Have you ever made a budget? If you have, you would record your spending limits and how much you wanted to save. And you would record all your financial transactions in it. Governments do the same thing! They record all their financial transactions in this account called the financial account.
What is the financial account in the BOP?
Financial accounts are the records of financial transactions across countries between residents and non-residents.
The financial transactions that are recorded here result in a change of ownership of financial assets or liabilities. The financial account experiences a deficiency when the country’s nationals purchase more foreign assets than foreign buyers purchase domestic assets.
When a country’s residents or multinational corporations (MNCs) invest in other countries, they start receiving money for these investments. In other words, their capital outflow results in inward flow in the proceeding years.
Net capital flow is the difference between the inward and outward flow of capital.
When a country experiences a positive net flow, it means that the country’s investments or capital assets in foreign countries are of greater value than the value of the assets bought by foreign nationals or MNCs in the country. The financial accounts consist of three main components: long-term direct investments, long-term portfolio investments, and short-term ‘hot-money’ capital flows. These are divided into sectors.
Long-term direct investments
Long-term direct investments or long-term capital flows are foreign direct investments (FDIs). As the word suggests, it refers to the investment made in foreign countries. FDIs can either be inward or outward direct investments. When a foreign MNC invests in the country, it is known as inward direct investment, and when the country’s MNC invests in a foreign country, such as when they open a subsidiary, it is known as outward direct investment.
FDIs also acquired in the form of mergers and takeovers or acquisitions are also examples of outward direct investments. Other examples of direct investments include the acquisition of shops, restaurants, hotels, offices, and other such assets in foreign countries.
When the inward direct investments increase, the country receives more money, thereby resulting in a positive financial account. This will result in positive economic growth in the country.
Long-term portfolio investments
Long-term portfolio investments consist of portfolio investments and other financial assets. Portfolio investments are the purchase of a country’s securities.
Securities are financial instruments that have a monetary value and can be interchanged for another asset or good of the same type.
This is typically the purchase of securities issued by foreign governments or shares from companies abroad.
Short-term ‘hot-money’ capital flows
Hot money is the money that moves between financial markets to avail maximum capital gain.
Hot money starts when interest rates rise. For example, if the Bank of England increased the rate for the Pound (£), investors would move their money into UK banks for a higher return on their savings and investments. This would appreciate the value of the £. An appreciation of the currency results in cheaper imports, increasing the volume of imported goods. The country will now become a less competitive exporter, as their domestic products cost more in the foreign market. This will lead to a trade deficit in the country.
It is called short term because investors move their money between financial markets based on the countries’ economic activities. They will continue to move their money to the country with a higher exchange rate.
Financial account balance formula
The balance of the financial account can be calculated using this formula:
Table 1 shows an example of a country’s positive financial account.
| Particulars | Amount |
| Net direct investment | £60,000.00 |
| Net portfolio investment | -£35,000.00 |
| Asset funding | £30,000.00 |
Errors and omissions | £15,000.00 |
Balance of financial account | £70,000.00 |
Table 1. Calculation of financial account - StudySmarter.Net direct investment = £60,000.00
Net portfolio investment = -£35,000.00
Asset funding = £30,000
Errors and commissions = £15,000
Using the formula:
Balance of financial account = £60,000.00 + -£35,000.00 + £30,000.00 + £15,000.00 = £70,000.00
What is the capital account?
The capital account is a small part of the Balance of Payments.
The capital account records the transfers of non-monetary and fixed assets.
It mainly records the transfers of immigrants and emigrants and other government transfers such as debt forgiveness. The capital account represents the balance of payments for the country.
The balance of the current account can be calculated using this formula:
BOP: Financial Account - Key takeaways
- Financial accounts are the records of financial transactions across countries between residents and non-residents.
- The financial accounts consist of three main components: long-term direct investments, long-term portfolio investments, and short-term ‘hot-money’ capital flows.
- ‘Hot-money’ moves around freely to countries with higher interest rates in order to earn the best rate of return.
- Balance of financial account = Net direct investment + Net portfolio investment + Assets funding + Errors and omissions.
- The capital account is the part of the Balance of Payments that records the transfers of non-monetary and fixed assets.
- The balance on capital account = Surpluses or Deficits of Net Non-Produced + Non-Financial assets + Net Capital Transfers.
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