17.4 Calculating the Current Account, Financial Account, and Capital Account

Current Account Calculation

The current account represents the sum of the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors), and cash transfers. It is called the current account as it covers transactions in the “here and now” – those that don’t give rise to future claims.

The balance of trade is the difference between a nation’s exports of goods and services and its imports of goods and services. A nation has a trade deficit if its imports exceed its exports. Because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports. This, however, is not always the case. Secluded economies like Australia are more likely to feature income deficits larger than their trade surplus.

The net factor income records a country’s inflow of income and outflow of payments. Income refers not only to the money received from investments made abroad (note: the investments themselves are recorded in the capital account but income from investments is recorded in the current account) but also to the money sent by individuals working abroad, known as remittances, to their families back home. If the income account is negative, the country is paying more than it is taking in interest, dividends, etc.

Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a return. Typically, such transfers are done in the form of donations, aids, or official assistance.

Normally, the current account is calculated by adding up the 4 components of current account: goods, services, income, and cash transfers.

Thus, a country’s current account can by calculated by the following formula:

[latex]CA = (X - M) + NY + NCT[/latex]

Where

[latex]CA[/latex] is the current account,

[latex]X[/latex] and [latex]M[/latex] are the export and import of goods and services respectively,

[latex]NY[/latex] is net income from abroad, and

[latex]NCT[/latex] is the net current transfers.

When the sum of these four components is positive, the current account has a surplus.

Financial Account Calculation

The financial account (also known as the capital account under some balance of payments systems) measures the net change in ownership of national assets.

When the financial account has a positive balance, we say that there is a financial account surplus. A financial account surplus means that the net ownership of a country’s assets is flowing out of a country – that is, foreign buyers are purchasing more domestic assets than domestic buyers are purchasing assets from the rest of the world. Likewise, we say that there is a financial account deficit when the financial account has a negative balance. This occurs when domestic buyers are purchasing more foreign assets than foreign buyers are purchasing domestic assets. For example, a financial accounts deficit would exist when Country A’s citizens buy $200 million worth of real estate overseas while overseas investors purchase only $100 million worth of real estate within Country A.

The financial account has four components:

• foreign direct investment
• portfolio investment
• other investment
• reserve account flows

Foreign direct investment (FDI) refers to long-term capital investment such as the purchase or construction of machinery, buildings, or even whole manufacturing plants. If foreigners are investing in a country, that is an inbound flow and counts as a surplus item on the financial account. If a nation’s citizens are investing in foreign countries, there is an outbound flow that will count as a deficit. After the initial investment, any yearly profits not re-invested will flow in the opposite direction but will be recorded in the current account rather than the financial account.

Portfolio investment refers to the purchase of shares and bonds. It is sometimes grouped together with “other” as a short-term investment. As with FDI, the income derived from these assets is recorded in the current account; the financial account entry will be for any buying or selling of the portfolio assets in the international financial markets.

Other investments include capital flows into bank accounts or provided as loans. Large short-term flows between accounts in different nations are commonly seen when the market can take advantage of fluctuations in interest rates and/or the exchange rate between currencies. Sometimes this category can include the reserve account.

The reserve account is operated by a nation’s central bank to buy and sell foreign currencies; it can be a source of large capital flows to counteract those originating from the market. Inbound capital flows (from sales of the account’s foreign currency), especially when combined with a current account surplus, can cause a rise in value (appreciation) of a nation’s currency, while outbound flows can cause a fall in value (depreciation). If a government (or, if authorized to operate independently in this area, the central bank itself) does not consider the market-driven change to its currency value to be in the nation’s best interests, it can intervene. Such intervention affects the financial account. Purchases of foreign currencies, for example, will increase the deficit and vice versa.

To calculate the total surplus or deficit in the financial account, sum the net change in FDI, portfolio investment, other investment, and the reserve account.

Capital Account Calculation

The capital account acts as a sort of miscellaneous account, measuring non-produced and non-financial assets, as well as capital transfers.

There are two common definitions of the capital account in economics. The first is a broad interpretation that reflects the net change in ownership of national assets. Under the International Monetary Fund (IMF) definition, however, most of these asset flows are captured in the financial account. Instead, the capital account acts as a sort of miscellaneous account, measuring non-produced and non-financial assets, as well as capital transfers. The capital account is normally much smaller than the financial and current accounts.

Like the financial account, a deficit in the capital account means that money is flowing out of a country and the country is accumulating foreign assets. Likewise, a surplus in the capital account means that money is flowing into a country, and the country is selling (or otherwise disposing of) non-produced, non-financial assets.

The capital account can be split into two categories: non-produced and non-financial assets and capital transfers. Non-produced and non-financial assets include things like drilling rights, patents, and trademarks. For example, if a domestic company acquires the rights to mineral resources in a foreign country, there is an outflow of money, and the domestic country acquires an asset, creating a capital account deficit.

Thus, the balance of the capital account is calculated as the sum of the surpluses or deficits of net non-produced, non-financial assets, and net capital transfers.

Attributions

“17.4 Calculating the Current Account, Financial Account, and Capital Account” is adapted from “Open Economy Macroeconomics: Capital Flows” by “Boundless Economics,” licensed under CC BY-NC-SA, except where otherwise noted, and shared on Course Sidekick.