THE BALANCE-OF-PAYMENTS ACCOUNTS show that a current account deficit is financed by capital inflows or decreases in official reserves. One way of presenting this identity is:

CA + KA ≡ ΔR,

where CA is the current account, KA is the capital account, and ΔR is the change in official reserves. As an item in the balance of-payments accounts, foreign direct investment (FDI) is one of several capital flows. Other things equal, therefore, an increase in FDI increases capital inflows. If the change in official reserves is unaffected, the increased capital inflow is matched by a smaller current account surplus or a larger current account deficit.

The current account itself can be defined as the difference between national saving S and domestic investment I:

CA ≡ S – I.

The most obvious link between FDI and the current account in equation 2 is through domestic investment. If FDI finances additional capital formation in the host country, it raises domestic investment I. Equation 2 shows that this worsens the current account as required by equation 1.

The current account can also be denned as the difference between exports of goods and services X plus net factor income from abroad NFI and imports of goods and services IM:

CA ≡ X + NFI – IM.

If FDI increases capital formation in the host country, the increased investment could involve increased imports of raw materials or capital equipment. Alternatively, it could reduce exports by diverting them into the additional investment. In either case, the current account must deteriorate in equation 3 by exactly the same amount as it does in equations 1 and 2.

If FDI finances additional capital formation, equation 2 demonstrates that the current account deteriorates to the same extent that FDI increases capital inflows. In such case, FDI cannot provide additional foreign exchange to finance a pre-existing current account deficit. The extra foreign exchange is entirely absorbed in financing a larger current account deficit.