The balance of payments summarises the economic transactions of an economy with the rest of the world. These transactions include exports and imports of goods, services and financial assets, along with transfer payments (like foreign aid). The balance of payments is an important economic indicator for ‘open’ economies like Australia that engage in international trade because it summarises how resources flow between Australia and our trading partners.
When analyzing a country’s balance of payments and international trade flows, you’ll come across the terms “current account” and “capital account.” While they may sound similar, these accounts actually track very different types of transactions
Understanding the distinction between current and capital accounts is crucial for interpreting balance of payments data accurately.
In this comprehensive guide, we’ll cover everything you need to know about current and capital accounts including:
- Definitions of each account
- The key transactions each account tracks
- Examples of current and capital account flows
- How the two accounts intersect
- Why the difference matters for understanding international trade
Let’s dive in!
What is the Current Account?
The current account records a country’s transactions that deal with goods, services, primary income, and current transfers between residents and non-residents.
Some major components of the current account include:
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Trade in goods: The imports and exports of physical items like raw materials, manufactured products, and agricultural goods.
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Trade in services Transactions related to services like tourism transportation, consulting and engineering.
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Primary income: Investment income like dividends, interest, and earnings on foreign investments.
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Current transfers: Money being sent or received for reasons other than buying/selling goods and services, like foreign aid payments or worker remittances.
What is the Capital Account?
The capital account records a country’s financial transactions that involve international capital transfers and changes in ownership of assets.
The main types of capital account transactions include:
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Capital transfers: The transfer of ownership of fixed assets from residents to non-residents, or vice versa. This includes things like migrants transferring assets.
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Acquisition or disposal of non-produced, non-financial assets: The purchase or sale of intangible assets like patents, copyrights, franchises, etc. between residents and non-residents.
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Foreign direct investment (FDI): Cross-border investments made by residents in one country into companies or assets based in another country.
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Portfolio investment: The purchase of foreign stocks, bonds, and other financial securities by overseas investors.
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Reserve asset transactions: A country’s central bank buying or selling foreign exchange reserves, gold, IMF special drawing rights (SDRs), etc.
Key Differences Between the Current and Capital Accounts
When analyzing a country’s balance of payments, it’s crucial to understand the key differences between the current and capital accounts:
| Factor | Current Account | Capital Account |
|---|---|---|
| Type of transactions | Goods, services, income | Capital transfers, financial flows |
| Frequency | Day-to-day trade transactions | Less frequent, longer-term |
| Visibility | More observable transactions | Less visible financial transactions |
| Parties involved | Individuals, businesses | Central banks, institutional investors |
| Accounting treatment | Debit/credit to balance immediately | Debited when transaction occurs, credited over time |
Some key takeaways:
- Current account flows relate to trade, capital account to financial assets
- Current account activities are more frequent and observable
- Capital account flows involve larger financial transactions
- The two accounts balance each other out
Understanding what each account measures and the frequency of flows is important for analyzing international trade patterns accurately.
Current Account Example
Let’s walk through an example of a current account transaction:
- A Chinese manufacturing company ships $5 million worth of electronics to a U.S. retailer
- This export of goods would be recorded as a credit in China’s current account
- It would show up as a debit in the U.S. current account for an import of $5 million
- When the U.S. retailer pays the Chinese company, this affects the primary income balance as an outflow of investment income from the U.S.
All the transactions related to the actual production and sale of the electronic goods flow through the two countries’ current accounts.
Capital Account Example
Now let’s look at an example capital account transaction:
- A major Japanese institutional investor purchases $1 billion worth of U.S. Treasury bonds
- This $1 billion purchase of a U.S. financial asset would be recorded as a credit in the U.S. capital account
- It represents a foreign inflow of portfolio investment into the U.S.
- The $1 billion outflow for the Japanese investor would be recorded as a debit in Japan’s capital account
This major cross-border financial transaction is recorded in the capital accounts, as no actual goods or services are immediately exchanged.
Connecting the Two Accounts
While current and capital accounts track different transactions, they connect with each other in several ways:
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A current account deficit is often financed by a capital account surplus, and vice versa. The flows balance each other out.
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Some current account activities like dividends on FDI affect the capital account over time.
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Changes in reserves due to currency market interventions flow through both accounts.
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The accounts follow the principle of double-entry accounting, so total debits equal total credits.
So while distinct in nature, current and capital account activities intersect within the overall balance of payments accounting framework.
Why the Difference Matters
Understanding the key differences between the current and capital account allows for better interpretation of balance of payments data, which leads to better economic analysis and policy decisions.
Some reasons the distinction is important:
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It improves the analysis of trade relationships and gaps
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Helps determine if deficits/surpluses are trade or investment driven
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Allows insight into short-term vs long-term capital flows
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Provides better context for the impact of central bank currency interventions
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Enables clearer forecasting of future trade and financial flows between countries
Key Takeaways
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The current account tracks trade of goods and services. The capital account tracks financial flows.
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Current account flows are frequent and visible. Capital account flows are longer-term and financial in nature.
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The two accounts balance each other out within the overall balance of payments framework.
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Understanding the key differences leads to better economic and policy analysis of trade relationships.
So in your study of international economics and trade, always distinguish current account activities from capital account activities. Getting this distinction right provides huge benefits for interpreting the true drivers of trade and financial flows between nations.
The Structure of the Balance of Payments
Australias balance of payments captures the transactions between Australian ‘residents’ and the rest of the world, in a given period. ‘Residents’ are defined broadly to include people who live in Australia, businesses that operate in Australia, the Australian Government and other organisations that operate here.
The balance of payments divides transactions into two broad accounts:
- the current account
- the combined capital and financial account
In essence, the current account captures the net flow of money that results from Australia engaging in international trade, while the combined capital and financial accounts capture Australias net change in ownership of assets and liabilities. These broad accounts are often referred to as the ‘two sides’ of the balance of payments.
The balance of payments are put together according to international standards (set out by the International Monetary Fund (IMF) and the United Nations) that make it easier to compare Australias balance of payments with that in other countries.
The current account records the value of the flow of goods, services and income between Australian residents and the rest of the world. There are three components to the current account – the ‘trade balance’, ‘primary income balance’ and ‘secondary income balance’. In economic analysis or commentary, most attention is usually given to the trade balance, which records the difference between the value of our exports and imports of goods and services. This is because the trade balance forms part of gross domestic product (see Explainer: Economic Growth).
| Current Account | |
|---|---|
| Trade balance | The value of goods and services that Australian residents export less those that they import. |
| Primary income balance | The income that Australian residents earn from, less that they pay to, the rest of the world from working (e.g. wages) and from financial investments (e.g. dividends). |
| Secondary income balance | Consists of two parts:
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The term ‘current’ is used in describing the current account because the goods, services and income being traded in will be consumed or received in the current period (specifically, within the quarter).
Net Errors and Omissions
While the total balance of payments should be zero, this does not always occur in practice. This can be due to measurement errors, because it is difficult to accurately record every single transaction between Australian residents and the rest of the world. And sometimes transactions are not measured at all – they are ‘omitted’. Because of this there is an additional item included in the balance of payments, known as ‘net errors and omissions’, to ensure that it always balances.
