Financial Resource

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 speculative 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 they 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 on 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 denominated 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 future 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 foreign 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 UK’s 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 between 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 4½%, i.e. prime lending rate in New York. If the Euro-dollar rate exceeded 4½% 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

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