The Effect of stock market development and inflation on economic growth in Sri Lanka

Abstract

In the modern financial system, the stock market plays a significant role. Currently, Sri Lanka is recovering from the worst economic crisis in Sri Lankan history. Various studies have been performed worldwide to explore the connection among stock market advancement and the uplift of national economies from diverse perspectives. In Sri Lanka, a limited number of studies were performed. This study aimed to determine the relationship between stock market advancement and economic uplift in Sri Lanka, utilizing four proxies called, market size, efficiency, stability, and accessibility to gauge the stock market's advancement in Sri Lanka. Market capitalization, annual turnover, all share price index, and the number of listed firms in CSE were considered to measure respective proxies and gross domestic product used to measure economic development in Sri Lanka. Annual time series data spanning from 1990 to 2022 were gathered from the Central Bank annual reports and the Colombo Stock Exchange data library for this study. Stock market development measuring proxies provide growth over the period with some significant fluctuations. GDP has increased gradually in the past 3 decades. Principal component analysis was conducted to make a collective measure using stock market development measuring variables which are highly correlated. Johanson's cointegration test indicates the existence of a long-term cointegration relationship among the variables. The Vector Error Correction model was performed to assess the long-term relationship. VECM model results indicate the significant long-term relationship between stock market advancement and economic uplift in Sri Lanka. The short-term causality relationship between variables was assessed using the Granger causality test. The Granger causality test confirms the bi- directional short-term relationship among share market advancement and the uplift of the Sri Lankan economy.