Question

(Related to Solved Problem 29.1 on page 1034 ) In early 2017 . a Chinese news service noted, "The country will continue to run a current account surplus, as well as a ... financial account deficit in 2017 ." After reading this account, a student comments, "I thought Chinese exports were very strong, so I don't understand why the country is expected to run a financial account deficit." Clear up the student's confusion.

Short answer

The term 'financial account deficit' does not mean that China's exports are weak. Rather, it means that China is using the money it earns from its strong exports - which cause the current account surplus - to buy or invest more in foreign assets. Hence, while the money is flowing into China due to exports (current account surplus), it is flowing out of the country because of foreign investments (financial account deficit).

Step-by-step solution

Understanding Current Account

The current account measures the flow of goods, services, and investments into and out of the country. When a country exports more than it imports, it runs a current account surplus. The comment on 'Chinese exports being very strong' suggests that China is likely selling more to other countries than it is buying, hence the current account surplus.

Understanding Financial Account

The financial account measures increases or decreases in international ownership of assets, whether they be individuals, businesses, governments, or central banks. When a country buys more assets (like stocks, bonds, physical plants, real estate, etc.) from foreign countries than it sells, it has a financial account deficit.

Relating Current and Financial Account

With a current account surplus, China earns more money from its robust exports. However, if it then uses that income to invest in foreign assets rather than its domestic economy, it means the money is flowing out of the country, hence creating a financial account deficit. That's likely why despite having strong exports, China is still expected to run a financial account deficit.

Key concepts

Current Account Surplus

The current account surplus is a critical measure in understanding a country's economic health. It reflects the balance of trade, net income from abroad, and net current transfers. If a country experiences a current account surplus, it essentially means it exports more than it imports. Exports include not just goods, but also services, and income generated from overseas investments.

This situation indicates a strong national production sector that is effectively competitive on an international scale. For China, having strong exports suggests that it is selling more to other countries than it is buying from them. The surplus means that foreign customers are paying more for Chinese goods and services than Chinese customers are paying for foreign goods and services. This trend usually brings in a steady flow of income to the country, contributing positively to the national economy.

• Exports > Imports
• Higher income from foreign transactions
• Indication of strong competitive international trade

Financial Account Deficit

On the other hand, the financial account tracks a country's transactions involving financial assets and liabilities. A financial account deficit occurs when a country is buying more international assets than it is selling its own assets to foreigners. These assets can be in the form of direct investments, like purchasing companies or constructing factories, or portfolio investments, such as acquiring stocks and bonds.

In China's case, although its export levels are high, leading to a current account surplus, it might simultaneously be investing heavily in international assets, thus spending more than it's receiving from such investments. Consequently, despite its strong ability to earn through exports, the financial outflow for foreign investments results in a deficit in the financial account. This balance allows China to diversify its investments and potential returns, although it leads to money flowing outward.

• Buying > Selling of international assets
• Investment in foreign ventures
• Change in international ownership of assets

International Ownership of Assets

International ownership of assets plays a significant role in both the current and financial accounts. It represents how different countries choose to allocate their capital globally. When a country invests in foreign assets, it acquires ownership stakes in businesses, real estate, or other ventures abroad.

This scenario is integral to understanding why one might observe an interplay between current account surpluses and financial account deficits. For example, with China's current situation, even as it stands as a net exporter, it channels its earnings into international assets. This transfer reflects a strategic global allocation of capital, which may offer future financial returns or influence globally.

• Acquisition of foreign businesses or stocks
• International real estate purchase
• Strategic global capital allocation