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.

How to read Money Flows: Study the Balance of Payments, especially the Current Account

Money flows

If the currency feels cheap and the economy is healthy, bargain hunters will pour money in it.

If the currency feels cheap but money is still fleeing, something is wrong.#

Study the balance of payments, particularly the current account

All the legal channels for money flows can be found in the balance of payments, particularly the current account.  

Current account = net trade (mainly) + other foreign income.

The current account captures how much a nation is producing compared to how much it is consuming and it reveals how much a nation has to borrow from abroad to finance its consumption habits.  

If a country runs a sizable deficit in the current account for too long, it is going to amass obligations it cannot pay.  The trick is to identify the tipping point.

Persistently high current account deficit leads to economic slowdown

Testing for various sizes of deficits, over various time periods, confirmed that when the current account deficit runs persistently high, the normal outcome is an economic slowdown.  

If the deficit averages between 2% and 4% of GDP each year over a five-year period, the slow-down is relatively mild.  

If the deficit averages 5% or more, the slowdown is sharper, shaving an average of 2.5% points off the GDP growth rate over the following five years.  

The growth slowdown hit countries rich and poor.  

This is the danger zone

If a country runs a current account deficit as high as 5% of GDP each year for five years, it is consuming more than it is producing and more than it can afford.

Running sustained current account deficits of more than 3% or 4% of GDP can also signal coming economic and financial trouble - just less urgently.

In fact, some emerging-world officials have come to believe that when the current account deficit hits 3% of GDP, it is time to restrain consumer spending and prevent the country from living beyond its means.

Below the 3% threshold, a persistent current account deficit may not be a bad thing.  

• If money is flowing out of the country to import luxury goods, which do not fuel future growth, it will be harder for the country to pay the import bills.  
• If it is going to buy imports of factory machinery, the loans financing those purchases are supporting productive investment in future growth.

One quick way to determine whether the rising deficit is a bad sign is to check whether investment is rising as a share of GDP.   Such a rise at least suggests that money is not flowing out for frivolous consumption.

Appendix:

# In late 2014, the Russian ruble collapsed because of the falling price of oil.  Russians were still pulling tens of billions of dollars out of the c0untry every month, fearing that the situation would get worse.  Cheap was not yet a good sign, because the ruble was not yet cheap and stable.

Summary

The article's key points:

To understand money flows, focus on studying the balance of payments, especially the current account.

The current account reflects a nation's production versus consumption and reveals how much it borrows from abroad.

Persistent high current account deficits lead to economic slowdowns.

Deficits between 2% and 4% of GDP cause milder slowdowns; deficits of 5% or more cause sharper slowdowns.

Running deficits above 3% or 4% of GDP can signal economic trouble.

When a country has a 5% GDP deficit for five years, it is living beyond its means.

For deficits below 3%, it depends on whether the money is invested productively or wasted on non-essential imports.

Appendix: In 2014, the Russian ruble collapsed due to falling oil prices, and money continued to leave the country, showing that cheapness of currency wasn't a positive sign until it stabilized.

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.

Current Account Deficit

A current account deficit occurs when a country spends more money on the goods and services it imports than it receives for the goods and services it exports. In other words, more money is leaving the country than flowing into it. The current account consists of money received and paid out for goods, services, investments, salaries, pension payments to foreign workers and money workers send to family members abroad.

When a country has a current account deficit, it must make up for the shortfall. A current account deficit is financed from the capital account and the financial account, which contain the money a country sends out and brings in from buying and selling tangible assets and foreign currency and from foreign direct investment.

Current account deficits are common in highly developed countries and in highly underdeveloped countries. Countries with emerging markets typically have current account surpluses.

Whether a current account deficit is bad or not depends on why it exists and how it is being paid for. A current account deficit might exist because a country is importing the inputs for goods it will export later; it may then create a current account surplus. It can also mean that foreign investors see the country as a desirable place to invest. While the domestic country will pay returns to those foreign investors, the additional capital can help expand the domestic economy.

On the other hand, a country could be overspending on expensive exports when it would be better off increasing domestic production. Also, a longstanding current account deficit could saddle future generations with debt and interest payments. A current account deficit also puts a country at risk of facing financial or political pressure from foreign suppliers.


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Current Account Balance in Balance of Payment

Current Account

The current account reflects the difference between a country’s savings and investments.

The three components of the current account are:

• The sum of the balance of trade (goods and services exports, less imports)
• Net income from abroad
• Net current transfers

By looking at a country’s current account, analysts are able to get a good indication of how a country is doing economically.

 If the country’s current account has a surplus balance, it means the country is a net lender as it relates to the rest of the world.

 Conversely, a deficit balance means the country is a net borrower.

But a current account deficit is not always a bad thing. Most often it is the result of temporary economic cycles.

For instance, a country with a surplus balance has been providing more resources to the rest of the world than it has been taking in.

The deficit balance country has been taking in more resources than it has been exporting.

In effect, the surplus balance countries have been financing the economic activities of the deficit countries.

Most likely, the deficit country government has made a decision to invest for future growth.

By taking in outside resources, and thus a deficit balance in its current account, it can use those resources for internal growth and someday become a country with a surplus current account.


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Exploring The Current Account In The Balance Of Payments

The balance of payments (BOP) is the place where countries record their monetary transactions with the rest of the world. Transactions are either marked as a credit or a debit. Within the BOP there are three separate categories under which different transactions are categorized:

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

In the current account, goods, services, income and current transfers are recorded.

In the capital account, physical assets such as a building or a factory are recorded.

And in the financial account, assets pertaining to international monetary flows of, for example, business or portfolio investments, are noted.

In this article, we will focus on analyzing the current account and how it reflects an economy's overall position.


The Current Account

The balance of the current account tells us if a country has a deficit or a surplus.

If there is a deficit, does that mean the economy is weak?

Does a surplus automatically mean that the economy is strong? Not necessarily.

But to understand the significance of this part of the BOP, we should start by looking at the components of the current account:

• goods, 
• services, 
• income and 
• current transfers.

1. Goods - These are movable and physical in nature, and in order for a transaction to be recorded under "goods", a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in) and an import is noted as a debit (money going out).

2. Services - These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service it is recorded like an import (a debit), and if money is received it is recorded like an export (credit).

3. Income - Income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production.

4. Current Transfers - Current transfers are unilateral transfers with nothing received in return. These include workers' remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production.

Now that we have covered the four basic components, we need to look at the mathematical equation that allows us to determine whether the current account is in deficit or surplus (whether it has more credit or debit). This will help us understand where any discrepancies may stem from, and how resources may be restructured in order to allow for a better functioning economy.


The following variables go into the calculation of the current account balance (CAB):
X = Exports of goods and services
M = Imports of goods and services
NY = Net income abroad
NCT = Net current transfers

The formula is:
CAB = X - M + NY + NCT


What Does It Tell Us?

Theoretically, the balance should be zero, but in the real world this is improbable, so if the current account has a surplus or a deficit, this tells us something about the government and state of the economy in question, both on its own and in comparison to other world markets.

A surplus is indicative of an economy that is a net creditor to the rest of the world. It shows how much a country is saving as opposed to investing. What this means is that the country is providing an abundance of resources to other economies, and is owed money in return. By providing these resources abroad, a country with a CAB surplus gives other economies the chance to increase their productivity while running a deficit. This is referred to as financing a deficit.

A deficit reflects government and an economy that is a net debtor to the rest of the world. It is investing more than it is saving and is using resources from other economies to meet its domestic consumption and investment requirements. For example, let us say an economy decides that it needs to invest for the future (to receive investment income in the long run), so instead of saving, it sends the money abroad into an investment project. This would be marked as a debit in the financial account of the balance of payments at that period of time, but when future returns are made, they would be entered as investment income (a credit) in the current account under the income section.

A current account deficit is usually accompanied by depletion in foreign-exchange assets because those reserves would be used for investment abroad. The deficit could also signify increased foreign investment in the local market, in which case the local economy is liable to pay the foreign economy investment income in the future.

It is important to understand from where a deficit or a surplus is stemming because sometimes looking at the current account as a whole could be misleading.


Analyzing the Current Account

Exports imply demand for a local product while imports point to a need for supplies to meet local production requirements. An export is a credit to a local economy while an import is a debit, an import means that the local economy is liable to pay a foreign economy. Therefore a deficit between exports and imports (goods and services combined) - otherwise known as a balance of trade deficit (more imports than exports) - could mean that the country is importing more in order to increase its productivity and eventually churn out more exports. This in turn could ultimately finance and alleviate the deficit.

A deficit could also stem from a rise in investments from abroad and increased obligations by the local economy to pay investment income (a debit under income in the current account). Investments from abroad usually have a positive effect on the local economy because, if used wisely, they provide for increased market value and production for that economy in the future. This can allow the local economy eventually to increase exports and, again, reverse its deficit.

So, a deficit is not necessarily a bad thing for an economy, especially for an economy in the developing stages or under reform: an economy sometimes has to spend money to make money. To run a deficit intentionally, however, an economy must be prepared to finance this deficit through a combination of means that will help reduce external liabilities and increase credits from abroad. For example, a current account deficit that is financed by short-term portfolio investment or borrowing is likely more risky. This is because a sudden failure in an emerging capital market or an unexpected suspension of foreign government assistance, perhaps due to political tensions, will result in an immediate cessation of credit in the current account.

The Bottom Line

The volume of a country's current account is a good sign of economic activity. By scrutinizing the four components of it, we can get a clear picture of the extent of activity of a country's industries, capital market, services and the money entering the country from other governments or through remittances. However, depending on the nation's stage of economic growth, its goals, and of course the implementation of its economic program, the state of the current account is relative to the characteristics of the country in question. But when analyzing a current account deficit or surplus, it is vital to know what is fueling the extra credit or debit and what is being done to counter the effects (a surplus financed by a donation may not be the most prudent way to run an economy). On a separate note, the current account also highlights what is traded with other countries, and it is a good reflection of each nation's comparative advantage in the global economy.


By Reem Heakal

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Zeti says Malaysia current account deficit unlikely to sink into deficit

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Investors exit Asian economies as US builds up steam

August 21, 2013

Shamim Adam

Asia's role as the world's growth engine is waning as economies across the region weaken and investors pull out billions of dollars.

The Indian rupee fell to a record low this week, Thailand is in recession and Indonesia's widest current account deficit pushed the rupiah to its lowest since 2009. Chinese banks' bad loans are rising and economists forecast Malaysia will post its second straight quarter of sub-5 per cent growth this week.

The clouds forming in Asia as liquidity tightens and China slows down are fuelling a sell-off of emerging market stocks, reversing a flow of money into the region in favour of nascent recoveries in the US and Europe. Emerging markets from Brazil to Indonesia have raised borrowing costs this year to try to help their currencies as the prospect of reduced US monetary stimulus curbs demand for assets in developing nations.

''The eye of the storm is directly above emerging markets now, two years after it hovered over Europe and four years after it hit the US,'' said Stephen Jen, co-founder of hedge fund SLJ Macro Partners in London and former head of foreign exchange strategy at Morgan Stanley. ''This could be serious for Asia.''

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Almost $US95 billion ($105 billion) was poured into exchange-traded funds of American shares this year, while developing-nation ETFs got withdrawals of $US8.4 billion. Signs of a stronger US economy may prompt the Federal Reserve to begin paring back its $US85 billion in monthly bond purchases as soon as next month.

''The pendulum is swinging back in favour of the advanced countries,'' said Shane Oliver, head of investment strategy at AMP Capital Investors.

Indian policy makers are battling to stem the rupee's plunge, attract capital to bridge a record current account deficit and revive growth.

The currency has weakened about 28 per cent against the US dollar in two years, reviving memories of the early 1990s crisis, when the government received an International Monetary Fund loan as foreign reserves waned.

''It seems now the pain is going to be in the emerging markets,'' said Nitin Mathur, an analyst in Mumbai at Espirito Santo Investment Bank. ''The problems in India are not temporary blips. The problems are much more serious, which will take a lot of effort to get resolved.''

In Thailand, the economy entered recession last quarter for the first time since the global financial crisis. Toyota said car sales in Thailand would fall 9.5 per cent this year. The government cut its 2013 growth forecast as exports cooled and local demand weakened. Higher household debt restricts scope for monetary easing.

Last week, Taiwan cut its 2013 growth and exports forecasts and said the global outlook for the second half was worsening.

''We are seeing a turning point,'' said Freya Beamish, an economist with Lombard Street Research, who says China's competitiveness has been hurt by labour costs that are 30 per cent too high.

Sentiment is also being subdued by the prospect of a decline in US stimulus, which often finds its way to export-based countries.

Investors will be looking for clues on how quickly the US Federal Reserve will trim its monthly asset purchases when the federal open market committee's July meeting minutes come out on Wednesday.

The $US3.9 trillion of cash that flowed into emerging markets over the past four years has started to reverse since Fed chairman Ben Bernanke talked about a tapering in quantitative easing this year.

''The emerging Asia story is crumbling and dollar is once again the king,'' said Indranil Pan, chief economist at Kotak Mahindra Bank in Mumbai.

India's moves to tighten cash supply, restrict currency derivatives and curb gold imports since July failed to arrest the rupee's slump to a record low of 63.23 against the US dollar. The deficit has widened to 4.8 per cent of gross domestic product. The government plans to narrow the gap to 3.7 per cent, or $US70 billion, this year.

India's slump is worse than elsewhere because the country has failed to carry out long-overdue structural changes to the economy.

''We have great policies on paper but the gap between the what's on paper and the implementation is unduly large,'' said R.C. Bhargava, chairman of Maruti Suzuki India, the nation's biggest carmaker. ''If we just implement what's already there, we can get back on track in the next two to three years.''

One bright spot is Japan, where the economy has bounced back on Prime Minister Shinzo Abe's fiscal and monetary stimulus.

The Topix stocks index has risen 34 per cent this year. Abe has yet to show he can sustain the recovery by restructuring company and labour laws and taming the nation's debt, which topped 1 quadrillion yen ($11 trillion) in June.

''Some Asian countries, especially India, have their own significant domestic challenges,'' said economist Jim O'Neill. ''But China is slowing primarily to improve its growth model and, at 7 to 7.5 per cent annual growth, is still delivering $US1 trillion nominal GDP. And Japan … is looking better than it has done for a very long time.''

The slowdown in Indonesia and Thailand was part of global weakness, World Bank chief economist Kaushik Basu said. The US recovery ''was so slow that even the slightest pick-up is looking like a pick-up'', he said. ''I don't think the Asian situation is any worse. In fact, if anything, Asia is probably better off than the rest of the world.''

But that may not help markets in Asia, as money continues to flow back to Europe and the US.

Bloomberg

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The age of the dollar is drawing to a close

The age of the dollar is drawing to a close
Currency competition is the only way to fix the world economy, says Jeremy Warner.

By Jeremy Warner
Published: 7:04AM GMT 05 Nov 2010

Dollar hegemony was itself a major cause of both the imbalances and the crisis Photo: BLOOMBERG

Right from the start of the financial crisis, it was apparent that one of its biggest long-term casualties would be the mighty dollar, and with it, very possibly, American economic hegemony. The process would take time – possibly a decade or more – but the starting gun had been fired.

At next week's meeting in Seoul of the G20's leaders, there will be no last rites – this hopelessly unwieldy exercise in global government wouldn't recognise a corpse if stood before it in a coffin – but it seems clear that this tragedy is already approaching its denouement.

To understand why, you have to go back to the origins of the credit crunch, which lay in the giant trade and capital imbalances that have long ruled the world economy. Over the past 20 years, the globe has become divided in highly dangerous ways into surplus and deficit nations: those that produced a surplus of goods and savings, and those that borrowed the savings to buy the goods.

It's a strange, Alice in Wonderland world that sees one of the planet's richest economies borrowing from one of the poorest to pay for goods way beyond the reach of the people actually producing them. But that process, in effect, came to define the relationship between America and China. The resulting credit-fuelled glut in productive capacity was almost bound to end in a corrective global recession, even without the unsustainable real-estate bubble that the excess of savings also produced. And sure enough, that's exactly what happened.

When politicians see a problem, especially one on this scale, they feel obliged to regulate it. But so far, they've been unable to make headway. This is mainly because the surplus nations are jealous defenders of their essentially mercantilist economic models. Exporting to the deficit nations has served them well, and they are reluctant to change.

Ironically, one effect of the policies adopted to fight the downturn has been to reinforce the imbalances. Fiscal and monetary stimulus in the US is sucking in imports at near-record levels. The fresh dose of quantitative easing announced this week by the Federal Reserve will only turn up the heat further.

What can be done? China won't accept the currency appreciation that might, in time, reduce the imbalances, for that would undermine the competitiveness of its export industries. In any case, it probably wouldn't do the trick: surplus nations have a habit of maintaining competitiveness even in the face of an appreciating currency.
Unable to tackle the problem through currency reform, the US has turned instead to the idea of measures to limit the imbalances directly, through monitoring nations' current accounts. This has already gained some traction with the G20, which has agreed to assess the proposal ahead of the meeting in Seoul. As a way of defusing hot-headed calls in the US for the imposition of import tariffs, the idea is very much to be welcomed, as a trade war would be a disaster for all concerned. China, for one, has embraced the concept with evident relief.

Unfortunately, the limits as proposed would be highly unlikely to solve the underlying problem. Similar rules have failed hopelessly to maintain fiscal discipline in the eurozone. What chance for a global equivalent on trade? With or without sanctions, the limits would be manipulated to death. And even if they weren't, the proposed 4 per cent cap on surpluses and deficits would only marginally affect the worst offenders: for a big economy, a trade gap of 4 per cent of GDP is still a massive number, easily capable of creating unsafe flows of surplus savings.


No, globally imposed regulation, even if it could rise above lowest-common-denominator impotence, is unlikely to solve the problem, although it might possibly stop it getting significantly worse. But what would certainly fix things would be the dollar's demise as the global reserve currency of choice.

As we now know, dollar hegemony was itself a major cause of both the imbalances and the crisis, for it allowed more or less unbounded borrowing by the US from the rest of the world, at very favourable rates. As long as the US remained far and away the world's dominant economy, a global system based on the dollar still made some sense. But America has squandered this advantage on credit-fuelled spending; with the developing world expected to represent more than half of the global economy within five years, dollar hegemony no longer makes any sense.

The rest of the world is now openly questioning the merits of a global currency whose value is governed by America's perceived domestic needs, while the growth that once underpinned confidence in its ability to repay its debts has never looked more fragile.

Already, there are calls for alternatives. Unwilling to wait for one, the world's central banks are beginning to diversify their currency reserves. This, in turn, will eventually exert its own form of market discipline on the US, whose ability to soak the rest of the world by issuing ever more greenbacks will be correspondingly harmed.

These are seismic changes, of a type not seen for a generation or more. I hate to end with a cliché, but we do indeed live in interesting times.


http://www.telegraph.co.uk/finance/comment/jeremy-warner/8111918/The-age-of-the-dollar-is-drawing-to-a-close.html

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

Understanding The Current Account In The Balance Of Payments

 

Understanding The Current Account In The Balance Of Payments

by Reem Heakal

The balance of payments (BOP) is the place where countries record their monetary transactions with the rest of the world. Transactions are either marked as a credit or a debit. Within the BOP there are three separate categories under which different transactions are categorized:

• the current account: goods, services, income and current transfers are recorded.
• the capital account:  physical assets such as a building or a factory are recorded.
• the financial account: assets pertaining to international monetary flows of, for example, business or portfolio investments, are noted.

In this article, we will focus on analyzing the current account and how it reflects an economy's overall position. (For background reading, see What Is The Balance Of Payments?)

 

The Current Account
The balance of the current account tells us if a country has a deficit or a surplus. If there is a deficit, does that mean the economy is weak? Does a surplus automatically mean that the economy is strong? Not necessarily. But to understand the significance of this part of the BOP, we should start by looking at the components of the current account: goods, services, income and current transfers.

 

Goods - These are movable and physical in nature, and in order for a transaction to be recorded under "goods", a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in) and an import is noted as a debit (money going out).

 

Services - These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service it is recorded like an import (a debit), and if money is received it is recorded like an export (credit).

 

Income - Income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production.

 

Current Transfers - Current transfers are unilateral transfers with nothing received in return. These include workers' remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production.

Now that we have covered the four basic components, we need to look at the mathematical equation that allows us to determine whether the current account is in deficit or surplus (whether it has more credit or debit). This will help us understand where any discrepancies may stem from, and how resources may be restructured in order to allow for a better functioning economy.

 

The following variables go into the calculation of the current account balance (CAB):

 

X = Exports of goods and services
M = Imports of goods and services
NY = Net income abroad
NCT = Net current transfers

 

The formula is:

 

CAB = X - M + NY + NCT

 

 

 

What Does It Tell Us?
Theoretically, the balance should be zero, but in the real world this is improbable, so if the current account has a deficit or a surplus, this tells us something about the state of the economy in question, both on its own and in comparison to other world markets.

 

A surplus is indicative of an economy that is a net creditor to the rest of the world. It shows how much a country is saving as opposed to investing. What this means is that the country is providing an abundance of resources to other economies, and is owed money in return. By providing these resources abroad, a country with a CAB surplus gives other economies the chance to increase their productivity while running a deficit. This is referred to as financing a deficit.

 

A deficit reflects an economy that is a net debtor to the rest of the world. It is investing more than it is saving and is using resources from other economies to meet its domestic consumption and investment requirements. For example, let us say an economy decides that it needs to invest for the future (to receive investment income in the long run), so instead of saving, it sends the money abroad into an investment project. This would be marked as a debit in the financial account of the balance of payments at that period of time, but when future returns are made, they would be entered as investment income (a credit) in the current account under the income section. (For more insight, read Current Account Deficits.)

 

A current account deficit is usually accompanied by depletion in foreign-exchange assets because those reserves would be used for investment abroad. The deficit could also signify increased foreign investment in the local market, in which case the local economy is liable to pay the foreign economy investment income in the future.

 

It is important to understand from where a deficit or a surplus is stemming because sometimes looking at the current account as a whole could be misleading.

 

Analyzing the Current Account
Exports imply demand for a local product while imports point to a need for supplies to meet local production requirements. As export is a credit to a local economy while an import is a debit, an import means that the local economy is liable to pay a foreign economy. Therefore a deficit between exports and imports (goods and services combined) - otherwise known as a balance of trade deficit (more imports than exports) - could mean that the country is importing more in order to increase its productivity and eventually churn out more exports. This in turn could ultimately finance and alleviate the deficit.

 

A deficit could also stem from a rise in investments from abroad and increased obligations by the local economy to pay investment income (a debit under income in the current account). Investments from abroad usually have a positive effect on the local economy because, if used wisely, they provide for increased market value and production for that economy in the future. This can allow the local economy eventually to increase exports and, again, reverse its deficit.

 

So, a deficit is not necessarily a bad thing for an economy, especially for an economy in the developing stages or under reform: an economy sometimes has to spend money to make money. To run a deficit intentionally, however, an economy must be prepared to finance this deficit through a combination of means that will help reduce external liabilities and increase credits from abroad. For example, a current account deficit that is financed by short-term portfolio investment or borrowing is likely more risky. This is because a sudden failure in an emerging capital market or an unexpected suspension of foreign government assistance, perhaps due to political tensions, will result in an immediate cessation of credit in the current account.

 

Conclusion

• The volume of a country's current account is a good sign of economic activity.
• By scrutinizing the four components of it, we can get a clear picture of the extent of activity of a country's industries, capital market, services and the money entering the country from other governments or through remittances.
• However, depending on the nation's stage of economic growth, its goals, and of course the implementation of its economic program, the state of the current account is relative to the characteristics of the country in question.
• But when analyzing a current account deficit or surplus, it is vital to know what is fueling the extra credit or debit and what is being done to counter the effects (a surplus financed by a donation may not be the most prudent way to run an economy).
• On a separate note, the current account also highlights what is traded with other countries, and it is a good reflection of each nation's comparative advantage in the global economy.

by Reem Heakal, (Contact Author | Biography)

 

 

http://www.investopedia.com/articles/03/061803.asp