Professional Documents
Culture Documents
CE
No. 125, December 1977
RONALD I. McKINNON
PRINCETON UNIVERSITY
Princeton, New Jersey
RONALD I. McKINNON
PRINCETON UNIVERSITY
CONTENTS
INTRODUCTION
10
14
17
22
27
34
REFERENCES
36
PREFACE
Frank Graham is probably best known for his generalization, from two
to "N" commodities, of Ricardo's theorem on comparative advantage and
international specialization. And his views on world monetary aff airs were
also influential: Witness his imaginative advocacy of a purely interna
tional money in the form of a commodity-reserve currency that would
serve both as a unit of account and as a means of payment in transactions
among nations.
Graham wrote during the financial chaos of the 1930s and 1940s, when
exchange controls and .. restrictions on converting one national currency
into another were rife. He saw his proposal as a way to loosen the finan
cial logjam that was repressing foreign trade and making bilateral barter
commonplace. If national currencies could not be exchanged directly,
perhaps they could be converted indirectly through a genuinely interna
tional money-one whose real purchasing power was guaranteed by its
instant redeemability into one or more major primary commodities.
If he were alive today, how would Frank Graham view the totally un
planned but spectacular growth of the Eurocurrency market? Would he
consider this worldwide and uninhibited use of a few national fiat monies
to be an adequate substitute for his commodity-reserve currency-a plan
for issuing an international money whose real value was solidly anchored?
Readers can make up their own minds after reading this description and
interpretation of the Eurocurrency market.
Introduction
TABLE 1
EXTERNAL PosrnoNs IN DOLLARS AND OTHER FOREIGN CuRRENCIES
OF REPORTING EUROPEAN BANKS FROM EIGHT EUROPEAN CouNTRIESa
Dollars
End of Year
Total
Vis-a-Vis
Nonbanks
Total
Vis-a-Vis
Nonbanks
Deutsche
M arks
Swiss
Francs
Pounds
Sterling
Dutch
Guilders
French
Francs
$ 30.4
47.6
60.4
71.5
98.0
132.1
156.2
190.2
224.0
$ 5.2
6.1
11.9
14.4
18.3
24.7
34.9
40.9
50.8
$ 7.3
10.5
17.9
28.6
33.8
55.5
58.9
68.0
81.3
$ 1.2
2.2
4.7
6.8
8.0
14.0
18.1
20.5
22.7
$ 3.9
6.0
10.1
16.2
20.4
31.4
35.0
41.6
48.7
$ 1.8
3.0
5.1
8.2
7.8
15.0
14.4
15.4
17.9
$0.6
0.6
0.6
1.6
2.2
3.1
2.1
2.0
2.2
$0.3
0.4
0.6
0.7
0.7
1.2
1.9
2.1
3.8
$0.2
0.2
0.4
0.5
0.7
1.8
1.5
2.6
2.6
3.0
4.6
8.1
14.6
19.5
32.0
34.4
39.9
47.2
2.3
4.0
5.7
7.8
8.8
17.2
18.3
15.3
15.9
0.8
0.8
0.9
2.1
2.2
4.6
3.6
3.1
4.0
0.3
0.4
0.6
0.9
1.4
2.3
2.8
3.6
3.5
0.2
0.2
0.4
0.4
Assets:
1968
1969
1970
1971
1972
1973
1974
1975
1976
1975
1976
66.5
74.7
17.4
21.3
22.8
26.9
6.6
7.6
26.9
46.2
58.7
70.8
96.7
131.4
156.4
189.5
230.0
6.2
10.5
11.2
10.0
11.8
17.5
22.2
24.3
29.6
6.8
10.5
16.6
27.0
35.2
60.7
64.3
69.2
80.6
1.5
1.3
2.5
2.7
3.6
5.6
8.1
6.7
9.0
Liabilities:
1968
1969
1970
1971
1972
1973
1974
1975
1976
1975
1976
58.2
64.1
9.4
10.7
19.8
23.7
3.2
4.3
1.1
2.1
2.3
3.4
3.2
TABLE 2
EXTERNAL ASSETS AND LIABILITIES OF BANKS IN INDIVIDUAL REPORTING
COUNTRIES, THE UNITED STATES, THE CARIBBEAN AREA, AND SINGAPORE,
IN Dor-.rnsnc AND FOREIGN CuRRENCIES
( in billions of U .S . dollars
)
Domestic Currency
1976
1974
1975
1976
$ 1.7
2.7
$ 2.4
3.4
$ 32.2
31.3
$ 39.1
37.9
$ 49.4
47.5
1.2
4.4
1.5
3.8
31.8
32.5
39.0
38.1
48.0
48.7
21.0
13.6
25.9
17.4
8.4
7.7
10.6
9.3
14.3
13.7
0.4
1.6
0.3
1.4
12.5
13.6
15.0
15.0
12.3
15.0
3.5
2.2
4.2
4.1
13.4
12.6
17.4
16.4
22.0
19.6
0.6
0.6
0.8
0.7
2.1
1.0
2.6
1.8
2.9
2.3
9.ia
4.68
10.9
5.1
12.3
10.6
16.3
12.0
18.4
15.3
1.7
9.2
1.8
7.1
102.6
111.5
118.2
128.2
138.0
148.6
$31.7
39.4
$39.2
38.9
$47.7
42.9
$215.2
220.8
$258.l
258.7
$305.3
310.7
$ 0.4
1.6
$ 0.5
2.0
$ 0.5
2.0
$ 13.5
11.7
$ 13.4
12.1
$ 17.1
14.6
1.4
0.9
1.5
1.5
2.1
1.9
19.2
24.1
18.8
25.2
19.6
27.2
45.0
59.6
58.3
58.2
78.8
69.8
1.3
0.8
1.4
0.6
1.8
0.8
33.2
33.2
51.1
51.0
74.9
74.1
Belgium-Luxembourg:
Assets
$ 1.7
Liabilities
2.5
France:
Assets
1.1
Liabilities
3.7
Germany:
14.2
Assets
Liabilities
11.3
Italy:
Assets
0.6
Liabilities
1.3
Netherlands:
2.7
Assets
Liabilities
2.1
Sweden:
0.4
Assets
Liabilities
0.5
Switzerland:
Assets
9.2
Liabilities
8.5
United Kingdom:
Assets
1.9
Liabilities
9.5
Total:
Assets
Liabilities
Canada:
Assets
Liabilities
Japan:
Assets
Liabilities
United States:
Assets
Liabilities])
Caribbean area and
the Far East:"
Assetsd
Liabilitiesd
Foreign Currency
1975
1974
These changes, taken together, suggest a shift away from financing thirdparty trade with sterling credits and deposits in London. The natural
beneficiaries were New York banks, which financed trade be tween third
parties using dollars, and TFEB in each of the newly con vertible European
currencies. Indeed, vigorous TFEB has been restored in many European
centers as well as in Japan, where full currency con vertibility came
somewhat later.
Nevertheless, lingeling restrictions on international capital movements
in Europe-with the major exceptions of Germany and Switzerland-and
the sometimes heavy-handed regulation of domestic banking systems in
the form of high reserve requirements, interest ceilings, and arbitrary al
locations of bank credit for domestic purposes often served to limit the
efficiency and flexibility of European and Japanese commercial banks
engaged in TFEB. While subject to much ebb and flow, such regulatory
curbs remain in Europe to the present time and were even intensified
by many governments ( e.g., the French ) during the break-up of the
Bretton Woods system in 1973 and the advent of floating exchange rates.
In contrast, in 1959-60 the United States imposed no restrictions on
capital movements, set modest reserve requirements on commercial
banks, and ran a highly developed international market for primary
securities of all kinds ( including a huge stock of short-term Treasury
bills, in which foreign central banks held much of their exchange re. serves ) . Thus the decline of sterling finance in London and the
restora tion of dollar convertibility for European currencies left the
United States well placed to be the dominant world financial center,
based on the tech niques of TFEB. But this idyllic development, as seen
through the eyes of the New York banking community, was soon to be
disrupted by the American government:
First, restraints were imposed on the flow of both long-term and short
term capital from the United States by ( a ) the Interest Equalization Tax,
introduced
President
Kennedy
which
imposed
substantial
levy on theby
sales
of foreign
bonds in
and1963,
equities
in the
United States;
(b)
guidelines imposed in 1965 on American commercial banks that limited
their acquisitions of foreign assets ( i.e., curtailed short-term lending
to foreigners ) ; and ( c ) the 1968 requirement that American
multinational corporations raise funds for new direct investment (
reinvestment ) out side the United States.3
3 For a more complete history of these controls, see Yeager ( 1976, Chap. 27 ). The
imposition of exchange controls on capital account by the American authorities, de
spite surpluses in the current account of the balance of payments, arose partly from
a peculiar accounting definition of a "deficit" in international payments to which the
( The other major country that does not discriminate in favor of off
shore banking is the United States, where Eurocurrency transacting is
negligi ble. ) Other European countries and Japan lie somewhere between
the extreme British and German approaches to the regulation of Eurocur
rency transactions, so that Eurocurrency trading predominates over TFEB
except in Germany and the United States.
Countries with convertible currencies and active Eurocurrency markets,
such as Belgium, France, Italy, and Japan, often insulate the purely
domestic portion of their banking system by a web of exchange controls
on capital-account transactions similar to the British. The logic here is
straightforward. If there are no controls on capital-account transfers into
foreign monies by domestic residents, the authmities tend to regulate
foreign-currency deposits more severely to prevent a decline in the use
of the domestic currency as domestic money. Among major countries,
Britain seems to grant the greatest regulatory freedom to commercial
banks accepting deposits and loans in foreign currencies. Consequently,
Britain has the greatest need to protect the domain of sterling with ex
change controls. The other countries mentioned, however, are not too
far behind.
To summarize by returning to the question posed at the beginning of
this section, financial expertise-the debris of history-is only a partial
explanation of London's importance. On the supply side of financial
services, freedom from reserve requirements or interest-rate restrictions
gives London in particular-and Eurocurrency centers generally-a com
petitive advantage in providing higher deposit rates of interest and
lower lending rates to each class of borrower. On the demand side, free
dom from exchange controls on capital account for nonbanks is
necessary in at least some countries ( say, Switzerland and the
Persian Gulf ) to create a pool of funds to be invested in Eurocurrency
markets in yet other countries ( say, the Bahamas ) . In addition, in
almost all developed coun tries, domestic commercial banks-which are
also authorized dealers in foreign exchange-are generally quite free to
take positions in foreign currency in these offshore centers.
Hence we can begin our analysis by presuming that banks and non
banking enterprises which are not subject to effective exchange control
and which acquire and want to hold convertible foreign monies are likely
to place much of this money with a Eurocurrency bank.
The Mechanics of Transacting and the Scope of the Market
all
11
TABLE 3
INTERBANK TRANSACTING IN THE EURODOLLAR MARKET
Assets
$1,020,000
( Deposit with
Chase Manhattan )
Liabilities
$1,020,000
( Deposit by a
French exporter )
Assets
$1,020,000
( Domestic
loans and
reserves )
Liabilities
$1,020,000
( Deposit
by
Barclays)
Barclays (London)
Assets
$20,000
( Deposit with
Chase
Manhattan )
$1,000,000
( Deposit with
Bank of
Tokyo)
Barclays
(London)
Liabilities
$1,020,000
Liabilities
0
Assets
0
Chase M anhattan ( N .Y .)
Assets
$1,020,000
( Loans and
reserves )
Liabilities
$20,000
( Deposit
by Barclays
)
$1,000,000
( Deposit
by Bank of
Tokyo)
Assets
$1,000,000
( Deposit
with Chase
Manhattan )
Liabilities
$1,000,000
( Deposit by
Barclays )
of payment in the system. Even when the United States imposed capital
account restrictions in the 1960s, foreigners remained free to place de
posits in, or withdraw deposits from, American banks in New York or San
Francisco. This freedom is essential to Eurodollar transacting. In contrast,
Euroyen transacting has not developed to any substantial extent-even
in natural offshore markets like that provided in Singapore. Foreigners
may be too much hampered by official restrictions when turning over their
yen demand deposits with Tokyo banks, and the Japanese government
may prefer to keep it that way.
In summary, the popular image of Eurodollars as U.S. dollars that
Hee to Europe in brown leather satchels and then circulate independentl y
abroad is simply incorrect.
Problems of Statistical Measurement: Some Conceptual .Difficulties
14
TABLE 4
ESTIMATED SOURCES AND USES OF EUROCURRENCY FUNDS
( in billions of U.S. dollars )
End of
Year
Uses:
1973
1974
1975
1976
Sources:
1973
1974
1975
1976
Reporting
European Area
Canada
Other
Offshore
and Developed Eastern Banking
Japan Countries Europec Centersd
Oil-Exparting DevelopUnalloCouning
triese Countries catedt
Totala Nonbankb
United
States
$49.0
61.5
63.0
75.1
$29.5
41.3
43.6
51.5
$13.5
18.2
16.6
18.3
$12.7
18.2
20.2
21.6
$14.7
20.4
25.8
33.0
$ 7.4
10.l
15.9
20.8
$18.7
26.7
35.5
40.7
$ 3.3
3.5
5.3
9.6
$1'1.0
15.7
19.5
24.7
$1.7
2.7
3.2
3.2
$132.0
177.0
205.0
247.0
50.8
67.8
79.5
87.6
27.5
36.2
38.5
44.7
9.5
11.9
15.4
18.3
9.8
8.7
8.3
10.5
17.7
18.5
19.9
21.3
3.7
5.1
5.4
6.4
12.5
17.8
21.8
30.1
10.0
29.1
34.6
45.2
14.6
15.5
16.2
21.3
3.4
2.6
3.9
5.8
132.0
177.0
205.0
247.0
Total
Yet, despite this netting out, neither the sources nor the uses of Euro
currencies so measured ( $247 billion in 1976) reflect a purely "retail"
relationship with nonbank enterprises-a conceptual state of bliss for
which we shive in defining domestic monetary aggregates. First, banks
outside the BIS inner group are major borrowers and depositors in the
market. Sec:ond, as demonstrated below, switching between foreign and
domestic currencies by any bank can influence the total size of the
"sources" or "uses" statistical aggregate. Thus, the BIS statistical concept
stops well short of netting out all interbank transactions. Indeed, inter
bank deposits still account for 70 per cent of the BIS sources, as shown
in Table 5 below. Hence, the commonly accepted BIS measure of the
size of the Eurocurrency market is not comparable to domestic monetary
aggregates, which measure stocks of monetary assets held by individuals
and firms that are not themselves banks.
A further difficulty with the BIS "net" statistical aggregate is its paro
chial European nature. For example, it omits growth in the "Asian dol
lar" market centered in Singapore. Like its European counterpart, the
Singapore market presents a mixture of wholesale transactions among
banks and retail transactions with nonbank firms for which a satisfactory
statistical aggregate is difficult to define. Total gross foreign-currency
assets of "Eurobanks" in Singapore rose from about nothing in 1968 to
over U.S. $12 billion by the end of 1975 ( Annual Report, 1975-76,
BIS, 1976 ).
Despite this proliferation of Eurocurrency trading in other parts of the
world, the European ( London ) segments seem to dominate in providing
a central market for interest-rate determination:
The opening quotations in the Singapore market are the previous day's
closing rates for Eurodollars in London and Europe. During the day there
are only minor fluctuations in the rates until late in the af ternoon when
trading between Singapore and London/Europe commences. Then any differ
ence in the rates between the two markets quickly disappears and the rates
equalize at whatever level the Eurodollar market dictates ( Emery, 1975,
p. 15) .
There would thus be some reason for the BIS to stick to its European
reporting procedures even if there were sufficiently detailed statistics on
other offshore centers. Nevertheless, the scope of the Eurocurrency market
is worldwide, with open access to banks or commercial ente1prises that
are not limited by exchange controls and that feel comfortable dealing
with deposits on the order of $250,000 or more. It is not a game in which
individuals-the little man-can easily participate.
16
Table 5 reveals the huge share that interbank trading comprises in the
Eurocurrency market even when all interbank foreign-currency trans
actions among the eight reporting countries are netted out. This domi
nance is superficially puzzling. A certain amount of churning of trans
actions at wholesale is perhaps necessary to match lenders with ultimate
borrowers, but the vast amount of interbank transacting within the Euro
currency system seems disproportionate if treated merely as a substitute
for domestic financial intermediation within the confines of a single
currency. And most formal academic models have treated the Eurocur rency
market as if it were merely an extension of domestic financial processes (
see the commonly used model of the "money multiplier" dis cussed in
the following section ) .
TABLE 5
SOURCES OF THE EUROCURRENCY MARKET, MID-1975
Per Cent
Banks:
1.
16
29
25
70
Nonbanks:
4. Domestic nonbank depositors
15
9
30
of the Euro-
'
17
18
bank switches out of francs and into U.S. dollars held in London. ( Note
again that switches from DM into foreign currencies would be captured
as a source by the BIS. ) The conceptual conflict in what the BIS is trying
to do becomes readily apparent. To construct an international monetary
aggregate analogous to M 1 or M2, as applied within any national monetary
system, all .interbank transactions must be consolidated to get a single
, net position of the banking system as a whole vis-a-vis nonbanks. How
ever, to measre the importance of foreign-exchange hedging and cover
ing operations, we do not want to consolidate all interbank foreign-cur rency
transactions.
In addition to the prevalence of interbank transacting, further indirect
evidence of the importance of transactions across national currencies is
the very liited amount of maturity transformation undertaken in trading
among Eurocurrency banks. Table 6 reproduces data on the maturity
structure of assets and liabilities of London-based Eurobanks as of Sep
tember 1973 and separates data on interbank transacting from claims on
and liabilities to nonbanks. The latter exhibit substantial transformation,
the average term to maturity of loans to nonbanks ( claims ) exceeding
that of deposits ( liabilities ) , whereas the more prevalent interbank
trading is nicely balanced at every term to maturity.
TABLE 6
MATURITY TRANSFORMATION: MATURITY STRUCTURE OF CLAIMS AND LIABILITIES
IN NoNSTERLING CURRENCIES, ALL U .K.-BASED EuROBANKS, SEPT. 30, 1973
M aturity
. Less than 8 days
8 days to <l month
I month to <3 months
3 months to <6 months
6 months to < 1 year
lyear to <3 years
3 years and over
All
maturities
All maturities
Total
Claims
Liab.
14.9
18.9
24..8
20.8
8.2
4.8
7.7
19.l
19.4
26.2
20.9
8.8
2.5
3.1
With Banks
Claims
Liab.
17.1
20.6
25.7
21.6
8.8
2.9
3.3
--
17.4
19.8
26.8
22.0
8.8
2.5
2.8
With N onbanks
Claims
Liab.
8.9
13.5
22.3
18.8
6.6
9.8
20.0
28.4
17.6
22.3
14.9
8.8
2.7
5.4
100.0
100.0
100.0
100.0
100.0
100.0
49,774 49,664 36,354 42,313 13,420 7,351
foreign exchange forward and exporters sell it, meeting under the aus
pices of their banks in the Eurocurrency market. While purchases and
sales of foreign exchange might take place at several maturity dates,
generally one would expect no net hedging pressure in one direction
for any given maturity in any one currency, because the flow of foreign
trade is in both directions. Therefore, these purely forward foreign-ex
change operations would not cause the deposit side to become more
liquid than the loan side. The tremendous depth of available forward
deposit and loan maturities allows Eurocurrency banks to quote forward
rates of exchange tailored quite precisely to the diverse needs of their
nonbank customers ( unlike trading in commodity futures, where con
tracts are written on particular months, and on given days in those
months ) .
A final, striking piece of evidence that the Eurocurrency market is
heavily used for forward covering is provided by the measurement of
covered interest .differentials. National money-market instruments are
still subject to various degrees of regulat01y control, interest restrictions,
and surveillance. Because of this asymmetrical regulation, foreigners may
perceive the "political risk" incurred by investing in a domestic-currency in
strument in a national money market to be higher than that incurred by
investing in foreign-currency deposits in the same country. Moreover, na
tional interest-rate structures on bank deposits and loans are often rigidi
fied by cartel-like arrangements. Because of either exchange controls or
cartels, the covered interest differential across Eurocurrency deposits
should be closer to zero than across national money-market instruments
with the same time to maturity. Aliber ( 1973, p. 1455) has provided us
with empirical confirmation of this hypothesis. The evidence is repro
duced in Table 7.
Aliber's example compares forward rates and interest rates on sterling
and U.S. dollars. Let us consider theoretically equivalent calculations for
two countries that are not Eurocurrency centers and do not provide an
international vehicle currency, say, Holland and Sweden, where Rs ( guild
ers/ kronor ) is the spot exchange rate; R1 ( guilders/ kronor ) is the
actual
forward exchange rate; rk is the interest rate on krona assets; ru is the
interest rate on guilder assets. Further, define R.1 as that hypothetical
forward rate such that-for given Rs, r\ and ru_..:...the interest-rate
parity
theorem holds exactly:
+
+
( 1 rk )
---( 1 ru )
1== 0
20
TABLE 7
COMPARATIVE DEVIATIONS OF PREDICTED FORWARD RATES
FROM ACTUAL FORWARD RATES, JANUARY 1968-JUNE 1970
(1)
Mean
Deviatio
n ( 2)
Median
Deviation
( 3)
Minimu
m
Deviation
U.S./U.K.
treasury
bills
1.94
1.348
London
dollars/
Paris
sterling
0.273
0.168
Interest
Agio
SouRcE: Data
Range of Standard
Maximum Deviations Deviation
Deviation (5)-(4)= of M ean
(5)
(6)
(7)
-0.25
8.40
8.65
1.93
-0.51
1.72
2.23
0.40
( 4)
21
22
r == pe .
(1)
e = eM 0 + a ,
( 2)
where
M == M - r
0
+e
( 3)
23
de
1
d a - 1- E( l P)
( 4)
- 1- E( 1- p )
( 1- P )a
1+
( 5)
E ( 1-P)
dM# .
1- P
d a = 1- E ( 1- p )
= l.l5
'
( 6)
interest rates ( see Tobin, 1971) . Niehans and Hewson suggest that a
flow of deposits to Europe ( because of changed portfolio preferences )
will bid down Eurodeposit rates of interest, which are unregulated and
are ultrasensitive to demand and supply. This bidding down of interest
rates in Europe will dampen the flow of deposits or diive them back to
the United States, because American banks are actively providing a com
peting monetary asset in the form of interest-bearing certificates of de
posit. Assuming that the commodity price level exhibits stability in the
short run, it seems unlikely that a monetary explosion could be generated
from a series of exogenous shif ts in dollar deposits from the United
States to Europe.
"Uncontrolled" deposit creation in Europe could occur only if mis
guided regulatory policy rendered American time-deposit rates of interest
uncompetitive and gave undue incentive to large American business firms
to hold dollar deposits overseas so as to earn much higher rates of interest.
Such perverse policy did in fact occur in 1969, when nominal rates of
interest on Eurodollar deposits rose sharply above the "Q" ceilings on
equivalent assets in the United States and American parent banks in
New York could borrow freely from their European affiliates with, effec
tively, a zero reserve requirement against such borrowing. The conse
quences are portrayed in Table 8. Multinational c01porations switched
their holdings on a large scale from dollar deposits in New York to dollar
deposits in London. The result was a sharp and "artificial" run-up of Euro
dollar deposits that were "borrowed" back by New York banks. However,
the whole process was quickly reversed in the early 1970s, when certifi
cates of deposit in large U.S. banks were freed of interest restrictions,
after American reserve requirements against certificates of deposit were
reduced to about 3 per cent and a 10 per cent reserve requirement on
overseas borrowing by Ameiican banks was imposed by the Federal
Reserve Board.
There is a more basic reason, however, for not worrying about "ex
cess" liquidity creation in th Euromarkets. The statistical aggregates com
piled by BIS, measuling the size of the Eurocurrency market, are simply
not comparable to M 1 or M 2 as currently measured in the United States.
Mayer ( 1976) makes dramatically clear that only 30 per cent of the
BIS "sources" to the Eurocurrency market represents deposit claims of
nonbanks ( Table 5, items 4 to 6 ) . Of these nonbank foreign-currency
deposits, those owned by domestic residents ( item 4 ) are already counted
in the monetary aggregates of reporting countlies, whereas "trustee
funds" ( item 6 ) have financial liabilities that may well be less
liquid
25
TABLE 8
BORROWINGS BY U.S. BANKS IN THE
EURODOLLAR MARKET, 1963-71
Years
1963
1964
1965
1966
1967
1968
1969
1970
April 1971
Size of Eurodollar
M arketa
$ 5.0
9.0
11.5
14.5
17.5
25.0
37.5
46.0
47.0
$ 1.04
1.18
1.35
4.04
4.24
6.04
Maximum 14.35 in
Sept. 1969
12.81
7.68
5.17
a As measured by the BIS for the U .K., Belgium, the Netherlands, France,
Germany, Italy, Sweden, and Switzerland.
SouRCES: From BIS Annual Reports and Federal Reserve Bulletin, com
piled by Patricia Decoster.
28
TABLE 9
OIL-EXPORTING COUNTRIES: ESTI1\1ATED DEPLOYMENT
OF INVESTIBLE SURPLUSES
1974
1975
1976
$ 4.0
1.7
22.8
8.0
$ 0.6
0.2
9.1
-0.4
$ 1.6
36.5
9.5
10.6
11.9
3.5
12.4
4.0
2.4
7.4
10.3
2.0
4.4
8.0
26.2
35.7
24.7
1.1
4.0
20.5
57.0
-1.4
12.6
-2.2
35.3
a Includes equity and property investment in the United States and the United
Kingdom, and foreign-currency lending.
SouRcE : Annual Report, 1976-77, BIS, 1977, p. 92.
29
countries with large oil deficits do not receive such a direct capital inflow
from abroad ( say, Sweden, Korea, and Brazil ) . But capital is fungible.
Eurobanks in London can use the proceeds from dollar deposits to lend
to Brazil. Either London banks can offer a higher rate of interest than
American or German banks, or they can borrow dollars from their Amer
ican affiliates ( in the absence of U.S. exchange controls ) if OPEC de
positors are determined to hold their funds in the United States. Of
course, American banks-even if regulated-have been able to compete
by providing the same intermediary service, since exchange controls
fortunately were largely removed in 1974. It can be seen from Table 2
above that dollar claims of American banks on foreigners also increased
rather sharply from 1974 to l976. Thus, the world capital market facili
tates both currency transformation and country transformation in the in
ternational recycling of oil revenues and other monies-always in the
context of the convertible-currency system. What might have been major
bottlenecks in a world of rigidly controlled national monetary systems in
1973-77 are nonproblems in free Euromarkets- supplemented by greatly
improved regulatory conditions in the United States. ( Of course, countries
with little or no debt-service capacity cannot borrow in a free market
and must rely on government-to-government grants or loans from official
international agencies. )
Flexible as it was, why then did the international capital market appear
temporarily to seize up in mid-1974? Stories appeared in the financial
press in 1974 that some Eurobanks refused to accept large OPEC de
posits, some creditworthy borrowers were being turned away, and there
was insufficient equity capital in the Eurobanking system to service the
oil transfers. The situation was exacerbated at the time by the failure of
two large banks, Herstatt and Franklin National, because of unsuccessful
speculation in foreign exchange. This temporarily dampened interbank
trading on the basis of "names"-the very heart of Eurocurrency transact
ing. The disappearance of this seeming financial incapacity by the end of
1974 was due, I believe, to a realignment of short- and long-term rates
of interest in the Eurocurrency market ( and in the United States ) and
to the restoration of general confidence in the major "name" banks.
What caused the initial misalignment in the term structure of interest
rates? Business activity in the United States ,and in much of Europe
culminated in a cyclical peak in 1973 and 1974, at a time when the
monetary authorities were determined to slow inflation. As a result, a
situation of "tight money" drove short-run deposit rates of interest extraor
dinarily high relative to longer-term bond rates ( see Figure 1). Call inter
bank lending ( deposit ) rates of interest-those based on first-class credit
30
15
15
13
13
11
11
1972
1973
1975
1974
International dollar
bonds 12-month
--- --- Call
SouRCE:
31
1976
that were net importers of oil. It also accentuated the cns1s in bank
confidence, because many commercial banks ran at a bookkeeping loss in
paying more on their short-maturity deposits by nonbanks than they
were earning on their older, but longer-term, loans to nonbanks.
Unaccustomed to the deluge of revenue and nervous about both pos
sible retaliation through expropriation of their convertible-currency assets
and significant fluctuations in exchange rates, the OPEC investors tried to
invest mainly at very short term. Indeed, time deposits for seven or eight
days-or simply overnight money-in relatively large discrete lumps were
commonplace. In contrast, governments and enterprises in the oil-import
ing countries wanted to borrow at much longer term, because several
years might elapse before their exports expanded sufficiently to cover
the amortization costs of current borrowings. These inconsistent prefer
ences were greatly accentuated by the unusual inversion of the interest
rate structure. It prevented banks from engaging in their normal limit2d
amount of maturity transformation: borrowing at short term and lending
long to nonbanks. Banks became unwilling to transact at the inverted
interest rates, and both potential depositors and borrowers were turned
away.
Fortunately, however, interest rates were not pegged. The pressure
from depositors drove down short-term rates of interest rather sharply
by early 1975 to less than half their former levels ( Figure 1), whereas
the demand for the longer-term Euro and other credits maintained long
rates of interest. ( This unraveling of the interest-rate inversion was
accentuated by the cyclical downturn in business activity in late 1974. )
When short term rates of interest fell, the portfolio preferences of
depositors for longer-term assets were enhanced, as was the willingness
of the private banking system to engage in maturity transformation. The
apparent im passe in the deposit-lending process was resolved, and talk in
the financial press of the inadequate capacity of the international banking
system simply disappeared. The flexibility of the Eurocurrency system
undoubt edly contributed to this successful resolution of the financial
aspect of the transfer problem, as did the fall in yields on American
certificates of deposit.
This brief interest-rate impasse did not cause even a temporary break
down in the recycling process! OPEC countries receive oil revenues in
convertible foreign currencies-largely U.S. dollars. This means of pay
ment ensures that financial recycling will occur automatically irrespective
of whether such funds are successfully "invested" in Eurocurrency de
posits or in national money markets in Germany, the United States, or
other countries. The interest-rate impasse did complicate the problem of
32
TABLE IO
INTERNATIONAL BQND lssuEsn
(in millions of U.S. dollars)
Borrowing
Countries
or Areas
Eurobond Issues
U.S.
Deutsche
Dollars
Marks
Total
1,780
840
l,7IO
3,410
3,980
4,960
$ 430
1,350
3,750
380
6IO
1,570
$ 370
1,770
1,200
40
IOO
220
400
PriVate
Placements
Total
$ 800
1,450
850
$ 1,400
2,840
4,860
350
310
150
1,960
3,380
5,870
IO
80
120
80
140
30
Foreign Issues
In
In SwitzU .S.
erland
$
Private
Placements
360
840
1,180
$ 650
1,760
3,2IO
$1,130
1,360
2,730
1,930
3,100
5,530
30
280
340
800
830
3,850
80
40
30
120
30
220
1,340
l,5IO
llO
700
5IO
10
6IO
3IO
150
l,OIO
1,480
30
380
690
120
600
790
130
650
660
120
230
450
80
300
IO
150
160
790
480
8IO
650
460
600
20
20
llO
520
240
200
7,790
ll,830
18,0IO
3,590
6,760
10,270
990
3,370
5,220
5,260
4,540
9,120
1,830
1,060
2,050
620
1,980
2,270
1974
4,520
3,080
1975
10,200
4,BIO
1976
14,930
9,730
a Based on IBRD and OECD sources.
90
670
770
640
2,890
2,780
2,650
1,340
1,650
2,960
3,440
3,300
countries.
My analysis suggests
that the "uncontrolled" Eurocurrency system is not now directly an
engine of inflation-of excess liquidity creationas is often posited.
that the foreign-exchange aspect of the market is particularly valuable in a
regime of floating exchange rates.
that the growth of the market would slow down naturally if onerous
regulation of domestic money markets was relaxed.
34
that the flexibility of the Eurocurrency system has at times served the
world economy extraordinarily well in transferring capital, and no prima
facie case for joint international regulation or supervision exists under
current institutional arrangements.
that countries and islands should continue to set policy individually
regarding the use of exchange controls to shield diff erential regulation of
domestic-. and foreign-currency deposits or . bond issues if and only . if
at least some major international currencies remain freely convertible on
both current and capital accounts.
Besides the more general third-party benefits they confer to socialist
and les developed countries, freely convertible national currencies re
main the life blood of the Eurocurrency system. Valuable though it is,
the Eurocurrency market by itself provides no substitute for using a few
widely accepted national monies to organize international trade.
35
References
Aliber, Robert" Z., "The Interest Rate Parity Theorem: A Reinterpretation,"
Journal of Political Economy, 81 ( November/December 1973) , pp. 14511459.
Clarke, William, The City in the World Economy, London, Institute of Eco
nomic Affairs, 1965.
Einzig, Paul, The Euro-Dollar . S ystem: Practice and Theory of International
Interest Rates, .5th ed., London, Macmillan, 1973.
Emery, Robert F., "The Asian Dollar Market," International Finance Dis
cussion Papers, Federal Reserve Board, November 1975; processed.
Friedman, Milton, "The Euro-Dollar Market: Some First Principles," M organ
GuarantY., Survey ( October 1969) , pp.. 4-14.
Gurley, J. G., and E. S. Shaw, M oney in a Theory of Finance, Washington,
The Brookings Institution, 1960.
Herring, Richard J., and Richard C. Marston, N ational M onetary Policies and
International Financial M arkets, Amsterdam; North-Holland, 1976.
Machlup, Fritz, "Euro-Dollar Creation: A Mystery Story," Banca N azionale del
Lavoro Quarterly Review, 94 ( September 1970), pp. 219-260.
McKinnon, Ronald I., Private and Official International M oney: The Case for
the Dollar, Essays in International Finance No. 74, Princeton, N.J., April
1969.
Mayer, Helmut W., "The BIS Concept of the Eurocurrency Market," Euro money
( May 1976) , pp. 60-66.
Niehans, Jiirg, and John Hewson, "The Eurodollar Market and Monetary
Theory," Journal of M oney, Credit and Banking, 7 ( February 1976) , pp. 127.
Swoboda, Alexander K., The Euro-Dollar M arket: An Interpretation, Essays
in International Finance No. 64, Princeton, N.J., February 1968.
Tobin, James, "Commercial Banks as Creators of Money," Chap. 16 in E ssays
in Economics, Vol. 1, M acroeconomics, Chicago, Markham, 1971.
Yeager, Leland, International M onetary Relations: Theory, History and Policy,
2d ed., New York, Harper & Row, 1976.
36
PUBLICATIONS OF THE
INTERNATIONAL FINANCE SECTION
Notice to Contributors
The International Finance Section publishes at irregular intervals papers in four
series: ESSAYS IN INTERNATIONAL FINANCE, PRINCETON STUDIES IN INTERNATIONAL
FINANCE, SPECIAL PAPERS IN INTERNATIONAL ECONOMICS, and REPRINTS IN
INTERNATIONAL FINANCE. ESSAYS and STUDIES are confined to subjects in interna
tional finance. SPECIAL PAPERS are surveys of the literature suitable for courses in
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ESSAYS and REPRINTS can also be ordered from the Section at $1.50 per copy,
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Subscribers should notify the Section promptly of a change of address, giving the
old address as well as the new one.
37
List of Publications
The following is a list of the recent publications of the International Finance Sec
tion. Most of the earlier issues and those marked by asterisks are no longer available
from the Section. 1 They may be obtained in microfilm and xerographic soft or
library-bound copies from University Microfilms International, 300 North Zeeb
Road, Ann Arbor, Michigan 48106, United States, and 18 Bedford Row, London
WClR 4EJ, England. Microfilm editions are usually $6 and xerographic editions
usually $10.
ESSAYS IN INTERNATIONAL FINANCE
91. Fritz Machlup, The Book Value of M onetary Gold . (Dec. 1971)
*92. Samuel I. Katz, The Case for the Par-Value S ystem, 1972. (March 1972)
93. W. M. Carden, M onetary Integration. (April 1972)
94. Alexandre Kafka, The I M F: The Second Coming? (July 1972)
*95. Tom de Vries, An Agenda for M onetary Refonn. (Sept. 1972)
96. Michael V. Posner, The World M onetary S ystem: A M inimal Refonn Program.
(Oct. 1972)
*97. Robert M. Dunn, Jr., E xchange-Rate Rigidit y, Investment Distortions, and
the Failure of Bretton Woods. (Feb. 1973)
*98. James C. Ingram, The Case for European M onetary Integration . (April 1973)
99. Fred Hirsch, An SDR Standard: Impetus, Elements, and I mpediments . (June
1973)
*100. Y. S. Park, The Link between S pecial Drawing Rights and Develo pment Fi
nance. (Sept. 1973)
101. Robert Z. Aliber, National Preferences and the Scope for International M one
tary Reform. (Nov. 1973)
102. Constantine Michalopoulos, Payments Arrangements for Less Developed
Countries: The Role of Foreign Assistance . (Nov. 1973)
103. John H. Makin, Capital Flows and E xchange-Rate Flexibilit y in the Post
Bretton Woods Era . (Feb. 1974)
104. Helmut W. Mayer, The Anato1ny of Official E xchange-Rate Intervention S ys
te1ns . (May 1974)
105. F. Boyer de la Giroday, M yths and Realit y in the Development of Interna
tional M onetary Affairs. (June 1974)
106. Ronald I. McKinnon, A New Tripartite M onetary Agreement or a Limping
Dollar Standard? (Oct. 1974)
107. J. Marcus Fleming, Reflections on the International M onetary Refonn. (Dec.
1974)
108. Carlos Diaz-Alejandro, Less Developed Countries and the Post-1971 Interna
tional Financial S ystem. (April 1975)
109. Raymond F. Mikesell and Henry N. Goldstein, Rules for a Floating-Rate Re
gime . (April 1975)
llO. Constantine Michalopoulos, Financing Needs of Developing Countries: Pro
posals for International Action. (June 1975)
111.Gerald A. Pollack, Are the Oil-Payments Deficits M anageable? (June 1975)
1
Essays 62, 67, 71, 73, 75, 88, and 90; Studies 12, 14 through 18, 20, 21, 23, and 24;
Special Paper l; and Reprints 6 through 12 are still available from the Section. For a
complete list of publications issued by the Section, write to the Section or consult the
publications list in Essay 91 or earlier.
38
112. Wilfred Ethier and Arthur I. Bloomfield, M anaging the M anaged Float . (Oct.
1975)
113. Thomas D. Willett, The Oil-Transfer Problem and International Economic
Stabilit y . (Dec. 1975)
114. Joseph Aschheim and Y. S. Park, Artificial Currency Units: The Formation of
Functional Currency Areas . (April 1976)
115. Edward M. Bernstein et al. , Reflections on Jamaica . (April 1976)
116. Weir M. Brown, World Afloat: National Policies Ruling the Waves. (May 1976)
117. Herbert G. Grubel, Do1nestic Origins of the M onetary Ap proach to the Bal
ance of Pay1nents . (June 1976)
118. Alexandre Kafka, The International M onetary Fund: Refonn without Recon
struction? (Oct. 1976)
119. Stanley W. Black, E xchange Policies for Less Developed Countries in a World
of Floating Rates . (Nov. 1976)
120. George N. Halm, ]ainaica and the Par-Value S ystem. (March 1977)
121. Marina v. N. Whitman, Sustaining the International Economic S ystem: Issues
for U.S . Polic y. (June 1977)
122. Otmar Emminger, The D-M ark in the Conflict between Internal and E xternal
Equilibrium., 1948-75. (June 1977)
123. Robert M. Stern, Charles F. Schwartz, Robert Triffin, Edward M. Bernstein,
and Walther Lederer, The Presentation of the Balance of Payments: A S ym
posium. (Aug.1977)
124. Harry G. Johnson, M oney, Balance-of-Pa y1nents Theory, and the International
M onetary Problem. (Nov. 1977)
125. Ronald I. McKinnon, The Eurocurrenc y M arket . (Dec. 1977)
PRINCETON STUDIES IN INTERNATIONAL FINANCE
26. Klaus Friedrich, A Quantitative Framework for the Euro-Dollar S ystem. (Oct.
1970)
27. M. June Flanders, The Denwnd for International Reserves , (April 1971)
28. Arnold Collery, International Adjustment, Open Economies, and the Quantity
Theory of M oney . (June 1971)
29. Robert W. Oliver, Earl y Plans for a World Bank . (Sept ..1971)
30. Thomas L. Hutcheson and Riehard C. Porter, The Cost of 'J;ying Aid: A M ethod
and S ome Colomhian Estimates , (March 1972)
31. The German Council of Economic Experts, Towards a New Basis for Interna
tional M onetary Policy. (Oct. 1972)
32. Stanley W. Black, International M oney M arkets and Flexible E xchange Rates.
(March 1973)
33. Stephen V 0. Clarke, The Reconstruction of the International M onetary S ys
fem: The Attempts of 1922 and 1933 , (Nov. 1973)
*34. Richard 'D, Marston, American Monetary Polic y and the Structure of the
Eurodollar M arket . (March 1974)
35. F. Steb Hipple, The Disturbances Approach to the Demand for International
Reserves . (May 1974)
36. Charles P. Kindleberger, The Formation of Financial Centers: A S tudy in
Comparative Economic History . (Nov. 1974)
37. Margaret L. Greene, Waiting Time: A Factor in E xport Demand for M anufac
tures , (April 1975)
39
13.Benjamin J. Cohen, Sterling and the City. [Reprinted from The Banker , Vol.
120 (Feb. 1970)]
14.Fritz Machlup, On Terms, Concepts, Theories and Strategies in the Discussions
of Greater Flexibilit y of E xchange Rates. [Reprinted from Banca N azionale del
Lavoro Quarterly Review , No. 92 (March 1970)]
15.Benjamin J. Cohen, The Benefits and Costs of Sterling. [Reprinted from
Euro-nwne y , Vol. 1, Nos. 4 and 11 (Sept. 1969 and April 1970)]
*16. Fritz Machlup, Euro-Dollar Creation: A M yster y Story. [Reprinted from
Banca N azionale del Lavoro Quarterly Review , No. 94 (Sept. 1970)]
*17. Stanley W. Black, An Econornetric Stud y of Euro-Dollar Borrowing by New
York Banks and the Rate of Interest on Euro-Dollars. [Reprinted from journal
of Finance , Vol. 26 (March 1971)]
18. Peter B. Kenen, Floats, Glides and Indicators: A Comparison of M ethods for
Changing E xchange Rates. [Reprinted from journal of I nternational Eco
nomics , Vol. 5 (May 1975)]
40