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Capital account 1
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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Capital account 2
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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Capital account 4
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,
Drooski, Duoduoduo, EGeek, Edward, Emilfarb, Everyking, Farcaster, Fayenatic london, FeydHuxtable, Finnancier, Funandtrvl, Gn842, Grick, Ground Zero, H falcon, Hal8999, Hut 8.5,
ImperfectlyInformed, Iohannes Animosus, JHP, Jackzhp, Jafol, John Quiggin, John of Reading, Jonnyboy88, Khlatrommi, LeeHunter, Leszek2, Lova Falk, MaCRoEco, MarceloB,
Materialscientist, MementoVivere, Merrynjoy, Mikevilkin, Ospalh, Philippe, RickK, Rjwilmsi, Rpf 81, Saval, StarryGrandma, Superzoulou, Sweikart, Temporaluser, Thesse, Trnj2000, Volunteer
Marek, 63 anonymous edits
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
uploader was Jkamyiu at en.wikipedia
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