Theoretical analysis

5.2.1.1 Macroeconomic conditions

According to the literature, such as Campbell and Ammer (1993), Chatziantoniou et al. (2013), Chen et al. (2010) and Sun and Ma (2003), some important macroeconomic factors can exert a significant effect on the volatility of stock markets, e.g., changes in the interest rate, exchange rate and inflation rate, economic development indicators of industrial production, international trading and total retail sales, money supply and the fiscal deficit.

Table 5.1 The Relationships between Macroeconomic Factors and Stock Markets

Macroeconomic Factor Relationship Macroeconomic Factor Relationship

Interest Rate - Inflation Rate -

Exchange Rate unsure Money Supply +

Economic Growth + Fiscal Deficit -

Notes: ‗-‘: negative relationship; ‗+‘: positive relationship. For exchange rate, ‗unsure‘ means the exchange rate

performs inconsistently across the world because of different economic conditions.

Source: Author‘s summaries based on economic analysis.

Table 5.1 summarises the relationships between macroeconomic factors and stock markets; the positive/negative relationship implies that the increase/decrease in the macroeconomic factor results in an increase/decrease in the stock market index. Generally, the interest rate level imposes a remarkable influence on stock market in two ways (Chen et al., 2010; Rigobon & Sack, 2003). On one hand, an expansionary monetary policy is treated as favourable news for market participants because boosting liquidity and lower interest rates help reduce the financing costs of listed companies so improving their earnings and share value. On the other hand, a decrease in interest rate is likely to encourage depositors to withdraw money to invest in the stock market for higher returns. It is common to see this phenomenon in China because there are limited types of investment available to investors to choose in the financial market. Similarly, adjustments of the money supply can change the interest rate level and have a significant influence on the stock market (Chatziantoniou et al., 2013; Nave & Ruiz, 2015).

The influence of the exchange rate on stock markets is somewhat ambiguous. The appreciation of the local currency is harmful to the promotion of exports but can be helpful in attracting more capital inflows because the market expects further appreciation. Therefore, it is likely to boom the local stock market on the condition that the effect of more capital inflow outweighs that of the reduced exports caused by appreciation of the local currency. However, in economies with strict regulation of capital inflows, appreciation of the local currency can affect the stock market negatively because it possibly reduces the profitability of listed international trading companies. As a result, the influence of the exchange rate on stock markets may differ from one market to another in terms of the specific market conditions. Generally, a prosperous macroeconomic performance is likely to provide a stable, healthy environment for stock markets. Thus, the rapid growth of industrial production, exports and social retail sales are favourable to the development of stock markets. Comparatively, for stock investors, an increase in the inflation rate is unfavourable news because a higher

inflation rate may lead to a tightening monetary policy such as the contraction of market liquidity or the raising of the benchmark interest rate. Thus, in general, there is a negative relationship between the inflation rate and the performance of stock markets (Hosseini et al., 2011; Omran & Pointon, 2001).

Similarly, fiscal deficit can affect stock markets significantly in some countries or economies. A reasonable level of the fiscal deficit means the economy is in a healthy condition, which helps to stabilize stock markets (Bekhet & bt Othman, 2012; Darrat, 1988). There is a limited number of studies concerning the effect of fiscal deficit in China. For example, Chen et al.'s (2010) and Sun et al.‘s (2013) empirical studies concentrate on the impact of fiscal deficit on the stock market and find no evidence to support the idea that fiscal deficit has a close relationship with the performance of the stock market.

5.2.1.2 Stock market-specific factors

The fundamentals of listed companies and the size of the shares‘ supply are two main reasons contributing to the volatility of stock prices in stock markets. Specifically, improvement in the fundamentals of listed companies is likely to trigger an upward movement of stock prices because a higher profitability of listed companies means a higher investment value, and thus attracts more investors. Conversely, deteriorating fundamentals or an unfavourable financial performance worsen the investment value of shares and induces a downward movement of stock prices (Campbell & Shiller, 1988; Chan et al., 1991).

For the supply of shares in stock markets, more IPOs (Initial Public Offerings) lead to a bigger number of tradable shares, which possibly causes a further downward movement of stock prices under the condition that the amount of invested funds remains unchanged. Conversely, a decrease in the stock supply is likely to ceteris paribus cause an upward movement of stock prices.

5.2.1.3 Policy risk and/or uncertainty

In the global financial markets, one common concern of stock investors is closely related to the unpredictable future; i.e., it is the risk and/or uncertainty that plays a crucial role in determining the volatility of stock prices. In practice, there are three types of policy-related risk and/or uncertainty in China‘s stock market. First, it is the stock market-related policy risk, which is mainly from the regulatory authorities. Secondly, policy risk and/or uncertainty is always closely connected to the economic policies formulated by central government. Thirdly, economic policy uncertainty derived from other economies in the world can also

possibly impose an important impact on the domestic stock market because of the increasing openness of the Chinese economy and financial markets.

In summary, theoretically, the factors discussed above are likely to impose a significant impact on the performance of the stock market. However, in practice, the real effects of the factors on the stock market still remain unknown in terms of the different market environments as well as different time spans. As a result, the factors need to be carefully treated in explaining the volatility of China‘s stock market.

To investigate the effect of policy risk on the stock market, some important hypotheses have been proposed based on the historical performance of China‘s stock market.