Capital Account Explained: How It Works and Why It's Important (2024)

What Is a Capital Account?

In international macroeconomics, the capital account is part of the balance of payments, tracking the flow of capital in and out of a country. It records changes in ownership of assets, including foreign investments, loans, and the transfer of financial assets.The capital account is important to track because it provides valuable insights into a country's economic health and interactions with the global economy.

The balance of payments consists of two primary components: the current account and the capital account.Sometimes, the capital account is split into two sections: one is still called the capital account, and the other is called the financial account. The capital account covers specific types of asset transfers and non-financial assets, while the financial account deals with investments and financial transactions across borders.

In accounting, the capital account shows a business's net worth at a specific point in time. For a sole proprietorship, it's known as owner's equity, and for a corporation, it's called shareholders' equity, reported in the bottom section of the balance sheet.

How Capital Accounts Work

Changes in the balance of payments can provide clues about a country’s relative level of economic health and future stability. The capital account indicates whether a country is a net importer or exporter of capital. Big changes in the capital account can indicate how attractive a country is to foreign investors and can substantially impact exchange rates.

Because the balance of payments must always be balanced, countries that run largetrade deficits(current account deficits), like the United States, must, by definition, also run large capital account surpluses. This means more capital flows into the country than goes out, caused by increased foreign ownership of domestic assets.

A country with a large trade surplus exports capital and runs a capital account deficit, meaning money flows out of the country in exchange for increased ownership of foreign assets. For example, China's merchandise trade surplus had reached an all-time high of nearly $890 billion in 2022.

It's important to remember that the U.S. trade deficit results from foreign investors finding U.S. assets particularly attractive and driving up the dollar's value. Should America's relative appeal to foreign investors fade, the dollar would weaken, and the trade deficit would shrink.

Capital Account vs. Financial Account

In recent years, many countries have adopted the narrower definition of capital account used by the International Monetary Fund (IMF). This definition splits the capital account into two top-level divisions: the financial account and the capital account. The capital and financial accounts measure net flows of financial claims (i.e., changes in a country’s asset and liability positions).

An economy's stock of foreign assets versus foreign liabilities is referred to as its net international investment position, or simply net foreign assets. This metric indicates a country's net claims on the rest of the world. If a country’s claims on the rest of the world exceed the claims against it, it has positive net foreign assets and is considered a net creditor. If negative, it is a net debtor. Changes in this position over time are reflected in the capital and financial accounts.

The financial account measures changes in international ownership of assets, whether individuals, businesses, governments, or central banks hold the assets. These assets include foreign direct investments, securities like stocks and bonds, and gold and foreign exchange reserves. The capital account, under this definition, covers financial transactions that don't affect income, production, or savings, such as the transfer of drilling rights, trademarks, copyrights, and other intangible assets.

Current Account vs. Capital Account

The current and capital accounts represent two halves of a nation's balance of payments. Thecurrent accountrepresents a country's net income over some time, while thecapital accountrecords the net change of assets and liabilities during a particular year.

In economic terms, the current account deals with cash receipts, payments, and non-capital items, while the capital account reflects sources and utilization of capital. The sum of the current and capital accounts reflected in the balance of payments will always be zero, meaning that an equal and opposite surplus or deficit in the capital and financial accounts combined offsets any surplus or deficit in the current account.

The current account deals with a country's short-term transactions or the difference between its savings and investments. These are also referred to as actual transactions (as they have a real impact on income), output, and employment levels through the movement of goods and services in the economy.

The current account consistsof visible trade (export and import of goods), invisible trade(export and import of services), unilateral transfers, andinvestment income(income from factors such as land or foreign shares).

The credit and debit offoreign exchangefrom these transactions are also recorded in thebalance of the current account. The resulting balance of the current account is approximated as the total ofthe balance of trade.

Capital Accounts in Accounting

In accounting, a capital account is a general ledger account that is used to record the owners' contributed capital and retained earnings—the cumulative amount of a company's earnings since it was formed minus the cumulative dividends paid to the shareholders. This account is part of the equity section at the bottom of the company’s balance sheet.

In a sole proprietorship, this section is referred to as "owner's equity," while in a corporation, it's known as "shareholder's equity." The equity section in a corporate balance sheet typically includes common stock, preferred stock, additional paid-in capital (APIC), retained earnings, and treasury stock accounts. All of the accounts have a natural credit balance except for treasury stock, which has a natural debit balance. Common and preferred stock are recorded at the par value of total shares owned by shareholders.

Additional paid-in capital is the amount shareholders have paid into the company in excess of the stock's par value. Retained earnings are the cumulative earnings of the company over time, minus dividends paid out to shareholders, that have been reinvested in the company's ongoing business operations. The treasury stock account is a contra equity account that records a company's share buybacks.

The Bottom Line

The balance of payments, which records all of a country's transactions with other countries in a specific period, consists of the capital account and the current account. The capital account looks at the net changes in assets and liabilities, while the financial account records cross-border investments and financial flows.

A capital account surplus means more money is coming into the country from foreign investors, while a deficit means that domestic investors are putting more money into foreign assets. In the balance of payments, when one account has a surplus, the other usually has a deficit, keeping the overall balance even. These figures help economists understand a nation's economic health and global standing.