IE - Financial Account

Financial Account in International Transactions

Overview of International Transactions

• Components of International Transactions:

  • Current Account: Records transactions of goods and services.

  • Financial Account: Records changes in asset holdings.

Financial Account Balance

• Definition:

  • The financial account balance is defined as:

  • $ext{Financial Account Balance} = ext{Change in Foreign Owned US Assets} - ext{Change in US Owned Foreign Assets}$

  • This can yield positive or negative values, in contrast to the current account which typically has positive values.

Comparison Between Accounts

• Current Account:

  • Calculated as exports minus imports ( ext{Exports} - ext{Imports}).

  • Always positive; one cannot have negative exports or imports.

• Financial Account:

  • Can be positive or negative, depending on foreign investment in and out of US assets.

Example Scenarios

1. If foreigners buy $500,000,000,000$ worth of US assets and sell $350,000,000,000$ worth, then:

   • Change in foreign assets: $500,000,000,000 - 350,000,000,000 = 150,000,000,000 ext{ (positive)}$

2. If foreigners buy $400,000,000,000$ and sell $600,000,000,000$ worth, then:

   • Change in foreign assets: $400,000,000,000 - 600,000,000,000 = -200,000,000,000 ext{ (negative)}$

3. For Americans buying $700,000,000,000$ worth of foreign assets (selling $500,000,000,000$):

   • Change in US owned foreign assets: $700,000,000,000 - 500,000,000,000 = 200,000,000,000 ext{ (positive)}$

4. If Americans buy $450,000,000,000$ worth of foreign assets and sell $550,000,000,000$ worth:

   • Change in US owned foreign assets: $450,000,000,000 - 550,000,000,000 = -100,000,000,000 ext{ (negative)}$

Defining Financial Accounts

• Financial Account Surplus:

  • Occurs when the financial account balance is greater than zero.

• Financial Account Deficit:

  • Occurs when the financial account balance is less than zero.

  • Example:

  • Change in foreign owned US assets is $100,000,000,000$ and US owned foreign assets are $200,000,000,000$:

    • Financial account balance: $100,000,000,000 - 200,000,000,000 = -100,000,000,000$

Types of Foreign Owned US Assets

• Categories:

  • Direct Investment Liabilities:

  • Involves foreign companies buying or building facilities in the US (e.g., manufacturing plants).

  • Portfolio Investment Liabilities:

  • Involves foreign purchasing US financial assets such as stocks and bonds.

  • Other Investment Liabilities:

  • Captures other investments not classified as direct or portfolio investments.

Changes in Foreign Owned US Assets

• An increase suggests capital inflows into the US.

Changes in US Owned Foreign Assets

• If these numbers increase, they indicate capital outflows from the US.

• Similarly categorized:

  • Direct Investment Assets: US investing in manufacturing plants abroad.

  • Portfolio Investment Assets: US purchases of stocks or bonds from foreign sources.

  • Other Investment Assets: Any other transaction type not specifically mentioned above.

Reserve Assets

• Definition:

  • Represents net purchases or sales of foreign currency by the domestic central bank or treasury.

• US Specific:

  • The Federal Reserve manages this for the US.

• If this value is positive:

  • The central bank is accumulating foreign exchange reserves (balance of payments surplus).

• If negative:

  • It means the central bank is selling off reserves (balance of payments deficit).

Balance of Payments

• Concept that encompasses all international transactions, ensuring all sums equal zero when considering all accounts:

  • $ext{Current Account} + ext{Financial Account} + ext{Statistical Discrepancy} = 0$

Statistical Discrepancy

• Refers to errors or omissions in reported transactions that ensure the combined accounts balance to zero.

  • If Current Account is $-1,018,05$:

  • Make adjustments for the financial account to equal this negative number with a statistical discrepancy.

Equation Dynamics

• Financial account involves breaking down into its components:

  • $ext{Change in Foreign Owned US Assets} = ext{Change in Direct Investment Liabilities} + ext{Change in Portfolio Investment Liabilities} + ext{Change in Other Investment Liabilities}$.

• Similarly for US owned assets:

  • $ext{Change in US Owned Foreign Assets} = ext{Change in Direct Investment Assets} + ext{Change in Portfolio Investment Assets} + ext{Change in Other Investment Assets} + ext{Change in Reserve Assets}$.

Closing Thought on Balances

• If current account and private financial account add to a surplus:

  • Yield a surplus in reserve assets.

• If they combine to a deficit:

  • Indicate a drawdown of foreign reserves.

Exchange Rate Systems

• Flexible Exchange Rate System:

  • Determines currency value via demand and supply without central bank intervention.

  • Balance of payments is generally equal to zero under this system.

• Fixed Exchange Rate System:

  • Central banks intervene to maintain a fixed currency exchange rate.

  • Results in either accumulation or depletion of reserves.

Exchange Rate Implications

• For maintaining fixed rates, central banks must curtail surpluses and adjust holdings actively.

• Coordinate supply and demand in currencies to enforce policy goals.

Comparative Example with China

• China historically has targeted an undervalued exchange rate to promote exports.

• Accumulated dollar reserves through ongoing trade surpluses and foreign direct investments leading to a balance of payments surplus.

• Countries like China adjust their currency values strategically influencing international trade dynamics.