IMAGE VIA SHUTTERSTOCK
ON AUGUST 24th 2007 the Nepal Stock Exchange switched from an open outcry system to automated trading. The modernisation did little to tame the market’s wild heart. Between mid-2016 and early 2017, the NEPSE index lost nearly a third of its value. By the following two months it had climbed 40%. Such swings invite a question that preoccupies Kathmandu’s chattering investors: do Nepal’s economic fundamentals drive these gyrations, or is the market just a casino in the Himalayas?
The answer, from a study by Mukti Bahadur Khatri, a lecturer at Trichandra Multiple Campus, is more nuanced than either camp might like. Examining 22 years of data from 1994 to 2015, Khatri finds that Nepal’s stockmarket does respond to macroeconomic forces—but selectively, and with a lag that undermines the case for efficiency.
The relationship between share prices and the real economy is, at first glance, perverse. Gross domestic product and stock prices move in opposite directions, though the link is statistically weak. This contradicts the textbook logic that growth swells corporate profits and lifts shares. One explanation lies in the market’s composition. Banking and financial institutions dominate the NEPSE, and their fortunes track interest-rate spreads more closely than they track national output.
Money supply tells a clearer story. Khatri finds a positive and significant long-run relationship between narrow money and stock prices. When the central bank expands credit, some of that liquidity finds its way into equities. This is hardly unique to Nepal—Mukherjee and Naka documented the same dynamic in Japan in the 1990s—but it carries particular weight in a financial system where alternatives are scarce. With few corporate bonds and a rigid banking sector, excess cash has limited places to go.
The influence of other variables is murkier. Exchange rates, foreign direct investment and inflation all show positive but insignificant relationships with stock prices. Interest rates point negative, as theory would predict, yet the statistical signal is too weak to trust. For investors hoping to decode the market using central bank announcements or trade figures, this is disappointing news.
More troubling is what the data say about market efficiency. If share prices fully reflected all available information, as Eugene Fama’s efficient market hypothesis would have it, past data should offer no clue to future returns. Khatri’s cointegration tests suggest otherwise. Stock prices and macroeconomic variables move together in the long run, meaning the former can be predicted—at least partially—using the latter. When he runs Granger causality tests, the results confirm that Nepal’s market fails the efficiency test in both the short and long term.
This puts Nepal in awkward company. Emerging markets tend to struggle with efficiency, but the Himalayan kingdom’s case is extreme. The adjustment speed from a shock back to equilibrium is glacial: about 28% a year, meaning it takes more than three years to correct a disturbance. In America or Britain, such dislocations typically resolve in months.
None of this means the NEPSE is entirely detached from reality. The positive money-supply link shows that monetary policy matters. When the Nepal Rastra Bank tightens credit, investors should expect headwinds. But the insignificance of GDP and inflation suggests that the transmission mechanism from economy to stockmarket is badly gummed up.
Part of the problem is structural. With less than 300 listed companies and trading concentrated in a handful of stocks, the index is a narrow window on the economy. Market capitalisation has ballooned from Rs14bn in 1994 to nearly Rs4.4trn today, but depth has not kept pace with size. Foreign portfolio investors, who might enforce greater discipline through arbitrage, are absent.
For policymakers, the implications are uncomfortable. A stockmarket that ignores GDP but follows money supply is vulnerable to boom-bust cycles driven by liquidity rather than fundamentals. The 2022 crash, which wiped out years of gains in months, have had more to do with panic selling than with any deterioration in corporate prospects.
Khatri’s paper stops in 2015, before the pandemic and the recent inflation surge. Updating the analysis might reveal whether the relationship has changed as Nepal’s economy has opened further. But the core finding—that macroeconomic variables influence prices, just not always as expected—is unlikely to be overturned.
For Kathmandu’s investors, the lesson is sobering. Predicting the market means watching the money supply, but that is not enough. The inefficiency that allows such forecasting also means prices can stray far from fundamentals for years. In Nepal’s bazaar, the rational investor is the one who knows the market is irrational—and acts accordingly. ■
