The balance of payments (BOP) is the record of any payment or receipt between one nation and its nationals with any other country. The current account, the capital account and the financial account make up a country's balance of payments. Together, these three accounts tell a story about the state of an economy, its economic outlook and its strategies for achieving its desired goals. A large volume of imports and exports, for example, can 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.

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 given as aid or sent to families. A financial account is used to measure the increases or decreases in international ownership assets that a country is associated with, while the capital account is used to measure the capital expenditures and overall income of a country.

Here we focus on the capital and financial accounts, which tell the story of investment and capital market regulations within a given country.

The Capital and Financial Accounts

The Financial Account

A country's financial account is broken further down into two sub-accounts: the domestic ownership of foreign assets and the foreign ownership of domestic assets.

If the domestic ownership of foreign assets portion of the financial account increases, it increases the overall financial account. If the foreign ownership of domestic assets increases, it decreases the overall financial account; the overall financial account increases when the foreign ownership of domestic assets decreases. Together, a country's domestic ownership of foreign assets and foreign ownership of domestic assets measure the international ownership of assets with which the country is associated.

The Capital Account

A country's capital account, on the other hand, isn't broken down into sub-accounts. Instead, it refers to any and all international capital transfers.  The overall expenditures and income are measured by the inflow and outflow of funds in the form of investments and loans flowing in and out of the economy. A deficit shows that more money is flowing out of a country, and a surplus shows that more money is flowing into a country.

Along with transactions pertaining to non-financial and non-produced assets, it includes to such dealings as debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received for the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, patents, copyrights, royalties and uninsured damage to fixed assets.

The financial account deals with money related to foreign reserves and private investments in businesses, real estate, bonds and stocks. Also detailed in the financial account are government-owned assets  – i.e., special drawing rights at the International Monetary Fund (IMF) – or private sector assets held in other countries, local assets held by foreigners (government and private) and foreign direct investment (FDI).

How They Work

Capital that is transferred out of a country for the purpose of investing is recorded as a debit in either of these two accounts. This is because money is leaving the economy. However, because it is an investment, there is an implied return. This return – whether a capital gain from portfolio investment (a debit under the financial account) or a return made from direct investment (a debit under the capital account) – is recorded as a credit in the current account (this is where income investment is recorded in the BOP). The opposite is true when a country receives capital: Paying a return on a said investment would be noted as a debit in the current account.

What Does This Mean?

Unlike the current account, which is expected to run at a surplus or deficit, theoretically, 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 International Monetary Fund's Balance of Payments Manual, the balance of payment formula, or identity, is summarized as:

Current Account + Financial Account + Capital Account + Balancing Item = 0

When an economy, however, has positive capital and financial accounts (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 that 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. See Is a deficit in the balance of payments a bad thing?

If the capital and financial accounts are negative (a net financial outflow), the country 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, indicating that 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, according to theory, greater prosperity for all. For this to happen, however, countries are required to have "open" or "liberal" capital and financial-account policies. Today, many developing economies implement as part of their economic reform program (often in conjunction with the IMF) "capital account liberalization," a process that removes restrictions on capital movement.

This unrestricted movement of capital means that governments, corporations and individuals are free to invest capital in other countries. This then paves the way not only for more FDI into industries and development projects, but for portfolio investment in the capital market as well. Thus, companies striving for bigger markets and smaller markets seeking greater capital and domestic economic goals can expand into the international arena, resulting in a stronger global economy.

The benefits 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 a FDI is the ability to expand market share into a foreign economy, thus collecting greater returns. Some have argued that even the country's domestic political and macroeconomic policies become affected in a more progressive fashion because foreign companies investing in a local economy have a valued stake in the local economy's reform process. These foreign companies become "expert consultants" to the local government on policies that will facilitate businesses.

Portfolio foreign investments can encourage capital-market deregulation and stock-exchange volumes. By investing in more than one market, investors are able to diversify their portfolio risk while increasing their returns, which result from investing in an emerging market. A deepening capital market, based on a reforming local economy and a liberalization of the capital and financial accounts, can thus speed up the development of an emerging market.

A Little Control Can Be Good

Aside from political ideologies, some sound economic theories state why some capital account control can be good. Recall the Asian financial crisis in 1997. Some Asian countries had opened up their economies to the world, and an unprecedented amount of foreign capital was crossing borders into these economies, mostly in the form of portfolio investment (a financial account credit and a current account debit). This meant that investments were short term and easy to liquidate instead of more long term and harder to dispose of quickly.

When speculation rose and panic spread throughout the region, the first thing that happened was a reversal in capital flows: Money was now being pulled out of these capital markets. Asian economies now had to pay 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 set in.

Analysts argue that financial disaster may have been less severe had there had been some capital-account controls. For instance, had the amount of foreign borrowing been limited (which is a debit in the current account), short-term obligations would have been limited and the economic damage could have been less severe.

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 into the current account, the capital account and the financial account.

Lessons from the Asian financial crisis have resulted in new debates about the best way to liberalize capital and financial accounts. Indeed, the IMF and World Trade Organization have historically supported free trade in goods and services (current account liberalization) and are now faced with the complexities of capital freedom. Experience has proven  that without any controls a sudden reversal of capital flows can not only destroy an economy, but can also result in increased poverty for a nation.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.