Testing for cointegration using the Johansen methodology when variables are near-integrated: size distortions and partial remedies

We investigate the properties of Johansen's (J Econ Dyn Control 12:231-254, 1988; Econometrica 59:1551-1580, 1991) maximum eigenvalue and trace tests for cointegration under the empirically relevant situation of near-integrated variables. Using Monte Carlo techniques, we show that in a system with near-integrated variables, the probability of reaching an erroneous conclusion regarding the cointegrating rank of the system is generally substantially higher than the nominal size. The risk of concluding that completely unrelated series are cointegrated is therefore non-negligible. We suggest ways of identifying the problem and different approaches to reduce the size distortions of the tests.