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Wednesday, June 13, 2012

The History of the Eurodollar Market in the 1960s



The Euro-dollar market* was in fact, and is indeed today, an international wholesale market in money, involving Euro-sterling and other national currencies such as Swiss franc and to a lesser degree the other major European currencies. This paper will briefly outline in a chronological order how the Euro-dollar market developed during the first five years of the 1960s. As these markets had one thing in common, the fact that they existed in centres foreign to the natural habitat of the currency concerned. US restrictions, such as Regulation Q of the Federal Reserve System limited the rates that may be paid to depositors, whether domestic or overseas, primarily in order to protect the great number of small US banks that constituted the American banking system. Hence, a banking business developed, involving borrowing and lending and, the evolution of an in vestment medium, in currencies outside the territory in which the currency is ordinarily regarded as domestic currency. This tended to produce a wider spread between the rate paid to overseas depositors and the rate charged to overseas lenders than was the case in London and certain other major centres.

For the second Labour government from 1966-1970, Labours taxation policy was important both for economic management and political strategy. This paper will briefly outline in a chronological order how the Euro-dollar market progressed during the second era of the 1960s. The UK position in the late 1960s required increases in financial capital (namely the Euro-dollar market) along with the restraint of domestic consumption. Business organisations had to be given incentives to borrow on the Euro-dollar market. Both the actual incidence of business taxation and its political impact, were going to play a part in Labours tax strategy. The environment of this strategy was shaped by a number of factors. The mid-1960s saw fresh hopes for the second Labour government to ending the UKs chronic deficit in its balance of payments, which looked to be almost in balance. However, the late sixties also saw large amounts of the countrys reserves, being spent in order to defend S terling. Euro-dollars proved to be a solution. However, the other side was how vigorously the business interest was going to respond to taxes levied against it. In the late 1940s-50s, it was criticised for being too defensive in its posture: the attitude of industry, when EPT (Excess Profits Tax) was raised to 100% had been weak. Industrialists previously appeared to be unwilling on political grounds to fight for what they knew to be right . However, both the Labour government and private industry were to some extent uncertain in their analysis of tax questions, and some of the issues involved in developing long-term business taxation received legislative enactment under Harold Wilsons first government in 1965 .

1961 Introducing the Euro-dollar Market

One can only guess at the amount of Euro-dollars and Euro-sterling outstanding between lenders and borrowers and, though the guesses of financial journalists have varied considerably, all of them fal l in the range of $1billion to $2billion. Due to this and other market reports, it was clear that before 1961, the Euro-dollar market was well established in that not only were there large number of buyers and sellers, but that large sums could be transferred easily and without big changes in rates. Turnover in this, as in all the Euro-currency markets, was probably very big. It was also suggested that Euro-dollars constituted 90% of all Euro-currency, Euro-sterling another 5%, and all other Euro-currencies combined the remaining 5%. It was not clear as to the amount of Euro-sterling outstanding, but its turnover in the Paris market in 1961 had been estimated to have reached 10m a day at times .

The rate of expansion in the Euro-dollar market was due to two main factors: Firstly, the continuing balance of payments deficit of the USA which had put into international circulation a steadily increasing volume of dollars seeking the most profitable form of use. Secon dly, the banning by the German and Swiss authorities of the payment of interest on foreign-owned balances which had caused holders of marks and Swiss francs to hawk their balances around the international money places with a view to earning any interest that can be obtained there. (The French also, followed the German and Swiss example).

This situation led to the development that depositors were able to find centres which offered a higher return, than offered at home. Also, borrowers were able to raise funds in this currency more cheaply than they would be able to do by going to the country of origin of the currency concerned or in their own currency. It was natural enough that London banks and merchant banks in particular with their expertise and international connections, participated actively in this business; since London was thought to be the largest market in Euro-dollars. The total of Londons liabilities in all currencies to non-sterling was a depositor s was around the 1 billion mark in 1961, and after allowing for double counting it was not unreasonable to suggest that London accounted for well over half of the real total . However what was significant was the number of banking institutions in London that have been most active in the Euro-dollar markets which have increased their business enormously since the end of 1958.

The Public Archives shows that four groups of banks increased their deposits by 884m or 80% between the end of December 1958 and the end of March 1961. At the same time their overseas lending increased by 479m and their loans to UK local authorities by 119m in each case nearly a three-fold increase. Euro-dollar transactions was also reflected in changes in the net spot position of UK Authorised Dealers (these was unpublished). A net liability here can be taken as an indication of the extent to which Dealers have switched Euro-dollars, and to a lesser extent other currencies, into sterling.

The movements of highly volatile Euro-currency must make for closer integration of the worlds main money markets. This must tend to make domestic money market rates in different centres more nearly equal than they would be in the absence of Euro-currency markets. Movements of Euro-currency was certainly a significant factor in the determination of forward rates. Differences in Euro-currency rates can induce big movements of short-term funds and have to be considered jointly with interest differentials on Treasury Bills as main determinants of the size and direction of the international flow of short-term capital. So far this did not seem to have had any significant effect on the balances of payments either of the UK or of the US. Euro-currency may be used in ways that monetary authorities regard as desirable. For example, it must have reduced the cost of financing foreign trade this must have benefited Japan in particular and it may even have increased trade. On the other hand, it could be used to exaggerate speculative movements of short-term capital and a system cannot be without dangers where funds which was liable to be withdrawn at very short notice was used to finance hire purchase finance companies and local authorities. There were two points that was worth taking into account:

The first considers the view that short-term capital movements will be bigger than they would otherwise have been . This statement was true in the sense that a greater number of transactions were taking place and the total of the flows in all directions was greater. The UK tended, however, to be most concerned about the flows into and out of the United Kingdom; it seemed that Euro-sterling transactions did not, in general, add to the influx or withdrawal of sterling. In other words, for example, the fact that transactions were going on in sterling between Frenchmen and Japanese did not exaggerate the large reduction of sterling holding s in the hands of non-sterling countries in the first seven months of this year. It was possible, of course, that the existence of the Euro-sterling market resulted in the lenders holding rather larger amounts of sterling than they would otherwise have done, so that the scope for a withdrawal from sterling may have been increased. On the other hand, the fact the Frenchmen could lend sterling profitably to the Japanese, and possibly for a rather extended period, may have added some element of stability to the Frenchmens holding of sterling. The fact was that there was no evidence, however, to confirm either of these hypotheses.

The effect of the UK authorised dealers transactions in Euro-dollars was not easy to expound clearly. The limits on the authorised dealers operations were that there was a limit on the spot convertible currency assets which any one dealer may hold against future liabilities and furthermore each authorised dealers spot and forward commitme nts must match. Perhaps it is easiest to think in terms of the net spot position of the authorised dealers, which became increasingly minus towards the end of 1960, stayed at about minus 100 million from January to May and later declined somewhat. This minus spot position reflects the switch of Euro-dollars and other currencies into sterling. There can be wide variations in the gross liabilities and assets of the authorised dealers, but only the net position affects the reserves, as, each transaction is self-liquidating. Nevertheless, the reserves, reflecting as they do the authorised dealers spot but not their forward position, will have benefited from the growing switching of Euro-dollars into sterling and will have suffered when this switching was unwound .

1962 - Developments for the demand of US dollars and other currencies

There were considerable statistical difficulties in estimating the size of foreign markets for dollars and other currenc ies. Hence, any estimate was little better than a guess. Given this qualification, Altman estimated that the market in Europe for dollars, sterling and other currencies as of June 1962 was more than $3 billion. Leading to the assumption that a world total of dollars and other foreign currencies used in foreign markets would be of the order of $4 to $5 billion.

It was estimated that 85% of foreign market operations in foreign currencies during 1962 were conducted in US dollars. Continental European currencies, particularly Swiss francs and deutsche marks were held and used in larger amounts in 1962 than in 1961, but, since operations in dollars were also larger, they did not increase greatly in relative importance. Deposits of Euro-sterling continued to be relatively small. The greater use of continental currencies stems from the smaller forward premium on the dollar which made it possible to pay rates of interest on Swiss franc deposits which were closer to tho se paid on dollar deposits. This in turn made it possible to obtain and use more Swiss francs in foreign market operations.

Euro-money operations were conducted almost entirely by commercial banks although brokers had become an important mechanism for organising the market as the number of participants has increased. A large proportion of the dollars were dealt with in foreign markets, but a modest proportion of the other currencies, were directly or indirectly owned by central banks and other monetary authorities. Altman estimated that about two-thirds of all funds in European markets in the summer of 1962 were of this character. Official funds reached the money markets in three ways: Firstly, central banks and monetary authorities provide their respective commercial banks with dollar funds through swap operations, with a general or specific understanding that these dollars will be based to acquire foreign currency assets. (The Deutsche Bundesbank had swap tra nsactions to carry out its monetary policy). Secondly, central banks deposit dollars in domestic commercial banks without requiring the surrender of the local currency equivalent (e.g. Italy). Thirdly, central banks in Europe, Latin America, the Middle and Far East deposit dollars with commercial banks in London, Paris, Canada and other money markets. The BIS had become an important intermediary between its members and the Euro-dollar markets .

The funds other than from official sources in the market represented deposits of commercial banks and business enterprises and individuals. Banks and other business enterprises used the major part of the dollars (etc.) in foreign markets, although governments and official agencies used significant amounts. Local authorities in the UK had been important borrowers in the London Euro-dollar market. Most of the funds, however, were used by the private sector. Interest rates on dollar deposits were determined on a highly compe titive basis, arrangements being available for depositing any sum for any period up to 18 or 24 months. At any one time in the market there was a range of rates rather than any one unique rate. The effective floor to the rate on Euro-dollar was determined by rates paid by US banks on time deposits and by other comparable short-term investments in the United States. In 1961, the Euro-dollar rate in London averaged 3.58% compared with 2.35% on new issues of US Treasury Bills and 2.80% on prime bankers acceptances. In the first eight months of 1962, the Euro-dollar rate averaged 3.66% compared with 2.76% on new issues of US Treasury bills and 3.02% on bankers acceptances.

The demand for Euro-dollars was obviously determined by their profitable use. Pure interest arbitrage was a factor, though not the major one, in the demand for such funds. Rates on Euro-dollars had been consistently too high to permit covered interest arbitrage in UK Treasury Bills, though not to o high for uncovered movements. During periods when confidence in sterling was high, it was possible that Euro-dollars were used to finance the purchase of Treasury Bills. Local authority and finance house deposits had been a profitable outlet for Euro-dollars. On average over the period 1961 and first eight months of 1962, the covered yield on deposits with local authorities, covered forward, was approximately the same as published rates on Euro-dollars. This follows, given that Euro-dollars was an important source of funds to the local authority market, and no arbitrage transactions would tend to even out disparities in rates. These averages, however, suggested that, smaller investment opportunities had in fact existed given the spread of rates on both Euro-dollars and local authority deposits.

For the blue chip industrial and commercial customers, the rates they have had to pay for borrowing funds from the market ranged between 5 - 5. 7/8% (i.e. prime borrow ing rate on the New York market). As the commercial banks were paying between 3-4% for three months dollar deposits, their gross interest margin would be in the region of 1-2%. Euro-dollar operations, however, were not confined to channelling funds to those borrowers who may be entitled to the prime rate in New York with the result that the lending rate is often considerably higher than 5 7/8%. Thus with banks being able to work on margins of 1 % upwards, the possibility of profitable business was great .

Rates of interest paid on deposits of sterling and other non-dollar currencies were closely related to those paid on Euro-dollars taking into account the cost of forward cover. This again illustrates the integrated form of the foreign currency markets, arbitrage transactions ironing out interest discrepancies. Most of the transactions in Euro-currencies was covered forward although banks may carry open positions for considerable periods. They have been known t o carry short positions in particular currencies over a long string of weekends when they expected changes in exchange parities. Loans in dollars and other foreign currencies was listed or regulated in three ways: Firstly, that attempts have been made (e.g. Italy) to increase the rate of interest charged in loans in dollars etc. Secondly, agreements have been made in some countries (e.g. Germany) that loans in foreign currencies should only be made to the foreign trade sector. This, by making an artificial distinction between the domestic and foreign trade sectors in the economy results in a highly unstable situation. Thirdly, in many European countries (e.g. the UK) the competitive effect of foreign currency loans is restricted by exchange or capital control regulations.

The effect of the abandonment of interest ceilings on foreign deposits for US banks was not, it was thought, to have a considerable effect on the Euro-dollar market. It was not clear whether US commercial banks were prepared to raise interest rates selectively to any great extent, and even if they did and funds did flow out of the Euro-market, Euro-dollar rates would be adjusted accordingly.

The growth of the Euro-dollar market raised interesting problems of monetary management for the UK authorities. The short-term money markets of the major industrial countries had become considerably unified and internationalized with the emergence of this market. It was possible for the monetary authorities to use the market as an aid to domestic control by operating in the forward market for dollars, so facilitating commercial bank buying of foreign short-term assets. If it was felt that the domestic short-term market was too liquid, it was possible for the bank, by lowering the forward premium on dollars and pegging it for such transactions, to supply commercial banks with dollars for profitable use abroad and thus reduce their supply of sterling. The Deutsche B undesbank had great use of the swap technique in its attempt to relieve pressure on the domestic market.

On the other hand, the Euro-dollar market imposed certain limitations on domestic policy. It was one thing to encourage banks to supplement their domestic assets with foreign assets, it was another to reverse the process. A tight money policy, by raising short-rates, attracts Euro-funds thus helping to defeat the object of control. Of course given exchange control in the UK arbitrage was not perfect but nevertheless there were considerable pressures which appeared when the UKs short-rates moved out of line with those prevailing in other centres. A very strong reason for the control of Local Authority short-term borrowing stems from the use by that market of Euro-dollars when domestic funds were in short supply. Apart from a fool-proof exchange control, the only way to regulate the flow of Euro-dollars into the UK was for the official authorities to have cont rol over all significant short-term interest rates.

The Times on the 13/09/1962 quoted that: the bill to remove the ceiling on interest rates paid by US commercial banks on certain dollar deposits from abroad has now passed the House of Representatives. This is bound to raise fresh doubts about the future of the market in Euro-dollars . If passed by Congress, the Bill would remove the Federal Reserve Boards present ceiling, which ranges up to 4% according to the size of the deposit, on interest rates paid on time deposits of foreign governments, their central banks or other monetary authorities, and international institutions of which the US is a member. This, in fact, covered a large part perhaps as much as 50-75% - of a total Euro-dollar market with an annual turnover now running in excess of $2,000 million. While the US move would undoubtedly serve to relieve the strain on the US gold stock, it must, according to The Times newspaper, ultimately be expected to diminish the size of the market in Euro-dollars to some extent. However, dealers in the market recalled the almost negligible effect of the liberalisation of the American Regulation Q, which from 1962 permitted a modest increase in rates paid on foreign deposits. It was pointed out that liquidity among US commercial banks was already running at a high level and that they would probably not be very keen in these circumstances to raise their interest rates further. Therefore, it was felt that any decline in the size of the market in Euro-dollars was likely to be a slow process.

So during the era of 1962, there was a view prevalent in the City of doubts whether there was a long-term future for the Euro-dollar market. This argument for supposing that the Euro-dollar market was a purely temporary phenomenon followed from the view that the market originated because of rigidities in the structure of interest rates in the United States. It was therefore suggested th at the Euro-dollar market was born out of the banking legislation limiting the rate of interest American banks pay on foreign deposits. Similarly with Euro-sterling, the interest rates paid by British banks were so low as to encourage foreign holders of sterling to lend it to other non-residents at the higher rates that prevail in the free market outside the UK.

Given this view, the revision to Regulation Q, enabling US banks to raise their rates on foreign deposits, was regarded as the beginning of a movement to allow interest rates to reach their natural levels, which would destroy the Euro-market. This, however, was to take a rather facile view of the workings of the Euro-market. The existence of Regulation Q (or its sterling equivalent) was only a subsidiary reason for the markets continued existence, and that market is likely to flourish so long as the American payments deficit continues to pump dollars into foreign hands. The Euro-dollar market was essent ially an international money market and as such was a convenient source of credit for the borrower and a useful and profitable outlet for the lender. The market may well have been born out of interest rate rigidities, but given the apparatus of an international finance market with dealers willing to operate on small margins, the system would not be allowed to rust. As it was always useful to have a ready source of finance available.

Of the more immediate significance was the stimulus given to the market by the American operations in the forward exchange markets. During 1961, in Switzerland and Germany, the dollar stood at a substantial forward discount against Swiss francs and D. marks respectively. By contrasting to buy forward dollars against these currencies, the US authorities attempted (with some success) to lower the dollar discount. In this operation it was fairly certain that they had cleaned-up some loosely held Euro-dollars (mainly from European trader s worried about the exchange risk). The effects of this operation was best considered by analysing two distinct positions. Firstly, when the dollar stood at a substantial discount, holders of Euro-dollars i.e. traders, would hardly sell them forward for say D. marks because of the cost involved unless they were really panic-stricken. However, when the US authorities managed to lower the forward discount, such holders would take advantage of this in getting out of dollars and to the extent that this happened there would be a gap in the Euro-dollar market. This outflow from the Euro-market would be more than balanced by inflows from the United States as Regulation Q continues to exist and because European holders of dollars realised, seeing that the US authorities stood ready to correct disorderly forward exchanges, they could convert their dollar holdings into other currencies without great cost. It was this factor which was presumably acting as a stimulus to the market in th at Euro-dollar holders can have confidence in the future value of their holdings. Therefore, one of the main features of the American operations has been to encourage the continued holdings of dollars in non-official sectors. The Euro-dollar market was only dangerous to the American balance of payments to the extent that holders sell their dollars to their respective Central Banks who earmark these for gold.

1963 - The growing developments of the Euro-dollar Market

The Euro-dollar market as a whole by 1963, amounted to $4-5 billion and was tending to grow. At 31st March 1963, there were about $3 billion outstanding in the UK market alone. A world total of dollars and other foreign currencies used in foreign markets was of the order of $5-6 billion . Euro-money operations were conducted almost entirely by commercial banks although brokers became an important mechanism for organising the markets as the number of participants increased. Central banks and other monetary authorities directly or indirectly owned a large proportion of the dollars dealt with in foreign markets. It had been established that about two-thirds of all funds in European markets was of this character.

The supply of dollars for the Euro-market came from American residents and non-residents. During 1963, it was the non-residents who supplied the vast majority of the dollars, generated by a continuing US balance of payments deficit on current and long-term capital account. The most important suppliers of funds by country were Canada, Western Germany, Italy, Switzerland and France, although other countries had contributed. American residents added to the market (and hence to the overall US payments deficit) by switching short-term funds to European banks in order to take advantage of higher interest rates than could be obtained domestically. In actual fact, most American resident funds reached the Euro-market via Canada, in which the resi dents switched short-term funds to Canadian banks, which had then placed them into European banks .

The process by which these dollars reached the Euro-market was as follows: As a result of the American deficit, foreigners build-up dollar deposits in American banks on current account. The foreigner could then invest the dollars in any number of ways, but assuming that they would lend the dollars to a European bank, as that bank would be willing to pay a higher interest rate than could be earned in the American short-term money market. The ownership of the deposit is then transferred, within the American bank, to the account of the European bank which is then able to use the funds to lend. When the new owner of the dollar deposit lends to a third party, the European banks account in the American bank is debited and the third partys credited. The whole process is essentially a transfer of the dollar deposits in the American banks between accounts, the deposit nev er actually leaving the American bank.

As stated previously, official authorities were the most important suppliers of dollars to the market. This was presumably because residents in many countries surrendered (voluntarily or otherwise) dollar earnings to their central authorities which then put the dollars back on to the market in three ways: Firstly, that central banks and monetary authorities provide their respective commercial banks with dollars through swap operations, with a general or specific understanding that these dollars will be used to acquire foreign currency assets. The Deutsche Bundesbank has over the past two years engaged in such operations. Also this operation had occurred in Italy. Secondly, central banks deposit dollars in domestic commercial banks without requiring the surrender of the local currency equivalent. In some cases this is because such deposits earn higher rates than in New York. In Italy, however, this operation was used to incr ease the liquidity of the banking system. Thirdly, Central banks in Europe, Latin America, the Middle and Far East, deposit dollars with commercial banks in London, Paris, Canada and other money markets. Members of the Bank for International Settlements deposit funds with it and the BIS has become an important intermediary between its members and the Euro-dollar market .

Although precise data was not available, Oscar Altman of the IMF estimates that the central monetary authorities of 20-25 countries have deposited dollars outside the United States . The non-official funds reaching the market represent the funds of commercial banks, largely in continental Europe, and funds of businesses and individuals in many countries including the United States. Corporations in the United States have made substantial time deposits in Canada and Europe in order to earn higher interest rates than can be earned domestically. The funds deposited in Canada were channelled into Eur opean banks, (particularly the UK) the Canadian banks acting as intermediaries for US dollars. Businesses and individuals in many other countries, e.g. Canada, Germany and Switzerland, can hold dollars and other foreign currencies without restriction as to time, amount or purpose. Some have themselves deposited funds in the Euro-market, or have placed them with domestic banks which have done so. In a number of industrial countries, where there is a residue of exchange control, as in France, business enterprises can hold dollars and other foreign currencies for limited periods of time through authorised banks.

The dollars emanating from the US current and long-term deficit remain deposited in the Euro-markets, and US resident funds was attracted, because of the higher interest rates paid on such deposits in these markets than in the USA. The effective floor to the deposit rate on Euro-dollars is determined for non-residents by rates paid by US banks on foreign t ime deposits and other comparable short-term investments in the United States. In 1961, the Euro-dollar rate in London averaged 3.58% compwasd with 2.35% on new issues of US Treasury Bills and 2.80% on prime bankers acceptances. In 1962, the Euro-dollar rate averaged 3.77% compared with 2.78% on US treasury bills and 3.01% on bankers acceptances .

The higher interest rate of dollar deposits in Europe was not the only cost factor determining the attraction of holding such deposits. The most favourable condition for non-American owned dollars was that the dollar exchange rate (spot) should be on the floor but that there should be no expectation of imminent dollar devaluation either in terms of foreign currencies or gold. European dollar holders did not then need exchange cover. If fears of a dollar devaluation become widespread, the supply of non-American dollars would tend to dry up as banks would sell their dollars to the central authorities which would convert into gold. If the dollar rose to the top of the range against European currencies, the possible 2% fall over three months could militate heavily against Europeans continuing to hold and lend dollars, although it would not of course affect deposits attracted from American residents.

European banks were willing to pay higher rates on dollar deposits than American banks because they could find a profitable use for them. The dollars were used in the following ways: without switching into another currency; with switching but without forward cover; and with switching and with forward cover. Any of these possibilities could lead to investment, which more than covered the deposit charge which led to a demand for Euro-dollars. The banks holding the dollar deposits lent to governments by investing in government debt instruments and to commercial borrowers. The amount of borrowing by the banks to take advantage of pure interest arbitrage was a factor, although not the maj or one, determining the demand for Euro-dollars. Rates on Euro-dollars had been consistently too high to permit covered arbitrage in UK Treasury Bills, but when confidence in sterling was high there has been uncovered arbitrage. However, the rates on UK local authority and finance house deposits have been high enough to enable covered arbitrage transactions to take place at times. This process was usually short lived as the process of switching on any large scale removes the arbitrage advantage.

Most of the demand for Euro-dollars came from businesses and commercial enterprises. As, the dollars may have been needed to finance export-import operations. Commercial banks may use the dollars to serve as a money market instrument. A bank that temporarily needs additional liquidity may accept dollars (or other foreign currency deposits) instead of discounting with its central bank or selling assets in the open market. Moreover, since deposits can be accepted or placed in a wide range of maturities, banks can use then very flexibly. Likewise, businesses may be in temporary need of liquidity or may need dollars to finance overseas investments. For blue-chip industrial and commercial customers the rates that they will pay for borrowing from the market will range upwards from 5% (i.e. from prime borrowing rate in the New York market). The maximum rate that can be charged in the Euro-market is the rate that the customers would have to pay in their domestic market. As the banks will be paying in the region of 3% - 4% for Euro-deposits, their maximum turn will be in the region of 1%-2% .
Switching out of dollars into European currencies can be profitable either for the Euro-banker direct or for the borrower who wants to finance in his own currency. In such a case the limit to such an operation would be where the cost of switching into the domestic currency and covering the transaction forward equalled the cost of securing funds on the domestic market. However, the business of switching is best regarded as a specialised concern operating in certain favourable times, but not essential to the functioning of the Euro-dollar market.

The growth of the Euro-dollar market has been basically the result of the difference in the interest rate structure of New York and European centres. Interest rates had been lower in the USA than in Europe and the deficit on trade and long-term capital accounts remained deposited in Europe rather than returning to New York, which had enabled European bankers to outbid New York for deposits (and deposit rates). Seco ndly, and of increasing concern to the American authorities, US residents have been attracted to the Euro-market, again because of higher rates, and this has added to the US capital outflow. Also, the widespread differences between borrowing and lending rates in New York and in most domestic capital markets had enabled the Euro-bankers to outbid their domestic counterparts for lending outlets by working on smaller margins, relying on a heavy volume of business to make their profit. The market had also been stimulated by certain non-interest rigidities in domestic markets, e.g. exchange control, credit squeezes etc.

The effect of the growth of this international currency had been: Firstly, to influence the structure and level of short-term rates in a number of countries. The Euro-market had tended to internationalise interest-arbitrage transactions. Secondly, to make it more difficult to carry out large changes of domestic monetary policy. Attempts to tighten li quidity would, by raising interest rates in the domestic market, lead to inflows of Euro-dollars. Thirdly to reduce the cost of foreign trade financing as the Euro-bankers have under-cut domestic charges.Finally, to increase the importance of the dollar as an international currency used in both trade and finance. As American non-residents were more willing to hold dollars because of the attractive interest rates to be obtained, international liquidity has been increased. The Euro-dollar market had been of help to the American balance of payments to the extent that non-residents have been willing to hold dollars instead of converting them into gold. However, higher deposit rates in the Euro-market had attracted US residents to invest in the market, and thus add to the US outflow. It had therefore been argued that it would be of advantage to the USA, if the latter could be reduced or eliminated without affecting the advantage to be gained by the former.

However, although the American authorities were concerned about the resident outflow resultant on the existence of the Euro-dollar market, there was evidence to suggest that the resident outflow was more than offset by a return flow of Euro-dollars back to the USA. Between December 1963 and March 1963, UK banks which were by far the biggest operators in the Euro-dollar market, increased their dollar claims on US residents by 147m while their US resident liabilities rose by only 4 million . These figures probably overstate the net inflow of dollars to the USA, as unknown quantity of resident funds reach the Euro-market via Canadian banks and were not picked up within the scope of these figures. Nevertheless, the amount of resident funds reaching the market was small and was probably offset by a substantial return flow. This return flow arose because of the wide-spread between the deposit and lending rates of US domestic banks which enabled European banks to outbid US banks for lending outlets in the US market. The existence of the Euro-dollar market certainly facilitated the lending by European banks to US residents.

American domestic banks were limited on the interest rates that they could pay on resident time deposits by regulation Q. The maximum interest rates payable varied between 1% on 30-day deposits to 4% on 360-day deposits . As a result, when they were short of funds, they often encouraged their European subsidiaries to enter into the Euro-dollar market and bid for dollars, the subsidiary then repatriated the dollars to its head office in America. To the extent that the European subsidiary attracted US resident deposits, this was a roundabout way of the US bank offering American residents a deposit rate in excess of that permitted by Regulation Q. The Euro-dollar market would cease to grow when rates in New York and in Europe for lending and borrowing were exactly aligned for all types of customers and when the differential betwee n the lending and borrowing rates was small enough to make any banking operations unprofitable. Even if such conditions held, the dollars outstanding would still continue to be utilised for arbitrage operations and so there will always be some scope for Euro-dollar operations.

When the Euro-dollar market would be naturally curtailed, there were attempts to restrict the operations of the market in the following ways: The rate of interest charged on dollar loans was artificially increased. Italy is the clearest example of this. Agreements by Italian banks covering minimum rates on loans in lire were supplemented in 1961 by minimum rates on dollars and other foreign currencies. This agreement has been continually revised. Secondly, under the stress of competition, it was agreed or understood by banks in some countries (e.g. Germany) that loans in foreign currency should be made only to the foreign trade sector. Finally, in many European countries, the competitive effect of foreign loans was restricted by exchange or capital control regulations.

There was some concern about the relationship of the Euro-dollar market to actual or potential speculation against the dollar as the Euro-market was largely beyond the immediate control of the American monetary authorities. There was two sides of the argument. As the interest rates on dollar deposits was attractive, this gives an incentive for the dollars resultant on the deficit on trade and long-term capital account to remain unconverted into gold. The fact that dollars were placed in the Euro-market rather than used to buy gold, indicated that someone was not speculating against the dollar. On the other hand, the attraction of the market did induce American residents to invest short-term capital abroad and added to the funds in the market. However, there has yet been no evidence that the market for Euro-dollars had been unstable, although these dollars could be used for a specu lative attack on the dollar.

It had been suggested that it would be preferable from the point of view of speculative pressure if the dollars resultant on the American payments deficit were held by foreign central banks. If there was a speculative attack against the dollar, the dollars held in Europe in private hands would be sold to the central authorities. Thus, it was the central authorities in Europe that was the holders of Euro-dollars at last resort. They were the focus of changing potential into actual speculation against the dollar to the extent that they were willing to hold dollars speculation was curbed. The real point was that New York had become an international banking centre whether or not this was liked by the American authorities and it was difficult to see what could be done about this other than by changing the payments and interest rate structure of the USA or imposing exchange restrictions. If American banks could raise the interest rates th ey were permitted to pay on deposits to residents, this would tend to reduce the resident funds going into the Euro-dollar market unless European authorities raised their own rates.

The evolution of the Market

By 1963, Euro-dollar operations were a particular form of banking whereby foreign banks, chiefly European, accepted deposits of dollar claims and in turn, lent these dollar claims to their customers. Typically, these deposits and loans were made for short periods. The supply of funds to the market came mainly from foreigners having dollar claims as a result of the US balance of payments deficit. The correspondent banks found that, operating with only a small interest rate spread, they could make a profit by lending these dollars balances at rates lower than those charged by traditional lending outlets in the United States. Other dollar holders soon found that they could engage in similar operations. Soon, British banks offered their customers and correspondents dollar facilities to take the place of the prohibited sterling credits, obtaining requisite balances in the European dollar market .

The demand for Euro-dollars came from a variety of sources, mostly in the private sector. The commercial banks of a large number of countries accepted and employed dollar deposits for use in both international and domestic operations. A substantial amount of Euro-dollars were used to finance firms engaged in international trade. These firms used Euro-dollar finance in preference to the more normal acceptance credits because of lower interest rate charges and because of the convenience of borrowing (given both the wide range of maturities available and the ready supply of funds in the market). Japan has figured prominently in the use of Euro-dollars for international trading. The highest interest rate that a Euro-banker could charge for lending dollars would be what it would cost that borrower to raise dollars o n the New York market. This does not mean however that the effective upper limit to lending charges is the New York prime rate, as relatively few foreign borrowers would be eligible for that rate .

Perhaps most of the funds provided in the Euro-dollar market were lent in the United States. Virtually since the market began, US banks, through their European branches, have been active in the borrowing side of the market. The European branches have actively bid for Euro-dollars and have then repatriated to the United States. To the extent that the subsidiaries have attracted US resident funds, domestic residents may have been paid, indirectly, rates on time deposits in excess of those permitted under Regulation Q.

A main feature in both the evolution of the Euro-dollar market and the revival of the London international capital market, was the issue of a Belgian Government loan in London during May 1963. The loan had a three-year maturity and was denomi nated in dollars. The subscribers were a group of British banks which, it is generally thought, financed the loan in Euro-dollars . This was a departure from the normal short-term lending prevalent in the market and was the first issue handled by British banks in currencies other than sterling since the war.

Also, by 1963, Euro-dollars were used as money market instruments by foreign commercial banks. In view of the fact that dollars could be loaned or borrowed for various periods they constitute an excellent medium for banks to adjust their liquidity positions. In these operations the market is analogous to the Federal Funds Market in the US. Often banks were trading on both sides of the balance sheet, both lending Euro-dollars and at the same time borrowing. As well as loaning dollars, Euro-bankers used the dollars to buy other currencies and lend in foreign markets. In such a case the bank will arrange to sell its foreign currency holdings for dollars at a fu ture date, i.e. it will hedge against the exchange risk. Occasionally, dollar deposits in European banks was used to take advantage of interest arbitrage opportunities. For example, there is likely to be a strong relationship between the amount of dollars switched into sterling and loaned to the UK Local Authority Market and the margin between rates of interest on Local Authority deposits (adjusted for the cost of forward cover) and the rates on Euro-dollar deposits. At times, Local Authorities have borrowed substantial short-term funds from the Euro-dollar market. Although Euro-bankers will not usually ignore an interest arbitrage possibility, the main type of transaction is that in which dollars was loaned directly .

Selling dollars for foreign currencies can be profitable either for the Euro-banker or for the borrower who wants to be financed in his own currency. In such a case, the limit would be where the cost of borrowing dollars and switching into the fo reign currency and covering the transaction for exchange risk equalled the rates charged on local funds. It can be seen that Euro-dollar operations was similar to normal foreign exchange operations. Therefore, the market can best be regarded as a supplement to normal foreign exchange operations whereby foreigners having claims on the United States sell their dollars for other currencies, and others, wanting dollars, buy them through exchanges.

It should again be emphasised that the whole complex of Euro-dollar operations was reflected in the transference of ownership of dollar deposits within the US. These dollar deposits will continue to be held in US banks unless: (1) at some stage, dollars was converted into a foreign currency, or (2) the dollars come into the hands of central banks, that, in turn, convert then into gold, or (3) the dollars were used to pay off a loan at a United States bank.

The three media articles at the back of this paper ( Appendix 1 and 2 referring to The Times, and Appendix 3 referring to The Financial Times) indicates that the Bank of England underestimated the significance of the Euro-currency markets for the UKs own problems of monetary management, internal and external. For example, in so far as short-term capital flows increasingly take the form of a movement out of sterling into the Euro-dollar market (and vice versa), what kind of offsetting action do we take? If the UK was not going to use short-term interest rates, can we in some way look to the market as a source of funds just as we have recently looked to foreign Central Banks.

The Euro-bankers were really worried by the growth of the negotiable certificate of deposit in the United States the interest rate on which has just risen so that it is now only at a slight discount on dollar deposits in the UK. UK bankers can of course increase the Euro-dollar rate (which I would suppose is inevitable) but the differential be tween the Euro-dollar and the time certificate of deposit rate is likely to be much less than we have seen in the past. This is because of the effective upper limit on the Euro-dollar rate of 4%, i.e. prime lending rate in New York. If the Euro-dollar rate exceeded 4% borrowers who previously used the Euro-dollar market would borrow direct from New York. The effect on the UK balance of payments of such a development is difficult to estimate as Europeans would still borrow dollars switching from the Euro-market to the New York market directly.

In order to combat the increasing development of the time certificate of deposit there were ideas from the City of a negotiable Euro-dollar deposit. The advantage of this instrument to the Euro-bankers was that the necessary differential to attract funds would be less in the case of a negotiable dollar deposit than with the usual dollar deposit. It was thought that there was a real possibility of such a development in the Euro-dollar market. The UK should not worry about this any more than about the present state of the Euro-dollar market and in fact such a development might well be welcomed as it would avoid putting too much upward pressure on the Euro-dollar rate which could be embarrassing for domestic short rate policies. A differential between UK Treasury Bill rates (adjusted for the cost of forward cover) and the Euro-dollar rate, in favour of Euro-dollars, could lead to switching of funds previously held in the UK, by non-residents into the Euro-market. It is the general problem of separating outflows of sterling which is causing great difficulty. One can only arrive at an approximate answer by correlating relative interest rates against the outflows. However, the Euro-dollar differential appears to have exerted little influence on the switching of funds out of sterling balances. This of course does not mean that the Euro-dollar/UK Treasury Bill differential has not exerted an influen ce in the past it simply means that as yet we have not proved it. As one would expect, sterling holders be tempted to switch their funds by an attractive premium in favour of Euro-dollars, (unless they was completely irrational).

The Euro-dollar market was composed of a very large amount of funds highly sensitive to relative movements in interest rates. If a position was postulated whereby UK interest rates fall relative to Euro-dollar rates, (US interest rates rise which pushes up the Euro-dollar rate and UK short rates do not follow), the effects on the UK balance of payments would be of two types: (a) funds invested in the UK directly by Euro-bankers (usually in Local Authority deposits) would be withdrawn; and (b) sterling balances of non-residents would be switched into dollars and invested in the Euro-dollar market . Funds invested in the UK directly by Euro-bankers will be shown up by changes in Dealers net deposit liabilities in foreign currencies. The se liabilities reflect the extent to which banks have switched any foreign currency deposits lodged with them into sterling. In all cases, the initiative is in the hands of the banks themselves. By no means all of the switching done by the dealers is the reflection of relative interest rate advantages, but nevertheless this is bound to be a part. As a large part of the foreign deposits lodged with UK banks will be dollars on which the banks pay the Euro-dollar rate, and as generally speaking, all switching is covered forward, the banks will have usually found it unprofitable to have borrowed these funds and to have invested in UK treasury bills. However, there have been arbitrage advantages in investing in local authority deposits or finance house deposits .

1964 The New Labour Administration

1964 was a significant era for the Euro-dollar market, as not only was there a change in Government, but it was at this time that Euro-dollars changed from be ing a new phenomenon into a prominent force in the market. The Labour Party had come to power, with Harold Wilson, as the new British Prime Minister. However, it was clear for the new Labour Administration that the UK was facing a deficit of 800m on its overseas payments for the year 1964. It was this inheritance from the Conservatives which was to dominate almost every action of the government for five years. The new administration was faced with three courses of action: devaluation of sterling, quantitative restrictions on imports (quotas), and a surcharge, in effect a temporary additional tariff, on a wide range of imports. At the time in 1964, devaluation was not an option, given the size of the new governments majority, it was not a surprising decision. Also, the new incoming government did not fully know the true facts of Britains deficit. However, there was no option but to accept devaluation. In 1967, there was no alternative, central bank and governments accepted th e decision as necessary. However, Wilson, had argued strongly (from 1964-67), that devaluation was not a easy way out, that by its very nature in cheapening exports and making imports dearer, it would require a severe and rapid transfer of resources from home consumption, public and private, to meet the demands of overseas markets. This would have meant, brutal restraints in both public and private expenditure over and above the domestic situation that the labour administration had inherited. Other considerations, were that devaluation could have started a competitive currency devaluations similar to those of the 1930s, and could have led to stimulating economic nationalism and blind protection abroad .

Quotas were rejected, due to the damage it could have inflicted on industrial production, no matter how selective the system, and in particular, their effect in ossifying the industrial structure, penalising new or growing or efficient firms and feather-bedding the un-competitive. Tariff was the third proposition left. However, this was not an easy option either. As, it would be argued abroad that a sudden rise in the tariff over a wide range of commodities was contrary to the UKs international obligations, particularly those of GATT, and EFTA. Other nations that had close economic relations with the UK, such as the Commonwealth countries, the Irish Republic, the USA, would have had strong grounds for protest. There was fear that once imposed, the surcharge would be difficult to remove. Other fears were that UK manufacturers that were enjoying a temporary protection against foreign competition, would slide into easy ways, instead of responding to the challenge by making themselves still more competitive. However, despite these anxieties, action had to be taken, so the import surcharge was recommended. It was decided that a rate of 15% would be imposed on all imports, except food, tobacco and basic raw materials. On the 26th Octobe r, ten days after taking office, a statement was issued underlying the economic situation. It concluded that the strength of sterling could and would be maintained, the underlying economic situation remained profoundly unsatisfactory. The balance of payments deficit for 1964 was most unlikely to be below 700m and might well reach 800m. While a considerable improvement was expected, in 1965, the deficit would still be at an unacceptable level. The position on imports and exports was surveyed together with the domestic economic situation, the problem of continually rising prices and the position on public expenditure. The statement went on to announce the introduction of surcharges, at 15%, on all imports, except food, tobacco, and basic raw materials. In its first ten days in office, it was clear that the new Labour administration had to deal with an explosive economic situation .

The Economy Speculation against Sterling and the drain on reserves

I n London, there were a number of large international companies which held considerable amounts of working capital in sterling. There was a growing business in the speculation in sterling (based on selling sterling to obtain foreign currencies). These players held the future of sterling particularly to the exchange rate itself tend to move their money out, even at a relatively high cost in terms of interest, to some currency they regard as more secure. At the time of heavy balance of payments deficit there was, a large quantity of sterling splashing about in the markets of the world and, when confidence in sterling was low, dealers in many markets sold sterling for US dollars, German Marks, Swiss Francs, or anything deemed safer. The only way in which British citizens were able to take a position in sterling, (as they expected either a marginal fall or an outright devaluation) was by postponing receipt of the payments that was due to them in some foreign currency, since aft er the fall in the sterling rate such foreign currencies would be worth more in sterling terms .

However, importers who had to make payments in foreign currency tended to advance their payments, paying the bill beforehand. In difficult times, there was clear evidence that importers were increasing the physical qualtities of their imports, buying their raw materials 3-6, even 12 months ahead, and paying as quickly as possible for the imports thus ordered. These Leads and lags had the effect of running into hundreds of millions of pounds on the sterling position and thus on the reserves. On top of this, speculation grew to great proportions when a devaluation was expected. Such dealings were confined to foreign exchange dealers/speculators. These were in the form of dealers getting rid of sterling, they held or selling sterling they did not possess with the idea of buying it back some days later. This meant that, if these dealers had to pay bills in sterling, the y had to borrow at extortionate rates of interest. Nevertheless, this speculation proved so severe that, it was becoming a threat to the balance of payments deficit. Indeed, it virtually disappeared as a threat once the UK moved into strong surplus, but that was after 1969. However, before the UK was in surplus, the government had to take actions against what the speculators might do, hereby looking at the confidence factor. So, things had to be rightly timed, in order to minimize possible speculative consequences, (this was also the case in 1969 when the UK were moving into a strong surplus). This meant that the City, closely monitored the actions of the Chancellor, the Governor of the Bank of England and the Prime Minister. One mistake the government admitted was always underestimating the power of the speculators. It was this understanding, that made the government more determined to strengthen the basic position of sterling, which meant strengthening the balance of payme nts which in turn strengthening the competitiveness of British industry. This was the point of the Chancellors statement on the 11th November 1964. As, there was, a considerable surplus of highly volatile sterling in world markets because of the balance of payments deficit .

Since the Chancellors statement, both the PM and the Chancellor received a daily tally of the movements on foreign exchange markets, recorded not only by the exchange rate, but the amount of money which the Bank of England had to throw into the market to stabilise the sterling rate, together with payments on government account. This was regular right until 1969. Day by day, the government listened to demands for immediate cuts in government expenditure, and faced heavy drain on the reserves. It was a situation where 50 million pounds could have been lost, sometimes more, and the UKs total gold reserves and convertible currency reserves barely totalled 1,000 million pounds. Short-term centr al bank assistance was near exhaustion, and there was no immediate prospect of the IMF borrowing on which the UK decided. The pound was at its support level. On the 25th November 1964, the Governor of the Bank of England stated to the PM that $3,000 millions was successfully raised by the central bankers. It seemed that sterling was safe, for a time. Long enough, to strengthen exports to the point where day-to-day speculation was not reinforced by a chronic balance of payments deficit .

Euro-dollars a prominent force in the market?

It was clear in 1964 that a large international money market in short-term dollars had developed outside the US. These transactions were made possible because Americans and foreigners deposited dollars with banks outside the US, which had profitable uses for them. It was estimated with some assurance that dollar deposits come from at least 25 countries and that the final users of dollars reside in at least 35 countries .

About 400 commercial and private banks were in the Euro-dollar market. Many of these banks were in the market all the time, and they were on one side or the other, depending upon profits that may be earned from interest rate differentials and arbitrage possibilities. Other banks were in the market irregularly in order to deal with the financing needs or the savings accumulations of particular clients. The Euro-dollar market held no bar to politics. The two large communist banks in Western Europe - the Moscow Narodny Bank in London and the Banque Commerciale de lEurope du Nord in Paris were important components in the market, sometimes to place deposits with other banks (lend) but more often to accept them (borrow) . The states banks behind most of the countries behind the iron curtain were in the market, and many of these regularly circularize commercial banks in the West in order to obtain funds. Brokers play an important specialised role as intermediaries a mong banks, and two of them one in Paris and the other in Lausanne, with their branches do a large international business . The market in Euro-dollars was a wide and complicated one spread over six continents and bound together by a network of cable, telex, and telephone communication. The paper work in the market tended to confirm rather than to initiate transactions. The financial standing of the banks in the market was such that transactions were based on names and did not involve collateral and guarantees.

As the market progressed, the movement of Euro-dollars became an important financial activity and it was clear from the City that there were three major uses for Euro-dollars: First, a large part of these dollars was used to finance external commercial transactions, i.e. exports and imports. Indeed many countries in Europe and elsewhere tried to restrict Euro-dollar activities to those business enterprises that were engaged in foreign trade. These restri ctions operated through systems of capital controls, or exchange controls, or moral persuasion by central banks. Even European countries with convertible currencies may restrict or prohibit business enterprises not engaged in foreign trade, e.g. hotels and department stores, from borrowing Euro-dollars, even though borrowing dollars may be cheaper than borrowing local currency. This was, for example, the situation in France. In 1961-63, with the expansion of issues of long-term securities denominated in dollars in European capital markets, underwriters and syndicate members have used Euro-dollars to finance their inventory positions. Italy made a large and noteworthy use of the Euro-dollar market in 1962-63, borrowing more than $750 million from abroad, of which about half came from the Euro-dollar market . These funds were used to finance external transactions and to make possible a continuing increase in domestic liquidity, which in effect, reduced the drain upon official reserves. Acting under instructions from the Bank of Italy, the commercial banks began to reduce their net external liabilities in the fourth quarter of 1963 and had gone a long way toward reversing their position.

Second, some Euro-dollar funds were used to finance commercial loans and other domestic transactions either in the form of dollars or in local currency purchased with dollars. There has been a large amount of such transactions in Germany, Italy, Japan and smaller amounts in many other countries, including Switzerland. In the UK, a substantial amount of Euro-dollars has been swapped into sterling and then placed with local authorities and instalment finance companies. The Kingdom of Belgium has, directly or indirectly, financed part of some of recent b

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