10.2.3Issues relating to eurocurrency markets

There has been a considerable debate over the years concerning the extent to which

the development of the eurocurrency market has been a good or a bad thing. The

principal argument for the defence is that it has increased the range of opportunities

for both borrowers and lenders, has narrowed the spread between lending and borrow-

ing rates of interest, and has provided important hedging facilities for transnational

corporations. It has thus greatly increased the international mobility of short-term

capital and has been a major force in integrating international capital markets.

Supporters also argue that it has played a particularly important role in the recycling

of funds from countries with balance of payments surpluses to those in decit, most

notably in the recycling of the surplus of the oil-rich OPEC countries following the

large oil price rises of 1973 and 1979.

The case for the prosecution comprises three issues: the contribution of the markets

to increased world ination; their impact on the ability of national governments to

control their own economies; and the threat to stability of the international monetary

and credit system. These days, the debate over these issues relates to the whole sys-

tem of international nance, not just to the eurocurrency market. The growth of the

offshore markets in the 1960s and 1970s and the consequent ability of nanciers to

avoid the regulations imposed by national monetary authorities was one of the major

factors in the decisions by national monetary authorities in the 1980s to remove

restrictions on convertibility. This allowed capital to move much more freely from

country to country without the necessary intervention of offshore banking.

The ination argument rests on the view that the eurocurrency market has acted

to increase the stock of international money. The usual form of this argument is

through a multiplier model derived from the domestic bank credit multiplier model

for domestic economies and can easily be seen from a consideration of Box 10.1.

This view is developed in Box 10.3 and is contrasted with the alternative portfolio

approach.

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10.2 Eurocurrencies

Box 10.3

The eurocurrency market and ination

A. The bank multiplier approach

This can be derived from Box 10.1 by inspection. It is clear that the loans of the 1st

Sunshine Bank are unaffected by subsequent eurobank activity. However, on the basis

of a single deposit (that of Death Mines plc), the eurobank system generates additional

lending to Weapons of Mass Destruction Inc and this in turn leads to extra expenditure.

Where the recipients of Weapons of Mass Destruction Inc’s expenditure re-deposit in

a eurobank, another round of expansion takes place. Thus, it is argued that there is a

multiplier in operation and the size of the multiplier will depend on the extent to which the

original eurobank loans are re-deposited in eurobanks.

It is usually accepted that most eurobank loans are deposited, rather, in domestic

banking systems, bringing the process to a halt. In other words, the re-deposit rate

within eurobanks is held to be small and hence the multiplier is thought to be quite small

– perhaps around 1.25. Even a small multiplier, however, supports the view that the

eurocurrency market has caused a growth in the world money stock and has thus con-

tributed to ination. Exercise 10.2 relates to the multiplier model.

B. The portfolio approach

Essentially this is based upon the view that eurobanks can lend only if someone wishes

to borrow. Borrowers, in turn, will be inuenced by prospects of prot on investments

undertaken with borrowed funds and the rate of interest payable on loans. Eurobanks will

not inuence the rst of these two. Thus, to the extent that they also do not inuence

interest rates, any loans made to end-users by eurobanks would have been made in any

case. All that has happened is that borrowers have moved from one source of funds to

another.

The eurobanks therefore cannot create credit. As long as there is a stable demand for

and supply of deposits, expansion within the eurobanks will be balanced by contraction

elsewhere. The weakness of this approach as we have suggested is that:

(i)	the eurobanks have allowed restrictions elsewhere in the nancial system to be avoided, increasing the effective demand for and supply of deposits; and

(ii)	by lowering borrowing rates and reducing the spread between lending and borrow-ing rates, they have encouraged borrowing.

The argument that the eurocurrency market has reduced the power of govern-

ments to control their own economies rests on the proposition that the rapid

movement of capital from one country to another removes the ability of single

countries to determine their own interest rates. Any attempt by governments to

control the ow of capital in or out through capital controls can be avoided with

increased ease because of the ability of banks and rms to move bank deposits

around. In the case of developing countries in particular, the eurocurrency market

facilitated capital ight and this put great pressure on many governments, forcing

them to operate much more stringent economic policies than would otherwise

have been needed.

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Chapter 10 • International capital markets

Exercise 10.2The eurocurrency multiplier

The eurocurrency multiplier may be written as:

1

E· D

1 dep(1 rve)

where Eis the total quantity of eurocurrency created, Drepresents deposits originally

transferred from domestic banks to eurobanks, depis the average propensity to re-deposit

with eurobanks, and rveis the minimum reserve ratio held by the eurobanks.

(a)	Assuming that dep0.2 and rve0.01, calculate the eurocurrency multiplier.

(b)	Do the assumed gures seem realistic? What special features of the eurocurrency market might inuence the re-deposit rate and reserve ratio?

(c)	Using your own words, argue the case against the applicability of the multiplier model.

The instability argument has two facets. Firstly, the free movement of large amounts

of capital has increased the ability of speculators to mount attacks on currencies

within xed exchange rate systems such as the attacks launched against sterling and

the lira in September 1992. It has also increased the volatility of exchange rates of

currencies not within xed exchange rate systems. Secondly, the fact that the market

is largely unregulated and does not have a formal lender of last resort, as in the case

of domestic banking systems, is argued to increase greatly the possibility of bank

failure. Further, any failure of a single bank is likely to have considerable implications

for other banks because of the high number of interbank transactions in the market.

In the early years of the international debt crisis of the developing countries after

1982, there were widespread fears of the failure of several major international banks

leading to a collapse of a large part of the international banking system. Similar fears

were expressed following the problems in the ‘newly emerging markets’ in 1998

(dealt with in Box 10.4) and the subsequent near-collapse of the US hedge fund,

Long-Term Capital Management, in September 1998 (see section 9.5).

Box 10.4The rise and fall of the newly emerging markets

In the late 1970s, Western banks lent large amounts to the more prosperous of the develop-

ing countries, particularly in Latin America. These countries built up large amounts of debt,

largely denominated in US dollars. The slow-down in growth of the industrial countries

following the world oil price rise in 1979, the rise in world interest rates and the strength of

the US dollar all helped to make it increasingly difcult for the heavily indebted countries

to meet their debt repayments. In 1982, Mexico and Brazil each imposed a moratorium

on debt repayments to the international banks and this precipitated what became known

as the Third World international debt crisis.

One outcome was that the banks provided no new capital to the countries involved in

this crisis for the rest of the 1980s and the early 1990s. International nance sought new

markets. This became pressing with the recession in Europe in the early 1990s. The ‘newly

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