What’s it: A financial account is a component of the balance of payments that records investment flows. It consists of direct investment, portfolio investment, other investments, and reserve accounts.
Financial transactions in the balance of payments
Well before discussing further, I will provide a summary of the balance of payments.
The balance of payments tells you a summary of a country’s economic transactions against the rest of the world. It consists of two main components, namely:
- Current account
- Capital account
The sum of the two must equal zero. However, it may not be precisely zero in practice due to differences in data sources and recording methods. To overcome this, economists then add a statistical discrepancy. So, mathematically, the balance of payments formula is:
Current account + Capital account + Statistical discrepancy = 0
The current account covers the trade balance, net investment income, and net unilateral transfers. Of the three, the largest component is usually the trade balance (the difference between exports and imports).
Furthermore, the capital account summarizes transactions about the sale and purchase of assets. It consists of financial account and capital transfers as well as net sales of nonproduced non-financial assets.
In some literature, the authors may separate the financial account from the capital account. While in other literature, they combine it.
Financial account components
The financial account does not tell you the total amount of assets owned by a country or a foreigner. However, it only sums up the change in foreign ownership. It tracks the shift in international asset ownership.
Some of the components in the financial account are:
- Portfolio investment
- Direct investment
- Financial derivatives
- Other investments
Based on their holdings, economists divide financial account into two groups:
- Domestic ownership of foreign assets
- Foreign ownership of domestic assets
The increased foreign ownership of domestic assets indicates an inflow of foreign investment. It falls into two categories based on their ownership:
- Private assets, representing ownership by the foreign private sector.
- Official assets, representing ownership by a foreign government or central bank
Meanwhile, an increase in domestic ownership of foreign assets indicates an outflow of domestic investment.
Domestic ownership of foreign assets consists of official reserve assets, government assets, and private assets. Private owners are individuals or businesses and can own assets that include foreign loans, deposits in banks in other countries, or direct investments made in other countries.
Government owners include local, state, or federal governments. Central banks can also own assets, including all of the assets mentioned above, except for reserve positions in the International Monetary Fund (IMF), assets that are uniquely held by government owners.
Consequences of financial account
The financial account deficit shows that domestic investment abroad exceeds foreign investment into the domestic economy. This may occur because the current account runs a surplus. So, to use the surplus, we invest and build an investment portfolio abroad. It generates future income such as interest, profits, and dividends.
The next impact is depreciation. Say we buy United States government bonds. To buy it, we have to have US dollars and sell domestic currency to get it. This leads to the depreciation of the domestic currency exchange rate against the US dollar. And, for Americans, their currency appreciates because demand is higher.
Meanwhile, the financial account surplus shows that foreign investment into domestic is higher than domestic investment abroad. Typically, it occurs during a current account deficit, where the domestic economy requires foreign capital to finance the deficit.
More investment inflows encourage appreciation of the domestic currency. Its demand increases, so its value against the foreign currency gets stronger. Appreciation may depress exports as domestic goods become more expensive for foreign buyers.
Foreign investments are also beneficial in the long term. They may consist of direct investments such as establishing a new company or construction of a production facility. That can increase economic growth and create more jobs.
However, if part of it is portfolio investments, it may cause instability in the domestic economy. They are usually short term, so they are prone to reversals.
When the domestic economy shows signs of weakness, they exit immediately and cause depreciation. In short, the inflows and outflows of portfolio investment cause the exchange rate to fluctuate, thereby destabilizing the domestic economy.