Capital Account Balance Essay

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The capital account balance measures the net value of transactions involving financial assets between residents and nonresidents of a country. It is equal to the difference between funds acquired from the rest of the world (capital inflows) and funds provided to the rest of the world (capital outflows) in a specific period of time. The capital account balance shows whether a country is a net debtor or a net creditor on a flow basis. If capital outflows are greater than capital inflows, the country in question is a net creditor and runs a capital account deficit. In contrast, being a net debtor means that capital inflows are greater than capital outflows; the capital account is in surplus.

The flow of funds between countries takes various forms. The capital account, under the balance of payments accounting, makes a distinction between direct investment, portfolio investment, reserve assets, and other investment. Direct investment refers to the establishment of a resident enterprise or the acquisition of a lasting interest in a resident enterprise by nonresidents. Portfolio investment denotes transactions in equity and debt securities such as stocks, bonds, and money market instruments. Reserve assets usually consist of foreign exchange reserves held by monetary authorities. The category of other investment covers transactions pertaining to financial assets such as trade credits, loans, and demand deposits. The capital account balance is the sum of net positions in direct investment, portfolio investment, reserve assets, and other investment.

The accounting identity of the balance of payments system implies that the balance on the capital account has a reverse sign of and is equal to the balance on the current account. In other words, the capital account and current account balances sum up to zero. While this accounting identity is true by definition, data collection, reporting, and estimation errors cause a statistical discrepancy between the two. This discrepancy is reported under the category of net errors and omissions.

A further understanding of the capital account balance can be obtained by analyzing its relation to national income. Consider a country where the consumption and investment of its residents and the spending of its public sector are greater than the national income. In a global economy, this excess demand is met by imports, which are financed through funds from the rest of the world. Thus, being a net debtor means that the residents of a country can spend beyond what they produce and can finance this excess spending by borrowing from residents of other countries.

The magnitude of the capital account balance does not—by itself—throw much light on a country’s economic strength and health. For example, the absolute size of the funds acquired by the United States in each calendar year is the biggest in the world.

Nevertheless, the stock of the U.S. foreign debt as a percentage of its gross domestic product is small compared to the majority of developing and emerging market economies.

A country can remain as a net debtor as long as private and public economic agents in the rest of the world are willing to provide funds. However, running a capital account surplus increases the stock of foreign debt held in a country. As the stock of foreign debt increases, the willingness of foreign creditors to provide funds diminishes. Thus, a country cannot run a capital account surplus indefinitely.

A stop in the funds acquired from the rest of the world forces an adjustment in national consumption and investment. The severity of adjustment increases if the stop of funds is accompanied and followed by a reversal; that is to say, if a country transitions from receiving funds to sending funds in a relatively short amount of time. In the past, many developing and emerging market economies had to endure severe economic crises as a result of sudden stop and reversal of foreign capital inflows.

Bibliography:

  1. Barry J. Eichengreen and Ricardo Hausmann, eds., Other People’s Money: Debt Denomination and Financial Instability in Emerging Market Economies (University of Chicago Press, 2005);
  2. Giancarlo Gandolfo, International Finance and Open-Economy Macroeconomics (Springer-Verlag, 2001);
  3. International Monetary Fund, Balance of Payments Manual, 5th ed. (IMF, 1993);
  4. Machlup, “Three Concepts of the Balance of Payments and the So-Called Dollar Shortage,” Economic Journal (v.60, 1950);
  5. Jeffrey D. Sachs, ed., Developing Country Debt and the World Economy (University of Chicago Press: 1989);
  6. Robert M. Stern, The Balance of Payments: Theory and Economic Policy (Aldine, 1973);
  7. S. Department of Commerce, The Balance of Payments of the United States: Concepts, Data Sources, and Estimating Procedures (U.S. Government Printing Office, 1990).

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