STOCK PRICES AND MONETARY POLICY:

EVIDENCE FROM MALAYSIA CASE

Chin Nyuk Fui

Bachelor of Finance with Honours

2011

UN

IVE

RS

IT

IMALAYSIA

SA

RA

WA

K

U N I M AS

Faculty of Economics and Business

STOCK PRICES AND MONETARY POLICY: EVIDENCE FROM MALAYSIA.

CHIN NYUK FUI

THIS PROJECT IS SUBMITTED IN PARTIAL FULFILLMENT OF THE

REQUIREMENT FOR THE DEGREE OF BACHELOR OF FINANCE WITH

HONOURS

Faculty of Economics and Business

UNIVERSITI MALAYSIA SARWAK

2011

Statement of Originality

The work described in this Final Year Project, entitled

“STOCK PRICES AND MONETARY POLICY: EVIDENCE FROM MALAYSIA”

is to the best of the author’s knowledge that of the author except

where due reference is made.

Date submitted Student’s signature

Chin Nyuk Fui

20798

ABSTRACT

STOCK PRICES AND MONETARY POLICY: EVIDENCE FROM MALAYSIA.

By

Chin Nyuk Fui

Faculty of Economics and Business, Universiti Malaysia Sarawak, Malaysia.

Studies to determine the relationship between stock prices and monetary policy have long

been pursued, however as Tobin (1969), Blanchard (1981) and Shah (1984) mentioned, there

are still no any empirical study illustrated the best on how the interaction between the

monetary policy and stock market as well as little effort has been place in identify the

relation of these variables for emerging market especially Malaysia compare to the advanced

market. This study explores empirically the integration between Malaysian stock prices and

monetary policy in post-crisis as well as linkage with other macroeconomic variables. The

study uses the Autoregressive Distributed Lag Model (ARDL), Variance Decomposition

(VDCs) and Impulse Response Function (IRFs). The study finds that the stock prices and

monetary policy has a bidirectional relation in short-run and long-run as consistent with

Bjornland and Leitemo (2008). Moreover, the macroeconomics variables display a

cointegration with stock prices and monetary policy. Astonishingly, Malaysian stock prices

also have significant interaction with the federal fund rate. To the certain extent the market is

informational inefficient, these findings make obvious evidence that are contradictory with

Efficient Market Hypothesis (EMH).

Key Words: Stock prices, monetary policy, macroeconomic variables, ARDL.

JEL classification numbers: E61, E52, E43

ABSTRAK

HARGA SAHAM DAN DASAR KEWANGAN: KES DARI MALAYSIA

Oleh

Chin Nyuk Fui

Faculty of Economics and Business, Universiti Malaysia Sarawak, Malaysia.

Kajian untuk menentukan hubungan antara harga saham dan dasar kewangan telah

lama dikaji, namun, Tobin (1969), Blanchard (1981) dan Shah (1984) mengatakan bahawa

kajian tentang interaksi antara harga saham dan dasar kewangan masih terhad terutamanya

di negara sedang membangun berbanding dengan negara maju. Kajian ini bertujuan untuk

mengkaji hubungan antara harga saham dan dasar kewangan serta hubungan dengan

beberapa pembolehubah makroekonomi di Malaysia selepas krisis kewangan di Asia.

Kajian ini menggunakan kaedah ARDL, Penguraian Varian (VDCs) dan Fungsi Tindak

Balas (IRFs). Selari dengan Bjornland dan Leitemo (2008), kajian ini mendapati bahawa

harga saham dan dasar kewangan mempunyai hubungan dua hala dalam jangka masa

pendek dan jangka panjang Pembolehubah makroekonomi di Malaysia juga menunjukkan

integrasi dengan harga saham dan dasar kewangan. Selain itu, harga saham Malaysia juga

mempunyai hubungan dengan kadar dana persekutuan di Amerika Syarikat. Keputusan

kajian ini bertentangan dengan hipotesis pasaran cekap (EMH) di Malaysia.

Kata kunci: Harga saham, dasar kewangan, pembolehubah makroekonomi, ARDL.

Nombor klasifikasi JEL: E61, E52, E43

ACKNOWLEDGMENT

The expression of gratitude to God, I had successfully completed my Final Year

Project in time although encountered many obstacles in proceed this research. Through this

research, it had enhanced my understanding as well as knowledge in financial market and I

believe that it is useful in my future career development.

I would like to give a million thanks to those who had assisted, guided and

encouraged me throughout the process to finish my Final Year Project. Initially, I feel

pleasure to give thanks to my friendly and gentle supervisor, Encik Bakri bin Abdul Karim

who had instructed and guided me as well as morally support me during doing the project.

Through such a good instructor and guider, I believe that I am able to generate a good project.

Besides, I would like to take the opportunity to thank all the staff and workers of

Faculty of Economic and Business who had assisted me direct or indirectly in term of the

facilities and equipment provided to ensure that students able to complete their project

effective and efficiently.

Lastly, I sincerely give thanks to my family and friends, especially Miss Chai Ai

Chen who had lend a hand and support me so that I am able to complete my project in well-

timed.

vi

TABLE OF CONTENTS

Tables viii

Figures x

CHAPTER I: INTRODUCTION

1.0 Introduction 1

1.1 The Malaysian Economic 4

1.2 Monetary Policy in Malaysia 11

1.3 Stock Development in Malaysia 14

1.4 Problem Statement 21

1.5 Objective 23

1.6 Significant of Study 24

1.7 Scope of Study 25

CHAPTER II: THEORETICAL FRAMEWORK AND LITERATURE REVIEW

2.0 Introduction of Theoretical Framework 26

2.1 Market Efficiency Hypothesis 27

2.2 Literature Review 28

CHAPTER III: METHODOLOGY

3.0 Introduction 44

3.1 Research design 45

3.1.1 Sample 45

3.1.2 Data collection 45

3.1.3 Data analysis 45

vii

3.2 Methodology 46

3.2.1 Autoregressive Distributed Lag Model (ARDL) 46

3.2.2 Variance Decompositions (VDCs) and Impulse-Response Functions (IRFs) 50

CHAPTER IV: EMPIRICAL FINDINGS AND DISCUSSIONS

4.0 Introduction 52

4.1 Graphically display 53

4.2 ARDL Cointegration Results 55

4.3 Variance Decomposition test 60

4.4 Impulse- Response test 65

4.5 CUSUM test 68

4.6 Summary of discussions 69

CHAPTER V: CONCLUSION

5.0 Introduction 71

5.1 Summary 71

5.2 Implication of study 74

5.3 Recommendations 75

5.4 Limitation 76

REFERENCES 77

viii

LIST OF TABLE

Table 1: Summary of Literature Review 36

Table 2: F-statistics for testing the existence of a long-run cointegration 55

Table 3: Error Correction Representation of ARDL Model 57

Table 4: Variance decomposition of LKLCI 60

Table 5: Variance decomposition of LCPI 61

Table 6: Variance decomposition of LER 62

Table 7: Variance decomposition of LOPR 63

Table 8: Variance decomposition of FED 64

x

LIST OF FIGURE

Figure 1: Figure 1: Malaysia’s GDP by Sector 2009 5

Figure 2: Exchange Rates in Malaysia from January 2007 to July 2010 6

Figure 3: Lending Rate for Commercial Banks in Malaysia from September

2008 to September 2010 7

Figure 4: M1 and M3 from September 2008 to September 2010 in Malaysia 8

Figure 5: Inflation in Malaysia from 2005 to 2011 9

Figure 6: Annual Gross Domestic Product Growth in Malaysia from 2005 to 2011 10

Figure 7: Number of Listed Company in Malaysia from 1990 to 2009 16

Figure 8: Market Capitalization in Malaysia from 1990 to 2009 17

Figure 9: KL Composite from the years of 1990 to 2008 18

Figure 10: Value of Share Trading from 1990 to 2008 19

Figure 11: Gross Dividend Yield (%) in Malaysia from Years of 1990 to 2008 20

Figure 12: KLCI, OPR, CPI, ER and FED from January 1999 to December 2009 53

Figure 13: Impulse- response functions of LKCI, OPR and FED 65

Figure 14: Plots of CUSUM and CUSUM of Square statistics 68

Figure 15: Bidirectional relationship between stock price and monetary policy 69

Figure 16: short-run dynamic causal linkages between stock market, monetary policy,

exchange rate, inflation rate as well as federal fund rate of Malaysia 70

- 1 -

CHAPTER I

INTRODUCTION

1.0 Introduction

The relationship between stock prices and monetary policy has been hotly debated by

academicians and practitioners since early period. As Tobin (1969), Blanchard (1981) and Shah

(1984) mentioned, there are still no any empirical study illustrated the best on how the

interaction between the monetary policy and stock market. Hence, academic researchers and

large practitioners are interested to explore some puzzle questions associated with the interaction

between stock prices and monetary policy. However, macroeconomic variables such as inflation,

exchange rate and federal fund rate also have a close interaction with stock prices and monetary

policy.

First, researchers and economists are questioning about whether the shock in monetary policy

has significant impact in stock prices or reverse causality of stock prices is one of the

determinations of monetary policy. According to Cassola and Morana (2002), monetary policy

action has a strong yet short-term shock toward stock prices. On the other hand, Chami,

Cosimano and Fullenkamp (1999) argued that stock market is a vital channel for monetary policy

setting. Contradiction happens when Kraft and Kraft (1976) used time series analysis and found

no causal relationship from money supply to stock prices.

Besides, they are interested to investigate whether stock prices and monetary policy have

reciprocal relationship between each other. Dufour and Tessier (2006) stated that stock price is

an information indicator in conducting the monetary policy while the instability in M1 is also

able to predict the rise and fall in stock return.

- 2 -

Some previous researchers, on the other hand also pointed out that there was insignificant

relationship between stock prices and monetary policy which also motivates researchers and

practitioners to reexamine about it. Based on the suggestion of Durham (2003), federal fund rate

was significant with Treasury bill but insignificant with stock return, yet little evidence showed

respond of monetary policy to the shock of stock price.

In addition, how sensitive the relationship between stock price and monetary policy across

different countries and different decades also brings attention of academic researchers and

practitioners. Sensitivity of stock prices toward the changes in monetary policy is differing

across different economics and time (Yun, Iscan & Kuan, 2007; Bordo, Dueker &Wheelock,

2008).

Last but not least, unclear connection of stock return and monetary policy with

macroeconomic variables such as inflation, exchange rate and interest rate also have been long

attempted to be understand by researchers and economists.

As Ibrahim & Yusoff (2001) highlighted, appropriate understanding about the significant

shock from various markets such as real, money, financial and international market are essential

for researchers and economists, investors and policy makers. Identifying the dynamic relation

between these variables enables researchers and economists to be assisted in implementing future

study. Investors always link the performance of stock market with the changes in monetary

policy, inflation and macroeconomics (Bordo, Dueker & Wheelock, 2008). Therefore, investors

are cautious and pay attention to the shock happen in market to predict the future stock market.

Laopodis (2007) stated that the investors have negative perspective toward the stock and bond

market when large budgetary fiscal was introduced.

- 3 -

As a policy maker or monetary authority, it is vital to understand clearly about the relation

between monetary policy, stock return and other macroeconomic variables. Knowledge about the

dynamic interaction between these variables has significant impact in monetary policy setting

and decision making. Ibrahim & Yusoff (2001) suggested that stock price, exchange rate and

other macroeconomics variables act as an important input to policy maker in monetary policy

determination. On the other hand, policy makers also need to be precautious in setting the

monetary policies and exchange rate as it may bring negative implication to financial market.

- 4 -

1.1 The Malaysian Economic

Malaysia is a relatively small country with around 330,000 square kilometers land area

located at South East Asian. Malaysia’s economic had grown rapidly since independent on 1957.

According to the United States State Department (2010), Malaysia achieved one of the best

economic records in Asia. Malaysian Government and private corporations act as an active role

to promote economic expansion and social development as well as supported by prudent

monetary policy and political stability. The real Gross Domestic Product (GDP) of Malaysia had

grown averagely 6.5% per year during the year of 1957 to 2005. On the other hand, Malaysia

achieved peak performance in economy during the early 1980s until the mid-1990s with average

8% a year (United States State Department, 2010). This country diversified and modernized its

economic through huge investment in domestic and foreign.

Malaysia is a country which prosperity in the mineral resources and soils. At the early period,

Malaysia focused on agricultural and primary commodities sectors. However, following the

growth in environment, Malaysia had switched the sector from agricultural and commodities to

manufacture and export based economic driven by “high technology, knowledge-based, capital-

intensive industries” (Malaysia Industrial Development Authority, 2008). Based on the Economy

Watch (2010), export is the most contributors for Malaysia’s economic growth.

- 5 -

Figure 1: Malaysia’s GDP by Sector 2009

Source: Economy watch

Figure 1 makes obviously that the Malaysia’s Gross Domestic Product in 2009 was mostly

contributed by industries and services sector rather than agricultural sectors. Nowadays,

Malaysia is a middle-income country focuses on services and manufacturing for various sectors.

Moreover, Malaysia becomes one of the largest exporters of world in semiconductor devices,

electric goods as well as information and communication technology (ICT) products (United

States State Department, 2010).

- 6 -

Monthly Statistical Bulletin on September had published by Central Bank of Malaysia (2010)

recently to evaluate and assess the macroeconomics condition and growth in Malaysia.

Figure 2: Exchange Rates in Malaysia from January 2007 to July 2010

Sources: Bank Negara Malaysia

Figure 2 shows the exchange rates in Malaysia from the years of January 2007 to July 2010.

The exchange rate was unstable throughout these periods. It rose and fell obviously especially on

the year of 2009. As demonstrated in figure 2, the exchange rates have fallen visibly during 2009

due to the disclosure to global financial crisis. However, the exchange rates began to rebound

gradually after the 2009 economic contraction in Malaysia.

- 7 -

Figure 3: Lending Rate for Commercial Banks in Malaysia from September 2008 to September 2010

Sources: Bank Negara Malaysia

The lending rate for commercial banks in Malaysia had drop since September 2008 as shown

in the figure in 3. However, it maintained at the same rate during the mid of 2009 to early of

2010. The lending rate started to increase after the early year of 2010. The performance of base

lending rates was higher than the average lending rates from September 2008 to September 2010.

- 8 -

Figure 4: M1 and M3 from September 2008 to September 2010 in Malaysia

Sources: Bank Negara Malaysia

Figure 4 shows that the growth of M1 and M3 in Malaysia from September 2008 to

September 2010 had rose and fell substantially. It was inconsistent and unsteady. Two of these

monetary aggregates significantly dropped especially during the period of December of 2008 to

2009.

- 9 -

Figure 5: Inflation in Malaysia from 2005 to 2011

Sources: Asian Development Outlook

Asian Development Outlook (2010) also had demonstrated the inflation in Malaysia from

2005 to 2009 as well as forecasted inflation in 2010 and 2011 in figure 5. The overall

performance of inflation in Malaysia is stable except in the year of 2009 which shows negative

value in inflation. The inflation in 2010 is forecasted to rise significantly from 2009 and drop

slightly on 2011.

- 10 -

Figure 6: Annual Gross Domestic Product Growth in Malaysia from 2005 to 2011

Sources: Asian Development Outlook

According to figure 6, the annual Gross Domestic Product growth in Malaysia from 2005 to

2011 taken as a whole was moving average. Abnormal circumstance only happened during 2009

which the annual Gross Domestic Product growth was in negative value, which is same as the

Malaysia’s inflation in 2009.

- 11 -

1.2 Monetary policy in Malaysia

Malaysia is a small, trade-dependent economy with a high degree of foreign presence in both

the real and financial sectors; globalization and capital flows have thus had a significant impact

on the operation of monetary policy in the country (Cheong, 2005, p.209). The Central bank of

Malaysia is the mechanism used to frame suitable monetary policy to ensure that the economic

growth in a stable price and low inflation, promote financial system steadiness and responsibility

to act as a developmental for financial institution (Central bank of Malaysia, 2010). In Malaysia,

monetary aggregate is divided into three categories which are M1, M2, and M3. M1 is defined as

narrow money while M2 and M3 are defined as board money (Digital Library Malaysia, 2005-

2010).

Malaysia had experienced variety of monetary policy operation changes since independent.

The development of monetary policy in Malaysia is transformed in response to the changes in

global development. Malaysia’s monetary policy evolutions are split into few stages since before

the Asian crisis to the transformation after crisis, and the movement from floating exchange rate

system to pegged exchange rate system and managed float exchange rate regime (Cheong, 2005).

Before the mid-1990s, monetary policy in Malaysia was based on the monetary targeting

aggregate. This policy was an informal and domestic strategy which did not disclosure to public.

Monetary targeting aggregate had been chosen as a policy at that period due to this strategy is

parallel to the ultimate objective of monetary authority to stabilize the price (Cheong, 2005).

Central Bank of Malaysia ensures price stability by making sure that the economic has sufficient

liquidity to meet the demand during that period.

However, following by the growth in the economic and financial system in the early of 1990s,

the power of monetary aggregate as a policy indicator had weakened. As a result, new monetary

- 12 -

policy using interest rate as a targeting has been introduced. Although new targeting has been

used, Central Bank of Malaysia still pays attention to the monetary aggregate and other useful

economic and monetary indicators.

Interest rate was selected as a more suitable targeted policy during that period because the

market transformed to more interest rate-oriented and interest-sensitive. Besides, positive real

rate of return in deposits and financial deregulation also increase the role of interest rate as an

effective indicator in monetary policy. Interest rate was selected as a preference in policy rather

than other variable such as reserve money which had been further reinforced again by the

globalization.

During the Asian crisis in 1997, the ability of Central Bank of Malaysia to control the

economic based on domestic consideration interest rate targeting was affected due to volatility of

Ringgit and short-term capital flows. In 1 September 1998, selective exchange controls and fixed

Ringgit exchange rate in the future have been set up to support the economic recovery (Cheong,

2005) . The development of Ringgit was driven by the US dollar during that period.

Following by the pegged exchange rate regime, Malaysia had increased its ability to

influence the monetary policy based on own domestic monetary policy goal. Stability in

economic was achieved by fixed exchange rate regime which open the chance of financial

market to further deregulation. Financial liberalization encourage market-based system in

determine interest rate. Base lending rate (BLR) has been liberalized to provide guideline for

ceiling lending rate and connected to monetary policy rate which will also directly bring impact

to the monetary policy framework (Cheong, 2005) .

According to Central Bank of Malaysia (2010) in press statement 2004, the new interest rate

framework had been introduced in the year of 2004. The main element of new monetary

- 13 -

operating procedure was the using of overnight policy rate as the main operating target.

Overnight operating corridor and standing facilities were used to minimize the instability of

overnight rate. Under these new framework, financial institutions are able to set up own BLR

based on their strategies and cost structures under the monitor of Central Bank of Malaysia.

Based on the declaration from Central Bank of Malaysia (2010) in annual report 2005, the

fixed exchange rate system of USD1 = RM3.80 since 2 September 1998 in Malaysia was

adjusted to manage float exchange rate regime on 21 July 2005. Ringgit was monitored against

currencies of Malaysia’s main trade partner. New position enables Malaysia to respond better

and gain advantages toward the structural changes in regional. Under this regime, the Ringgit

exchange rate mainly determined by Ringgit demand and supply in the foreign exchange market

(Central Bank of Malaysia, 2010).

The spotlight of monetary policy in 2010 is encouraging the sustainability of economic

recovery which was stated in annual report 2009 (Central Bank of Malaysia, 2010). Subsequent

to the meeting of Monetary Policy Committee (MPC) currently on 8 July 2010, Central Bank of

Malaysia decided to change the Overnight Policy Rate (OPR) to 2.75 percent with the floor and

ceiling rate of the corridor between 2.50 to 3.00 percent (Central Bank of Malaysia, 2010). MPC

did this decision by considering about the current economic growth and inflation viewpoint. To

promote effectiveness in economic growth and stability, policy makers used not only one

instrument but combined several instruments to achieve more effectual result.

- 14 -

1.3 Stock Development in Malaysia

The capital market plays an important role to raise needed fund to stimulate and sustain an

economic in a country. Medium and long term funds have been mobilized to finance the public

and private activities as well as to support the bank system. Capital market is divided into two

which are primary market and secondary market. Primary market is mainly for new issues of

government and private corporation securities for public while secondary market focuses on

trading of existing securities.

Chong, Yusop, Law and Liew (2003) claimed that the stock market growth has a close

relationship with economic growth in Malaysia. They pointed out that there is positive long term

effect of stock market development toward the economic growth using Granger-causality test

based on vector error correction model (VECM). The stock market in Malaysia began to robust

growth since the late 1980s (Shimomoto, 1997-1999). Malaysian open and liberal economy

coupled by prudent macroeconomic management make possible for it to attain rapid economic

growth in previous four decades (Ali, 2001).

Two regulators were developed to monitor and supervise the stock market which is Kuala

Lumpur Stock Exchange (KLSE) and Securities Commission (SC). KLSE is established at 1973

and function as a self-regulator organization to offer a central place for counterparties in

transaction of securities. KLSE achieved a significant milestone at 1990 when Malaysian stocks

listed at Security exchange of Singapore (SES) and vice versa.

The stock index which is used as a benchmark in Malaysia is Kuala Lumpur Composite

Index (KLCI). The expansion of Malaysian market can be seen clearly at the end of the 1989

when Malaysian companies’ stock exchange was delisting. During 1993, large numbers of