International Financial Markets Prices and Policies. Second Edition Richard M. Levich. The Eurocurrency Market. Overview

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1 Prices and Policies Second Edition 2001 Richard M. Levich 9A The Eurocurrency Market Historical Overview Overview The Origins of Supply and Demand for Offshore Banking Onshore Banking Regulations Boost the Offshore Market The Offshore Markets Endure Growth of the Eurocurrency Market Chap 9 (A), p. 2

2 The Eurocurrency Market The Eurocurrency market is the market for deposits placed under a regulatory regime different from the regulations applied to deposits used to execute domestic transactions. US$ in London, in Paris, and US$ in NY IBFs It owes its existence to differences in national financial regulation combined with declining barriers to international capital movements. In effect, it is a parallel market in competition with the traditional domestic market. Chap 9 (A), p. 3 Sectors of the International Money Markets Onshore Regulatory Dimension Offshore Currency Dimension US$ U.S. bank deposit U.S. Treasury bills and bonds U.S. corporate bonds Euro-$ deposit Euro-$ bond (corporate and sovereign issuers) U.K. bank deposit U.K. government bonds U.K. corporate bonds Euro- deposit Euro- bond (corporate and sovereign issuers) Chap 9 (A), p. 4

3 The Origins of Supply and Demand for Offshore Banking The Eurocurrency market evolved through a combination of forces. The supply and demand for Eurodollars had always been present. The innovation came in the mid-1950s when banks elected to lend these funds within Europe rather than invest them in the U.S. money market. The demand for Eurodollars further multiplied when the Bank of England restricted the external use of sterling in Chap 9 (A), p. 5 Onshore Banking Regulations Boost the Offshore Market Under Regulation Q, the Federal Reserve established ceilings on the interest rate that banks could pay on deposits. To reduce the U.S. capital outflow, more regulations were imposed in the 1960s: The Interest Equalization Tax (IET) taxes U.S. purchases of foreign securities. The Foreign Credit Restraint Program limits the volume of bank lending with foreigners. Chap 9 (A), p. 6

4 Onshore Banking Regulations Boost the Offshore Market However, these regulations only further encouraged borrowers to investigate the Eurocurrency markets. Provided a cushion of support Regulations removed in 1974 with advent of floating But offshore markets endured, even prospered Illustrates the hysteresis effect, whereby some business practices persist even though fundamentals have changed logic: changing back is costly Chap 9 (A), p. 7 Onshore Banking Regulations Boost the Offshore Market European governments also experimented with capital controls in the 1970s. Both Germany and Switzerland imposed regulations to try to limit the nonresident demand for their currencies. Similarly, these regulations helped to promote the non-dollar segments of the Eurocurrency market. Chap 9 (A), p. 8

5 Growth of the Eurocurrency Market As in the onshore markets, funds are deposited, lent, re-deposited, and re-lent in the Eurocurrency market. The market has grown from essentially zero in 1960 to roughly $9.5 trillion on a gross basis and $5.5 trillion on a net basis in The U.S. dollar is the main currency, while Europe is the dominant region for Eurocurrency deposits. Chap 9 (A), p. 9 Figure 9.2 Dimensions of the International Banking Market Total of Offshore Deposits and Share Denominated in US$ 10, % 9,000 90% 8,000 80% 7,000 70% Billions of US$ 6,000 5,000 4,000 3,000 60% 50% 40% 30% Percentage of Gross 2,000 20% 1,000 10% 0 0% Gross Size Net Size US$ Share (See Right Scale) Chap 9 (A), p. 10

6 Figure 9.3 Euromarket Deposits By Currency (Percentage of Deposits Across All Reporting Countries) 60% 50% 40% 30% 20% 10% 0% US$ Euro Japanese Yen UK Pound Swiss Franc Other Data for 1990, 1993 and 1996 include DM, FFr and ECU only Chap 9 (A), p. 11 The Offshore Markets Endure Even though many of the regulations that initially fostered the market had since been abolished, the Eurocurrency markets have continued to grow and prosper. Today, we describe the innovation that permits the Eurocurrency market to sustain its existence as unbundling - taking the exchange risk of one currency and combining it with the regulatory climate and political risk of another financial center. Chap 9 (A), p. 12