THE INTERNATIONAL CAPITAL MARKET is a market in which investors deal in securities that represent, for them, foreign assets. Final claims on borrowers, or the assets to which the securities give title, are usually to be made in countries outside the legal jurisdiction of the holder of the claim. The more active part of the international capital market is concerned with facilitating the transfer of outstanding domestic securities between resident and foreign investors, such as a British resident investing in American securities sold in New York. International transactions in outstanding securities, however, are difficult to quantify and are generally subject to relatively loose exchange controls. Although, in most respects, the heart of the international capital market is the trade in outstanding securities carried out by nonresidents (activities which might be called its transfer of ownership function), attention is generally concentrated on the issue of securities by nonresidents on domestic security markets (activities which might be called its new issue function).1 The two functions—the new issue and transfer functions—necessarily merge and both result in an international redistribution of capital resources. Nevertheless, national monetary authorities have exercised much closer control over the issue of new foreign securities on domestic security markets (often by direct control) than over resident investors’ dealings in securities on foreign securities markets (often controlled by differential taxes and exchange rates).2

Abstract

THE INTERNATIONAL CAPITAL MARKET is a market in which investors deal in securities that represent, for them, foreign assets. Final claims on borrowers, or the assets to which the securities give title, are usually to be made in countries outside the legal jurisdiction of the holder of the claim. The more active part of the international capital market is concerned with facilitating the transfer of outstanding domestic securities between resident and foreign investors, such as a British resident investing in American securities sold in New York. International transactions in outstanding securities, however, are difficult to quantify and are generally subject to relatively loose exchange controls. Although, in most respects, the heart of the international capital market is the trade in outstanding securities carried out by nonresidents (activities which might be called its transfer of ownership function), attention is generally concentrated on the issue of securities by nonresidents on domestic security markets (activities which might be called its new issue function).1 The two functions—the new issue and transfer functions—necessarily merge and both result in an international redistribution of capital resources. Nevertheless, national monetary authorities have exercised much closer control over the issue of new foreign securities on domestic security markets (often by direct control) than over resident investors’ dealings in securities on foreign securities markets (often controlled by differential taxes and exchange rates).2

THE INTERNATIONAL CAPITAL MARKET is a market in which investors deal in securities that represent, for them, foreign assets. Final claims on borrowers, or the assets to which the securities give title, are usually to be made in countries outside the legal jurisdiction of the holder of the claim. The more active part of the international capital market is concerned with facilitating the transfer of outstanding domestic securities between resident and foreign investors, such as a British resident investing in American securities sold in New York. International transactions in outstanding securities, however, are difficult to quantify and are generally subject to relatively loose exchange controls. Although, in most respects, the heart of the international capital market is the trade in outstanding securities carried out by nonresidents (activities which might be called its transfer of ownership function), attention is generally concentrated on the issue of securities by nonresidents on domestic security markets (activities which might be called its new issue function).1 The two functions—the new issue and transfer functions—necessarily merge and both result in an international redistribution of capital resources. Nevertheless, national monetary authorities have exercised much closer control over the issue of new foreign securities on domestic security markets (often by direct control) than over resident investors’ dealings in securities on foreign securities markets (often controlled by differential taxes and exchange rates).2

The asymmetry both in type and in extent of controls on the international capital market has tended to produce, since World War II and particularly since the early 1960’s, a series of attempts to widen the new issue function of the international capital market by increasing the facilities for borrowers to raise loans—usually by the issue of long-term bonds—in security markets of which the borrowers are nonresident and, in addition, to encourage investors to purchase new foreign securities which can also be regarded as nonresident issues. The most effective extension of the international capital market has been to denominate bonds in U.S. dollars—a reserve currency—and to issue such bonds by making use of the capital market machinery of a reserve currency center—London or, latterly, New York—on behalf of third country lenders and borrowers. The new international capital market, in short, is foreign to both borrower and lender and thereby escapes the usual sort of control on the issuance of new foreign securities.

This “new” international capital market has grown up not only because of the existence of various types of long-established controls but also in response to more recently imposed controls on the international movements of long-term funds and securities. The most important of the new restrictions resulted from the announcement and later retroactive imposition in the United States of an Interest Equalization Tax on the issue of foreign securities by certain countries, effective from August 1963. The effect of the tax was not only to shut off the supply of international capital flowing from the United States to the developed countries but also, initially, to immobilize the extremely efficient machinery of the New York capital market for the issue of foreign securities for the developed countries.

The New York market was shut off to foreigners at a time when foreign lenders were eager to acquire high-yielding securities denominated in U.S. dollars.3 Demand for these securities had grown throughout the postwar period, partly because of the stability of the exchange value of the U.S. dollar (which thus came to be regarded as a hedge against devaluation) and partly because of the relative ease with which securities could be disposed of on a broad securities market such as New York. The foreign demand for U.S. dollar-denominated securities has not abated with the passage of the Interest Equalization Tax. It has been met, however, by the issuance of bonds denominated in U.S. dollars in markets outside the United States for both U.S. and other borrowers, supplemented by a relatively small number of issues denominated in other currencies. Such issues are often called Eurocurrency bonds, although there is little direct link with the Eurocurrency money market. This paper refers to such bond issues as foreign currency issues, since the currency in which the bonds are denominated is usually foreign to both lender and borrower. It is the purpose here to analyze various aspects of the latest extension of the international capital market in the form of foreign currency new issues.

Development of the Foreign Currency New Issues Market

Throughout the post-1945 period there has been an acute world-wide shortage of long-term capital. The scarcity of capital in many countries—exhibited by rising domestic prices and periodic balance of payments crises—has been so severe that relatively tight and long-standing controls against the export of capital have been in force more or less throughout the postwar period. Where and when controls have been relaxed, private investor enthusiasm for foreign securities, contrasted with the growth of direct investment, has often been weak. The breakdown in investor confidence characteristic of the 1930’s was not completely overcome in the 1950’s and early 1960’s. This lack of confidence has been based on, among other factors, the fear of inflation, exchange control, and exchange rate changes.

As one means of overcoming investor reluctance, particularly in Europe, and also of minimizing the effects of controls on new foreign issues and international capital transactions, bond issues on behalf of foreign borrowers have been made in foreign currencies (i.e., in currencies other than that of the market of issue or of the borrower). A variant of the foreign currency issue has been the provision of currency options (i.e., a multi-currency issue) for payment of principal and interest and, occasionally, for the initial subscription. These options reduce the exchange risk for the investor purchasing the bonds, and any change in the exchange rates in which the bond was issued would give the investor a capital gain to the extent of the relative appreciation of one of the currencies.

The currency option (i.e., the ability to demand repayment of a foreign issue in more than one currency) is an old technique and was used, for example, by Canadian borrowers in New York who permitted repayment of principal and interest in sterling or in U.S. dollars at the rate of $4.86 to the pound. The most fundamental form of a foreign issue giving safeguard from the exchange rate risk is the denomination of the security in terms of gold or to include a gold clause guarantee in the prospectus. Gold clauses were frequently used before 1914 and during the period of unstable exchange rates and violent inflations in the 1920’s. Since gold clauses are now generally forbidden, the principle of an exchange rate guarantee is exemplified, but without implying a gold guarantee, by issues denominated in units of account with a relatively large number of reference currencies—including, possibly, the domestic currency of the lender.4

The unit of account as a basis for new foreign issues was introduced (for a Portuguese borrower) in February 1961, and in 1963 and again in 1966 the technique achieved some popularity. Multi-currency loans, or loans with currency options to the lender, were reintroduced in the mid-1950’s. The first important postwar loan with a currency option, for South Africa, was floated in New York in December 1955 with an option of principal and interest payable in Swiss francs. During 1956–62 about 10 important new public issues incorporated an option for one or more currencies. For example, an issue for Petrofina of Belgium in 1957 is quoted in Amsterdam and denominated in U.S. dollars, but bondholders have a currency option in Canadian dollars, Belgian and Swiss francs, and Dutch guilders. Similarly, an issue for the Government of Argentina in 1961 contained a currency option of seven currencies other than U.S. dollars, in which the loan was nominally denominated. Apart from issues containing a multi-currency option, the popular single-currency option was normally between U.S. dollars and deutsche mark; a loan sponsored in New York for the City of Oslo in June 1960, however, contained a currency option in sterling.

By the early 1960’s the technique of floating foreign currency issues, with or without currency options, was well established, though used on a very small scale, partly because the bulk of issues on behalf of European or other borrowers was made on the New York or Swiss markets. In those markets there was little need to tempt investors with currency options, as U.S. dollars and Swiss francs were regarded as the strongest international currencies.5 In 1963 and early 1964, however, severe restrictions were placed on foreign issues in both the United States and Switzerland. By then, however, European investors had become fairly active in absorbing foreign issues, particularly those issued in New York. The expansion of the foreign currency new issues market is largely a consequence of those new restrictions and of a concerted attempt to maintain and widen European investor interest in foreign new issues.

An increasing proportion of new foreign security issues on New York (after about 1960) and Swiss markets had been for the industrial nations of Western Europe, Canada, Japan, and the international institutions. It was the industrial countries which thus found themselves virtually excluded from the main international capital markets of the world in mid-1963. The effective closure of the New York market and the restricted access to the Swiss market to European and Japanese borrowers came at an inopportune moment for the industrial countries.

The only feasible alternative source of international funds was Western Europe itself. In fact, just before the announcement of the Interest Equalization Tax, the Euro-dollar market in London was tapped for funds for a foreign currency issue for the Government of Belgium. This issue, made in May 1963, for $20 million with a three-year maturity, was handled in London and subscribed for in Euro-dollars. This operation opened a new phase in tapping a large capital market dealing in foreign funds. The earlier issues denominated in units of account could be regarded as a specific attempt to internationalize the foreign new issues market in Europe by issuing an international security. Before the announcement of the U.S. intention to impose an Interest Equalization Tax, the British authorities had already inaugurated a policy (in late 1962) of reviving the use of London as an international capital market. This policy led fairly quickly to the London merchant banks experimenting with foreign currency issues—vide the Belgian loan of May 1963.

In October 1962 the Governor of the Bank of England declared: “The time has now come when the City once again might well provide an international capital market. . . . This entrepôt business in capital . . . would fill a vital and vacant role in Europe in mobilising foreign capital for world economic development.”6 Steps were taken to make the London new issues market more attractive to nonresidents when, in the Budget of 1963, the 2 per cent stamp duty on security transfers was cut to 1 per cent (with effect from August 1963). The issue of bearer securities in London was again permitted though subject to stamp duty (2 per cent on market value for issues by foreigners) if securities were delivered in London. In May 1963 the Bank of England extended the facilities of the London market to certain groups of borrowers to raise funds in sterling, and by October 1963 the Chancellor of the Exchequer announced that foreign currency loans were being “allowed almost without restriction.”

The London market quickly responded to the official invitation to greater international activity, taking good advantage of its position. The institutional structure of the London market is well suited to the issue of loans, and the market has a long tradition in the issuance of overseas loans. There was no question that the issuing houses in London could and were prepared to handle the loans. In addition, British financial connections overseas, particularly in Europe, are based on a correspondent system, not by directly owned representative offices and branches. This system has the benefit of close and continuous contact with the local financial institutions, and the placing of loans with foreign institutions is based on a long-standing customer-banker relationship rather than on a competitive basis. Further, the cost of placing an issue in London is somewhat lower than in continental centers and, on average, no higher than in New York. Finally, London not only provided the advantages of a broad securities market, which could accommodate fairly active trading conditions, but was also the center of the Eurodollar market from which funds could be drawn for use as a float or short-term prop to the long-term dollar bond issues.

These were some of the advantages which gave London an early lead in the sponsoring and underwriting of the issues of foreign currency bonds. The placing of the bonds, however, has always been a cooperative business, and the underwriting syndicates and selling groups are large and international (see below). Gradually the London institutions that had been active in this market lost their lead as the market grew and the type of client changed. The German banks became more actively interested and have often acted as cosponsors. More significantly, U.S. banks have increasingly taken the leading position in the sponsorship of these loans.

A number of developments explain this ascendancy of the U.S. banks. In the first place, many borrowers, particularly Europeans, desired to have their bonds quoted on the New York stock exchange, even though few bonds would be sold immediately to U.S. investors. This required the issuance of a prospectus approved by the Securities and Exchange Commission and virtually full compliance with U.S. corporation and securities law. Obviously the U.S. banks were in the best position to advise and handle such matters. Further, the U.S. banks have built up their European financial connections and, consequently, have greatly increased their placing power with European institutions. Another impetus to U.S. participation in this market came from the growing activity of U.S. corporations, or their overseas financial subsidiaries, in issuing dollar-denominated obligations to foreigners. U.S. borrowers use mainly their New York bankers to handle the issue of their securities abroad.

Broadly speaking, the relatively quick changes in the organization of the market have been due to the need to sell bonds to an international investment public which is fairly small and geographically widespread. Most of the leading sponsoring houses are in New York and London because these centers have a complicated network of overseas bank branches, offices, and close correspondent banking relationships. Both are international banking centers containing many foreign financial representatives. Both have large stock exchanges and provide good and relatively cheap trading facilities. They are, in short, convenient and economical international financial centers which are accustomed to coordinating the task of placing new issues of international securities in a number of different and smaller European financial centers. Neither market provides more than a small part of the funds subscribed to international bond issues. Their coordinating procedures must therefore be efficient. Strong competition for the issuance of international loans prevails among continental financial centers. As the bulk of the bonds is placed in continental Europe, in time London and, to a lesser extent, New York may be bypassed as entrepôt markets. The belated entry of the Swiss banks as underwriters in September 1966 could change the order of importance of the issuing markets fairly quickly. Though London and New York houses often sponsor the issue, the success of the market depends on the cooperative effort of a large number of financial institutions throughout Europe to place the loans with international investors. The organization of the market is more complicated than that of most domestic capital markets, as its main function is to induce foreign investors to take up a wide variety of foreign bonds.

Organization of the Market

The new issue market for foreign currency bonds in Europe is mainly a placement market; no active attempt is made to sell the securities initially on a direct and competitively open basis to the general investing public. All the issues are fully underwritten and initially placed before the loan is announced; the published prospectus is simply an information advertisement to the general public, or a legal requirement to obtain a stock exchange quotation. It is not an invitation to the public to subscribe to the issue. An issue is not brought forward to the market if the sponsors have not succeeded in both fully underwriting it and placing it with the selling groups. General public investment, of course, is possible after the securities are quoted on a stock exchange (usually in Luxembourg and in either London or New York), and an open market is established. The volume of trading in these bonds, however, is not very high; in fact, the low volume might be regarded as a measure of the success of the placement system.

The technique of making the issue follows the New York pattern rather than the usual London pattern, which involves only one issuing house, a group of underwriters, and a broker who is prepared to make a market in the new issue. For foreign currency issues, the pattern is usually as follows: An initial syndicate—normally a minimum of 4 or 5 members, of which 1 or 2 members will actively head the syndicate—agrees to subscribe for the issue at a given price (i.e., the issue price) less a commission of about 2½ per cent. The syndicate then makes arrangements with a group of underwriters—containing perhaps 10–50 members, among them bankers, brokers, and dealers—which agrees to place firmly a part of the bonds at a commission of usually 1½ per cent of the nominal amount of the bonds. The underwriters and the subscribing syndicate itself form selling groups or sometimes act largely as the selling group itself. When the underwriting-selling group sells to recognized security dealers, it can concede ½ per cent of the nominal amount of the bonds from its commission of 1½ per cent. The principal underwriters comprise, in total, about 100 of the leading European banks, of which as many as 50 may be involved in marketing a single issue.

The sponsoring syndicate (or issuing and subscribing consortium) chooses the membership of the underwriting and selling groups, so as to achieve a wide geographic coverage within Europe, and attempts to allocate a specific portion of the loan to each country represented by the underwriting group. Members of the underwriting group of one country are not expected to try to place the bonds in another country; the national tranche of the loan, therefore, is based on the assessed absorptive capacity of the various local markets. Recently, however, the selling groups have tended to crisscross national boundaries, thereby intensifying competition in each market. In addition, the syndicate itself endeavors to arrange for securities to be sold direct to those members of the selling group not represented in the underwriting group, particularly the Swiss banks which were not normally represented as underwriters until September 1966. For this purpose, about 50 per cent of the total issue is often reserved for the leading bank or banks of the underwriting group or for the group itself. In this manner, virtually the whole of the European capital market is tapped for funds, and the careful arrangements in placing the securities are such that the syndicate is assured that the whole of the loan will be taken up. Competition is avoided in the placing of the bonds; at least formally, there is little undercutting of the price of issue and no problem of clearing the market as occurs in New York.7 However, members of the underwriting and selling groups, especially the banks, are often themselves investors. Therefore, they often subscribe for a larger amount of bonds than they intend to hold, and still earn brokerage even if they sell a portion of the newly issued bonds below par; they simply cut their commission rate and allow the lower rate to be reflected in a lower selling price on the market.

The leading members of the sponsoring syndicate are normally drawn from London, New York, Belgium-Luxembourg, and Germany. Generally, the syndicate includes at least a British and a U.S. house; some syndicates have consisted entirely of U.S. houses (particularly for U.S. borrowers) even though the bonds were sold outside the United States. Many syndicates include a leading bank of the borrowing country, particularly for Scandinavian, Japanese, and U.S. borrowers. They rarely included a Swiss issuing house before September 1966, partly because the securities are not usually quoted on Swiss stock exchanges, but mainly because the banks in Switzerland need authorization from the Swiss National Bank to participate in the syndicate or underwriting groups. Authorization by the National Bank is not automatic for this reason: the banks, while acting as underwriters, are firmly committed to support the issue, and this commitment might drain off funds from the Swiss market and cause a rise in domestic interest rates. Furthermore, Switzerland levies a 2 per cent stamp duty on new issues; in addition, it requires foreigners to pay a 3 per cent coupon tax on interest payments. These two taxes add about 1 per cent to the interest rate cost of the issue. The statutory internal taxes effectively discourage Swiss participation—by reducing profits—in the issuing and underwriting of these loans, but not of course in subscribing for the issues underwritten and issued elsewhere.

Underwriting groups are chosen not only for the size of their own resources and capacity to absorb the issues if the need arises, but also for their financial contacts, placing ability, and expertise in forming national selling groups, which in turn will place the issue at a virtually fixed price. The whole efficiency of the foreign currency bond market in Europe rests on the ability to place the bonds, from the outset, in relatively firm hands.

All this does not imply that there is no market for these securities. Most of the issues are quoted in Luxembourg and in London or New York; a few, particularly those having strong German participation and those denominated in deutsche mark as well as other currencies, are quoted in Germany. There are no new issue taxes in London or Luxembourg, and the costs of obtaining a stock exchange quotation are relatively low. Luxembourg has the further advantage that the transfer of securities is tax free. A stamp duty is imposed on the transfer of foreign bearer bonds in London if the bonds are for delivery in London. The rules of the London Stock Exchange do not require, however, that, though transactions in bonds occur in London, the bonds need be physically delivered in London; payment of the stamp duty can therefore be avoided by arranging for delivery of the bonds in Luxembourg. Another important consideration is that, under Luxembourg law, dividends and interest paid by holding (and financial subsidiary) companies registered in Luxembourg can be paid without deducting the withholding tax—an important consideration for many international investors. It is usual, therefore, for almost all the foreign currency bonds to have a Luxembourg quotation or be regarded as a foreign issue of a Luxembourg registered subsidiary or holding company. Although a number of the foreign currency bond issues are quoted in New York, virtually no transactions are made there, mainly because of the incidence of the Interest Equalization Tax.

Foreign currency bonds are quoted on at least two stock exchanges, but little trade is carried out after the first six months of issue; even during the initial period, the bulk of the trade is interbank. Furthermore, much of the interbank trade is handled in an over-the-counter market centered on Zürich, though a leading brokerage house in London also provides extensive dealing facilities. Transactions are based on London and Luxembourg prices.

The foreign currency bond market is essentially a placement market, particularly in the complicated initial selling procedure; nevertheless it is based on the principle of the public new issues market. About 85 per cent of the foreign currency bonds issued between mid-1963 and the end of 1966 had stock exchange quotations. This emphasis on making public issues contrasts with the tendency in New York for a growing proportion of issues (especially of foreign issues before the announcement of the Interest Equalization Tax in July 1963) to take the form of private placements without a stock exchange quotation.8

The preponderance of foreign public issues in Europe denominated in U.S. dollars, compared with similar borrowings through the private placement market in 1962 and the first half of 1963 in New York, might well reflect the relatively limited availability of funds by the leading institutional investors in Europe, many of which are, in any case, prohibited from investing a large proportion of their assets in foreign securities. The public issue technique seems to be necessary in Europe to attract as wide a range of investors as possible and, at the same time, provide a means—through public quotation of the security—by which the securities could be sold or generally marketed if the need arises to dispose of the assets or to attract new potential investors (including U.S. investors at present excluded by the Interest Equalization Tax). A further consideration is that exchange control requirements in some European countries permit the purchase of foreign securities only if those securities are quoted on a foreign stock exchange. The public issue technique, however, is a more costly form of borrowing than privately placing new securities, a fact which presumably accounts for the general trend toward making private placements rather than public issues in New York.

Although bonds are issued for a multitude of borrowers, most of the issues are denominated in U.S. dollars (Table 1). Some bond issues have an option in deutsche mark, or are denominated in deutsche mark or deutsche mark and external account sterling.9 In one issue, the Swiss franc was used as the currency unit for a bond issue made in London in 1963. The predominant use of the U.S. dollar can be ascribed to a number of reasons.

Table 1.

Foreign Currency New Issues on European Security Markets, by Currency Denominated, 1957–66

(In millions of U.S. dollars)

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Preliminary.

First, a number of the borrowers in the foreign currency bond market had been increasing borrowers in the New York market before 1963. They had begun a tradition of borrowing in U.S. dollars, which it was convenient to continue. Second, from both the investor and borrower point of view, securities denominated in U.S. dollars offered a good chance of exchange rate stability. Third, through the operation of the Euro-dollar market and with the relatively large private holdings of U.S. dollars in Europe, the U.S. dollar has been increasingly regarded as a capital investment medium in Europe; it was almost inevitable that this consideration would induce investors to absorb dollar-denominated foreign securities. In short, no other currency is so widely used on an international scale in Europe as the U.S. dollar for both international transactions and international investment. As pointed out above, there were also apparent advantages in having newly issued foreign bonds quoted on the New York Stock Exchange.

A further consideration leading to the widespread use of the U.S. dollar as a capital investment currency in Europe has been the restrictions on, or disadvantages in, the use of some of the leading European currencies.

For example, the deutsche mark has been in relative short supply for nonresidents owing to the prolonged balance of payments surplus and the capital-importing activities of the commercial banks. This currency also is comparatively expensive to borrow. From a long-run borrowing aspect, the relative hardness of the currency also made it an exchange risk in the sense of possible upward valuation against other leading currencies, a fact which would have increased the relative burden of repayment of debt.

As another example, the Swiss franc has been difficult to use outside Switzerland—except for specific loans raised by foreigners on the Swiss capital market—mainly because the Swiss authorities have objected to and resisted any tendency to internationalize the franc. Among other things, they have objected to loans that are denominated in Swiss francs and issued outside Switzerland because of the effect these issues would have on the level of domestic interest rates. It has been claimed, further, that the Swiss economy is too small to support a reserve currency and that the volume of Swiss francs available to nonresidents must, consequently, be strictly controlled (hence the restrictions on the inward movement of capital in early 1964). On the whole the views of the Swiss authorities have been respected.

The Netherlands guilder has not been used because few loans have been directly sponsored by Dutch banks but mainly because the Dutch banks operate extensively in U.S. dollars. The Netherlands monetary authorities have also been reluctant to extend the international use of their currency for many of the reasons which influenced the Swiss authorities. The use of sterling, of course, has been restricted for residents (except through purchase of dollars at a substantial premium), and holders of external account sterling have tended to be also holders of dollars which they have used for investment purposes.

Loans with the option of deutsche mark or sterling have had some speculative attraction in terms of possible long-run exchange rate changes giving an appreciation of one currency against the other to the investor. Recently, however, such optional loans have not been popular with investors nor, for obvious reasons, with borrowers. Neither have the Belgian banks, which have been active in the international bond market, had much success with their experiment of creating a new type of international security denominated in units of account. The U.S. dollar, on the other hand, has been readily accepted as a convenient and cheap medium for long-term capital investment.

Borrowers and Lenders

Distribution of foreign currency loans by country is shown in Table 2 and by type of borrower in Table 3. Europe has accounted for nearly half of the total amount of loans issued since 1957. As a group, the Scandinavian countries, particularly Norway and Denmark, have taken about one fifth of this amount although they were exceeded by the countries of the European Economic Community in 1966. The United States, entering the market only in the second half of 1965, dominated it in 1966 and by the end of the year accounted for nearly one third of the total issued since 1957. International institutions (largely the European Coal and Steel Community and European Investment Bank) have borrowed steadily, accounting for roughly 8 per cent of the total. Japan was a large borrower only in 1964. Together these countries, predominantly industrialized or with high per capita income, have taken more than four fifths of the total; less than 2 per cent has gone to the less developed countries.

Table 2.

Foreign Currency New Issues on European Security Markets, by Country of Borrower, 1957–66

(In millions of U.S. dollars)

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Preliminary.

Table 3.

Foreign Currency New Issues on European Security Markets, by Category of Borrower, 1957–66

(In millions of U.S. dollars)

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Preliminary.

A number of reasons may be advanced for the heavy borrowing by the comparatively rich, industrialized countries. A common feature was their reliance on the New York market, from which they, though not the less developed countries, were excluded after mid-1963. Denmark borrowed heavily in 1964 to encourage a long-term capital inflow as a means of building up international reserves, as well as to obtain lower interest rates than those prevailing in the domestic market. Norwegian borrowing resulted from the continuing and large-scale investment boom, particularly in capital intensive industries, at a time when domestic credit was directly rationed. Borrowing by Belgium reflected, in part, the Government’s long-run policy of borrowing abroad for budgetary reasons. Italy, Japan, and some of the smaller countries found it considerably cheaper to borrow abroad than to finance their investment demands at home. The United States entered the market largely as a consequence of the application of guidelines by the U.S. authorities to U.S. foreign investment abroad.

By category of borrower, nearly half the total of issues has been on account of private industrial and commercial borrowers; the proportion increased sharply once the U.S. corporations became heavy borrowers. The international institutions have borrowed only slightly less than the central governments, mainly those of Norway, Denmark, and Belgium. Other public sector borrowing on behalf of local authorities or state enterprises and publicly owned utilities has accounted for nearly one fourth of total borrowing.

The bulk of all loans issued, including over 10 per cent of the commercial and industrial issues, have some form of state or central government guarantee attached to them; consequently, the market is characterized almost uniformly by high-quality paper. If a guarantee is not possible, as on loans to international institutions, the indirect backing to the borrower is sufficient to give the paper a high-quality rating. Though most of the industrial and commercial issues do not have government backing, the bond issues (e.g., those of overseas U.S. corporations) are commonly unconditionally guaranteed by the parent companies, many of which command the highest investment rating. Nevertheless, concessions are made to subscribers of industrial issues in the market, not only in the form of higher interest rates and more currency options but also in the issuance of convertible debentures having attractive conversion rights into common stock or equity in the future. The technique of issuing convertible debentures was used mainly by Japanese firms in late 1963 and early 1964 and by U.S. firms in late 1965 and the first half of 1966.

As pointed out above, the market for foreign currency issues is overwhelmingly a bond market. Only five small issues of equities have been handled through this market, and these represented about 2 per cent of the total funds raised. This proportion will rise, of course, as subscribers to convertible debenture issues exercise their right of conversion. Although the average quality of the bonds issued has been comparatively high, the average size of the bond issues has been less than $18 million. Maturity of the bonds issued has ranged from 3 to 25 years and has averaged about 12 years. In no sense, therefore, has the market been burdened with overlong maturities or overhung with large stocks of single issues. The relative small size of issue and short maturity (characteristic of a placement market) reflect, in part, the geographic spread of the market. It thus seems to be an exceptionally favorable market for investment—offering a wide variety of guaranteed bonds and attractively priced convertible debentures, virtually free of tax, with high yields and public quotations. Furthermore, the noninterest rate concessions granted by the borrower, in the interests of making a market, seem fairly generous.10

Nevertheless, investors have not been readily forthcoming, and the market has developed to its present size only by patient and continuous expansion of the range of investors through extending the range and number of the sponsoring and underwriting consortia. In terms of number and size of issues, the market has at times been overpressed with consequent short periods of virtual standstill in placing new issues on the market. These periods of “indigestion” tend to confirm the view that there is relatively little use of short-term funds, particularly Eurodollars, in continuously supporting successive bond issues. Furthermore, the system of placing bonds firmly from the outset would militate against appealing to investors dealing in largely short-term funds.

Although there are strong indications that the source of funds used in the foreign currency new issues market is not, on any extensive scale, the Euro-dollar market,11 it is difficult to determine quantitatively where the investment dollars come from. The Euro-dollar market, however, does play some role; for example, the two $20 million, three-year loans for the Government of Belgium in 1963 were directly subscribed for in Euro-dollars, as was a similar loan issued in mid-1966. Furthermore, those underwriters unable to unload their bonds at agreed prices often prefer to extend their commitments until bond prices improve, and they tend to carry their inventory of bonds with the use of Euro-dollars borrowed at relatively short-term. To this extent, the Euro-dollar market provides a useful ancillary source of funds. The relationship between the foreign currency bond market and the Eurodollar market is essentially two way.

Apart from the Euro-dollar market, five main sources of funds can be drawn upon to finance foreign currency new issues. First, countries running a surplus on their international accounts may invest funds in the United States, or in the foreign currency new issues market, or, if short-term investment is desired, in the Euro-dollar market. An important source of such funds, which are generally invested long term, is likely to be the Middle East rather than the European dollar-surplus countries (e.g., Italy), which prefer to invest short term in the Euro-dollar market.

A second source of funds may become available from nonresidents (and, possibly, some U.S. residents) switching out of relatively low-yielding U.S. domestic securities into higher-yielding foreign securities denominated in dollars, particularly when (as in issues of overseas subsidiaries of U.S. companies) the quality of the security is comparable. Many U.S. corporate stocks now have two market quotations, and the temptation to switch funds from the low-yielding New York stock to the high-yielding European stock is strong. U.S. balance of payments statistics suggest such switching became fairly substantial as soon as U.S. corporations began to issue securities abroad.12

A third source of funds may be found in countries which retain their privilege of borrowing comparatively cheap dollars from the United States (and, again, U.S. residents themselves), and reinvest dollars in the foreign currency bond market. To some extent, this applied to Canada until certain foreign bond issues specifically excluded Canadian investors; in March 1966 the Canadian authorities requested 450 Canadian financial institutions not to subscribe to foreign dollar bond issues.

The fourth main source of funds is the traditionally famous, and possibly much exaggerated, but constantly replenished, pool of flight capital from the politically disturbed and economically mismanaged parts of the world which finds refuge and income in certain European countries.

The fifth, and potentially the most important, source of funds is “subscribers. . . . mainly residents of continental [European] countries, [who] simply convert domestic currencies into the necessary foreign exchange, thus indirectly affecting the central reserves.”13 Few countries on the Continent have regulations that impede the flow of international direct or portfolio investment, and, from the viewpoint of the national monetary authorities, foreign currency bond issues are a type of international portfolio investment. Broadly, then, the main sources of funds for investment in the foreign dollar securities market are the structural balance of payments surplus countries, countries experiencing capital flight, and the central official reserves of, mainly, continental European countries.

It is impossible to state accurately the extent to which each of these sources contributed funds to the foreign currencies issues market. It is also difficult, though something can be said, to analyze the broad geographical distribution of the initial investors. The foreign currency bonds are not yet old enough for a close analysis of data held by the paying agents to be worthwhile, and initial purchases of the bonds—for which data are not publicly available—are not necessarily good guides to discovering the eventual and firm distribution of the bonds. National balance of payments data are not much help in this matter.

Some notion of the initial distribution of the issues can be gleaned from the remarks of market commentators made at the time of issue in the press and elsewhere. Further sources of information are the comments of bankers and market operators on the functioning of the international bond market. Table 4 contains some rough guesses as to initial subscribers, based mainly on press comments at the time of the issues. Taking London first, it is generally believed that some London-based dollars are used in the foreign currency bond market there; for example, three Belgian Government loans were taken up in Euro-dollars and were largely absorbed in London with the residue of the first two loans taken up by Canadian banks.

Table 4.

Estimated Initial Sources of Funds in the Foreign Currency New Issues Market, 1957–66

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This sort of operation seems rare, but dollars—Euro- and “official”—are used in the foreign currency securities market mainly to provide a float to allow brokers to take up a certain volume of bonds and thus be in the position to make a market. Owing to the thinness of trading in the foreign currency bond market, it is impossible to ensure a ready and quick sale of the bonds; initial subscribers, therefore, must expect to have to hold the bonds for some time after the time of issue. The periods of “indigestion” which arise in the market are largely the consequence of the failure of long-term investors to be continuously in the market and the reluctance of other investors to overcommit themselves with the use of funds borrowed at short term. However, given the relatively small amount of trading and the necessity of allowing the brokers to deal readily in the bonds, officially owned dollars are made available to the London market on a six-month basis for the purpose of making a market. After six months, the dollars have to be returned to the Bank of England, and the brokers then have to borrow Euro-dollars or purchase dollars by paying the dollar premium if they continue to hold bonds.

The same considerations apply to other potential London-based investors intending to make a long-term investment in the securities. The supply of dollars to finance the issues must be found outside the official pool of dollars in London—this means purchasing investment dollars at a premium, using Euro-dollars, borrowing dollars from New York, or selling already owned foreign currency assets. Taking into account the cost of obtaining dollars through these means, the U.K. tax on unearned income, and the relative bond rates in London, the London investors have little incentive to purchase any straightforward foreign currency bond issue. Indeed, it is believed that only nominal amounts of the “straight” bond issues have been bought for long-term investment. On the other hand, issues of convertible debentures (e.g., those of Japanese companies in late 1963 and U.S. corporations in 1965–66) or bonds with some equity rights attached (e.g., the Istituto per la Ricostruzione Industriale issue in London in July 1964) are believed to have attracted London investors. It is improbable that British reserves were used to finance the limited domestic subscription for these issues, particularly as, for example, two British investment trusts raised $19 million in New York in 1964 to invest in dollar securities and apparently used part of these to acquire some of the European dollar issues. In total, then, the London subscription—including the Euro-dollar loans but excluding the use of “float dollars”—is not likely to have exceeded 5 per cent of the total volume of bonds issued.

Participation from the outer sterling area has probably been on a larger scale. By far the largest and continuous investors of the sterling-using countries are believed to be the Middle East countries, which possess large quantities of sterling and dollars and are known to be following a policy of diversifying the currency element of their reserves and investments. Furthermore, these countries are particularly attracted by the tax-free advantages in holding foreign currency bonds. Middle East participation in this market is difficult to assess largely because some of the funds are invested through Swiss intermediaries. Nevertheless, there is also direct “official” investment, and, perhaps, $225 million is a reasonable minimum figure for such investment.

The Hong Kong market—through the free dollar market there—has also provided funds for investment in European issues of dollar bonds. The issues of bonds on behalf of Japanese borrowers have been relatively attractive to Hong Kong investors, and since Hong Kong banks are traditionally large-scale dealers in U.S. securities, presumably they took up some of the convertible debentures issued by U.S. corporations. Conceivably as much as $65 million was invested. It is impossible to estimate how much of this amount represented genuine Hong Kong investment and how much came from outside the sterling area and the remainder of Southeast Asia for investment through Hong Kong banks. Hong Kong plays a role in the Far East similar to that of Switzerland in Western Europe, though on a smaller scale, as a channel for acquiring effectively tax-free investments.

From early 1965, financial trusts and other monetary institutions established in the Bahamas have been reported to be interested in subscribing for high-yielding international bonds—including foreign currency issues. Buying has been reported in the press as persistent, though not on a large scale; further, some institutions in the Bahamas were receiving funds direct from the larger capital markets and simply reinvested these funds. It is unlikely that the Bahamas supplied investment funds of over $115 million.

In all, sterling area investment in these bonds may have amounted to $605 million, or about 17 per cent of the total. It needs to be reiterated that this amount did not necessarily represent the extent of the drain from sterling area reserves, as some capital was “imported” specifically for reinvestment in assets denominated in non-sterling currency. Rather, the relatively high rate of investment in these bonds might measure the importance of London, Hong Kong, and the Bahamas as entrepôt money and capital markets.

Press reports and market commentaries also suggest considerable North American buying of bonds issued, particularly the convertible debentures issued by U.S. corporations, up to about March 1966. A fairly frequently mentioned figure for Canadian buying has been about 10 per cent of the total of issues made up to the end of March 1966. It has also been thought that some U.S. residents had invested in some of the outstandingly attractive convertible debenture offerings of the U.S. corporations abroad. As a best guess, then, North American subscription for new foreign currency bonds could well amount to about $340 million.

The bulk of the foreign currency issues floated in Europe in 1957–66 were absorbed by European investors. On the basis of initial subscription, it seems that Belgium (with Luxembourg), the Netherlands, and Switzerland were the most important investors. The issues denominated in units of account were particularly popular in Belgium; two Belgian banks played the leading part not only in developing this type of issue but also in sponsoring and underwriting the issues. In all, it is believed that Belgium and the Netherlands between them absorbed slightly more than 10 per cent of the total issues denominated in foreign currencies—or about $395 million. This estimate would also accord with their participation in the underwriting and selling group arrangements in arranging the flotation of the securities.

A large proportion of the foreign currency issues was on behalf of Scandinavian borrowers—outstandingly Norwegian and Danish. Scandinavian investors are also believed to have subscribed for part of the issues, but their participation has tended to increase after the bonds have been issued. Scandinavian banks, however, have been active members of the managing syndicates for those loans issued by Scandinavian borrowers. Nevertheless, it is unlikely that initial Scandinavian participation exceeded $100 million of the total issued.

Germany is a further source of funds for investment in these bonds. German banks participate quite actively in the underwriting and selling group arrangements of the bond issues. In terms of domestic interest rates, however, the bonds are not attractively priced, and domestic German investment is believed to be rather low—perhaps only $30 million of the foreign currency bonds issued since 1957. It has been estimated that German investors had absorbed not more than 50 per cent of the foreign issues floated in Germany up to the end of 1964. It is unlikely that domestic investors have subscribed for any issues yielding less than 6 per cent or that German residents bought any foreign bonds in 1965 and 1966. German capital centers, like London and New York, have, in practice, an important business in floating “transit loans.” Indeed, as a means of attracting foreign capital, German companies have established overseas affiliates—usually in Luxembourg—for the express purpose of issuing bonds to foreigners who would thereby avoid paying the German withholding tax. French and Italian investment, particularly since early in 1966, has increased markedly, and Italy is now a significant factor in determining the future supply of funds in the market; together they might have absorbed as much as $275 million of new issues.

Switzerland is regarded as the most important single investor in the foreign currency bond market. It has been estimated that 40 per cent of each issue was directly subscribed for on Swiss account, but the actual participation was likely to be higher. During the course of 1966 the Swiss banks reduced their direct subscription quite markedly until in September 1966 they entered the market as formal underwriters and, on that basis alone, tended to take about a third of an issue. Assuming this estimate to be near the mark and taking into account a substantial non-European residual item, then about $1,805 million was absorbed on Swiss and on non-European accounts (most of which would have been activated through Switzerland), or about 50 per cent of the total. It is impossible, however, to estimate the extent of Swiss subscription on behalf of Swiss residents and on behalf of nonresidents. Switzerland is considered a “tax haven” country and is also the recipient of a great deal of flight capital—not all of it on short-term account. It is improbable, however, that the bulk of investment was on Swiss domestic account. The estimated volume of relatively liquid nonresident funds has been put at about Sw F 9.5 billion at the end of 196314 (compared with Sw F 7.0 billion at the end of 1960), and it is likely that the large Swiss subscription reflects the investment of long-term flight money resident in Switzerland (including funds switched out of securities quoted in Switzerland), the investment of funds sent into the country specifically for the purpose of buying international bonds, and finally—and possibly least—foreign investment by Swiss individuals and institutions.

Structure of Interest Rates

Except for Switzerland, the foreign currency new issues market is, from the point of view of interest costs, about the cheapest source of international long-term capital raised in the form of issues of securities. As shown in Chart 1, the average interest cost of foreign currency issues is very close to interest costs charged in New York in 1963 and 1964, and falls below the New York average in 1965 and 1966. The high yields on new foreign issues in New York in 1965 and 1966, compared with new issue yields on the foreign currency market, can be largely explained by the growing difference between the borrowers in New York as a result of the Interest Equalization Tax and those on the foreign currency issues market. The comparative cheapness of Switzerland as a source of long-term funds for foreigners is strikingly clear. Only Japan and Norway have needed to offer, mainly in 1964, slightly higher yields in the foreign currency new issues market compared with the interest costs of their foreign borrowing elsewhere, particularly in Germany.

Chart 1.
Chart 1.

Structure of Yields of Foreign Issues, by Category of Loan, 1962–66

(In per cent per annum)

Citation: IMF Staff Papers 1967, 001; 10.5089/9781451956191.024.A002

Among the countries listed as borrowers in the foreign currency bond market in the Appendix, Table 5, only Norway, Sweden, Portugal, Switzerland, and the United States found it relatively more expensive to borrow in the foreign currency bond market than at home.15 In some countries (e.g., Belgium, Denmark, Germany, Japan, and the United Kingdom) the differential between the higher cost of borrowing at home and the cost of borrowing abroad up to late 1965 exceeded 1 per cent. Since early 1966, with the general equalization of interest rates within Europe (except Germany, which has maintained its differential) and with the very rapid rise of long-term interest rates in New York, differentials have narrowed considerably. In short, there have been strong interest cost incentives to utilize the foreign currency new issues market.

The relatively low yield on foreign currency issues is, on the surface, somewhat surprising, particularly in the light of the increased mobility of even long-term funds between the European securities markets. The market has grown, largely as a result of administrative actions by various governments (United States, Germany, Switzerland, and the United Kingdom) to insulate their markets, which are the leading international securities markets. To the extent that the market has grown because of restrictions, it can properly be called a “parallel” market and might be expected to disappear when these restrictions are removed. A characteristic of this kind of market, however, is that it is usually less efficient. That is, its costs are usually higher than those in the more permanently based securities markets, which function on a more or less continuous flow of investible funds and proffered securities. The permanence of their institutionalization generally gives them an advantage over a market which has grown in consequence of a conscious attempt to rechannel or cut off the flow of funds from their previous course. Usually, the costs of dislocation are relatively high.

Operations of the foreign currency new issues market, however, seem to show the opposite (as does the Euro-dollar market in comparison with other short-term money markets). This market has managed to attract a stream of investors prepared to take up issues at yields averaging less than those prevailing in most of the leading international capital markets. Part of the explanation of this phenomenon would seem to be that almost all the issues are free of income or withholding tax of the borrowing countries, and since most bonds are issued in bearer form and held outside the country of the investor, domestic income taxes can also often be avoided. The gross yields on such securities can for practical purposes be regarded as virtually tax free, giving a relatively high net yield compared with net yields elsewhere. A further explanation is that the relatively low interest costs in this market is due partly to the generally high creditworthiness of the borrowers themselves. Many of the countries represented in the list of borrowers in the foreign currency new issues market are generally regarded as prime borrowers in the international capital markets and can therefore command the lowest interest costs. Because of the greater element of risk for industrial and commercial issues, these issues are often made more attractive in the form of convertible debentures (such as the Japanese issues in 1963 and 1964) or have currency options (such as some Finnish and Swedish industrial issues). In short, the different rating for many borrowers often takes the form of special inducements rather than of large discrepancies in interest costs and yields.

Still another explanation is to be found in the general management of the new issues market. Because of the widespread use of the placement technique and the relatively careful regulation of the pace at which issues are brought forward, the periods of a heavy overhang of securities in the market are few and relatively short. Consequently, there is no need to throw large blocks of securities on the market to meet the requirements of new borrowers wishing or able to persuade issuing houses to handle a loan on their behalf.16 In any case, cooperation between the various financial houses handling the new issues seems to take the form both of regulating the flow of issues—presumably because most of the issuing houses appeal largely to the same group of investors whose support in taking up the issue is crucial to the issuing house in handling the loan in the first instance—and of initially absorbing the whole new issue as it comes on the market. Additions to the supply of bonds are restricted and issue prices are carefully tailored to a specific and reasonably small investment clientele.

Two further points, however, are of some significance in helping to explain the relatively low bond yield in the foreign currency new issues market. One point is that the restrictions imposed by the Swiss authorities in early 1964, together with the imposition of the withholding tax on foreign ownership of domestic securities in Germany also in 1964, effectively reduced the supply of securities which had been heavily bought by international investors. The introduction of a withholding tax on foreign-held German securities led to a substantial reduction in nonresidents’ holdings of such securities and to some switching into foreign securities denominated in deutsche mark, which are not subject to tax. Foreign demand for foreign issues in both Switzerland and Germany pushed yields so low that, by the first half of 1965, yields on foreign securities in Switzerland and Germany averaged less than on domestic securities. This situation has continued in Germany, though not in Switzerland.

The second point is that the U.S. monetary authorities have not imposed any restrictions on the use of the dollar as an international currency. Since the U.S. dollar does not seem to have lost any of its attractions as an investment currency for private holders, foreigners can deal easily in dollar issues quoted in New York or elsewhere. This ability of foreigners to switch between New York and other centers has helped greatly to determine and stabilize interest rates and yields in the foreign currency bond market. The yield in New York on foreign issues is, in a broad sense, the effective minimum yield which could be offered to investors in the foreign currency new issues market. If yields in the foreign currency bond market fell below the yields for comparable foreign securities in New York, foreigners would tend to buy outstanding foreign bonds in New York. Furthermore, net yields on foreign securities quoted in New York are, on balance, higher than those on foreign issues in Switzerland and (since the imposition of the withholding tax) those on domestic issues in Germany. An important alternative investment for those holding U.S. dollars without wishing to convert them or invest them at long term is the Euro-currency markets; in fact, long-term yields in the foreign currency bond market tended to be about 1.25 to 1.50 per cent above the three-month U.S. dollar deposit rate in London although the sharp rise in Euro-dollar rates since May 1966 has changed this relationship. In general, the main high-yielding investments denominated in U.S. dollars and available for foreigners—yields on foreign securities in New York and Euro-dollar deposits in Europe—provide a maximum price for new issues of securities denominated in U.S. dollars.17 Swiss financial institutions, however, have absorbed, on average, about half of the foreign currency bond issues, and the yields on foreign currency bonds must also be sufficiently attractive in relation to yields in the Swiss market (more particularly since early 1964 in relation to the yield on foreign securities in the Swiss securities market). Again yields on new issues in the foreign currency bond market have averaged about 1.25 per cent above yields on comparable bonds in the Swiss market (though, again, this margin widened considerably during the first half of 1966 as a result of the extraordinarily sharp rise in Euro-dollar deposit rates), or about the same margin as with the interest rate on three-month dollar deposits in London. (See Appendix, Tables 68.)

The significant determinants of a minimum rate in the foreign currency bond market would seem to be, then, the ruling interest rate on foreign securities in New York and a margin of about 1.25 per cent above foreign issues in Switzerland. It is probable, given a continued stream of new foreign issues in Switzerland and active Swiss investor participation in international issues and in contrast to the consequences of the “freezing in” effect of the Interest Equalization Tax in New York,18 that the key determinant of the yield on new foreign currency issues is the yield on foreign securities in Switzerland plus a margin which is likely to vary in accordance with changing investment opportunities in other foreign markets—but especially in markets dealing extensively in U.S. dollars (i.e., the Euro-dollar market and New York itself).

The gap between the yields of foreign issues in New York and Switzerland, however, has not significantly widened between 1963 and 1966. Both markets, therefore, have continued to exercise their influence on the foreign currency bond market, partly because most new issues in the foreign currency bond market are aimed specifically at Swiss investors, and the yield on foreign currency issues has risen with the rise in yields on foreign securities in Switzerland and New York. The yield on foreign currency bonds (and the attraction of favorably priced convertible debenture issues) has not been unattractive to an extent that would encourage international investors to take up assets denominated in alternative currencies or place funds in the Euro-dollar market.19 That yields on foreign currency bonds have not, on the whole, needed to be higher than a comparable foreign bond in New York is a measure of the thoroughness with which the European market has been tapped for funds and the still strong private investor demand for assets denominated in U.S. dollars.

If the pattern of alternative international investment opportunities changes drastically, however, under the stress of generally rising interest rates, the position and importance of the foreign currency bond market is likely to shift in the sense that borrowers rather than lenders will tend to withdraw from the market. (No such change took place through 1966; hence the market continued to expand.) If lending rates are determined mainly by yields on foreign securities in New York and Switzerland, borrowing rates are determined largely by the cost of money in the domestic market of the borrower and/or in the foreign market in which the borrower intends to invest. Given the risk of borrowing in a foreign currency and taking into account a relationship between the relative profitability of domestic investment and domestic money interest costs, it might be preferable, under conditions of high and rising international interest rates, to borrow domestically rather than abroad.

How far rates in the foreign currency bond market could rise above what has here been called the minimum rate will depend, to a very great extent, on the trend in Euro-dollar deposit rates (the most obvious short-term dollar investment outlet). If the rise in interest rates in the Euro-dollar market is considerable and sustained and if the level of Euro-dollar rates tends to exceed the level of short-term and long-term rates in various domestic money and capital markets, it is very likely that the whole pattern of international portfolio investment will change. The higher the level of Euro-dollar rates, the more likely that the structure of interest rates in the foreign currency bond market will be influenced more by Euro-dollar rates than by long-term rates for foreign securities in New York and Switzerland. Under these conditions, the flow of new issues on the foreign currency bond market could dry up while interest rates—or effective yields—are likely to remain high. The elasticity of substitution of borrowers between domestic and the foreign currency bond markets is likely, at generally high levels of interest rates, to be high.

Conclusion

It has been argued in this paper that the main basis for the growth of the foreign currency bond market has been the asymmetry between the relative tightness of controls on the issuance of new foreign securities on domestic security markets and the relatively loose controls on international portfolio investment by residents of most of the countries in Western Europe and, until August 1963, of the United States. As a result of this asymmetry, attempts have been made to widen the international new capital issues market by arranging for new foreign issues in a manner which could be regarded as nonresident for both borrower and lender. An important impetus to this development came from an attempt by London, with official encouragement, to assume the role of an entrepôt capital market, an attempt greatly stimulated by the announcement of an Interest Equalization Tax on borrowing in New York by the developed countries. The use of a currency other than sterling was an essential prerequisite—in order to safeguard international reserves in the United Kingdom—to the development of London as an entrepôt capital market. In this manner the institutional structure of the capital market of one reserve currency country was geared to the currency of another reserve currency country. The U.S. dollar was used because it is probably the most widely used currency in Europe for the purpose of international investment and is most readily available in large amounts within Europe itself.

Further developments in the organization of the market, especially the emergence of New York, German, and Swiss markets as entrepôt new issue centers and the use of external account sterling, deutsche mark, and Swiss francs as currency denominations for bond issues, have been, essentially, elaborations of the original technique. The denomination of bonds in hard currencies has also probably increased investor confidence in acquiring foreign bonds.

The widespread use of the process of issuing foreign currency bonds, however, has introduced a new element of fluidity into the structure of European capital markets and in the international mobility of long-term funds. Conceptually, a new issue of foreign currency bonds is comparable in its effects on the level of domestic saving as an ordinary foreign issue on an individual European security market—or, indeed, comparable in its effects as the long-standing habit of European investors to acquire a portfolio predominantly of outstanding international securities. To some extent, therefore, the foreign currency bond market could have drained off savings from various individual European capital markets. It is unlikely that such a “drain” has had significant effects on individual domestic markets for two reasons: First, European countries have themselves been the most important group of borrowers in this market, and no individual European country except Switzerland has been a heavy lender in the market. Further, it would be reasonable to infer that one of the chief consequences of the growth of the foreign currency bond market has led to a redistribution of capital resources within Europe which might well have had some equalizing effect on the level of European interest rates. Secondly, on the basis of very tentative estimates regarding the initial subscription of these bonds, it would seem that the new international bond market has been supported to a considerable extent by long-term funds from outside Europe. On both grounds, it could be said that the foreign currency bond market not only has led to an international redistribution of long-term capital on market criteria but also has tended to augment the stock of long-term investible funds by mobilizing funds (European and other) that might well have remained in official stocks or in other forms of short-term investments. In this sense the market—by mobilizing and channeling funds for long-term investment—has been an important addition to the structure of the world’s capital markets.

The foreign currency bond market has, in essence, been grafted onto the present structure of European capital markets. It would be difficult to conclude that the development of the foreign currency bond market has had anything more than an informal integrative influence on the European markets. Those markets are still fragmented. From some points of view, they have become more so since 1964 with the onset of new controls on the working of some of the leading security markets. Indeed, the foreign currency bond market has developed largely in consequence of some of those controls and, to that extent, bears a relationship to the domestic capital markets in Europe similar in kind, if not in degree, to the relationship that the Euro-currency money markets bear to the domestic money markets in Europe.

It would be extremely hazardous to forecast either the future growth or demise of this new international bond market. The Euro-dollar market has grown rapidly despite the changes in some of the conditions, particularly the level of U.S. short-term interest rates, which gave rise to it. The foreign currency bond market has already established itself as a useful, relatively inexpensive international capital market in which to operate. Its successful growth can be partly explained by the thorough way in which international investors have been encouraged to place funds in this market. It is unlikely that the complicated organizational structure which has been built up to achieve this end will be dismantled as controls on various capital markets—especially New York—are removed.

Future growth might well turn more on the continued attraction of the market for high-grade borrowers rather than ensuring a steady, though probably not spectacular, stream of investible funds. The traditional international investor, particularly those who desire to denominate their assets in U.S. dollars, have as an alternative to investment in the foreign currency bond market the vast array of securities available in the U.S. securities market and, for short term, the Euro-dollar market. International borrowers, however, have a greater range of alternative sources of funds, particularly the domestic markets in which they intend to invest as well as the older international capital markets like Switzerland and New York. Through 1966, interest costs in the foreign currency bond market did not exceed (with few exceptions) those prevailing in most leading domestic security markets.20 If, however, a fairly large discrepancy should arise between bond yields in the international market and in various domestic markets, borrowers might switch their sources of funds. The extent to which international interest rates (both short-term and long-term) can and do move independently of domestic interest rates in important money and capital markets has been no part of this paper; but the consequences of large-scale changes in the structure of interest rate differentials both within and between national markets have profound significance for the development of emerging and seemingly independent international money and capital markets.

APPENDIX

Table 5.

Structure of Yields of Foreign Currency New Issues on European Security Markets, by Country of Borrower, 1963–66

(In per cent per annum)

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Preliminary.

Table 6.

Structure of Yields of Foreign New Issues in New York, 1963–66

(In per cent per annum)

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Preliminary.

Table 7.

Structure of Yields of Foreign New Issues in Switzerland, 1963–66

(In per cent per annum)

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Preliminary.

Includes an international issue made elsewhere.

International Bank for Reconstruction and Development and Inter-American Development Bank.

Includes one finance company and two investment companies, two of the issues denominated in deutsche mark.

Includes international issue by Government of Portugal.

Includes industrial bond denominated in deutsche mark.

Table 8.

Structure of Yields of Foreign Issues, by Category of Loan,1 1962–66

(In per cent per annum)

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Figures in parentheses are redemption yields of a selection of outstanding bonds in the market; the remainder are redemption yields on new issues. The selection of bonds already outstanding was based largely on borrowers who also used the foreign currency new issues market. The new issues yields for New York (which exclude Canadian borrowers) are influenced by the changes in the type of borrowers who used the New York market after the announcement of the U.S. Interest Equalization Tax; the yield on outstanding bonds on the New York market is influenced by the high credit standing of borrowers using the market before the imposition of the Interest Equalization Tax; owing to the restricted supply of such bonds, their price has kept up remarkably, leading to a considerable gap between the average yield on new foreign issues and yield on outstandings.

Preliminary.

Includes part of the $20 million loan for Portugal at 5¾ per cent taken directly by the Swiss banks; the bulk of the issue, however, was underwritten through the London market.

Largely Inter-American Development Bank, IBRD, and European Coal and Steel Community.

Largely European Coal and Steel Community, European Investment Bank, and Council of Europe.

Largely European Coal and Steel Community and IBRD.

Emissions en devises sur les Bourses européennes

Résumé

Le présent article décrit la croissance et l’évolution d’un secteur du marché international des capitaux spécialisé dans l’émission de valeurs libellées en monnaies différentes de celles des souscripteurs, et fréquemment, des émetteurs eux-mêmes. Ces émissions sont lancées sur des marchés de capitaux — principalement Londres et New York — qui ne fournissent virtuellement aucune des ressources d’épargne absorbées par les nouvelles émissions dont le marché est connu sous le nom de marché des nouvelles émissions en devises. On a prétendu que ce marché devait son existence aux contrôles relativement sévères qui régissent l’émission de valeurs étrangères sur les marchés nationaux des capitaux, et la souplesse des contrôles qui s’exercent sur les résidents qui achètent des valeurs étrangères à l’extérieur. En faisant jouer à certains grands marchés des capitaux le rôle d’entrepôts, il est possible de considérer une nouvelle émission libellée en une monnaie “étrangère” comme non-résidente à la fois du point de vue du souscripteur et de l’émetteur, et d’éviter ainsi les problèmes que posent différentes catégories de contrôles.

L’article décrit la structure institutionnelle du marché et les modalités de lancement des nouvelles émissions, et souligne la complexité des arrangements internationaux auxquels il faut normalement avoir recours pour assurer le succès d’une émission. Il estime également le volume des nouvelles émissions en devises et l’importance et la nature des ressources d’épargne qui, au départ, ont financé le marché. Il analyse les facteurs qui déterminent les taux d’intérêt sur le marché, et en conclut que le taux d’intérêt effectif minimum sera vraisemblablement le même que celui que le marché de New York applique aux valeurs étrangères de même nature, et d’environ 1,25 pour cent supérieur au taux d’intérêt de valeurs étrangères de même nature cotées en Suisse. Le plafond des taux d’intérêt dépendra vraisemblablement des taux des Euro-devises, et, du fait de la facilité avec laquelle les emprunteurs peuvent passer d’un marché à l’autre, du niveau des taux d’intérêt en vigueur sur les différents marchés monétaires nationaux. En conclusion, l’article estime qu’il se peut très bien qu’à l’avenir ce soit l’attrait que ce marché continuera d’exercer sur les emprunteurs de premier ordre qui en déterminera l’expansion et non les difficultés d’approvisionnement en capitaux.

Las emisiones de valores en moneda extranjera en los mercados europeos

Resumen

Este artículo trata del crecimiento y evolución de un sector del mercado internacional de capitales que se ocupa de lanzar emisiones de valores denominados en monedas distintas de las de los subscriptores y, frecuentemente, de las de los emisores. Dichas emisiones se lanzan en mercados de capital—principalmente Londres y Nueva York—que en la práctica no proporcionan ninguno de los ahorros que se emplean para esas emisiones. A este mercado se le denomina mercado de nuevas emisiones de valores en moneda extranjera. Se sostiene que su surgimiento se debe en gran parte al relativo rigor de los controles sobre las emisiones extranjeras de valores en los mercados nacionales de capital y a la laxitud de los controles que se imponen a los residentes que compran valores extranjeros fuera del país. Al utilizar los grandes mercados de capital como mercados intermediarios, una nueva emisión denominada en moneda “extranjera” puede ser considerada como no residente, tanto por el emisor como por el subscriptor, y de ese modo se pueden eludir los problemas inherentes a los diversos tipos de controles.

También se reseñan la organización institucional del mercado y los procedimientos seguidos para lanzar las nuevas emisiones; se pone de relieve la complejidad de los arreglos internacionales que por lo general es necesario hacer para asegurar el éxito de la nueva emisión. El artículo contiene una estimación del volumen aproximado que alcanzan las nuevas emisiones en moneda extranjera, y también las fuentes que probablemente han suministrado los fondos inicialmente empleados en el mercado. Al analizar los factores determinantes de las tasas de interés que rigen en el mercado se llega a la conclusión de que es probable que la tasa efectiva mínima sea igual a la que prevalece en el mercado de Nueva York para valores extranjeros análogos y que supere a la de los valores extranjeros comparables que se cotizan en Suiza por un margen de alrededor de 1,25 por ciento. Es probable que la tasa máxima de interés dependa de las tasas a corto plazo para los valores en Euro-divisas y, dada la facilidad que tienen los prestatarios para cambiar de un mercado a otro, del nivel de las tasas predominantes en diversos mercados monetarios nacionales. El artículo concluye expresando que es posible que el futuro crecimiento del mercado dependa más de la continua atracción que logre ejercer sobre los inversionistas de importancia que de los problemas de suministro de fondos.

*

Mr. Williams, economist in the Research and Statistics Department, was formerly lecturer in economics at the University of Leeds and the University of Hull, England. He has contributed articles to a number of economic journals.

1

Theoretically, there is little difference between a nonresident buying an American security in New York and a U.S. company issuing securities abroad to be bought by foreigners. Economically, however, the latter transaction might involve the raising of new capital while the former could be regarded as an international transfer of existing assets.

2

The U.S. Interest Equalization Tax is almost unique in its nondiscriminatory application to the purchase of both new foreign issues (with certain exemptions) and outstanding foreign securities other than those held by U.S. residents as of August 1963; its main effect, however, was to virtually freeze the volume of outstanding foreign securities in the New York market.

3

U.S. official balance of payments statistics suggest that a large proportion of new foreign loans issued in New York between 1961 and mid-1963 was actually purchased by foreigners; to this extent New York was becoming an entrepôt capital market.

4

Cf. James C. Ingram, “Unit-of-Account Bonds: Their Meaning and Function,” Moorgate and Wall Street (London), Autumn 1964, pp. 65–80, especially pp. 66–74, and Jean O. M. van der Mensbrugghe, “Bond Issues in European Units of Account,” Staff Papers, Vol. XI (1964), pp. 446–56.

5

Just as in the period before 1914, when few foreign loans issued in London and Paris were denominated in other than sterling or French francs.

6

“Speech by the Governor of the Bank of England,” Quarterly Bulletin, Bank of England, Vol. II (1962), p. 265.

7

The terms of sale of the securities to the selling groups may expressly provide that the selling groups have to hold the new securities for a certain period or incur a penalty of reimbursement of the entire commission.

8

During 1962, non-Canadian noninternational institutions raised $476 million by public issue and $150 million by private placement; in 1963 the corresponding totals were $411 million (excluding a $115 million issue for the Shell Funding Corporation) and $183 million. Indeed, during the first seven months of 1963, only 13 issues were publicly offered for non-Canadian noninternational institutions, but well over three times that number were privately placed.

9

Technically, the German authorities regard all issues denominated in deutsche mark as being ordinary foreign issues made on the German domestic capital market. In effect, however, most, if not all, foreign issues denominated in deutsche mark are sold outside Germany and are priced so that they appeal only to foreigners. They are also sold in the same way as foreign currency bonds. New foreign issues floated in Germany yield, on the average, about 2 percentage points less than domestic bond yields. Since foreign issues denominated in deutsche mark have all the characteristics of foreign currency bonds, they are regarded as such in this paper.

10

In July and August 1966, some significant changes occurred in the manner of tapping funds for the foreign currency issue market. The overseas subsidiary of IBM Corporation arranged a $35 million line of credit from 14 banks in Europe to be used when needed in a period of 3–5 years. Indeed, this technique of arranging credit lines (usually on an overdraft basis) from international consortia of banks, with the credit denominated in various currencies, has expanded rapidly since the IBM arrangement. About 15 such arrangements, involving more than $400 million, have been concluded. Furthermore, a number of formal private placements were made without public quotation (i.e., there was no quotation of the bonds on any stock exchange, and the placements were handled by far fewer financial houses than has been usual in this market). Also, in December 1966, two important banks (Bank of America and Banque de Paris et des Pays-Bas) formed a joint company to issue bonds on the foreign currency market; the proceeds were to be reloaned to customers not willing to make a formal issue themselves. These changes may well be forerunners of fundamental shifts in the form of medium-term financing by public issues.

11

Indeed, the Bank for International Settlements (BIS) has suggested that “it is extremely likely that the proceeds of dollar bonds issued in Europe will, to the extent that they are not required for immediate spending by the borrowers, in the meantime be placed in the Euro-dollar market. Furthermore, the European banks that underwrite these bond issues need to maintain a pool of dollars . . . and that part of it is kept in the Euro-dollar market” (Thirty-Sixth Annual Report (Basle, Switzerland, 1966), p. 142).

12

Cf. Survey of Current Business, U.S. Department of Commerce, Vol. 46, March 1966, p. 28. BIS has suggested that “as much as one-third of the funds raised by these [U.S.] corporations in Europe has been derived from switching out of other dollar securities or diverting potential new purchases from the U.S. domestic market” (loc. cit., p. 51).

13

BIS, loc. cit., p. 51.

14

Total foreign investment in Switzerland at the end of 1960 was estimated at $4.0 billion (Poul Høst-Madsen, “How Much Capital Flight from Developing Countries,” Finance and Development, The Fund and Bank Review, Vol. II, March 1965, p. 27).

15

For Norway and Sweden, the interest cost of borrowing abroad exceeded the cost of borrowing at home by an average of about 0.5 per cent; for Portugal, 1 per cent; and for U.S. corporations (excluding issues of convertible debentures), 1.65 per cent. On this basis, U.S. corporation issues are treated as foreign issues in relation to the New York market, and they have to pay the interest rate broadly applicable to foreign issues in New York, thus incurring a sharp rise in the cost of money which they have traditionally needed to pay. To overcome the high interest cost, U.S. corporations have turned increasingly to issuing convertible debentures with a coupon yield of about 5 per cent. It should also be added that the high-cost money raised by U.S. corporations is generally used to finance their overseas business. Compliance with U.S. guidelines on overseas investment, however, has reduced the profitability of overseas investment to the extent that the U.S. corporations have raised funds abroad rather than export funds from the New York market.

16

There are, of course, periods of “indigestion” in the market, and prices have fallen soon after the issue has been made, particularly in early 1964 and again in late 1965 and early 1966. Up to mid-1966, however, there had been no serious break in prices or obvious overstrain in this market, and it may be premature to introduce, following the proposal by S. G. Warburg, a form of capital issues committee made up of the leading underwriting houses to regulate the pace of issues in the market (The Times (London), March 29, 1966, p. 15).

17

That yields of foreign issues on domestic security markets play an important role in determining the yield of foreign currency issues denominated in particular currencies, or having currency options, is illustrated by the following events: In October 1963 a foreign currency issue, denominated in Swiss francs, was made in London for the City of Copenhagen to yield about 5.06 per cent, and a foreign issue was made in Switzerland for a local authority to yield about 5 per cent. On the other hand, U.S. dollar issues made in London about the same time were yielding over 5.65 per cent, or about the same as the average yield for foreign issues in New York. Issues denominated in deutsche mark or in deutsche mark and sterling tend to yield even more than issues denominated in U.S. dollars. The difference cannot be fully discounted by the higher risk attached to some of the borrowers who had made issues in this form. To a relatively small extent, there is a structure of interest rates in this market, a structure determined in part by the currency denomination of the bonds and in part by the level of yields of foreign issues on domestic security markets.

18

So that most foreign bond issues in New York have shortening maturities.

19

Notwithstanding that the rise in yields on domestic German securities is now higher than on most foreign securities even after payment of the 25 per cent withholding tax in Germany.

20

The rise vis-à-vis domestic securities in New York is the exception, but the relevant comparison is with the yield on foreign securities quoted in New York; in this respect the rise in interest rates on foreign currency bonds has not been out of line.

IMF Staff papers: Volume 14 No. 1
Author: International Monetary Fund. Research Dept.