Even before the 2007-2009 financial crisis started there has been a heated debate whether central banks should respond to asset price developments. However, this global financial crisis has stimulated various researches on the interdependence between monetary policy and assets prices worldwide, Chatziantoniou, Duffy and Filis (2013). Although there have been several studies on analyzing monetary policy and stock returns, especially in the developed world, there has been little empirical evidence on the interaction between monetary policy and fiscal policy on stock returns.
In a modern financial system, monetary policy is transmitted into the real economy through several channels, such as, the interest rate channel, credit channel, channel determining the asset prices in the economy and the exchange rate channel. If the value of the stocks owned by a household increases, this has a direct positive effect on the net worth of the households, so the household will consume more and vice versa. The extent of the wealth effect depends significantly on the share of household in the country that own stock. There should be a positive correlation between stock ownership in a country and the effect of stock prices on the household’s wealth. The higher the percentage of households that own stock, the greater the effect of stock prices on the household’s wealth. For example; Results from Boone, Giorno and Richardson (1998) indicated that a 10% fall in stock prices result in a minimum of 0.45% reduction in consumption in the United States, United Kingdom and Canada after a year. Stock prices also influence firm’s ability to finance investment projects, see Rigobon and Sack (2001). Moreover, High interest rates mean high cost of borrowing, so firms invest less. If firms are unable to invest it means that the present value of their future cash flows will also decline, and this has a direct negative impact on firms’ stock prices. With the credit channel, if government uses tight monetary policy, then there is less credit available and economic activity slows down. A fall in the money supply relative to money demand will lead to a fall in interest rates which inevitably will result in an increase in stock prices.
On the other hand, fiscal policy is quite effective in stimulating the economy. In the Keynesian manner, expansionary fiscal policy can lead to an increase in aggregate demand and employment. This translates into increased spending and consequently higher levels of consumer confidence, thereby boosting the economy and potentially driving stock prices higher. In contrast, classical economists focus on the crowding out effects of fiscal policy in the market for loanable funds and of the productive sectors of the economy. Thus, fiscal policy could possibly drive stock prices lower through the crowding out of private sector activity.
2. Problem statement
There is significant evidence from the Keynesian paradigm that monetary policy should not be examined in isolation from fiscal policy and vice versa as both their individual stance as well as their interaction play an important role in the economy. Given that over the years, especially after the financial crisis of 2007-2008, great emphasis has been placed on analyzing the effect of both fiscal and monetary policies on the economy.
An understanding of how policy actions affect the stock market is certainly pivotal to the formulation of economic policies aimed at enhancing stock market efficiency in resource mobilization. Resultantly, bank financing has become highly inaccessible to the private sector, leading to a growing emphasis on alternative sources of finance for long term investment. The Namibian stock exchange, being one such source, has consequently gained significant importance and focus as a source for the same. However, if the NSE is to play its allocative role properly, the implications of the factors affecting it, macroeconomic policies among them, must be well determined and appropriately addressed. Studies that have been done to inquire into the interactive relationship between these policies as it affects the stock market mainly focus on advanced economies with very little or none on emerging economies especially the Namibian economy.
For this purpose, the study owes to fill the gap in the empirical literature in Namibia by investigating the extent to which stock returns incorporate all publicly available information on fiscal and monetary policy actions and to answer questions appertaining to policy implications on stock market performance in Namibia.
The main objective of this paper is to investigate the effects of fiscal and monetary policy on stock market returns in Namibia. The specific objectives are to:
• To investigate the impact of the interaction between the fiscal and monetary policy on the Namibian stock exchange.
• To examine the impact of the volatility of the interactions between fiscal and monetary policies on stock market behavior in Namibia.
• To draw policy implications from the findings.
4. Research questions
1. Does fiscal policy have a significant effect on the stock market?
2. Does monetary policy have a significant effect on the stock market
3. What is the combined effect of fiscal and monetary policy on the stock market?
5. Significance of the study
The interaction between fiscal and monetary policy plays a crucial role in the economy hence should not be examined in isolation. A stock return is regarded as one of the main considerations for making investment decision in the stock market. This is because investors expect a certain return consisting of capital gains and dividend payment which motivates their wealth maximization behavior. A clear understanding of the relationship between monetary policy and stock returns in the context of Namibia’s macroeconomic environment is significantly important to various agents in the economy and especially monetary authorities to inform on policy. Monetary authorities and policy makers would need to understand the effects of the interaction between fiscal and monetary policy on stock prices so that they can understand how policies influences the real economy through stock prices. This would help them understand whether they should target stock prices or use securities price volatility as indicators of the fiscal and monetary policy stance. This study also aims to contribute to the already existing knowledge regarding stock markets, fiscal and monetary policy in emerging capital markets such as Namibia and to provide new evidence regarding asset channel of monetary transmission in emerging economies. Further, the study findings would also provide a platform for quality discussion and debates amongst academicians, mainly economist, policy makers, professionals and corporate leaders and provide a basis for further research regarding stock markets in emerging markets. In addition, it would assist in terms of informing policy by making appropriate policy recommendations.
6. Literature Review
6.1. Theories of Monetary Policy and the Stock market
Researchers are divided on whether monetary policy has an impact on stock returns or not. Some researchers like Fama and French (1989), Jensen and Johnson (1995), Patelis (1997) as well as Ioannidis and Kontonikas (2006), believe that changes in monetary policy affects the stock market performance and in turn leads to changes in stock prices. Whereas others like Bordo and Jeanne (2000) and Fair (2002) believe that changes in monetary policy have little to no impact on stock market performances. Among those that believe that changes in monetary policy affects stock market performance, there are disparities as to which tool of monetary policy is more important and to what extant they affect stock returns.
Monetary policy can either be expansionary or contractionary. Expansionary monetary policy is used by monetary authorities to stimulate the economy. This can either be done by increasing money supply or lowering interest rates to encourage borrowing by companies, individuals and banks. A contractionary monetary policy on the other hand is used to fight inflation in an economy. Since inflation is a sign of an overheating economy, monetary authorities must slow growth by increasing interest rates to make lending more expensive. Authors such as Thorbecke (1997) and Conover, Jensen, Johnson and Mercer (1999) reported a strong positive relationship between an expansionary monetary policy and stock market returns. While Ehrmann and Fratzscher (2004), Rigobon and Sack (2001), and Sousa (2010) found evidence of a negative relationship between a contractionary monetary policy and stock returns.
Empirical studies that aimed at investigation the relationship between macroeconomic variables and stock returns in developed and developing economies have reported varying outcomes. In one of the most recent and related study, Yoshino, Taghizadeh-Hesary, Hassanzadeh and Prasetyo (2014), have studied the response of stock markets to monetary policy (An Asian Stock Market perspective) a case of Tehran stock market. They estimated the response of Asian stock market prices to exogenous monetary policy shocks employing the VECM. The results indicated that stock prices increase persistently in response to exogenous monetary policy easing. Further they conclude that there is an endogenous response of the stock prices to monetary policy as evidenced by variance deposition results. Bernanke and Kuttner (2005) examined the reaction of equity prices following a change in federal rate. Using Campbell and Ammer model to assess the relationship between behavior of stock prices in response to change of interest rate the results were a 0.25 percent reduction on interest rate increased securities price indices by 1 percent.
In terms of methodology, Sellin (2001) noted that most of the studies have relied on vector autoregressive model particularly in the last decades in studying the relationship between monetary policy and securities market. Patelis (1997) Using a simple two-equation system where one equation represented the monetary policy and the other equation representing the securities returns investigated whether observed changes in US securities returns could be ascribed to shifts in the monetary policy stance. The findings showed that monetary policy variables are significant predictors of future stock returns.
6.2. Theories of Fiscal Policy and the stock market
Although a significant number of past studies have concentrated their attention on the relationship between monetary policy and stock market performance, only few studies have focused on the effects of fiscal policy on stock markets, Afonso and Sousa (2011). The gap in the study of the impact of fiscal policy on stock returns remains despite the theoretical effects that have been set out since the 1960’s in papers by Tobin (1969), Blanchard (1981) and Shah (1984). Fiscal policy is a sister strategy to monetary policy whereby the government adjusts its spending levels and tax rates to influence the economy. Theoretically fiscal policy plays a significant role in determining asset prices. Increases in taxes, ceteris paribus, for instance, lowers expected asset returns as they discourage investors from investing further in the stock market. Also, increases in government borrowing raise the short-term interest rates which, in turn, lowers the discounted cash flow value from an asset and thus signals a reduction in stock market activity.
6.3. Fiscal and monetary policy interactions
Besides evaluating the effect of monetary policy and fiscal policy on stock market individually, many researchers also have empirical researches to determine how the combination of these policies has effects on stock market. According to this approach, researchers find out not only the changes in stock market connected with the changes in both macroeconomics policies but also the interaction between monetary policy and fiscal policy in explaining the activities of stock market.
The theoretical literature has focused on the strategic elements of the interaction using tools of game theory while the empirical analysis has focused on the complementarity and strategic substitutability of monetary and fiscal policy.