International Financial Markets

Prices and Policies

Second Edition 2001

Richard M. Levich

&

9A

The Eurocurrency Market

Overview
w Historical 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

Prof. Levich

International Financial Markets

Chap 9 (A), p. 2

The Eurocurrency Market

w 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

w It owes its existence to differences in national financial regulation combined with declining barriers to international capital movements. w In effect, it is a parallel market in competition with the traditional domestic market.
Prof. Levich International Financial Markets Chap 9 (A), p. 3

Sectors of the International Money Markets

Currency Dimension US$ Onshore Regulatory Dimension Offshore
U.S. bank deposit U.S. Treasury bills and bonds U.S. corporate bonds Euro-$ deposit Euro-$ bond (corporate and sovereign issuers)
International Financial Markets

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

Prof. Levich

The Origins of Supply and Demand for

Offshore Banking

w The Eurocurrency market evolved through a combination of forces. w 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. w The demand for Eurodollars further multiplied when the Bank of England restricted the external use of sterling in 1957.
Prof. Levich International Financial Markets Chap 9 (A), p. 5

Onshore Banking Regulations

Boost the Offshore Market
w Under Regulation Q, the Federal Reserve established ceilings on the interest rate that banks could pay on deposits. w 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.

Prof. Levich International Financial Markets Chap 9 (A), p. 6

Onshore Banking Regulations

Boost the Offshore Market
w However, these regulations only further encouraged borrowers to investigate the Eurocurrency markets.

Provided a cushion of support

w 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

Prof. Levich International Financial Markets Chap 9 (A), p. 7

Onshore Banking Regulations

Boost the Offshore Market
w 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.

w Similarly, these regulations helped to promote the non-dollar segments of the Eurocurrency market.

Prof. Levich

International Financial Markets

Chap 9 (A), p. 8

Growth of the Eurocurrency Market

w As in the onshore markets, funds are deposited, lent, re-deposited, and re-lent in the Eurocurrency market. w 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 1999. w The U.S. dollar is the main currency, while Europe is the dominant region for Eurocurrency deposits.
Prof. Levich International Financial Markets Chap 9 (A), p. 9

Figure 9.2 Dimensions of the International Banking Market Total of Offshore Deposits and Share Denominated in US$ 10,000 9,000 8,000 7,000 Billions of US$ 6,000 5,000 4,000 3,000 2,000 1,000 0 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Percentage of Gross

Gross Size

Net Size

US$ Share (See Right Scale)

Prof. Levich

International Financial Markets

Chap 9 (A), p. 10

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 1990 1993 UK Pound 1996 1999 Swiss Franc Other

Data for 1990, 1993 and 1996 include DM, FFr and ECU only

Prof. Levich

International Financial Markets

Chap 9 (A), p. 11

The Offshore Markets Endure

w Even though many of the regulations that initially fostered the market had since been abolished, the Eurocurrency markets have continued to grow and prosper. w 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.
Prof. Levich International Financial Markets Chap 9 (A), p. 12