The Growth of Eurocurrency Trading

The growth of Eurocurrency trading illustrates the importance of all these factors in the internationalization of banking.

Eurodollars were bom in the late 1950s, a response to the needs generated by a growing volume of international trade. European firms involved in trade frequently wished to hold dollar balances or to borrow dollars. In many cases, banks located in the United States could have served these needs, but Europeans often found it cheaper and more convenient to deal with local banks familiar with their circumstances. As currencies other than the dollar became increasingly convertible after the late 1950s, offshore markets for them sprang up also.

While the convenience of dealing with local banks was a key factor inspiring the invention of Eurodollars, the growth of Eurodollar trading was encouraged at an early stage by both of the two other factors we have mentioned: official regulations and political concerns.

In 1957, at the height of a balance of payments crisis, the British government prohibited British banks from lending pounds to finance non-British trade. This lending had been a highly profitable business, and to avoid losing it British banks began financing the same trade by attracting dollar deposits and lending dollars instead of pounds. Because stringent financial regulations prevented the British banks' nonsterling transactions from affecting Britain's domestic asset markets, the government was willing to take a laissez-faire attitude toward foreign currency activities. As a result, London became—and has remained—the leading center of Eurocurrency trading.

The political factor stimulating the Eurodollar market's early growth was a surprising one—the Cold War between the United States and the U.S.S.R. During the 1950s the Soviet Union acquired dollars (largely through sales of gold and other raw materials) so that it could purchase goods such as grains from the West. The Soviets feared the United States might confiscate dollars placed in American banks if the Cold War were to heat up. So instead, Soviet dollars were placed in European banks, which had the advantage of residing outside America's jurisdiction. Indeed, the folklore of international banking has it that the term Eurobank originated as the telex code of a Soviet-controlled Paris bank.

The Eurodollar system mushroomed in the 1960s as a result of new U.S. restrictions on capital outflows and U.S. banking regulations. As America's balance of payments weakened in the 1960s, the Kennedy and Johnson administrations imposed a series of measures to discourage American lending abroad. The first of these was the Interest Equalization Tax of 1963, which discouraged Americans from buying foreign assets by taxing those assets' returns. Next, in 1965, came "voluntary" guidelines on the amounts U.S. commercial banks could lend abroad, followed three years later by a set of wide-ranging mandatory controls. Ail these measures increased the demand tor Eurodollar loans by making it harder for would-be dollar borrowers located abroad to obtain the funds they wanted in the United States.

Federal Reserve regulations on U.S. banks also encouraged the creation of Eurodollars—and new Eurobanks—in the 1960s. The Fed's Regulation Q (which was phased out after 1980) placed a ceiling on the interest rates U.S. banks could pay on time deposits. When U.S. monetary policy was tightened at the end of the 1960s to combat rising inflationary pressures (see Chapter 18), market interest rates were driven above the Regulation Q ceiling and American banks found it impossible to attract time deposits for relending. The banks got around the problem by borrowing funds from their European branches, which faced no restriction on the interest they could pay on Eurodollar deposits and were able to attract deposits from investors who might have placed their funds with U.S. banks in the absence of Regulation Q. Many American banks that had previously not had foreign branches established them in the late 1960s so that they could end-run Regulation Q.

With the move to floating exchange rates in 1973, the United States and other countries began to dismantle controls on capital flows across their borders, removing an important impetus to the growth of Eurocurrency markets in earlier years. But at that point, the political factor once again came into play in a big way. Arab members of OPEC accumulated vast wealth as a result of the oil shocks of 1973-1974 and 1979-1980 but were reluctant to place most of their money in American banks for fear of possible confiscation. Instead, these countries placed funds with Eurobanks, (In 1979 Iranian assets in U.S. banks and their European branches were frozen by President Carter in response to the taking of hostages at the American embassy in Teheran. A similar fate befell Iraq's U.S. assets after that country invaded neighboring Kuwait in 1990, and the assets of suspected terrorist organizations after the Septembei* 11. 2001 attacks on New York's World Trade Center and the Pentagon.)

The history of Eurocurrencies shows how the growth of world trade, financial regulations, and political considerations all helped form the present system. The major factor behind the continuing profitability of Eurocurrency trading is, however, regulatory: In formulating bank regulations, governments in the main Eurocurrency centers discriminate between deposits denominated in the home currency and those denominated in others and between transactions with domestic customers and those with foreign customers. Domestic currency deposits are heavily regulated as a way of maintaining control over the domestic money supply, while banks are given much more freedom in their dealings in foreign currencies. Domestic currency deposits held by foreign customers may receive special treatment, however, if regulators feel they can insulate the domestic financial system from shifts in foreigners' asset demands.

The example of U.S. reserve requirements shows how regulatory asymmetries can operate to enhance the profitability of Eurocurrency trading. Every time a U.S. bank operating onshore accepts a deposit, it must place some fraction of that deposit in a non-interest-bearing account at the Fed as part of its required reserves.2 The British government imposes reserve requirements on pound sterling deposits within its borders, but it does not impose reserve requirements on dollar deposits within its borders. Nor are the London branches of U.S. banks subject to U.S. reserve requirements on dollar deposits, provided those deposits are payable only outside the United States. A London Eurobank therefore has a competitive advantage over a bank in New York in attracting dollar deposits: It can pay more interest to its depositors than the New York bank while still covering its operating costs. The Eurobank's competitive advantage comes from its ability to avoid a "tax" (the reserve requirement) that the Fed imposes on domestic banks' dollar deposits.

Freedom from reserve requirements is probably the most important regulatory factor that makes Eurocurrency trading attractive to banks and their customers, but there are others. For example, Eurodollar deposits are available in shorter maturities than the corresponding time deposits banks are allowed to issue in the United States. Regulatory asymmetries like these explain why those financial centers whose governments impose the fewest restrictions on foreign currency banking have become the main Eurocurrency centers. London is the leader in this respect, but it has been followed by Luxembourg, Bahrain, Hong Kong, and other countries that have competed for international banking business by lowering restrictions and taxes on foreign bank operations within their borders.

Neither the United States nor Germany has attracted a significant share of the world's Eurocurrency business because both countries apply fairly uniform regulations to all domestic deposits, regardless of their currency of denomination. Recently, however, the U.S. government has tried to help the American banking industry get more of the action. In 1981, the Fed allowed resident banks to set up international banking facilities (IBFs) in the United States for the purpose of accepting time deposits and making loans to foreign customers. IBFs are not subject to reserve requirements or interest rate ceilings, and they are exempt from state and local taxes. But an IBF is prohibited from accepting deposits from or

2Alterrtalively, the bank could add the same amount to its holdings of vault cash, which also pay no interest. The discussion assumes the bank holds reserves at the Fed.

lending money to U.S. residents (other than the establishing bank or another IBF). Before 1981, much of the business currently carried out by IBFs was done less efficiently through "shell" branch offices located in the Caribbean.

Technically speaking, a dollar deposit in an IBF is not a Eurodollar because the IBF resides physically within the United States. U.S. regulators have imposed rules, however, that fence off IBFs from onshore banks as effectively as if the IBF were overseas. IBFs provide an excellent example of how countries have lured lucrative international banking business to their shores while trying to insulate domestic financial systems from the banks' international activities. Similar international banking enclaves in other countries include the Offshore Banking Units of Bahrain, the Asian Currency Units of Singapore, and the Tokyo Offshore Market.

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