This book offers a chronological account of the history of the Euro-dollar Market. The Euro-dollar market* was in fact, and is indeed today, an international wholesale market in money, involving Euro-sterling, the "Euro" and other national currencies.
THE HISTORY OF THE EURODOLLAR MARKET IN THE 1960s (A CHRONOLOGICAL ACCOUNT)
Introduction
The Euro-dollar market* was in fact, and is indeed today, an international wholesale market in money, involving Euro-sterling and other national currencies such as Swiss franc and to a lesser degree the other major European currencies. This paper will briefly outline in a chronological order how the Euro-dollar market developed during the first five years of the 1960s. As these markets had one thing in common, the fact that they existed in centres foreign to the natural habitat of the currency concerned. US restrictions, such as Regulation Q of the Federal Reserve System limited the rates that may be paid to depositors, whether domestic or overseas, primarily in order to protect the great number of small US banks that constituted the American banking system. Hence, a banking business developed, involving borrowing and lending and, the evolution of an investment medium, in currencies outside the territory in which the currency is ordinarily regarded as domestic currency. This tended to produce a wider spread between the rate paid to overseas depositors and the rate charged to overseas lenders than was the case in London and certain other major centres.
For the second Labour government from 1966-1970, Labours taxation policy was important both for economic management and political strategy. This paper will briefly outline in a chronological order how the Euro-dollar market progressed during the second era of the 1960s. The UK position in the late 1960s required increases in financial capital (namely the Euro-dollar market) along with the restraint of domestic consumption. Business organisations had to be given incentives to borrow on the Euro-dollar market. Both the actual incidence of business taxation and its political impact, were going to play a part in Labours tax strategy. The environment of this strategy was shaped by a number of factors. The mid-1960s saw fresh hopes for the second Labour government to ending the UKs chronic deficit in its balance of payments, which looked to be almost in balance. However, the late sixties also saw large amounts of the countrys reserves, being spent in order to defend Sterling. Euro-dollars proved to be a solution. However, the other side was how vigorously the business interest was going to respond to taxes levied against it. In the late 1940s-50s, it was criticised for being too defensive in its posture: the attitude of industry, when EPT (Excess Profits Tax) was raised to 100% had been weak. Industrialists previously appeared to be unwilling on political grounds to fight for what they knew to be right . However, both the Labour government and private industry were to some extent uncertain in their analysis of tax questions, and some of the issues involved in developing long-term business taxation received legislative enactment under Harold Wilsons first government in 1965 .
1961 Introducing the Euro-dollar Market
One can only guess at the amount of Euro-dollars and Euro-sterling outstanding between lenders and borrowers and, though the guesses of financial journalists have varied considerably, all of them fall in the range of $1billion to $2billion. Due to this and other market reports, it was clear that before 1961, the Euro-dollar market was well established in that not only were there large number of buyers and sellers, but that large sums could be transferred easily and without big changes in rates. Turnover in this, as in all the Euro-currency markets, was probably very big. It was also suggested that Euro-dollars constituted 90% of all Euro-currency, Euro-sterling another 5%, and all other Euro-currencies combined the remaining 5%. It was not clear as to the amount of Euro-sterling outstanding, but its turnover in the Paris market in 1961 had been estimated to have reached £10m a day at times .
The rate of expansion in the Euro-dollar market was due to two main factors: Firstly, the continuing balance of payments deficit of the USA which had put into international circulation a steadily increasing volume of dollars seeking the most profitable form of use. Secondly, the banning by the German and Swiss authorities of the payment of interest on foreign-owned balances which had caused holders of marks and Swiss francs to hawk their balances around the international money places with a view to earning any interest that can be obtained there. (The French also, followed the German and Swiss example).
This situation led to the development that depositors were able to find centres which offered a higher return, than offered at home. Also, borrowers were able to raise funds in this currency more cheaply than they would be able to do by going to the country of origin of the currency concerned or in their own currency. It was natural enough that London banks and merchant banks in particular with their expertise and international connections, participated actively in this business; since London was thought to be the largest market in Euro-dollars. The total of Londons liabilities in all currencies to non-sterling was a depositors was around the £1 billion mark in 1961, and after allowing for double counting it was not unreasonable to suggest that London accounted for well over half of the real total . However what was significant was the number of banking institutions in London that have been most active in the Euro-dollar markets which have increased their business enormously since the end of 1958.
The Public Archives shows that four groups of banks increased their deposits by £884m or 80% between the end of December 1958 and the end of March 1961. At the same time their overseas lending increased by £479m and their loans to UK local authorities by £119m in each case nearly a three-fold increase. Euro-dollar transactions was also reflected in changes in the net spot position of UK Authorised Dealers (these was unpublished). A net liability here can be taken as an indication of the extent to which Dealers have switched Euro-dollars, and to a lesser extent other currencies, into sterling.
The movements of highly volatile Euro-currency must make for closer integration of the worlds main money markets. This must tend to make domestic money market rates in different centres more nearly equal than they would be in the absence of Euro-currency markets. Movements of Euro-currency was certainly a significant factor in the determination of forward rates. Differences in Euro-currency rates can induce big movements of short-term funds and have to be considered jointly with interest differentials on Treasury Bills as main determinants of the size and direction of the international flow of short-term capital. So far this did not seem to have had any significant effect on the balances of payments either of the UK or of the US. Euro-currency may be used in ways that monetary authorities regard as desirable. For example, it must have reduced the cost of financing foreign trade this must have benefited Japan in particular and it may even have increased trade. On the other hand, it could be used to exaggerate speculative movements of short-term capital and a system cannot be without dangers where funds which was liable to be withdrawn at very short notice was used to finance hire purchase finance companies and local authorities. There were two points that was worth taking into account:
The first considers the view that short-term capital movements will be bigger than they would otherwise have been . This statement was true in the sense that a greater number of transactions were taking place and the total of the flows in all directions was greater. The UK tended, however, to be most concerned about the flows into and out of the United Kingdom; it seemed that Euro-sterling transactions did not, in general, add to the influx or withdrawal of sterling. In other words, for example, the fact that transactions were going on in sterling between Frenchmen and Japanese did not exaggerate the large reduction of sterling holdings in the hands of non-sterling countries in the first seven months of this year. It was possible, of course, that the existence of the Euro-sterling market resulted in the lenders holding rather larger amounts of sterling than they would otherwise have done, so that the scope for a withdrawal from sterling may have been increased. On the other hand, the fact the Frenchmen could lend sterling profitably to the Japanese, and possibly for a rather extended period, may have added some element of stability to the Frenchmens holding of sterling. The fact was that there was no evidence, however, to confirm either of these hypotheses.
The effect of the UK authorised dealers transactions in Euro-dollars was not easy to expound clearly. The limits on the authorised dealers operations were that there was a limit on the spot convertible currency assets which any one dealer may hold against future liabilities and furthermore each authorised dealers spot and forward commitments must match. Perhaps it is easiest to think in terms of the net spot position of the authorised dealers, which became increasingly minus towards the end of 1960, stayed at about minus £100 million from January to May and later declined somewhat. This minus spot position reflects the switch of Euro-dollars and other currencies into sterling. There can be wide variations in the gross liabilities and assets of the authorised dealers, but only the net position affects the reserves, as, each transaction is self-liquidating. Nevertheless, the reserves, reflecting as they do the authorised dealers spot but not their forward position, will have benefited from the growing switching of Euro-dollars into sterling and will have suffered when this switching was unwound .
1962 - Developments for the demand of US dollars and other currencies
There were considerable statistical difficulties in estimating the size of foreign markets for dollars and other currencies. Hence, any estimate was little better than a guess. Given this qualification, Altman estimated that the market in Europe for dollars, sterling and other currencies as of June 1962 was more than $3 billion. Leading to the assumption that a world total of dollars and other foreign currencies used in foreign markets would be of the order of $4 to $5 billion.
It was estimated that 85% of foreign market operations in foreign currencies during 1962 were conducted in US dollars. Continental European currencies, particularly Swiss francs and deutsche marks were held and used in larger amounts in 1962 than in 1961, but, since operations in dollars were also larger, they did not increase greatly in relative importance. Deposits of Euro-sterling continued to be relatively small. The greater use of continental currencies stems from the smaller forward premium on the dollar which made it possible to pay rates of interest on Swiss franc deposits which were closer to those paid on dollar deposits. This in turn made it possible to obtain and use more Swiss francs in foreign market operations.
Euro-money operations were conducted almost entirely by commercial banks although brokers had become an important mechanism for organising the market as the number of participants has increased. A large proportion of the dollars were dealt with in foreign markets, but a modest proportion of the other currencies, were directly or indirectly owned by central banks and other monetary authorities. Altman estimated that about two-thirds of all funds in European markets in the summer of 1962 were of this character. Official funds reached the money markets in three ways: Firstly, central banks and monetary authorities provide their respective commercial banks with dollar funds through swap operations, with a general or specific understanding that these dollars will be based to acquire foreign currency assets. (The Deutsche Bundesbank had swap transactions to carry out its monetary policy). Secondly, central banks deposit dollars in domestic commercial banks without requiring the surrender of the local currency equivalent (e.g. Italy). Thirdly, central banks in Europe, Latin America, the Middle and Far East deposit dollars with commercial banks in London, Paris, Canada and other money markets. The BIS had become an important intermediary between its members and the Euro-dollar markets .
The funds other than from official sources in the market represented deposits of commercial banks and business enterprises and individuals. Banks and other business enterprises used the major part of the dollars (etc.) in foreign markets, although governments and official agencies used significant amounts. Local authorities in the UK had been important borrowers in the London Euro-dollar market. Most of the funds, however, were used by the private sector. Interest rates on dollar deposits were determined on a highly competitive basis, arrangements being available for depositing any sum for any period up to 18 or 24 months. At any one time in the market there was a range of rates rather than any one unique rate. The effective floor to the rate on Euro-dollar was determined by rates paid by US banks on time deposits and by other comparable short-term investments in the United States. In 1961, the Euro-dollar rate in London averaged 3.58% compared with 2.35% on new issues of US Treasury Bills and 2.80% on prime bankers acceptances. In the first eight months of 1962, the Euro-dollar rate averaged 3.66% compared with 2.76% on new issues of US Treasury bills and 3.02% on bankers acceptances.
The demand for Euro-dollars was obviously determined by their profitable use. Pure interest arbitrage was a factor, though not the major one, in the demand for such funds. Rates on Euro-dollars had been consistently too high to permit covered interest arbitrage in UK Treasury Bills, though not too high for uncovered movements. During periods when confidence in sterling was high, it was possible that Euro-dollars were used to finance the purchase of Treasury Bills. Local authority and finance house deposits had been a profitable outlet for Euro-dollars. On average over the period 1961 and first eight months of 1962, the covered yield on deposits with local authorities, covered forward, was approximately the same as published rates on Euro-dollars. This follows, given that Euro-dollars was an important source of funds to the local authority market, and no arbitrage transactions would tend to even out disparities in rates. These averages, however, suggested that, smaller investment opportunities had in fact existed given the spread of rates on both Euro-dollars and local authority deposits.
For the blue chip industrial and commercial customers, the rates they have had to pay for borrowing funds from the market ranged between 5½ - 5. 7/8% (i.e. prime borrowing rate on the New York market). As the commercial banks were paying between 3½-4½% for three months dollar deposits, their gross interest margin would be in the region of 1-2½%. Euro-dollar operations, however, were not confined to channelling funds to those borrowers who may be entitled to the prime rate in New York with the result that the lending rate is often considerably higher than 5 7/8%. Thus with banks being able to work on margins of 1½ % upwards, the possibility of profitable business was great .
Rates of interest paid on deposits of sterling and other non-dollar currencies were closely related to those paid on Euro-dollars taking into account the cost of forward cover. This again illustrates the integrated form of the foreign currency markets, arbitrage transactions ironing out interest discrepancies. Most of the transactions in Euro-currencies was covered forward although banks may carry open positions for considerable periods. They have been known to carry short positions in particular currencies over a long string of weekends when they expected changes in exchange parities. Loans in dollars and other foreign currencies was listed or regulated in three ways: Firstly, that attempts have been made (e.g. Italy) to increase the rate of interest charged in loans in dollars etc. Secondly, agreements have been made in some countries (e.g. Germany) that loans in foreign currencies should only be made to the foreign trade sector. This, by making an artificial distinction between the domestic and foreign trade sectors in the economy results in a highly unstable situation. Thirdly, in many European countries (e.g. the UK) the competitive effect of foreign currency loans is restricted by exchange or capital control regulations.
The effect of the abandonment of interest ceilings on foreign deposits for US banks was not, it was thought, to have a considerable effect on the Euro-dollar market. It was not clear whether US commercial banks were prepared to raise interest rates selectively to any great extent, and even if they did and funds did flow out of the Euro-market, Euro-dollar rates would be adjusted accordingly.
The growth of the Euro-dollar market raised interesting problems of monetary management for the UK authorities. The short-term money markets of the major industrial countries had become considerably unified and internationalized with the emergence of this market. It was possible for the monetary authorities to use the market as an aid to domestic control by operating in the forward market for dollars, so facilitating commercial bank buying of foreign short-term assets. If it was felt that the domestic short-term market was too liquid, it was possible for the bank, by lowering the forward premium on dollars and pegging it for such transactions, to supply commercial banks with dollars for profitable use abroad and thus reduce their supply of sterling. The Deutsche Bundesbank had great use of the swap technique in its attempt to relieve pressure on the domestic market.
On the other hand, the Euro-dollar market imposed certain limitations on domestic policy. It was one thing to encourage banks to supplement their domestic assets with foreign assets, it was another to reverse the process. A tight money policy, by raising short-rates, attracts Euro-funds thus helping to defeat the object of control. Of course given exchange control in the UK arbitrage was not perfect but nevertheless there were considerable pressures which appeared when the UKs short-rates moved out of line with those prevailing in other centres. A very strong reason for the control of Local Authority short-term borrowing stems from the use by that market of Euro-dollars when domestic funds were in short supply. Apart from a fool-proof exchange control, the only way to regulate the flow of Euro-dollars into the UK was for the official authorities to have control over all significant short-term interest rates.
The Times on the 13/09/1962 quoted that: the bill to remove the ceiling on interest rates paid by US commercial banks on certain dollar deposits from abroad has now passed the House of Representatives. This is bound to raise fresh doubts about the future of the market in Euro-dollars . If passed by Congress, the Bill would remove the Federal Reserve Boards present ceiling, which ranges up to 4% according to the size of the deposit, on interest rates paid on time deposits of foreign governments, their central banks or other monetary authorities, and international institutions of which the US is a member. This, in fact, covered a large part perhaps as much as 50-75% - of a total Euro-dollar market with an annual turnover now running in excess of $2,000 million. While the US move would undoubtedly serve to relieve the strain on the US gold stock, it must, according to The Times newspaper, ultimately be expected to diminish the size of the market in Euro-dollars to some extent. However, dealers in the market recalled the almost negligible effect of the liberalisation of the American Regulation Q, which from 1962 permitted a modest increase in rates paid on foreign deposits. It was pointed out that liquidity among US commercial banks was already running at a high level and that they would probably not be very keen in these circumstances to raise their interest rates further. Therefore, it was felt that any decline in the size of the market in Euro-dollars was likely to be a slow process.
So during the era of 1962, there was a view prevalent in the City of doubts whether there was a long-term future for the Euro-dollar market. This argument for supposing that the Euro-dollar market was a purely temporary phenomenon followed from the view that the market originated because of rigidities in the structure of interest rates in the United States. It was therefore suggested that the Euro-dollar market was born out of the banking legislation limiting the rate of interest American banks pay on foreign deposits. Similarly with Euro-sterling, the interest rates paid by British banks were so low as to encourage foreign holders of sterling to lend it to other non-residents at the higher rates that prevail in the free market outside the UK.
Given this view, the revision to Regulation Q, enabling US banks to raise their rates on foreign deposits, was regarded as the beginning of a movement to allow interest rates to reach their natural levels, which would destroy the Euro-market. This, however, was to take a rather facile view of the workings of the Euro-market. The existence of Regulation Q (or its sterling equivalent) was only a subsidiary reason for the markets continued existence, and that market is likely to flourish so long as the American payments deficit continues to pump dollars into foreign hands. The Euro-dollar market was essentially an international money market and as such was a convenient source of credit for the borrower and a useful and profitable outlet for the lender. The market may well have been born out of interest rate rigidities, but given the apparatus of an international finance market with dealers willing to operate on small margins, the system would not be allowed to rust. As it was always useful to have a ready source of finance available.
Of the more immediate significance was the stimulus given to the market by the American operations in the forward exchange markets. During 1961, in Switzerland and Germany, the dollar stood at a substantial forward discount against Swiss francs and D. marks respectively. By contrasting to buy forward dollars against these currencies, the US authorities attempted (with some success) to lower the dollar discount. In this operation it was fairly certain that they had cleaned-up some loosely held Euro-dollars (mainly from European traders worried about the exchange risk). The effects of this operation was best considered by analysing two distinct positions. Firstly, when the dollar stood at a substantial discount, holders of Euro-dollars i.e. traders, would hardly sell them forward for say D. marks because of the cost involved unless they were really panic-stricken. However, when the US authorities managed to lower the forward discount, such holders would take advantage of this in getting out of dollars and to the extent that this happened there would be a gap in the Euro-dollar market. This outflow from the Euro-market would be more than balanced by inflows from the United States as Regulation Q continues to exist and because European holders of dollars realised, seeing that the US authorities stood ready to correct disorderly forward exchanges, they could convert their dollar holdings into other currencies without great cost. It was this factor which was presumably acting as a stimulus to the market in that Euro-dollar holders can have confidence in the future value of their holdings. Therefore, one of the main features of the American operations has been to encourage the continued holdings of dollars in non-official sectors. The Euro-dollar market was only dangerous to the American balance of payments to the extent that holders sell their dollars to their respective Central Banks who earmark these for gold.
1963 - The growing developments of the Euro-dollar Market
The Euro-dollar market as a whole by 1963, amounted to $4-5 billion and was tending to grow. At 31st March 1963, there were about $3 billion outstanding in the UK market alone. A world total of dollars and other foreign currencies used in foreign markets was of the order of $5-6 billion . Euro-money operations were conducted almost entirely by commercial banks although brokers became an important mechanism for organising the markets as the number of participants increased. Central banks and other monetary authorities directly or indirectly owned a large proportion of the dollars dealt with in foreign markets. It had been established that about two-thirds of all funds in European markets was of this character.
The supply of dollars for the Euro-market came from American residents and non-residents. During 1963, it was the non-residents who supplied the vast majority of the dollars, generated by a continuing US balance of payments deficit on current and long-term capital account. The most important suppliers of funds by country were Canada, Western Germany, Italy, Switzerland and France, although other countries had contributed. American residents added to the market (and hence to the overall US payments deficit) by switching short-term funds to European banks in order to take advantage of higher interest rates than could be obtained domestically. In actual fact, most American resident funds reached the Euro-market via Canada, in which the residents switched short-term funds to Canadian banks, which had then placed them into European banks .
The process by which these dollars reached the Euro-market was as follows: As a result of the American deficit, foreigners build-up dollar deposits in American banks on current account. The foreigner could then invest the dollars in any number of ways, but assuming that they would lend the dollars to a European bank, as that bank would be willing to pay a higher interest rate than could be earned in the American short-term money market. The ownership of the deposit is then transferred, within the American bank, to the account of the European bank which is then able to use the funds to lend. When the new owner of the dollar deposit lends to a third party, the European banks account in the American bank is debited and the third partys credited. The whole process is essentially a transfer of the dollar deposits in the American banks between accounts, the deposit never actually leaving the American bank.
As stated previously, official authorities were the most important suppliers of dollars to the market. This was presumably because residents in many countries surrendered (voluntarily or otherwise) dollar earnings to their central authorities which then put the dollars back on to the market in three ways: Firstly, that central banks and monetary authorities provide their respective commercial banks with dollars through swap operations, with a general or specific understanding that these dollars will be used to acquire foreign currency assets. The Deutsche Bundesbank has over the past two years engaged in such operations. Also this operation had occurred in Italy. Secondly, central banks deposit dollars in domestic commercial banks without requiring the surrender of the local currency equivalent. In some cases this is because such deposits earn higher rates than in New York. In Italy, however, this operation was used to increase the liquidity of the banking system. Thirdly, Central banks in Europe, Latin America, the Middle and Far East, deposit dollars with commercial banks in London, Paris, Canada and other money markets. Members of the Bank for International Settlements deposit funds with it and the BIS has become an important intermediary between its members and the Euro-dollar market .
Although precise data was not available, Oscar Altman of the IMF estimates that the central monetary authorities of 20-25 countries have deposited dollars outside the United States . The non-official funds reaching the market represent the funds of commercial banks, largely in continental Europe, and funds of businesses and individuals in many countries including the United States. Corporations in the United States have made substantial time deposits in Canada and Europe in order to earn higher interest rates than can be earned domestically. The funds deposited in Canada were channelled into European banks, (particularly the UK) the Canadian banks acting as intermediaries for US dollars. Businesses and individuals in many other countries, e.g. Canada, Germany and Switzerland, can hold dollars and other foreign currencies without restriction as to time, amount or purpose. Some have themselves deposited funds in the Euro-market, or have placed them with domestic banks which have done so. In a number of industrial countries, where there is a residue of exchange control, as in France, business enterprises can hold dollars and other foreign currencies for limited periods of time through authorised banks.
The dollars emanating from the US current and long-term deficit remain deposited in the Euro-markets, and US resident funds was attracted, because of the higher interest rates paid on such deposits in these markets than in the USA. The effective floor to the deposit rate on Euro-dollars is determined for non-residents by rates paid by US banks on foreign time deposits and other comparable short-term investments in the United States. In 1961, the Euro-dollar rate in London averaged 3.58% compwasd with 2.35% on new issues of US Treasury Bills and 2.80% on prime bankers acceptances. In 1962, the Euro-dollar rate averaged 3.77% compared with 2.78% on US treasury bills and 3.01% on bankers acceptances .
The higher interest rate of dollar deposits in Europe was not the only cost factor determining the attraction of holding such deposits. The most favourable condition for non-American owned dollars was that the dollar exchange rate (spot) should be on the floor but that there should be no expectation of imminent dollar devaluation either in terms of foreign currencies or gold. European dollar holders did not then need exchange cover. If fears of a dollar devaluation become widespread, the supply of non-American dollars would tend to dry up as banks would sell their dollars to the central authorities which would convert into gold. If the dollar rose to the top of the range against European currencies, the possible 2% fall over three months could militate heavily against Europeans continuing to hold and lend dollars, although it would not of course affect deposits attracted from American residents.
European banks were willing to pay higher rates on dollar deposits than American banks because they could find a profitable use for them. The dollars were used in the following ways: without switching into another currency; with switching but without forward cover; and with switching and with forward cover. Any of these possibilities could lead to investment, which more than covered the deposit charge which led to a demand for Euro-dollars. The banks holding the dollar deposits lent to governments by investing in government debt instruments and to commercial borrowers. The amount of borrowing by the banks to take advantage of pure interest arbitrage was a factor, although not the major one, determining the demand for Euro-dollars. Rates on Euro-dollars had been consistently too high to permit covered arbitrage in UK Treasury Bills, but when confidence in sterling was high there has been uncovered arbitrage. However, the rates on UK local authority and finance house deposits have been high enough to enable covered arbitrage transactions to take place at times. This process was usually short lived as the process of switching on any large scale removes the arbitrage advantage.
Most of the demand for Euro-dollars came from businesses and commercial enterprises. As, the dollars may have been needed to finance export-import operations. Commercial banks may use the dollars to serve as a money market instrument. A bank that temporarily needs additional liquidity may accept dollars (or other foreign currency deposits) instead of discounting with its central bank or selling assets in the open market. Moreover, since deposits can be accepted or placed in a wide range of maturities, banks can use then very flexibly. Likewise, businesses may be in temporary need of liquidity or may need dollars to finance overseas investments. For blue-chip industrial and commercial customers the rates that they will pay for borrowing from the market will range upwards from 5½% (i.e. from prime borrowing rate in the New York market). The maximum rate that can be charged in the Euro-market is the rate that the customers would have to pay in their domestic market. As the banks will be paying in the region of 3½% - 4½% for Euro-deposits, their maximum turn will be in the region of 1%-2% .
Switching out of dollars into European currencies can be profitable either for the Euro-banker direct or for the borrower who wants to finance in his own currency. In such a case the limit to such an operation would be where the cost of switching into the domestic currency and covering the transaction forward equalled the cost of securing funds on the domestic market. However, the business of switching is best regarded as a specialised concern operating in certain favourable times, but not essential to the functioning of the Euro-dollar market.
The growth of the Euro-dollar market has been basically the result of the difference in the interest rate structure of New York and European centres. Interest rates had been lower in the USA than in Europe and the deficit on trade and long-term capital accounts remained deposited in Europe rather than returning to New York, which had enabled European bankers to outbid New York for deposits (and deposit rates). Secondly, and of increasing concern to the American authorities, US residents have been attracted to the Euro-market, again because of higher rates, and this has added to the US capital outflow. Also, the widespread differences between borrowing and lending rates in New York and in most domestic capital markets had enabled the Euro-bankers to outbid their domestic counterparts for lending outlets by working on smaller margins, relying on a heavy volume of business to make their profit. The market had also been stimulated by certain non-interest rigidities in domestic markets, e.g. exchange control, credit squeezes etc.
The effect of the growth of this international currency had been: Firstly, to influence the structure and level of short-term rates in a number of countries. The Euro-market had tended to internationalise interest-arbitrage transactions. Secondly, to make it more difficult to carry out large changes of domestic monetary policy. Attempts to tighten liquidity would, by raising interest rates in the domestic market, lead to inflows of Euro-dollars. Thirdly to reduce the cost of foreign trade financing as the Euro-bankers have under-cut domestic charges.Finally, to increase the importance of the dollar as an international currency used in both trade and finance. As American non-residents were more willing to hold dollars because of the attractive interest rates to be obtained, international liquidity has been increased. The Euro-dollar market had been of help to the American balance of payments to the extent that non-residents have been willing to hold dollars instead of converting them into gold. However, higher deposit rates in the Euro-market had attracted US residents to invest in the market, and thus add to the US outflow. It had therefore been argued that it would be of advantage to the USA, if the latter could be reduced or eliminated without affecting the advantage to be gained by the former.
However, although the American authorities were concerned about the resident outflow resultant on the existence of the Euro-dollar market, there was evidence to suggest that the resident outflow was more than offset by a return flow of Euro-dollars back to the USA. Between December 1963 and March 1963, UK banks which were by far the biggest operators in the Euro-dollar market, increased their dollar claims on US residents by £147m while their US resident liabilities rose by only £4 million . These figures probably overstate the net inflow of dollars to the USA, as unknown quantity of resident funds reach the Euro-market via Canadian banks and were not picked up within the scope of these figures. Nevertheless, the amount of resident funds reaching the market was small and was probably offset by a substantial return flow. This return flow arose because of the wide-spread between the deposit and lending rates of US domestic banks which enabled European banks to outbid US banks for lending outlets in the US market. The existence of the Euro-dollar market certainly facilitated the lending by European banks to US residents.
American domestic banks were limited on the interest rates that they could pay on resident time deposits by regulation Q. The maximum interest rates payable varied between 1% on 30-day deposits to 4% on 360-day deposits . As a result, when they were short of funds, they often encouraged their European subsidiaries to enter into the Euro-dollar market and bid for dollars, the subsidiary then repatriated the dollars to its head office in America. To the extent that the European subsidiary attracted US resident deposits, this was a roundabout way of the US bank offering American residents a deposit rate in excess of that permitted by Regulation Q. The Euro-dollar market would cease to grow when rates in New York and in Europe for lending and borrowing were exactly aligned for all types of customers and when the differential between the lending and borrowing rates was small enough to make any banking operations unprofitable. Even if such conditions held, the dollars outstanding would still continue to be utilised for arbitrage operations and so there will always be some scope for Euro-dollar operations.
When the Euro-dollar market would be naturally curtailed, there were attempts to restrict the operations of the market in the following ways: The rate of interest charged on dollar loans was artificially increased. Italy is the clearest example of this. Agreements by Italian banks covering minimum rates on loans in lire were supplemented in 1961 by minimum rates on dollars and other foreign currencies. This agreement has been continually revised. Secondly, under the stress of competition, it was agreed or understood by banks in some countries (e.g. Germany) that loans in foreign currency should be made only to the foreign trade sector. Finally, in many European countries, the competitive effect of foreign loans was restricted by exchange or capital control regulations.
There was some concern about the relationship of the Euro-dollar market to actual or potential speculation against the dollar as the Euro-market was largely beyond the immediate control of the American monetary authorities. There was two sides of the argument. As the interest rates on dollar deposits was attractive, this gives an incentive for the dollars resultant on the deficit on trade and long-term capital account to remain unconverted into gold. The fact that dollars were placed in the Euro-market rather than used to buy gold, indicated that someone was not speculating against the dollar. On the other hand, the attraction of the market did induce American residents to invest short-term capital abroad and added to the funds in the market. However, there has yet been no evidence that the market for Euro-dollars had been unstable, although these dollars could be used for a speculative attack on the dollar.
It had been suggested that it would be preferable from the point of view of speculative pressure if the dollars resultant on the American payments deficit were held by foreign central banks. If there was a speculative attack against the dollar, the dollars held in Europe in private hands would be sold to the central authorities. Thus, it was the central authorities in Europe that was the holders of Euro-dollars at last resort. They were the focus of changing potential into actual speculation against the dollar to the extent that they were willing to hold dollars speculation was curbed. The real point was that New York had become an international banking centre whether or not this was liked by the American authorities and it was difficult to see what could be done about this other than by changing the payments and interest rate structure of the USA or imposing exchange restrictions. If American banks could raise the interest rates they were permitted to pay on deposits to residents, this would tend to reduce the resident funds going into the Euro-dollar market unless European authorities raised their own rates.
The evolution of the Market
By 1963, Euro-dollar operations were a particular form of banking whereby foreign banks, chiefly European, accepted deposits of dollar claims and in turn, lent these dollar claims to their customers. Typically, these deposits and loans were made for short periods. The supply of funds to the market came mainly from foreigners having dollar claims as a result of the US balance of payments deficit. The correspondent banks found that, operating with only a small interest rate spread, they could make a profit by lending these dollars balances at rates lower than those charged by traditional lending outlets in the United States. Other dollar holders soon found that they could engage in similar operations. Soon, British banks offered their customers and correspondents dollar facilities to take the place of the prohibited sterling credits, obtaining requisite balances in the European dollar market .
The demand for Euro-dollars came from a variety of sources, mostly in the private sector. The commercial banks of a large number of countries accepted and employed dollar deposits for use in both international and domestic operations. A substantial amount of Euro-dollars were used to finance firms engaged in international trade. These firms used Euro-dollar finance in preference to the more normal acceptance credits because of lower interest rate charges and because of the convenience of borrowing (given both the wide range of maturities available and the ready supply of funds in the market). Japan has figured prominently in the use of Euro-dollars for international trading. The highest interest rate that a Euro-banker could charge for lending dollars would be what it would cost that borrower to raise dollars on the New York market. This does not mean however that the effective upper limit to lending charges is the New York prime rate, as relatively few foreign borrowers would be eligible for that rate .
Perhaps most of the funds provided in the Euro-dollar market were lent in the United States. Virtually since the market began, US banks, through their European branches, have been active in the borrowing side of the market. The European branches have actively bid for Euro-dollars and have then repatriated to the United States. To the extent that the subsidiaries have attracted US resident funds, domestic residents may have been paid, indirectly, rates on time deposits in excess of those permitted under Regulation Q.
A main feature in both the evolution of the Euro-dollar market and the revival of the London international capital market, was the issue of a Belgian Government loan in London during May 1963. The loan had a three-year maturity and was denominated in dollars. The subscribers were a group of British banks which, it is generally thought, financed the loan in Euro-dollars . This was a departure from the normal short-term lending prevalent in the market and was the first issue handled by British banks in currencies other than sterling since the war.
Also, by 1963, Euro-dollars were used as money market instruments by foreign commercial banks. In view of the fact that dollars could be loaned or borrowed for various periods they constitute an excellent medium for banks to adjust their liquidity positions. In these operations the market is analogous to the Federal Funds Market in the US. Often banks were trading on both sides of the balance sheet, both lending Euro-dollars and at the same time borrowing. As well as loaning dollars, Euro-bankers used the dollars to buy other currencies and lend in foreign markets. In such a case the bank will arrange to sell its foreign currency holdings for dollars at a future date, i.e. it will hedge against the exchange risk. Occasionally, dollar deposits in European banks was used to take advantage of interest arbitrage opportunities. For example, there is likely to be a strong relationship between the amount of dollars switched into sterling and loaned to the UK Local Authority Market and the margin between rates of interest on Local Authority deposits (adjusted for the cost of forward cover) and the rates on Euro-dollar deposits. At times, Local Authorities have borrowed substantial short-term funds from the Euro-dollar market. Although Euro-bankers will not usually ignore an interest arbitrage possibility, the main type of transaction is that in which dollars was loaned directly .
Selling dollars for foreign currencies can be profitable either for the Euro-banker or for the borrower who wants to be financed in his own currency. In such a case, the limit would be where the cost of borrowing dollars and switching into the foreign currency and covering the transaction for exchange risk equalled the rates charged on local funds. It can be seen that Euro-dollar operations was similar to normal foreign exchange operations. Therefore, the market can best be regarded as a supplement to normal foreign exchange operations whereby foreigners having claims on the United States sell their dollars for other currencies, and others, wanting dollars, buy them through exchanges.
It should again be emphasised that the whole complex of Euro-dollar operations was reflected in the transference of ownership of dollar deposits within the US. These dollar deposits will continue to be held in US banks unless: (1) at some stage, dollars was converted into a foreign currency, or (2) the dollars come into the hands of central banks, that, in turn, convert then into gold, or (3) the dollars were used to pay off a loan at a United States bank.
The three media articles at the back of this paper (Appendix 1 and 2 referring to The Times, and Appendix 3 referring to The Financial Times) indicates that the Bank of England underestimated the significance of the Euro-currency markets for the UKs own problems of monetary management, internal and external. For example, in so far as short-term capital flows increasingly take the form of a movement out of sterling into the Euro-dollar market (and vice versa), what kind of offsetting action do we take? If the UK was not going to use short-term interest rates, can we in some way look to the market as a source of funds just as we have recently looked to foreign Central Banks.
The Euro-bankers were really worried by the growth of the negotiable certificate of deposit in the United States the interest rate on which has just risen so that it is now only at a slight discount on dollar deposits in the UK. UK bankers can of course increase the Euro-dollar rate (which I would suppose is inevitable) but the differential between the Euro-dollar and the time certificate of deposit rate is likely to be much less than we have seen in the past. This is because of the effective upper limit on the Euro-dollar rate of 4½%, i.e. prime lending rate in New York. If the Euro-dollar rate exceeded 4½% borrowers who previously used the Euro-dollar market would borrow direct from New York. The effect on the UK balance of payments of such a development is difficult to estimate as Europeans would still borrow dollars switching from the Euro-market to the New York market directly.
In order to combat the increasing development of the time certificate of deposit there were ideas from the City of a negotiable Euro-dollar deposit. The advantage of this instrument to the Euro-bankers was that the necessary differential to attract funds would be less in the case of a negotiable dollar deposit than with the usual dollar deposit. It was thought that there was a real possibility of such a development in the Euro-dollar market. The UK should not worry about this any more than about the present state of the Euro-dollar market and in fact such a development might well be welcomed as it would avoid putting too much upward pressure on the Euro-dollar rate which could be embarrassing for domestic short rate policies. A differential between UK Treasury Bill rates (adjusted for the cost of forward cover) and the Euro-dollar rate, in favour of Euro-dollars, could lead to switching of funds previously held in the UK, by non-residents into the Euro-market. It is the general problem of separating outflows of sterling which is causing great difficulty. One can only arrive at an approximate answer by correlating relative interest rates against the outflows. However, the Euro-dollar differential appears to have exerted little influence on the switching of funds out of sterling balances. This of course does not mean that the Euro-dollar/UK Treasury Bill differential has not exerted an influence in the past it simply means that as yet we have not proved it. As one would expect, sterling holders be tempted to switch their funds by an attractive premium in favour of Euro-dollars, (unless they was completely irrational).
The Euro-dollar market was composed of a very large amount of funds highly sensitive to relative movements in interest rates. If a position was postulated whereby UK interest rates fall relative to Euro-dollar rates, (US interest rates rise which pushes up the Euro-dollar rate and UK short rates do not follow), the effects on the UK balance of payments would be of two types: (a) funds invested in the UK directly by Euro-bankers (usually in Local Authority deposits) would be withdrawn; and (b) sterling balances of non-residents would be switched into dollars and invested in the Euro-dollar market . Funds invested in the UK directly by Euro-bankers will be shown up by changes in Dealers net deposit liabilities in foreign currencies. These liabilities reflect the extent to which banks have switched any foreign currency deposits lodged with them into sterling. In all cases, the initiative is in the hands of the banks themselves. By no means all of the switching done by the dealers is the reflection of relative interest rate advantages, but nevertheless this is bound to be a part. As a large part of the foreign deposits lodged with UK banks will be dollars on which the banks pay the Euro-dollar rate, and as generally speaking, all switching is covered forward, the banks will have usually found it unprofitable to have borrowed these funds and to have invested in UK treasury bills. However, there have been arbitrage advantages in investing in local authority deposits or finance house deposits .
1964 The New Labour Administration
1964 was a significant era for the Euro-dollar market, as not only was there a change in Government, but it was at this time that Euro-dollars changed from being a new phenomenon into a prominent force in the market. The Labour Party had come to power, with Harold Wilson, as the new British Prime Minister. However, it was clear for the new Labour Administration that the UK was facing a deficit of £800m on its overseas payments for the year 1964. It was this inheritance from the Conservatives which was to dominate almost every action of the government for five years. The new administration was faced with three courses of action: devaluation of sterling, quantitative restrictions on imports (quotas), and a surcharge, in effect a temporary additional tariff, on a wide range of imports. At the time in 1964, devaluation was not an option, given the size of the new governments majority, it was not a surprising decision. Also, the new incoming government did not fully know the true facts of Britains deficit. However, there was no option but to accept devaluation. In 1967, there was no alternative, central bank and governments accepted the decision as necessary. However, Wilson, had argued strongly (from 1964-67), that devaluation was not a easy way out, that by its very nature in cheapening exports and making imports dearer, it would require a severe and rapid transfer of resources from home consumption, public and private, to meet the demands of overseas markets. This would have meant, brutal restraints in both public and private expenditure over and above the domestic situation that the labour administration had inherited. Other considerations, were that devaluation could have started a competitive currency devaluations similar to those of the 1930s, and could have led to stimulating economic nationalism and blind protection abroad .
Quotas were rejected, due to the damage it could have inflicted on industrial production, no matter how selective the system, and in particular, their effect in ossifying the industrial structure, penalising new or growing or efficient firms and feather-bedding the un-competitive. Tariff was the third proposition left. However, this was not an easy option either. As, it would be argued abroad that a sudden rise in the tariff over a wide range of commodities was contrary to the UKs international obligations, particularly those of GATT, and EFTA. Other nations that had close economic relations with the UK, such as the Commonwealth countries, the Irish Republic, the USA, would have had strong grounds for protest. There was fear that once imposed, the surcharge would be difficult to remove. Other fears were that UK manufacturers that were enjoying a temporary protection against foreign competition, would slide into easy ways, instead of responding to the challenge by making themselves still more competitive. However, despite these anxieties, action had to be taken, so the import surcharge was recommended. It was decided that a rate of 15% would be imposed on all imports, except food, tobacco and basic raw materials. On the 26th October, ten days after taking office, a statement was issued underlying the economic situation. It concluded that the strength of sterling could and would be maintained, the underlying economic situation remained profoundly unsatisfactory. The balance of payments deficit for 1964 was most unlikely to be below £700m and might well reach £800m. While a considerable improvement was expected, in 1965, the deficit would still be at an unacceptable level. The position on imports and exports was surveyed together with the domestic economic situation, the problem of continually rising prices and the position on public expenditure. The statement went on to announce the introduction of surcharges, at 15%, on all imports, except food, tobacco, and basic raw materials. In its first ten days in office, it was clear that the new Labour administration had to deal with an explosive economic situation .
The Economy Speculation against Sterling and the drain on reserves
In London, there were a number of large international companies which held considerable amounts of working capital in sterling. There was a growing business in the speculation in sterling (based on selling sterling to obtain foreign currencies). These players held the future of sterling particularly to the exchange rate itself tend to move their money out, even at a relatively high cost in terms of interest, to some currency they regard as more secure. At the time of heavy balance of payments deficit there was, a large quantity of sterling splashing about in the markets of the world and, when confidence in sterling was low, dealers in many markets sold sterling for US dollars, German Marks, Swiss Francs, or anything deemed safer. The only way in which British citizens were able to take a position in sterling, (as they expected either a marginal fall or an outright devaluation) was by postponing receipt of the payments that was due to them in some foreign currency, since after the fall in the sterling rate such foreign currencies would be worth more in sterling terms .
However, importers who had to make payments in foreign currency tended to advance their payments, paying the bill beforehand. In difficult times, there was clear evidence that importers were increasing the physical qualtities of their imports, buying their raw materials 3-6, even 12 months ahead, and paying as quickly as possible for the imports thus ordered. These Leads and lags had the effect of running into hundreds of millions of pounds on the sterling position and thus on the reserves. On top of this, speculation grew to great proportions when a devaluation was expected. Such dealings were confined to foreign exchange dealers/speculators. These were in the form of dealers getting rid of sterling, they held or selling sterling they did not possess with the idea of buying it back some days later. This meant that, if these dealers had to pay bills in sterling, they had to borrow at extortionate rates of interest. Nevertheless, this speculation proved so severe that, it was becoming a threat to the balance of payments deficit. Indeed, it virtually disappeared as a threat once the UK moved into strong surplus, but that was after 1969. However, before the UK was in surplus, the government had to take actions against what the speculators might do, hereby looking at the confidence factor. So, things had to be rightly timed, in order to minimize possible speculative consequences, (this was also the case in 1969 when the UK were moving into a strong surplus). This meant that the City, closely monitored the actions of the Chancellor, the Governor of the Bank of England and the Prime Minister. One mistake the government admitted was always underestimating the power of the speculators. It was this understanding, that made the government more determined to strengthen the basic position of sterling, which meant strengthening the balance of payments which in turn strengthening the competitiveness of British industry. This was the point of the Chancellors statement on the 11th November 1964. As, there was, a considerable surplus of highly volatile sterling in world markets because of the balance of payments deficit .
Since the Chancellors statement, both the PM and the Chancellor received a daily tally of the movements on foreign exchange markets, recorded not only by the exchange rate, but the amount of money which the Bank of England had to throw into the market to stabilise the sterling rate, together with payments on government account. This was regular right until 1969. Day by day, the government listened to demands for immediate cuts in government expenditure, and faced heavy drain on the reserves. It was a situation where 50 million pounds could have been lost, sometimes more, and the UKs total gold reserves and convertible currency reserves barely totalled 1,000 million pounds. Short-term central bank assistance was near exhaustion, and there was no immediate prospect of the IMF borrowing on which the UK decided. The pound was at its support level. On the 25th November 1964, the Governor of the Bank of England stated to the PM that $3,000 millions was successfully raised by the central bankers. It seemed that sterling was safe, for a time. Long enough, to strengthen exports to the point where day-to-day speculation was not reinforced by a chronic balance of payments deficit .
Euro-dollars a prominent force in the market?
It was clear in 1964 that a large international money market in short-term dollars had developed outside the US. These transactions were made possible because Americans and foreigners deposited dollars with banks outside the US, which had profitable uses for them. It was estimated with some assurance that dollar deposits come from at least 25 countries and that the final users of dollars reside in at least 35 countries .
About 400 commercial and private banks were in the Euro-dollar market. Many of these banks were in the market all the time, and they were on one side or the other, depending upon profits that may be earned from interest rate differentials and arbitrage possibilities. Other banks were in the market irregularly in order to deal with the financing needs or the savings accumulations of particular clients. The Euro-dollar market held no bar to politics. The two large communist banks in Western Europe - the Moscow Narodny Bank in London and the Banque Commerciale de lEurope du Nord in Paris were important components in the market, sometimes to place deposits with other banks (lend) but more often to accept them (borrow) . The states banks behind most of the countries behind the iron curtain were in the market, and many of these regularly circularize commercial banks in the West in order to obtain funds. Brokers play an important specialised role as intermediaries among banks, and two of them one in Paris and the other in Lausanne, with their branches do a large international business . The market in Euro-dollars was a wide and complicated one spread over six continents and bound together by a network of cable, telex, and telephone communication. The paper work in the market tended to confirm rather than to initiate transactions. The financial standing of the banks in the market was such that transactions were based on names and did not involve collateral and guarantees.
As the market progressed, the movement of Euro-dollars became an important financial activity and it was clear from the City that there were three major uses for Euro-dollars: First, a large part of these dollars was used to finance external commercial transactions, i.e. exports and imports. Indeed many countries in Europe and elsewhere tried to restrict Euro-dollar activities to those business enterprises that were engaged in foreign trade. These restrictions operated through systems of capital controls, or exchange controls, or moral persuasion by central banks. Even European countries with convertible currencies may restrict or prohibit business enterprises not engaged in foreign trade, e.g. hotels and department stores, from borrowing Euro-dollars, even though borrowing dollars may be cheaper than borrowing local currency. This was, for example, the situation in France. In 1961-63, with the expansion of issues of long-term securities denominated in dollars in European capital markets, underwriters and syndicate members have used Euro-dollars to finance their inventory positions. Italy made a large and noteworthy use of the Euro-dollar market in 1962-63, borrowing more than $750 million from abroad, of which about half came from the Euro-dollar market . These funds were used to finance external transactions and to make possible a continuing increase in domestic liquidity, which in effect, reduced the drain upon official reserves. Acting under instructions from the Bank of Italy, the commercial banks began to reduce their net external liabilities in the fourth quarter of 1963 and had gone a long way toward reversing their position.
Second, some Euro-dollar funds were used to finance commercial loans and other domestic transactions either in the form of dollars or in local currency purchased with dollars. There has been a large amount of such transactions in Germany, Italy, Japan and smaller amounts in many other countries, including Switzerland. In the UK, a substantial amount of Euro-dollars has been swapped into sterling and then placed with local authorities and instalment finance companies. The Kingdom of Belgium has, directly or indirectly, financed part of some of recent budget deficits with the local currency proceeds of Euro-dollar borrowings .
Third, the Euro-dollar deposit was a new and international money market instrument which makes it possible for hundreds of commercial banks to deal with each other continually in order to adjust their own liquidity positions. Each bank makes its own adjustments for this purpose by dealing in funds with different stated and implicit maturities, different interest rates, and different counterparties. On an international scale, Euro-dollar deposits used in this way were analogous to the many kinds of domestic funds in the American market: federal funds , short-term government securities, certificates of deposit , and that recent newcomer, short-term unsecured promissory notes issued by a number of leading American banks .
European commercial banks were able to invest in Euro-dollar deposits with a broad range of maturities. This facility was the more important because few countries had short-term money markets that were as liquid, and investment media that were as broad, as those in the US. For one reason or another, some industrial countries had only had a small amount of tradeable money market instruments, while others had domestic money market instruments that were available only in a controlled market, or at a regulated interest rate. It was therefore understandable, that commercial and private banks in Europe should welcome an uncontrolled, flexible, and international money market instrument to facilitate their own operations. Moreover, Euro-dollar deposits help commercial and private banks to obtain funds outside of the channels of their regular customers.
The role of Euro-dollars as a money market instrument had some important implications. A substantial part of the Euro-dollar pool circulates and recirculates endlessly among banks. To this extent, any discussion about using short-term Euro-dollar funds to finance long-term investments in plant, equipment, or inventory was beside the point. Furthermore, attempts to find the specific end uses of particular Euro-dollar deposits were often quite vain. On the one hand, the sources and uses of Euro-dollar affect what the bank does with the rest of its funds; on the other hand, the funds that the bank had, and what it does with these funds, affect its operations in Euro-dollars. As banks had acquired more experience with Euro-dollar operations, they had modified their views on putting lending and borrowing operations in Euro-dollars in a separate compartment and treating them as an adjunct to their exchange operations. More and more banks look on their dealings in Euro-dollars as an operation run by senior officers to increase the profits of the bank as a whole in both the short run and the long run. This had been the attitude of American banks whose foreign branches had been and were major operators in the Euro-dollar market. The amount of deposits accepted by foreign branches, and the interest rates paid on them, were determined by or cleared with the head offices. A large part of the Euro-dollar deposits obtained by foreign branches of American banks was made available to their head offices .
The proportion of Euro-dollar deposits made available by foreign branches of American banks to their head offices had decreased for some time. 3 or 4 years ago, the bulk of these funds, perhaps 75% or more, was handled in this way. But this percentage had fallen markedly with the overseas expansion of American banking and industry. Foreign branches of American banks had become more familiar with loans to foreign corporations as well as to foreign subsidiaries and branches of American corporations. Managers of foreign branches of American banks wished to pursue an aggressive policy to show maximum profits for their branches by lending their own deposits rather than the much lower profits that would accrue to them from putting Euro-dollars at the disposal of their head offices. In some cases, the percentage of Euro-dollars funds put at the disposal of head offices was now apparently well below 50% .
Virtually all commentators on the Euro-dollar market had warned of the possibilities of abusing it. And it was true that the facilities offered by the Euro-dollar market may be abused in a number of ways. But it was also true that similar abuses were not unknown in commercial banking that does not make use of Euro-dollars. Individual banks, or all of the banks in the Euro-dollar market collectively, may obtain funds on short-term and lend them on very much longer term. Though some of this was inherent in banking operations, too much of a spread between borrowing and lending maturities will impair banking liquidity. Again, the rapid expansion of Euro-dollar facilities, and the growing international competition among banks, can easily lead to undue reliance on the quality of names. Such reliance, when combined with a premium on quick decisions, can lead to relaxation of banking requirements for good and up-to-date information on assets and liabilities, profits, and the total of outstanding borrowings and contingent obligations. Losses within the past two years in several well-publicised cases had underlined such risks.
The rapid development of the Euro-dollar market, the facilities offered by a new money market instrument, and the increased although gentlemanly competition among banks on both the domestic and international scene, had been accompanied by a certain amount of exuberance. The recent losses in Euro-dollars appear to had curbed some of this exuberance and thus strengthened the market without interfering with its growth. It should be noted that banks had gone international very rapidly. Many banks and their investment subsidiaries had been anxious to get in on the ground floor. They had tried to develop, even at some cost, new customer relationships that would be profitable in the long run. They had considered certain low profit business as institutional advertising . It had taken a bit longer, perhaps, to realise that every country differs from every other in the number of sets of accounting records that it regards as good business; in the amount of disclosure that it regards as good for the Board of Directors, the stockholders, and the stock exchanges; in accounting standards and practices; and in views of tax morality.
Such a simple problem as determining how much a European corporation had borrowed, and from whom, may be very difficult when corporate structures were complicated, and when borrowings were made from many countries and from many banks that had traditionally refused to disclose anything to each other or to third parties. It was understandable therefore, that there had been voices asking for better advisory and rating services on an international scale, and for more uniform accounting standards and disclosure along the lines of those administered by the Securities and Exchange Commission, and encouraged by stock exchanged and accounting firms. There had recently been discussions in Europe advocating more uniform accounting practices, better reporting, and a European credit agency which would collect and consolidate data on corporate borrowings what in Europe was called a centralization of risk service. The Bank of France had for a number of years required banks in France to report all loans to business enterprises over stated minima; the Bank then tabulates these reports to obtain and make available data on consolidated borrowings of various types. Italy had recently announced the formation of a similar official service . Great Britain had private facilities of this type. But most other industrial countries had neither the one nor the other.
European and American bankers would undoubtedly welcome a centralised reporting system on outstanding commercial credits of European corporations. But it would probably take a good deal of time to establish this, and M. Julien Koszul, Director-General of Foreign Services of the Bank of France, may well be right in thinking that a system of European scope will depend upon each major countrys first developing its own reporting system . If commercial banks in Europe will not collaborate voluntarily to report their larger loans to an independent private agency, so that they can all benefit from consolidated totals, information on outstanding loans and credits can then only be collected by official national agencies acting with mandatory powers.
The point of this discussion about credit reporting and accounting standards was that some of the possibilities of abuse in the Euro-dollar market were also inherent in the rapid internationalisation of commercial banking. Many of the same banks, and many of the same banking officers, operate in both wereas. Improvements made for Euro-dollar operations will flow over to more customary banking operations, and vice versa. In the process the whole level of international banking will be improved.
A few words should be said about the supposed lack of liquidity and stability that arose in the Euro-dollar market from borrowing short and lending long: First, there were no over-all or consolidated data showing the distribution by maturity of Euro-dollar deposits and loans. Some banks may had developed statistics covering their own operations; and Japan collects data on the distribution by maturity of Euro-dollar deposits accepted by Japanese banks in order to improve its overview of the balance of payments and the significance of its international finance.
In the second place, there would be great difficulties in interpreting data on the maturity distribution of Euro-dollar deposits and loans, even if they were available. Things very often were not precisely what they seemed. Euro-dollar deposits may be accepted as short-term by a bank, and may so appear on its books , even though both the depositor and the bank know that the money will remain on deposit for substantial periods of time, perhaps for several years. The depositor may prefer to show his deposits as short-term to comply with legal requirements or customary practice. E.g. deposits by monetary authorities and insurance companies were often made on such arrangements. When this is the understanding, the depositor will, quite reasonably expect to earn something more than the short-term rate, and actual interest payments may be negotiated at intervals of (say) three or six months. In transactions involving several corporations in the same business family, the maturity of loans to one may be tied to the maturity of the deposits of others. In other cases, loans may be subject to termination, and longer term loans may be subject to interest rate adjustments which may put pressure upon the borrower. The real or effective distribution by maturity of Euro-dollar deposits and loans may thus differ significantly from the distribution calculated from the banks records . Neither should it be overlooked that when banks accept risks of this kind, they expect to be compensated for them by charging higher rates.
Thirdly, many of the worlds largest and best regarded banks were in the Euro-dollar market. Not one of these banks thinks that it was taking any undue or uncompensated risks, though it may be willing to concede or even to affirm that its competitors were. There was nothing in the Euro-dollar market equivalent to the off-lot investor buying five shares of stock. The chips in this game were high and transactions run to six or seven figures. Everybody who operates in the market knows the risks, as well as the potential profits, of arbitraging loans and deposits of different maturities. No one wishes to be caught in a squeeze which was too tight or in an increase in interest rates which was too costly. Hence, behind the network of Euro-dollar deposits and redeposits, behind the network of lending and relendings, there was a network of stand-by agreements, lines of credit, and banking guarantees. Business enterprises may had these second line defences with banks, and banks may had them with other banks. Exposure in the Euro-dollar market was thus both direct and indirect. Some commercial banks and central banks had a larger stake in the market than they suspect .
Despite all these qualifications, there was no doubt that some aspects of the Euro-dollar market can be improved. The fact that individual risks may be smaller and more widespread than appears at first glance does not reduce the total risks of everybody. Indeed, to the extent that the network of reinsurance, in the form of lines of credit and stand-bys, was largely concentrated in the US, the exposure of this country may be larger than that based only on the Euro-dollar deposits and loans of the American banks that operate directly in the market. Hence, steps to improve the information available in and about the Euro-dollar market were more than desirable they were necessary.
Interest rates on Euro-dollars were determined by very broad competitive forces. These include interest rates on loans and deposits in other major currencies, such as sterling, deutsche mark, and Swiss francs, and spot and forward exchange rates of each of these currencies relative to the dollar. Since there was extensive arbitraging by commercial banks, among all the major currencies, the covered interest rate paid on (say) Euro-sterling deposits was, except in very unusual circumstances, approximately equal to the interest rate paid on Euro-dollar deposits. Thus, in 1962, interest rates on Euro-dollar deposits averaged 3.77%, while the cost of dollars obtained through swapping sterling deposits into dollars was equal to 3.83%. this cost of dollars obtained indirectly was equal to an interest rate of 4.95% on Euro-sterling deposits less the forward discount of sterling with respect to the dollar of 1.12% .
In general, interest rates on deposits of all currencies that command a forward premium over the dollar tend to be lower than interest rates on Euro-dollar deposits by the amount of this premium, while interest rates on deposits of currencies that stand at a forward discount relative to the dollar tend to be higher than interest rates on Euro-dollar deposits by the amount of this discount. All of these rates were mutually self-determining, but the foreign markets for dollars was so much more important than the foreign markets for all other currencies combined perhaps in the order of three to one - that the interest rates on all non-dollar Euro-currencies tend to be adjusted to the interest rate on Euro-dollars.
The rate of interest on Euro-dollar deposits was thus truly an international rate that reflects the interplay on demand and supply factors in many countries, so that a change in any one element was unlikely to change the nature or the course of the Euro-dollar market in any decisive way. It was often assumed, e.g., that if commercial banks in the US could compete freely for the time deposits of foreign governments and foreign monetary authorities, free from the restraints of Regulation Q, they would attract large amounts of such deposits . After these restraints were removed in October 1962, foreign time deposits increased from about $2.2 billion to $3.2 billion at the end of 1963, and to $3.8 billion in August 1964. Interest rates on all other time deposits were increased at the beginning of 1962, and again at the beginning of 1964, and the development of certificates of deposit had had the practical effect of raising interest rates on the short end despite the restrictions of Regulation Q. Nevertheless, the Euro-dollar market was still there, stronger and bigger than ever.
Since 1961, short-term interest rates had risen in the US, in the Euro-dollar market, and in virtually all the major countries in Europe. Euro-dollar rates had gone up less than US Treasury bill rates, so that the difference between the two had become much narrower.
The US had been trying for several years to increase domestic short-term interest rates without increasing long-term rates, which might limit the current economic expansion before full employment was reached. Debt and monetary policies had been keyed to this objective. In the last few years, the shortest term interest rates had risen the most, while long-term rates had been remarkable steady and mortgage rates had been under downward pressure. The structure of interest rates in the US had thus become considerably flatter. But the same development can be observed in the Euro-dollar market, within the range of maturities dealt with there, as well as in the major countries of Europe.
Interest rates on Euro-dollars had clearly been an important factor in pulling up short-term interest rates in the US. Short-term interest rates in the major continental European countries had also increased. The pressures of full employment and rising prices in these countries were increasing the demand for money, and the monetary authorities were reacting to these pressures with a tighter monetary policy. A number of European countries would probably prefer even higher interest rates. But these would encourage larger inflows of foreign capital as well as larger repatriations of funds by residents. The authorities would not like to add to the tasks they already had the need to deal with larger capital inflows.
Interest rate developments may be interpreted in a number of ways. The interest rates increases in the US and in the Euro-dollar market may be regarded as permissive, in that they made it possible for many European countries to follow a higher interest rate policy without the danger of augmenting capital inflows. Or, the increases in interest rates in Europe may be regarded as initiating, in that they tended to pull up rates in the US and in the Euro-dollar market. Or, increases in European interest rates may be regarded as offsetting, in the sense that higher short-term rates in the US would had greater international effects if European countries had not seized the opportunity to tighten domestic credit. On this latter interpretation, American monetary policy, would had been more effective if European countries had made greater use of fiscal policy and less use of monetary policy .
Beginning 15th October 1962, for a period of three years, maximum interest rates could not be imposed under Regulation Q on time deposits for foreign governments, monetary and financial authorities of foreign governments when acting as such, and international financial institutions of which the US was a member. Foreign time deposits of American banks had increased by three-quarters since October 1962. The part of this increase that can be attributed to the removal of interest ceilings under Regulation Q must be much less than this, since time deposits at all commercial banks increased by one third in the same period.
On the size of the Euro-dollar market (estimated to account for over 80% of the Euro-currency markets, with Swiss francs in second place) the best estimate is $3.7 billion at the end of March 1963. This was, of course, only an approximation based on the Euro-dollar liabilities of the seven main European countries to countries outside this group, to the BIS and to European non-banks. The assumption here was that inter-bank deposits within Europe may be excluded as a duplication. There were some reasons for believing that this estimate may be too small, but also some for thinking it may be exaggerated. Between March and September 1963, it was believed that the unduplicated total on the same basis probably rose to about $4.3 billion .
In 1964, Mr Bell of the Treasury took a gloomy view of the prospects of a development of an international bond market of any economic significance because he thought that this depended mainly on whether continental countries will be willing to relax exchange controls. There had been a great deal of talk in the City about the need for an international capital market centred in Europe. Most of the discussion had concentrated on the development of non-resident bond issues and so will this paper. The subject was first given prominence as a result of a speech by Mr Dillon, the US Secretary of the Treasury, made at the meeting in Rome of the American Bankers Association in May 1962. In emphasising how legal and institutional restrictions and an insufficient development of machinery for placing new issues prevented Europes saving potential from being effectively used, Mr Dillon argued that all this placed an excessive burden on the New York Capital Market. New York was, in fact, compelled to absorb a volume of new issues which could be better divided out, in the interest of a better balance between the US and Europe, provided that Europes capital markets were able to fulfil their functions.
The introduction of an Interest Equalisation Tax in the US (July 1963), although only enacted in August 1964, had a marked impact on the volume of new foreign issues on the New York market. The tax effectively reduces the net yield on new issues to US residents by about 1%. From a total volume of new foreign issues of about $1 billion in 1962, the volume rose to an annual rate of about $2 billion in the first half of 1963. In the year since July 1963, the level of new issues had fallen back to about that of 1962 . It was the purpose of this to point out some of the barriers to the development of an international bond market in Europe, and also some of the techniques which had been used in the flotation of new foreign issues. It was the conclusion of this that Europe is unlikely to develop an international capital market in bonds of any major significance in the foreseeable future, partly because any investor preferences, and partly because of the reluctance of national monetary authorities to accept the corollary of a major international market i.e. the equalisation of long-term interest rates and the consequent lack of an independent monetary policy.
Size of the European markets
A major barrier to the development of an international bond market in Europe was the fact that most of the continental countries did not generate a volume of savings of any magnitude, which seek investment in long-term fixed interest securities. The absolute size of the European long-term markets and the volume of transactions were such that a substantial new issue around $50 million, - typically meets a thin market in the sense that it cannot be absorbed easily and will consequently have a pronounced impact on the level of interest rates. In other words, the current market rate of interest was not necessarily (or even usually) indicative of the cost of raising new funds.
The comparisons were drawn between the totals for business, state and local governments (central government was excluded because such issues were based on considerations of fiscal policy), the total for the US was approximately equal to that of the European countries combined.
However, even though the total European new issue activity was about the same as that of the US, the individual markets themselves were typically small. Thus, a foreign bond issue of a significant amount would find great difficulty in raising sufficient funds if it were placed in one national market. Partly, as a result of this, the holders of the security would find difficulty in selling their investments at the market rates. It would therefore seem to follow that if the flotation of new foreign bonds issues was to be successful that, amongst other things, a number of individual markets will had to be tapped simultaneously.
Structure of the markets
Certain factors can be listed as contributing to the limited size and imperfections of the European markets for long-term securities. It should be stressed that these factors were applicable to the continental European countries and not to the UK. The structure of the European markets was contrasted to that of the US which can be regarded as highly developed.
First, in Europe, government and other quasi-public institutions play a much larger role in gathering savings and channelling them into alternative uses. Moreover, a characteristic phenomenon the most evident case was the change in the French markets structure from 1958-59, which was maintained in subsequent years was that when public sector issues diminish, the global volume of fixed-interest security issues also contrasts. In general the governments, either to provide for its own financial needs, or to canalise resources to preferred uses, exercises a predominant influence on the markets. Recourse to the capital markets takes place within large measures therefore under the control of the authorities and within the limits determined by administrative choice .
Second, a smaller proportion of European saving was channelled through private non-bank financial intermediaries. A large part of breadth and stability of the long-term capital markets in the US and UK was directly related to the activities of non-bank intermediaries, particularly pension funds and life insurance companies.
The limited role of life insurance and pension funds in Europe was partly linked to the preferences for more liquid forms of investment. Table III illustrates the predominance of short-term saving outlets in the portfolios of the household sector. It would seem therefore, that an important reason for the lack of a long-term security market in the European countries was absence of important and regular flows of savings channelled through institutional investors. Many observers had argued that the greater continental preference for liquidity was connected with inflation experience. If they were correct, then a basic precondition for any increase in the flow of personal savings into fixed interest bonds, was the maintenance of a considerable degree of monetary stability over a long period.
A third factor that contributes to the limited size of the long-term securities market was a fiscal one. Two types of taxation were applied to new bond issues; a direct tax on interest distributed to bondholders, which in some countries was borne directly by the issuers, and an indirect tax in the form of stamp duties. These were often administered in a way which inhibits the functioning of the private bond market. E.g. discriminatory treatment was sometimes encountered as between public issuers, who bear few or no charges, and private issuers for whom the fiscal factor means a considerable increase on issue costs. The result of the poor markets in long-term securities in Europe had been to concentrate external business financing into non-marketable forms of credit.
Also, it had tended to make European business firms rely to a much greater extent during the post-war period upon reinvested earnings for investment financing. However, there was some evidence that European firms were decreasing their reliance on reinvested funds.
Foreign lending and European Capital Markets
It can be argued from sections of this paper on the size and structures of the European markets that for foreign bond issues to be successful amongst other things two crucial technical factors were to be overcome: Firstly that the necessity of tapping a number of individual markets simultaneously. Secondly that the necessity of changing investment preferences so as to attract investors into long-term fixed interest securities, and to make a stable market in these securities . In recent years, the securities markets of Switzerland and the UK had regularly accommodated a significant volume of new security issued by foreign borrowers.
However, foreign issues were strictly controlled in both these markets, and almost all of the borrowing in the UK market had been limited to the sterling area. Germany, which does not impose restrictions on capital movements, had provided only relatively small amounts for new foreign security issues because of high issue costs and the high level of interest rates. The Netherlands permitted a substantial volume of foreign issues in 1961, but no foreign issues in 1959 or 1960, and only a very small amount in 1962 and 1963. France permitted no foreign security issues until late 1963, apart from franc were issues, while Belgium and Italy had opened their markets to limited borrowings by international institutions but to few others.
The failure of most European markets to absorb new foreign security issues in significant amounts stands in marked contrast to the extensive participation by Europeans in foreign lending through the New York market. Information was incomplete, but in some past years up to one-half, or even more, of European bonds publicity issued in New York were purchased by Europeans. Some of these foreign purchases of European securities can be attributed to special factors, such as exemption from US withholding tax on interest paid to non-resident alien holders of foreign dollar bonds, and possibly to the avoidance of domestic taxation. Long-term interest rates in some European countries Switzerland, and the Netherlands had been below those in the US and therefore dollar bonds had been purchased to take advantage of the higher yield. However, even though these special factors had undoubtedly played some part, perhaps the most important reason for the purchase of foreign dollar bonds in New York, was to be found in the much greater marketability of foreign security issues in New York. Investors can, therefore, usually liquidate their securities at a firm price.
Techniques of foreign security issues in Europe
In an attempt to develop an international capital market in Europe, various solutions had been put forward to surmount the problems outlined in this paper. These solutions can be grouped in five categories , according to their technical features:
(a.) Admission of foreign firms and bodies to the individual national markets, their issues being denominated in the currency where they were placed. (b.) Issues placed simultaneously on various markets and divided into tranches, each denominated in the currency of the country where the tranche is placed. (c.) Issues characterised by clauses that enable the bearer, when interest is paid or the securities redeemed, to, choose between two or more currencies (exchange option). (d.) Issues on a given market of securities denominated in the currency of a third country and intended for placing largely in other third countries. (e.) Issues denominated in European Units of Account.
Solution (a) corresponds to what had been happening as national markets had been opened. However, most national authorities had been unwilling to treat domestic and foreign lending equally because of the effects of respective balance of payments.
Solution (b) was put forward in October 1963, by Herman J. Abs, and it concerns a method which had never been put into practice since the war. In these issues, allowance would be made for the differences in the rate levels ruling on the different markets by varying the issue prices, while the nominal rate of interest and other features of the loan would be uniform in all tranches. The major problem with such a technique would be to prevent subscriptions being concentrated on the tranche that offered the highest yield. Also, trading could take place between the different tranches which could increase speculative pressure when a particular currency became suspect. Again another factor is that authorisation to make such an issue would had to be made simultaneously in a number of countries and to surmount the different administrative barriers.
An issue with an exchange option gives the bond holders the right of requesting normally with only a few days notice payment of interest and amortization in one or more currencies different in that in which the securities were denominated, at a exchange rate based on the parity existing at the time of issue. Investors, in other words, had an exchange rate Guarantee in terms of the other currencies denominated in the option. However, the same clause that guarantees the investors funds, may prove burdensome to the issuer; here the normal risk run by any issuer of foreign currency securities that of seeing his debt in his own national currency increased because of a possible devaluation of the latter is multiplied.
The most popular form of foreign currency issues had recently been issues denominated in dollars and Swiss francs which had been placed outside the US, and Swiss markets by English and Belgian banks. London, had in these issues, acted as an entre-pot, providing the issuing syndicate but using funds drawn from abroad and then lending the funds abroad. Although the London and Belgian markets had organised the issues, the securities had been distributed and traded elsewhere in Europe usually in Luxembourg, for tax purposes. A fundamental problem that these issues raise concerns their repercussions on the situation of the countries whose currency is used as a reference currency. In the case of the US, such issues could be used as a way of evading the Interest Equalisation Tax. As a general rule, subscriptions to these securities will be of no interest to American residents subject to the tax. However, it is possible that the tax could be evaded by means of the purpose of securities with funds kept by American residents in European banks.
Controversy on the use of the Swiss franc had centred upon the effects of such operations on the Swiss capital market, on the foreign exchange market and on the international status of the Swiss franc. When franc issues were made abroad on terms more favourable to subscribers than in the domestic market, this puts pressure on domestic rates as investors arbitrage the foreign and domestic Swiss franc lending rates. The fear about the foreign exchange markets is that the Swiss franc will become, through such issues, an international currency and so increase the possibilities of speculation in the franc. The Swiss National Bank expressed great concern about the Copenhagen Loan in the UK which was denominated in Swiss francs and although the Swiss authorities cannot formally prevent such issues they can certainly bring strong pressure to bear .
Loans issued in European Units of Account first appeared in 1960 at the initiative of a Belgian bank. The essential character of the European U.A. which is a monetary yardstick used for measuring the contractual obligations arising from a loan, but is not a means of exchange is that of attempting to stabilise as much as possible in a loan agreement the respective obligations and rights of the parties involved. The U.A.s value is defined in terms of a gold weight, with 17 reference currencies (the old European Payments Union members) were linked through their Gold Parity. The U.A.s value can change if the gold parity of all the reference countries should change, provided that at least two-thirds of the currencies had moved in the same direction. In this case, the U.A.s value varies to the same extent and in the same direction as the currency which had experienced the smallest percentual variation in comparison with its original gold parity .
In substance, therefore, the bond-holder enjoys not a gold guarantee but an exchange guarantee in terms of the most stable currency among those forming part of the group considered. Thus, the U.A. formula enables the bond holder to consider his credit as equivalent to a credit in his own currency, added to which is the protection provided by the exchange guarantee against the case of an isolated devaluation of this currency.
To the issuer, a U.A. loan is preferable to either a simple loan in foreign currency or an exchange option loan as it carries lesser risk. The issuer suffers no unforeseen burden as long as his currency remains stable; in the case of other loans, instead, he would run an identical risk should his currency be devalued, in addition to the risk of upward revaluation of the currency or currencies in which his debt is expressed.
It can be argued that the U.A. formula steers clear of most the negative sides of the other categories of foreign issues outlined and had their advantages. The formula gives a wider market, stability of prices (i.e. it moderates speculative movements) and does not exert too much pressure on individual capital market because of the wide distribution of the issues. On the other hand, the formula had not had too much success because of its complex nature which does not appeal to most investors. Also, the formula had run into the objection, particularly by the Swiss authorities, that it internationalises the franc. As a result, the Swiss franc had been left out of the reference currencies which thereby takes one national capital market out of the picture. Similarly, any national authority could eliminate its own currency being used if it so desired.
Overview
The outstanding consideration, which will determine whether or not Europe will develop an international bond market of any economic significance, is whether national monetary authorities will be willing to relax exchange control restrictions. If exchange controls were dismantled so that capital can flow freely between the European countries, this means that the independence of national authorities with regard to interest rate policies is severely curtailed. Just as the movement to current account convertibility, since 1958 had resulted in an integrated international money market (i.e. Euro-currencies) which had virtually eliminated any independence of a short-term interest rate policy, a movement towards capital account convertibility would tend to curtail an independent long-term rate policy. Also, the freeing of the capital accounts will probably add to the overall magnitudes of confidence movements of funds. This argument is illustrated by the experience of the US which tried to keep its capital market open while running a balance of payments deficit.
However, as a result of the need to keep domestic long-term interest rates low while not worsening the balance of payments deficit, the US authorities were obliged to close their capital market in July 1963, by introducing an interest-rate equalisation tax. This tax is still in force and will presumably remain until the US balance of payments shows a significant improvement. Again, both Holland and Italy, closed their capital markets to foreign borrowers when experiencing balance of payments difficulties in 1962 and had not re-opened them since. The Swiss authorities had also imposed severe restrictions on the amount of capital that can be raised on their market by foreign borrowers ($60m per annum).
Assuming that the European countries will be unwilling to dismantle exchange controls independent of other departments, the only conceivable situation in which this could occur would be as a consequence of an integrated European monetary and fiscal policy so that the need for an independent policy ceases to exist. As such a movement towards integration is only likely in the EEC countries, then a European capital market would seem likely to had to develop without the aid of the UKs domestic capital market unless the UK were able to increase greatly her gold reserves. Given the present priorities in economic policies, which put higher preferences on domestic objectives rather than international objectives, then it can be argued that the development of a European capital market will follow, rather than precede, other economic policies.
Apart from the need for a relaxation of exchange controls which is essential if foreign issues were to attract a sufficient supply of funds, an international market will had to change investor preferences so as to attract savings into fixed-interest long-term securities. Moreover, if recent trends continue so that European business firms rely less on internal financing in the future, foreign borrowers will be competing with increasing demands from domestic firms. It can be argued that the various techniques used recently had not managed to appeal to domestic savers on any scale. A large part of the foreign issues placed in Europe had been subscribed to by Europeans with excess dollar funds. The longer term issues had, therefore, been a way in which Europeans had been able to find their dollar balances. This means that, to some extent, the future success of foreign issues in Europe depends on the continuance of a US payments deficit. The more the US moves towards equilibrium, and the more accumulated dollar balances were mopped-up, the less able will Europe be to issue foreign securities.
This does not mean, however that some domestic savings will not be used to subscribe to foreign issues. Foreign issues were being encouraged in Germany by the repeal of a 2½% securities tax which had previously made issues prohibitively expensive. (But issues were still relatively expensive). However, it is argued in this paper that even if certain technical obstacles were removed, such as the German securities tax, or the UK stamp duty, national authorities were most unlikely to permit their remaining independence of monetary policy to be restricted which is the same as saying that as soon as an international securities market in Europe becomes all successful, then it will be curtailed. Thus either New York continues in its role as virtually the sole international capital market in the world, or if the New York market is closed, them borrowers will had to rely on domestic sources, except for marginal amounts of funds. If this conclusion is correct then this implies that any future international flows will be the result of overseas aid and/or direct investment (both of which had been increased in recent years). The advantage of this form of capital flow to monetary authorities is that it can be controlled more easily.
Regulation Q should be abolished as it is preventing US banks from competing effectively with European banks. Undoubtedly its correct in assuming that the existence of Regulation Q had enabled European banks to outbid US banks for dollar deposits, but it does not necessarily follow, a the writer appears to be assuming, that the abolition of Regulation Q would result in the elimination of the Euro-dollar market. The implicit assumption is that the level of interest rates which is the crucial variable, whereas, it is in fact, the structure of rates which is the crucial variable. The main reason for the existence of the market is that European banks work on a smaller spread between borrowing and lending rates than US banks and consequently, the abolition of Regulation Q would not necessarily, unless it led to a narrowing of domestic margins, curtail the Euro-dollar market. There had been some contraction in the market since the middle of 1963. The Hugo Stinnes and De Angelis affairs had undoubtedly shaken confidence in the market which had meant that some US resident deposits in Europe had not been renewed on maturity. The other factor leading to the contraction of funds had been the rise in US domestic rates in the second half of 1963. An interesting development in the market that the paper does not mention is that there is impressionistic evidence that European banks were increasingly lending dollars for medium term. The margins of profit on short-term transactions were not so small that banks, in order to find reasonable profit margins, were undertaking capital transactions. It is possible that a part of the funds invested in the European Capital market represent a funding of Euro-dollars. It was quite common in the market for a New York Bank to agree to offer a line of credit to a UK bank which is active in the Euro-market. This means that the UK bank could lend long with the knowledge that it could always pay off its depositors by drawing on its credit facility in New York if necessary.
Conclusion
There was much speculation on too much free sterling splashing around the world, and there was too much encouragement to convert it into safer currencies or into gold. The consequences of the run on sterling following May 1965 trade figures were recorded in the gold figures at the end of the month, and had started off a fresh run, and causing a second panic. The PM and the Chancellor agreed that new measures were needed. On the 26th July 1965, the Governor of the Bank of England and the Chancellor of the Exchequer had prepared an economic package. That all public capital expenditure (with the exception of industrial building, housing, school-building and hospitals) should be postponed. Also, that the nationalised industries did the same with their own investment proposals. Local government building was to be controlled by a firm exercise of loan sanctions. Local authority mortgages to private house buyers, which had been rising from a figure of some £83 m in the early sixties to £179m in 1964 and were increasing to £190m, had to cut back to £130m. New plans for the economy were constructed. This involved a postponement of the income-related guaranteed pension for those retiring from industry, and reductions of NHS charges. Hire purchase was tightened, by cutting the three-year repayment period to thirty months, and a further extension of exchange control. In general the economic package involved a cut in public expenditure. Nevertheless, this had worked and sterling began to pick-up, to ensure the security of the pound, and the money began to flow back into the reserves .
The first impact of the US measures had been felt mainly in the Euro-dollar market, with corporations showing greater alacrity than had initially been expected in withdrawing surplus balances. This had led to a hardening of rates. There were signs however that the immediate flurry had drawn out some fresh funds, e.g. money formerly placed by foreigners direct in the US. On the other hand, additional demands may be made on the market as borrowers whose requirements had been refused by US banks turn to the Euro-dollar market for accommodation. The UK would not wish to over-emphasise what had been taking place; the position would stabilise, provided that heads were kept and that remedial action is taken where possible. If this is done, the market could well settle quickly into balance with a high level of demand being met from new money attracted by higher rates. The Americans were already conscious of the fact that withdrawals should be made gradually, and the Federal Reserve were trying to arrange phasing of withdrawals by US corporations .
Other monetary authorities had a part to play. Their actions could be two-fold. They could endeavour to arrange for some money to go into the Euro-dollar market, rather through their banks than by direct placement, and they could administer their credit policies so that their own residents could find the finance which they legitimately require at home and not be forced to borrow dollars in the international money market. Within the EEC countries, the main possibilities of assistance in this field would seem likely to lie in Germany and Italy. The German banks were net lenders of dollars to the Euro-dollar market and at present the Bundesbank grant preferential deutschemark/dollar swaps provided the proceeds were invested in US Treasury Bills. In earlier years, the Bundesbank provided similar preferential swaps but made no stipulation as to how the proceeds should be used, and it is conceivable that they might be willing to revert to this earlier system. With regard to Italy, the commercial banks were, of course, net borrowers in the Euro-currency market: their net position in US dollars (end-January) is $625m. With the rise in rates in the Euro-market, the Ufficio had increased its swaps with the commercial banks mainly in order to reduce the cost of imports, a large part of which were financed with the Euro-currencies. If the Italian banks, had replaced part of their market borrowing with Ufficio swaps then the effect will had been to reduce the demand and therefore to increase the potential supply for other borrowers in the Euro-dollar market by the amount in question. As to France, it is not easy to forecast whether the authorities would be prepared to take similar steps .
There is undoubtedly a large amount of short-term money belonging to the US corporations placed directly or indirectly in the Euro-dollar market; some of this is put direct into London but we were told that a larger amount is put with Canadian banks in the first instance. The total funds which could be removed were put by the Federal Reserve at $3 billion. In the four weeks since 17th February, when the American measures may had started to take effect, the UKs external currency liabilities had fallen by some £60m. A possible consequence for the UK could be the withdrawal of sterling lent to local authorities and to other UK residents which had originated from US dollars which had been swapped into sterling for these placements. There were signs that this had been happening since about 10th March, contributing to the weakness of spot sterling and obscuring its undoubted technical strength. The volume of Euro-dollars swapped is large (perhaps £300m altogether); the most recent figures show that some £20m is switched out of sterling between 10th and 17th March the first movement in that direction since the beginning of the year. Apart from the Euro-dollar market, indications were that the American measures had produced a very marked initial effect. The dollar is currently stronger in all markets and the Americans were said to be elated at the success of their measures, through receiving a great many complaints about the effects on various people who were being hurt. It is much too early to translate these movements into figures but the Americans expect that a great deal of the target $1.5 billion improvement in their balance of payments over 1965 will in fact show up in the second quarter .
The Euro-dollar market by the end of the first five years
The BIS (Bank for International Settlements) estimated in its Annual Report that at end-March 1965, the net size of the Euro-currency market could be put at about $9 billion, somewhat more than $7 billion of which is in US dollars. This estimate is based on banking returns for eight European countries and Japan covered, in addition to dollars, sterling Swiss francs, Deutsche Marks and Dutch florins. Between September, 1963 and March 1965, the reporting banks total liabilities to non-residents in all the reporting currencies rose by $2.4 billion of which the whole increase is in US dollars. At the same time practically the whole of the increase in total assets came from a rise in dollar assets. On net basis, the total dollar position of the reporting banks vis-à-vis non-residents shifted from assets of $120m to liabilities of $260m . It appears that part of this change may had been offset by an improvement in their net position in the other four currencies.
The action of the Italian authorities in August 1963, in calling for a reduction in Italian banks net indebtedness in foreign currencies brought the expansion of the Euro-dollar market to a temporary halt. This impact on the market is reinforced by the failures of Hugo Stinnes and Ira Haupt , which caused some la
