Dynamic Relationships between Economic Fundamentals and Capital Market Nepal: Evidence from Vector Error Correction Model Analysis

Abstract

Nepal's stock market (NEPSE), though steadily growing since its establishment in 1993, remains structurally fragile, illiquid, and vulnerable to macroeconomic fluctuations, making it critical to understand the fundamental drivers of its performance. Despite growing academic interest, existing studies have examined macroeconomic determinants in isolation using limited econometric frameworks, leaving the short-run and long-run dynamics of NEPSE performance insufficiently understood. This study investigates the dynamic effects of key macroeconomic variables — specifically GDP, money supply, gross fixed capital formation, and market capitalization on NEPSE performance using annual time-series data form 1994-2024. The Johansen cointegration test and Vector Error Correction (VEC) model were employed to capture both short-term fluctuations and long-term equilibrium relationships among the variables. The results reveal a significant long-run equilibrium relationship between the selected macroeconomic indicators and NEPSE performance, with money supply exerting a positive influence and interest rates demonstrating a negative impact on stock market returns. These findings suggest that Nepal's stock market is highly sensitive to monetary and fiscal conditions, emphasizing the need for stable macroeconomic governance to sustain market development. The study offers empirically grounded, context-specific insights that equip investors and policymakers with a clearer understanding of the forces shaping Nepal's evolving financial market landscape.