3.2.2
Note

The Financial Account

3.2.2 Macro issues

Idea

The financial account is the part of the balance of payments that records transactions changing the ownership of financial assets and liabilities across a country’s borders. Where the current account tracks payments for goods, services and income, the financial account tracks movements of capital.

Mechanism

Three forms of capital flow are distinguished, ordered roughly from most to least durable:

  • Foreign direct investment (FDI) — investment in tangible foreign assets, typically a firm acquiring a significant stake in a foreign firm or building operations abroad. FDI is the most desirable form of inflow because it directly finances new infrastructure, capital goods and jobs in the receiving country. Dyson building factories in Singapore is an FDI inflow for Singapore.

  • Portfolio investment — money spent on intangible foreign financial assets such as shares, government bonds or treasury bills. It is the money spent acquiring the assets, as distinct from the income those assets later earn (which is net primary income). A Singaporean buying a share of Amazon creates a portfolio-investment outflow for Singapore.

  • Short-term capital flow (“hot money”) — transfers of short-term funds, usually cash, moved between countries to exploit more favourable interest or exchange rates, and moved frequently. A fund manager shifting deposits to a bank offering a higher interest rate creates a short-term capital inflow for that country — withdrawn just as quickly when the advantage disappears.

Considerations

The forms differ in stability, and that difference matters. FDI is durable and builds capacity. Portfolio investment and hot money are volatile: a large inflow exerts upward pressure on the currency, because foreign funds must be converted into domestic currency, which raises demand for it and causes it to appreciate. A stronger currency makes exports relatively dearer and imports relatively cheaper, which can in turn worsen the balance of trade. A country can also run a net capital outflow — driven by firms offshoring production to lower-cost economies, or by a fall in domestic interest rates relative to abroad prompting investors to move funds out.