We study the determinants of the explosive stock market growth and increased foreign portfolio investment in Pakistan. Our results indicate that in contrast to evidence from developed markets, the aggregate stock returns are not driven by macroeconomic fundamentals in Pakistan. Moreover, foreign portfolio investors do not tend to react to changes in economic variables in Pakistan. As fundamentals fail to affect stock returns in Pakistan, they may be based more on speculative motives. Our results suggest that in the absence of a strong institutional and regulatory framework, economic policies have only a limited effect on stabilizing an emerging market.KEY WORDS: emerging markets, foreign portfolio investment, macroeconomic announcements, speculative trading Emerging stock markets have become an integral part of the global financial markets, and they have attracted lively interest from international investors. 1 Gross portfolio flows to emerging markets have more than tripled since 1999, amounting to about USD 421 billion in 2009. This growing interest in emerging market investments has generally been attributed to economic growth, political stability, and stock market reforms undertaken in a number of countries. We study the role of those factors in the very fast growth of stock markets in Pakistan. We also explore the drivers of foreign portfolio investments in the country.Pakistan provides an interesting setting for our study as it experienced many contrasting developments during the past decade. Pakistan's stock market capitalization increased from $5 billion in 2001 to more than $70 billion in 2007. As part of the stock market growth, Pakistan experienced a significant rise in capital inflows. 2 With data on macroeconomic fundamentals, market-related measures, country risk, and political developments, we are able to conduct an in-depth analysis of the determinants of stock markets growth and the role of foreign portfolio investments in an emerging market. To the best of our knowledge, there are no prior studies on Pakistan with such a rich set of variables.The relation between aggregate stock prices and macroeconomic fundamentals is well documented for developed markets (see, for example, Andersen et al. 2003Andersen et al. , 2007Fama 1981;Hamao 1988;Harju and Hussain 2011). 3 However, the relationship between macroeconomic fundamentals and aggregate equity prices in emerging markets is more complicated. Recent studies suggest that stock prices in emerging markets are speculative and thus less affected by the economic fundamentals (Khwaja and Mian 2005;Mei et al. 2004). Moreover, the role of foreign portfolio investors in volatile emerging markets is not well understood. It is possible that they generate market fluctuation that is unrelated to the underlying fundamentals. Singh and Weisse (1998) argue that portfolio capital inflows to the developing markets are generally short term and speculative, and thus often not related to economic Downloaded by [University of Western Ontario] at 12:57 12 April 2015 fun...
