Question

Describe the components of the capital and financial accounts: Direct investment & portfolio investments.

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Abstract

There are various components of the capital and financial accounts, Main components are Direct Investment and portfolio investments

Most countries keep a record of their international transactions. The best-known element is probably the balance between imports and exports. However, the capital inflow and outflow are also important international transactions, and governments measure them as well.

The financial account measures a country's capital flows regarding international ownership of assets. It provides a record of the capital that enters and leaves the country during a specific time period, like a quarter or a year. The owners of these assets can be government agencies, the central bank, domestic businesses, domestic banks, and local residents.

Component of Financial accounts

The financial account groups international buying and selling operations with assets, which are types of capital that affect savings and income. Commodities (gold and foreign currency), direct investments, securities (bonds and stocks) and physical capital (factories and machinery) are some of them.

A country's financial account usually has two major sub accounts, based on whether domestic actors gain ownership of foreign assets, or if foreign actors acquire domestic assets.

Financial accounts comprise the following two chief components:

1. The domestic ownership of foreign assets. If these increase, so does the total balance of the financial account. These foreign assets may be grouped into the following three components: private, government, and central bank reserves.
2. The foreign ownership of domestic assets. If this sub-account increases, the value of the overall financial account decreases. Domestic assets can be divided into private assets and foreign official assets

Component of Capital accounts

The components of the capital account include foreign investment and loans, banking and other forms of capital, as well as monetary movements or changes in the foreign exchange reserve. The capital account flow reflects factors such as commercial borrowings, banking, investments, loans, and capital.

1.Capital Transfers

The sub account of capital transfers records transactions that involve a change in ownership of assets that do not cause a monetary compensation. When a government or bank forgives foreign debt, it generates an outflow of capital for which the country receives no compensation. Therefore, these movements go to the sub account of capital transfers.

2.Acquisition and Disposal of Non-produced, Non-financial Assets

Acquisition and disposal of non-produced, non-financial assets groups the operations with assets that don't currently generate income but might do in the future. These assets can be intangible and tangible.

The intangible assets include franchises, copyrights, patents and trademarks. They have the potential of generating profit, so the international purchase or sale of these assets is tracked in this sub account.

Direct investment & portfolio investments.

A) Direct Investment

Meaning

Direct investment, more commonly referred to as foreign direct investment (FDI), refers to an investment in a foreign business enterprise designed to acquire a controlling interest in this enterprise. The direct investment provides capital funding in exchange for an equity interest without the purchase of regular shares of a company's stock.

Factors and importance of Direct Investment

1.The purpose of foreign direct investment (FDI) is to gain an equity interest sufficient to provide control of a company. In some instances, it involves a company in one country opening its own business operations in another country, while in other cases it involves acquiring control of existing assets of a business already operating in the foreign country.

2.A direct investment can involve gaining a majority interest in a company or a minority interest large enough to provide the investor with effective control of the company.

3.Direct investment is primarily distinguished from portfolio investment, the purchase of common or preferred stock shares of a foreign company, and by the element of control, that is sought.

4.In fact, foreign direct investment is frequently not a simple monetary transfer of ownership or controlling interest but also involves complementary factors, such as organizational and management systems or technology.

5. Example, A vertical direct investment is one where the investor adds foreign activities to an existing business, such as in the case of an American auto manufacturer establishing dealerships or acquiring a parts supply business in a foreign country.

Horizontal direct investment is perhaps the most common form. In horizontal investments, a business already existing in one country merely establishes the same business operations in a foreign country, such as in the case of a fast-food franchise based in the United States opening restaurant locations in China.

B) Portfolio Investment

Meaning

A portfolio investment is ownership of a stock, bond, or other financial asset with the expectation that it will earn a return or grow in value over time, or both. It entails passive or hands-off ownership of assets as opposed to direct investment, which would involve an active management role.

Portfolio investment may be divided into two main categories:

• Strategic investment involves buying financial assets for their long-term growth potential or their income yield, or both, with the intention of holding onto those assets for a long time.
• The tactical approach requires active buying and selling activity in hopes of achieving short-term gains.

For Example, The term portfolio investments covers a wide range of asset classes including stocks, government bonds, corporate bonds, real estate investment trusts (REITs), mutual funds, exchange-traded funds (ETFs), and bank certificates of deposit.

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