What is an artificial rate?

Canada is a small open economy with free capital flows and a flexible exchange rate. This shouldn’t be news to anyone, least of all those professionals that work in the financial markets. You might imagine how surprised we were to find an article in the Globe and Mail quoting Warren Lovely of CIBC World Markets in a comment on foreign buying of Canadian securities. (Click here for article)

“But could this foreign buying spawn a new style of crowding out, displacing some domestic investors by driving yields and spreads to artificial and unattractive levels?”

As a small country, we are unable to affect the world price of anything. This includes the price of loanable funds – the interest rate. In its attempt to prevent deflation the US Federal Reserve Board has been flooding the market with US dollars. Countries such as China that have current account surpluses end up holding these dollars. Eventually these dollars move around the globe seeking positive yields.

According to an article in the Economist, one of the biggest recipient thus far seems to have been Brazil. When international investors try to buy Brazilian bonds, whose yields are 112 basis points above equivalent US bonds, they must first purchase Brazilian Reais. This increase in demand causes the Reais to rise, reducing their exports and increasing their imports. This slows their economic growth. The increase in demand for Brazilian bonds increases the price of these bonds and reduces their yields. The capital inflow continues until yields are equated on a risk adjusted basis. The reduction in interest rates should increase domestic consumption and investment spending. Brazil has recently imposed a tax on foreign holdings of Brazilian bonds in an attempt to slow capital inflows. (Click here for article)

An article in Bloomberg Businessweek shows that Mexico is experiencing the same situation as Brazil. Money flowing into Mexico has increased the value of the peso and central bank Governor Agustin Carstens has indicated that he may reduce borrowing costs to offset the reduction in exports. (Click here for article)

Canada is now experiencing the same phenomenon. Money is flowing in from international markets driving up the Canadian dollar exchange rate and the price of Canadian bonds. As with all open economies, yields in Canada must be equal to the rest of the world on a risk adjusted basis.