Panel cointegration testing in the presence of common factors

C. Gengenbach, F.C. Palm, J.R.Y.J. Urbain

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Abstract

Panel unit root and no-cointegration tests that rely on cross-sectional independence of the panel unit experience severe size distortions when this assumption is violated, as
has e.g. been shown by Banerjee, Marcellino and Osbat (2004, 2005) via Monte Carlo simulations. Several studies have recently addressed this issue for panel unit root test
using a common factor structure to model the cross-sectional dependence, but not much work has been done yet for panel no-cointegration tests. This paper proposes a model for panel no-cointegration using an unobserved common factor structure, following the work on Bai and Ng (2004) for panel unit roots. The model enables us to distinguish two important cases: (i) the case when the non-stationarity in the data is driven by a reduced number of common stochastic trends, and (ii) the case where
we have common and idiosyncratic stochastic trends present in the data. We study the asymptotic behavior of some existing, residual-based panel no-cointegration, as suggested by Kao (1999) and Pedroni (1999, 2004). Under the DGP used, the test statistics are no longer asymptotically normal, and convergence occurs at rate T rather than √ NT as for independent panels. We then examine the properties of residual-based tests for nocointegration applied to defactored data from which the common factors and individual components have been extracted.
Original languageEnglish
Place of PublicationMaastricht
PublisherMETEOR, Maastricht University School of Business and Economics
Number of pages40
DOIs
Publication statusPublished - 1 Jan 2005

Publication series

SeriesMETEOR Research Memorandum
Number051

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