Every international exchange between residents of one country and those of another is recorded in the balance of payments for that country and that time period. The BOP is comprised of a country's current account, capital account and financial account. All three of these reports paint a picture of a country's economic health, prognosis, and plans for reaching those goals.

For instance, if imports and exports are both high, that might suggest a liberal economy that welcomes free trade. However, a country with a thin capital or financial account may suffer from a lack of FDI and a stagnant domestic capital market.

The Capital Account

Capital account data chronicles the money flows into and out of a country. Investments and loans are used as a proxy for money coming in and going out of the business. When there is a negative balance, more money is leaving the economy than is coming in, and vice versa.

The Financial Account

Sub-Accounts

There are two components to a country's financial statement. One example is people in one country owning things in another. The second issue is when foreign investors buy properties in their home country. The financial account rises if the domestic ownership of foreign assets sub-account rises.

Put another way, if the sub-account for foreign ownership of domestic assets goes up, the financial account goes down. This means that a decline in the sub-account measuring foreign ownership of domestic assets contributes to expanding the total current account surplus. These two financial account categories reveal how much of the world's wealth a country controls.

How Capital and Financial Accounts Operate

When money leaves the nation to be invested elsewhere, it is debited from one of these two accounts. In particular, if the investment is part of a portfolio, the transaction will show up as a negative in the relevant financial ledger. Any direct investment will result in a negative entry into the capital account.

There is an expected return on these transfers since they constitute investments. This refund is shown as a current account credit in the BOP. The converse is true when a country outside of the originating country reaps a profit. For example, if you had to fork out money as interest on an investment, it would show up as a negative entry in your checking account.

What You Need to Know About the Balance of Payments

Balanced Accounts

In contrast to the current account, which may show a surplus or deficit, the BOP should always be balanced. This means that the capital and financial account should counterbalance the current account. As an illustration, if a resident of Greenland purchases an item made in Canada, both countries benefit.

Greenland receives the jacket, and Canada receives the monetary equivalent. A balancing entry is entered into the ledger until the transaction amount equals zero. The current account plus the financial account plus the capital account plus the balancing item equals zero, as stated in the IMF's Balance of Payments Manual.

Strong Financial and Capital Accounts

On the other hand, a net financial inflow occurs when an economy's capital and financial accounts show a surplus. Due to a rise in liabilities to other economies or a decrease in claims in other nations, the country now has more debits than credits.

The return on an investment is a debit on the current account, which is why it often occurs simultaneously as a current account deficit. As a result, international savings are being used to finance domestic investment and consumption. It owes money to other countries.

Financial and Capital Account Deficits

A negative capital and financial accounts balance indicate a country's net financial outflow. Either the foreign economy has increased its claims or decreased its liabilities so that the total claims and liabilities are greater than the latter. At this point, there should be a surplus in the current account. Thus, the economy supplies monies to the rest of the globe, making it a net creditor.

Unrestricted Accounts

As both measure changes in foreign capital, the capital and financial accounts are inextricably linked. Today's global economy relies on free trade and investment flows to maintain growth and prosperity. Capital account and financial account policies that are open or liberal are necessary for this to occur. Capital account liberalization is a common component of modern economic reform efforts in many developing nations. Capital flow limitations are therefore lifted.

Gains from Overseas Investment

Capital may flow freely between countries, allowing governments, businesses, and individuals to invest anywhere they see fit. As a result, more Foreign Direct Investment (FDI) in sectors and development projects may be possible. It may also facilitate increased capital market portfolio investment. Businesses that want to grow can expand into foreign markets, while smaller economies can attract more investment and advance toward their own domestic economic goals. The world economy could improve as a result of this.