the relationship between capital account balance and current account balance?

The balance of payments, then, is the sum of the balance on current account and the balance on capital and financial account. It is important to understand that the deficit indicated by the current account is financed through activities recorded on the capital and financial account. The deficit on the current account must be exactly offset by the surplus on the capital and financial account (if it is not, net errors and omissions will correct it). This means then that the sum of the current account and the capital and financial account is equal to zero: 

1. The basic equation of a country's balance of payments is analogous to a company's balance sheet. The capital account and current account have to net out to zero, with central bank reserves functioning as the plug to account for any difference. If a country has a capital surplus (ie, foreigners are net investors of capital into the country), then it will run a current account deficit. The US is a pretty stable example of this: for a long time, the US has consumed more than it earned, leading to a current account deficit, which has been balanced out by a capital account surplus (ie, foreigners financing our spending--mainly by buying our debt.)

Reserves can come into play as a form of making the whole thing balance. China runs both a capital account surplus AND a current account surplus--foreigners are both investing into China and buying more exports from China than China imports from them. As a result, Chinese currency reserves must grow every year by the amount of the combined surpluses to make things balance out. 

V. CAN CURRENT ACCOUNT DEFICITS INDICATE THE HEALTH OF AN 

ECONOMY? 

• One very important artefact of understanding BOP accounting is that it sheds light on some important public policy debates. Very often these debates ignore fundamental principles of BOP accounting and can lead to disastrous policy remedies for problems that may not really exist. For instance, the U.S. has recently been running all time record trade de?cits and,accordingly, pretty sizeable current account de?cits as well. 

• The public hand wringing over the allegedly disastrous impact of substantial current account de?cits leads to the question of whether having a CA de?cit is necessarily a bad omen for the economic health of a country. 

• Should running a current account surplus be a goal that a country should strive to achieve? 

Is a country with a current account surplus always better o? than a country with a currentaccount de?cit? 

• The most important thing to keep in mind is that the current account de?cit will be accom-panied by a combined capital account and OSB surplus of equal magnitude. Politicians, andother “experts†will often bemoan current account de?cits and laud capital account surpluseswithout realizing that they in fact go hand in hand. 

• We have to realize that the underlying causes of a current account de?cit can be very di?erent 

• Consider the United States in the late 1990s - we had a booming economy, rapidly increasing stock market and limitless growth prospects. As a result, we would attract a lot of investment from abroad, bringing about a KA surplus. However, since the U.S. government holds very few reserves (OSB = 0) this KA surplus MUST be accompanied by a CA de?cit. 

• Contrast this with Russia in the late 1990s - a shrinking economy, rapidly decreasing stock market and terrible growth prospects. As a result, Russia had substantial capital ?ight -money leaving the country bringing about a KA de?cit. If Russia had a ?exible exchange rate (it initially did not, but eventually did) this KA de?cit MUST be accompanied by a CA surplus. 

• In the above two examples, the CA de?cit was inversely related to the health of the economy: the strong economy was running a CA de?cit and the weak economy was running a CA surplus. In reality though, there is NO relationship between the two. Two more examples will help illustrate the fact. 

• Consider the country of Sao Tome, a small African country that recently discovered substan- tial deposits of oil. In time, Sao Tome will see a substantial increase in exports, bringing about a CA surplus. In other words economic prosperity will accompany a CA surplus in Sao Tome. 

• Finally, consider the current state of Iraq. With very few exports of oil, it needs to import vir-tually all its consumption needs. Iraq will therefore run a CA de?cit, and economic weakness will be associated with a CA de?cit. 

• Simply put, there is no relationship between CA de?cits and the state of the economy. Weonly know that CA de?cits are associated with surpluses in either the capital or OSB accounts,i.e. in?ows of capital and that CA surpluses are associated with de?cits in either the capital or OSB accounts, i.e. out?ows of capital.