The Effect of the Current Account Balance on Interest Rates

The international capital market is the marginal provider of capital to the Canadian economy, and the current account balance is the measure of demand pressure from Canadian borrowing in that market. If the foreign supply of capital to Canada is less than perfectly elastic, Canadian interest rates will have to rise as Canadian borrowing increases. Past attempts to test empirically for the effect of Canadian fiscal policy on interest rates have generally been unsuccessful, because the link between fiscal policy and the current account balance is indirect and influenced by other factors such as monetary policy. In equilibrium, there is likely to be a strong correlation between fiscal balances and the current account balance. Econometric analysis is complicated by the fact that the current account balance and the Canada- U.S. interest differential are non-stationary variables, which may render OLS estimates unreliable. These variables were found to be cointegrated, and vector error correction was used to estimate the relationship, which produced estimates quite similar to those coming from OLS regressions. Over the past two decades, it appears that the Canadian three month T-bill rate increased by at least 50 basis points for each percentage point increase in the current account deficit as a percentage of GDP. There is no guarantee that an impact of this magnitude will hold in the future, but it is a strong indication that lower foreign borrowing by Canada should result in considerably lower real interest rates than those experienced in the past.