10.2.2The nature of the market

We have noted the existence of eurocurrencies other than eurodollars. Nonetheless,

the market has been dominated by eurodollar deposits. These are typically time

deposits for short periods. However, terms tended to lengthen over the years, with

an increasing amount of intermediate credit. The existence of differential yields in

various nancial centres caused arbitrage and interbank activity to be very important

within the market.

From the point of view of the domestic economy, the eurocurrency market is a

parallel money market serving as a source of funds for the short-term nancing of

foreign trade, for banks to make window-dressing liquidity adjustments at certain

times of the year and, occasionally, as a major source of nance for some borrowers (for

example, for local authorities and hire-purchase companies in the UK). The market is

outside the control of any single country and is largely unregulated. It would, of course,

be possible for individual countries to seek to regulate more thoroughly offshore

banks operating from their territories. However, countries in which the market is

important fear that such action would cause the market to move elsewhere, resulting

in a signicant loss of invisible earnings for the country in question. The market

is large relative to most domestic European markets and consequently is capable of

exerting a considerable impact on domestic short-term interest rates.

Just as most deposits were for very short to short periods, loans initially also tended

to be for short periods. However, borrowers’ need for loans of longer time periods

(eurocredits) was met by the development of rolloverloans with a oating interest rate.

In these cases, the borrower typically receives a six-month credit with a guarantee

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10.2 Eurocurrencies

that it will be renewed (rolled over) every six months for the life of the loan, which

may be for ten years or longer. Each rollover is accompanied by adjustment of

the interest rate payable to keep it in line with the market interest rates banks are

having to pay on their deposits. Such adjustments are made according to a formula

such as (LIBOR spread). Box 10.2 deals with international inuences on domestic

interest rates. The spread is specic to each loan to cover the administration costs

of the bank and its gross prot including lending risk (sovereign risk + default risk).

The estimate of the default risk will depend largely on the borrower’s credit rating

issued by the international credit-rating agencies, principal among which are the US

rms Moody’s and Standard and Poor’s. Because eurocredits tend to be for very large

amounts, they are often made by syndication, with a lead bank acting to coordinate

a loan from many banks (running sometimes, particularly in the case of sovereign

lending, into the hundreds).

Box 10.2

International and UK interest rates

In Box 8.5 we stated that, with oating exchange rates, countries retained control over

their own monetary policies – that is, over their own interest rates. Sterling has technically

been oating against both the US dollar and the euro since the introduction of the euro

at the beginning of 1999. It was not a party to any agreement to restrict the range within

which sterling could move, although the British government did have a general obligation

not to follow an economic policy strongly counter to the interests of other EU members.

Thus, in theory, the Bank of England Monetary Policy Committee (MPC) can set its short-

term interest rate paying attention only to its domestic target – the achievement of an

ination rate of 2.0 per cent per annum.

Nonetheless, the great increase in international capital mobility had introduced

complications even for countries without xed exchange rates. We know from our dis-

cussion of interest rate parity in section 8.3 that, with mobile capital, movements of

capital from one country to another are inuenced by (a) interest rate differentials among

countries, and (b) expectations of changes in exchange rates. We also know that even

the governments and the central banks of countries that have not joined xed exchange

rate systems are strongly interested in the value of their currencies. In the UK’s case,

a high value of sterling against the euro can make it difcult for British rms to compete

internationally. In addition, it puts downward pressure on UK ination rates, possibly

causing the ination rate to fall below the MPC’s target. In these circumstances, cuts in

European interest rates leading to a movement into sterling and pushing up the value

of sterling are likely to put pressure on the MPC to cut its interest rate. Equally, rises in

short-term interest rates by the European Central Bank (ECB) may have a powerful

impact on the sterling exchange rate and hence on UK competitiveness and ination.

However, the fact that sterling does not need to maintain a xed relationship with the

euro gives the MPC the freedom to allow the spread between its base rate and the ECB’s

renancing rate to grow. Thus, since the beginning of 2004 this spread has varied from

1.75 per cent (Bank of England (BOE) 3.75%; ECB 2.0%) to 2.75 per cent (BOE 4.75%;

ECB 2.0% – from August 2004 to August 2005). On 8 June 2006 the ECB raised its rate

to 2.75 per cent, again narrowing the spread between the BOE and ECB rates to 1.75%.

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Chapter 10 • International capital markets

In contrast, in Denmark, which has maintained a xed relationship between its currency

and the euro despite not joining the euro, the Central Bank needs to change its discount

rate in line with the renancing rate on the euro.

Given the importance of the US dollar in the world economy, US monetary policy

has also always been important. Rumours of possible changes in the short-term rates

of the US Federal Reserve Board can thus have an effect on the value of sterling – not

just against the dollar but also against the euro and other currencies. It is an interesting

reection of the closer integration between the UK and European economies that the Bank

of England’s repo rate did not respond at all to the steady increase in US short-term rates

from 1 per cent at the beginning of 2004 to 4.75 per cent at the end of March 2006.

Of course, it is not only international interest rates that have an impact on UK monetary

policy. Any other international change that affects exchange rate expectations will affect

the mobility of capital and this will put some pressure on the MPC to change UK interest

rates.