The balance of payments (BOP) is the record of all international transactions (payments and receipts) between the individuals and entities (including government) of one nation and other countries during a specific time period. The current account, the capital account, and the financial account make up a country's BOP. Together, these three accounts tell a story about a country's economy, economic outlook, and strategies for achieving its desired goals.
A large volume of imports and exports, for example, may indicate an open economy that supports free trade. On the other hand, a country that shows little international activity in its capital or financial account may have an underdeveloped capital market and little foreign currency entering the country in the form of foreign direct investment (FDI).
A current account records the flow of goods and services in and out of a country, including tangible goods, service fees, tourism receipts, and money sent directly to other countries either as official aid or family to family. A financial account measures the increase or decrease in a country's ownership of international assets. The capital account measures the capital transfers between U.S. residents and foreign residents.
In this article, we focus on the capital and financial accounts, which reflect investment and capital market regulations within a given country.
Key Takeaways
- A country's balance of payments is represented by its current account, capital account, and financial account.
- The current account records the flow of goods and services in and out of a country (imports and exports).
- The capital account measures the capital transfers between U.S. residents and foreign residents.
- The financial account reflects increases or decreases in a country's ownership of international assets.
- Positive capital and financial accounts mean a country has more debits than credits and is a net debtor to the world; negative capital and financial accounts make the country a net creditor.
The Capital Account
A country's capital account records all international capital transfers.The income and expenditures are measured by the inflow and outflow of funds in the form of investments and loans. A deficit shows more money is flowing out, while a surplus indicates more money is flowing in.
Along with non-financial and non-produced asset transactions, the capital account includes:
- Dealings such as debt forgiveness
- The transfer of goods and financial assets by migrants leaving or entering a country
- The transfer of ownership of fixed assets and of funds received for the sale or acquisition of fixed assets
- Gift and inheritance taxes
- Death levies, patents, copyrights, royalties
- Uninsured damage to fixed assets
Complex transactions with both capital assets and financial claims may be recorded in both the capital and current accounts.
The Financial Account
Sub-accounts
A country's financial account can be broken down into two sub-accounts. One is the domestic ownership of foreign assets. The other is the foreign ownership of domestic assets.
If the sub-account for the domestic ownership of foreign assets increases, the overall financial account increases. If the sub-account for the foreign ownership of domestic assets increases, the overall financial account decreases. Thus, the overall financial account increases when the foreign ownership of domestic assets sub-account decreases.
Together, these two sub-accounts of the financial account measure a country's ownership of international assets.
The financial account deals with money related to:
- Foreign reserves
- Private investments in businesses, real estate, bonds, and stocks
- Government-owned assetssuch as special drawing rights at the International Monetary Fund (IMF)
- Private sector assets held in other countries
- Local assets held by foreigners (government and private)
- Foreign direct investment
How the Capital and Financial Accounts Work
Capital transferred out of a country for the purpose of investing in a foreign country is recorded as a debit in either of these two accounts. Specifically, if it's a portfolio investment, it's recorded as a debit in the financial account. If it's a direct investment, it's recorded as a debit in the capital account.
Since these transfers involve investments, there's an implied return. In the BOP, this return is recorded as a credit in the current account. The opposite is true when a foreign country earns a return. Paying a return on an investment would be noted as a debit in the current account.
The U.S. Bureau of Economic Analysis records and provides information to the public about the current account, capital account, and financial account balances.
Understanding the Balance of Payments
Accounts in Balance
Unlike the current account, which theoretically is expected to run at a surplus or deficit, the BOP should be zero. Thus, the current account on one side and the capital and financial account on the other should balance each other out.
For example, if a Greenland national buys a jacket from a Canadian company, then Greenland gains a jacket while Canada gains the equivalent amount of currency. To reach zero, a balancing item is added to the ledger to reflect the value exchange. According to the IMF's Balance of Payments Manual, the balance of payment formula, or identity, is summarized as:
Current Account + Financial Account + Capital Account + Balancing Item = 0
Positive Capital and Financial Accounts
However, when an economy has positive capital and financial accounts it has a net financial inflow. The country's debits are more than its credits due to an increase in liabilities to other economies or a reduction of claims in other countries.
This is usually in parallel with a current account deficit—an inflow of money means the return on an investment is a debit on the current account. Thus, the economy is using world savings to meet its local investment and consumption demands. It is a net debtor to the rest of the world.
Negative Capital and Financial Accounts
If the capital and financial accounts are negative, the country has a net financial outflow. It has more claims than it does liabilities, either because of an increase in claims by the economy abroad or a reduction in liabilities from foreign economies.
The current account should be recording a surplus at this stage. That indicates the economy is a net creditor, providing funds to the world.
Liberal Accounts
The capital and financial accounts are intertwined because they both record international capital flows. In today's global economy, the unrestricted movement of capital is fundamental to ensuring world trade and eventually, greater prosperity for all.
For this to happen, countries must have open or liberal capital account and financial account policies. Today, many developing economies implement capital account liberalization as part of their economic reform programs. This removes restrictions on capital movement.
Liberalization of a country's capital account may signal a shift toward more open economic policy.
Benefits of Foreign Direct Investment (FDI)
This unrestricted movement of capital means governments, corporations, and individuals are free to invest capital in other countries. That can pave the way for not only more FDI in industries and development projects. It can also allow for more portfolio investment in the capital market as well.
Thus, companies striving for bigger markets, and smaller markets seeking more capital and the achievement of domestic economic goals, can expand into the international arena. This can result in a stronger global economy.
The benefits that the recipient country reaps from FDI include an inflow of foreign capital into its country as well as the sharing of technical and managerial expertise. The benefit for a company making an FDI is expanding market share in a foreign economy and, potentially, greater returns.
Another benefit, according to some, is that a country's domestic political and macroeconomic policies can take on a more progressive stance. That's because foreign companies investing in a local economy have a valued stake in the local economy's reform process. These foreign companies can become expert consultants to the local government on policies that will facilitate businesses.
Other Benefits
Portfolio foreign investments can encourage capital market deregulation and boost stock exchange volume. By investing in more than one market, investors are able to diversify their portfolio risk. They can potentially increase their returns by investing in an emerging market.
A deepening capital market based on local economic reforms and a liberalization of the capital and financial accounts can speed up the development of an emerging market.
Some Capital Account Control Can Be Good
Some sound economic theories assert that a certain amount of capital account control can be good. Recall the Asian financial crisis in 1997. Some Asian countries opened up their economies to the world. An unprecedented amount of foreign capital crossed their borders. Primarily, it was portfolio investment—a financial account credit and a current account debit. This meant short-term investments that were easy to liquidate.
When speculation increased, panic spread throughout the region. Capital flows reversed. Money was pulled out of these capital markets. Asian economies were responsible for their short-term liabilities (debits in the current account) as securities were sold off before capital gains could be reaped. Not only did stock market activity suffer, but foreign reserves were depleted, local currencies depreciated, and financial crises resulted.
Analysts argue that the financial disaster could have been less severe had there had been some capital account controls. For instance, had the amount of foreign borrowing been limited (debits in the current account), that would have limited short-term obligations. In turn, some degree of economic damage could have been prevented.
What Does the Balance of Payments Mean?
The term balance of payments refers to all the international transactions made between the people, businesses, and government of one country and any of the other countries in the world. The accounts in which these transactions are recorded are called the current account, the capital account, and the financial account.
Why Should an Economy Be Liberalized?
A more open or liberal economy can mean more international trade for a country. The income that results from that trade can benefit a country's citizens. It could raise their standard of living. For a country as a whole, freer trade can raise its standing in the world and attract investors. That can open up all kinds of beneficial financial and economic opportunities.
What Is the Capital Account?
The capital account is one of the accounts used in the balance of payments. It's used to record international transfers between the residents in one country and those in other countries. The capital account can reflect a country's financial health and stability. It can indicate how attractive a country is to other countries that seek to invest internationally.
The Bottom Line
A country's balance of payments is a summarized record of that country's international transactions with the rest of the world. These transactions are categorized by the current account, the capital account, and the financial account.
Lessons from the Asian financial crisis resulted in new debates about the best way to liberalize capital and financial accounts. Indeed, the IMF and World Trade Organization historically have supported free trade in goods and services (current account liberalization). They are now faced with the complexities of capital freedom.
Experience has proventhat without controls, a sudden reversal of capital flows can destroy an economy and result in increased poverty for a nation.
