10.2 Eurocurrencies

The eurocurrency markets could not develop prior to 1958 since it was only then

that the major currencies were made convertible following the Second World War.

Even then, they became convertible only for non-residents. Restrictions on resident

convertibility of the currency continued in the UK until 1979 and in most of the

other major industrial countries into the 1980s or 1990s. Following the introduc-

tion of non-resident convertibility, major US and European banks began to open

branches outside their country of origin. This was particularly true of US banks

because restrictions on branch banking within the US allowed banks to operate only

in their home states. Thus the ambitious banks from the major US nancial centres

sought expansion outside the US.

The opening of bank branches abroad meant that foreign currency earned through

ordinary trading transactions could be placed anywhere where there was a demand

for such funds, allowing depositors to seek out banks with the highest yields. The

growth of the market can then be explained by a variety of supply and demand

factors and the interaction between them.

The principal causes of the growth in the supply of funds to the market were:

l	regular US balance of payments decits which produced large dollar holdings byEuropean companies;

l

US central bank regulations which (a) established upper limits on the interest ratesthat could be paid on deposits in US banks and that made it easy for eurobanks tooffer more attractive rates; and (b) forbade the payment of any interest on depositsplaced for less than thirty days, whereas eurobanks were able to offer interest evenon overnight deposits;

l	the existence of exchange controls that limited the activities of domestic banksbut from which the eurobanks were relatively free;

l	the concern of eastern European countries that their dollar deposits in the US mightbe blocked by the US government for political reasons;

l	from 1973 on, the large volume of oil receipts that the OPEC countries wished todeposit on favourable terms, again preferably outside the US for political reasons;

l	the dramatic growth of ight capital to Swiss and other banks, encouraged by thedevelopment of nancial centres such as Luxembourg and Liechtenstein in whichregulations ensured the protection of the anonymity of lenders;

l	the use by central banks of the market in order to increase returns on their hold-ings of international reserves.

Thus, the supply of funds to the market increased as a result of a mixture of com-

mercial, economic and political factors. The market would not have grown in the

way that it did, however, if there had not also been a large demand from borrowers

for eurodollars. Reasons for this included:

l	US government discouragement from 1963 of borrowing by foreign companiesdirectly from the US market through the imposition of a tax (the interest equalisa-tion tax) that increased the cost of borrowing in the US for borrowers in most ofthe industrial nations;

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Chapter 10 • International capital markets

l	the fact that the eurobanks were free of the reserve requirements imposed on domestic banks, allowing them to maintain a lower spread between borrowing and lending rates (paying higher rates to depositors and charging lower rates to borrowers);

l	the invoicing of a growing proportion of world trade in US dollars, increasing the advantage to rms of holding their working balances for nancial and commercial use in dollars in order to avoid exchange rate risk;

l	US government limitations on the amount of capital that US transnational corporations could shift out of the US to invest abroad, forcing them to borrow outside the US and providing the market with a major group of very creditworthy borrowers.

The eurocurrency market is largely an interbank or wholesale market with a

chain of interbank transactions normally occurring en route to an end-user of funds.

It deals only in large amounts, usually of $1 million or more, and loans are made

on an unsecured basis. The size of the sums involved means that the xed costs of

transactions can be spread over large quantities of funds, increasing still further the

attractiveness of terms the market has been able to offer to both borrowers and lenders.

Efciency has been increased and costs lowered further by rapid improvements in

communications and computer technology.