In describing the capital account we must first distinguish among the various types of private capital flows: direct investment portfolio investment. and short-term investment.

DIRECT INVESTMENT

This is the type of long-term investment where the investor controls a substantial portion of the management of the foreign operation. (For balance of payments purposes. substantial management control has often been defined as 10 percent or more of the ownership of the foreign unit.) The reasons for extending business operations into foreign lands in the form of direct investment are many. On the cost side, investment abroad may be due to better accessibility to raw materials or to lower labor costs. On the marketing side, it may be a defensive move to preserve a market that was previously supplied by exports.

In addition to the economic considerations which motivate starting a new business in a foreign country, there are also considerations of a political nature. These considerations can be translated into economic terms; however, the triggering force is usually political. For example, investments may be made in one country rather than a neighboring one because of the relative political stability of the two countries. Also, one country may encourage direct investment more than another by giving special concessions, such as tariff protection, to the foreign investor.

PORTFOLIO INVESTMENT

For balance of payments purposes, portfolio investment involves investments with a maturity longer than one year. This investment can be in bonds or stocks. The expected returns on these investments in one country relative to the others are the determinants of the flows in this account. Given the scope of financial markets in most countries, the comparisons of expected returns are limited to the handful of countries with developed financial forex markets, such as the United States and the United Kingdom. In assessing the relative returns on securities, the element of foreign exchange risk must be introduced. It is not sufficient to compare the respective yields of ten-year bonds issued by the governments of the United States and the United Kingdom; rather, one must also assess the expected performance of the pound against the U.S. dollar to obtain the effective yields of the two securities.

SHORT-TERM INVESTMENT

There are two major types of short-term capital flows:  those made in connection with other entries in the balance of payments, such as a bank deposit received in payment for merchandise exported; and  those made in search of profit. The short-term capital flows in search of profit are the flows considered in a comparison of relative returns. Again, as in the case of portfolio investments, the effective returns on short-term investments are a composite of the relative interest rates and the expected fluctuations of the exchange rate. In many cases, one of these two elements is the dominant one. For example, investments are made because of the rela- tively high interest rate paid in a given currency. The implicit assumption is that the given currency will remain relatively stable. In other cases, investors are willing to forgo high interest rates and invest in a currency with a very low interest rate in expectation of an up valuation in the exchange rate of that currency. 

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