverse or uncertain
behavior of the stock market. The dominant role of nominal variables in
influencing stock price behavior makes this point more relevant since
disturbances in money supply can create nominal disturbances. Moreover,
while the Central Bank has stated multiple objectives for monetary policy, it
seems that it has an overriding concern on stabilizing the exchange rate. If this
is the case, an additional channel for possible instability in the financial market
may exist, which stems from instability in the exchange rate stock market
dynamic interactions. Accordingly, to the extent that policymakers can control
the stock of money supply, they have to be well cautious of possible
destabilizing effects of monetary shocks on the financial market. Given that
stock price movements are tied to other macroeconomic variables, monetary
disturbances can generate real disturbances.
Finally, from the rolling regressions, it is worth mentioning that the Asian
crisis seems to create irregularity in the interactions between stock prices and
macroeconomic variables. Excluding the crisis years, we note consistent
patterns of interactions among the stock prices and the macroeconomic
variables, which conform to the findings for the whole sample. Accordingly, we
doubt that the Asian crisis has changed the pattern of dynamic interactions
among the variables. In other words, the crisis may have only created
temporary irregularity in the variables interactions. To state this conclusively,
however, is premature since more data are needed for the purpose, a potential
avenue for future research.
Notes
1. The 1997/1998 Asian crisis began with devaluation of the Thai baht on 2 July 1997, which
subsequently affected exchange rates, stock prices and economic activities of many
countries in the East Asian and Southeast Asian regions. In the context of the Malaysian

2.

3.
4.

5.

economy, both currency value and the Kuala Lumpur Composite Index plunged drastically.
As a result, in 1998, Malaysian GDP recorded a negative growth of more than 7 percent.
The broadest monetary aggregate for Malaysia is M3. However, monthly data on M3 are
available only from 1986 onwards. Since the analysis requires sufficiently long span of data
sample for us to be able to evaluate changing relations among variables, we use M2 for our
purpose.
These tests are now well known and, accordingly, are not explained here. Interested readers
may refer to Johansen (1988), Johansen and Juselius (1990) or Enders (1995) for detail.
Ibrahim (2001) provides some background information on financial developments in
Malaysia. In the context of the Malaysian equity market, various studies have noted its
increasing integration to major international market particularly the US. Arshanapalli et al.
(1995), in particular, note that the cointegrating structure that ties the Asian stock markets
(including Malaysia) and the US has increased especially after the October 1987.
Additionally, Groenewold and Ariff (1998) attribute the greater predictability of the Asia
Pacific equity markets (including again Malaysia) to the greater integration of international
capital markets.
Henceforth, we refer to the Asian crisis that started with the devaluation of the Thai baht as
simply the recent financial crisis.

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