Balance of Payments and Capital Inflows

Question

We know from the balance of payments identity that: $$ BOP=CA+KA+FA=0 $$ where $CA$ is current account, $FA$ is financial account, and $KA$ is capital account. The BOP is an identity that always balances. Although in some cases, the intuition is quite clear how this happens, it is not always transparent. Specifically, there are a few types of external financing that take place: bond finance, FDI, portfolio investment and government foreign bank borrowing. Note that these will show up as a + in the Financial Account. Imagine then that these funds are used to fund domestic purchases (building a damn, building an office etc). These are technically inflows of external capital that are funding domestic purchases, and hence not imports. I wonder then, how do these activities balance out mechanically in the BOP? In other words, how are capital inflows that go towards financing domestic consumption balanced out in the BOP? Thanks!

Answer 1

Take a country like Uganda, a net importer. Let's say that the government borrows foreign capital to finance a dam construction. Using the funds, it pays for construction materials, most of which are probably imported; it pays for the design of the dam, the architects and specialists are foreigners; construction companies purchase fixed capital stock (trucks, cranes, etc), most of which are imported, and builders and workers receive wages and they spend most of their income on consumption of imported goods. Hope this helps.