THE HISTORICAL DEVELOPMENT OF THE EURO-DOLLAR MARKET
A. Introduction
The development of the Euro-dollar market* (see endnote) can arguably be described as one of the most important transformations in international financial activity. However, very little is known or written about its origins. This paper will explain some of the controversies that have surrounded the market?s development. What are the factors and the main issues that appear to have been relevant to the market?s development? Using an analytical framework, several concepts will be introduced involving, the size of the Euro-dollar market, the factors responsible for the growth of the Euro-dollar market, and a brief history of international finance, looking at the historical perspective from the late 1950s to the early 1970s. As it seems that these very concepts has important implications for how factors are interpreted when considering the ?actual? origins of its early development.
B. A ?brief history? of the Euro-dollar Market
Many developments in the 1960s-1970s coincided with the birth and expansion of the Euro-markets. This had became a key means through which the City of London could sustain its position as an international financial centre, as well as a means for US banks to develop their international business and avoid many of the capital controls imposed in the USA in the 1960s. The Euro-markets were the first relatively free international capital and money markets, to be created after the Second World War, and the emergence of the market has been crucial to the internationalisation of money capital. As both Susan Strange and Jeffry Frieden have shown that, the creation and growth of this market was a product of the US and UK government policy. The off-shore governments now constitute a huge wealth of mobile capital, which is serving to erode the ?international and domestic, economic and political underpinnings of the post-war world order? .
Political support for the off-shore markets in the 1960s stemmed from their growing importance in the short and long term financing of the operations of the international multinational firms, many of whom had influence in US politics in the 1960s. Due to the openness of the City of London, the markets grew quickly, creating a similarity of interests between the City and New York finance. However, Helleiner argues , that the Euro-dollar market was a means for the US government to allay fears concerning ?seigniorage? gains accruing from the dollar, because the market was outside the direct control of the USA. Also, the Euro-dollar market became attractive to the oil-exporting states, who deposited their massive increased earnings in the London offshore markets, whose value expanded ?to over $1 trillion ($1000 billion) by 1994. Its appeal for the oil states was that it was apparently beyond the reach of the US government; it was movable, it was secret; and it paid a handsome and floating rate of interest? . The growth of the markets was paralleled by an enormous exploitation in the demand for and supply of credit, even when real interest rates rose dramatically in the 1980s.
A key time was in the early 1970s, between the USA and the other major states . The USA wanted to implement a more fully liberal financial system, whereas the others favoured collective action and more substantial international co-operation. The USA sought to devalue its foreign debts by a dollar depreciation, and force other countries to expand to absorb increases in US exports (this was the 1971 strategy, which was repeated in 1985 and again in 1992). Other countries were forced to accept the implications of the new US unilateralism, because of the renewed centrality of the USA in the global political economy. In particular, to the US centrality in the international financial system, which was caused by the international role of the dollar as the major reserve currency and international unit of account; by the depth and liquidity of the US financial markets; and the fact that the offshore markets were largely Euro-dollar markets .
Thus, due to the aggressive and unilateral approaches, the USA was able to sustain its ability to pursue a relatively autonomous macro-economic policy, with foreigners underwriting US deficits, by holding dollars, as well as to internationalise the costs of US adjustment (in relation to the oil shocks of the 1970s). An interesting point was made by Helleiner, citing a CIA report arguing that, the USA would receive the majority of OPEC funds for precisely those reasons, and that therefore OPEC, like Europe and Japan in the 1960s, would in effect support US policy autonomy .
Britain strongly supported the early growth of the Euro-dollar market in London. This provided an ?off-shore? regulation-free environment in which to trade financial assets denominated in foreign currencies, predominately dollars. In a world of extensive capital controls, it acted as a kind of ?adventure playground? for private bankers, marking a significant break from the tightly controlled pattern of financial relations characteristic of the world political economy since the war .
British support for the Eurodollar market was crucial, because it provided a physical base for the market, permitting it to operate in London, free from regulation. This support stemmed from a kind of a hegemonic ?lag? in the British state, in which financial officials and institutions, (particularly the Bank of England), remained strongly committed to promoting London?s role as an international financial centre, long after Britain?s days of financial predominance was over . As British capital markets were required upon the international use of sterling to defend the country?s weak balance of payments in the 1950s and 1960s, British officials recognised that London?s internationalism could best survive by allowing bankers to operate in foreign currencies, especially the US dollar. Once the market emerged, they actively supported its growth.
The 1970s saw several states granting market actors an extra degree of freedom by fully abolishing their systems of capital controls, such an example is the UK in 1979, and the US in 1974. This marked the beginning of the liberalisation trend. The UK?s decision stemmed in part from the strong neo-liberal orientation of the new Thatcher government in Britain, and in part a desire to increase the attractiveness of London as an International financial centre, by replicating its fully liberal status. The US strongly supported the early growth of the Euro-dollar market. This was important due to the dominant presence of US banks and corporations in the market. Although, it had power, the US government did not prevent these banks and firms from operating in the market. This approach had two roots:
First, the US banks and US multinational corporations demanded the freedom to operate offshore to compensate for the limitations on their freedom that stemmed from the introduction of US Capital Controls in the mid 1960s, and the constraints of domestic banking legislation dating from the depression of the 1930s. As the capital controls programme acted as a catalyst in encouraging US industrial interests to turn away from the restrictive Bretton Woods financial order. As the early 1970s showed, the US banks and the transnational corporations strongly supported neo-liberal approaches to finance, demanding not only the freedom to operate in the Euro-markets, but also the abolition of capital controls at home. Secondly, foreseeing the developments in the early 1970s, US policy-makers recognised that the unregulated nature of the Euro-dollar market would help increase the attractiveness of dollar holdings to private investors and foreign central banks, at a time of growing US balance-of-payments problems. So, support of the Euro-dollar market signalled an early recognition of the fact that, a more liberal international order would help finance growing US deficits, and preserve US central financial position in the world.
C. The size and growth of the Euro-dollar Market
One problem encountered throughout my research was that the initial emergence of the market was not very clear, due to the fact that statistics relating towards the total size of the Euro-dollar market were not collected by the BIS until 1963. However, it would be safe to acknowledge that the size of the market grew significantly from the late 1950s to the early 1960s. Nevertheless, the following offers an account towards the development of the Euro-dollar market.
US policy in the late 1960s was heavily concerned with financing military spending, particularly by printing dollars to finance the Vietnam War . In 1960, official dollar holdings exceeded US gold stocks by over 300%. So long as there was confidence in the health of the US economy, this ?dollar overhang? was considered manageable. However, growing US trade deficits began to reflect a loss of US competitive advantage as other economies had now fully recovered from the Second World War. The US balance of payments deficit had grown from $1.9 billion in 1965 to $10.6 billion in 1971. This led to the dilemma whereby the volume of dollars would have to be stemmed to ensure confidence in the system, but nevertheless, this could have precipitated a lack of credit in the system. Notably, while this was termed the ?Triffin Dilemma?, announced by the economist Robert Triffin, this essential problem was always common nature in a growing liberal economy.
During the time when the US balance of payments worsened in the 1960s, it instituted a series of capital controls, which led to the holding of dollars in banks outside the US . In 1964, the US passed the Interest Equalisation Tax to discourage foreign borrowers from raising money in the US market. The Foreign Credit Restraint Program of 1965, limited American bank loans to foreign borrowers. Finally, the Foreign Investment Program of 1968 restricted US corporations from using domestic dollars to fund foreign investments. These measures encouraged the establishment of an off-shore dollar market which became known as the Euro-market. The name derives from the telex sign-off of a Soviet dollar-denominated bank account in London, Eurobank. This Soviet Dollar holding was necessary for international commercial transactions by the USSR, since oil and other commodities are denominated in US dollars. The fear that the US would seize these funds if they were kept on US soil prompted the USSR to keep dollars outside the US . The notion that the federal government sought to regulate the effects of dollars deposited outside the United States upon monetary policy. As these dollars were outside the domestic banking system, the Federal Reserve had no jurisdiction (i.e. those deposits were not subject to reserve requirements set by the Fed). Various legislation, designed to limit the use of Eurodollar deposits by domestic companies ultimately drove the market overseas – intact and stronger than before.
Another argument was that, the surpluses of oil producing states (such as OPEC) and short-term deposits of multinational corporations, fuelled the development of the Euro-market industry. This was confirmed, by Born (1977) , and also Lees (1974) . The American Federal Reserve Act of 1937 did not permit banks to pay interest on sight-deposits, and interest rates on time-deposits could not exceed the rate set by the Federal Reserve. It was thus more profitable to deposit dollars in accounts outside the US. This point was developed by Windecker (1993) , and Smedresman and Lowenfeld (1989) , by stressing the size of the Euro-market industry. That the Euro-market grew at over 25% per annum through the 1970s, and between 1971 and 1984, the Euro-currency market grew from $85 billion to $2,200 billion. In 1988, the Euro-markets comprised of $4 trillion, which exceeded the domestic deposit market of the United States by $1 trillion.
Today, the vast majority of Eurodollar transactions are conducted in London. The Bank of England in 1964 stated that: ?Banks in London have been able to attract large sums in dollars by quoting better rates for deposits, including interest on money at call and short notice ? categories which earn nothing at all with New York ? and have employed them at less than the US lending rate and still made a worthwhile turn. They are able to operate on a fairly small profit margin because the additional overhead expenses of conducting their Eurodollar activities are minimal.
Throughout the 1960s, the markets grew at a great pace. Not only did they grow in size; they also spread geographically, moving to other centres in Europe and Asia. London nevertheless maintained its central role. (Table One, Table Two and Table Four offer an indication of the growth). A feature of the markets from their inception is the prominence of the US dollar. Table Three shows that, the dollar has consistently accounted for over 70% of the total markets. In the later 1960s, the dollar proportion was as high as 80%.
An important point to clarify was the ?deepness? of London as a financial centre. Whilst this role of long standing importance, the numbers of banks represented there increased steeply in the 1960s and 1970s. Table Four shows this, which records the number of foreign banks in London from 1967-1986. Initially, during the early 1960s, US banks came to London to ?tap? the Euro-markets for funds, which they would pass back to the US. Soon, American banks were building up a presence in London to avoid the Voluntary Foreign Credit Restraint programme (VFCR) restrictions imposed in 1964. In the 1970s, their numbers increased further as they began to participate in lending in the Euro-markets. Initially this participation was largely through consortium banks because they offered banks the ability to develop a specialist knowledge in the area of syndicated lending, whilst at the same time pooling risk with other large banks. Once this specialist knowledge was secured, the banks tended to pull out of these agreements as they established their own international departments, and set-up branches in London (if they were not represented in that form) .
Another factor which encouraged the US banks to invest in London, was emphasized in various studies , (and also from Table Four), was the liberal regulatory environment which foreign banks in London enjoyed. Throughout the period before exchange control, the Bank of England excluded abolition, foreign currency business with non-residents, from regulatory control. London retained its role as a financial centre by conducting business in non-sterling currencies.
D. Factors responsible to the Euro-dollar Market
There are specific factors were are said to have been directly responsible for the development of the Euro-dollar market. In specific were: the return to convertibility; the US balance of payments; US monetary policy and capital controls; the breakdown of the Bretton Woods and the floating exchange rates; recycling and the international debt crisis; and the Inter-bank Market and Financial Innovations. These will be explained in greater detail.
1. The return to convertibility and associated events
The summer of 1957 witnessed a key initial boost to the market with the sterling crisis. The Bank of England re-imposed restrictions on the granting of external sterling credits: in particular, they prohibited the sterling financing of non-UK trade. It had been usual for banks in London and indeed other European centres to provide their customers with dollar deposits, but up until 1957, they had been reinvested in the US . As the restrictions were re- introduced to limit UK banks? ability to use sterling for external purposes (such as; trade credit), they resorted to using dollars for their external operations.
Progressively during the 1950s there has been a change in the US balance of payments, with the large persistent surplus of 1945-50 being replaced by a deficit by 1957 . This deficit resulted in increased foreign holdings of dollars; ?by mid-1958, a European Market in dollar deposits and loans had become established? .
The return of convertibility in Europe at the end of 1958, with its associated relaxation of exchange controls, gave a further motive to the market. It permitted an increase in the supply of privately held dollars, which could now be swapped into local currency. Foreign exchange markets became more active, encouraging arbitrage between the various Euro-currencies and national markets, and potentially increasing the extent of financial integration and interdependence.
2. The US balance of payments
As noted in the previous point, a basic deficit on the US balance of payments emerged in the late 1950s. The net outflow on the long-term capital account had been running at between $2 and $2.5 billion per year between 1959 and 1963, and increased thereafter because of US companies? direct investment overseas . There had been much debate concerning the role, if any, played by the deficit in the growth of the Euro-dollar market. Friedmen (1969) , argued that the deficit was neither a necessary nor sufficient condition for the market?s growth. It was not necessary, because one could point to the case of West Germany, and the existence of a market in Euro-DM despite the German balance of payments surplus. It was not sufficient because, although a deficit provided dollar holdings for foreigners, it could not be presumed that they would be held in the form of Euro-dollar deposits. This depended on the expected return on such deposits relative to other investments.
Klopstock (1970) , suggested that the deficit had been an important source of funds for the growth of the market. He implied that the source was central banks rather than private individuals. Such as: when individuals went to exchange domestic currency into dollars, to make deposits with Euro-banks (that is banks dealing in Euro-currencies), they drew on central bank holdings of dollars, which were the result of the US deficit. In addition, central banks placing monetary reserves in the Euro-dollar market were also employing dollars accumulated as a consequence of the deficit.
This was further acknowledged by the BIS in 1964 , which argued that the deficit was useful in the market?s initial period of growth, but that once the market had become established, dollars were directly attracted to it from US residents. This added to the US deficit.
3. Monetary Policy and capital controls in the US
In an attempt to deal with the worsening balance of payments, the US authorities introduced the Interest Equalisation Tax in 1963 to discourage foreign bond issues in New York, and this was followed by the Voluntary Foreign Credit Restraint (VFCR) programme and the Foreign Direct Investment regulations in 1965. Limitations were placed on loans to foreigners and investment in other foreign assets. The programme applied only to businesses located in the US, so resulting in a shift of operations to foreign branches of US firms and in particular to the Euro-dollar market . The role of the external deficit in this instance was an indirect one, in contrast to the direct role it played in the initial development of the market.
The conditions under the VFCR programme, credits to non-residents by US banks? offices in the US were limited during 1965 to 105% of their December 1964 level. These restraints continued in a similar fashion throughout the rest of the 1960s. The limits led overseas borrowers to turn to the Euro-dollar market, which in turn helped to keep Euro-dollar interest rates at a relatively high level. Johnston (1983) quotes evidence from Brimmer and Dahl (1975) on the resulting growth of overseas branches of US banks. In 1964, the number of US banks with branches overseas was 11: this had increased to 79 in 1970. Over the same period, the assets of overseas branches increased from $6.9 billion to $52.6 billion, and the number of overseas branches increased from 181 to 536. The effect of the US and other regulators on capital flows, was to shift emphasis of international banking away from national banking systems to the Euro-banks.
The second effect of US monetary policy was through Regulation Q . This prohibited the payment of interest on demand deposits, as well as authorising the Federal Reserve to set a maximum interest rate payable on savings and time deposits in US banks. During 1966 and 1969, the Federal Reserve relied to a great extent on the operation of Regulation Q to enforce tight monetary policy. Normally, the ceiling set by the Federal Reserve was inoperable because market interest rates were lower than the ceiling rate. In contrast, in times of tight monetary policy, interest rates rose and would have risen above the ceiling were it not for its existence. The mechanism through which this operated can be described as follows:
The level of interest rates in the money supply was raised through slowing down the growth of the money supply. However, while money market interest rates rose, the interest rates payable on time deposits, were held down by the ceiling. Investors moved their time deposits from the banking system, causing the banks to experience a shortage of funds. The banks then looked to the Euro-dollar market for funds, and in 1966, when money was tight, borrowing from European Branches of US banks by their head offices rose by $2.5 billion. Nevertheless, banks began to regard the market as a substitute source of dollars even when Regulation Q was not effective as in 1967. Funds raised through this method were then used to continue lending to customers in the US.
Regulation Q, as the BIS recognised , stimulated the growth of the Euro-dollar market in two ways: firstly, it reinforced the market?s ability to offer higher interest rates on deposits ? even deposits at call. Two other reasons why they could offer higher interest rates were that Euro-banks operated on lower margins; and the effect of domestic reserve requirements. Secondly, the growth of the market was stimulated because of the demand for dollars from commercial banks in the US in order to go around domestic credit restraint policies.
This leads to a third important component of policy: that of reserve requirements. Domestic banks, for reason of monetary control, are subject to reserve requirements on deposits. In the period up to 1969, the Euro-dollar market was exempted from this requirement. This allowed Euro-banks to offer higher deposit rates. This advantage was further heightened by the fact that Euro-banks did not need to hold large precautionary reserves, because of an efficient inter-bank market. Euro-banks could earn a return on all their deposits, through re-lending. In June 1969, the US government imposed what was effectively a 10% marginal reserve requirement on Euro-dollar borrowings. This was an attempt to reduce the rate of repayments by ensuring that if the US banks did not repay, and subsequently re-borrowed from the market, the cost of such borrowing would have substantially increased . The reserve requirement was applicable on the amount by which US bank borrowings from foreign branches exceeded their level of 28 May 1969. On 30 November 1970, the Federal Reserve increased the marginal reserve requirement to 20%. The measure proved to be ineffective since US interest rates continued to fall, causing the cost of maintaining Euro-dollar borrowing to become too expensive.
In January 1974, the US removed the capital controls in had introduced in the 1960s. As mentioned before, the imposition of the controls stimulated the Euro-dollar market. In effect, their removal also enhanced the market in the same respects. After, the removal of the controls, US banks could freely arbitrage between the US domestic market and the Euro-dollar market. This led to a greater integration of the national and Euro-currency segments of the dollar market. Johnston (1983) argues that the removal of capital market controls in West Germany in 1974, and in the UK in 1979 had a similar effect in integrating the Euro-DM and the Euro-Sterling markets with their respective national markets.
4. The Breakdown of the Bretton Woods and the floating of exchange rates
A major economic event of 1971 was the breakdown of the Bretton Woods system of fixed exchange rates. The official link between the dollar and gold was broken, and the exchange rate parities re-aligned under the Smithsonian Agreement (December 1971). As it became clear, that there might be further re-alignment with a devaluing of the US dollar, there was a demand to borrow dollars to buy stronger European currencies. After the UK decision to float (June 1972), Germany and Switzerland imposed capital controls and more restrictive monetary policy to reduce inflation. An intensified dollar outflow resulted, and the dollar was devalued a second time in February 1973. In the following month, when the flight from the dollar continued, European countries decided to move to floating exchange rates.
Bell (1973) , pointed out that the inflows into Europe in 1970 and 1971, led to increases in European central bank? holdings of dollars. The Bundesbank was affected to a greater extent than other central banks, and this was reinforced after February 1971 by speculative pressure against the dollar, and in favour of the DM and to a lesser extent the Swiss-Franc (SFr). Given, that the dollar inflows from the underlying US balance of payments deficit, were perhaps only a quarter of the total dollar flow in Western Europe, and Japan over the year to August 1971 , the Euro-dollar market may have greatly magnified the problem of the dollar. Bell concludes that the existence of the Euro-dollar market probably caused re-alignment and the subsequent breakdown to occur sooner than it would have done in the absence of a Euro-dollar market.
5. Recycling and the International Debt Crisis
Shortly after the breakdown of the Bretton woods system, the quadrupling of oil prices created both a demand and a supply stimulus to the Euro-market. The IMF?s oil fund facility was inadequate to meet the resulting demand for balance of payments deficit financing, especially by the non-oil developing countries. However, with the breakdown of the pegged rate international monetary system, there was little hope for an international political initiative on the problem of balance of payments adjustment. The partial placement of OPEC surpluses, amounting in 1974 to some $58 billion with the Euro-dollar market, providing an obvious and politically convenient channel for capital to be removed from surplus to deficit countries .
The Euro-dollar market was attractive because it offered slightly higher deposit rates on funds placed short-term, allowing good returns to be made, whilst the OPEC countries decided what long term investments they wished to undertake. Along with this, there were political advantages for OPEC to be able to invest dollars in Europe rather than in the US.
6. The Inter-bank Market and Financial Innovations
The domestic and the international markets have two major components: the inter-bank mechanism, and the channeling of funds from initial depositors to ultimate borrowers. However, in the Euro-markets, the former plays a far more important role, with respects to the latter, in which the markets introduced important innovations.
In the Euro-markets, the inter-bank market accounts for around 70% of the bank?s aggregate liabilities. In the case of, for example, the US domestic markets, the Federal Funds inter-bank market accounts for only 12.5% of the aggregate liabilities of US banks . The existence of such a large inter-bank market allows banks to match the inflow and outflow of funds from deposits and loans by lending excess funds or borrowing to meet lending commitments. This reduces the need to maintain a stock of liquid assets which would act as a safety margin.
Ellis (1981) further developed this point by adding that, there is much variety in the reliance on inter-bank funds between different banks. The larger, better known banks, tend to have a smaller percentage of their foreign currency liabilities in the inter-bank market with American banks for example, over the period 1978-81, the percentage varied between 42% and 54%. This is in contrast with the consortium banks whose reliance on the inter-bank market over the same period was about 80%. Another feature is that, these better known banks were not borrowers. Ellis (1981) concludes that, ?the very large inter-bank segment of the Euro-market performs a necessary and valuable role in linking non-bank depositors and lenders in different parts of the world? .
The general efficiency of the inter-bank mechanism in allowing banks access to funds at very short notice, as well as allowing them to place funds in the market for very short periods to earn some interest, helps to reduce the transactions and information costs in the Euro-currency markets. This also allows them to operate on smaller margins. However, Ellis (1981), also recognises that the inter-bank mechanism has led to increased interdependence, increasing the speed at which crisis might spread through the system.
Two innovations, which are associated with lending to non-banks, and which have facilitated the expansion of the Euro-currency markets, are roll-over credits and the syndicated loan system.
The introduction of roll-over credits reduces the risk of interest rates moving against a bank when it tends to borrow short and long-term. It enables banks to offer higher interest rates on short-term deposits, whilst at the same time being able to commit these funds long-term, through reducing the risk of making losses if deposit rates should rise again. On the borrower?s side of the market, such roll over credits imply that interest rates at the time of borrowing are less important, because if they should fall over the course of the loan, the borrower should reap the benefits. Naturally, the borrower will also pay the cost if interest rates rise.
The second innovation is that of syndication of loans. ?A syndicated credit is a loan in which a group of financial institutions makes funds available on common conditions to a borrower . It allows credits of larger sizes (over $1 billion in some cases), to be put together, a factor that was especially important in the financing of national balance of payments deficits.
In the lender?s point of view, it reduces the risks of international bank lending , through diversification of loans to political entities. It also provides more protection against selective defaults: unwillingness of a nation to repay its debts will be met with pressure from several countries, whose banks are involved. Negotiations were also feasible, because at the same time, there are few enough creditors involved. On the other hand, a possible danger of the process, which has become increasingly recognised, is that in the event of a default, the repercussions will be spread over a wide part of the Euro-currency system. This has raised questions regarding the stability of the international banking system.
E. Economic factors
Many scholars on Euro-dollars had one thing in common, the fact that: overwhelming strong regulatory action, only served to drive a useful market from the US, moving dollars into off-shore bank accounts, while failing in its intended purpose to limit the effects of Eurodollars on the banking system. The events which led the financial system from this heavy regulated one to the ?explosion? of finance, in which the US paved the way for the development of the market led international monetary system (M-IMS), and a government-controlled monetary system (G-IMS), have been recounted by a number of scholars. In particular: Susan Strange , Eric Helleiner , Phil Cerny , and Geoffrey Underhill .
Another interesting point was that the Euro-dollar market has shown the capacity to adapt itself to changing conditions, and had emerged as a truly international short-term money market, providing attractive opportunities for short term investment, while at the same time relative cheap access to short term finance. The Bank of England (1964) , developed this further by stating that, evidence of the advantage of the market to both givers and takers of deposits is provided by the magnitude of the growth of foreign currency liabilities and claims of banks in London, which has become the principal centre. The market has helped to stimulate banking competition and reduce interest rates in the main borrowing countries; and has probably added to the total funds available for the finance of international business. In addition, the article shows that the Bank of England has took the position that even though there are risks involved, the UK authorities had not discouraged London banks from participating in this business, relying on their good judgement in the way they conduct their operations.
However, a major question, still being argued about today, is whether Euro-dollar deposits provide a possibility for multiple deposit creation, in the way cash deposits do in domestic banking systems? Bell (1964) provides an answer by arguing that ?the Euro-dollar market, by the process of intermediation, can increase the flow of international credit and can thus affect total world demand in a meaningful sense. Moreover, the market could, under certain conditions, act in the same manner as a domestic banking system, and from a given flow of dollars from the United States, increase the total stock of world dollar liquidity by some multiple?.
As far as the balance of payments was concerned, for both the UK and for the US, there was no doubt that high interest rates in the Euro-dollar market had caused private non-residents of the US to hold bigger dollar balances, which lessened the flow of US dollars to official monetary institutions, Christie (1967) . This action had benefited the US payments balance on an official settlement definition . Various risks had arisen from the market, particularly the increased dimensions of ?hot money? flows, and the encouragement it gives reserve currency countries to delay correction of their payments imbalance, Reading (1967) . One main risk was the sheer global exposure of the Euro-dollar market itself, and the dangers exposed to the UK. As, no one country could exercise control of the market, in a sense that, Euro-dollar deposits were no longer used solely for trade-finance, and hence were not self-cancelling. Due to the extent of the value of trade in Euro-dollars, a breakdown would inevitably throw doubt on sterling, as the market is ?running an extensive banking business on very limited reserves and are thus in a very exposed position? . Another risk is that a collapse of the Euro-dollar market could unsettle the entire international financial system, seriously undermining both trade and capital flows.
However, one of the roles of the Euro-dollar is that, it enables countries with deficits to finance rather than correct them, and the Euro-dollar plays a part as an underminer of national monetary policies, as well as the irritant factor in inter-national interest rate wars, Chalmers (1968) . The significance has been to emphasise the unfavourable side effects of the Euro-dollar. The development of the market has undoubtedly enlarged short-term capital movements, giving deficit countries greater opportunity to ?mask? rather than cure their deficits; and in doing so they have ultimately jeopardised international monetary stability. Chalmers stated further that these flows of Euro-dollars have spread the contagion of high interest rates; and an irritant factor in this has been the particular inter-relationship which the market with the US monetary system. Chalmers concludes that the existence of the Euro-dollar has made the task of monetary policy more difficult and even less effective.
The risk aspect is an important factor as it suggests the need for an international body to act, not only as a lender of last resort, but also as a regulatory agency, as noted by Clendenning (1968) . The risks and problems associated with the Euro-dollar market make themselves visible at three levels: the individual bank, the individual country and the level of the international financial system as a whole. An individual bank?s main risk is the possibility that a borrower may not repay his Euro-dollar loan. This is always a risk facing any bank in its commercial banking operations. However, the Euro-dollar market, due to its international nature, and its long chain of transactions involved in most Euro-dollar operations, has added a new dimension to this risk. In their domestic operations (also in foreign operations in their own currency), most commercial banks lend directly to their own customers with whom they are in close contact. Consequently, they have at their disposal considerable information about the financial standing of these borrowers, and the proposed use of the borrowed funds. Leading to the point, in the case of Euro-dollar operations, commercial banks are dealing in large unsecured loans denominated in US dollars. This kind of operation undoubtedly, involves a greater risk of default than, the ordinary domestic banking operations.
The determination of the Euro-dollar rate, had been an issue that had interested many economists, with many offering a comparison between the US domestic and the Euro-dollar markets. One such example had been the impact of US monetary policy on the Euro-dollar market. Using monthly data, involving the Euro-dollar rate, from January 1961 to March 1971, Argy and Hodjera (1973) highlight the impact of Regulation Q. Their research found that during the periods when Regulation Q was effective, there was a resemblance. As for every 1% the market rate was above the ceiling rate, the Eurodollar rate would rise by 0.4%. This was further supported by Kwack (1971) , Hendershott (1967) , and Mills (1984) , which agreed that changes in the US interest rate has a great influence on changes in the Euro-dollar interest rate.
Other works offered comparisons between the Euro-dollar and the UK Domestic rates. Herring and Marston (1977) , found that, during the periods in the 1960s, a 1% rise in the Euro-dollar rate would bring about a 0.44% rise in the UK money market rates. This suggested that there was some degree of interdependence between the two markets. Rich (1972) concluded that the significance of the UK Treasury Bill rate and of the exchange rate, ?supports the view that Euro-dollar assets are close substitutes for sterling…assets?. He further suggests that the development of the Euro-dollar markets has led to a greater degree of financial integration between the US and the UK interest rates.
F. Conclusion
The City of London was a highly successful international commercial, banking and financial centre, despite growing fears of competition from other centres. It presented strength, derived largely from the generalised ?trust? with which the world views the City. The survival and revival of London as an international financial centre after the disruptions of the Second World War and the weakness of sterling as an international reserve currency had been largely based upon the development of the Euro-currency markets. In specific the growth of new or ?parallel? markets alongside the old ?classic? discount market, which with the relative decline of sterling as an international currency, had become a domestic concern. These new markets had revitalised the foreign exchange markets in response to the emergence of barriers of various kinds between ultimate borrowers and lenders. On the one hand, the domestic parallel money market in sterling evolved out of responses which were intended to evade the credit restrictions which successive British governments had attempted to impose during the 1960s through their participation in the old discount market. On the other hand, the decline of sterling and the difficulties associated with the US governments? restrictions on the use of the dollar as an international currency gave rise to new markets in Euro-dollars and other Euro-currencies. New money markets where money is lent and borrowed between banks, companies and other organisations without the control of the monetary authorities (governments and central banks). It is a measure of the City?s autonomy that such developments can take place.
The imposition of credit restrictions in the 1960s in order to reduce the balance of payments deficit and preserve the value of sterling occurred at a time when both government and private expenditure were increasing, and this resulted in the growth of the new markets. After WW2, US dollars began to flow steadily to Europe by means of the operations of American multinational corporations, and the trade deficits of the USA with European countries. In addition, interest rates in the USA were held down by the government (Regulation Q) and the European banks (especially London?s merchant banks), were able to bid higher rates of interests for these dollars. Furthermore, the US? capital controls (in particular the interest equalisation tax) effectively closed New York to foreign borrowers, who turned to London. The availability of ?off-shore? dollars to the City closely followed on the abrupt and final demise of sterling in one of its most traditional roles (the financing of international trade between non-UK residents). The UK?s balance of payments problems had culminated in the 1957 sterling crisis, and consequently led to a sharp rise in interest rates in order to attract sterling to the UK, (in other words, there were too few UK pounds in circulation to perform old functions).
The merchant banks simply turned to the expatriate dollars, and used them in the way they have used sterling, operating freely on a global scale in the financing of international trade and the arrangement of longer term loans. American and other foreign banks wanting to take advantage of the paucity of financial controls in the UK soon joined this new market that was dominated by the merchant banks. Hence, between 1967-1978 the representation of foreign banks in London grew from 113 to 395. As, for the City?s banks, the establishment of sterling convertability in 1958 ?was arguably the most important event of this century?, for it heralded the rise of the London Euro-dollar market.
To conclude, there are certain important consequences of the rise of the Euro-dollar markets. The first, is the shift in the financial system from one depending on a state to manage the flow of international liquidity, to a system where liquidity is provided by private banks. As previously noted, where international financial systems were threatened with a lack of credit, there is now, excess international liquidity, and private bank lending provides this. In 1980, the US inter-bank loan market stood at $74 billion, this almost doubled to $170 billion by 1995. The international inter-bank lending market by contrast had grown to $5.8 trillion by June 1995 .
However, much of the risks in international banking today, have been confronted through past historical processes of domestication and harmonisation. As, in December 1981, pressure from US banks for deregulation, led to International banking Facilities (IBFs), so that banks on US soil could compete with off-shore banking. It is important to recognise that the ?race to the bottom? in regulation has taken place mainly outside the OECD countries. Don Marshall (1996) explained, ?competition between states to attract and retain finance-capital has intensified, with peripheral countries seeking to make their sites more attractive to investment?. There are many ?off-shore financial centres? such as the Bahamas, Bermuda, Antigua, Cayman Islands and Barbados, which maintain lax regulatory regimes. However, the OECD countries control more than 80% of the lending market, and their banks? share of the world total as assets and liabilities has continued to grow, while that of offshore centres has grown less quickly, and those of developing countries has remained almost static .
While it may not have been the intention of the US government in the 1960s and the 1970s to drive dollars into off-shore bank accounts, it did believe that the Euro-market would provide a quasi-Keynesian ?clearing house? function to redistribute money from surplus nations to deficit nations. According to Eric Helleiner (1992) , by the mid 1960s, ?US officials were in fact actively encouraging US banks and corporations to move their operations to the off-shore London market?. In doing so, American banks would not lose business while at the same time, the government could pursue its policies of adjusting its economy. Some of the earlier articles , tend to be fairly complimentary about the Euro-dollar market, accepting it as making a valuable addition to world liquidity, although noting the attendant ?banking? risks, which became apparent from the failure of one or two links in unsecured on-lending chains. The critical approach to the market can also clearly be detected, and it was considered a desirable phenomenon. As, when British Prime Minister Harold Wilson introduced his crisis package of July 1966, he laid part of the blame for the pressure on sterling on withdrawals of Euro-dollar deposits in London. He said: ?Action taken by the United States? authorities has led to an acute shortage of dollars and Euro-dollars in world trade and this has led to a progressive rise in interest rates and to the selling of sterling to replenish dollar balances? . As the Euro-dollar market grew up quite simply from private financial institutions pursuing their own self-interests, as well as those of their clients. This of course, was no guarantee that they were also necessarily furthering the best interests of national and international economies.
Some governments and monetary authorities recognised this at an early stage and took action to insulate the impact of the Euro-dollar on their monetary systems. In Britain, the authorities have for the most part pursued a ?laissez-fare? policy, primarily not wishing to hinder London?s international banking role, but also glad of the opportunity. As the British Government was keen to promote London as a financial centre, and bankers in the city were ?eager to capture international business without being constrained by sterling controls?. Helleiner concluded that the globalisation of finance was supported by states through ?granting freedom to market actors through liberalisation initiatives? and choosing not to implement more effective controls on financial movements?, because it suited their interests.
ENDNOTE
* Here are two very similar definitions of the term Euro-dollars:
? Robert Gilpin, (The Political Economy of International Relations, Princetown University Press, 1987, p. 314-315), states that: ?The Euro-dollar market received its name from American dollars on deposit in European (especially in London) banks yet remaining outside the domestic monetary system, and the stringent control of national monetary authorities?.
? Enzig and Quinn (The Euro-dollar System: practice and theory of international interest rates, MacMillan Press, 6th edition, 1977, p. 1) state that: ?the Euro-dollar system is a term used to describe the market in dollar deposits and credits which exists outside the United States of America?.
1. Jeffry Frieden, Banking on the World, New York, Harper and Row, 1987.
2. Jeffry Frieden, Banking on the World, p80.
3. E. Helleiner, American Hegemony and Global Economic Structure: from Closed to Open Financial Relations in the Postwar World, London School of Economics, 1991.
4. Susan Strange, States and Markets, London, Pinter, 1988, p105.
5. In specific the Group of Ten meetings of finance ministers (so called: Rich Men?s Club) during the 1970s, following President Nixon?s decision in August 1971, to end the convertibility of dollars into gold and thus terminate the regime of fixed parities, or pegged exchange rates anchored around the US dollar. Attempts to return to fixed exchange rates ( such as the Smithsonian meeting of December 1971) quickly failed, and the world moved to a regime of flexible exchange rates.
6. Susan Strange, Casino Capitalism, Oxford, Basil Blackwell, 1986.
7. E. Helleiner, American Hegemony and Global Economic Structure: from Closed to Open Financial Relations in the Postwar World, London School of Economics, 1991.
8. Quote from Susan Strange, Finance, Information and Power, Review of international studies, No 16, 1990, p264.
9. This phrase hegemonic ?lag? is used by Stephen Krasner, State Power and the structure of International Trade, World Trade, no 28, 1976, p341-343.
10. Joan Spero, The Politics of International Relations, 3rd edition, St. Martins Press, New York, 1985, p68-69.
11. For further details see: Francis A. Lees, International banking and finance, Macmillan, Basingstoke, 1974, p100-106.
12. PRO: HW 15 28: Moscow and US Dollars, 19/3/1945.
13. Karl Erich Born, International Banking in the 19th and 20th Centuries, Berg Publishers Ltd, Warwickshire, 1977, p203
14. Francis A. Lees, International banking and finance, p297-312
15. George H. Windecker, The Euro-dollar Deposit Market: Strategies for Regulation, The American University Journal of International Law and Policy, Vol. 9, Fall 1993, p278
16. Peter Smedresman and Andreas F. Lowenfeld, Eurodollars, Multinational Banks, and National Laws, New York University Law Review, Vol. 64, 1989, p751-761
17. Quarterly Bulletin, Bank of England, June 1964
18. See A. F. Brimmer and F. R. Dahl (Growth of American International Banking: implications for public policy, JF, no: 30(2), 1975, p341-63), and Buttrill-White: (Foreign Banking in the United States: a regulatory and supervisory perspective, FRBNY Quarterly Review, Summer 1982).
19. A consortium bank is owned by a group of (around five) other banks, usually large banks, which are well established in their own domestic markets.
20. The Banker, May 1983, p10
21. Such as: Brimmer and Dahl (1975), and Buttrill-white (1982)
22. See G. McKenzie, The Economics of the Eurocurrency System, Macmillan, London, (1976) p. 88
23. The liquidity balance method of calculating the US balance of payments was the most widely used measure by the authorities, (see W. Clendenning, The Eurodollar Market, Clarendon Press, Oxford 1970). It is essentual to divide the balance of payments into two sections: (1) net autonomous transactions; (2) net balance of compensatory financial transactions. 24. Represents the deficit/surplus. The main problem was determining whether short-term capital movements belonged to category (1) or (2). In the US, this was resolved by distinguishing between short-term capital flows initiated by residents and non-residents. If the latter altered the short-term assets that the non-resident held in the US, then it would fall into category (2). 25. If a resident made the same change, it would fall into category (1), and be an autonomous transaction.
26. See Johnston (1983), p. 10
27. See G. Bell, The Eurodollar Market and the International Financial System, Macmillan, London, (1973), p. 84
28. M. Friedman, The Euro-dollar Market: Some First Principles, Morgan Guaranty Survey, October 1969, p. 4-14
29. F. Klopstock, The Euro-dollar Market: Some Unresolved Issues, PEIF, no. 65, 1968
30. Bank for International Settlements, BIS Annual Report: 1964, 1964, p. 140
31. See Johnston, 1983, p. 14
32. A. F. Brimmer and F. R. Dahl, Growth of American International Banking: implications for public policy, JF, no: 30(2), 1975, p341-63
33. This regulation had its impact prior to 16 May 1973, when three-month maximum interest rate ceilings were abolished for time deposits over $100,000. This implied that US domestic assets that were substitutes for Euro-dollar deposits were no longer subject to Regulation Q.
34. Bank for International Settlements, BIS Annual Report, 1965
35. The effective cost of borrowing extra funds in the Euro-dollar market is derived by, dividing the actual Euro-dollar rate by the proportion of funds that can be loaned out.
36. See: G. Bell, The Eurodollar Market and the International Financial System, 1973
37. G. Bell, The Eurodollar Market and the International Financial System, 1973, p. 91
38. In 1974, the Euro-currency market accounted for about 25% of total financing requirement of deficit countries: other channels included direct investment, concessionary loans and other capital market finance, (see Johnston, 1983, p. 148). By 1979, Euro-markets accounted for 50% of financing.
39. J.C. Ellis, Eurobanks and the Interbank Market, BEQB, no. 21(3), 1981, p. 351-64
40. J.C. Ellis, Eurobanks and the Interbank Market, BEQB, no. 21(3), 1981, p. 360
41. L. S. Goodman, The pricing of syndicated Euro-currency credits, FRBNY Quarterly Review, No. 5(2), 1980, p. 39-49
42. Goodman points to one specific risk particularly associated with international banking, that of political risk associated with sovereign lenders that is, the lender may choose to default and the legal protection in this case is much less than in the case of a private lender?s default.
43. Susan Strange, Casino Capitalism, Blackwell, London 1986.
44. Eric Helleiner, Explaining the globalisation of financial markets, (also: states and the future of global finance), review of international studies, vol 18, no1, 1992, p315-341.
45. Phil Cerny, finance and world politics, the political economy in international finance, Edward Elgar, Aldershot
46. Geoffrey Underhill, Markets beyond Politics?, the State and the Internationalisation of Financial Markets, European journal of Political Research, vol 19, no 2-3, 1991.
47. Bank of England, UK Banks? External Liabilities and Claims in Foreign Currencies, Bank of England Quarterly Review, June 1964.
48. Bell, Geoffrey L., Credit Creation through Euro-dollars, The Banker, August 1964
49. Christie, Herbert, Euro-dollars and the Balance of Payments, The Banker, January 1967.
50. Which defines the balance as the change in reserve assets, and in liquid and non-liquid liabilities to foreign monetary institutions.
51. Reading, Brian, Euro-dollars ? Tonic or Toxic?, The Bankers? Magazine, November 1967
52. Reading, Brian, Euro-dollars ? Tonic or Toxic?, (1967)
53. Eric B. Chalmers, Monetary Policy Aspects of the Euro-dollar, UK Monetary Policy, June 1968
54. E. Wayne Clendenning, Euro-dollars: the Problem of Control, The Banker, April 1968
55. V. Argy and Z. Hodjera, Financial Integration and Interest Rate Linkages in Industrial Countries, 1958-71, IMF Staff Papers, 20 (1), p1-77, 1973
56. Sung Y Kwack, The structure of international interest rates: an extension of Hendershott?s test, Journal of Finance, No. 26, p897-900, 1971
57. Patric H, Hendershott, The Structure of the International Interest rates: US Treasury Bill Rate and the Euro-dollar deposit rate, Journal of Finance, No. 22, p455-65, 1967
58. R.H. Mills and H.S. Terrell, How Front-end Fees on Syndicated Euro-loans are determined, the Banker, no. 134, Dec 1984, p27-33
59. R. Herring and R. Marston, National Monetary Policies and International Financial Markets (also: Euro-Currencies and the International Monetary System-1976), North-Holland, American Institute for Public Policy Research, Washington 1977
60. G. Rich, A Theoretical and Empirical Analysis of the Euro-dollar Market, JMCB, 4(3), 1972, p 633
61. International banking: coping with the ups and downs, The Economist, Survey, 27 April 1996, p15
62. Don D. Marshall, Understanding Late-Twentieth-Century Capitalism: Reassessing the Globalisation Theme, Government and Opposition, vol. 31. No2, 1996, p193-215. See also: Marshall, Tax Havens in the Commonwealth Caribbean: a merchant capital-global finance connection, Global Society: Journal of Interdisciplinary International Relations, vol 10, no 3, 1996, p255-280
63. Industry and Trade Summary: Commercial Banking, USITC Publication 2638 (SV-4), June 1993, p26
64. Eric Helleiner, Explaining the globalisation of financial markets, (also: states and the future of global finance), review of international studies, vol 18, no1, 1992, p315-341.
65. Articles such as: Bell, (credit creation through Euro-dollars, The Banker, August 1964); and Christie, (Euro-dollars and the Balance of Payments, The Banker January 1967).
66. Hansard, 20 July 1966, Column 628
67. Eric Helleiner, Explaining the globalisation of financial markets, 1992, p315-341.