A newcomer to the literature on the Eurocurrency market may seem to need, at least, a course in witchcraft, magic, and the mind of Sherlock Holmes, for it abounds with allusions to “mystery,” “puzzles,” “magic,” and so on, by some of the most distinguished contemporary economists. Professor Machlup alludes, on one occasion, to The Euro-Dollar Market: A Mystery Story, and on another to the similarities between Euro-dollars and a “magician’s rabbits”; Charles Kindle-berger devotes himself to Two Puzzles of the Euro-Dollar Market, while Milton Friedman is inclined to attribute it all to the magic of a mere bookkeeper’s pen.
There are, of course, many factors which have contributed to this mystery and confusion. First, the lack of statistical data and qualitative information on the market has made it difficult to determine the precise nature and extent of Eurocurrency operations. The absence of data, in particular, has encouraged observers to make more or less informed guesses about the relative orders of magnitude involved; guesses which unfortunately are often influenced by analytical concepts frequently used in relation to domestic money markets such as a multiplier model, and which may have little relevance in the international sphere. These problems have been compounded by the rapid changes in the nature of Euro-currency operations and institutions as the market has matured.
Second, the little statistical data that is available suggests an extremely rapid growth in the net size of the market. As a result, a large part of the literature has been devoted to explaining the growth of the Euro-currency market and to debating its implications. This extremely rapid growth apparently encouraged the use of the word magic and, for want of a better explanation, suggested a comparison with other cases of supposed economic magic, like the deposit multiplier process so familiar in the context of a domestic banking system. Although subsequent debate sought to expose much of this trick, considerable concern developed about both the market’s influence on the effectiveness of domestic economic policies, particularly the monetary ones, and the market’s contribution to world inflation because of its effective expansion of the world’s money supply. More recently this concern spread to the market’s role in destabilizing short-term capital flows and in the “collapse” of the international monetary system.
Third, and the most important source of mystery and confusion, has been the lack of an appropriate theoretical base and a broader perspective for discussions on the Euro-currency market. This need is most obvious when discussions concentrate on policy questions like the control of the market, particularly when there is an attempt to compare alternative methods of control.
The multiplier analysis
Since the dominant institutions in the Euro-dollar market are commercial banks it seemed a logical first step to draw a parallel between the Euro-banking system and a typical domestic banking system, and to argue that the deposit expansion or money multiplier model, which is generally applicable in the domestic case, is also a relevant conceptual framework for discussion of the Euro-dollar market. Typically, analysts adopted a fixed coefficient version of the deposit expansion model, which assumes that the public holds a fixed ratio of currency to bank deposits and that banks hold a fixed ratio of reserves to deposits. Having calculated the relevant multipliers they attempted to appraise the credit creating power of the Euro-banking system on the basis of a given primary deposit or increase in reserves. This type of multiplier model essentially implies disequilibrium, and continuous expansion of credit until some constraint intervenes.
Initially, few people disputed the applicability of the multiplier analysis, since the debate was essentially confined to the magnitude of the assumed leakage ratios. It was thus a simple matter for the “low-leakage-high-multiplier” school to attribute the net size of the market, and its rapid growth, to the inherent magic of the deposit-expansion process, while the “high-leakage-low-multiplier” school was forced to resort to alternative explanations of the market size and growth.
More recently, however, several writers have withstood the temptation of associating with either school, choosing instead to abandon the multiplier analysis—at least in its simple fixed-coefficient form—as a conceptual framework for analyzing the Euro-dollar market. Essentially, two main criticisms have been leveled against the simple multiplier analysis. First, some writers have warned against interpreting the total Euro-dollar deposit figure as a measure of liquidity created by the Eurodollar market (or of the net credit impact of the market). Therefore, they are against interpreting the multiplier as an indicator of the liquidity impact of a given primary deposit or reserve base change, as indeed each is in the context of a domestic banking system. It is argued that positive asset transformation (lending long-term on the basis of demand deposits), which is the essence of liquidity creation in a domestic banking system, may be less prevalent in the Euro-currency market. Therefore, instead of primarily creating additional liquidity Euro-banks function more as a distribution system for existing liquidity, from areas of surplus to areas of deficit all over the globe.
Second, it has been argued that the conditions assumed by the simple multiplier framework—specifically an exoge-nously determined base and stable reserve and currency leakage ratios-are not evident in the Euro-dollar market. For example, the assumption that the Eurocurrency markets are incapable of achieving equilibrium within a reasonable time span may not be justified.
In the domestic markets where there are legal reserve requirements and ceilings on interest rates charged on time and demand deposits, it may not be too unreasonable to assume continuous dis-equilibria. The Euro-currency market, however, is characterized by a lack of banking controls, the interest rates in the Euro-market move flexibly, and the adjustments of both depositors and borrowers in the markets are fairly fast.
Under these conditions, it seems far more reasonable to adopt an equilibrium model where the Marshallian scissors of supply and demand, rather than the institutionally determined multiplier, determine the output of the banking services.
The general equilibrium model
In an empirical study conducted by the author with John Hewson within the framework of a general equilibrium model, it was suggested that at most the Euro-currency deposit multiplier was around unity in the period 1968-72. (“Euro-dollar deposit multiplier: a portfolio approach,” International Monetary Fund, StaffPapers, July 1975.) At least two important implications are to be drawn from this finding. First, the impact of the Euro-currency market on the world money supply has not been very significant, and the Euro-currency market by itself has probably not been the source of much inflationary pressure. Hence, explanations of the source of world inflationary pressure are to be found elsewhere, such as in the expansion of the monetary bases of major industrial countries of the world. The Euro-market has simply functioned as a distribution system for transmitting the monetary expansions of one country to other countries of the world.
Second, our findings showed that the idea of controlling the Euro-currency market as a means of regulating the overall level of global liquidity seems to lack the appropriate conceptual base. However, this should not preclude the possibility of some form of official intervention in these markets for other purposes. The Euro-currency market provides the vital link between the national financial markets of the world and, therefore, some form of close surveillance and fine tuning may be warranted for the effective monitoring of the world economy. In this interdependent world, where one economy cannot be isolated from developments in others, problems of one area of the world economy are soon transmitted to other areas. This increasing interdependence and the greater internationalization of the economies of the world have been major undercurrents of the rapid growth of the Euro-currency market.
Greater internationalization and increasing interdependence
The development of Euro-currency banking within the general equilibrium system of international and domestic finance can best be characterized as the logical result of the internationalization and liberalization of banking operations that have traditionally been closely controlled by national authorities. It is not by coincidence that the return to external convertibility and the substantial relaxation of exchange controls throughout Western Europe in 1958 were instrumental in initiating Euro-currency banking operations. The elimination of these exchange and capital controls, along with the competitive edge enjoyed by Eurocurrency banks over their U. S. counterparts in being able to operate without any restrictions in the form of interest rate ceilings and legal reserve requirements, seem to have been important factors in the subsequently rapid growth of the Euro-currency markets.
Thus, it may be reasonable to attribute the emergence and the expansion of the Euro-currency market to the liberalization of exchange and capital controls and the resulting international competition for more efficient and cheaper banking operations. Although the increases in the U. S. balance of payments deficit during the late 1960s and early 1970s have often been cited among the major stimuli to the growth of the Euro-currency market, the direction of causation is not clear cut. The development of relatively free international banking, prompted in part by the existence of interest rate regulations in the United States, would cause short-term capital outflow from the United States, and, therefore, a deterioration of the U. S. balance of payments on both a liquidity and official settlements basis. Thus, the deficits in the U. S. balance of payments could be called the result, and not the cause, of the rapid expansion of the Euro-currency market.
It seems proper, therefore, to view the development of the Euro-currency markets in the broader context of the general process of internationalization of economic activities involving trade, direct investment, portfolio investment, and short-term to medium-term banking operations. The development of Euro-currency operations, along with the rapid expansion of international trade and investment, has indeed changed the basic structure of the world economy during the past decade or so. The world has moved from a regime of relatively controlled international activities toward that of comparatively free international transactions. The internationalization and liberalization of short-term to medium-term international capital should be viewed as, more or less, the beginning of the final stage of this transition from a comparatively controlled to a free regime in place of the somewhat rigid Bretton Woods system of international finance.
The 1960s and early 1970s may, therefore, be viewed as the transition period from the U.S. dominated and tightly controlled international economic system to a freer system where the U.S. influence is less dominant. The rapid expansion of the transactions of international banks in the Euro-currency market, as well as the activities of other nonfinancial multinational corporations, has served as the vehicle for this transition. Although the Euro-banks and other multinationals have often been accused of creating unnecessary disruption in world markets, this allegation would only be true if the world economy were still operating under the old regime, or if the world could or should revert to the old controlled system.
The effects of capital controls
Throughout the late 1960s and early 1970s many of the authorities that constitute the official sector repeatedly attempted to react to observed developments in the private sector of the world economy. Consequently, there were numerous instances where these authorities attempted to fix exchange rates through official intervention either with or without the imposition of new controls on short-term capital transactions. Only lately has the official sector of the world economy begun to realize that such attempts to control private capital transactions in the international money and capital markets are, in general, not feasible in the present international environment, where the internationalization of private transactions has progressed to such a degree that some way is almost always found to circumvent these controls or to force further and increasing corrective action to be taken.
It is quite ironical that the imposition of exchange and capital controls in some developed countries in the late 1960s and the early 1970s was one of the key factors in the rapid growth of the Eurocurrency market during this period. Since, in most cases, the controls that were instituted during this period were not intended to completely choke off all international transactions, there was always some way to circumvent them. The process of circumventing these controls generally produced an expansion in the volume of Euro-currency transactions. For example, the imposition of a host of capital controls in the United States in 1968, supplemented by tight monetary policy during the period, increased the activities of overseas branches of American banks by tremendous amounts in 1968 and 1969. The assets of overseas branches of U.S. banks more than doubled during these two years, from $15.7 billion in 1967 to $41.1 billion in 1969, while the number of overseas branches jumped from 295 to 459 in the same period. Similarly, the activities of foreign branches of German banks, particularly in Luxembourg, expanded quite rapidly in the early 1970s following the imposition of the minimum reserve requirement on German banks’ external liabilities. According to published annual accounts at the end of 1971 and the beginning of 1972, the consolidated balance sheet of the subsidiaries of large German banks in Luxembourg alone was some DM 6 billion, compared with DM 2 billion a year previously. The bulk of this increase was thought to be the result of offsets to the control.
Therefore, had it not been for these controls, New York, as well as other smaller money markets such as Frankfurt and Paris, probably would have kept pace with the growth in London, Luxembourg, and other Euro-centers as the volume of international transactions in trade and capital expanded. The imposition of controls served to concentrate these free transactions in short-term capital in London and, to a lesser degree, in Luxembourg, and other “off-shore” Euro-centers. However, the increasing volume of aggregate international transactions in short-term capital was the consequence of the internationalization of economic activities of the countries of the world and not the result of the imposition of capital controls. The imposition of capital controls should perhaps be viewed as a futile attempt by the official sector of the world economy to retaliate against the increasingly strong waves of internationalization in the private sector and such attempts only encourage private transactors to search for ways to circumvent them and this serves to skew the geographical distribution of these transactions to the areas of the world economy where controls are absent.
Recent developments and the future
In 1974 the Euro-currency market went through a difficult period of adjustment as the world economy strived to adapt itself to a new environment after the quadrupling of the oil price late in 1973. By the middle of the year, confidence in the market was strained by the announcement of foreign exchange losses and a number of much publicized bank failures, although these losses were not directly connected to Euro-market business. Concern also spread that Euro-banks could not continue to play a major role in recycling oil surpluses because of capital inadequacy of commercial banks and because of the difficulty of maturity transformation that was required in oil financing. Danger of the lack of a clearly defined lender-of-last-resort in the Euromarket was also emphasized in relation to this problem of maturity transformation and the deteriorating creditworthiness of some borrowers in the markets.
Furthermore, it was feared in some quarters that the termination of U. S. capital controls in January 1974 would strip the Euro-currency market of its raison d’être as a substitute market for New York.
Indeed, the gross side of the Euro-currency market contracted in the third quarter of 1974 for the first time in its history: external foreign currency liabilities of the banks in the eight reporting countries (Belgium, France, the Federal Republic of Germany, Italy, the Netherlands, Sweden, Switzerland, and the United Kingdom) declined by US$12 billion (over 5 per cent) from their June level. Concern about the stability of the market, however, soon subsided—reflecting, in part, confidence derived from the central banks’ statement of support issued after the Bank for International Settlements (BIS) meeting in September 1974—and the market growth, although moderate, was resumed in the fourth quarter of 1974 and the first half of 1975.
Major worldwide role
The developments during 1974 are, in a sense, suggestive of the true nature of the Euro-currency markets in the context of the broad structure of the world economy. The market, which may have started as a substitute for U. S. markets and which could have been viewed as an anomaly or aberration ten years ago, has now established itself as the major cornerstone of world capital and the monetary scene. Without the enormous expansion of the Euro-currency market in the first half of 1974, the recycling of oil funds would have been very difficult, at least in the short run, and the world economy would have suffered from additional pains and strains. The sag in the market in the third quarter was nothing but the reflection of the fact that this market is a short-run and competitive one, which cannot bear the burden of medium-term and long-term functions of recycling, and that even a competitive market needs some overall framework supported by the official authorities of the world. In any event, the re-emergence of New York as a world capital and money center cannot take away the major role which the Euro-currency market has played during the last decade. The Eurocurrency market will continue to function as a major financial center of the world and will be integrated more and more with U. S. markets now that major restrictions on U. S. markets have been lifted.
The importance of the Euro-currency market in the world economy has increased to such a point that its future cannot be discussed separately from the future of world economy as a whole. As long as the international transactions of the world, or the integration of the world economy, proceed as smoothly as they have in the past, the Euro-currency market will continue to play a major role in the world economic scene. Conversely, the sound development of the world economy cannot be maintained without the smooth functioning of the Eurocurrency market.
Official interventions in the market
The degree of development of the Eurocurrency market, which is also an indication of the degree of monetary interdependence of the economies of the world, is such that effective coordination of the monetary and other policies of, at least, the major countries of the world seems essential to the proper management and monitoring of the world economy. In this sense, agreements on some form of coordinated surveillance and official intervention in the Euro-currency market may lay the foundation for further cooperation in coordinating economic policies of the countries of the world.
Since Euro-banks are international financial intermediaries which do not create money or net liquidity but merely distribute money created elsewhere in the system, they primarily serve to increase the velocity of domestically created money. In these circumstances, official intervention in the Euro-currency market could be directed at controlling this velocity. The volume of international money can only be controlled by the effective coordination of the monetary policies of the authorities of the reserve centers. Under the present “limping” or defacto dollar standard only the Federal Reserve Bank of the United States has the power to control the supply of U. S. dollars and, therefore, the supply of international money. In these circumstances, because the Federal Reserve is likely to give priority to domestic considerations, thus tending to set the supply of dollars in accordance with domestic needs, the supply of U.S. dollars may not be consistent with the requirements of other countries. As a result, there may be significant scope for other countries to meet their own policy objectives by intervening in the Euro-currency market in an attempt to vary the velocity of U. S. created dollars. The explicit or implicit agreement by the Federal Reserve on such intervention could lead a way to more full-fledged coordination of monetary and other policies of the countries of the world.