As we watch China’s reserve balance shrink, I wanted to do a high level and sort of basic review (for myself really) of the economic conventions of cross-border capital and currency flows. The dynamics are complicated enough to begin with, and are made even tougher to follow by sloppy language in some of the mainstream press.
A country’s “balance of payments” (BoP) is made up of two high-level components, which by definition must sum to zero. Specifically, the balance of payments (zero) = the current account + the capital account. In other words, the current account and the capital account must be of equal size, and offsetting in sign. There must be a balance of payments*. In total, the BoP identity equates supply and demand for domestic currency in exchange for foreign currency. However, the current account and the capital account do not represent supply and demand respectively, but rather divide the supply and demand components roughly into those attributable to foreign trade and income flows (current account) and those resulting from foreign investment flow (capital account). Generally a surplus in either account reflects net demand for local currency in exchange for foreign currency, with the caveat that such a capital account surplus would exclude the effect of changing central bank reserves (more on this below).
The current account = exports – imports (a.k.a. the trade balance) + income received from abroad + transfer payments (gifts or aid) received from abroad. Each of those latter terms may be negative, for example when the country is a net payer of interest to external debt holders, or when the country is a net provider of aid or transfer payments externally. When the current account total is positive, it’s said to be in surplus, reflecting net demand for domestic currency arising from trade activity. Conversely, current account deficits reflect supply of domestic currency, and this current account deficit must be “financed” through the capital account:
The capital account, sometimes called the financial account = foreign direct investment + portfolio investment – change in central bank reserves. Foreign direct investment is the acquisition of local physical assets by offshore buyers, and portfolio investment is the net foreign purchasing of stocks, bonds including government bonds, and other financial instruments. The distinction is subtle and non-sticklers will sometimes lump it all together as “FDI,” though usually only portfolio investments are referred to as “hot money.” These investment terms, which together represent the change in ownership of domestic assets, may be negative if foreigners are net sellers of assets, so-called “capital outflows,” and it is exactly this effect which is raising concern with respect to China. Confusingly, references to a capital account surplus (when positive) or deficit (when negative) may or may not include the change in central bank reserves. Excluding the change in reserves, a capital account deficit reflects supply of domestic currency arising from capital flows.
Countries which run a current account surplus can, in theory, experience capital outflows of the same magnitude without pressure on the foreign exchange rate or central bank reserves; supply of foreign currency through trade channels meets demand for foreign currency through capital flow channels. In a perfectly free-floating currency regime, where central bank reserves are held constant, the current account will always offset the capital account, which is easiest to illustrate by example: imagine a world with two countries, the US and the UK, and the US exports a single new Corvette Z06 to our friends in England. The Brit will pay the American with GBP, and the American exporter has to do something with the GBP it now has. It can hold a bank deposit, or loan it back to the buyer to finance the Corvette or purchase a GBP government bond.** All of these and other alternatives, from the perspective of the UK would count as a surplus in the capital account offsetting the current account deficit arising from the Corvette import.
In reality, things rarely work out so neatly, particularly when we introduce central bank management of FX rates via reserve fluctuations in certain critical currencies. China effectively ran a current account surplus and capital account surplus (ex-reserve growth) for much of the past fifteen years. These two forces reflect not offsetting supply and demand but rather a double-shot of demand for local currency. Instead of allowing their currency to appreciate to levels which made their exports uncompetitive or their domestic assets too expensive for foreign buyers, the central bank accumulated very large quantities of foreign currency reserves in exchange for local currency. This building of reserves effectively swung the capital account from a surplus (ex-reserves) to a deficit (including reserves) to offset the current account surplus. The reserve accumulation resulted from the combination of the cumulative current account surpluses and cumulative capital inflows. The resulting pile is quite large, and the current account is still in surplus. Spending reserves now to satisfy capital outflow is not necessarily a bad thing. In future posts we’ll explore the impact on global markets and Chinese monetary policy, which is still more complex.
* As you hear commentators refer to a balance of payments surplus or deficit, this is typically a reference to the BoP excluding the change in central bank reserves, itself a component of the capital account.
** The American can sell the GBP in exchange for USD, but the eventual GBP buyer will still need to reinvest the currency into the UK, because GBP has no use outside of the UK.