Balance of Payments, Capital Account

A deficit on the current account of the balance of payments has to be financed by external financial resources. This is where the capital account of the balance of payments comes into the argument. The deficit has to be counter-weighed by a surplus on the capital account. It means that international money has to be borrowed abroad, unless the deficit country possesses foreign reserves.

This monetary relationship relates to a country with its own national currency, which is only accepted as a means of payments domestically, like for instance the non-Euro countries.

Today, without any international capital control, transaction on the capital account consists of financial flows directed by the relative rates of interest. A surplus can be established by raising the rate of interest. This procedure goes quite well as long as the creditworthiness and solvency of the financial institutions of the borrowing country is not questioned. These international capital flows ensure that the current and capital accounts quite easily equalise as long as the foreign debt is within a reasonable size compared to GDP. Furthermore, most countries with a sovereign currency also practise a floating exchange rate. Hereby, these countries get extra flexibility with regard to ironing out a deficit (or surplus) of foreign exchange. An imbalance in the market for foreign exchange will disappear when demand and supply make the exchange rate go down (or up) by market forces until equilibrium is established. Usually, it just means minor changes in the exchange rate to secure a balance between demand and supply. But, in cases like Brexit, the exchange rate suddenly can drop by nearly 10 % to establish a new equilibrium due to a brief but massive deficit at the capital account.

In rare cases where a country with a sovereign currency chooses to follow a fixed exchange rate policy, the central bank is committed to intervening in the foreign exchange market to secure that demand and supply in the foreign exchange market do equalise. Instead of letting the exchange rate adjust, the central bank needs to have a pile of foreign exchange in its ‘cellar’ for intervention whenever there is a lack of foreign exchange in the market. The Danish governments have chosen a fixed exchange rate policy in relation to the Euro. Hereby the Danish central bank has been forced to subordinate its monetary policy to the aim of keeping the exchange rate fixed. As a consequence, the central bank has to adjust its monetary policy in accordance with the surplus/deficit at the combined current and capital accounts. Hence, a (small) EU country following a fixed exchange rate policy towards the Euro has no monetary policy independence with regard to real sector activities, inflation and asset bubbles control. What is gained with respect to exchange rate stability is lost with regard to independent monetary policy unless the country takes up external capital controls.

Within a monetary union, the situation with regard to a combined deficit on the current and capital account is quite similar to the Danish case, except that Euro countries have no independent central bank. When borrowing in foreign private banks ceases and access to the European capital market dries up, which happened for a number of Euro countries during the crisis of 2010-2012, they have to rely on credit facilities within the ECB and other EU institutions. The conditions for the use of these facilities are decided case by case through a ‘letter of understanding’. In the cases of Greece and Cyprus, while negotiations were dragging along, the private banking systems were literally for a while running dry of euro-notes. So, the withdrawal of deposits was limited in amount and capital control imposed. The national banking system of these two countries could not start working properly until an ‘understanding’ with the Euro institutions was ‘agreed’.

These cases demonstrate that a surplus in the balance of payments is crucial when a country has given up monetary sovereignty; otherwise there is a risk of losing even more political sovereignty.

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