The Capital and Financial Accounts
Foreign funds entering a country from the sale or purchase oftangible assets - as opposed to non-physical assets such as stocks or bonds - are recorded in the capital account of the BOP. (Again, money entering the account is noted as a credit, and money leaving the account is a debit.) Financial transactions such as money leaving the country for investment abroad are recorded in the financial account. Together, these two accounts provide financing for a current account deficit.
Balance of Trade Deficit With the long-term in mind, a country may run a deficit by importing more than it's exporting, with the ultimate goal of producing finished goods for export. In this scenario, the country will plan to pay off the temporary excess of imports at a later time with proceeds made from future export sales. The proceeds made from these sales would then become a current account credit. (To learn more, read In Praise Of Trade Deficits.)Investing for the Future Instead of saving money now, a country could also choose to invest abroad in order to reap the rewards in the future. The outing funds would be recorded as a debit in the financial account, while the corresponding incoming investment income would eventually be earmarked as a credit in the current account. Often, a current account deficit coincides with depletion in a country's foreign reserves (limited resources of foreign currency available to invest abroad).Foreign Investors When foreign investors send money into the domestic economy, the latter must eventually pay out the returns due to the foreign investors. As such, a deficit may be a result of the claims foreigners have on the local economy (recorded as a debit in the current account). This kind of deficit could also be a sign of a strong, efficient and transparent local economy, in which foreign money finds a safe place for investment. The United States capital market, for example, was seen as such when "quality assets" were sought out by investors burned in the Asian crisis. The U.S. experienced a surge of foreign investment into its capital markets. And while the U.S. received money that could help increase domestic productivity and hence expand its economy, all of those investments would have to be paid off in the form of returns (dividends, capital gains), which are debits in the current account. So a deficit could be the result of increased claims by foreign investors, whose money is used to increase local productivity and stimulate the economy.Overspending Without Enough Income Sometimes governments spend more than they earn, simply due to ill-advised economic planning. Money may be spent on costly imports while local productivity lags behind. Or, it may be deemed a priority for the government to spend on the military rather than economic production. Whatever the reason, a deficit will ensue if credits and debits do not balance.
Public and Private Foreign Funds Funding channeled into the capital and financial accounts (remember, these accounts finance the deficits in the current account) can come from both public (official) and private sources. Governments, which account for official capital flows, often buy and sell foreign currencies. Credit from these sales is recorded in the financial account. Private sources, whether institutions or individuals, may be receiving money from some sort of foreign direct investment (FDI) scheme, which appears as a debit in the income section of the current account but, when investment income is finally received, becomes a credit.Balanced Financing To avoid unnecessary extra risks associated with investing money abroad, the financing of the deficit should ideally rely on a combination of long-term and short-term funds rather than one or the other. If, for example, a foreign capital market suddenly collapses, it can no longer provide another country with investment income. The same would be true if a country borrows money and political differences cut the credit line. However, by planning to receive recurrent investment income over the years, such as by means of an FDI project, a country could intelligently finance its current account deficit.Capital Flight In times of global recession, the financing of a deficit can sometimes be traced to capital flight, that is, private individuals and corporations sending their money into "safe" economies. This money is recorded as a credit in the current account but, in reality, it is not a reliable source of financing. In fact, it is a strong indication that the world economy is slowing and may not be able to provide financing in the near future.