CHAPTER 1

Euro currency market : Their development and areas

of concerns

1.1 Eurocurrency Market : Defination of 'Eurocurrency Market'

The money market in which Eurocurrency, currency held in banks outside of the country where it
is legal tender, is borrowed and lent by banks in Europe. The Eurocurrency market is utilized by
large firms and extremely wealthy individuals who wish to circumvent regulatory requirements,
tax laws and interest rate caps that are often present in domestic banking, particularly in the
United States.

Currency deposited by national governments or corporations in banks outside their home market.
This applies to any currency and to banks in any country. For example, South Korean won
deposited at a bank in South Africa, is considered eurocurrency.

Also known as "euromoney."

Eurodollars have little to do with the official currency of the European Union, the euro (EUR). In
1999, the euro was implemented as the official currency of the European Union as a means to
further integrate the economies of that region. Most of the member states of the European Union
have dropped their former domestic currencies completely, and all the major banking institutions
in Europe now deal with euros in their transactions and operations.

Eurodollars, though, are not found only in Europe. Eurodollars refer to American dollar-
denominated money market deposits found in any bank not located in the U.S.;Eurocurrency is
any currency deposited in a bank that is not located in the home country where the currency was
issued.

The origins of the name "eurocurrency" stem from 1950s. The Soviet Union's currency, the ruble,
was considered to be a soft currency. Furthermore, it was extremely difficult, and perhaps even
impossible, to exchange rubles for hard currency because the Cold War had caused many
countries to avoid the Soviet Union. As a result, the Soviet Union sold commodities in order to
receive U.S. dollars. Those dollars could not be deposited into conventional American banks,
because it was likely that the U.S. government would freeze those accounts in the event of a
confrontation between the two superpowers. In the end, the dollars were deposited in a European
bank that had a telex address code called "euro-bank". These deposits would be the start of the
eurocurrency market.

1
2. Dealership on currency markets

Trading in currencies is performed through the intermediation of international banks who act as
clearing houses for debts. Unlike most of the equity markets there is no central market place for
currencies, and transactions arc made by direct negotiations among banks covered by telegraphic
transfers of deposits. Professional dealers are entrusted with the buying and selling of currencies
on behalf of their institutions. The operation of the currency dealer is best understood when a
distinction between the dealers bid-ask quotations and market spreads is explicitly drawn.
Quotations are made by the dealer to his customers suggesting at which price he is willing to buy
or sell telegraphic transfers from the customer on his own

1.1 DEFINITION of 'Eurodollar'

U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks. By
locating outside of the United States, eurodollars escape regulation by the Federal Reserve
Board.

Originally, dollar-denominated deposits not subject to U.S. banking regulations were held almost
exclusively in Europe; hence the name eurodollars. These deposits are still mostly held in
Europe, but they're also held in such countries as the Bahamas, Canada, the Cayman Islands,
Hong Kong, Japan, the Netherlands Antilles, Panama and Singapore. Regardless of where they
are held, such deposits are referred to as eurodollars.

Since the eurodollar market is relatively free of regulation, banks in the eurodollar market can
operate on narrower margins than banks in the United States. Thus, the eurodollar market has
expanded largely as a means of avoiding the regulatory costs involved in dollar-denominated
financial intermediation.

Easily confused with the currency pair EUR/USD or Euro FX futures, eurodollars have nothing
to do with Europe's single currency that was launched in 1999. Rather, eurodollars are time
deposits denominated in U.S. dollars and held at banks outside the United States. A time deposit
is simply an interest-yielding bank deposit with a specified date of maturity.

As a result of being outside U.S. borders, eurodollars are outside the jurisdiction of the Federal
Reserve and subject to a lower level of regulation. As eurodollars are not subject to U.S. banking
regulations, the higher level of risk to investors is reflected in higher interest rates.

2
The name eurodollars was derived from the fact that initially dollar-denominated deposits
were largely held in European banks. At first these deposits were known as eurobank
dollars. However, U.S. dollar-denominated deposits are now held in financial centers across the
globe and referred to as eurodollars.

Similarly, the term eurocurrency is used to describe currency deposited in a bank that is not
located in the home country where the currency was issued. For example, Japanese yen deposited
at a bank in Brazil would be defined as eurocurrency.

1.2 History of Eurodollars :

After the conclusion of World War II, the quantity of U.S. dollar deposits held outside the United
States greatly increased. Contributing factors included the increased level of imports to the
United States and economic aid to Europe as a result of the Marshall Plan.

The eurodollar market traces its origins to the Cold War era of the 1950s. During this period,
the soviet union started to move its dollar-denominated revenue, derived from selling
commodities such as crude oil, out of U.S. banks. This was done to prevent the U.S. from being
able to freeze its assets. Since then, Eurodollars have become on of the largest short-term money
markets in the world and their interest rates have emerged as a benchmark for corporate funding.

Eurodollar Futures

The eurodollar futures contract was launched in 1981 by the Chicago Mercantile
Exchange (CME), marking the first cash-settled futures contract. On expiration, the seller of cash
settled futures contracts can transfer the associated cash position rather than making a delivery of
the underlying asset.

Eurodollar futures were initially traded on the upper floor of the Chicago Mercantile Exchange in
its largest pit, which accommodated as many as 1,500 traders and clerks However, the majority
of eurodollar futures trading now takes place electronically. The underlying instrument in
eurodollar futures is a eurodollar time deposit, having a principal value of $1,000,000 with a
three-month maturity.

3
 Chapter 2

1. Euro to pound and euro to dollar conversion forecasts based on both

technical and fundamental studies.

The euros reaction to this week's FOMC statement, when compared to its peers, sums up the
currencys newfound strength: whilst the pound and the yen weakened following the
announcement, the euro rose against the dollar.

It was not a major rise, as can be seen on the daily chart of the EUR/USD below, however, it was
significant in that it represented the euros recently-aquired resilience.

The gently-descending column of activity which characterises the currencys price action in
January is beginning to show an upside bias, illustrated by the rising Chaikin Money Flow
indicator in the lower pane.

This is a useful indicator to watch during sideways markets as it can give a heads up as to where
the smart money is going, and therefore in which direction the final break will probably happen.

Like all indictors it isnt fail safe, and we could still see a surprise break lower, particularly given
the euros less-than-gold-plated background, however, given other elements it favours an upside
breakout.

As such, if the exchange rate breaks above the 1.0985 Jan 15 highs, that will probably signal a
breakout from the consolidation, and a continuation higher, towards a target at the 200-day MA,
at 1.1050.

4
 2.1. Euro to Pound Forecast: Strength Not Over?
Moving on now to the chart of euro-pound and we immediately see an inverted head and
shoulders pattern across the bottom of the chart, with volume increasing on the right shoulder as
expected.

The exchange rate has breached the neckline already and moved up a fair distance, but has not
reached the 61.8% extrapolation of the height of the pattern higher, which is the minimum price
expectation, and minimum target for the breakout.

Nevertheless, the picture is complicated by the exhaustion blow-off circled on the chart, where
the exchange rate moved out of the top of its channel and then reversed.

Overall, however, the evidence is still bullishly-biased and I expect the exchange rate to recover
eventually and push higher, with a fresh up-trend confirmed by a move above the 0.7755 highs,
and an initial target at the 61.8% extrapolation at 0.7830.

5
From a fundamental perspective there is a lot of support for more euro strength.

The euro is being supported by a steadily improving economic picture, which includes modest
renewal in several key sectors, the most noteworthy of which include housing, bank-lending and
employment.

The major downside risk remains deflation.

2.2 ECB Will Struggle to Engineer Weaker Euro

Analyst Petr Krpata, of ING Bank, in a report, this morning, entitled: Its much more difficult to
generate a weaker Euro, suggests it will get harder for the ECB to engineer a weaker euro,
removing a major risk factor for more euro-downside:

It is likely to get harder and harder for the ECB to generate weaker EUR given that

(a) its toolkit is narrowing and

(b) some factors behind the stronger trade weighted EUR look to be beyond the ECBs
influence.

Krpata says INGs economists share the current voguish view that the ECB will probably
introduce a 10 basis point cut to the deposit rate in March, with a possible 5 to 10bn per month

6
QE add-on, however, he sees this as having limited downside for EUR/USD since a 10bp cut
is now fully priced in while the modest increase in QE should only send EUR/USD lower by
around one big figure.

A stronger dollar is therefore required to take the euro -dollar exchange rate lower, but given the
FOMC rather dovish statement, which actually seemed to reflect the markets recalculation of its
tightening trajectory radically lower, a rate hike now seems much less likely than at the start of
the year.

However, Krpata goes on to say that although theoretically a much more aggressive increase of
40-50bn in monthly asset purchases by the ECB would push the EUR/USD down, this is unlikely
due to technical constraints, which include a lack of supply of available bonds.

Whilst such a problem could be resolved through a widening of the eligible assets, for example
by including corporate bonds into the mix, the ING analysts sees the likelihood of the ECB doing
this as small:

this would be only possible if the scope of eligible assets to purchase is broadened (ie, to
corporate bonds). However, the bar for this to happen is very high.

He also points out that is is becoming harder to prevent the Euros Trade Weighted Index from
strengthening, and this is pushing higher and uncoupling from the EUR/USD rate, due to the
combination of safety and yields investors seem to be finding so attractive in the form of euro-
zone assets.

He ends the report saying:

As long as these idiosyncratic (non-monetary) drivers remain place, it will be difficult for the
ECB to lean against the trade weighted EUR strength.

CHAPTER 3

3. Credit and liquidity creation in the international banking sector

Introduction

7
One of the most remarkable features of post-war economic history has been the progressive
internationalisation of banking. The big banks, which had previously concentrated primarily on
their domestic markets, have set up a network of affiliates around the globe bringing them closer
to potential depositors and borrowers all over the world. One central feature of this development
bas been the emergence of an international banking sector, the so-called Euro-currency market,
largely specialising in "across-the-border" business and enjoying far-reaching freedom from
regulatory constraints and centralised mircroeconomic controls. The banks active in this
international banking sector are essentially the same as those in the domestic markets but their
Euro-currency business is usually kept apart from their domestic business by limiting the
privileged regulatory status to transactions denominated in foreign currency. Banks domiciled in
countries that do not grant such regulatory privileges, or banks in the United States, for which the
US dollar, the principal currency denomination used in the Euromarket, is also the domestic
currency, participate in the Euro-currency market largely through affiliates set up in places where
regulatory and fiscal privileges are readily granted, although these affiliates are sometimes little
more than an accounting fiction.

The banks use the international banking sector mainly for wholesale business, liquidity
management and funding operations. Besides transacting a substantial amount of business among
themselves, their offices in the Euro-currency market take deposits from banks in the domestic
markets, central banks, other public-sector entities and private entities. They use the proceeds for
financing the affiliates in the national markets and for lending to other banks, to public-sector
entities and to private firms, particularly those of international stature. As the Euro-currency
market counts among its creditors and debtors residents of virtually every country in the world, it
is a worldwide market in the truest sense of the term. Moreover, the transparency and integrating
power of the market is supported by the predominant use of a single currency denomination, the
US dollar.

The economic advantages of the internationalisation of banking, and of the Euro-currency

market in particular, are obvious. Competition between banks on an international scale has
exerted pressure on them to lower their costs and to pioneer new financing techniques.
Moreover, the Euro-currency market has reduced the segmentation into national markets of the
global supply of savings and of the overall demand for credit and has thereby tended to improve
the allocation of scarce capital on a worldwide basis. By increasing the international mobility of
capital, the market has enhanced - at times when there has been a reasonable degree of
confidence in the existing exchange rate structure - the effectiveness of monetary policy as an
instrument for marshalling international capital rows. It has boosted the amount of finance
available for covering temporary balance-of-payments disequilibria or for long-run economic
development needs. And, as a result of these various influences, it has added to international
flows of trade and investment, thereby contributing to a higher level of world economic activity
and growth.

8
There are also, however, a number of problems and dangers. The increased international
integration of money and capital markets has reduced national autonomy in the use of monetary
policy for domestic purposes; this may he particularly hard to accept when the influences
transmitted by the international banking sector are the result of policy failures in other countries.
Moreover, it is feared that at times when macro-economic management in individual countries is
not too firm, the very free availability of international financing may encourage policy stances
that are not in the interests of the long-run stability of the world economy as a whole. Also, at
times of currency unrest and unstable exchange rate expectations, when monetary policy loses its
grip on international capital movements, the increased international mobility of capital may add
to the magnitude of destabilising capital flows. Finally, the privileged regulatory status of the
Euro-currency market may pose problems of equity and cause distortions of competitive
conditions to the disadvantage of smaller banks and other firms with less ready access to the
Euro-currency market. And, what may be worse, large banks can use their affiliates in the Euro-
currency market to evade the macro-economic or prudential constraints to which their business is
subject at home.

It is therefore not very surprising that the Euro-currency market and its macro-economic
consequences are highly controversial. What has added to the dispute is the very complex and in
some respects abstract nature of the market, which makes it difficult to fit it into a simple
analytical framework and to evaluate its macro-economic effects and consequences. The centre
of the controversy - which is also the main subject of the present paper - has been the question of
whether the market simply transmits national policy influences or whether, being largely
independent of what happens in the national markets, it can exert expansionary, inflationary or
other destabilising influences of its own. In other words, while the Euro-currency market may
undeniably interfere with the policies of individual countries, can it also give rise to unwanted
expansionary monetary impulses on a worldwide scale and thwart internationally co-ordinated
macro-economic policy efforts?

This paper will start out with a model of an inter-regional banking sector in a world without
national borders and with just one currency. Chapters II and III, which look at the Euro-market in
its actual multicurrency setting, discuss the macro-economic consequences of the "across-the-
border" nature of the market and of the reserve currency role of the US dollar. Chapter IV
examines the impact of official deposits on the functioning and monetary repercussions of the
Euromarket. Chapter V re-examines the question of an autonomous multiplier potential in the
international context. Chapter VI discusses the factors determining the growth of the market and
Chapter VII looks into the question of whether destabilising influences may emanate from the
volume of credit at present outstanding in the Euro-market.

Finally, it may be appropriate to add a few words about what this paper does not include within
its scope. Firstly, it does not deal with the prudential type of question related primarily to
banking supervision, such as the dangers for the banks' liquidity and solvency which might

9
conceivably result from their international risk exposure. Secondly, the paper does not seek to
review the existing literature on credit and liquidity creation in the Euro-market, but simply
presents the author's own very personal views on this highly controversial topic.

CHAPTER 4

4. Theories of the growth of the euro-market: a review of the euro-

currency deposit multiplier.

Introduction

One of the most controversial issues surrounding the development of Euro-currency banking
concerns the ability of Euro-markets to expand autonomously the stock of money and credit
outside the control of national authorities. The rapid expansion of international banking
aggregates, which have grown by around 25 per cent, per annum, is said itself to provide
evidence of monetary expansion in the Euro-markets. A short-hand name frequently used to
describe this process is the Euro-currency credit or deposit multiplier.

Two important questions in this issue are: the ability of the Eurocurrency banking system to
expand because a proportion of the funds the banks lend out is redeposited with them -
endogenous money or credit creation and the Euro-currency multiplier proper; and second, the
role of the Euro-markets in increasing the credit-creating or multiplier potential of the banking
system as a whole, i.e. the domestic and international banking systems combined. When these
effects are large they are said to undermine national monetary policies, in the first case because
the monetary expansion is beyond the direct control of domestic authorities (unlike, for example,
domestic bank deposits in Germany and the United States, Euro-currency deposits are not subject
to legally imposed reserve ratios or direct credit controls); in the second, because the relationship
between the domestic control variable - the supply of domestic bank reserves - and the stock of
money is weakened when deposits are placed in the Euro-currency market.

This paper reviews the models that have been used to estimate and explain the size of these
"multiplier" effects, and their implications for the rate of expansion of the Euro-market. Two
distinct approaches have been adopted: one characterises the depositing and redepositing process
by fixed coefficients (discussed in Section I), the other suggests that the size of any multiplier is
variable and reflects general portfolio considerations and interest rate adjustments (Section II).
Both depend on making "plausible" guesses at the likely size of the coefficients and interest rate
adjustments in order to estimate the size of the multiplier. As estimates are, however, based on ex
ante guesses without any ex post verification, the size of the monetary influence of Euro-banking
remains an untested hypothesis. Some new approaches have therefore evolved to explain the
growth and influence of the Euro-market in terms of empirically observed "institutional" links
between the Euro-markets and national banking systems (Section III). These suggest that it is
completely inappropriate lo treat the Euro-market as a closed or autonomous banking system and
that the role of the Euro-markets in adding to the volume of credit can only he seen in the context

10
of the world financial system as a whole. The paper concludes with a short summary of the main
analytical conclusions.
Throughout, this paper, as with much of the literature on the subject, focuses on the role of Euro-
banks in intermediating between private non-banks rather than between banks, although this
latter activity is numerically the largest function of the Euro-market. The main issue of
importance is the impact of the Euro-markets on the liquidity of the non-banking sector and
whether this is significantly increased by the activities of Euro-banks outside the control of
national authorities. By increasing the flow of liquidity between national money markets, Euro-
markets might enhance the credit-creating ability of some national banking systems and thus the
liquidity of the non-banking sector. The channelling of funds to domestic commercial or central
banks may also provide balance-of-payments finance which can be used to sustain the level of
world activity. To that extent, Euromarkets will have larger expansionary effects on the wealth
and liquidity of private non-banks. But that is a separate issue and may be regarded as being
caught by national policies. These effects would, however, be factors explaining any Euro-
currency redepositing multiplier. Another issue which is briefly considered, because of its policy
implications, is the role of central-bank deposits in explaining the size of any Euro-currency
multiplier.

Euromarkets

These can broadly be classified as Eurocurrency and Eurobond markets. We want to focus on
how MNCs can use these international markets to meet their financing requirements.

The Eurocurrency market consists of banks (called Eurobanks) that accept deposits and make
loans in foreign currencies. A Eurocurrency is a freely convertible currency deposited in a bank
located in a country which is not the native country of the currency. The deposit can be placed in
a foreign bank or in the foreign branch of a domestic US bank.

[Note of caution! The prefix Euro has little or nothing to do with the newly emerging currency in
Europe.]

In the Eurocurrency market, investors hold short-term claims on commercial banks which
intermediate to transform these deposits into long-term claims on final borrowers.

Euro currency loans

Eurocurrency loans are made on a floating rate basis.

Interest rates on loans to governments, corporations and nonprime banks are set at a fixed margin
above LIBOR for a given period and currency.

11
Example

If the margin is 75 basis points (b.p.) and the current LIBOR is 6%, the borrower is charged
6.75% for the relevant period. LIBOR is the underlying variable rate of interest, usually set for a
6 month period.

The margin or spread between the lending banks cost of funds and the interest charged by the
borrower is based on the borrowers perceived creditworthiness / riskiness. The spreads can
range from 15 b.p. to more than 300 b.p., the median of the range varying from 100 to 200 b.p.

The maturity of the Eurocurrency loan can range from 3 to 10 years. Eurocurrency loans are
made by bank syndicates. The bank originating the loan becomes the lead bank managing the
syndicate, inviting one or two other banks to be co-managers of the loan. The borrower is
charged a one-time syndication fee ranging from 0.25 % to 2 % of the loan value according to
the size and type of the Eurocurrency loan.

The drawdown [period over which the borrower may use the loan] of the loan and the repayment
period vary in accordance with the borrowers needs. A commitment fee of about 0.5 % per
annum is paid on the unused balance, and prepayments in advance of the agreed upon schedule
are permitted but are sometimes subject to a penalty fee.

i) EAC of Eurocurrency loan

A corporate borrower has arranged a DM 500 million, five-year EuroDM loan with a bank
syndicate led by two managing banks. The upfront syndication fee is 2 %.

Net proceeds to the borrower = $ 500 mn 0.02 (US $ 500 mn) = DM 490 mn.

12
The interest rate on the EuroDM loan is LIBOR + 1.75 %, with LIBOR reset every 6 months. If
the initial LIBOR6 rate for DM is 6 %, the first semiannual debt service payment is:

[(0.06 + 0.0175) / 2] * DM 500 mn = DM 19.3750 mn

Therefore the borrowers effective annual rate (EAC) for the first six months is:

[DM 19.3750 mn / DM 490 mn] * 2 * 100 = 7.9082 %

This EAC changes in every reset period (in this case 6 months) with LIBOR6.

ii) Multicurrency loans

Though most Eurocurrency loans are Eurodollar loans, these often come with a multicurrency
clause. This clause gives the borrower the right (subject to availability) to switch from one
currency to another on any rollover (or reset) date. This option allows the borrower to match
currencies with cash inflows and outflows (which is an effective way of managing exposure to
currency risk, and thus an effective risk-management

The euro weakened to an almost nine-year low and Asian stocks fell amid concern Greece will
exit the European currency union. Oil slumped to its lowest level since 2009, while silver and
Chinese shares climbed.

Greece's political parties have embarked on a campaign for elections this month that may
determine the fate of the country's membership in the euro currency area, with Der Spiegel
magazine reporting German Chancellor Angela Merkel is ready to accept a Greek exit.

Data this week will probably show consumer prices in Europe fell for the first time in five years
in December, adding to the argument for European Central Bank President Mario Draghi to
extend stimulus.

"The reasons to be selling the euro were pretty clear over the weekend: Draghi being a step
closer to QE and deepening concerns about the Greek political situation," Sean Callow, a
currency strategist at Westpac Banking Corp in Sydney, said.

13
"The euro was so close to such a keenly watched round number as $1.20 that we didn't need any
fresh news to tip us over the cliff."

The euro was trading at $1.1951 after falling to $1.1862 on Monday, its lowest since December
2005.

It also extended its loss over the past year to 12 percent as euro-region and US monetary policy
diverged. While the Federal Reserve has wound back its own bond-buying program and floated
the prospect of raising interest rates from near zero, the ECB reduced rates and started asset
purchases in a bid to stoke economic growth.

Draghi told German newspaper Handelsblatt last week that while deflation risks are "limited",
policymakers "have to act against such risk".

Asked how much the ECB might spend on government bonds, he answered that it is "difficult to
say".

The pound dropped to its weakest level since August 2013, the Swiss franc lost 0.5 percent, and
the New Zealand dollar declined 0.8 percent.

Consumer staples and telecom stocks led declines on MSCI's Asian Pacific index, while energy
shares gained. The Kospi lost 0.4 percent in Seoul and Taiwan's Taiex Index retreated 0.6
percent. Japan's Topix was little changed. The Shanghai Composite Index climbed 3.6 percent,
extending its rally over the past six months to 61 percent. Hong Kong's Hang Seng Index fell
0.57 percent.

West Texas Intermediate crude slipped to $51.77 a barrel after capping a sixth straight weekly
loss on Jan 2. Brent crude traded in London fell 1.5 percent to $55.58 per barrel, with both
blends headed for their lowest settlement levels since 2009.

WTI and Brent tumbled more than 40 percent last year as the highest US oil output in about 30
years collided with slowing global demand and OPEC's reluctance to reduce its own production.

Iraq plans to boost crude exports this month, according to the oil ministry in the second-largest
producer of the Organization of Petroleum Exporting Countries.

Jan 25: triumph or tragedy?

Greece's political parties have embarked on a flash campaign for elections in less than three
weeks that Prime Minister Antonis Samaras said will determine the fate of the country's
membership in the euro currency area.

Samaras used a Friday speech to warn that victory for the main opposition Syriza party would
cause default and Greece's exit from the 19-member euro region, while Syriza leader Alexis
Tsipras said his party would end Germanled austerity.

Der Spiegel magazine reported German Chancellor Angela Merkel is ready to accept a Greek
exit, a development Berlin sees as inevitable and manageable if Syriza wins, as polls suggest.

14
The high-stakes run-up to the Jan 25 vote returns Greece to the center of European policymakers'
attention as they strive to fend off a return of the debt crisis that wracked the region from late
2009, forcing international financial support for five EU countries.

While Greek 10-year bond yields rose to about 9 percent last week from a post-crisis low of 5.57
percent in September, the relative improvement in yields from Italy to Ireland suggests that the
contagion has been contained.

"Many European officials believe a Greek exit would be manageable and in contrast to 2010-
2011 we wouldn't see the same cascading effect on countries like Spain or Ireland," said Fredrik
Erixon, director of the European Centre for International Political Economy in Brussels.

Erixon said it is realistic to expect greater flexibility in Germany and other euro members
regarding Greece as they now have more lee-way given that the crisis has cooled.

15
 CHAPTER 5

5. Theories of the growth of the euro-market: a review of the euro-currency

deposit multiplier.

Introduction

One of the most controversial issues surrounding the development of Euro-currency banking
concerns the ability of Euro-markets to expand autonomously the stock of money and credit
outside the control of national authorities. The rapid expansion of international banking
aggregates, which have grown by around 25 per cent, per annum, is said itself to provide
evidence of monetary expansion in the Euro-markets. A short-hand name frequently used to
describe this process is the Euro-currency credit or deposit multiplier.

Two important questions in this issue are: the ability of the Eurocurrency banking system to
expand because a proportion of the funds the banks lend out is redeposited with them -
endogenous money or credit creation and the Euro-currency multiplier proper; and second, the
role of the Euro-markets in increasing the credit-creating or multiplier potential of the banking
system as a whole, i.e. the domestic and international banking systems combined. When these
effects are large they are said to undermine national monetary policies, in the first case because
the monetary expansion is beyond the direct control of domestic authorities (unlike, for example,
domestic bank deposits in Germany and the United States, Euro-currency deposits are not subject
to legally imposed reserve ratios or direct credit controls); in the second, because the relationship
between the domestic control variable - the supply of domestic bank reserves - and the stock of
money is weakened when deposits are placed in the Euro-currency market.

This paper reviews the models that have been used to estimate and explain the size of these
"multiplier" effects, and their implications for the rate of expansion of the Euro-market. Two
distinct approaches have been adopted: one characteris the depositing and redepositing process
by fixed coefficients (discussed in Section I), the other suggests that the size of any multiplier is
variable and reflects general portfolio considerations and interest rate adjustments (Section II).
Both depend on making "plausible" guesses at the likely size of the coefficients and interest rate
adjustments in order to estimate the size of the multiplier. As estimates are, however, based on ex
ante guesses without any ex post verification, the size of the monetary influence of Euro-banking
remains an untested hypothesis. Some new approaches have therefore evolved to explain the
growth and influence of the Euro-market in terms of empirically observed "institutional" links
between the Euro-markets and national banking systems (Section III). These suggest that it is
completely inappropriate lo treat the Euro-market as a closed or autonomous banking system and
that the role of the Euro-markets in adding to the volume of credit can only he seen in the context
of the world financial system as a whole. The paper concludes with a short summary of the main
analytical conclusions.

16
Throughout, this paper, as with much of the literature on the subject, focuses on the role of Euro-
banks in intermediating between private non-banks rather than between banks, although this
latter activity is numerically the largest function of the Euro-market. The main issue of
importance is the impact of the Euro-markets on the liquidity of the non-banking sector and
whether this is significantly increased by the activities of Euro-banks outside the control of
national authorities. By increasing the flow of liquidity between national money markets, Euro-
markets might enhance the credit-creating ability of some national banking systems and thus the
liquidity of the non-banking sector. The channelling of funds to domestic commercial or central
banks may also provide balance-of-payments finance which can be used to sustain the level of
world activity. To that extent, Euromarkets will have larger expansionary effects on the wealth
and liquidity of private non-banks. But that is a separate issue and may be regarded as being
caught by national policies. These effects would, however, be factors explaining any Euro-
currency redepositing multiplier. Another issue which is briefly considered, because of its policy
implications, is the role of central-bank deposits in explaining the size of any Euro-currency
multiplier.

The euro should stand up very well. It has two great strengths: a large and expanding transactions
size; and a culture of stability surrounding the ECB in Frankfurt. Initially, the EU-11 will be
smaller than the dollar area, but as other members enter, as the EU expands, and as the poorer
countries catch up, the euro area will eventually be larger than the dollar area. From the
standpoint of monetary policies, there is also not much to choose between the two areas.
Information is globally mobile and there is no reason why the ECB should not become as
efficient as the Federal Reserve System in the United States.

The euro also has also two weaknesses: it is not backed by a central state, and it has no fallback
value. In an unstable world, these weaknesses would be fatal. But the present environment is far
from unstable. The Pax Americana has been just as efficient in preventing major conflicts as the
Pax Britannica and the Pax Romana of earlier eras. If, as one should expect, NATO survives in a
post-euro world, the stability of the next decades should be as assured as the past four decades.
Coupled with very substantial EU gold and currency reserves, which could be centralized or ear-
marked for the ECB if the need arises, membership in NATO suffices to mitigate the weakness of
the EU central government. Provided political coordination proceeds in the direction of
integration, and important conflicts of conceit and nationalism are resolved, the euro should be
able to maintain itself on an even keel with the dollar.

Changes can be expected in the liquidity position of Europe when the euro is introduced. Four
effects can be expected to aggravate inflationary pressure: the replacement of national currencies
with a more efficient euro; the increase in the money multiplier (it will also be more unstable);
the pooling of reserves; and the reduction of fiscal discipline arising from the general acceptance
of the euro as a means of payment. These tendencies will have to be carefully monitored in the
early stages of the transition.

17
Against these potentially inflationary effects, there will be two not unrelated factors that will
promote an appreciation of the euro and hence be potentially deflationary. One is the fact that the
rest of the world (including the United States) will want to hold part of its reserves in euros. On
the assumption that after twelve years the world will want to hold half its reserves in dollars and
half in euros, there would be a buildup of euros averaging $100 billion a year, leading to a
massive change in either trade balances and capital movements. To the extent that this demand
materializes, the ECB will have to follow a looser monetary policy to provide the high-powered
reserves that will be needed to back up these euro balances (most of which will be held in bank
deposits). The other factor is that which will arise from diversification. The buildup of euros is
not likely to be smooth. Once a cycle starts in which the dollar starts to depreciate against the
euro, speculation will make the cycle self-reinforcing. This presents a potential danger point for
the international monetary system which will have to be managed internationally.

The EU-11 or even the EU-15 will not be the end of the euro area. It is highly probable that if the
euro is successful in the early stages that the three northern members will see it in their interest
also to join. Expansion will also proceed to several of the countries in Central and Eastern
Europe, with as many as five new entrants by 2005 and eleven by 2010. The CFA franc countries
will also be associated directly with the euro, and their example will probably be followed by
other countries in Africa or the Middle East. The best approach to convergence for these
countries is to establish currency boards with the euro-or alternatively an ERM solution with
very small or zero exchange rate margins and the cessation of changes in holdings of domestic
assets. Because a currency board mimics the monetary policy that is automatic under a common
currency, it is the best mechanism for establishing convergence. If a country cannot do a
currency board, it cannot do monetary union!

It should not be thought that a change as momentous as the introduction of the euro promises to
be will leave "other things constant." The only thing that will remain constant are the laws of
change, which include competition and expansion. By 2010 if not before the euro area will be
larger than the transactions area of the United States and competition will probably provoke
policy reactions in the United States and other countries. It may further be assumed-because it is
in their self-interest--that the euro will be adopted as a kind of currency-board anchor by several
of the states lining up for entry into the EU. When that occurs, the "weight"of the euro-bloc will
begin to exceed that of the dollar area. Countervailing steps will then by taken by the United
States, including perhaps an expansion of the dollar area into Latin America and/or Asia, and
even the formation of a yen-dollar bloc, a G-2 counterpoise to the Euro-bloc.

Whatever the prognosis, the dollar-euro rate will become a matter of great concern to Europe, the
United States and the rest of the world. Diversification from the dollar into the euro would create
the threat of a soaring euro which would play havoc with the sensitive issue of unemployment in
Europe. The alternative of a falling euro would raise the specter of an outbreak of inflation that
would necessitate deflationary policies. It would be a grave mistake to believe that the closed
nature of the three big blocs, would make exchange rates less important.

18
The most urgent focus of management will be on the dollar-euro rate. As the world moves from
monetary unilateralism to monetary bilateralism, policy coordination will become more
important. Under unilateralism, other countries were comparatively free to fix or change their
currencies against the dollar, with a kind of benign neglect of exchange rate on the part of the
United States. That will no longer be possible with the euro. If intervention is required it will
have to be cooperative. In view of the long period of transition from a mainly dollar world to a
world in which the dollar and euro are quasi-equal partners, it may be necessary to develop new
institutions capable of dealing with the problem.

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 CHAPTER 6

6. International Reactions and the Euro-Dollar Rate.

It should not be thought that a change as momentous as the introduction of the euro promises
to be will leave "other things constant." The only constant is the law of change, governed by
competition and self-interest. After the euro is launched, it will be adopted, as already argued, by
the remaining four members of the EU, including, importantly, Britain. It may further be
assumed that it will be adopted as a kind of currency-board peg by several of the states lining up
for entry into EU. When that occurs, the "weight"of the euro-bloc will exceed that of the dollar
area. It would be an illusion to suppose that the expansion of the euro area will not provoke
countervailing expansion of the dollar area. Like the merger movements going on in industry and
banking. Bigness begets bigness.

Expansion of the dollar area is likely in Latin America. After decades of monetary instability, a
growing number of countries in Latin America are perceiving the benefits of stable prices and
exchange rates. If there were a large stable country in Latin America, it might be attractive to
envisage a system of stable exchange rates anchored on that country. There is not, however, and
at the present time the most attractive anchor for stability is the dollar. Among the larger
countries, Argentina has taken the lead with a new (and weaker) variant on the currency board
idea. It is conceivable that Mexico, at last on the road to recovery from its 1994-95 fiasco, and
Brazil, currently in the throes of an all-too-similar trauma, will see a solution along the same
lines as Argentina. If so, we could see in the next decade as an expansion of the dollar area
throughout much of Latin America.

What about Asia? It is tempting to think that Asia might go the way of Europe, with its own
currency area. However, this misses a fundamental point. Europe's currency area would have
been dead in the water in the inter-war period or even before 1914 when the Franco-German
conflict was unresolved. It is unlikely that an Asian currency area could contain simultaneously
powers with such diverse interests as Japan and China. It seems much more likely that for the
next two decades the dollar will be the main default international currency. Under certain
circumstances, one could even imagine the formation of a yen-dollar bloc.

Whatever the currency area formation, one thing is certain. The dollar-euro rate will become a
matter of great concern to Europe, the United States and the rest of the world. Diversification
from the dollar into the euro would create the threat of a soaring euro and play havoc with the
sensitive issues of competitiveness and unemployment in Europe. The alternative of a falling

20
euro on the other hand would raise the specter of an outbreak of inflation that would necessitate
deflationary policies. It would be a grave mistake to believe that the closed nature of the three
big blocs, would make exchange rates less important or that the dollar-euro rate can be treated
with "benign neglect."

The most urgent focus for management will be on the dollar-euro rate. As the world moves from
monetary unilateralism to bilateralism, policy coordination will become more important. Under
unilateralism, other countries were comparatively free to fix or change their currencies against
the dollar, with a kind of benign neglect of exchange rate on the part of the United States. That
will no longer be possible with the euro. If intervention is required it will have to be cooperative.
In view of the long period of transition from a mainly dollar world to a world in which the dollar
and euro vie on equal terms, it may be necessary to develop the infrastructure capable of dealing
with the problem.

International management of the dollar-euro rate will not be easy. Suppose the dollar is
depreciating against the euro and it is agreed that intervention is desirable. Where should the
responsibility for intervention lie? Should the U.S. support the dollar by selling reserves, or
should Europe support the dollar by buying reserves? Action by the U.S., taken alone, without
sterilization, is deflationary for the world economy; action by Europe is inflationary. Obviously
action by the US would be desirable if there were excess inflation in the world economy,
whereas action by Europe would be desirable if there were excess deflation. The division of
responsibility would have to be determined by an inflation index for the world economy.(9) If
gold were stable in terms of commodities the price of gold would itself serve as a satisfactory
index

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 CHAPTER 7

7. The Stability of the International Monetary system.

The ground has now been prepared for a discussion of the questions posed about
the stability of the international monetary system. We shall take up the subject in
terms of the three concepts of the word stability noted in the introduction.

The second is whether the new pattern of currency areas will tend to persist. The
third question concerns any change in the mathematical structure of the system that
would make it explosive rather than convergent.

7.1 Exchange Rate Volatility

The first is whether variables in the system will fluctuate more or less as a result of the
introduction of the euro. Will exchange rate or balance-of-payments fluctuations be larger or
smaller as a result of the introduction of the euro. The initial presumption must be that they
will be smaller. Exchange rate fluctuations among the EU-11 will disappear completely as
the eleven currencies are replaced by the euro. As long as the union is considered to be
irrevocable, forward margins will also disappear and interest rates will converge completely,
except for residual tax differences or differentials in default risk. The EU-11 will represent a
new and large zone of exchange stability of a size only somewhat smaller than the dollar
itself. As more countries enter EMU the zone of exchange rate stability will represent a larger
economic area than the United States.

Will balance-of-payments fluctuations be increased or diminished as a result of the single-

currency EU? The answer here is not completely unambiguous but there is a strong

22
presumption that balance of payments are smaller and fluctuate less under a common
currency than under flexible exchange rates? Two sources of instability will be removed. The
first is that with the removal of exchange rate fluctuations as an incentive for capital flows,
speculative capital movements will be eliminated or reduced. The second source of instability
is monetary policy, especially the disequilibrium practice of sterilizing the monetary effects
of capital flows. Under a common currency capital movements will conform to those that
would prevail under a well-functioning currency board. 'The money goes where the action
is." Rapidly-growing regions will have surpluses and slow-growing smaller surpluses or
deficits.(11) Surpluses greater or less than desired levels will be automatically corrected by the
expenditure-specie-flow mechanism of the balance of payments. Intra-EU balances of
payments will continue to exist, correction of excess balances will become automatic and
unobservable if not relatively painless.

Another issue concerns the volatility of the euro against other currencies. A case could be
made that the erection of a zone of stability in Europe will increase the volatility of the
exchange rates of those countries that did not enter EMU, including the pound sterling, the
Swiss franc, and the Swedish and Danish crowns. That instability could be reduced or
eliminated if those countries joined the new ERM or adopted ERM-like policies. The
drachma-euro rate, for example, can be expected to hover around its central parity against the
euro as long as its economic reform package proceeds on schedule. A similar argument holds
for the prospective members of EU in Central and Eastern Europe.

What about the dollar-euro rate? This will become the most important price in the
world. It might be thought that because the EU economy is more closed than its national
components, the dollar-euro rate will fluctuate more than its most important predecessor, the
dollar-DM rate. This proposition, however, is not strictly correct. Long before the
introduction of the euro, the ERM of the EMS already exhibited many of the monetary
characteristics of a common currency. It is not the ratio of imports or exports to GDP that
determines exchange rates but the whole pattern of the balance of payments including
especially capital movements. Once speculation over entry into EMU is settled, there will no
longer be destabilizing shifts from the 'weaker' members into the stronger currencies.

Nevertheless instability could arise from another source. The mark-dollar has gone from an
average of DM 4.0 in 1968 to DM 1.82 in 1980 to DM 2.94 in 1985 to DM 1.56 in 1992 to
DM 1.43 in 1995 to DM 1.73 in 1997. Under equilibrium circumstances, it is hard to imagine
that the dollar-euro rate will be more unstable than the dollar-mark rate has been. However,
once the euro has been established the reserve-configuration of the payments system will no

23
longer be in equilibrium. Diversification will mean a tendency for the euro to appreciate
against the dollar. There is no reason to expect that the appreciation would be steady and
smooth. More likely it would be erratic. This seems to be a case where international
management of the rate will become necessary. .

7.2 Stability of Currency Areas

Will the euro create a new equilibrium configuration of currency areas that will be
quasi-permanent, in the sense that they will survive for, say several decades? The
answer, I believe, is yes. The creation of the euro will automatically carry with it
the development of a substantial euro area, comprising countries that elect to
stabilize their currencies to the euro and use the EU capital markets. The Mecca for
the euro will be in Africa and Eastern Europe. At the same time, the expanding
euro area will provoke explicit attention to the dollar area, involving most of Latin
America and perhaps a considerable part of Asia. The competing dollar and euro
areas will be features of the international monetary landscape for a long time to
come-barring another great war or unforeseeable acts of God, perhaps another
century. The great uncertainty lies not with these two currency areas, but the nature
of the structure that will develop in Asia. As already noted, unlike Europe, Asia
does not have the political structure to create a unified currency area. For the next
few decades, it seems likely that the dollar will remain the dominant outside
currency in Asia with the yen independently floating or attaching itself, depending
partly on political considerations, more to the dollar or the euro area.

7.3 Dynamic Stability

Will the euro create a situation that will alter the convergence conditions of
exchange rate dynamics, i.e., will it turn a stable system into an unstable one or
aggravate any instability of the existing exchange rate system? The answer to this
question requires a comparison of the stability conditions of a decentralized
currency system with that of system in which some of the countries combine into a
new currency area. There is implicit in this question a general mathematical
problem: How are convergence conditions of dynamic stability altered by
collapsing several balance-of-payments equations into one. How is stability of a

24
system altered by economic union? More generally how is the dynamic stability of
an equilibrium affected by choices of currency area?

There is not to my knowledge any answer to this question in the economics

literature. One could presume that integration in special cases would work in one
way or another. For example, the integration of a small unstable country with a
large stable one would probably improve the stability characteristics of the system
as a whole. It seems on balance likely that the removal of the currencies of
formerly weak economies from the European system, assuming that they are not
large enough to destabilize the large stable countries will tend to strengthen rather
weaken the stability characteristics of the system.

It is also true that the elimination of intra-European exchange rate fluctuations

should reduce the frequently-reversible capital flows that have been a source of
instability in the past.

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