Oscar L. Altman
IT WOULD NOT BE SURPRISING if the Euro-dollar were something of a mystery to those unfamiliar with it. To begin with, it is a comparative newcomer on the international financial scene, dating only from 1958-59. Again, the expression “Euro-dollar market” is rather misleading, since the market is not confined to Europe and does not trade only in dollars. Sterling deposited in Paris is traded in what is called the Euro-dollar market, and residents of the United States borrow Euro-dollars outside the country as well as dollars in it. Small wonder if the Euro-dollar market seems to be a confusing institution, best left to the international bankers who created it and the economists who presumably understand it.
It is, however, also important to people who have no direct connection with it, since all the major institutions which have a part in determining the character of international trade—which facilitate it or hinder it, or which make it more or less flexible or convenient—are important. There is no doubt that the Euro-dollar market, although new and wholly unofficial in character, has become an indispensable part of the international monetary system.
Having grown from virtually nothing to more than $10 billion in net assets in the last eight years, the Euro-dollar market is now one of the world’s largest markets for short-term funds—mostly dollars. It is an international market, and it is one of the freest, most competitive, and most flexible capital markets that exists anywhere. Its flexibility is demonstrated by the manner in which, with scarcely a sign of strain, and with little short-term effect upon interest rates, it has handled large in-and-out movements of funds. A notable example is the repatriation of dollars in 1965, which the United States made part of its program of voluntary restraint to deal with its balance of payments deficit. Another example is the large borrowings by Italian commercial banks in 1963-64, amounting to perhaps $750 million, followed in 196566 by a reduction of these borrowings and investment of more than $1 billion. The market has survived a number of business failures involving losses of Euro-dollar funds in Germany and the United States that have had considerable publicity; it seems to have tightened its procedures as a result of them.
What Is the Euro-Dollar Market?
The Euro-dollar market is a market, located principally in Europe, for lending and borrowing the world’s most important convertible currencies. The currency mainly dealt in is the dollar, but the market also deals in such major European currencies as the pound sterling, the Swiss franc, the deutsche mark, the Netherlands guilder, and the French franc. The professional participants in it are commercial banks, but merchant banks, private banks, and some investment banking firms are included.
Funds flow into the market from 40 or 50 countries on all continents; these are owned by official monetary institutions, other government agencies, banks, industrial and commercial enterprises, and private individuals. Funds flow out for investment in a large number of countries, including Japan and the United States. Commercial banks in London, Paris, and other European cities are the principal intermediaries or dealers in the Euro-dollar market, and they “make” the market in the sense that they are willing to accept Euro-dollars in the form of time deposits (since June 1966 a few banks also have been prepared to issue negotiable certificates of deposit) or to make loans or investments in Euro-dollars. It is characteristic of the market that these transactions are made in large amounts, often of $1 million or more, at competitive rates of interest.
The Euro-dollar market attracts funds because it offers higher rates of interest, greater flexibility of maturities, and a wider range of investment qualities than other short-term capital markets; and the market is able to attract borrowers because it lends funds at relatively low rates of interest. It thus renders the financial service of intermediating between owners of funds and would-be borrowers. The market operates with low costs because the banks and other firms that use it are well known, because the transactions are for substantial sums, and because dealings are highly competitive. The low costs are reflected in competitive advantages to both depositors and borrowers.
But this description does not touch upon one aspect of the market that gives it its unique character, namely, that the transactions in each currency take place outside the country where that currency originates. The market for Eurodollars refers to the market in dollars outside the United States, not to the origin or the character of the dollars being dealt in. The Euro-dollar market in, say, London, thus deals overwhelmingly with titles to dollar deposits, i.e., dollars deposited in banks in the United States. Similarly, the market for Euro-sterling refers to the market for sterling outside the United Kingdom.
The Euro-dollar market (to use this common term to cover all the external markets in all the major convertible currencies) is closely allied to the great network of arbitrage transactions—that is to say, transactions designed to take advantage of differences in exchange rates and interest rates in the different trading centers. Thus, banks may borrow dollars and then lend them; they may borrow deutsche mark, swap them into dollars, and then lend dollars; or they may borrow dollars, swap them into deutsche mark, and then lend deutsche mark. Eurodollar operations basically deal with the flow of funds from an initial owner to a final borrower, but in the process they affect the level of interest rates in different countries for funds lent for as short a time as one day or for as long as 18 months. They also influence the exchange rates of the major convertible currencies, and the relationship of the rates being offered for present funds (spot rates) to the rates being offered for the same currency on specified future dates (forward rates). Although Eurodollar operations affect all these other components of the international financial market, they do not determine them. All the components of the market are interrelated, and all of them are arbitraged in all directions.
How Are Euro-Dollars Used?
The process of using Euro-dollars and other currencies begins when some bank in the market collects funds in the form of deposits. The bank uses some of these funds in its own operations, and transfers the balance to another bank in the form of a deposit. This process may be repeated two or more times until all the funds are finally used in either of two ways: first, they are lent to a business enterprise other than a bank to finance commercial or industrial transactions; or second, they are used by banks to improve their reserves or liquidity and thus to contribute to their over-all operations.
A large part of the world’s international trade is invoiced in, and must be paid for with, dollars and sterling and—to a much smaller extent—in and with the major currencies of continental Western Europe. Therefore, importers have found it useful to borrow Eurodollars and other currencies when this was cheaper than borrowing their domestic currency—and Euro-dollars have often been notably cheaper than domestic funds. In the same way, exporters have often found it cheaper to finance the period between shipment of their goods, and payment for these goods in dollars or other major currencies, by borrowing dollars rather than their local currency. All in all, a substantial amount of international trade is financed by Euro-dollars.
But while international trade is the usual business of Euro-dollars, not all Euro-dollars are involved in it all the time. Where it is cheaper to borrow Euro-dollars than domestic currency, it is not surprising that some Eurodollars are borrowed to finance operations or inventories of businesses not directly engaged in international trade, or to carry temporarily parts of new security issues. However, the domestic use of Euro-dollars has not been welcomed by all governments. When a country has domestic interest rates and monetary and credit policies that differ a good deal from the world average, residents can use Euro-dollars to limit their effects or even escape from them. Hence, some governments have, as a matter of general policy, restricted the ability of their corporations to borrow Euro-dollars for domestic purposes while permitting them to borrow Eurodollars for international purposes. In effect, they have recognized that borrowing Eurodollars for financing exports, imports, shipping, and the like is a “natural” procedure that strengthens the international trading positions of their corporations, while banning such borrowing would be difficult to enforce, especially where corporations have widespread international activities. Thus, even countries that limit Euro-dollar borrowings (e.g., France and Sweden) may permit a wool or banana importer or a shipping company to borrow Eurodollars but forbid a department store or hotel chain to do the same thing.
Other countries, however, including Italy, Germany, and the United States, allow (and sometimes encourage) their corporations to borrow Euro-dollars and other foreign currencies. Indeed, a substantial part of all bank loans to Italian corporations is made in foreign currencies, notably dollars and Swiss francs. Corporations in Germany have borrowed large amounts from abroad; and even when such borrowings have been denominated in deutsche mark, the funds for these transactions were probably obtained by borrowing Euro-dollars and then swapping them into domestic currency. In the last two years, U.S. corporations have been strongly encouraged to borrow funds abroad, as part of that country’s balance of payments adjustment program.
Who Owns Euro-Dollars?
The “original” owners of the dollars and other currencies initially placed in the market are a widely varied group; they may be individuals, commercial banks, international agencies such as the Bank for International Settlements, or national central banks or monetary authorities; they may or may not be residents of the country where the currency originates.
Until 1965, when the United States first took steps to control the export of capital in order to improve its balance of payments position, a substantial part of the dollars deposited in the Euro-dollar market was owned by U.S. residents. They placed deposits either in Canadian banks (which in turn redeposited part of them with banks in Europe) or in European banks. In response to the current U.S. informal controls on short-term capital movements, most of these Euro-dollar deposits have been repatriated. Moreover, since a large amount of dollars deposited with European branches of U.S. banks is now being put at the disposal of the head offices of these banks in the United States—making these head offices borrowers of Euro-dollars—the United States has become a net debtor to the Euro-dollar market. This situation would, of course, be reversed if money market conditions in the United States became easier and if the balance of payments situation of the United States improved.
Only a small part of the dollar deposits in the Euro-dollar market at the present time is, therefore, owned by residents of the United States. The overwhelming bulk of these deposits represents dollars already owned by foreigners or purchased by them with other currencies. Nonresidents already own large amounts of dollars. At the end of 1965 foreign holdings of dollars totaled $25 billion, of which $14 billion was held by central banks and other governmental agencies outside the United States, $7 billion was held by commercial banks (other than U.S. banks), and $4 billion was held by all other non-U.S. holders.
Central Banks Are Large Owners
In an earlier article, the writer pointed out that, in the summer of 1962, some 20 or 25 central banks or monetary authorities had directly or indirectly deposited dollars in the Euro-dollar market. He also pointed out that it was conservative to assume that two thirds of all the funds in the European markets came from this source. The conclusion that a substantial part of the dollars in the market was owned directly or indirectly by central banks and monetary authorities was considered quite surprising.
At the present time, the number of central banks or monetary authorities that have placed funds in the Euro-dollar market is probably more than 25, but their percentage of total funds has decreased. Yet it is probably fair to say that at least one third of the Euro-dollar deposits in the eight major European countries at the end of 1965 were owned, directly or indirectly, by monetary or governmental agencies.
The decrease in the proportion of official funds in the Euro-dollar market since 1962 is probably attributable to two factors: foreign official dollar holdings have increased less in this period that foreign nonofficial dollar holdings—by $1 billion compared with $3 billion; and the rate of interest obtainable on funds lent in the United States is now nearly as great as can be earned in the Euro-dollar market.
Commercial banks own a sizable amount of the dollars deposited in the Euro-dollar market. Their funds come from four sources: dollars deposited by their customers; other foreign currencies deposited by their customers and swapped into dollars; domestic currency owned by the bank and swapped into dollars; and dollars borrowed by the bank in the Eurodollar market and redeposited in other banks at a higher rate of interest or for a more convenient length of time. All these actions reflect the self-interest of the banks and the desire to earn the higher rate of interest available on Euro-dollar deposits compared with that obtainable on short-term securities in their own countries. The banks may also wish to improve the liquidity of their assets or to obtain a better distribution of the maturities of these assets. The Euro-dollar market provides greater flexibility in these respects than do any short-term money markets except those in the United States and the United Kingdom.
Other business enterprises, particularly those in international trade, may find it profitable to hold excess balances, or even working funds, in dollars, partly because dollars can easily be invested and partly because so much of international trade and services is denominated or paid in dollars.
It has sometimes been said that Euro-dollar funds may be borrowed to finance issues of long-term securities in Europe, particularly those denominated in dollars. A more recent and potentially more important development has resulted from these security issues denominated in dollars, particularly the most recent ones by subsidiaries or affiliates of corporations. Many such issues were floated in advance of need, so that the proceeds could be deposited in the Euro-dollar market until they were used to pay for plant and equipment. Thus, through the mechanism of this market, private and institutional holdings of dollars for long-term investment were temporarily converted into additional supplies of short-term dollars for the Euro-dollar market.
The owners of deposits made in sterling are probably broadly similar to those who make them in dollars, though the proportions held by classes of owners are somewhat different. Deposits denominated in currencies other than dollars and sterling probably show a quite different pattern of ownership, since central banks do not hold reserves in these currencies (except for the relatively small amount held in French francs) and therefore cannot deposit them in the Euro-dollar market.
An “Unofficial” Creation
The Euro-dollar market has grown up, and continues to grow, without official favors, subsidies, or tax advantages. The market is so broad, so international, and so competitive that it cannot be controlled or even greatly influenced by any one country. This has important advantages in mobilizing capital, lowering and unifying interest rates, and increasing competition in banking. On the other hand, as we have seen, a number of countries have taken the view that their national economies should be shielded, to a greater or lesser extent, from the operations of the Euro-dollar market. Therefore, individual countries have from time to time increased or decreased the ability of their banks and business enterprises to use the facilities of the market.
Rates of interest charged by banks for loans in Euro-dollars tend to be lower—and sometimes very much lower—than those charged by these same banks for loans made in domestic currencies. Because of the market, large enterprises have access to more banks in more countries. The market has thus intensified banking competition in many countries, and notably those in which competition is restricted by regulation, cartel arrangements, or gentlemen’s agreements. This competition has been welcomed in some countries (Italy is one example) because it has tended to lower domestic interest rates, including those charged on loans made in local currency by local banks. in other countries (such as Germany) this competition has been criticized on the grounds that it has fostered unsound banking competition and therefore encouraged the making of riskier loans.
The International Financial System and the Euro-Dollar Market
As well as increasing competition in banking, the Euro-dollar market has had two important effects upon the international financial system.
First, it has strengthened for the time being the position of the dollar, largely because it has made it more profitable to borrow or to hold dollars. As already noted, official and non-official holders of dollars have been able to earn higher rates of return in the Euro-dollar market than in the United States; and to the extent that their total holdings are responsive to higher rates of interest they perhaps hold more dollars than they would if there were no Euro-dollar market. And it is obvious that when more dollars are used in international trade and financing, fewer dollars are converted into gold.
Second, the market has facilitated the financing of balance of payments surpluses and deficits. This aspect of the market has not as yet received the attention it deserves. Countries with balance of payments deficits have borrowed funds from the Euro-dollar market to reduce the demands upon their reserves. Thus, when the Bank of Italy in 1963-64 encouraged its commercial banks to borrow in the Eurodollar market, it shielded Italian reserves from the full effects of a capital outflow and a payments deficit. On the other hand, countries with balance of payments surpluses have been able to minimize the domestic effects of these surpluses (and the growth of official reserves) by encouraging their residents to deposit dollars in the Euro-dollar market directly or through the commercial banking system. This was done in Germany in the early 1960’s and in Italy when its balance of payments recovered in 1965-66.
The Euro-dollar market, then, has come to play an important role in providing a mechanism for attracting funds from governments, banks, business enterprises, and individuals, and for lending funds to banks, business enterprises, and individuals, and, directly or indirectly, to governments. In doing so, it has contributed to both private and public international liquidity and it has improved the level and the efficiency of this liquidity.
Is It Here to Stay?
Two related questions are frequently asked about the Euro-dollar market: is it here to stay? and—in particular—can it continue after the United States swings into a balance of payments surplus? The answer to the first question is that the Euro-dollar market has become an integral part of international financial markets, and its functions will have to be performed by itself or by some other market unless the world moves toward financial autarchy.
The answer to the second question is more difficult to state briefly. Because the Eurodollar market dates from 1958-59, when the United States first developed large balance of payments deficits, it is often assumed that its deficits created the market and that a balance of payments surplus will reduce or even destroy it. But since governments and residents of many countries have found the market valuable and make extensive use of it, the size is not determined by the U.S. position alone. It is also affected by the extent of the balance of payments surpluses of all countries, and by the balance of payments deficits of the major countries with good credit standing that are willing to borrow, or to let their banks borrow.
It seems likely that the operations of the Euro-dollar market would not be significantly curtailed if the United States developed a balance of payments surplus—and, indeed, might even continue to increase.
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