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Capital account

In macroeconomics and international finance, the capital account (also known as financial account) is one of two

primary components of the balance of payments, the other being the current account. Whereas the current account 

reflects a nation's net income, the capital account reflects net change in ownership of national assets.

A surplus in the capital account  means money is flowing into the country, but unlike a surplus in the current 

account , the inbound flows will effectively represent borrowings or sales of assets rather than payment for work. A

deficit in the capital account means money is flowing out the country, and it suggests the nation is increasing its

ownership of foreign assets.

The term "capital account" is used with a narrower meaning by the International Monetary Fund (IMF) and affiliated

sources. The IMF splits what the rest of the world calls the capital account into two top level divisions:  financial

account and capital account , with by far the bulk of the transactions being recorded in its financial account.

The capital account in macroeconomics

At high level:

Breaking this down:

The International Finance Centre in Hong Kong

where many capital account transactions are

processed.

• Foreign direct investment (FDI), refers to long term capital

investment such as the purchase or construction of machinery,

buildings or even whole manufacturing plants. If foreigners are

investing in a country, that is an inbound flow and counts as a

surplus item on the capital account. If a nation's citizens are

investing in foreign countries, that's an outbound flow that will

count as a deficit. After the initial investment, any yearly profits not

re-invested will flow in the opposite direction, but will be recorded

in the current account rather than as capital.

• Portfolio investment refers to the purchase of shares and bonds. It's

sometimes grouped together with "other" as short term investment.As with FDI, the income derived from these assets is recorded in the

current account; the capital account entry will just be for any buying

or selling of the portfolio assets in the international capital markets.

• Other investment includes capital flows into bank accounts or

provided as loans. Large short term flows between accounts in

different nations are commonly seen when the market is able to take

advantage of fluctuations in interest rates and / or the exchange rate

between currencies. Sometimes this category can include the reserve account .

•  Reserve account . The reserve account is operated by a nation's central bank to buy and sell foreign currencies; it

can be a source of large capital flows to counteract those originating from the market. Inbound capital flows (from

sales of the account's foreign currency), especially when combined with a current account surplus, can cause a

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rise in value (appreciation) of a nation's currency, while outbound flows can cause a fall in value (depreciation). If 

a government (or, if authorized to operate independently in this area, the central bank itself) doesn't consider the

market-driven change to its currency value to be in the nation's best interests, it can intervene.

Central Bank operations and the reserve account

Conventionally, central banks have two principal tools to influence the value of their nation's currency: raising orlowering the base rate of interest and more effectively by the buying or selling of their currency. Setting a higher

interest rate than other major central banks will tend to attract in funds via the nation's capital account, and this will

act to raise the value of its currency. A relatively low rate will have the opposite effect. Since World War II, interest

rates have largely been set with a view to the needs of the domestic economy and, anyway, changing the interest rate

alone has only a limited effect.

A nation's ability to prevent its own currency falling in value is limited mainly by the size of its foreign reserves: it

needs to use the reserves to buy back its currency.[1]

Starting in 2013, a tend has developed for some central banks

to attempt to exert upwards preasure on their currencies by means of Currency swaps, rather than directly selling its

foreign reserves. In the absence of foreign reserves, central banks may affect international pricing indirectly by

selling assets (usually government bonds) domestically, which does however diminish liquidity in the economy and

may lead to deflation.

When a currency rises higher than monetary authorities might like (making exports less competitive internationally),

it is usually considered relatively easy for an independent central bank to counter this. By buying foreign currency or

foreign financial assets (usually other governments' bonds) the central bank has a ready means to lower the value of 

its own currency - if it needs to, it can always create more of its own currency to fund these purchases. The risk 

however is general price inflation. The term "printing money" is often used to describe such monetization but is an

anachronism, most money is in the form of deposits and its supply is manipulated through the purchase of bonds. A

third mechanism that Central Banks and governments can use to raise or lower the value of their currency is simply

to talk it up or down, by hinting at future action that may discourage speculators. Quantitative easing ( Q.E.), a

practice used by major central banks in 2009, consisted of large scale bond purchases by central banks. The desire

was to stabilize banking systems and if possible encourage investment to reduce unemployment.

As an example of direct intervention to manage currency valuation, in the 20th century Great Britain's central bank,

the Bank of England, would sometimes use its reserves to buy large amounts of pound Sterling to prevent it falling in

value - Black Wednesday was a case where it had insufficient reserves of foreign currency to do this successfully.

Conversely, in the early 21st century, several major emerging economies effectively sold large amounts of their

currencies in order to prevent their value rising - and in the process building large reserves of foreign currency,

principally the dollar.

Sometimes the reserve account  is classed as "below the line" and so not reported as part of the capital account .

Flows to or from the reserve account can substantially affect the overall capital account. Taking the example of China in the early 21st century, and excluding the activity of its central bank, China's capital account had a large

surplus as it had been the recipient of much foreign investment. If the reserve account is included however, China's

capital account has been in large deficit as its central bank purchased large amounts of foreign assets (chiefly US

government bonds) to a degree sufficient to offset not just the rest of the capital account , but its large current 

account surplus as well.[2]

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Sterilization

In the financial literature, sterilization is a term commonly used to refer to a central bank's operations which mitigate

the potentially undesirable effects of inbound capital - currency appreciation and inflation. Depending on the source,

sterilization can mean the relatively straightforward re-cycling of inbound capital to prevent currency appreciation

and/or a wide range of measures to check the inflationary impact of inbound capital. The classic way to sterilize the

inflationary effect of the extra money flowing into the domestic base from the capital account is for the central bank to use open market operations where it sells bonds domestically, thereby soaking up new cash that would otherwise

circulate around the home economy. A central bank normally makes a small loss from its overall sterilization

operations, as the interest it earns from buying foreign assets to prevent appreciation is usuall y less than what it has

to pay out on the bonds it issues domestically to check inflation. However in some cases a profit can be made. In the

strict text book definition, sterilization refers only to measures aimed at keeping the domestic monetary base stable -

an intervention to prevent currency appreciation that involved merely buying foreign assets without counteracting

the resulting increase of the domestic money supply would not count as sterilization. A textbook sterilization would

be, for example, the Federal Reserve's purchase of $1 one billion in foreign assets. This would create additional

liquidity in foreign hands. At the same time the Fed would sell $1 billion of its assets into the U.S. market, draining

the domestic economy of $1 billion in funds. With $1 billion created abroad and $1 billion removed from thedomestic economy, the operation to influence the currency's value relative to other currencies has been sterilized.

The IMF definition

The above definition is the one most widely used in economic literature,[3]

in the financial press, by corporate and

government analysts (except when they are reporting to the IMF) and by the World Bank. In contrast, what the rest

of the world calls the capital account is labelled the "financial account" by the International Monetary Fund (IMF),

by the Organisation for Economic Co-operation and Development (OECD), and by the United Nations System of 

National Accounts (SNA). In the IMF definition, the capital account represents a small subset of what the standard

definition designates the capital account, largely comprising transfers. Transfers are one way flows, such as gifts, as

opposed to commercial exchanges (i.e. buying/selling and barter). The biggest transfers between nations is typically

foreign aid, however that is mostly recorded in the current account . An exception is debt forgiveness, as that in a

sense is the transfer of ownership of an asset. When a country receives significant debt forgiveness it will typically

comprise the bulk of its overall IMF capital account entry for that year.

The IMF's capital account  does include some non transfer flows, which are sales involving non-financial and

non-produced assets, e.g., natural resources like land, leases & licenses, and marketing assets such as brands -

however the sums involved here are typically very small as most movement in these items occurs when both seller

and buyer are of the same nationality.

Transfers apart from debt forgiveness recorded in IMF's Capital account include the transfer of goods and financial

assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of fundsreceived to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and uninsured damage to

fixed asset. In a non IMF representation, these items might be grouped in the other sub total of the capital account .

They typically sum to a very small amount in comparison to loans and flows into and out of short term bank 

accounts.

Capital controls

Capital controls are measures imposed by a state's government aimed at managing capital account transactions. They

include outright prohibitions against some or all capital account transactions, transaction taxes on the international

sale of specific financial assets, or caps on the size of international sales and purchases of specific financial assets.

While usually aimed at the financial sector, controls can affect ordinary citizens, for example in the 1960s British

families were at one point restricted from taking more than £50 with them out of the country for their foreign

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holidays. Countries without capital controls that limit the buying and selling of their currency at market rates are said

to have full Capital Account Convertibility.

Following the Bretton Woods agreement established at the close of World War II, most nations put in place capital

controls to prevent large flows either into or out of their capital account. John Maynard Keynes, one of the architects

of the Bretton Woods system, considered capital controls to be a permanent part of the global economy. Both

advanced and emerging nations adopted controls; in basic theory it may be supposed that large inbound investmentswill speed an emerging economies development, but empirical evidence suggests this does not reliably occur, and in

fact large capital inflows can hurt a nation's economic development by causing its currency to appreciate, by

contributing to inflation, and by causing an unsustainable "bubble" of economic activity that often precedes financial

crisis. The inflows sharply reverse once capital flight takes places after the crisis occurs. As part of the displacement

of Keynesianism in favour of free market orientated policies, countries began abolishing their capital controls,

starting between 1973 -74 with the US, Canada, Germany and Switzerland and followed by Great Britain in 1979.

Most other advanced and emerging economies followed, chiefly in the 1980s and early 1990s.

An exception to this trend was Malaysia, which in 1998 imposed capital controls in the wake of the 1997 Asian

Financial Crisis. While most Asian economies didn't impose controls, after the 1997 crises they ceased to be net

importers of capital and became net exporters instead. Large inbound flows were directed "uphill" from emerging

economies to the US and other developed nations. According to economist C. Fred Bergsten the large inbound flow

into the US was one of the causes of the financial crisis of 2007-2008. By the second half of 2009, low interest rates

and other aspects of the government led response to the global crises have resulted in increased movement of Capital

back towards emerging economies. In November 2009 the Financial Times reported several emerging economies

such as Brazil and India have begun to implement or at least signal the possible adoption of capital controls to reduce

the flow of foreign capital into their economies.

Notes and references

[1][1] By the law of supply and demand, reducing the supply of currency available by buying up large quantities on the forex markets tends to raise

the price.

[2][2] However, in late 2011 China also had periods when it was selling foreign reserves to prevent depreciation, this was due to surges of funds

leaving the country through the private sector component of the capital account.

[3] Though with a few exceptions, e.g. International economics by Krugman and Obstfeld which uses the IMF definition in at least its 5th

edition.

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Article Sources and Contributors 5

Article Sources and ContributorsCapital account  Source: http://en.wikipedia.org/w/index.php?oldid=572869186 Contributors: 7, Aleksd, All4peace, Atlastawake, Beland, Bender235, Bruiser07, Carlsmith, ChrisGualtieri,

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Image Sources, Licenses and ContributorsFile:Two International Finance Centre.jpg  Source: http://en.wikipedia.org/w/index.php?title=File:Two_International_Finance_Centre.jpg  License: Public Domain Contributors: Original

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