Economic Infrastructure, Private Capital Formation, and FDI inflows to Hungary: A Unit Root and Cointegration Analysis with Structural Breaks

This paper investigates the important question of what relationship, if any, exists between economic infrastructure, gross fixed capital formation, and FDI inflows to Hungary during the 1995-2012 period. Although this question has great significance from an economic policy standpoint, there has been little to no empirical analysis undertaken so far in the case of transition economies such as Hungary. Utilizing single-break unit root and cointegration analysis, this study finds a stable long-run relationship among the included variables, thus an error correction model is developed to capture both the short-and long-run behavior of the variables. In the short run, lagged changes in economic infrastructure, as well as lagged changes in private capital formation are positively associated with changes in FDI inflows; a dummy variable to capture the 2008 financial crisis and euro crisis has a negative and highly significant effect. In the long run, however, FDI inflows and private capital formation are substitutes for one another, while economic infrastructure crowds in private capital formation. The real effective exchange rate is positively correlated with FDI inflows in the long run, but not in the short run. The VEC model leads to the general conclusion that FDI flows and real GFCF have a significant short-run adjustment mechanism, while economic infrastructure and the real exchange rate can be treated as weakly exogenous. (JEL, C22, F21, O52). Key words : Granger causality test, error correction model (ECM), foreign direct investment (FDI), Gregory-Hansen single-break cointegration test, Gross fixed capital formation (GFCF), Johansen cointegration test, KPSS unit root test, vector error correction model (VECM), Zivot-Andrews single-break unit root test.