Capital Account

A concept of Macroeconomics that requires it to be distilled for mental digestion

The capital account is a concept of Macroeconomics that requires it to be distilled for mental digestion and is a vital topic that may be difficult to understand for others. And this may be a complex subject to understand for others. 

The world is one global village where one nation is connected with the other. This is a result of international business and trade. Transactions flow into and out of a country, and as a result, the concept of balance of payment was established.

Since the world is more intertwined due to international trade, the need to account for this trade arises.  

That is why the balance of payment systems exist. Its sole purpose is to record these transactions. Nevertheless, we must record particular types of transactions in this account.

There are two classifications of transactions that get recorded in the BOP system. These classifications are Current or Capital and Financial transactions.

BOP has two main accounts where specific transactions are recorded. Thus, it would be an error to miscategorize a transaction. This is because a misrepresentation in any of these accounts would lead to inaccurate economic performance. 

What is a Capital Account?

  • It is a Balance of payment account. It records the transactions made between nations. This is an account that records both capital and financial transactions. It involves transactions made between people and entities of different nations.  

  • This is one of the most critical topics in Economics, and it comes under the Balance of Payments topic. Most often, this concept gets confused with the Accounting definition.

  • This topic usually gets introduced at the undergraduate level of the university. No matter, this subject does not need you to come from a business background.

  • In a nutshell, this concept is a record of international trade by a nation involving changes in assets. This account, together with the current account, makes up the BOP.

  • Thus, these two accounts are essential because they help measure economic performance.

It should be noted that the Capital account cant is summed up by the equation below.

Capital Account = Change in foreign Ownership of Domestic assets - Changes in domestic ownership of foreign assets.

Understanding Capital Accounts

For us to fully grasp the concept, we need to understand the Balance of Payment and International trade.

The world is more connected than ever due to trade and transactions made by international parties. Every nation is, in one way or another, tied and connected to another under trade and finance.

As a result of this connection of commerce by international players, the system of Balance of Payment gets set up by nations. The aim is to keep records and account for transactions along with the changes in transactions between international parties.

So, all nations around the world pay close attention to this account. And its sister account is called the Current account.

It is essential to understand two points when it comes to this account.

  1. Surplus funds in this Balance of payment account mean money flows into the country or economy. However, this is the opposite when it comes to Current accounts.

  2. A deficit in this account indicates money is flowing out of the country. While the latter suggests that the nation is increasing its ownership of foreign assets.

Balance of Payment 

According to the Reserve Bank of Australia, the Balance of Payment is a summary of economic transactions by one economy and the rest of the world. BOP involves an array of transactions.

These transactions include exports and imports of goods and services, financial assets, and grants.

The structure of BOP is the same or at least similar in all countries. Therefore, almost all nations with an open economy policy will have a similar accounting system for capturing international transactions.

Balance of Payment categorizes transactions in two forms. These forms are

  • Current Account

  • Capital and Financial Account.

Understanding BOP is fundamental. This is because the balance of payment is one of a country's most important economic indicators. And it sets to measure the financial performance of a nation. 

There is a clear distinction between the two accounts of the Balance of Payment, more so is the fact that they record different transactions. 

These two accounts are distinct by the transactions they record and report. It is important to remember that to appreciate this concept entirely; it is necessary to look at the current account as well.

The current account captures transactions from selling goods and services to net incomes from abroad. It is vital to know that under this account, there is a division into three parts. These parts are 

  •  Balance of Trade

The balance of trade is sometimes called commercial balance or net exports. It is the difference between the revenue of a nation's exports and imports over a defined period. In some cases, a distinction is made between a balance of trade for goods against one for services.

  •  Primary Income Balance

According to the International Monetary Fund, this is defined as an economy's total value of primary income receivable less the full value of primary income payable.

  • Secondary Income Balance

This is the last part of the current account. It is the total credits of an economy less total debt.

The latter account is broken down into two categories- capital and financial transactions.

Examples of Current account transactions

There are several examples of transactions that can be placed under this category. These can be:

  • Minerals are imported or exported

  • Import or export of agricultural and electrical products.

  • Consultancy services

  • Construction services

The transactions recorded in this account are the most familiar ones because they involve transactions from the trade of goods and services.

The list is not exhaustive. The account is further divided into three parts, which are:

  •  Balance of Trade

This includes only physical goods imported or exported. These can either be finished or semi-finished goods.

  •  Primary Income Balance

This account includes income from labor and compensations to employees.

  • Secondary Income Balance

This may include social security transfers and other miscellaneous transactions.

All in all, the word current gets used in economics to describe the goods and services that are either used or consumed in a quarter.

The formula for calculating the current account is represented by X - M (Exports minus Imports), a country's trade balance. This balance can be positive if a country exports more than its imports. Thus, it is essential to know that imports and exports comprise services and goods.

In simple words, a current account indicates the overall nation's earnings and spending. Goods and services flow inside and outside. And this is calculated by adding goods and services plus Net Income and  Net Current transfers. 

All the trade exports (goods and services) are recorded and summed up, and then all imports are added. Finally, the imports are subtracted from the exports. The result may be positive or negative; this translates to either trade surplus or trade deficit.

It is essential to note that this Balance of Payment account records transactions resulting from the trade visible.

Examples of Capital and Financial accounts transactions

As part of a BOP, the Capital Account gets divided into two categories- capital and financial account. This is because capital and financial transactions are separate and different processes.

Thus, it depends on the type of transaction the country makes with the rest of the world.

This account differs from the current account in many ways but also does have some similarities. So the question is, what kind of transactions can be classified under this category of the BOP?

The following are examples of transactions that are recorded in this account.

  • Gifts: This account includes gifts to individuals, institutions, or nations.

  • Grants: This account records grants to or from an economy. This includes all forms of grants.

  • National Aid: This can be emergency relief or any other aid. Again, this can be bilateral or from many countries.

  • Bonds: These are debt obligations by a company to investors. This type of debt is different from one from a commercial bank.

  • Preference Shares: These are shares where dividends get paid out first before ordinary stock dividends.

  • Ordinary Shares: These are shares where dividends get paid out last or after preference shareholders.

  • Buildings: These are long-term assets on the balance sheet of a company.

  • Factories: Like buildings, factories are also considered long-term assets.

Capital Account Vs. Current Account

It is essential to identify and distinguish these two accounts.

Both BOP accounts and record transactions; however, the two need to be distinguished. First, it is essential to know that these accounts also share similarities. And as such, it is imperative to understand the similarities and differences between the two accounts.

This enables you to understand what transactions can not be part of what account. This is done by comparing and contrasting the two aspects of the BOP.

The similarities between the two accounts are

  • Both accounts are part of the BOP system. Therefore, they are helpful in an economy to track transactions in international trade.

  • Both accounts use the double-entry system of accounting. They record debits and credit from the transactions resulting from international trade.

  • Both accounts are essential for measuring economic growth and vital economic indicators.

  • Both accounts record transactions made by a nation with the rest of the world.

The differences between a Capital and a Current account are presented in the table below. The table below shows the Current account on the Left and the Capital and Financial account on the right side. The following are the differences between the two Balance of Payment accounts.

Capital Account Vs Current Account
CURRENT ACCOUNTCAPITAL AND FINANCIAL ACCOUNT
A Current account records transactions from imports and exports of goods and services.While the other account records gains & losses resulting in gifts and aid given. But also it records transactions involving foreign assets
Current account records revenues from the selling and buying of goods and services.It records gains or inflows from outside, which are often intangible.
The Current account has three componentsIt is categorized in two folds.
Examples of things included in Current account transactions include goods and services. These can be items coming in or going out of the country.While in this account, transactions may include grants, gifts, and gains or losses on assets or securities.

 

For a further and deeper understanding of the subject in discussion, please watch the video below.

Capital vs. Financial Transactions

There is a distinction between Financial and Capital transactions in the Balance of Payments. This is because even though both transactions are part of one account under the balance of payment, there is more. Nevertheless, the two form the one account that is part of the BOP, which is an important economic indicator.

According to the IMF, this account has an array of transactions under it. These transactions can be distinguished into categories. It should be noted that regardless of whether the country calls this account a capital account or capital and financial account, the transactions recorded are still the same.

The capital and financial account hold two categories of transactions, although it's one account. Even so, it is vital to acknowledge the similarities and differences between these two kinds of transactions. For example, a country records two types of transactions in this account.

There are some common features between these two categories. The similarities of these transactions are

  • Both transactions relate to the transfer of money into or outside an economy. Whether as gifts, aid or investments.

  • Both transactions get recorded using the debit and credit accounting system. This means that transactions are entered in a double entry representing money coming into and going out of the country.

The following are the differences between the two categories. The table below represents capital transactions on the left and financial transactions on the right. The following are the differences between the two transactions.

CAPITAL TRANSACTIONSFINANCIAL TRANSACTIONS
Capital transactions give something to another party without receiving anything in returnFinancial transactions involve long-term investments in businesses
An Example of a Capital transaction may include debt cancellation, aid, and gift.The component of finance transactions in Capital accounts records transactions that involve Assets. An Example of this transaction recorded can be buying or selling of shares held abroad.

Capital accounts and growth

According to the International Monetary Fund (IMF), the growth of international financial transactions and international capital flows is one of the groundbreaking economic developments of the late twentieth century. Capital flows and international trade have developed over the past three decades.

The IMF, the World Bank, and the World Trade Organization have been instrumental in campaigning, promoting, and supporting the liberalization of trade and capital flows.

According to the International Monetary Fund article, there has been rapid development concerning capital flows and international trade liberalization. As a result, for the past 30 to 40 years, there has been an evolution in international trade. 

It is anticipated that this liberalization of international trade will furthermore increase. The IMF believes this leads to global prosperity.

It is acknowledged that it has been improving since the 1980s due to several factors.  

The IMF argues that these factors have led to the growth of international capital flows. According to the IMF and the World Bank, these factors have been said to be the main contributors to the interdependence of nations. The World Bank, together with the World Trade Organization, have from time to time initiated proposals, programs and policies to open up trade, thus, leading to a rise in capital flows among nations.

The following are the factors that led to the liberalization of capital flows.

  • The removal of restrictive policies on capital transactions. Economic liberalization and deregulation in both industrial and developing nations.

  • Macroeconomic stabilization and policy reforms have led to a growth of commercial issuers of debt instruments in developing nations.

  • The evolution of trade and multilateralism of trade has encouraged international financial transactions. This is due to hedge exposure to currency and commercial risk.

  • There has been a growth in derivative financial instruments. Financial instruments such as swaps, options, and futures have enabled investors to assume some risks.

Key Takeaways

  • It is a Balance of payment account. This account records the transactions made by a nation with the rest of the world. This account records capital and financial transactions made with the rest of the world.

  • The world is more connected than ever before due to international trade by nations.

  • Every nation is, in one way or another, tied and connected to another. This is because of trade and international finance.

  • The subject of the capital account is under Balance of Payments in Economics. Most often, this concept gets confused with the Accounting definition. Even so, the two are entirely different.

  • Surplus funds in the capital account mean money flowing into the country or economy. However, this is the opposite when it comes to Current accounts.

  • A deficit in the capital account means money is flowing out of the country. While the latter suggests that the nation is increasing its ownership of foreign assets.

  • Balance of Payment categorizes transactions in two forms. These forms are the Current Account and Capital and Finance Account.

  • These two accounts are distinct by the transactions they record and report.

  • A Current account captures transactions from abroad. This includes the sale of goods and services to net incomes from abroad.

  • There are several examples of transactions that are under the current account category. These include minerals, agricultural and electrical products, consultancy services, and construction services.

  • The two accounts are part of the Balance of Payment mechanism. They track transactions in international trade.

  • The two accounts use the double-entry system of accounting. This means the transaction gets recorded as debit or credit.

  • Capital and finance accounts have two categories. At the same time, the other account has three types of transactions.

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Researched and Authored by Mazyopa Jonathan | Linkedin 

Reviewed and Edited by Parul Gupta | LinkedIn

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