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THE CAPITAL ACCOUNT

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THE CAPITAL ACCOUNT - September 13th, 2010

THE CAPITAL ACCOUNT

The capital account records all international transactions that involve a resident of the country concerned changing either his assets with or his liabilities to a resident of another country. Transactions in the capital account reflect a change in a stock – either assets or liabilities.


It is often useful to make distinctions between various forms of capital account transactions. The basic distinctions are between private and official transactions, between portfolio and direct investment and by the term of the investment (i.e. short or long term). The distinction between private and official transaction is fairly transparent, and need not concern us too much, except for noting that the bulk of foreign investment is private.


Direct investment is the act of purchasing an asset and the same time acquiring control of it (other than the ability to re-sell it). The acquisition of a firm resident in one country by a firm resident in another is an example of such a transaction, as is the transfer of funds from the ‘parent company in order that the ‘subsidiary’ company may itself acquire assets in its own country.


Such business transactions form the major part of private direct investment in other countries, multinational corporations being especially important. There are of course some examples of such transactions by individuals, the most obvious being the purchase of the ‘second home’ in another country.


Portfolio investment by contrast is the acquisition of an asset that does not give the purchaser control. An obvious example is the purchase of shares in a foreign company or of bonds issued by a foreign government. Loans made to foreign firms or governments come into the same broad category. Such portfolio investment is often distinguished by the period of the loan (short, medium or long are conventional distinctions, although in many cases only the short and long categories are used).


The distinction between short term and long term investment is often confusing, but usually relates to the specification of the asset rather than to the length of time of which it is held. For example, a firm or individual that holds a bank account with another country and increases its balance in that account will be engaging in short term investment, even if its intention is to keep that money in that account for many years.


On the other hand, an individual buying a long term government bond in another country will be making a long term investment, even if that bond has only one month to go before the maturity. Portfolio investments may also be identified as either private or official, according to the sector from which they originate.


The purchase of an asset in another country, whether it is direct or portfolio investment, would appear as a negative item in the capital account for the purchasing firm’s country, and as a positive item in the capital account for the other country.


That capital outflows appear as a negative item in a country’s balance of payments, and capital inflows as positive items, often causes confusions. One way of avoiding this is to consider that direction in which the payment would go (if made directly).


The purchase of a foreign asset would then involve the transfer of money to the foreign country, as would the purchase of an (imported) good, and so must appear as a negative item in the balance of payments of the purchaser’s country (and as a positive item in the accounts of the seller’s country).


The net value of the balances of direct and portfolio investment defines the balance on capital account.
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