Why Large Countries Have Low Interest Rates

If you poll Wall Street traders or economics students, you will likely hear that the carry trade between currencies makes money because high-interest-rate currencies appreciate faster than low-rate ones. In a carry trade, an investor purchases a higher-yielding currency and sells a lower-yielding one—for example, borrowing Japanese yen to lend in Brazilian reals—in order to pocket the difference.

But research by Associate Professor Tarek Alexander Hassan suggests there’s more to this explanation of the carry trade. Such a trade is profitable because there’s a permanent interest-rate difference between countries, he says, not due to predictability in exchange rates.

The differences in real interest rates across developed economies remain curiously large and persistent. Canadian consumers, for example, will always have to pay more to borrow than US consumers. Japan, for all its overleveraged fiscal affairs, taps debt capital markets on easier terms—its bonds cost more—than hale Norway.

Hassan proposes that is because bonds are essentially a form of insurance that is country specific. Bonds issued in the currencies of larger economies are comparatively expensive simply because they insure against shocks that affect a larger portion of the global economy.

If you buy a US dollar denominated bond, that’s insurance on the $17 trillion US economy. If you buy a bond denominated in Australian dollars, it’s insurance on that far smaller economy. However, if something goes wrong in a large economy like the United States or Japan, it’s far more likely to affect the rest of the world than a crisis in a country such as Australia or Egypt. As a result, the currencies of large economies tend to gain value when times are bad. Bonds issued in the currencies of larger countries are thus more expensive and hence offered at chronically lower interest rates. The onset of a currency union, moreover, lowers interest rates in participating countries, and stocks in the nontraded sector of larger economies pay lower expected returns.

Hassan tests his predictions using data from 27 developed countries in the Organization for Economic Cooperation and Development (OECD). He compares the average forward premium of their currencies against the dollar with a simple measure of the relative size of their economies—the share that each country contributes to total OECD output (see chart). “We see an economically large negative correlation between this simple measure of country size and forward premia,” he writes. In other words, larger countries pay lower interest rates on their bonds. That thinking, challenging long-held beliefs, could impact how and where people invest globally.