The Eurocurrency market

An important innovation in international banking occurred during the Bretton Woods era when commercial banks in several countries began to accept deposits and to extend loans in currencies other than their own national currency. We will briefly describe this activity, which was known as the "Eurodollar market." As currencies other than the dollar became more central to its operation this became known as the "Eurocurrency market," or merely as "offshore banking."As noted in earlier chapters, creation and control of a nation's money are among the most sensitive and jealously guarded attributes of national sovereignty. Traditionally, it has been accepted that every nation has an exclusive right to coin and print its own money. When money actually took the form of coins and currency, this exclusive national privilege was generally respected, except by counterfeiters, and even when bank deposits became the principal form of money, the primacy of national control was respected - at least until recently.

In 1960, however, European commercial banks discovered that they could earn handsome profits by accepting deposits in US dollars and by engaging in banking operations in terms of dollars. Since they were dealing almost entirely in bank deposits, or bookkeeping money, it was easy enough to keep accounts in dollars, whether the bank was located in London, Paris, or Zurich.

From a modest beginning in 1960, commercial banks proceeded to increase their foreign currency deposits at a rapid rate. Although this market is sometimes referred to as the Eurodollar market, banks in world financial centers now accept deposits and make loans in several other national currencies as well (euros, pounds, and yen are important examples), and commercial banks throughout the world are participating in this market. There is an Asian US dollar market centered in Singapore, and many banks collect deposits in branches located in the Bahamas. Thus even the term "Eurocurrency" is not really adequate, although it is much used. Our discussion will primarily concern the Eurodollar portion of the market. US commercial banks are heavily involved through their branches and subsidiaries in foreign financial centers, especially in Europe.

The rise of the Eurodollar market may be interpreted as an evolutionary response of the private banking sector to the need for an international money market. Since no international money exists, commercial banks have proceeded to internationalize some of the national monies, particularly the US dollar. These have been made to serve as international monies, and a huge, highly competitive money market has been created. Every important nation is linked into this vast money market, and every nation is influenced by it with respect to credit conditions, interest rates, and so on. Thus it has become a major force pulling toward a more closely integrated world economy. One of the most striking facts about the development of this important institutional form is that it was entirely unplanned. Central bankers watched it grow with some apprehension, but they did not try to suppress it.

How the Eurodollar market works

Transactions in the Eurodollar market are extremely simple, in essence. Suppose Firm A, which has a $10 million deposit in a US bank, decides to place that sum in a bank in London (a "Eurobank," as we will call any commercial bank in the rest of the world that accepts deposits denominated in dollars and other currencies besides its own national currency). Firm A simply writes a check on its US bank and deposits the check in the Eurobank. The effects of this transaction may be shown in balance sheets, as in Table 20.1. In the US bank, the deposit is simply switched from Firm A to Eurobank 1, leaving its total deposit liabilities unchanged. Firm A now has a time deposit in Eurobank 1, on which it may earn a higher rate of interest (say, 4 percent) than it could earn in a domestic time deposit, and Eurobank 1 now has a $10 million demand deposit in the US bank.

Table 20.1 The creation of a Eurodollar deposit

US bank

Assets Liabilities

Demand deposit, Firm A -$10 million Demand deposit, Eurobank 1 +$10 million

Eurobank 1

Assets Liabilities

Demand deposit in US bank +$10 million Time deposit, Firm A +$10 million

Eurodollar deposits are time deposits, with maturities ranging from 1 day to many months, and they earn interest. (Until the early 1980s, banks in the US were not allowed to pay interest on deposits of less than 30 days' duration, which is one reason Eurodollar deposits have been attractive to firms holding large cash balances.)

Now Eurobank 1 has a $10 million time deposit liability on which it pays 4 percent, and a $10 million asset (demand deposit in a US bank) on which it earns little or nothing. To hold such a nonearning asset is like holding a hot potato - one wants to get rid of it as quickly as possible. Thus Eurobank 1 will be anxious to convert that deposit into an interest-bearing asset, say by making a loan or buying an asset. For example, it may place $10 million in a time deposit at 4/2 percent interest with an Italian commercial bank (Eurobank 2) that is temporarily in need of funds. (Eurobank 1 may keep a small portion of the demand deposit as a reserve, but in practice reserve ratios are quite small in the Eurodollar market, and we will omit them.) The spreads between interest rates received and paid are very small in the Eurodollar market, as low as % or M of 1 percent. It is a wholesale market, with large transactions and low margins.

Table 20.2 A Eurodollar redeposit

US bank

Assets Liabilities

Demand deposit, Firm A -$10 million

Eurobank 1 Demand deposit, Eurobank 2 +$10 million


Eurobank 1


Demand deposit in US bank -$10 million Time deposit in Eurobank 2 +$10 million h $10 million

Eurobank 2

Assets Liabilities

Demand deposit in US bank +$10 million Time deposit from Eurobank 1 +10 million

This second transaction can also be shown in balance sheets, as in Table 20.2. In the US bank, the deposit is again simply switched from one holder to another. Eurobank 1 acquires an earning asset, while Eurobank 2 incurs a time deposit liability in return for which it acquires the dollar demand deposit. Note that Eurodollar deposits of $20 million now exist: $10 million payable to Firm A by Eurobank 1 (Table 20.1), and $10 million payable to Eurobank 1 by Eurobank 2 (Table 20.2). This process could be repeated several times, with the amount of Eurodollars increasing each time. The cycle will stop, however, if the dollar demand deposit is used to make a direct payment to a firm in the United States. We can illustrate by taking our example one step further.

The Italian Bank, Eurobank 2, now has the demand deposit in the US bank. It too will want to convert this deposit into an earning asset. Let us suppose it lends $10 million to an Italian leather producer (Firm B) at 5 percent interest, and Firm B uses the money to pay for hides it has bought from a US exporter (Firm C). Now the $10 million demand deposit in the US bank is switched from Eurobank 2 to Firm C, an American firm. Firm C may draw checks on this deposit to pay for wages and other expenses, but if these are paid to domestic persons and firms, they will involve monetary circulation within the United States. There is no basis for further rounds of credit creation in the Eurodollar market. However, Eurobank 1 still has a $10 million time-deposit liability to Firm A, matched by a time-deposit claim on Eurobank 2; and Eurobank 2 still has a $10 million time-deposit liability to Eurobank 1, matched by a loan receivable from Firm B. The expansion process in the Eurodollar market stopped because the funds lent to the Italian leather producer were not redeposited in a Eurobank, but were paid to a firm that deposited them in a US bank.

Much discussion has occurred about the extent to which multiple creation of deposits can and does take place in the Eurodollar market. In the absence of any formal reserve requirements, there is no definite limiting value for the multiplier. However, it seems clear that an important factor determining how much multiple expansion of deposits can occur is the extent to which funds lent by Eurobanks are redeposited in the Eurobank system. The larger the ratio of redepositing, the greater the potential for multiple expansion of deposits in the Eurocurrency system.

Although simple in essence, Eurodollar transactions can become intricate in details, with a complex variety of links to trace out. We need not pursue these complications. The main point is that a large external money market now exists, based on dollars. Many governments, persons, and business firms (American, foreign, and multinational) find it to their advantage to place funds (i.e. hold deposits) in Eurobanks, and many governments, persons, and firms borrow in that market.

Why the Eurodollar market exists

An obvious question is probably floating through the reader's mind at this point: why did this money market develop outside the United States? Why aren't banks within the United States doing all this business in dollar loans and deposits?

The first and principal answer is that the Eurodollar market provides a way to circumvent the many regulations and controls that national governments have placed on domestic money markets and bank operations. In the exercise of their sovereign power to operate monetary, fiscal, and other economic policies at the national level, governments have imposed numerous restrictions, regulations, and controls on the use of money and on the operations of commercial banks. The opportunity to escape from this maze of legal restrictions provided much of the stimulus and incentive for the Eurodollar market. We will mention a few examples:

1 Until the mid-1980s US banks were subject to Regulation Q of the Federal Reserve System, which specified the maximum interest rates American banks could pay on time deposits. In the early 1960s the maximum rate was 4 percent. Eurobanks, not subject to Regulation Q, were willing to pay 6 to 8 percent at that time. Consequently, persons and firms with large sums to place in time deposits were induced to hold dollar deposits in the Eurodollar market.

2 During the 1960s and early 1970s the United States imposed a tax on foreign bond issues in New York and placed restrictions on loans to foreigners by US banks. The natural result was that foreigners borrowed money from Eurobanks instead. Furthermore, US firms, facing restrictions on the transfer of funds to finance their subsidiaries in Europe and elsewhere, also turned to Eurobanks for loans. (Note that the US regulations generated both a supply of funds to the Eurodollar market and a demand for loans from it.)

3 Other nations had even more exchange controls and legal restrictions on their citizens than did the United States. Consequently, the opportunity to hold funds in Eurobanks was extremely attractive to firms and individuals in those countries. Eurodollar deposits were subject to no controls, they could be exchanged into any currency, they could be used for payments anywhere in the world, and they were largely beyond the reach of the tax collector.

4 US banks are required to maintain reserves against their deposit liabilities, but Eurobanks are not required to maintain such reserves. Since reserves earn no interest, the requirement to hold them has adversely affected the ability of US banks to compete with their Eurobank rivals. (This factor may be less important now. In 1981, the Federal Reserve System authorized US banks to establish international banking facilities through which they may conduct banking business with foreigners, exempt from domestic regulations such as reserve requirements.)

A second reason for the rapid growth of the Eurodollar market is that it is a highly competitive and efficient market. Eurobanks pay attractive interest rates on time deposits placed with them, and they charge competitive rates of interest on loans they make. As we noted, spreads are small in this market - considerably smaller than in US banks. Eurobanks can operate in this way because they are dealing in large sums, their clerical costs are low because they do not operate a retail banking business, they have no legal reserve requirements to meet, and they are dealing mostly with blue-chip clients whose credit ratings are excellent. If a Eurobank accepts a 1-year time deposit of $100 million at 4 percent and simultaneously makes a 1-year loan of $100 million to IBM at 4/8 percent, its gross profit is $125,000. Operating costs would be low and risk practically nil.

The effect of the Eurocurrency market on national monetary autonomy

The existence of this huge, highly competitive money market has tended to reduce the ability of any individual nation to operate an independent monetary policy while maintaining a fixed exchange rate. Such a policy usually entails an attempt to raise or lower the domestic interest rate. But, as Geoffrey Bell observed, "short-term funds, like water, find their own level, and there is little that even Canute-minded central bankers can do to arrest the forces of the market."1 In the 1960s, for example, Germany tried to maintain a tight money policy to restrain inflationary pressures. But when interest rates rose in Germany and credit became scarce, German banks had an incentive to seek funds in the Eurodollar market where lower interest rates prevailed. To block that channel, the German central bank placed restrictions on commercial bank access to outside funds, but then German business firms themselves borrowed the funds they needed in the Eurodollar market. The German central bank tried to insulate the German economy by imposing various additional rules and regulations, but these proved to be difficult to enforce. The financial markets have shown great ingenuity in discovering new ways to get around the regulations.

Similarly, if a single country tried to stimulate its economy by pursuing an easy-money policy and reducing interest rates, funds would tend to flow out of that country. If its time-deposit rates dropped, firms would shift deposits to the Eurobanks. Borrowers would increase their borrowing in the low-interest-rate country and use the proceeds to repay higher-cost loans in other places. These actions tend to equalize interest rates in the various financial markets. The United States was in this position in the 1960s. The authorities wanted to keep interest rates low in order to stimulate economic activity and reduce unemployment. Regulation Q was used to limit the rate of interest paid on time deposits. But that led to an outflow of funds to the Eurodollar market, and forced the authorities to introduce a variety of regulations and restrictions designed to curb that outflow. Then, in 1969, the Federal Reserve instituted an extremely tight monetary policy in an effort to stop inflation. Interest rates rose sharply and US banks were put in a double bind - they could not raise their own time-deposit rates to attract and hold funds, but short-term interest rates were rising sharply and inducing depositors to switch to other types of assets. In their desperate search for funds, the banks turned to the Eurodollar market. They borrowed $15 billion in 1969, a huge sum at that time. This heavy demand for funds drove up interest rates in the Eurodollar market and, through it, put upward pressure on interest rates in countries in Europe and elsewhere. Their access to Eurodollar funds enabled US banks to escape or at least to moderate the tight-money pressure from the Federal Reserve, but it also transmitted that pressure to the rest of the world.

The advent of floating exchange rates has not greatly changed the role of the Eurocurrency market and the functions it performs. It has continued to grow at a rapid rate since floating began. To a considerable extent, the Eurocurrency market has become a world money market. National money markets are linked into it in many ways. Some scope for an independent monetary policy still exists for countries that maintain a flexible exchange rate, but the monetary authority in one country cannot change its policy without taking account of conditions in this world money market. Through arbitrage, domestic interest rates are kept in line with Eurocurrency interest rates in the same currency.

Interest rates in the US money market are closely linked to interest rates on comparable maturities in the Eurodollar market. For example, at any given time the interest rate on 3-month Eurodollar market deposits is about equal to the interest rate on 3-month certificates of deposit or Treasury bills in New York. Similarly, interest rates on Euro-Swiss franc deposits are closely linked to interest rates in the Swiss money market. But interest rates on financial assets denominated in euros can and do diverge from rates on assets denominated in dollars. As noted in Chapter 14, these differences are related to spot/forward exchange rate differentials and to the possibility of exchange rate changes. We will return to this matter later in this chapter.

Recycling oil payments

The Eurocurrency market played a major role in financing the huge current account imbalances that followed the oil shocks of the 1970s. The resulting build-up of international debt produced another difficult problem, however. After the sharp increases in oil prices in 1973 and in 1979, much concern was expressed about the ability of the international monetary system to handle the enormous flows of funds that would be involved. Many experts feared that a crisis or collapse of the system would occur, so massive was the disturbance to which it had to adjust. As it turned out, the system accommodated itself very smoothly to this major shift in direction and amount of international payments. Basically, the mechanism is quite simple, and it could possibly be compared to a game of musical chairs. The Eurocurrency markets played a major role in the mechanism through which payments were made from the oil-importing countries to the oil exporters, especially to members of OPEC. We will explain briefly what the problem was and how it was handled.

The oil price increase meant that oil-importing countries had to pay about $50 billion per year to the OPEC countries. This is an estimate of their current account deficit relative to OPEC; that is, the $50 billion represents OPEC exports minus their imports of goods and services. It was clear that OPEC nations could not quickly increase their imports to match the sudden huge rise in their exports.

Oil-importing countries had to pay for the oil largely in dollars. Thus in making payments they drew checks on their dollar deposits in US banks. OPEC countries then had to decide what to do with these large receipts of dollars. They chose to place a large part of them in the Eurodollar market - that is, they placed time deposits in Eurobanks. This gave the Eurobanks an immediate increase in their lending capacity, and they were eager to make new loans to match their new deposit liabilities. (Remember, they were paying perhaps 8 percent on those time deposits, and they could not afford to hold non-earning assets.)

Many oil-importing countries, having just drawn down their dollar balances and facing the need to pay for next month's oil as well, were eager to borrow dollars from the Eurobanks. When they did borrow, they paid the dollars to OPEC nations, who redeposited them in Eurobanks, thus making possible further loans to oil importers who could then pay for more oil, and so on. This process is what came to be called "recycling the petrodollars." The Eurocurrency market served as a financial intermediary between the oil importers and OPEC. OPEC nations could have made loans directly to oil importers (i.e. sold the oil on credit), but they much preferred to be paid in dollars and then to place deposits in large, prestigious commercial banks such as Barclays, Chase Manhattan, Bank of America, Lloyds, and other major participants in the Eurocurrency market. Furthermore, these banks then had to assume the risks of lending to the oil-importing countries. The borrowers were not only industrial countries, but also oil-importing underdeveloped countries throughout the world.

Very large sums were recycled in this way during the 1970s. The process involved a rapid build-up of debt, especially in certain Latin American countries such as Brazil and Argentina. When interest rates rose sharply in the 1980s and exports fell as a result of the worldwide recession, many debtor countries became unable to service their debt - that is, to pay the interest and repay the principal when it became due. The problem was aggravated by the fact that much of the debt was in short-term forms. Even if these loans were renewed (rolled over), the required interest payments rose sharply. This was a factor in the creation of the Latin American debt crisis of the early 1980s, which is discussed later in this chapter.

0 0

Post a comment