Capital flows in a Globalized World

Countries need foreign currency to pay their import bills.   

They can obtain these from:

- foreign bank loans,

- foreign purchases of stocks or bonds of their countries, or,

- direct foreign investment in local factories.

These flows all are recorded in the capital account of the balance of payments.

Analysts and newspaper headlines tend to focus only on foreign purchases of stocks and bonds.  These are often called "hot money" because foreigners looking for a quick profit can dump stocks and bonds like hot potatoes when crises begin.

Bank loans:  the real hot money 

In recent decades, the most volatile capital flows have actually been bank loans, which are now the real hot money.

China and other emerging markets began opening their doors to foreign capital.  Capital flows rose from 2% of global GDP in 1980 to 16% (a whopping $19 trillion) by early 2007.

Then came the 2008 crisis and optimism about emerging nations vanished. 

By 2014, capital flows had fallen back to $1.2 trillion - once again about 2% of current global GDP.  , Bank lending, the largest portion of capital flows, turned negative during the crisis, indicating that banks were liquidating loans to bring money home.

When capital flows slowed

With capital flows slowing, those countries with persistent current account deficits may run into trouble financing these deficits much sooner.

In the pre-2008 era, the tipping point came when the deficit had been increasing by 5% of GDP for five years in a row.  

In the post-crisis era, the tipping point may come faster and at a lower deficit levels; the 5 percent rule may become a 3% rule.

Multiparty trade system. Current account is balanced by the country's capital account.

Multiparty trade system

In any multi-party trade system, there will always be imbalances, deficits or surpluses in the monetary value of goods and services traded.

These imports, if not made up for in an equal number of exports, are "paid for" by sending something else abroad - usually paper assets, such as stocks and bonds.  

The purchase of U.S. dollar securities is the way most countries have compensated for the imbalances in trade with the United States.  

• Many countries, in Asia and the Middle East especially, have used their earnings from exports to purchase trillions of dollars' worth of U.S. Treasury bonds to use as a store against future uncertainties - or to buy U.S. goods and services in the future.

What gets spent never stays in one place

In the interconnected global economy, what gets spent never stays in one place. What India earns from its many call centers can be spent on South Korean televisions, and what South Korea earns from its exports can be spent on Brazilian chickens or American tractors.  In the end, it all adds up.

Deciding to start a trade war because you run a deficit against any one country is like saying you want to punish the country that sells you what you really want.

Trade deficits and Trade surpluses

The economic terms used by most politicians when beating the drums for trade wars are trade deficits and trade surpluses, which focus mainly on the trade in physical goods.  

But many countries are making more and more money exporting services like 

• banking
• entertainment, 
• tourism, and 
• technology platforms.  

A few lucky countries, such as U.S., have the privilege of receiving massive amounts of money every year in the form of investments from abroad.

Trade Balance:  Current account is balanced by the country's capital account

The obsession with trade deficits is misplaced because the deficit and surplus in goods and services is offset by monetary transfers.  

Most economists, therefore, look at the total trade in goods and services, referred to as the current account, which also includes such financial transfers as money sent home by citizens working abroad and interest paid on foreign debt.  

This current account is balanced by the country's capital account, which adds up all investments - mainly international purchases and sales of financial assets.  

These two measures, when added together, always add up to zero.  One balances out the other.  Which is why the total measure of trade is referred to as the trade balance.

The benefits of free trade outweigh the disadvantages

Politicians who speak of "winning" and "losing" in trade don't understand that all trade in goods and services is balanced by monetary transfers moving in the opposite direction.  

Essentially, all the global trade in goods and services and flows of money between countries add up to zero, but trade is not a zero-sum game, where one country's loss is necessarily another country's gain.

The benefits of free trade outweigh the disadvantages  

• While free trade does expose a country, and its workers, to foreign competition - which can lead to layoffs and idle factories - putting up barriers to imports from abroad can destroy far more jobs as the rest of the world's economies respond with trade barriers of their own.

What Is The Balance Of Payments?

What Is The Balance Of Payments?

by Reem Heakal

The balance of payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time.

• Usually, the BOP is calculated every quarter and every calendar year.
• All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country.
• If a country has received money, this is known as a credit, and, if a country has paid or given money, the transaction is counted as a debit.
• Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance.
• But in practice this is rarely the case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.

The Balance of Payments Divided
The BOP is divided into three main categories:

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

Within these three categories are sub-divisions, each of which accounts for a different type of international monetary transaction.

The Current Account
The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account.

• Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods that are bought, sold or given away (possibly in the form of aid).
• Services refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and royalties from patents and copyrights.
• When combined, goods and services together make up a country's balance of trade (BOT).
• The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports.
• If a country has a balance of trade deficit, it imports more than it exports, and if it has a balance of trade surplus, it exports more than it imports. 
• Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded in the current account.
• The last component of the current account is unilateral transfers. These are credits that are mostly worker's remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that is directly received.

The Capital Account
The capital account is where all international capital transfers are recorded. This refers to the acquisition or disposal of

• non-financial assets (for example, a physical asset such as land) and
• non-produced assets,

which are needed for production but have not been produced, like a mine used for the extraction of diamonds.

The capital account is broken down into the monetary flows branching from

• debt forgiveness,
• the transfer of goods, and financial assets by migrants leaving or entering a country,
• the transfer of ownership on fixed assets (assets such as equipment used in the production process to generate income),
• the transfer of funds received to the sale or acquisition of fixed assets,
• gift and inheritance taxes,
• death levies, and,
• finally, uninsured damage to fixed assets.

The Financial Account
In the financial account, international monetary flows related to investment in

• business,
• real estate,
• bonds and stocks

are documented.

Also included are government-owned assets such as

• foreign reserves,
• gold,
• special drawing rights (SDRs) held with the International Monetary Fund,
• private assets held abroad, and
• direct foreign investment.

Assets owned by foreigners, private and official, are also recorded in the financial account.

/div>
The Balancing Act
The current account should be balanced against the combined-capital and financial accounts. However, as mentioned above, this rarely happens.

• We should also note that, with fluctuating exchange rates, the change in the value of money can add to BOP discrepancies.
• When there is a deficit in the current account, which is a balance of trade deficit, the difference can be borrowed or funded by the capital account.
• If a country has a fixed asset abroad, this borrowed amount is marked as a capital account outflow. However, the sale of that fixed asset would be considered a current account inflow (earnings from investments). The current account deficit would thus be funded.

When a country has a current account deficit that is financed by the capital account, the country is actually foregoing capital assets for more goods and services. If a country is borrowing money to fund its current account deficit, this would appear as an inflow of foreign capital in the BOP.

Liberalizing the Accounts
The rise of global financial transactions and trade in the late-20th century spurred BOP and macroeconomic liberalization in many developing nations. With the advent of the emerging market economic boom - in which capital flows into these markets tripled from USD 50 million to USD 150 million from the late 1980s until the Asian crisis - developing countries were urged to lift restrictions on capital and financial-account transactions in order to take advantage of these capital inflows.

• Many of these countries had restrictive macroeconomic policies, by which regulations prevented foreign ownership of financial and non-financial assets.
• The regulations also limited the transfer of funds abroad.
• But with capital and financial account liberalization, capital markets began to grow, not only allowing a more transparent and sophisticated market for investors, but also giving rise to foreign direct investment.
• For example, investments in the form of a new power station would bring a country greater exposure to new technologies and efficiency, eventually increasing the nation's overall gross domestic product by allowing for greater volumes of production.
• Liberalization can also facilitate less risk by allowing greater diversification in various markets.

by Reem Heakal, (Contact Author | Biography)

http://www.investopedia.com/articles/03/060403.asp

Also read:
http://www.investopedia.com/terms/c/currentaccountdeficit.asp