1. The Eurocurrency Market 99 Prices and Policies Second Edition ©2001 Richard M. Levich International Financial Markets McGraw Hill / Irwin

2. 9 - 2 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Overview  Historical Overview  The Origins of Supply and Demand for Offshore Banking  Onshore Banking Regulations Boost the Offshore Market  The Offshore Markets Endure  Growth of the Eurocurrency Market

3. 9 - 3 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Overview  Pricing Of Eurocurrency Deposits and Loans  Pricing in the Case of One Currency and Two Financial Centers  Can Offshore and Onshore Markets Coexist?  The Impact of Capital Controls and Taxes  Market Share and Pricing in Competing Offshore Centers  The General Case with Many Currencies and Many Financial Centers

4. 9 - 4 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Overview  Policy Matters - Private Enterprises  Concerns of Depositors  Concerns of Borrowers  Policy Matters - Public Policymakers  Offshore Markets and Macroeconomic Stability  Could the Offshore Markets Expand Indefinitely?  Approaches to Regulating Offshore Markets  Competing for Markets: U.S. Policy Initiatives  Offshore Markets: European Policy Concerns

5. 9 - 5 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Eurocurrency Market  The Eurocurrency market is the market for deposits placed under a regulatory regime different from the regulations applied to deposits used to execute domestic transactions.  It owes its existence to differences in national financial regulation combined with declining barriers to international capital movements.  In effect, it is a parallel market in competition with the traditional domestic market.

6. 9 - 6 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Sectors of the International Money Markets US$ £ Onshore Offshore U.S. bank deposit U.S. Treasury bills and bonds U.S. corporate bonds U.K. bank deposit U.K. government bonds U.K. corporate bonds Euro-$ deposit Euro-$ bond (corporate and sovereign issuers) Euro-£ deposit Euro-£ bond (corporate and sovereign issuers) Currency Dimension Regulatory Dimension

7. 9 - 7 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Origins of Supply and Demand for Offshore Banking  The Eurocurrency market evolved through a combination of forces.  The supply and demand for Eurodollars had always been present. The innovation came in the mid-1950s when banks elected to lend these funds within Europe rather than invest them in the U.S. money market.  The demand for Eurodollars further multiplied when the Bank of England restricted the external use of sterling in 1957.

8. 9 - 8 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Onshore Banking Regulations Boost the Offshore Market  Under Regulation Q, the Federal Reserve established ceilings on the interest rate that banks could pay on deposits.  To reduce the U.S. capital outflow, more regulations were imposed in the 1960s:  The Interest Equalization Tax (IET) taxes U.S. purchases of foreign securities.  The Foreign Credit Restraint Program limits the volume of bank lending with foreigners.

9. 9 - 9 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Onshore Banking Regulations Boost the Offshore Market  However, these regulations only further encouraged borrowers to investigate the Eurocurrency markets.

10. 9 - 10 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Onshore Banking Regulations Boost the Offshore Market  European governments also experimented with capital controls in the 1970s.  Both Germany and Switzerland imposed regulations to try to limit the nonresident demand for their currencies.  Similarly, these regulations helped to promote the non-dollar segments of the Eurocurrency market.

11. 9 - 11 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Offshore Markets Endure  Even though many of the regulations that initially fostered the market had since been abolished, the Eurocurrency markets have continued to grow and prosper.  Today, we describe the innovation that permits the Eurocurrency market to sustain its existence as “unbundling” - taking the exchange risk of one currency and combining it with the regulatory climate and political risk of another financial center.

12. 9 - 12 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Growth of the Eurocurrency Market  As in the onshore markets, funds are deposited, lent, re-deposited, and re-lent in the Eurocurrency market.  The market has grown from essentially zero in 1960 to roughly $9.5 trillion on a gross basis and $5.5 trillion on a net basis in 1999.  The U.S. dollar is the main currency, while Europe is the dominant region for Eurocurrency deposits.

13. 9 - 13 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. $$ Pricing of Eurocurrency Deposits and Loans  Consider the case of one currency (the U.S. dollar) and two financial centers (New York and London).

14. 9 - 14 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Pricing of Eurocurrency Deposits and Loans In the onshore market... Quantity of Funds Interest Rates D The demand (D ) for funds depends on the required rate of return on available projects, S while the supply (S ) of funds depends on individuals’ rates of time preference. A In the absence of transaction costs, the equilibrium is at A. X When banks incur costs X, RDRD RLRL Q equilibrium deposit rate = R D, lending rate = R L, market size = Q.

15. 9 - 15 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Pricing of Eurocurrency Deposits and Loans Since R D can be earned in the onshore market, the supply curve to the offshore market (S* ) will begin at R D. In the offshore market... S* D* Eurobanks incur cost X* < X, X* Quantity of Funds Interest Rates S D A RDRD RLRL Q X ** resulting in offshore deposit rate R D, lending rate R L, market size Q*. RLRL RDRD * * Q* Similarly, the demand curve for offshore funds (D*) must begin at R L.

16. 9 - 16 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. $$ Pricing of Eurocurrency Deposits and Loans  The relationships among onshore and offshore interest rates are :  In other words, for US$ : New York lending rate (“Prime”) London Interbank Offered Rate (LIBOR) London Interbank Bid Rate (LIBID) New York deposit rate >>>

17. 9 - 17 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Pricing of Eurocurrency Deposits and Loans Onshore and Offshore Deposit and Borrowing Rates Percentage per Annum as of June 20, 2000 Canada Euro Area Japan Switzerland United Kingdom United States 7.50 NA 1.375 4.75 7.00 9.50 5.9063 4.5313 0.1875 3.4375 6.1875 6.8125 5.8125 4.4375 0.0938 3.3125 6.0313 6.6875 3.70 3.04 0.03 3.29 6.00 5.99 Prime Lending Rate (R L ) Offshore Borrowing Rate: LIBOR (R L ) * Offshore Deposit Rate: LIBID (R D ) * Onshore Deposit Rate (R D ) Note: Prime lending rates may not be comparable as lending practices may vary across countries. LIBID, LIBOR, and deposit rates are for three-month maturities.

18. 9 - 18 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Can Offshore and Onshore Markets Coexist?  If the offshore market provides a similar service at a lower cost, what prevents all onshore transactions from migrating there?  Offshore depositors bear the additional risk of exchange controls or taxes, plus the inconvenience of having deposits outside their home country.  For borrowers, size and credit quality may act as barriers that restrict some firms from access to the offshore market.

19. 9 - 19 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Impact of Capital Controls and Taxes  When capital controls are present, the inequality may be affected.  When there are controls on the movement of funds into the onshore market, it is possible that.  When interest rate ceilings or central bank lending guidelines lead to a shortage of funds, borrowers may be prepared to pay.

20. 9 - 20 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. $$ Market Share and Pricing in Competing Offshore Centers  Consider the case of one currency (the U.S. dollar) and several offshore centers (London, Frankfurt, Singapore, and Beijing).

21. 9 - 21 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Market Share and Pricing in Competing Offshore Centers D*D* RLRL Quantity of Funds Interest Rates S Beijing S Singapore S Frankfurt S London RDRD * * * * 8.25% 8.00% QAQA X*X* The demand for offshore dollars The supply of funds to each offshore center depends on the assessed costs and risk of using the center. Suppose each center incur cost X* = 0.25%. QDQD QCQC QBQB Once the most efficient and least risky center has set the price, the others must follow suit. Then for London, deposit rate = 8.00%, lending rate = 8.25%, market size = Q A.

22. 9 - 22 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The General Case with Many Currencies and Many Financial Centers US$ UK£ € SFr S$ Real NY US$ NY IBF US$ NY IBF £ NY IBF € NY IBF SFr London US$ Frankfurt US$ Zurich US$ Singapore US$ London £ Frankfurt £ Zurich £ Singapore £ London € Frankfurt € Zurich € Singapore € London SFr Frankfurt SFr Zurich SFr Singapore SFr London S$ Zurich S$ Singapore S$ Rio Real United States United Kingdom GermanySwitzerlandSingaporeBrazil Onshore marketOffshore market regulatory costs and political risk vary exchange risk vary

23. 9 - 23 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Arbitrage and Interest Rate Parity  The interest rate differential between an onshore market and an offshore market has been analyzed using a loanable funds approach.  Arbitrage and regulatory competition should keep the offshore interest rates for a single currency nearly equal.  The interest rate differential between offshore instruments should conform to the interest rate parity condition.

24. 9 - 24 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Private Enterprises  Depositors are concerned about the riskiness of offshore deposits.  If a dispute arises between the depositor and the bank in a cross-border transaction, it is difficult to know in advance which country will claim jurisdiction and which legal precedents apply.  A further complication concerns whether the offshore bank is organized as a separate subsidiary or a branch of the parent bank.

25. 9 - 25 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Private Enterprises  The simple distinction between assets and liabilities in banking frequently offers a useful guide for sorting out the complex legal issues that arise in a cross-border banking dispute.

26. 9 - 26 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Private Enterprises  Borrowers are primarily concerned about the costs of borrowing onshore versus offshore.  Note that the reference rate (prime or LIBOR) is only one element in the overall cost of bank funding.  Borrowers may need to post some form of collateral (often in the form of compensating balances), pay a multiple of the reference rate or an additional x %, and/or put forward a lump-sum up-front fee.

27. 9 - 27 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Private Enterprises  Borrowers also need to deal with the interest rate risk that is associated with floating-rate Eurocurrency loans.  Borrowers may choose to hedge this risk using Eurodollar interest rate futures contracts or interest rate swaps.

28. 9 - 28 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Public Policymakers  For some offshore financial centers, the rise of the Eurocurrency market has been an important boost to employment and economic activity.  For some major industrial countries, the rise was perceived as a threat to their ability to control macroeconomic conditions within their borders, and perhaps even as a threat to the fundamental safety and soundness of the financial system.

29. 9 - 29 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Public Policymakers  With the passage of time, most of these fears have been put to rest, either through new policy agreements or a better understanding of how the Euromarkets operate.  Even though the Eurocurrency market has no required reserves, the interaction of supply and demand for funds means that “the specter of uncontrolled credit expansion, made possible by an infinite [deposit] multiplier, is illusory.”

30. 9 - 30 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Public Policymakers  The Eurocurrency markets are now acknowledged as being fully competitive with the traditional onshore banking system.  Policymakers have thus opted to factor in the Euromarkets when setting domestic monetary and financial policies.  Eurocurrency interest rates are closely linked to those in the domestic money markets of the same currency because the two kinds of deposits are reasonably close substitutes for each other.

31. 9 - 31 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Public Policymakers  In the Basle Concordat (1974), the United States and 30 other countries agreed to assume lender-of-last-resort responsibility for their offshore banks.  In 1980, the Bank for International Settlements (BIS) announced an agreement among central banks requiring commercial banks headquartered within their territories to consolidate their worldwide accounts.

32. 9 - 32 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Public Policymakers  In some cases, policymakers have elected to adapt their local regulations to compete head-on with the Euromarkets too.  In 1981, the Federal Reserve Board amended its regulations to allow the creation of International Banking Facilities (IBFs).  In effect, the IBF legislation creates an offshore banking environment located physically within the United states, although there are import restrictions on their operations.

33. 9 - 33 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Public Policymakers  To create a level playing field in financial services, the European Union (EU) has sought to harmonize rules on withholding taxes and the disclosure of interest paid to depositors and shareholders.  Such a policy will be detrimental to Luxembourg, which generates 20% of its GDP from its attractive financial services. But there can also be a wider impact on the cost of capital for EU firms.