Does Financial and Goods Market Integration Matter for the External Balance? A Comparison of OECD Countries and Canadian Provinces

Large current account deficits have become a policy concern. The trend toward international capital market liberalization has improved access to foreign pools of saving which has allowed the expansion of current account deficits. There are minimal barriers to capital flows within a country, so an understanding of the determinants of within-country regional external balances could illustrate the likely path of external balances between countries as international economic integration proceeds. This study investigates the determinants of external balances for the regions within a single country— Canada—in order to provide a benchmark for country-level comparisons. The estimates show that the short run response of the external balance to disturbances, such as a deterioration in the terms of trade,is typically larger for Canadian provinces than for a sample of 18 OECD countries. The larger response at the regional level is consistent with greater financial market integration which facilitates the movement of capital and goods. The empirical results also reveal a much greater speed of adjustment of the external balance in the Canadian provinces. This faster adjustment speed, combined with the larger response of net exports, suggests that economic integration may promote the quicker resolution of external imbalances, but it may also allow larger deficits to emerge before they are addressed by market adjustments.