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Applied Economics
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Public investment and private capital formation in a vector error-correction model of growth
Khalifa H. Ghali Available online: 04 Oct 2010

To cite this article: Khalifa H. Ghali (1998): Public investment and private capital formation in a vector errorcorrection model of growth, Applied Economics, 30:6, 837-844 To link to this article: http://dx.doi.org/10.1080/000368498325543

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Applied Economics, 1998, 30, 837 844

Public investment and private capital formation in a vector error-correction model of growth
K H A L I FA H . G H A L I Department of Economics, School of Business and Economics, PO Box 17555, United Arab Emirates University, Al Ain, United Arab Emirates

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Most of the literature dealing with the impact of public investment on private capital formation and economic growth focuses either on cross-section or static analysis. However, investigation of the long-run dynamic interactions between private and public investment and growth is much more insightful for public policy aiming at the determination of the appropriate size of its public sector. This paper extends the model of Barth and Cordes (1980) and uses multivariate cointegration techniques to develop a vector error-correction model useful for investigating the long-run e ects of public investment on private capital formation and economic growth. We apply our methodology to a developing country implementing the IMF debt-stabilization programmes and show how, in this country, public investment is having a negative short-run impact on private investment and a negative long-run impact on both private investment and economic growth. I. INTRODUCTION In recent years, many researchers have focused their attention on the complex and controversial question of whether private and public investment are related (Ramirez, 1986b, 1991, 1994; Easterly, 1992; Barro, 1981, 1990, 1991; Aschauer, 1988, 1989b; Ram, 1986; Barth and Cordes, 1980), among others. The resurgence of interest in endogenous growth theory and the ongoing process of liberalization and privatization in many developing countries, are the principal reasons for looking at the relationship between private and public investment and its potential impact on long-run economic growth. In the aftermath of the debt crisis, many developing countries adopted IMF-sponsored debt stabilization programmes in which it is assumed that private and public investment are not related. Therefore, since public spending was considered to be the main source of debt, these programmes have, among other things, drawn upon governments to cut their spending on public investment. This measure is to be accompanied by the privatization of state-owned monopolies and the creation of a favourable environment that allows the private sector to compete successfully in the global economy. Therefore, a study of the relationship between private and public capital
0003 6846

formation is necessary for determining the relevance of such measures. Theoretically, one point of view suggests that public investment undertaken by heavily subsidized and ine cient state-owned enterprises in agriculture, manufacturing, energy, banking and nancial services, has more often reduced the possibilities for private investment and long-run economic growth. In addition, the nancing of public capital expenditures through external and internal indebtedness, the repression of the private nancial system, has crowded out the private sector from pro table investment opportunities. For this, and in the aftermath of the debt crisis, many developing countries have changed their overall development strategies. The new growth models rely heavily on market forces, as is proven by the ongoing processes of deregulation of product and factor markets and the privatization of state owned enterprises. On the other hand, there are points of view for which public investment is generally believed to be of critical importance, not only as a component of nal aggregate demand, but also in terms of the impact of public investment on the economys growth and employment opportunities. Moreover, in countries characterized by the existence of monopolies, the lack of fully developed markets of capital, insurance, information and
837

1998 Routledge

838
public investment can make product and factor markets work more e ciently and, hence, generate substantial spillover e ects for the private sector. Public investment is also regarded to be of critical importance when con ned to those goods that are necessary for the proper functioning of a market system. For instance, public investment in social and economic infrastructure facilitates the implementation and realization of private investment plans. This paper uses the Johansen (1988, 1992) and Johansen and Juselius (1990) multivariate cointegration techniques and develops a vector error-correction model of growth to investigate the temporal causal dynamics between the private and public investment. Application of this methodology to data from Tunisia, which is a developing country that adopted the IMF debt-stabilization programmes since 1986, has allowed us to identify a substantial crowding-out e ect of public investment on private capital formation. The paper is organized as follows. Section II presents a neoclassical production function where the private and public capital stocks are treated as separate inputs, and discusses its implications on the e ects of public investment on private investment and growth. It also demonstrates how multivariate cointegration techniques can be used to model the long-run behaviour of these variables and test for cointegration and Granger-causality . Section III presents the empirical results and Section IV contains the conclusion. I I . TH E M O D E L AN D T H E M E TH O D A neoclassical production function Following Barth and Cordes (1980), Aschauer (1988) and Ramirez (1994), it is possible to treat the private and public capital stocks as separate inputs in a neoclassical production function, that is

K. H. Ghali
(F2 3 > 0). Lastly, it will increase output through its positive impact on the marginal productivity of labour, that is by increasing the amount of both private and public capital per worker (F1 2 and F1 3 > 0). Second, in the case where private and public capital are direct substitutes, an increase in public investment via, say, the operations of state-owned enterprises, generates a positive direct e ect, but a negative indirect e ect that could more than o set it. This happens when [(F3 + F1 3 ) + (F2 3 - F1 2 )] < 0. Lastly, when private and public capital are independent, a ceteris paribus increase in public investment will generate a positive e ect on output. Similarly, one can think of the possible e ects of a ceteris paribus increase in private investment on public investment. For instance, a growing private sector will, in due course, induce the public sector to provide essential investments in social and economic infrastructure. The private and public investment behaviour, described above, suggests that their long-run movements may be related. Furthermore, if we allow for short-run dynamics in such private and public investment behaviour, the analysis presented above would also suggest that past changes in private and public investment should contain useful information for predicting their future changes, ceteris paribus. These implications can be easily examined using the tests for multivariate cointegration and Granger-causality .

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T esting for cointegration

Consider the vector autoregressive (VAR) model Xt = F
1

Xt

+ F 2 Xt

+ F k X t k + m + h t,
(2)

t = 1,

,T

Y = F(L , Kp, Kg) + Ey

F1 , F2 F3

(1)

> 0; F1 1 , F2 2 < 0; F1 2 > 0

0; F2 3 0; F1 3 0

where Y is the level of real output, L denotes the level of employment, K p is the stock of private capital, K g is the stock of public capital, and Ey is a shift parameter of the production function. With this speci cation it is possible to analyse interactions between the private and public capital stocks and their impact on the level of output and employment. For instance, a ceteris paribus increase in public investment gives rise to three conceptually distinct e ects. First, if the public capital stock is productive and complements the private capital stock, then a ceteris paribus increase in the public capital stock will directly increase output (F3 > 0). Secondly, it will indirectly increase private investment and output by raising the marginal productivity of the private capital stock relative to the real interest rate

where X t is a 33 1 vector containing Y , Ip and Ig where Y is real GDP, Ip is real private investment and Ig is real public investment. Suppose that these variables are I(0) after applying the di erencing lter once. If we exploit the idea that there may exist co-movements of these variables and possibilities that they will trend together towards a long-run equilibrium state, then by the Granger representation theorem, we may posit the following testing relationships that constitute our vector error-correction (VEC) model of growth
D

Xt = G

1D

Xt
P Xt

+G
k

2D

Xt

+G

k 1D

Xt

k+ 1

+ m + h t, t = 1,

,T

(3)

where D Xt is the vector of the growth rates of these variables, the G s are estimable parameters, D is a di erence operator, h t is a vector of impulses which represent the unanticipated movements in Xt, with h t ~ niid(0, S ) and P is the long-run parameter matrix. With r cointegrating vectors (1 < r < 3), P has rank r and can be decomposed as

Public investment and private capital formation

839
direction. This result is a consequence of the relationships described by the error-correction model. Since the variables share common trends, then either D Y t, D Ipt, D Igt, or a combination of any of them must be Granger-caused by lagged values of the error-correction terms, which themselves are functions of the lagged values of the level variables. Intuitively, if Y t p , Ipt p , Igt p , share common trends, then the current change, say in Y t (i.e. D Y t), is partly the result of Y t moving into alignment with the trend values of Ipt and Igt. Given this, the temporal Granger-causalit y between the variables can be investigated through the following three channels. (i) The statistical signi cance of the lagged error-correction terms by applying separate t-tests on the coe cients of each of them. (ii) A joint F-test or Wald x 2 test applied to the coe cients of each explanatory variable. (iii) A joint F-test or Wald x 2 test on all the terms in Equation (1) and all the terms in Equation (2). If the adjustment coe cients of a dependent variable are not signi cant, it means that it is weakly exogenous, and the VEC model should be reformulated, conditioning on this variable. In the reformulated model, the weakly exogenous variable will have an equation that does not include the cointegrating vectors and, hence, will behave as a random walk variable with a drift term. I I I . A PP L I C A T I O N T O T U N I S I A N D A T A In the following we apply our methodology to data from Tunisia, which is a developing country that has recently embarked on a large-scale process of privitization and deregulation of state-owned monopolies based on recommendations from the International Monetary Fund (IMF). The results of our analysis are found to be consistent with these recommendations. Data and variable de nitions We dispose of annual series on private and public investment and GDP for Tunisia over the period 1963 93.2 The variables used in this study, where ln denotes the natural logarithm of the variable, are the following.

= a b , with a and b both 3 3 r matrices. b are the parameters in the cointegrating relationships and a are the adjustment coe cients which measure the strength of the cointegrating vectors in the VEC model. The Johansen (1988, 1992) and Johansen and Juselius (1990) multivariate cointegration techniques allow us to estimate the long-run or cointegrating relationships between the non-stationar y variables using a maximum likelihood procedure, which tests for the cointegrating rank r and estimates the parameters b of these cointegrating relationships. As proved by Johansen (1991, 1992), the intercept terms in the VEC model should be associated with the existence of a deterministic linear time trend in the data. If, however, the data do not contain a time trend, the VEC model should include a restricted intercept term associated with the cointegrating vectors. The novelty of the cointegration approach is that empirical modelling of growth is not restricted to a particular functional relationship concerning the variables behaviour. Rather, the approach is to let the data suggest the type of relationships that variables have in the long-run. The cointegration methodology illustrates well the con ict that exists between the equilibrium framework and the disequilibrium environment from which the data are collected. As formulated by the VEC model, this con ict can be easily resolved by extending the equilibrium framework into one that accounts for disequilibrium by including the adjustment mechanisms represented by the error correction terms. Once the equilibrium conditions are imposed, the VEC model describes how the system is adjusting in each time period towards its long-run equilibrium state. Since the variables are supposed to be cointegrated, then in the short term, deviations from this long-run equilibrium will feed back on the changes in the dependent variables in order to force their movements towards the long-run equilibrium. Hence, the cointegrating vectors from which the error correction terms are derived are each indicating an independent direction where a stable, meaningful long-run equilibrium state exists. The coe cients of the error-correction terms, however, represent the proportion by which the long-run disequilibrium (or imbalance) in the dependent variables are corrected in each short-term period.
P

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T esting for Granger-causality

The cointegration methodology pioneered by Granger (1986), Hendry (1986) and Engle and Granger (1987) opened a new channel towards testing for Granger-causality .1 As Granger (1986, 1988) pointed out, if two variables are cointegrated then Granger-causality must exist in at least one
1

Y = ln(Real GDP) Ip = ln(Real Private Investment) Ig = ln(Real Government Investment)

Fig. 1 shows plots of the variables over the sample period.

Causality is a subject of great controversy among economists. See Zellner (1988) for a detailed discussion of this issue. Interested readers could also refer to a supplementary issue of the Journal of Econometrics, September October 1988, which include studies discussing the subject. This paper uses the concept of causality in the probabilistic sense rather than in the deterministic sense. Moreover, causality de ned here is in the Granger temporal, rather than the structural sense. 2 Data used in the study are obtained from the Institut dEconomie Quantitative (IEQ) at the Tunisian Ministry of Economy.

840

K. H. Ghali
augmented Dickey Fuller (ADF), 1979, and the Phillips and Perron (P P), 1988, tests. They can be performed using variates of the following regression.
D

yt = a

+ r yt

+ b T + + ds D yt s + e
s= 1

(4)

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where yt is the relevant time series, e t is the residual term and T is a time trend. This test is performed on the level variables as well as on their rst di erences. The null hypothesis is that the variable under investigation has a unit root, against the alternative that it does not. In each case the lag-length is chosen by minimizing the nal prediction error (FPE) due to Akaike (1969). We also tested for the existence of up to the tenth-order serial correlation in the residuals of each regression using the Ljung Box Q statistics. The tests for unit roots are performed sequentially. The second and third columns of Table 1 report tests of stationarity about a non-zero constant. As shown in the rst half of the table, the null hypothesis that the level variables contain unit roots cannot be rejected by both tests. We then test for stationarity about a deterministic linear time trend. The results of these tests are reported in the fourth and fth columns of Table 1. Again the null hypothesis that each of the time series has a unit root cannot be rejected. The bottom half of Table 1 reports results of testing for unit roots after di erencing the data once. Both tests reject the null hypothesis. Since the data appear to be stationary in rst di erences, no further tests are performed. Hence, the results of Table 1 are consistent with the null hypothesis that the level variables are each integrated of order one.

T est results for cointegration

Before applying the Johansens procedure to estimate a and b , it is necessary to determine the lag length, k, of the VAR, Equation (2), which should be high enough to ensure that the errors are approximately white noise, but small enough to allow estimation. Since the Johansen procedure is sensitive to the choice of the lag length, we based our decision on the Akaikes Final Prediction Error (FPE) criterion and selected k = 4. Table 2 reports the diagnostic tests for normality and serial correlation in the residuals for each of the three equations in the VAR using k = 4. This lag length left the residuals approximatel y independently identically normally distributed (niid) for all the equations. The results for testing for the number of cointegrating vectors are reported in Table 3, which presents both the maximum eigenvalue (l max) and the trace statistics, the 10% critical values as well as the corresponding l values. This test is performed using an unrestricted intercept term in the VAR model which assumes the existence of a deterministic time trend in the data. As can be noticed, both the l max and the trace tests suggest the existence of a unique cointegrating

Fig. 1. Plots of the variables, sample 1963 93

T est results for unit roots

The tests used to investigate the existence of unit roots in the level variables as well as in their rst di erences are the

Public investment and private capital formation

Table 1. T est results for unit roots Stationarity around a non-zero mean Variable ADF P P Stationarity around a linear trend ADF P P

841

Y
D

Ip Ig

- 1.297 - 2.490 - 1.241 - 6.891 - 4.639 - 3.107 - 2.966

- 1.212 - 1.670 - 1.397 - 6.691 - 4.609 - 3.652 - 2.963

- 0.829 - 1.932 - 1.976 - 3.579

- 1.321 - 1.408 - 1.733 - 3.573

D Ip D Ig

5% critical values

Table 2. Residual diagnostic tests for the V AR equations, k Variable TSC(10) 13.483 4.663 6.653 N(2) 2.514 1.059 1.496

=4

Table 4. a and b vectors Variable

b 9 a

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Ip Ig

Y
Ip Ig (-

1.000

- 1.710

(-

- 0.014 -

Notes: TSC(10) is a test for up to the tenth-order serial correlation, TSC(10)

= T S (ri ), i = 1,
2

, 10 ~ x

(10)

8.550) 2.035 (5.781)

(-

0.481) 0.393 (2.053) 0.193 3.070)

N(2) is the Jarque and Bera (1980) test for normality, which is asymptotically distributed x 2 (2).

Notes: t-ratios are in parentheses.

Table 3. T esting the rank of P Trace H0 r=0 r< 1 r< 2 H1 r> r> r> 1 2 3 Stat. 28.43 6.27 1.51 90% 26.70 13.31 2.71 H0 r=0 r< 1 r< 2 H1 r=1 r=2 r=3
l
max

Stat. 22.16 4.76 1.51

90% 13.39 10.60 2.71

0.560 0.161 0.054

vector, which means the existence of two common stochastic trends. Since the speci cation of the deterministic components in the VEC model is essential for determining the method of estimation and, because the results above are obtained assuming the existence of an unrestricted intercept term, we now check this assumption by testing the null hypothesis of the absence of a deterministic linear time trend in the data. To do this, we use the likelihood ratio test developed by Johansen and Juselius (1990). In our case, the likelihood ratio statistic is given by

- T + ln{(1 i= 2

* l 1 )/(1

l i )} as ~ x 2 (2)

(5)

The computed value for this statistic is 65.027 and the 5% critical value is 5.991. Consequently, the result of the test is highly signi cant suggesting the existence of a deterministic linear time trend in the data, which is consistent with the

evidence presented by the plots of the data. (see Fig. 1 above.) Hence, in the following we continue to use an error correction model with an unrestricted intercept term and one cointegrating vector. The estimates of b and a are presented in Table 4. From the a vector, one quickly notices that the coe cient on the cointegrating vector in the D Y equation is small and insigni cant. Testing that this coe cient is equal to zero, is a test that Y is weakly exogenous, which enables the VEC model to be respeci ed as a two equation system conditioning on Y . Testing weak exogeneity of Y , that is a 1 = 0, yields a likelihood ratio test = 0.20 which, compared to the 5% critical value x 2 (1) = 3.84, enables us to accept the null hypothesis easily. Estimates of a and b and their t-ratios from the restricted model are presented in Table 5. Given the results of Table 5, we can say that the system is now completely identi ed. We have estimated a model with

842
Table 5. a and b vectors from the restricted model Variable
b 9 a

K. H. Ghali
variables. Hence, it is behaving as a random walk variable with a drift term.

Ip Ig

(-

1.000 1.707 8.665) 2.005 (5.778)

Granger-casuality test results

0.465 (2.404) 0.193 3.022)

(-

The unit root and cointegration test results presented above imply that the variables have a vector error-correction representation of the form
D

Notes: t-ratios are in parentheses. Table 6. T he eigenvalues of the companion matrix Real 1.000 1.000 0.791 0.641 0.641 0.221 0.221 0.604 0.604 0.185 0.185 0.461 Complex 0.000 0.000 0.000 0.426 0.426 0.686 0.686 0.314 0.314 0.633 0.633 0.000 Modulus 1.000 1.000 0.791 0.770 0.770 0.721 0.721 0.680 0.680 0.659 0.659 0.461 Argument 0.000 0.000 3.142 0.587 0.587 1.259 1.259 2.662 2.662 1.855 1.855 0.000
D

Yt = u

+ +
3

s= 1

1 , sD

Y t
s

+ +
e

s= 1
1, t 3

2, sD

Ipt

+ +
Ipt

s= 1

3 , sD 3

Igt
1 , sD

(6)
2, sD

= /

+ + /
s= 1
3 3 , sD 3

Y t
s

+ + /
s= 1
2 n t 1 3

Ipt

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+ + /
s= 1

Igt
1, sD

+a
s

+
e

2,t

(7)
s

Igt

=
d

+ +
3

s= 1

Y t
s

+ +

s= 1
3 n t 1

2 , sD

Ipt
3,t

+ +

s= 1

3 , sD

Igt

+a

+
e

(8)

one cointegrating vector and two common stochastic trends. To check the model after imposing the weak exogeneity of Y and make sure that none of the unrestricted roots have come close to unity as a result of imposing this restriction, the eigenvalues of the companion matrix are presented in Table 6. These eigenvalues con rm that the restricted system has two unit roots, and the remaining roots are well inside the unit disc, which is in agreement with the statistical model. The results above indicate that the variables are moving together towards a stable, long-run equilibrium state. The cointegrating vector is indicating the direction where such equilibrium exists and the adjustment coe cients are indicating the speed of adjustment of each variable to this longrun equilibrium. From the long-run relationship between the variables given by the cointegrating equation, we can see that, in the long-run, private investment has a positive e ect on Y , and hence on growth, while public investment has a negative e ect on it. Since the coe cients in this equation represent the elasticities of Y to Ip and Ig, we note that the negative e ect of public investment is about to o set the positive e ect of private investment. Moreover, from the estimated a vector we can see that the speed of adjustment of private investment to the long-run equilibrium is higher than the speed of adjustment of public investment. For the Y variable, however, while its long-run behaviour is responding to the trend movements of Ip and Ig, in the short-run it is responding only to the short-term changes in these

where n t is the cointegrating vector and where a 2 and a 3 are the adjustment coe cients. OLS estimates of the error-correction model are presented in Table 7. Since the results are sensitive to departures
Table 7. Estimates of the error-correction model Variable
D

Y
(-

D Ip

D Ig

Constant
n
1

0.064 (0.185)

- 2.489

Y
D D

Y Y
D Ip D Ip D Ip D Ig D Ig D Ig

(
2

R2
s

TSC(10) N(2) RESET(1)

0.094 (0.308) - 0.068 ( - 0.261) 0.007 (0.149) 0.004 (0.106) 0.035 (1.057) 0.135 (2.011) - 0.069 ( - 0.880) 0.014 (0.169) 0.28 0.0347 12.723 5.495 2.043

- 0.355 - 1.569)

(((-

((-

2.489) 0.465 (2.404) 3.272 (2.155) 5.570 (2.721) 3.765 (2.175) 0.082 0.271) 0.188 0.738) 0.136 0.617) 0.641 (1.420) 1.446 2.763) 1.060 1.874) 0.47 0.233 3.300 3.643 3.612

((((-

(-

3.033 (3.031) 0.193 3.022) 1.268 2.534) 1.052 1.558) 0.009 0.017) 0.016 (0.159) 0.035 0.416) 0.003 (0.040) 0.434 (2.915) 0.084 (0.486) 0.188 (1.010) 0.61 0.0768 12.484 0.944 2.104

Public investment and private capital formation

Table 8. T est results for Granger-causality Null hypothesis Public investment does not Granger-cause growth Public investment does not Granger-cause private investment F(3,17) 1.39 F(3,16) 4.40 5% critical values 3.20 3.24

843

from the standard assumptions, we present some diagnostic tests on the residuals of each equation. The rst test, TSC(10) is a test for up to the tenth-order serial correlation in the residuals, which is distributed x 2 (10). The second test, N(2), is the Jarque and Bera (1980) normality test which is asymptotically distributed x 2 (2). The third test, RESET(1), is the RESET test for parameter instability which is asymptotically distributed x 2 (1). Residuals from the three equations pass the tests at the 95% signi cance levels and, hence, there is no signi cant departure from the standard assumptions. To test whether public investment Granger-cause s growth, we test the null hypothesis H0 : u 3 , 1 = u 3 , 2 = u 3 , 3 = 0 using the standard F-statistic. Similarly, to test whether public investment Granger-causes private investment, we test the null hypothesis H0 : / 3 , 1 = / 3 , 2 = / 3 , 3 = 0. The results of testing these hypotheses are presented in Table 8. From the D Ip equation in Table 7 we can see that public investment is having a signi cant negative e ect on private investment, especially public investments undertaken two years in the past. This means that private investment reacts negatively to changes in public investment with two time lags. Hence we can conclude that, in Tunisia, investments made by the public sector are having a `crowding-out e ect on private investment. This result is quite realistic in the case of Tunisia where public investment undertaken by heavily subsidized and ine cient state-owned enterprises in agriculture, manufacturing, energy, banking and nancial services, has often reduced the possibilities for private investment. Moreover, the nancing of public capital expenditures through internal indebtedness, the repression of the private nancial system, has crowded out the private sector from pro table investment opportunities. However, since the VEC model contains three time lags, we can test that all three lagged changes in public investment jointly a ect current changes in private investment. This is the test for temporal Granger-causalit y presented in column two of Table 9, and is signi cant. Given the results above, a useful policy recommendation is that the Tunisian government should withdraw from those activities that reduce the possibilities for private investment. The deregulation of state-owned monopolies as in banking, transport, telecommunications, energy and agriculture, and the privatization of public enterprises should be useful measures for promoting productive and allocative e ciency.

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Looking at the e ects of the private and public investment in the growth equation (D Y ) and the results of the Granger-causalit y tests, we can say that neither of them helps predict future growth. The ow of causality is rather going from growth to these two variables. For public investment, this result stresses further the recommendations made by the IMF to the Tunisian government concerning the shrinking of the public sector in order to reduce its budget de cits. For the private sector, these results are in accordance with the fact that the Tunisian private sector is not yet su ciently developed to take the lead and promote economic growth. The provision of an adequate infrastructure, the enforcement of regulations encouraging private investment and the reduction of sectoral distortions are the sorts of measures the Tunisian government may undertake in order to enhance the competitiveness of the economy in a global market environment.

I V . C O N CL U S I O N S Many developing countries have adhered to the IMF-sponsored debt stabilization programmes by reducing their nancing to the public sector without having any evidence on the relevance of such measures. Using multivariate cointegration techniques, this paper developed a vector error-correction model of growth useful for investigating the temporal causal dynamics between private and public investment. We applied our methodology to data from Tunisia over the period 1963 93. For this country we found that GDP, private investment and public investment have two common stochastic trends and one cointegrating vector. In the long-run, public investment is found to have a negative impact on growth and private investment. In the short-run, public investment has a negative impact on private investment and no e ect on growth. Our ndings are found to be consistent with recommendations the IMF made to the Tunisian government concerning the shrinking of the public sector.

RE F ER E N C E S
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