Dynamic Linkages Between Macroeconomic Factors and Islamic Stock Indices in a Non-Islamic Country India

The interaction between macroeconomic variables and share returns has been a debatable topic since decades. Much of the earlier studies have talked about significant relationships between stock market and macroeconomic indicators. In recent years Islamic finance has shown persistent growth worldwide. India has approximately 177 million Muslims, accounting for 12% of India's total population. Islamic finance differs from conventional investing in different ways like prohibition of gambling, pork, alcohol, entertainment, tobacco, profiting from interest rates etc. This paper aims to explore the long run and short run relationships of macroeconomic indicators and stock returns in the Indian context. The study is unique as it employs Shariah compliant indices to check on the stock market in India, a non - Islamic country. Data spans the period from January 2006 to July 2015. Monthly data is used and the selected macroeconomic variables are inflation rate (wholesale price index), interest rate (365 day government of India T-bill rate), money supply (M3) and exchange rate (US Dollar/Indian Rupee). 'Dow Jones Islamic Market India Total Return Index' is considered to track for the Shariah compliant stock index in Indian equity market. The study employs Johansen's co-integration and VECM to check for long run and short run equilibrium relationships. We check for long run equilibrium relationships through co-integration analysis. Johansen's test is a preferable multivariate cointegration test as it accounts for more than one cointegrating relationships. Granger causality is applied to check for the direction of causality. Variance decomposition in VAR system dynamics is also analyzed. Study reports the presence of a long run equilibrium relation between macroeconomic indicators and Dow Jones Islamic India market index. We are getting a positive and statistically significant relationship between WPI and stock returns as well as money supply and stock returns. Interest rate is showing negative and statistically significant relation with stock returns. Further uni-directional causality is observed from money supply and exchange rate to Dow Jones Islamic India market index. We can say that exchange rate as well as money supply granger causes Dow Jones Islamic India Market Index. Variance decomposition of exchange rate shows that 21.66% of variance in exchange rate is explained by Dow Jones index. Variance decomposition of Dow Jones index shows that money supply M3 explains 16.01% of variation in Dow Jones index. India's Islamic capital markets are showing signs of market inefficiency because of long run equilibrium relationships. This paper caters to the needs of Islamic investors and also to the policy makers as it provides a broad understanding of dynamic relationships between Shariah compliant stock returns and macroeconomic factors in India.