Balance of Payments: Financial Account and Capital Account - Online Tutor, Practice Problems & Exam Prep

The financial account of the balance of payments focuses on long-term transactions, including foreign direct investment and financial assets like stocks and bonds. It consists of two main components: foreign holdings of U.S. assets and U.S. holdings of foreign assets. For instance, a foreign company building a factory in the U.S. represents foreign investment, while a U.S. citizen purchasing property abroad reflects U.S. investment overseas. The balance of payments must always equal zero, meaning any inflow in the current account is matched by an outflow in the financial account, ensuring equilibrium in international transactions.

Balance of Payments: Financial Account and Capital Account

Alright. So now, let's go more into the balance of payments regarding the financial account, and we'll also discuss the capital account. So we're really going to focus on the financial account here. Remember, the capital account is kind of beyond the scope of this course, and it's really small when it comes to the big picture here. So the balance of payments, remember, we're focused on a country's transactions with other countries. This is where we're trading with other countries and where we're buying foreign assets. So these financial account transactions, they're focused more on long-term transactions, okay? We're thinking of long-term flows of funds compared to when we were talking about the current account, and it was short-term things where we dealt with those net exports and things like that. So the financial account, we've got another snippet here, from our balance of payments and we're going to focus here on the financial account and then we'll discuss the capital account just a little bit and then we'll close up our discussion on the balance of payments here.

So let's think about the financial account. What is included? What are these items that go into the financial account? So it's long-term investments and financial assets. So when we talk about financial assets being stocks and bonds. So the long-term investments may be building a factory or buying equipment. It also includes buying a house. When you buy a house in another country, it is included here as well. Financial assets include the purchase of stocks and bonds, okay? Stocks and bonds, when you buy, say, a bond in a European company, they're selling bonds, well, you're making a transaction that falls into the financial account. Okay?

So we break it up into 2 things, and they're basically the opposite of each other. First, we have the change in foreign holdings of US assets. So foreign holdings of U.S. assets, that's foreigners holding US assets, right? Say, a Japanese citizen buying a US Treasury bond, right? That's what we have here. A foreigner spends money to buy US assets, and that's the ones we defined up here. So let's say that BMW comes and builds a factory in the United States to make cars here in the United States and make it cheaper to sell them here in the US. Well, that would be a foreign holding of US assets, right? They're building something here in the US. They're buying US land. They're building a factory here in the US, but a foreigner owns it, right? So buying US assets. So an example would be a European citizen buying shares of Microsoft, right? That's another example there. Microsoft being a US corporation and a European citizen, a foreigner buying stock in that company. Toyota builds a manufacturing plant in the United States that's similar to the example I just said.

And then we have the opposite. This is US holdings of foreign assets. So now, this is a US citizen owning something overseas, right? US citizen spending money to buy foreign assets. Same as above. What we defined above. The stocks and bonds, factories, buying a house, right? So US citizen buys a vacation home in Barcelona. Well, there you go. That is a US citizen spending their money to buy something overseas, right? And that's like I said, buying a house, right? Buying a house also fits into this category. It's not just those firm investments like factories and things like that. How about AT&T building a customer service center in India? So this is the same idea, right? AT&T being a US company, they go to India, and they now own this service center in India. So it's US owned in a foreign country, right?

So that's the main thing with the financial account. You can see that it's these longer term things like it's not just selling, you know, just some goods to another country, right? We're not just importing toys that we buy from China. No, this is a longer-term investment like a stock, a bond, a house, a factory, things like that. That's what goes in the financial account. The capital account, remember I said, it's not as big of a deal here. We're not going to focus on this as much and it's trivial items that are beyond the scope of this class. We talk about migrant transfers when someone moves to another country and they take their stuff with them. Intangible assets, debt forgiveness. Don't worry too much about the capital account. You can even notice that up here, it rounds down to 0, right? There are a few million dollars. It doesn't reach even one billion dollars there, okay?

And so one last thing about the balance of payments, remember that since the capital account is essentially 0, right? Since it's essentially 0, everything that happens in the current account must balance out with the financial account. So, basically, the current account is the opposite of the financial account, okay? The balance of payments must always equal 0. This is one of the biggest takeaways of the balance of payments is that it must always equal 0. Especially in this class where we don't go into too much detail about the balance of payments. This is one of the big things to remember is that it always equals 0 because any inflow in the current account must be matched by an equal outflow in the financial account, okay? So an example of that is, let's think of that car sale, okay? So let's say BMW sells a car to a US citizen. Right? And they pay for, let's say, I don't know how much a BMW costs. Let's say $30,000, right? $30,000 for this BMW. Well, now what happens? The US citizen has there's been this import. Right? There's an import which is in the current account. But now what's happened is that BMW owns US assets, right? They own the US asset, which in this case is the $30,000. The $30,000 itself is a US asset. They own dollars, right? These dollars are US assets, and now, BMW has imported assets. So these $30,000 are in the financial account, right? As a foreign holding of US assets, right? A foreign, the German company now owns US assets dollars, right? By selling this car in the US, okay? So that's basically how this works. And then, BMW can exchange those $30,000, but it's always going to have this balance, right? Where this current account is going to be balanced with this financial account, and that's the main takeaway here is that they're always going to equal 0. The balance of payments always equals 0, okay?

So that's about it when it comes to the financial account, this balance of payments. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the financial account in the balance of payments?

The financial account in the balance of payments records long-term transactions involving financial assets and investments between countries. It includes foreign direct investment (FDI) and the purchase of financial assets like stocks and bonds. The financial account is divided into two main components: foreign holdings of U.S. assets and U.S. holdings of foreign assets. For example, if a foreign company builds a factory in the U.S., it is recorded as a foreign holding of U.S. assets. Conversely, if a U.S. citizen buys property abroad, it is recorded as a U.S. holding of foreign assets. The financial account ensures that the balance of payments always equals zero by offsetting the current account.

How does the financial account differ from the current account in the balance of payments?

The financial account and the current account are two components of the balance of payments, but they focus on different types of transactions. The financial account deals with long-term investments and financial assets, such as foreign direct investment and the purchase of stocks and bonds. In contrast, the current account focuses on short-term transactions, including trade in goods and services, income from investments, and current transfers. While the current account records the flow of goods and services, the financial account records the flow of capital. Both accounts must balance each other out, ensuring that the overall balance of payments equals zero.

What are examples of transactions recorded in the financial account?

Transactions recorded in the financial account include long-term investments and financial assets. Examples include: 1) A foreign company building a factory in the U.S., which is recorded as a foreign holding of U.S. assets. 2) A U.S. citizen purchasing a vacation home in another country, recorded as a U.S. holding of foreign assets. 3) A foreign investor buying U.S. Treasury bonds, which is a foreign holding of U.S. financial assets. 4) A U.S. company establishing a customer service center abroad, recorded as a U.S. holding of foreign assets. These transactions reflect the movement of capital and investments between countries.

Why must the balance of payments always equal zero?

The balance of payments must always equal zero because it is an accounting identity that ensures all international transactions are balanced. This means that any inflow in the current account must be matched by an outflow in the financial account, and vice versa. For example, if a U.S. citizen buys a car from a foreign company, the payment for the car is recorded as an import in the current account. Simultaneously, the foreign company now holds U.S. dollars, which is recorded as a foreign holding of U.S. assets in the financial account. This balancing act ensures that the sum of the current account and the financial account is always zero.

What is the role of foreign direct investment (FDI) in the financial account?

Foreign direct investment (FDI) plays a significant role in the financial account by representing long-term investments made by a company or individual in another country. FDI includes activities such as building factories, acquiring businesses, or establishing operations abroad. For example, if a Japanese company builds a manufacturing plant in the U.S., it is recorded as a foreign holding of U.S. assets in the financial account. FDI is crucial for economic growth as it brings capital, technology, and expertise to the host country, while also providing returns to the investing country. It reflects the interconnectedness of global economies through long-term capital flows.