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Term Paper # 1. Meaning and Origin of Euro-Currency Market:
The Euro-currency market is an international financial market, which specialises in the borrowing and lending of the U.S. dollars and other European currencies, outside their respective countries of issue. The main centres of Eurocurrency transactions include London, Paris, Frankfurt, Zurich and Amsterdam. Since the U.S. dollar was predominantly transacted in these centres, the market was called as Euro-dollar market for a long time.
But presently it is not exclusively a Euro-dollar market as other European currencies like Pound Sterling, Frank, German Mark, Dutch Guilder too are being transacted in these financial centres. The prefix ‘Euro’ too has become a misnomer because of the following reasons.
Firstly, a number of financial centres dealing in Dollar, European and other currencies have appeared in the countries outside Europe. These include Tokyo, Hong Kong, Singapore, Panama, Bahamas, Bahrain, Beirut etc.
Secondly, the Euro-currency market does not deal only in the European currencies.
The U.S. dollar continues to remain the dominant currency in the European and other centres. But other currencies also account for a substantial part of total deposits of the international banking institutions. Thirdly, the name ‘Euro’ has been given to the common currency of the countries of European Union (EU).
In view of the above reasons, many writers prefer to call the Euro-currency markets as the off-shore markets. The participants in the Euro-currency markets are commercial banks, central banks, large corporate enterprises, government and semi- government agencies and international organizations.
The largest and fastest growing part of these markets is the inter-bank transactions. About one-third of the total Euro-currency transactions consist of the non-bank sources and uses of funds through these markets.
The origin of the Euro-currency market can be traced back to the period of First World War, when the banks in most of the European countries accepted deposits in every other European country. The British pound sterling was the predominant currency and the interest rate earned on any other currency was determined primarily by the rate payable on sterling deposits, in conjunction with the spot and forward exchange rates of sterling.
During 1950’s, the U.S. dollar assumed the position of predominant international currency. The emergence of Euro-dollar or Euro-currency market occurred on account of some major developments in the late 1950’s.
Firstly, towards the close of 1958, the currencies of major West European countries were made convertible for non-residents. That enabled the banks in those countries to buy and sell dollars freely and to use dollar in the financing of international trade.
Secondly, subsequent to the sterling crisis in 1959, the tight controls on non-resident borrowings or lendings were imposed on the British banks by the government. This made the banks to turn towards dollars as a substitute for sterling.
Thirdly, the countries of erstwhile Soviet block and East European countries too had a hand in the origin of Euro-dollar market.
They did not want to retain their deposits of dollars with the U.S. banks. They preferred to keep their dollar balances in Paris and London rather than New York. By 1961, the Euro-dollars accounted for at least 90 percent of all Euro-currencies and sterling perhaps accounted for only 5 percent of the aggregate currency deposits with the banks in London and Paris.
Term Paper # 2. Growth of Euro-Currency Market:
During 1960’s and 1970’s, the Eurocurrency markets experienced a very rapid growth.
It was on account of the following factors:
(i) Advantage of London Market:
Although New York money market was larger from the viewpoint of volume of transactions, the London money market enjoyed the locational advantage on account of greater proximity to some prominent customer.
(ii) Flow of Economic and Military Aid:
During 1950’s and 1960’s, the U.S. economic and military assistance continued to flow on a large scale to the West European countries. This resulted in large transfers of dollars to the banks in the European countries.
(iii) Decline in the Importance of Pound Sterling:
In the post-war decades, Britain became a debtor country. The dominant position that sterling had enjoyed in the world financial markets before the Second World War had been assumed by the U.S. dollar. The British Exchange Control Act enacted in the early post-war period continued to restrain the grant of sterling to central banks outside the sterling area. As a result, the position of dollar got reinforced in the European financial centres.
(iv) Regulation Q:
An important factor responsible for the rapid expansion of Euro-dollar market in 1960’s was the Regulation Q of the U.S. Federal Reserve System. Under this regulation, a ceiling was imposed on the interest rate payable on time deposits with the U.S. banks.
The banks had been restrained from paying any interest at all on the deposits upto 30 days. This resulted in the U.S. banks opening their branches in Europe. Consequent upon it, there was a large scale flow of dollars from the United States to the European countries in the late 1960’s.
(v) Other U.S. Restrictions:
In 1960’s, there were a series of other restrictive measures enforced in the United States that stimulated the banking operations in Britain and other West European countries. In 1963, an interest equalisation tax was introduced in the United States. It raised the cost of borrowing by the non-American corporations and governments in the U.S. capital markets to such an extent that the borrowers were scared away from the U.S. capital market.
They naturally turned to the European financial markets. Since 1965, another regulation was enacted in the United States. Under this voluntary foreign credit restraint programme, the U.S. domestic banks and non-bank financial institutions were asked to scale their overseas lending to 103 percent of outstanding foreign credit and investments as on 31st December, 1964.
This measure cut off Europe, U.S. Corporations overseas and certain countries such as Mexico from the U.S. financial markets. The potential borrowers had to turn to the European banks for having access to dollar borrowings.
In 1968, Foreign Direct Investment Regulation was enacted in the United States. It sought to restrain the U.S. Corporations in the use of domestic dollar overseas. It meant that their future expansion programmes could be financed by raising capital from the overseas financial markets. This provided opportunity to Euro-banks to extend their lending operations by a significant measure.
(vi) U.S. Internal Monetary Controls:
In 1969, the U.S. adopted a tight money policy to contain the inflationary conditions. In this situation, the U.S. banks started borrowing heavily in the Eurodollar market through their overseas branches with the object of satisfying the liquidity requirements of their customers.
(vii) Size of Borrowers Needs:
On the one hand, the United States continued to tighten the regime of monetary and exchange controls and, on the other hand, the credit needs have both developed and less developed countries continued to expand. As the inter-governmental borrowings involved difficult and prolonged negotiations, the borrowers turned to the more flexible, although more expensive Euro-currency markets for meeting their growing credit needs.
Since the latter half of 1960’s, the Euro-currency markets witnessed very rapid expansion. Between 1967 and 1969, the number of the United States overseas branches rose from 295 to 459. Their assets got more than doubled from 15.7 billion dollar to 41.1 billion dollars in those two years. Apart from the growth of U.S. overseas banks, there was also very substantial expansion of the branches of British, German, French and Dutch banks transacting in dollars and other European currencies.
The rapid growth of the Euro-currency markets continued until 1974. In 1973-74, it recorded an estimated growth rate of over 49 per cent. The relaxation of controls by the United States on capital exports in mid-1974 caused a temporary setback in its growth. In 1974 and 1975, the annual growth rates of the Euro-currency market were 34.1 per cent and 15.8 per cent respectively. The revival, however, took place in 1976, when it registered a growth rate of 20.5 per cent to be followed by the growth rates of 25 per cent and 26 per cent in 1978 and 1979 respectively.
The overall compound annual growth rate of international banking transactions between 1964 and 1985, according to Ralph Bryant, has been 26 per cent. The size of Euro-currency market in the mid-1990 stood at about $ 8 trillion. In 1963, the size of Euro-currency market was just $ 7 billion out of which $ 5 billion were Euro dollars. The introduction of Special Drawing Rights (SDR’s) has provided a strong stimulus to the expansion of the Euro-currency market since 1980’s.
Term Paper # 3. Features of Eurocurrency Market:
The main features of the Euro-currency or Eurodollar market are as below:
(i) Wholesale Market:
The Euro-currency market is essentially a wholesale market. The transactions include, on the one hand, large banks extensive international operations and, on the other hand, governments, large government agencies or private corporations. The average size of transactions, lending or borrowing, is quite large. On account of the extensive scale of operations, the overhead expenses of Euro-banks are quite low.
(ii) Inter-Bank Transactions:
An outstanding feature of the Euro-currency market is that the interbank transactions constitute the largest proportion of its transactions. In this context, it may be pointed out that Euro-banks are against other banks. As the inter-bank transactions are generally concerned with a short period, the lending and borrowing operations of Euro-banks are essentially short term in nature.
(iii) Highly Competitive Market:
The Eurocurrency market is a highly competitive market. The new banking institutions have almost unrestricted entry. As a result of greater extent of competition, the margin between interest rates on deposits has sometimes made the Euro-banks to take greater risk in the matters of choice of borrowers, security of loan and the maturity of loan. In the recent years, however, the Euro-banks have become more cautious about the element of risk.
(iv) Distinct from Domestic Money Market:
Although in many respects the Euro-currency market is similar to the domestic money market, yet it is distinct from the latter in a significant respect. The Euro-banks have no central monetary authority and they are free from central monetary and exchange restrictions.
(v) Greater Extent of Risk:
The transactions in the Euro-currency market involve a greater degree of risk than that existing in the case of domestic banking. Apart from the normal risk associated with a given transaction in a given currency, there is additional risk on account of possibility of imposition of new banking regulations or exchange controls by the government of the country in which the transactions are affected.
Term Paper # 4. Operation of Euro-Currency Market:
The operation of Euro-currency or Euro-dollar market is concerned with the acceptance of deposits and extension of loan by the Euro-banks.
The Euro-banks receive deposits from the commercial banks from within the country in which they operate. They receive deposits from the commercial banks and residents of the other countries in foreign currencies. The deposits are received by them also from central banks, either directly or through the Bank for International Settlements.
The flow of deposits from the foreign commercial banks and residents is influenced by a relative fall in foreign interest rates, an increased desire for asset diversification, a fall in the covered yield of foreign assets and an expected appreciation of the foreign currency.
The Euro-banks get engaged in a process of deposit creation of the same type as is followed by the typical commercial banks. It may be illustrated through an example. Suppose a London-based bank acquires dollar deposits on a New York bank. If the former just keeps these dollars, no Eurodollars are created. However, if it extends loans of these dollars to some customers, it creates dollar claims against itself and earns interest on loans.
Those created claims are Euro-dollars which the London-based bank has created in excess of what it holds on a New York bank. The ultimate increase in Euro-dollars will be many times more than the initial deposit inflows on account of subsequent Euro-dollar inflows induced by interest rate differentials and portfolio adjustments.
The loan operations of the Euro-banks can be put into two broad categories:
(a) Fixed Rate Loans:
The Euro-banks extend fixed rate loans to their customers. These are termed as Euro-Bonds. These are similar to the public debt issues raised in the domestic capital markets.
The distinctive features of the fixed rate loans or Euro-Bonds are as follows:
(i) The maturity of such loans ranges between 10 and 15 years.
(ii) The interest rate remains fixed over the life of the loan.
(iii) The purchasers of Euro-Bonds, by and large individual and institutional investors, are permitted to hold foreign currency denominated issues under the law of their country of incorporation.
(iv) There is a single drawing of funds and a set of repayment schedules that cannot be varied by the borrower without incurring a penalty.
(v) The borrowers are of international repute and clean standing.
(vi) The issues are arranged through an underwriting group. Even for an issue of 25 million dollars, there may commonly be a hundred or more underwriting banks.
(vii) The issues are arranged normally in dollars, pound sterling, marks or Swiss francs. Occasionally, the issues may be arranged in some other foreign currencies.
(viii) The bonds are transacted after issue in the secondary market.
(b) Floating Rate Loans:
The floating rate credit represents a type of roll over credit with interest rate determined periodically, usually every three or six monthly, on the basis of rates prevailing in the interbank segment of the Euro-currency market. Through the provision of floating rate loans, the Euro-banks try to reduce the interest rate risk which is inherent in unmatched maturities of assets and liabilities.
Most of the Euro-bank loan agreements specify lending rates as a margin over the deposit rate that is usually the London Interbank Offer Rate (LIBOR). So the lending rates of Euro banks are determined by the deposit rates plus a specified margin. The floating rates hedge the banks from risk.
The main features of the floating rate loans are as follows:
(i) The maturity of loan ranges between three years and ten years. It is, therefore, essentially a medium term loan arrangement.
(ii) The interest rate fluctuates according to the period of loan and the currency borrowed.
(iii) A loan of 10 million dollars or more may be syndicated. The number of participating banks in any single loan will depend on the size of loan and the size of lending bank. The largest bank can lend upto 30 million or 50 million dollars in one transaction and it may be the only participant in the loan.
(iv) The size of the loan may be even upto 1 billion dollars. The needs of the customer and the availability of currency determine the currency in which the loans could be provided to the customer. The loan may even be a multi-currency loan. It allows the borrower the right (subject to availability) to switch from one currency to another on any specified date. That can enable the borrower to take advantage of lowest inter-bank rate after considering revaluation risks.
(v) The period of drawing of loan and the repayment schedules vary in accordance with the needs of the borrower. On non-drawn balances, a committee fee which is normally half per cent per annum is levied upon the borrower. In addition, the borrower is allowed the facility of pre-payment ahead of the agreed schedule, sometimes subject to payment of a penalty.
(vi) The floating rate loans are governed by the formal legal agreement that specifies the terms of loan and possible eventualities over the life of the agreement to affect the loan. The form of the loan agreement is fairly standard and it is signed between all the participating banks and the borrower.
The above analysis can help in determining that the floating rate loans are better than the fixed rate loans.
The superiority of the former over the latter is clear from the following facts:
(i) The amount of loan that can be made available under the floating rate can be much larger than the amount to be provided under the fixed rate loan.
(ii) The cost of borrowing is lower in the floating rate loan than in case of a fixed rate loan.
(iii) There is much flexibility in the floating rate loan from the viewpoints of drawing of funds and pre-payment, currency of loan and the period of roll over for switching from one currency to another. In all these respects, the fixed rate loan is deficient.
(iv) The floating rate loan is better than the fixed rate loan from the viewpoints of speed and sophistication.
Term Paper # 5. Role of Euro-Currency Market in International Financial System:
During the last few decades, the Euro-currency or Euro-dollar market has played a highly significant role in the international financial system. Although the prime function of this market is to borrow and lend the U.S. dollars and other principal currencies, yet it confers several benefits including the increasing mobility of international capital, improvement in asset portfolios of banks, extension of services to the non-bank private sector, attraction of large scale capital flows, imparting of flexibility in the financial market and reduction in the interest rate structures related to deposits and loans.
The Euro-currency market has brought about a closer integration in the international capital market. The central banks, government treasuries, commercial banks, international banks like the Bank of International Settlements (BIS) and the transnational corporations act as borrowers and lenders in this market. Their mutual interdependence leads to a greater measure of co-operation and closer co-ordination.
The expansion of Euro-currency market has greatly increased the international mobility of capital. The interest rate differentials between the different financial centres bring out large scale transfer of short-term and medium-term funds throughout the world. The funds flow out from low interest financial centre to high interest centre. The Euro-currency market has played a crucial role in recycling of funds generated through steep rise in petroleum prices.
Similarly the Euro-currency Market has been effectively recycling funds from countries having balance of payments surplus to those having balance of payments deficit. In brief, the Euro-currency market has imparted greater mobility to the international capital and thereby improved the economic efficiency and reduced the interest rate differentials among the various financial centres and countries.
If a country has the objective of controlling the international capital movements, the Eurocurrency market can render useful assistance in this direction. Suppose there is transfer of deposits from a U.S. bank to a Euro-bank, there will be reduction of U.S. surplus or increase in its deficit on account of capital outflow. On the contrary, an inflow of funds from a Euro-bank to the U.S. bank will reduce the U.S. payment deficit or increase its surplus.
However, if the Euro-bank is the central bank of a country, the transfer of funds in one direction or the other will have no effect on the U.S. payments deficit or surplus but serves to finance it because the transfer consists of the official foreign exchange.
The possible adverse effects of the Eurocurrency flows should not, however, be overlooked. Firstly, these flows can have offsetting influences upon the domestic monetary policy. When the monetary authority of a country is engaged in the task of curbing inflation through a restrictive monetary policy, an inflow of short-term capital due to higher domestic interest rate structure will neutralise the restrictive monetary policy.
Similarly the permissive monetary policy to remove unemployment and recession may get defeated because of the outflow of capital. Thus the international flows of funds are likely to render domestic monetary policy as ineffective. Secondly, the enormous amounts of liquid resources provided by the Euro-currency market can result in speculative capital movements and consequent serious economic instability, particularly when the countries concerned are not protected by trade barriers and exchange controls.
Term Paper # 6. Eurocurrency Market and Developing Countries:
The Euro-currency or Euro-dollar market has not only contributed in resolving the liquidity problem of the developed countries, but also in meeting, to some extent, the resource requirements of the developing counties. Some of the developing countries could have access to international and foreign bond markets and bank loans. In this regard, it must, however, be pointed out that the borrowings have been largely in the form of medium term (3 to 10 years maturity) syndicated loans.
According to an estimate made by the Bank for International Settlements, the medium-term loans from banks in the Group of Ten countries and Switzerland to the developing countries registered a substantial increase from 2 billion U.S. dollars in 1971 to 30 billion U.S. dollars in 1980.
No doubt, there has been a very sizeable increase in the transfer of funds to the developing countries, yet it is not widely or evenly distributed among them. The major proportion of Euro-currency funds has gone to the relatively few high income countries like Brazil, Argentina, Mexico and Peru in the underdeveloped world.
There has been some marked shift in favour of the middle income developing countries since mid-1970 but subsequently there was a fall in their capacity to absorb large amounts of Euro-dollars and other currencies. In case of low income developing countries, the borrowings from Euro-currency market have been very meager and erratic. There has been a contraction in the lending of the Euro-banks to the non-oil exporting developing countries.
On the whole, the access of developing countries to the Euro-currency market has remained very limited. In addition, it does not provide any assurance for providing funds to these capital- deficient countries at a low cost. An excessive dependence of the less developed countries on the Euro-currency market is likely to make their economies more sensitive to destabilising capital movements and interest rate variations.
From the point of view of the less developed countries, it is more worthwhile to obtain finances for development from IDA and other institutions affiliated to the World Bank. It is only when the funds are not available to them from those sources; they should take recourse to the commercial borrowings from the Euro-currency market or from other bilateral sources of finance.