How Interest Rates Impact the Nepalese Stock Market: Correlation, Investment Tips, and Key Facts

By Arun Dahal Khatri

The Nepalese stock market has grown significantly in recent years, attracting domestic and international investors. However, like other financial markets, the Nepal Stock Exchange (NEPSE) is heavily influenced by macroeconomic factors, with interest rates being one of the most significant. Interest rates, determined by Nepal Rastra Bank (NRB), play a pivotal role in determining the flow of investment, borrowing costs, and the overall profitability of companies listed on NEPSE. In this article, we will explore how changes in interest rates impact the Nepalese stock market and examine the mathematical correlation between these variables.

The Relationship Between Interest Rates and Stock Market Performance

Interest rates and stock market performance are inversely related. When the NRB increases interest rates, businesses' borrowing costs rise, reducing their profitability and leading to lower stock prices. Conversely, when interest rates fall, borrowing becomes cheaper, leading to increased investment in business activities, improved profitability, and higher stock prices.

1. Impact of Rising Interest Rates on NEPSE: Higher interest rates typically lead to a contraction in the stock market as businesses face increased borrowing costs. When companies need to pay more to finance their operations and expansions, their profit margins are squeezed, reducing the attractiveness of their stocks. Moreover, investors often shift their funds from the stock market to safer investments, such as government bonds or fixed deposits, which offer better returns due to higher interest rates. This reduction in stock demand can lead to a decline in stock prices, as witnessed in many developing economies like Nepal.
2. Impact of Lower Interest Rates on NEPSE: In contrast, lower interest rates usually positively affect stock prices. When borrowing is cheaper, companies can invest in growth opportunities, driving up future cash flows and profitability. Additionally, investors seeking higher returns than what fixed deposits or government bonds offer are likely to move their money into equities, increasing demand for stocks and pushing prices up. For Nepal, periods of low interest rates have generally been associated with bullish trends in the NEPSE index.

The Mathematical Correlation Between Interest Rates and Stock Market Returns

To understand the precise relationship between interest rates and the stock market in Nepal, it is important to look at the correlation between these variables. A correlation coefficient ("r") is a statistical measure describing the strength and direction of a relationship between two variables. It ranges from -1 to +1, where -1 represents a perfect negative correlation, +1 represents a perfect positive correlation, and 0 indicates no correlation.

Let us assume a hypothetical set of data based on actual trends observed in Nepal, where we can compute the correlation between NEPSE index performance and interest rates over a certain period:

Year        Interest Rate (%)    NEPSE Index (Annual Change %)

2015       8.5                           -2.0

2016       7.0                            12.0

2017       6.5                            9.5

2018       9.0                           -5.0

2019       8.0                           4.0

2020       6.0                          15.0

By calculating the correlation coefficient, we can measure the strength of the relationship between these two variables:

Correlation Formula:

r=n(∑xy)−(∑x)(∑y)/[n∑x2−(∑x)2][n∑y2−(∑y)2]

Where:

• n = number of data points
• x = interest rate
• y = NEPSE index change

Without going into the detailed computation, assume that the resulting correlation coefficient is -0.75. This suggests a strong negative correlation between interest rates and stock market performance, meaning that as interest rates decrease, stock market returns tend to increase, and vice versa.

This inverse relationship is consistent with economic theory and the experience of many emerging markets, including Nepal.

Key Research Findings on Nepal's Stock Market

A 2023 study by Nepal Rastra Bank (NRB) analyzing the impact of macroeconomic factors on NEPSE revealed that interest rate fluctuations significantly affect Nepal's stock prices. The study found that lower interest rates, typically induced by expansionary monetary policies, have been associated with bullish stock market trends. On the other hand, periods of higher interest rates, often implemented to curb inflation, have been linked to downturns in NEPSE. Another important finding from NRB's research highlighted that external factors, such as remittance inflows and the economic policies of neighboring countries (like India), indirectly influence the stock market. For instance, when remittance inflows are high, there is more liquidity in the market, leading to higher stock market activity. However, rising interest rates can negate this effect by making alternative investments more attractive, pulling liquidity away from NEPSE.

Advice for Nepalese Investors in the Stock Market

Given the relationship between interest rates and stock market performance, there are several strategies Nepalese investors can adopt to maximize their returns:

1. Monitor Interest Rate Trends: Investors should closely monitor NRB's monetary policy announcements. A rise in interest rates could signal an impending decline in stock prices, while a cut in rates could create an opportunity for stock market gains. Investors should consider diversifying their portfolio when interest rates are expected to rise by including bonds or other safer assets.
2. Invest for the Long Term: Although interest rates affect short-term market fluctuations, stock prices tend to recover and grow in the long run, especially if the underlying economy remains stable. Nepalese investors should avoid panic selling during rising interest rates and instead focus on long-term investment goals.
3. Diversify Investments: Given the volatility of the Nepalese stock market, it is advisable to diversify investments across different sectors. Sectors such as banking, hydropower, and insurance tend to respond differently to interest rate changes, and diversification can help mitigate risks.
4. Consider Macro and Global Factors: While interest rates are important, investors should not ignore other macroeconomic factors such as inflation, GDP growth, and remittance flows. Additionally, global market trends, particularly those in India, can significantly impact Nepal's stock market.

Facts Investors Should Consider

1. Volatility in NEPSE: NEPSE has experienced significant fluctuations in recent years. For instance, during the COVID-19 pandemic, the NEPSE index saw both steep declines and rapid recoveries due to global market sentiment, liquidity fluctuations, and interest rate cuts by the NRB.
2. Impact of Remittances: Remittance is a significant driver of liquidity in the Nepalese economy, and any changes in remittance inflows can affect stock market performance. In 2020, remittances accounted for approximately 24% of Nepal's GDP, and changes in this inflow can either bolster or suppress stock market activity.
3. Inflation and Currency Fluctuations: Rising inflation can lead to higher interest rates as the NRB tries to control price levels. Additionally, the exchange rate of the Nepalese rupee, particularly against the Indian rupee and U.S. dollar, can influence investor sentiment.

Conclusion

In conclusion, the Nepalese stock market is strongly influenced by changes in interest rates, as seen through the inverse relationship between these two variables. Investors should be mindful of macroeconomic trends, particularly those set by the NRB, and use these insights to make informed investment decisions. By diversifying portfolios, monitoring interest rate trends, and adopting a long-term perspective, Nepalese investors can better navigate the challenges and opportunities the stock market presents.

References

Nepal Rastra Bank (2023). Macroeconomic Impacts on NEPSE: An Analytical Review. Retrieved from https://www.nrb.org.np/red/vol31-1_art3.