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Economic infrastructure, private capital formation, and FDI inflows to Hungary: a unit root and cointegration analysis with structural breaks.

Introduction

The relationship between foreign direct investment (FDI) flows, economic infrastructure and private capital formation in developing countries is a widely discussed topic in economics. It is important because a rapid and sustained rate of private capital formation is the basis for future economic growth and employment creation in both developed and emerging nations. However, the literature analyzing the impact of FDI flows and economic infrastructure spending on private capital formation (and vice versa) does not speak with one voice regarding the strength of the relationship or the direction of causality, given that it tends to vary from country to country and over time. Local economic and political factors strongly influence the macro variables in question, which makes country-specific analysis particularly important. Only recently have sufficiently long time-series macro data become readily available for transition economies; the FDI dynamics of transition economies such as Hungary or Czech Republic, important as it is, is not yet a well-researched nor understood topic in the literature. To the best of our knowledge, there is no extensive time-series analysis of the impact of economic infrastructure on private capital formation or FDI inflows in the Hungarian case, which makes studying this question vital. During the 1995-2012 period Hungary's economy changed from a post-transition economy to a fast growing, market-based, and outward-oriented economy. For example, the country's exports of goods and services as a proportion of its GDP rose from 45.2 % in 1995 to 71.2 % in 2001, and to 81.7 % in 2008 before it was hit by the global crisis of 2008-09 (World Bank 2012). More importantly, gross fixed capital formation also experienced a robust increase, particularly during the years of 1998-2008, when it grew at an average annual rate of 4 %, reaching 23.5 % of GDP in 2008 (World Bank 2012).

Hungary led the way among the eastern central European countries in terms of socioeconomic and political reforms during the transition period and became highly integrated with the EU countries, so much so that over 70 % of its trade is now undertaken with European countries. The country's rapid integration with the West culminated in its accession to the European Union in 2004, but not the adoption of the euro as it tries to meet the Maastricht Convergence criteria. However, during the period in question Hungary slowly lost its initial regional advantage. The transition created multi-layered and long-lasting social and economic problems. The economy was shaken after the "post-accession crisis" and the market opening of the new EU member states and, as discussed below, was hard hit by the global economic crisis of 2008-2009 due to high levels of private and public borrowing (Hungary 2012, BTI).

The opening and integration of the Hungarian economy has also led to a surge in inward FDI flows, with FDI inflows as a percentage of GDP rising from 2.7 % in 1994 to 7.5 % in 2001, and an incredible 48.6 % in 2008. Table 1 shows that, from the standpoint of contributing to the financing of gross fixed capital formation, FDI inflows as a percentage of gross fixed capital formation rose impressively from 24.1 % in 2000 to 33.7 % in 2005, and an incredible 75.5 % in 2007. Table 1 shows that FDI flows as a percentage of gross fixed capital formation averaged 30.3 % for the 1998-2006 period, excluding the very high figures for 2007 and 2008 which appear to be anomalous and may have been influenced by the 2008-09 crisis. The stock of FDI more than quadrupled between 2000 and 2009, from $22.8bn to $99.1bn--the latter figure representing 78.3 % of the country's GDP (UNCTAD 2012). In 2009 the country was severely hit by the global crisis of 2008-09 and its GDP plummeted by 6.8 % only to recover slowly since then, growing by 1.3 % in 2010 and 1.7 % in 2011. The unemployment rate also jumped from 7.4 % in 2007 to 10 % in 2010 and 10.9 % in 2011 (UNCTAD 2012). Finally, gross fixed capital formation which had grown so impressively up to the eve of the crisis, dropped precipitously in 2009 by 29.3 % and its ratio to GDP fell to 17.9 % in 2010 and 16.7 % in 2011 (World Bank 2012).

The most detailed time-series analysis of the economic role of FDI in Hungary is by Balatoni and Pitz (2012) who report that the FDI/GDP ratio in Hungary, already the highest among eastern European countries in 1995, rose from 24.5 % in 1995 to 71.0 % in 2010. They also indicate that 68 % of FDI inflows are invested by other European countries, mostly EU member states, and that 82 % of these flows are channeled to the services sector. Using cointegration analysis they examined the relationship between FDI inflows (as a proportion of GDP), GNI, and Total Factor Productivity (TFP). Their findings suggest that FDI inflows not only accounted for 69-89 % of the average annual GDP growth over the 1995-2009 period, but contributed to enhanced TFP growth--more so than other sources of financing investments. To the best of our knowledge, there are no rigorous time series studies which examine the direction of causality and/or strength of the potential feedback between FDI inflows and economic infrastructure, the real exchange rate, and private capital formation for Hungary in the presence of structural breaks. In view of this, we investigate the economic relationship between Hungarian gross fixed capital formation, the Hungarian Forint/Euro real effective exchange rate, gross value added in economic infrastructure, and FDI during the period 1995-2012 using quarterly data. The paper is organized as follows. First, it develops a conceptual framework of analysis that seeks to identify some of the major economic and institutional determinants of private capital formation and FDI inflows. Second, it discusses the nature and sources of the data used in this study. Third, single break unit root and Johansen cointegration analysis is undertaken to investigate the time series properties of the variables and whether a unique long-run relationship exists among them. This study also undertakes a Gregory Hansen cointegration test with a level shift (break) in the data. It is determined that a unique cointegrating relationship exists which makes it possible to generate an error correction model that reconciles the short-and long-run properties of the estimated model. Fourth, a more general vector error correction model (VECM) framework is estimated to investigate the causal relationships and the adjustment process of the variables in the system as a whole; it is determined that a negative adjustment process exists for two equations in the system and that the real effective exchange rate and economic infrastructure spending are weakly exogenous. The conclusion summarizes the main results and points to some shortcomings that can be addressed by future research and data availability.

Conceptual Framework

Economic theory suggests that FDI inflows to developing countries increase their stock of capital or private capital formation, which in turn raises the host country's labor productivity and incomes, a process that eventually translates into higher levels of output, employment creation, and potential tax revenues. A similar line of reasoning can be undertaken for increases in the stock of public capital provided that the latter is directed to expenditures on roads, highways, bridges, and ports--expenditures that complement rather than substitute for private capital formation (see Aschauer 1990; Ramirez 2000). In addition to the direct effects of FDI, De Mello (1997) and Kehal (2005) observe that indirect positive spillover effects on overall efficiency may arise from the enhanced competition generated by foreign firms, the transfer of needed technology and managerial knowhow to local firms, and trade-induced learning-by-doing effect as local firms attempt to overcome competition in the global market.

The voluminous empirical literature on the hypothesis of FDI-Led Growth (FLG) by no means speaks with one voice but, in general, finds in cross-country studies that the "nexus between FDI and the host country's growth in private capital formation (or GDP growth) seems generally positive" when host countries adopt a more liberalized trading regime (see Ram and Zhang 2002; Zhang 2001). Recent country studies also suggest that export-oriented FDI, such as that undertaken by TNCs in Chile, Mexico and China, may promote exports (and private capital formation) by establishing assembling plants and helping host firms access international markets for exports (see Aitken et al. 1997). Other country studies by Chakraborty and Basu (2002) for India and De Mello (1997) for Brazil have found no support for the FLG hypothesis; in fact, their empirical work suggests that the line of causality runs from private capital formation (or GDP) growth to FDI-consistent with the market-seeking FDI hypothesis of Dunning (1988) and Mortimore (2003). FDI flows may also have a negative effect on the growth prospects of a country if they give rise to substantial reverse flows in the form of remittances of profits and dividends and/or if the TNCs obtain substantial tax or other concessions from the host country. After Ram and Zhang (2002) and Ramirez (2000), it is possible to analyze the potential impact of inward FDI (or public capital) on private capital formation and economics growth in Hungary by appealing to the modified neoclassical production function given in Eq. (1) below.

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (1)

where: Y is the level of real output; L denotes labor; [K.sub.p] is the stock real private capital; [K.sub.f] refers to the stock of real FDI capital; A captures the efficiency of production; and a; represents other relevant variables that researchers have incorporated into the modified production function to explain the level of GDP such as real exports of goods and services, real bank credit to the private sector, and real government consumption expenditures (see De Mello 1997).

A ceteris paribus increase in inward FDI gives rise to three conceptually distinct effects. First, if the stock of FDI capital is productive and complements the private capital stock by augmenting domestic savings and investment, a ceteris paribus increase in the stock of FDI capital will increase output directly in the same way that an increase in any other factor of production raises output ([F.sub.3]>0). Second, if it generates (unmeasured) positive spillover effects via the transfer of advanced technology and managerial skills to local firms, then it will indirectly increase private investment and output by further raising the marginal productivity of domestic capital ([F.sub.23]>0) relative to the real interest rate. Third, it will increase output via its positive impact on the marginal productivity of labor; i.e., by increasing the amounts of both domestic private and foreign capital per worker ([F.sub.12] and [F.sub.13]>0). A similar line of reasoning can be undertaken with respect to increases in the stock of public capital (see Aschauer 1990).

FDI is also considered to be a source of external financing that is relatively more stable and involves a longer term commitment than portfolio flows such as bond and equity investments. For capital scarce economies such as Hungary's, FDI is essential for financing private capital formation and promoting economic growth, as well as bringing needed technology and managerial know-how (Ramirez 2006; Kumar 2007). This technological and managerial transfer, particularly if it involves the establishment of new enterprises in leadings sectors--so-called "Greenfield investments"--generally has a positive spillover effect on the country's economy as a whole. (1) The majority of the literature has found a strong connection between the economic growth of the host country and the inflow of FDI (see Chakraborty and Basu 2002; Kehal 2005; Ram and Zhang 2002; Ramirez 2006).

Another important factor in determining private capital formation (or FDI inflows) in developing countries is the real exchange rate, given that most capital inputs and intermediate goods are imported (and denominated in euros or dollars); it is also the most important link between economic policy and international competitiveness. However, there is no consensus in the literature as to whether a real depreciation or appreciation of the exchange rate stimulates private capital formation or FDI inflows, ceteris paribus. On the one hand, if the domestic currency depreciates in real terms, it raises the domestic currency costs of imported capital inputs and intermediate goods, thus lowering profits and investment levels (particularly in those industries that lack mark-up rules for passing rising costs to consumers in the form of higher prices). On the other hand, it could encourage FDI inflows and private capital formation because it reduces the costs of domestic inputs and enhances the competitiveness of leading export-oriented sectors in the economy by lowering the foreign currency price of domestic goods, for a given set of domestic prices. Therefore, the effect of the depreciation of the host country's currency on both private capital formation and FDI inflows is ambiguous and depends on which of the above mentioned factors is stronger.

Finally, it is likely that there is bidirectional causality between FDI flows and other macro variables (including the real exchange rate and infrastructure expenditures). Several studies have found that higher inflows of FDI have a positive effect on GDP as it leads to greater private investment spending, exports, and production (see Zhang 2001). While other studies suggest that the line of causation runs the other way, viz., robust private capital formation (or GDP growth) acts as a proxy for a larger market size which, in turn, attracts market-seeking FDI (see Mortimore 2003). Modeling the macro determinants of FDI or private capital formation in a transition economy such as Hungary's is fiaught with conceptual challenges and empirical difficulties that, in the best case scenario, can only lead investigators to formulate tentative conclusions.

Data

The data used in this study were obtained from the databases of the National Bank of Hungary (NBH), the Hungarian Central Statistical Office and Haver Analytics. The data is quarterly for the period 1995 Q1-2012 Q4 (72 observations for each variable). The Stock FDI variable is measured in millions of Hungarian Forints (HUF) at constant prices (1995 Q1 price levels). (2) The real gross domestic fixed capital formation variable is measured in constant average prices of 2005. The series are seasonally adjusted. The exchange rate data used in this paper is the real effective exchange rate index, which takes into account the average relative purchasing power of the domestic currency relative to the currencies of its main trading partners. An increase in the real effective exchange rate denotes a real average effective depreciation of the Hungarian Forint relative to the currencies of its trading partners. Finally, the economic infrastructure variable, also seasonally adjusted, is proxied by gross value added in transportation, communication, and information, and it is measured in millions of Hungarian Forints at constant, 2005 prices.

Unit Root and Cointegration Analysis

Stationarity

In time-series analysis it is critical to test for unit roots or non-stationarity in order to avoid misspecified or spurious regressions (see Engle and Granger 1987). This study used a variety of tests: the Augmented Dickey-Fuller (ADF), the non-parametric Phillips-Perron test (PP) unit root tests and the (confirmatory) Kwiatkowski-Phillips-Schmidt-Shin (KPSS 1992) stationary (no unit root) test. The Doldado et al. (1990) procedure was used to determine the best specification of the test equation (in terms of whether to include an intercept and/or a deterministic trend while testing). The appropriate lags were determined using the SBC as a criterion. Finally, Zivot-Andrews single-break unit root tests were also undertaken because the power of unit root tests is reduced significantly when the stationary alternative is true and a possible structural break is ignored.

The ADF and PP results consistently and indicate that for the level data the null cannot be while for first differences it can be rejected at the 1 % level. The confirmatory KPSS LM test, which reverses the null hypothesis of a unit root and tests for stationaiy concluded the same. The results for the Zivot-Andrews test also lead to the same general conclusion, viz., a failure to reject the null a unit root in the presence of a single structural break for the variables in level form. Overall, the results, reported in Tables 2 and 3 below, suggest that all the series used in this study are integrated of the first order, 1(1) series. The variables in level form are non-stationary while in first difference they are stationary.

Cointegration Analysis

The Johansen and Juselius (1990) cointegration method was used to determine whether there is a stable, long-term 1(0) relationship among the 1(1) series. The Johansen test includes the log of the stock of FDI, log of real GFCF, log of real infrastructure expenditures, and the log of the effective exchange rate. The number of lags in the test equation is 4, which is the usual choice when using quarterly data. (3) The Pantula Principle was used to select the appropriate specification of the model regarding the deterministic components, trend, and intercept of the equation. The procedure compares the trace and the Max-Eigen statistics of Models 2, 3 and 4 (in this order) to their critical values starting from the most restrictive model (no cointegration) to the least restrictive one (two cointegrating vectors), and stops when the null hypothesis of no cointegration cannot be rejected for the first time.

Based on the Pantula selection procedure, there is one unique cointegrating vector and Model 4 should be chosen because it is the last significant estimate before the null of no cointegration cannot be rejected (denoted by an asterisk for both the trace and Max-Eigen statistics). However, the estimated trend for Model 4 (available upon request) is not statistically significant, which is consistent with the unit root tests for the level and differenced series suggested by the Doldado et al. procedure. Therefore, Model 3 which allows for an intercept (but no trend) in both the CE and VAR specification is selected instead to estimate the Vector Error Correction Model presented in Section "Gregory-Hansen single-Break Cointegration Analysis". At any rate, no matter which relevant model is chosen, there exists a unique linear combination of the I(1) variables that links them in a stable and long-run relationship.

Gregory-Hansen Single-Break Cointegration Analysis

Before turning to the EC models, it should be noted that the cointegrating test performed in the previous section does not allow for structural breaks in the sample period, whether level (intercept) shifts or regime (intercept and slope) shifts. Gregory and Hansen (1996) have shown that ignoring these breaks reduces the power of conventional cointegration tests similar to conventional unit root tests and, if anything, should lead to a failure to reject the null hypothesis of no cointegrating vector. This study therefore undertook a G-H cointegration test with level shift and the results are consistent with the Johansen test above. The G-H cointegration test (ten lags) with endogenously determined level (intercept) shift (CC) generated a minimum ADF* stat. = -6.164 [break point=2001:02] which is smaller than the tabulated 5% critical value [-6.05 (1%); -5.56(5%)] reported by Gregory and Hansen. Thus, the null hypothesis of no cointegration with endogenously determined break is rejected at the 1% level of significance. It should be noted that the break date is found by estimating the cointegrating relationship for all possible break dates in the sample period. The Rats program selects the break date where the modified [trimmed] ADF*=inf ADF (t) test statistic is at its minimum. (4)

The cointegrating equation (normalized on the log of SFDI) is reported below and it shows that the long- run estimate for the log of INFR and the log of the real effective exchange rate are positive, while the long-run estimate for the log of GFCF is negative (signs are reversed because of the normalization process) (5); the t-ratios for all included variables are significant at least at the 5% level for a one-tailed test. In other words, a ceteris paribus increase in real economic infrastructure and the real exchange rate induces FDI flows to Hungary, while a ceteris paribus increase in GFCF (a proxy for market size) reduces inflows to the country. Thus, in the long run, it appears that FDI inflows and private capital formation are substitutes for one another which is a somewhat unexpected result and in line with the critics of FDI flows to emerging nations (see Cypher and Dietz 2004). That is, instead of augmenting the pool of resources available for financing GFCF, FDI inflows may actually divert resources away from the financing of private capital formation. The presence of one cointegrating equation from which residuals (EC terms) can be obtained also makes it possible to investigate whether there is a short-run adjustment back to the long-term relationship after a shock, using the Engle-Granger two-step procedure.

Short-Run Error Correction Model

In view of the results above, it is possible to estimate an error correction (EC) model that captures both the short-and long-run behavior of the FDI relationship (Engle and Granger 1987). The changes in the relevant variables represent short-run elasticities, while the coefficient on the EC term represents the speed of adjustment back to the long-run relationship among the variables. Treating the percentage change in FDI inflows as the dependent variable, an estimated EC model is reported below in terms of logarithmic differences of the variables.

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (2)

The short-run estimate for real GFCF suggests that a 10% increase in this variable during the current quarter generates a statistically significant 1.95% increase in FDI flows in the following quarter. The positive effect supports Dunning's market size hypothesis and is contrary to that for the long-run relationship reported above where the effect is negative. The short-run impact of the real effective exchange rate is positive and statistically significant at the 5% level, which is consistent with its long-run effect; it suggests that a 1% real depreciation generates a 0.453% increase in FDI flows during the current period. Thus, in both the short and the long run, foreign investors focus more on the real domestic costs of labor and raw materials (which a real depreciation of the domestic currency would lower in terms of the investors' currency), rather than the real rate of return on their investment per se. The short-run impact of economic infrastructure spending is positive and significant at the 5% level; it suggests that 10% increase gross value added in economic infrastructure during the current quarter will increase FDI inflows by 7.9% within three quarters. The lagged effect makes economic and intuitive sense because it takes time for these types of expenditures to gestate and have their full effect. (6) As the theory predicts, the EC term is negative and highly significant, suggesting that a 10% deviation from the long-run FDI relationship during the current quarter is corrected by about 4.22% in the next quarter, and by 16.9% on an annual basis. Finally, the dummy variable for the crisis years of 2008, 2009 (1st quarter), and 2010-11 is negative and highly significant, indicating that the economic and financial debacle of 2008-09, as well as the ongoing euro crisis, has had a damaging effect on the Hungarian economy. The adjusted R-squared is relatively high at 53.6%, and the p-value for the F-stat. suggests that the EC model as a whole is statistically significant at the 1% level. To ensure that the model does not suffer from higher order serial correlation, an AR(4) specification was fitted and a Breusch-Godfrey test was performed. The results indicate that there is no serial correlation in the model. The non-significant p-values of the Ramsey Reset Test with 1 to 4 powers also suggest that the model is not misspecified.

The EC model was also used to track the historical data on the percentage change in FDI flows for the period. Figure 1 above shows that the model was able to track the turning points in the actual series relatively well. D(LSFDI) refers to the actual series and D(LSFDIF) denotes the in-sample forecast. The Theil inequality coefficient is 0.268, which is below the threshold value of 0.3, and suggests that the predictive power of the model is quite good (see Theil 1966). (Graph is available upon request). Ideally, the bias and variance components should equal zero, while the covariance proportion should equal one. The reported estimates suggest that all of these ratios are relatively close to their optimum values (bias=0.0000, variance=0.0315, and covariance= 0.9684). Sensitivity analysis on the coefficients also revealed that changes in the initial or ending period did not alter the predictive power of the selected models.

Vector Error Correction Model

The VECM framework allows investigators to model the short-run correction mechanism of a system of variables to their long-mn equilibrium without deciding, apriori, about the endogeneity or exogeneity of the included variables. The vector autoregressive framework treats all variables as endogenous and determines the direction of causality between them based on econometric tests instead of assuming exogeneity based on economic theory. In our case there are advantages from not predetermining the direction of causality. First, as indicated in Section "Conceptual Framework", there is no consensus in the literature about the direction of causality between the exchange rate, GFCF, FDI flows, and economic INFR. Second, Hungary is not only a developing country, but a relatively small economy that has experienced significant structural and institutional change and opened itself to the West in a very short period of time. This could cause any predictions from economic theory about the behavior of some key macro variables to deviate significantly from their actual trajectory. Thus, the flexibility of this specification represents a distinct advantage in modeling the system-wide error correction mechanisms of the relevant variables. VECM specifications can only be estimated if there is a cointegrating relationship among the variables which, according to the Johansen test, is indeed the case for our study.

First, an unrestricted VECM is estimated using LSFDI, LGFCF, LREER, and LINFR variables to examine whether a system-wide error correction mechanism exists for these variables. The VECM is estimated based on Model 3 with seven lags (based on AIC and SBC criteria) to allow for the impact of real infrastructure expenditures which, a priori, is likely to have a delayed effect on FDI inflows. (7) The unrestricted VECM finds a negative and highly significant adjustment coefficient for two of the four equations: the D(LFSDI) and D(LGFCF) ones. This means that for these system equations there is a short-run adjustment mechanism based on the adjusted R-squared values and the AIC/SBC criteria, in the equation with D(LSFDI) as the "dependent variable". In this specification, the long-run cointegration equation has significant coefficients for all the variables and is consistent with the results obtained for the Johansen test. (8) Turning to the short-run EC specification for D(LSFDI), the EC term is negative and highly significant, implying that a 10% shock (deviation) away from the long-run equilibrium in the current quarter is corrected by 8.36% in the subsequent quarter. The short-run estimates for this equation also suggest that percentage changes in real GFCF "crowd-in" FDI inflows when lagged one, five, six, and seven periods. Insofar as percentage changes in infrastructure expenditures are concerned, the short-run estimates suggest that it has a positive and highly significant effect on FDI inflows when lagged three and four quarters which is consistent with the ECM presented in the previous section. Finally, percentage changes in the real effective exchange rate have a negative effect on FDI inflows, which is contrary to the results reported for the ECM model presented in the previous section, albeit in that specification the real exchange rate is only significant contemporaneously--not when lagged.

On the other hand, treating D(LGFCF) as the "dependent variable," it can be ascertained from Tables 4 and 5 that the error correction term is negative and significant, implying that a 10% deviation away from equilibrium during the current quarter is corrected in the subsequent quarter by 8.79%. Changes in D(LFDI) have a negative and significant effect when lagged five quarters, while percentage changes in real infrastructure expenditures have a positive and highly significant effect when lagged six to seven quarters. Finally, percentage changes in the real effective exchange rate have a negative and significant effect on D(LGFCF) when lagged three periods.

The VECM framework enables the investigator to impose zero restrictions on the adjustment coefficients of each equation, thus determining which variables can be treated as weakly exogenous in the system, thereby omitting them from the interdependent system of variables. Based on this weak exogeneity test, Table 6 below indicates that the real effective exchange rate and real value added in economic infrastructure can be omitted from the system (treated as weakly exogenous) because the null hypothesis of a zero restriction is not rejected for these variables at the 5% level. In other words, in this simple four equation system, we can treat LSFDI and LGFCF as endogenous variables, while LREER and LINFR are weakly exogenous.

To investigate further the "causal" relationship among these variables, we performed a Granger Block Causality test with the restrictions. This test examines all four equations and tries to determine whether the presumed exogenous variables can be omitted from each equation. This test finds "causality" or precedence in the D(LSFDI) equation at the 5% level, for GFCF, INFR, and the real effective exchange rate (p-value DLGFCF: 0.0128, p-value DLINFR; 0.0101; p-value DLREER:).0001. Not surprisingly, the test finds the presence of reverse "causality" or precedence in the D(LGFCF) for the percentage change in FDI inflows (p-value DLSFDI: 0.0329). Somewhat surprisingly, it finds precedence in the D(LINFRA) equation from percentage changes in the real exchange rate ([p-value.sub.DLEER]: 0.0250), but not the other way around; that is, from D(LINFR) to D(LREER) ([p-value.sub.DLINFR]: 0.5426). (9)

The impulse response functions for the variables in our simple system are shown in Fig. 2 above. Given that the Cholesky decomposition is arbitrary and sensitive to the ordering of the variables, we use the generalized decomposition process first proposed by Pesaran and Shin (1998)--one in which the orthogonal set of innovations does not depend on the VAR ordering. The graphs show the responses of the four variables in question to both a unitary shock in their own values and the rest of the variables over a ten quarter period. The response of FDI inflows to a one standard deviation (SD) innovation in economic INFR is significant and sustained (particularly after three to four periods); on the other hand, the reverse line of "causation is not as strong. The lagged response of private GFCF to a one (SD) innovation in FDI inflows to be positive and sustained (after two to three periods), while the reverse is not as strong. Interestingly, and somewhat unexpectedly, the response of the real effective exchange rate is relatively strong to both a one standard innovation in real GFCF and a one standard innovation in economic INFR, but this strong "causal' effect is not captured in the Granger Block causality test reported above. Finally, the response of GFCF to a one standard deviation in FDI inflows is negative and sustained after one to two periods and then increases dramatically in magnitude after three periods, corroborating the results in the VECM. Next, we trace the variance decomposition (VDC) of each variable over a ten quarter period. The VDC gives information about the relative importance of each random (one-standard deviation) shock to the endogenous variables in the VECM. The results (available upon request) suggest that, after ten quarters, a unitary shock in economic INFR explains 40.3% of the accumulated forecast error variance of FDI inflows and 37.5% of that of private real GFCF. Again, both proportions are significant while the reverse proportions (viz., the accumulated percentage variance of FDI inflows due to GFCF and the accumulated percentage variation of INFR due to FDI inflows) are only 7.1 and -3.5%. A unitary shock in FDI inflows explains 10.2% of the accumulated variance in the real exchange rate, while a unitary shock in economic INFR explains 10% of the accumulated variance in the real exchange rate. Finally, a unitary innovation in the real effective exchange rate explains approximately 5% of the variance in the economic INFR variable.

Based on the unrestricted VECM specifications, we conclude that short-run deviations of the included variables from their long-run cointegrated relationship are corrected in subsequent quarters between 8.2 and 8.8 % for two of the equations in the system. The restricted VEC models suggest that there are two weakly exogenous variables in the system, that is, not all variables can be treated as endogenous. In line with this finding, the Block Granger causality test finds two-way "causality" between FDI inflows and GFCF, and one-way causality or precedence from real INFR spending and the real effective exchange rate to FDI inflows (as well as from the real exchange rate to INFR expenditures). In general, the short-run impulse response functions (and variance decompositions) are consistent with the VECM and Granger Block exogeneity tests with the exception of the real effective exchange rate equation. In light of the findings reported in this paper, policy makers should consider paying close attention to maintaining a competitive and stable real effective exchange rate, as well as making sure that adequate and reliable economic infrastructure is in place to attract FDI flows.

Conclusion

This is the first rigorous time-series study to investigate the potentially causal relationship between inward FDI flows to Hungary, real GFCF, economic infrastructure, and the Hungarian Forint / Euro real effective exchange rate during the 1995-2012 period. Unit root and stationarity tests indicated that the economic variables are integrated of order one. The multivariate cointegration tests showed that there is a stable long-run relationship among the included variables even in the presence of an endogenously determined structural break. An error correction model was generated that has relatively good explanatory power and was able to track the turning points of the in-sample data relatively well. In the long run, increases in both real economic infrastructure and a higher real exchange rate (real depreciation of the domestic currency) increase the stock of FDI, while increases in the level of real GFCF are negatively associated with changes in the stock of FDI. In the short run, the real exchange rate has a negative effect on FDI inflows when lagged more than one period, while lagged increases in real GFCF have a positive and statistically significant effect. Lagged real economic infrastructure also has a positive and highly significant effect on FDI inflows in the short run--consistent with the long-run results. The EC term is negative and significant for both the D(LSFDI) and D(LFCF) equations, suggesting that deviations during the current quarter from the equilibrium relationship are corrected in subsequent quarters. The unrestricted VECM model suggests that two of the variables in the system have a statistically significant adjustment (reversion) mechanism. Restricted versions of the VECM model suggest that the real effective exchange rate and real gross value added in economic infrastructure are weakly exogenous. Granger Block Causality tests and impulse response functions generate results which suggest that there is two-way causality between FDI inflows and GFCF, but one way-causality or precedence from real infrastructure expenditures and the real effective exchange rate to FDI inflows.

However, further research and data is needed to come to more general and robust conclusions regarding the determinants of both FDI flows and private capital formation in Hungary. First, although the sample size of 72 data points exceeds the 50 data point threshold recommended in time series analysis, it is still relatively small so the results have to be taken as tentative. Second, the lack of data did not allow for the inclusion of other macro variables that are important in terms of explaining the variation in FDI flows and gross fixed capital formation in Hungary, such as unit labor costs, the real interest rate, real bank credit to the private sector or proxies for human capital such as secondary or tertiary enrollment ratios. Finally, the VECM results regarding the direction of causality give mixed results in the long and short run for some variables, particularly the real effective exchange rate, which might be a sign of some problem with the specification of the model.

DOI 10.1007/s11293-014-9436-0

Published online: 21 October 2014

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M. D. Ramirez ([mail])

Department of Economics, Trinity College, Hartford, CT 06106, USA

e-mail: miguel.ramirez@trincoll.edu

Z. Komuves

Central European University, Budapest, Hungary

(1) However, the short-and long-run effects of FDI can differ from each other and might even be negative, if it leads to the elimination of domestic firms and/or substantial reverse flows of profits and dividends to the parent company that divert resources away from financing domestic capital formation (see Ram and Zhang 2002).

(2) The FDI series used in this paper includes capital in transit flows and the operation of special purpose entities (SPE).

(3) Other lag specifications were tried but the results were not altered.

(4) Similar significant results were obtained for the G-H test with eight and nine lags. (The detailed results and the log file are available upon request).

(5) The Johansen test was also normalized on the log of real GFCF and the results are consistent with those reported in the text and are available upon request.

(6) The length of the lags in the EC model was determined by the AIC and SBC criteria.

(7) Model 3 is chosen because, as indicated in Section 4.2, the trend variable in Model 4 was not statistically significant. The VECM was also estimated with a dummy variable for the 2008-09 crisis and the ongoing eurocrisis and the results were significantly better and more significant. (Detailed results are available upon request).

(8) VECM/VAR modeling is especially useful for building strong forecasting models on the basis of R-squared and SBC/AIC criteria. In this study we focus on the relationship among the four variables and a forecast model is not estimated.

(9) Detailed Results are available upon request.

Table 1 Hungarian FDI flows as a percentage of Gross Fixed Capital
Formation, 1998-2008

Country:  1998   1999   2000   2001   2002   2003

Hungary   29.7   28.9   24.1   31.8   19.2   11.6

Country:  2004   2005   2006   2007    2008

Hungary   18.5   33.7   75.5   238.7   223.9

Computed from World Bank (2012), World Bank Indicators

Table 2 Stationarity tests

       Logarithmic level data

       ADF      PP       KPSS        ZA

REER    1.843    2.104   0.253 ***   -3.710
GFCF   -1.553   -1.678   0.209 **    -3.734
SFDI   -2.266   -2.455   0.266 ***   -2.910
INFR   -0.337   -2.208   0.277 ***   -3.604

       First log-difference

       ADF         PP           KPSS    ZA

REER   -8.125 ***  -6.772 ***   0.225   -8.937 ***
GFCF   -8.841 ***  -8.831 ***   0.079   -9.828 ***
SFDI   -8.856 ***  -9.497 ***   0.124   -7.295 ***
INFR   -13.02 ***  -15.24 ***   0.071   -8.209 ***

* Denotes a significance of 10 %, ** stands for 5 % and *** is for 1 %.
The ADF and PP test critical values are 1 %: -4.09, 5 %: -3.48, 10 %:
-3.17. The KPSS critical values are 1 %: 0.216, 5 %: 0.146, 10 %: 0.119.
The Zivot Andrews critical values are 1 %: -5.57, 5 %: -5.08, 10 %:
-4.82

Table 3 Johansen test results

R   Trace statistics

    Model 2             Model 3           Model 4

0   75.991 (54.079)     67.786 (47.856)   73.336 (63.876)
1   32.326 * (35.192)   29.411 (29.797)   32.352 (42.195)
2   14.550 (20.261)     12.307 (15.495)   14.877 (25.872)

R   Max--Eigen statistics

    Model 2             Model 3           Model 4

0   43.664 (28.588)     38.375 (27.584)   40.984 (32.118)
1   17.775 * (22.299)   17.104 (21.132)   17.475 (25.823)
2   9.153 (15.892)      7.032 (14.265)    8.083 (19.387)

Table 3 reports the Trace and Max-Eigenvalue statistics of the
Johansen cointegration test for the three relevant models. The test
is conducted on the logarithmic series. R stands for the number of
cointegrating vectors and the 5 % critical values of the tests are
in parenthesis. Model 2 includes a constant but no trend in the
cointegration equation (CE) and does not allow a trend in the VAR
part of the test equation. Model 3 allows 311 intercept, but no
trend in both the CE and the VAR parts of the test equation. Model
4 includes an intercept in both the CE and VAR, a trend m the CE,
but no trend in the VAR

Table 4 Normalized cointegration coefficients

                             LSFDI    LGFCF          LREER

Cointegration coefficients
  t-ratios                   1.0000   0.854 (5.94)   -2.218 (-2.93)

                             LINFR            C

Cointegration coefficients
  t-ratios                   -3.583 (-7.08)   41.96(10.2)

Table 5 Error correction table

                   D(LSFDI)     D(LGFCF)     D(LREER)    D(LINFR)

Error correction
  coefficient       -0.8687      -0.8370      0.1058      -0.0659
Standard Error      (0.01868)    (0.39529)   (0.13504)    (0.06443)
t-statistics       [-4.6519]    [-2.1176]    [0.7836]    [-1.0232]
R-squared            0.6891       0.4507      0.5731       0.6141
Adj. R-squared       0.4405       0.3028      0.2316       0.3055
Akaike AIC          -3.109       -1.609      -3.757       -5.237
Schwarz SBC         -2.130       -0.631      -2.779       -4.259

Table 6 Exogeneity test


HO: weakly exogenous variable   Chi-Square            Probability
                                statistics (65 obs)

D(LSDFI), A(1,1)=0              19.311                0.0000
D(LGFCF), A(2,1)=0              7.4657                0.0062
D(LREER), A(3,1)=0              1.0542                0.3045
D(LINFR), A(4,1)=0              1.2082                0.2716
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Title Annotation:direct investment
Author:Ramirez, Miguel D.; Komuves, Zsofia
Publication:Atlantic Economic Journal
Geographic Code:4EXHU
Date:Dec 1, 2014
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