Rationale of current and capita account

CFA Level I
#1

Hi all, Can someone give me the rationale for why if the current account is a negative and the capital account should must be positive? Is this in general because if a country runs a trade surplus, the country is likely to spend this surplus in the other country (with a trade deficit)???

thanks!

#2

Current acccont reflects net income of the country and capital account reflects change in national ownership of assets and yes BOP (balance of payment) has to be balanced (zero) which means Current account surplus(decifit) must be offset by Capital account deficit(surplus).

If u know accrual basis of accounting (debit and credit) then u also know that debit is always equal to credit. Same with current and capital acounts.

I give a very very simple example to understand how current and capital account works.

Assume u (Holland) purchases a bond issued by USA of Euro1 billion par value of 2 yrs (ignore interest/coupon payments)

USA BOP (for Euro)

Current account = 0

Capital account = 1 billion Euro (an inflow which increases Reserves)

BOP = 1 billion surplus

US govt issued the bond for some purpose lets say it wanna build a dam. US govt converts Euro into dollars bcoz US domestic currency is dollar not Euro. A simple question rises at this point. Who will gonna buy Euros ?? Certainly those Corporations/ppl who have to make certain Euro payments have the demand and will buy those euros like there are 50 guys who wanna buy BMW latest model, one hundred thousand tourists who plan to visit Europe this yr will demand Euros. So US govt sells Euros into market where those ppl/corporations will buy those Euros.

So after that all transantions US BOP (in Euro) would look like

Current account = - 1 billion

Capital account = 1 billion

BOP = 0

After 2 yrs US govt has to redeem the bond. Before bond redemption BOP would look like

Current account = 0

Capital account = - 1 billion

BOP = - 1 billion

US govt must acquire Euros to pay back the bond. There are three ways to do so

  1. issue another bond (in Euros)

then capital account will b = 1 billion - 1 billion = 0. BOP will also b zero

  1. Sell Euro denomiated bond which has been held by US govt. (Sell foreign asset)

treatment of capital account would be same as above.

  1. Sell goods/services or other current account activities to acquire Euros. Like US multinationals repatriate profits back to US earned in Euro zone etc etc.

Then BOP would look like

Current account = 1 billion

Capital account = - 1 billion

BOP = 0

Hope now u get the idea how BOP, current and capital account work.

#3

thanks for clearifying this!