The Eurocurrency Market

The foreign exchange market is a market in which monies are traded. Money serves as a means of paying for goods and services, and the foreign exchange market exists to facilitate international payments. Just as there is

a need for international money payments, there also is a need for international credit or deposits and loans denominated in different currencies. The international deposit and loan market is often called the Eurocurrency market, and banks that accept these deposits and make loans are often called Eurobanks.

The use of the prefix Euro, as in Eurocurrency or Eurobank, is mislead- ing, since the activity described is related to offshore banking (providing foreign currency borrowing and lending services) in general and is in no way limited to Europe. For instance, the Eurodollar market originally referred to dollar banking outside the United States. But now a type of Eurodollar banking also occurs in the United States. The Euroyen market involves yen-denominated bank deposits and loans outside Japan. Similarly, there are Euroeuros (the name for euro-denominated bank deposits) and Eurosterling (the name for the U.K. pound denominated bank deposits).

The distinguishing feature of the Eurocurrency market is that the currency used in the banking transaction generally differs from the domestic currency of the country in which the bank is located. However, this is not strictly the case, as some international banking activity in domestic currency may exist. Where such international banking occurs, it is segregated from other domestic currency banking activities in regard to regulations applied to such transactions. As we learn in the next section, offshore banking activities have grown rapidly because of a lack of regula- tion, which allows greater efficiency in providing banking services.

102 International Money and Finance

certain elements. Given the reserve currency status of the dollar, it was only reasonable that the first external money market to develop would be for dollars. Some argue that the Communist countries were the source of early dollar balances held in Europe, since these countries needed dollars from time to time but did not want to hold these dollars in U.S. banks for fear of reprisal should hostilities flare up. Thus, the dollar deposits in U.K. and French banks owned by the Communists would represent the first Eurodollar deposits.

Aside from political considerations, the Eurobanks developed as a result of profit considerations. Since costly regulations are imposed on U.S. banks, banks located outside the United States could offer higher interest rates on deposits and lower interest rates on loans than their U.S. competitors. For instance, U.S. banks are forced to hold a fraction of their deposits in the form of non-interest-bearing reserves. Because Eurobanks are essentially unregulated and hold much smaller reserves than their U.S. counterparts, they can offer narrower spreads on dollars. The spread is the difference between the deposit and loan interest rate. Besides lower reserve requirements, Eurobanks also benefit from having no government-mandated interest rate controls, no deposit insurance, no government-mandated credit allocations, no restrictions on entry of new banks (thus encouraging greater competition and efficiency), and low taxes. This does not mean that the countries hosting the Eurobanks do not use such regulations. What we observe in these countries are two sets of banking rules: various regulations and restrictions apply to banking in the domestic currency, whereas offshore banking activities in foreign currencies go largely unregulated.

Figure 5.1 portrays the standard relationship between the U.S. domestic loan and deposit rates and the Euroloan and Eurodeposit rates. The figure shows that U.S. spreads exceed Eurobank spreads. Eurobanks are able to offer a lower rate on dollar loans and a higher rate on dollar deposits than their U.S. competitors. Without these differences the Eurodollar market would likely not exist, since Eurodollar transactions, lacking deposit insurance and government supervision, are considered to

The Eurocurrency Market 103

Interest rate

U.S. loan Euroloan

U.S. spread Eurodeposit

Eurobank spread

U.S. deposit

Figure 5.1 Comparison of U.S. and Eurodollar spreads.

for loans from Eurobanks, U.S. loan rates provide a ceiling for Euroloan rates because the demand for dollar loans from Eurobanks is perfectly elastic at the U.S. loan rate (any Eurobank charging more than this would find the demand for its loans falling to zero).

The Eurocurrency Market