10.2Eurocurrencies

Eurocurrency markets began to develop in the 1950s and grew most spectacularly in

the 1960s and 1970s. Since the mid-1960s the growth rate of eurodeposits has been

more than double that of the world money supply. According to Podolski (1986,

pp. 112–13): ‘The development of the eurocurrency system was perhaps the most

important nancial innovation of the post-war period...comparable to that of coke

smelting in the development of iron and steel, the steam engine in the development

of the railways...’

Eurocurrency:A deposit held in a bank outside the country in whose currency the

deposit is denominated. For example, eurodollars are US dollar deposits held in banks

outside the US – not necessarily in Europe.

A eurodollar deposit, then, is created when a holder of a dollar bank deposit in

the US transfers that deposit to a US bank located outside the US (an offshore bank).

The depositor then has a dollar claim on the offshore bank and it, in turn, has a

dollar claim on the bank in the US. At this stage, a eurodollar is simply an indirect

way of holding a dollar deposit with a bank in the US.

However, the offshore bank now has an asset and will lend it on to a borrower

outside the US. If we next assume that the borrower spends the borrowed funds and

the recipient of those funds re-deposits them with an offshore bank, then eurodollar

liabilities outside the US are no longer fully matched by claims within the US and

we may say that eurodollars have been created. This process is shown in Box 10.1.

It is clear then that there must be dollar deposits within the US at the base of

the eurodollar market but these deposits need not be very large for the market to

function efciently. Eurodollars represent by far the most important element in the

eurocurrency markets, but euroyen, eurosterling and other eurocurrencies also exist

– indeed, the procedure can in theory be applied to any currency in international

demand. Now there are even euroeuro.

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10.2 Eurocurrencies

Box 10.1

The creation of eurodollars

Stage one

Death Mines plc is a British exporter that has earned $1 million on the sale of goods

abroad for which it has been paid in US dollars. It has deposited this sum in a US bank.

The bank, in the normal way, has used this deposit to make loans within the US. Thus,

our starting point is:

Balance sheet of 1st Sunshine Bank in New York
Assets	Liabilities

bank loans to US	$1 million deposit by
borrowers	Death Mines plc

Stage two

Death Mines plc decides that it wishes to keep its funds in dollars but to shift its deposit

to a branch of Lucky Chance Bank, a US bank in London (a eurobank). This has no effect

on the US bank in the US since the only change from its point of view has been in the

title to the deposit. At this stage the eurodollars are just an indirect way of holding a

dollar deposit with a US bank. We now have balance sheets of both the bank in the

US and the bank in London:

A.	Balance sheet of 1st Sunshine Bank in New York
	Assets	Liabilities

bank loans to US	$1 million deposit by
borrowers	Lucky Chance Bank, London

B.	Balance sheet of Lucky Chance Bank, London
	Assets	Liabilities

$1 million deposit with	$1 million eurodollar
1st Sunshine Bank, New York	deposit by Death Mines plc

Stage three

The Lucky Chance Bank in London now lends to an end-user of funds, say the Frankfurt

subsidiary of a US multinational company, Weapons of Mass Destruction Inc. This loan

takes the form of a transfer of the title to the original bank deposit in the US. Our set of

accounts now reads:

A.	Balance sheet of 1st Sunshine Bank in New York AssetsLiabilities

bank loans to US	$1 million deposit by
borrowers	Death Mines plc

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Chapter 10 • International capital markets

B.	Balance sheet of Lucky Chance Bank, London
	Assets	Liabilities

$1 million loan to Weapons of	$1 million eurodollar
Mass Destruction Inc, Frankfurt	deposit by Death Mines plc

C.	Balance sheet of Weapons of Mass Destruction Inc AssetsLiabilities

$1 million deposit with	$1 million loan from
1st Sunshine Bank, New York	Lucky Chance Bank, London

The next stage depends on what Weapons of Mass Destruction Inc does with its loan.

It could, for example, use it to buy goods in the US. In this case, the sellers of the goods

to Weapons of Mass Destruction may simply re-deposit the funds within the US domestic

banking system and the whole process comes to an end. Alternatively, Weapons of Mass

Destruction Inc may choose to use its loan in Europe, buying British goods instead of

American ones. If we assume that the British rms re-deposit the funds in British banks,

and that they convert the dollars into sterling, the title to the dollar deposit will nish up

with the Bank of England and the process will come to a halt unless the Bank of England

chooses to hold part of its dollar reserves with eurobanks.

Suppose, however, that the British rms that make sales to Weapons of Mass Destruc-

tion Inc re-deposit not in domestic British banks but in other eurobanks. Then the process

will continue as these eurobanks are able to make further loans to end-users of funds.

Exercise 10.1

In practice, there is a great deal of interbank activity within the eurocurrency market. In other words, the Lucky Chance Bank is not very likely to lend directly to an end-user such as Weapons of Mass Destruction Inc. Rather, assume it lends to another eurobank, the Shanghai and Bristol Bank, and that it on-lends to Weapons of Mass Destruction Inc.

(a)	Reconstruct the nal set of accounts to include a balance sheet for the Shanghai and Bristol Bank.

(b)	Construct the accounts for stage four, assuming that the British rm that sells goods to Weapons of Mass Destruction Inc deposits its receipts with yet another eurobank, All Nippon Bank.

10.2.1

The growth of the eurocurrency markets

A convertible currency:A currency that can be exchanged freely for any other currency

in any amount by any holder of the currency. Restrictions on convertibility take many

forms – limiting the amount that can be exchanged, the currencies into which exchange

is possible, the uses for which foreign exchange can be obtained, or the range of

holders who are allowed foreign exchange.

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