Chapter 11 Outline

The Eurocurrency Market

A eurocurrency is any currency banked outside of its country of origin. Eurodollars, which account for about two-thirds of all eurocurrencies, are dollars banked outside of the United States. Other important eurocurrencies include the euro-yen, the euro-deutsche mark, the euro-franc, and the euro-pound. The term eurocurrency is actually a misnomer because a eurocurrency can be created anywhere in the world; the persistent euro- prefix reflects the European origin of the market. As we shall see, the eurocurrency market is an important, relatively low-cost source of funds for international businesses.

Genesis and Growth of the Market

The eurocurrency market was born in the mid-1950s when Eastern European holders of dollars, including the former Soviet Union, were afraid to deposit their holdings of dollars in the United States lest they be seized by the US government to settle US residents' claims against business losses resulting from the Communist takeover of Eastern Europe. These countries deposited many of their dollar holdings in Europe, particularly in London. Additional dollar deposits came from various Western European central banks and from companies that earned dollars by exporting to the United States. These two groups deposited their dollars in London banks, rather than US banks, because they were able to earn a higher rate of interest (which will be explained).

The eurocurrency market received a major push in 1957 when the British government prohibited British banks from lending British pounds to finance non-British trade, a business that had been very profitable for British banks. British banks began financing the same trade by attracting dollar deposits and lending dollars to companies engaged in international trade and investment. Because of this historical event, London became, and has remained, the leading center of eurocurrency trading.

The eurocurrency market received another push in the 1960s when the US government enacted regulations that discouraged US banks from lending to non-US residents. Would-be dollar borrowers outside the United States found it increasingly difficult to borrow dollars in the United States to finance international trade, so they turned to the eurodollar market to obtain the necessary dollar funds.

The US government changed its policies after the 1973 collapse of the Bretton Woods system (see Chapter 10), removing an important impetus to the growth of the eurocurrency market. However, another political event, the oil price increases engineered by OPEC in the 1973 - 74 and 1979 - 80 periods, gave the market another big shove. As a result of the oil price increases, the Arab members of OPEC accumulated huge amounts of dollars. They were afraid to place their money in US banks or their European branches, lest the US government attempt to confiscate them. (Iranian assets in US banks and their European branches were frozen by President Carter in 1979 after Americans were taken hostage at the US embassy in Tehran; their fear was not unfounded.) Instead, these countries deposited their dollars with banks in London, further increasing the supply of eurodollars.

Although these various political events contributed to the growth of the eurocurrency market, they alone were not responsible for it. The market grew because it offered real financial advantages--initially to those who wanted to deposit dollars or borrow dollars and later to those who wanted to deposit and borrow other currencies. We now look at the source of these financial advantages.

Attractions of the Eurocurrency Market

The main factor that makes the eurocurrency market so attractive to both depositors and borrowers is its lack of government regulation. This allows banks to offer higher interest rates on eurocurrency deposits than on deposits made in the home currency, making eurocurrency deposits attractive to those who have cash to deposit. The lack of regulation also allows banks to charge borrowers a lower interest rate for eurocurrency borrowings than for borrowings in the home currency, making eurocurrency loans attractive for those who want to borrow money. In other words, the spread between the eurocurrency deposit rate and the eurocurrency lending rate is less than the spread between the domestic deposit and lending rates (see Figure 11.8). To understand why this is so, we must examine how government regulations raise the costs of domestic banking.

Domestic currency deposits are regulated in all industrialized

Figure 11.8

Interest Rate Spreads in Domestic and Eurocurrency Markets

branches of US banks subject to US reserve requirement regulations, provided those deposits are payable only outside the United States. This gives eurobanks a competitive advantage.

For example, suppose a bank based in New York faces a 10 percent reserve requirement. According to this requirement, if the bank receives a $100 deposit, it can lend out no more than $90 of that and it must place the remaining $10 in a non-interest-bearing account at a Federal Reserve bank. Suppose the bank has annual operating costs of $1 per $100 of deposits and that it charges 10 percent interest on loans. The highest interest the New York bank can offer its depositors and still cover its costs is 8 percent per year. Thus, the bank pays the owner of the $100 deposit (0.08 * $100 =) $8, earns (0.10 * $90 =) $9 on the fraction of the deposit it is allowed to lend, and just covers its operating costs.

In contrast, a eurobank can offer a higher interest rate on dollar deposits and still cover its costs. The eurobank, with no reserve requirements regarding dollar deposits, can lend out all of a $100 deposit. Therefore, it can earn 0.10 * $100 = $10 at a loan rate of 10 percent. If the eurobank has the same operating costs as the New York bank ($1 per $100 deposit), it can pay its depositors an interest rate of 9 percent, a full percentage point higher than that paid by the New York bank, and still cover its costs. That is, it can pay out 0.09 * $100 = $9 to its depositor, receive $10 from the borrower, and be left with $1 to cover operating costs. Alternatively, the eurobank might pay the depositor 8.5 percent (which is still above the rate paid by the New York bank), charge borrowers 9.5 percent (still less than the New York bank charges), and cover its operating costs even better. Thus, the eurobank has a competitive advantage vis-à-vis the New York bank in both its deposit rate and its loan rate.

Clearly, there are very strong financial motivations for companies to use the eurocurrency market. By doing so, they receive a higher interest rate on deposits and pay less for loans. Given this, the surprising thing is not that the euromarket has grown rapidly but that it hasn't grown even faster. Why do any depositors hold deposits in their home currency when they could get better yields in the eurocurrency market?

Drawbacks of the Eurocurrency Market

The eurocurrency market has two drawbacks. First, when depositors use a regulated banking system, they know that the probability of a bank failure that would cause them to lose their deposits is very low. Regulation maintains the liquidity of the banking system. In an unregulated system such as the eurocurrency market, the probability of a bank failure that would cause depositors to lose their money is greater (although in absolute terms, still low). Thus, the lower interest rate received on home-country deposits reflects the costs of insuring against bank failure. Some depositors are more comfortable with the security of such a system and are willing to pay the price.

Second, borrowing funds internationally can expose a company to foreign exchange risk. For example, consider a US company that uses the eurocurrency market to borrow euro-pounds--perhaps because it can pay a lower interest rate on euro-pound loans than on dollar loans. Imagine, however, that the British pound subsequently appreciates against the dollar. This would increase the dollar cost of repaying the euro-pound loan and thus the company's cost of capital. This possibility can be insured against by using the forward exchange market (as we saw in Chapter 9) but the forward exchange market does not offer perfect insurance. Consequently, many companies borrow funds in their domestic currency to avoid foreign exchange risk, even though the eurocurrency markets may offer more attractive interest rates.