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 BOP. 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, 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.

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 aid or sent to families. A financial account measures the increases or decreases in international ownership assets that a country is associated with, while the capital account measures 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 Account

A country's capital account 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 more money is flowing out, while a surplus indicates more money is flowing in.

Along with non-financial and non-produced asset transactions, the following are also included:

  • Dealings such as debt forgiveness
  • The transfer of goods and financial assets by migrants leaving or entering a country
  • The transfer of ownership on 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 Accounts

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, so 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 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 such as 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 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 leaves the economy. But 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 said investment would be noted as a debit in the current account.

The Bureau of Economic Analysis measures the capital account in the U.S.

What Does This Mean?

Unlike the current account, which is expected to theoretically 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

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 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.

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 the economy is a net creditor, providing funds to the world.

Key Takeaways

  • A country's balance of payments is made up of its current account, capital account, and financial account.
  • The capital account records the flow of goods and services in and out of a country, while the financial account measures increases or decreases in international ownership assets.
  • Positive capital and financial accounts mean a country has more debits than credits making it a net debtor to the world. Negative accounts make the country a net creditor.  

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, however, countries are required to have "open" or "liberal" capital and financial-account policies. Today, many developing economies implement capital account liberalization —a process that removes restrictions on capital movement—as part of their economic reform program.

Liberalization of a country's capital account may signal a shift toward sound economic policy.

This unrestricted movement of capital means 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 an FDI is the ability to expand market share into a foreign economy, thus collecting greater returns. Some argue 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 opened up their economies to the world, and an unprecedented amount of foreign capital was crossing entering their borders, mostly in the form of portfolio investment—a financial account credit and a current account debit. This meant investments were short-term and easy to liquidate instead of more long-term.

When speculation rose and panic spread throughout the region, a reversal in capital flows happened first, with money being 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 set in.

Analysts argue 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), it would have limited short-term obligations 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.