4-1b The Financial Account

4-1a-(iii) Income Balance The third subaccount in the current account of BOP is income balance, which is the net of investment income from abroad (1 sign reflects earnings from overseas investment) and investment income paid to foreigners (2 sign indicates payments are sent overseas).

4-1a-(iv) Balance of Transfers Finally, the balance of transfers is the net of transfer payments between countries based on outflows (2 sign means that a payment is going abroad as foreign aid, retirement benefits, etc.) and inflows (1 sign reflects repayment of foreign aid loans, etc.).

4-1a-(v) Current Account Balance The sum of these four subaccounts equals the current account balance, which is more important than the trade balance discussed earlier in the chapter. Whether the current account balance is positive (surplus) or negative (deficit) is important because it provides a measure of the financing needs of a particular country. A country with a current account surplus is called a capital surplus country. For example, China, France, Japan, Singapore, and Switzerland have consistently had current account surpluses over recent years. These countries maintain surplus funds, which they invest abroad. The United States, in contrast, has had large current account deficits each year, which implies that it will need to attract capital from abroad in order to finance current account deficits. If foreign capital will not be available to finance the U.S. current account deficit, it can be predicted that the dollar will become weaker and U.S. interest rates will increase in order to attract foreign capital. Countries with current account surpluses generally finance countries with current account deficits.

The financial account describes the second half of a country’s balance of payments, which shows how the country’s current account balance is financed. Exhibit 4.4 shows that foreignowned assets in the United States average around $1 trillion per year from 2000 to 2013. Hence, foreign capital finances the large U.S. current account deficit. Keeping current account deficits for long periods of time is unsustainable for most countries. Foreign countries (investors) will be less willing to continue investing in current account deficit countries for extended periods of time because of the perceived risk of nonpayment of debt. In this case investors will require a risk premium that increases interest rates of the borrowing country.3

The financial account of the BOP consists of three subaccounts: (1) U.S.-owned assets abroad; (2) foreign-owned assets in the United States; and (3) net financial derivatives. Each of these accounts reports the inflow (1 sign) or outflow (– sign) of funds to and from the country being analyzed. The former two accounts—U.S.-owned assets abroad and foreignowned assets—are greatly affected by foreign direct investment (FDI) and security investments across national borders.

4-1b-(i) Foreign Direct Investment FDI encompasses the purchases of fixed assets (such as factories and equipment) abroad used in the manufacture and sales of goods and services for local consumption or exports. Acquisitions of a foreign company (including

income balance

the net of investment income from abroad and investment payments to foreigners

balance of transfers

the net of transfer payments going overseas and inflows from abroad

financial account

consists of domestic-countryowned assets abroad, foreignowned assets in the domestic country, and net financial derivatives

risk premium

the added return required by investors for risk associated with a security or asset

foreign direct investment (FDI)

encompasses purchases of fixed assets (such as factories and equipment) abroad used in the manufacture and sales of goods and services

Exhibit 4.4 u.S. FInanCIal aCCounT (In BIllIonS oF DollaRS)

(Credits 1 ; debits 2)

2000 2002 2004 2006 2008 2010 2012 2013

U.S.-owned assets abroad 2560 2294 21,000 21,285 2108 21,024 2171 2645

Foreign-owned assets in the United States 1,038 795 1,533 2,065 534 1,245 602 1,017 Financial derivatives, net n.a. n.a. n.a. 29 229 15 7 2

TOBIAS SCHWARZ/Reuters/Landov

German Chancellor Angela Merkel and Former Greek Prime Minister George Papandreous resolving problems in the 2008–2009 financial crisis.

those being privatized), creation of new manufacturing or research facilities abroad, and expansion of an existing plant in a foreign country are all examples of foreign direct investments. The flow of FDI is dictated by opportunities to earn profit overseas.

There are thousands of examples of FDI that one can relate to in the world around us. In the automobile industry, for example, there has been significant FDI inflow into the United States. Mercedes Benz (Germany) has a plant manufacturing M-Class SUVs in Alabama; Honda (Japan) manufactures the Accord in Ohio; and Hyundai (South Korea) has a plant in Alabama. Similarly, General Motors and Ford have car-manufacturing operations in several countries overseas.

FDI decisions have important implications to consumers, businesses, government, and society. Consumers gain through greater choice of products (or services) at competitive prices, businesses face increased competition as well as profit opportunities, governments reap additional tax revenues, and society benefits through increased employment opportunities and corporate social responsibility.

4-1b-(ii) Security Investments Security investments also have a significant impact on the BOP’s financial account. Financial capital flows between countries in search of higher rates of return on foreign stocks and bonds. Often, individuals and firms hold foreign financial assets in order to diversify their investments beyond domestic stocks and bonds only. During the technology boom years of the mid to late 1990s, massive inflows of funds for investment in U.S. stocks occurred as foreign investors tried to take advantage of the perceived profit opportunities. Capital flows generally represent investments for the long term (more than one year). Central banks, government agencies, and large financial institutions make other financial investments. Central banks (such as the U.S. Federal Reserve and Germany’s Deutsche Bundesbank) hold foreign exchange, or currencies, of major countries (U.S. dollar, euro, yen, etc.) as part of their reserves in addition to their local currency. To earn interest on their foreign exchange reserves, central banks deposit some of their reserves with foreign central banks. Certain government agencies (e.g., Export Import Bank and USAID, which are involved in international lending activities) make foreign loans to pursue foreign policy objectives (e.g., economic and military). In addition, large financial