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The original documents are located in Box B33, folder "Eurodollars, 1970-73 (1)" of the
Arthur F. Burns Papers at the Gerald R. Ford Presidential Library.
Copyright Notice
The copyright law of the United States (Title 17, United States Code) governs the making of
photocopies or other reproductions of copyrighted material. Gerald R. Ford donated to the United
States of America his copyrights in all of his unpublished writings in National Archives collections.
Works prepared by U.S. Government employees as part of their official duties are in the public
domain. The copyrights to materials written by other individuals or organizations are presumed to
remain with them. If you think any of the information displayed in the PDF is subject to a valid
copyright claim, please contact the Gerald R. Ford Presidential Library.
CONFIDENTIAL (FR)
Reserve-Free Bases for Banks Using an Historical Base
Reserve-Free Bases
May
Computation period
Bank
1969
ended Sept. 30, 1970 Change
First National, Boston
448.1
448.1
--
New England Merchants
17.0
-- 1/
-17.0
State Street Bank
24.8
24.8
--
The Bank of New York
84.1
79.2
-4.9
Bankers Trust
998.3
810.9
-187.4
Chase
2,239.2
2,239.2
--
Chemical
853.4
853.4
--
FNC, N.Y.
1,453.4
1,453.4
--
Irving Trust
828.9
722.8
-106.1
583.5
583.5
--
Manufacturers Hanover
Marine-Midland
280.9
270.3
-10.6
Morgan
1,269.8
1,249.6
-20.2
Provident, Phila.
20.8
20.8
--
Mellon
175.7
175.7
--
Union Bank, L.A.
93.6
93.6*/
--
Bank of America
678.1
678.1*/
--
First National, Chicago
485.6
347.62/
-138.0
Continental Illinois
679.4
670.0
-9.4
Total
11,214.6
10,721.0
-493.6
1/ Switched to 3 per cent of deposits base in computation period
ended September 2, 1970.
2/ Reduced after negotiation with the Board as of the computation
period ended June 10, 1970.
*/ N.A., assumed unchanged from the previous period.
FORD & LIBRARY GERALD
PRELIMINARY DATA
CONFIDENTIAL (FR)
Net Liabilities of U.S. Banks to Foreign Branches Plus Assets Sold to Foreign Branches
(Four Week Computation Period Ending September 30, 1970)
(millions of dollars)
Four weeks ending:
Reserve-free base
Change from
September 30, 1970
Sept. 2, 1970
Computation
previous
Daily
Excess over
Excess over
May
period ending.
computation
average
reserve-free
reserve-free
Banks using historical base
1969
9/2/70
9/30/70
period
outstanding
base
base
First National Boston
448.1
--
448.7
0.6
4.4
New England Merchants
17.04/
State Street Bank
24.8
--
32.3
7.5
8.3
The Bank of New York
84.1
79.2
--
109.6
25.5
3.2
Bankers Trust Company
998.3
810.9
-187.4
810.9
--
15.5
Chase Manhattan
2,239.2
--
2,242.3
3.1
24.7
Chemical
853.4
--
854.2
0.8
1.4
First Nat'1. City, N.Y.
1,453.4
--
1,462.6
9.2
7.9
Irving Trust Company
828.9
731.6
722.8
-8.8
722.8
:
:
Manufacturers Hanover
583.5
--
586.4
2.9
57.7
Marine-Midland Grace
280.9
270.3
--
280.4
10.1
13.9
Morgan Guaranty
1,269.8
1,249.6
--
1,255.0
5.4
10.0
Provident N.B., Phila.
20.8
--
26.6*/
5.8*/
5.8
Mellon
175.7
--
182.7
7.0
13.1
Union Bank, L.A.
93.6
--
93.6*
--
:
Bank of America
678.1
/
:-
799.4
121.3*/
121.3
First National, Chicago
485.6
3/
347.6
--
348.1
0.5
10.5
Continental Illinois
679.4
670.0
-9.4
670.0
--
1.3
Total
11,214.6
10,926.6
10,721.0
-205.6
10,925.6
199.7
299.0
1/ Four week daily average of net liabilities to foreign branches plus assets sold to foreign branches.
For purposes of reserve requirement calculations this base is reduced by the amount of "direct borrowings"
in the current computation period. Among the above banks, only Irving Trust Company ($6.4 million) and Morgan
Guaranty ($16.3 million) had "direct borrowing" in the September 2 computation period.
2/ No entry indicates that the reserve-free base in the previous period shown was still in use.
3/ Reduced to $347.6 million as of the computation period ending June 10, 1970, as a result of negotiations
with the Board.
4/ Bank began using 3 per cent of deposits base in the computation period ended September 2, as this
exceeded the historical base for the first time.
Not yet available, assumed unchanged from previous computation period.
GERALD FORD LIBRARY
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
admin. DAY
CONFIDENTIAL (FR)
October 13, 1970.
TO:
Chairman Burns
FROM:
Robert Solomon
SUBJECT: Bank Attitudes toward their Eurodollar
Liabilities.
On October 8-9, I visited with senior officials (list
attached) of seven large New York banks to learn their present
attitudes toward their liabilities to their branches and to try
to form a view as to how their attitudes might be affected by a
suspension of the remaining ceilings on CDᵍs under Regulation Q.
In general I found a fair degree of diversity in present
attitudes toward Eurodollar positions. Three of the banks had
already decided to let their liabilities fall significantly below
their bases. The other four are prepared to preserve their bases
for the time being but, because of the costs involved, are likely
to re-examine this view and possibly to change it soon. There was
no evidence that the latter four banks are yet aware of the extent
to which the other three have decided to give up their Eurodollar
positions.
Some suggestions were made for modifying the Board regulation
on Eurodollar liabilities so as to make it less onerous. If the
Board were to decide to use moral suasion to discourage further large
repayments of Eurodollar liabilities, the adoption of one or more
of these proposals would be a suitable quid-pro-quo, apart from any
action to suspend Regulation Q on large CD's.
FORD is LIBRARY GERALD
To: Chairman Burns
-2-
There follows a brief report on each of the banks, in
the order in which I visited them.
First National City Bank
This bank, which has a Eurodollar base of almost $1.5
billion, has decided to reduce its liabilities by $300 million in
October and by $200 million each in November and December. The
main reasons for this decision is that Eurodollars now cost about
3/4 per cent more than domestic CD's, the bank expects short-term
rates to be relatively low for some time, and it thinks another
Regulation Q squeeze is unlikely. Furthermore, loan demand has
been quite weak recently and the bank is prepared to repay Euro-
dollars out of the proceeds of net loan repayments here in the
United States.
FORD is LIBRARY 9FRALD
Manufacturers Hanover Trust
I was told that this bank views its Eurodollar base as
"sacred," even though domestic funds (Federal funds and CD's) are
cheaper. The bank does not regard the suspension of Regulation Q
on shorter-term CD's as being permanent. Even a suspension of Q
for the rest of the maturity spectrum would not change the bank's
attitude toward its Eurodollar base, unless "Washington" provided
some assurance that the suspension was permanent. The bank is willing
to trade off the higher cost of funds in the short-run for the longer
range benefit of reserve free funds from the Eurodollar market, par-
To: Chairman Burns
-3-
ticularly in view of the bank's heavy loan commitments. This view
of the Eurodollar position is unlikely to change within the next
six months.
The bank regards its Eurodollar base as being small
relative to its size. It feels that it was being cooperative in
limiting its Eurodollar borrowings in early 1969 and was penalized
by the Board regulation, which took May 1969 borrowings as a base.
The Chase Manhattan Bank
This bank has not reduced its liabilities below its base
because of (1) a sense of responsibility for safeguarding the balance
of payments ("cooperation with the U.S. Treasury"), and (2) a concern
that giving up the base may be costly in the future. Their calculations
put a high value on the base, as against the present cost of maintaining
it, unless either Regulation Q or the Eurodollar regulations are
administered more flexibly in the future.
GERALD FORD LIBRARY
A suspension of the remaining Q ceilings on large CD's
would have little effect: with market rates tending to fall, the
present ceilings are almost "academic." But an "elimination" of Q
ceilings would lead the bank to let a substantial part of its Eurodollar
base go.
One of the motivations for holding on to the base now is that
Chase's foreign branches may need substantial amounts of funds in the
future to meet loan demands abroad. Thus the Chase officials feel that
they are saving the base, though at a cost, for this possible use.
To: Chairman Burns
-4-
Three specific suggestions were made for modifying
Regulation M: (1) reduce the 10 per cent reserve requirement to
6 per cent (sic: they no doubt meant 5 per cent); (2) permit
banks to go below their bases for a period of time without losing
the base; (3) rotate computation periods among the banks so that
they are not all trying to adjust at the same time in maintaining
average liabilities equal to the base.
The Chase officials feel that the Eurodollar regulation
is an artificial restraint on the free movement of funds. Without
it, funds would flow more freely to the Eurodollar market and would
quickly "equalize" rates as between that market and the United States.
Though I pointed out that several billion dollars had flowed back
to the Eurodollar market already and that heavy demands from Europe
were also influencing rate differentials, they persisted in the view
that the flow might stop quickly if the "artificial" restraint were
removed.
Bankers Trust Company
This bank has recently decided to let its Eurodollar
liabilities decline from its base of about $1 billion to $800 million,
replacing with CD's and commercial paper. It may go further but it
will re-examine its position carefully before giving up more of the
base.
FORD & GERALD LIBRARY
To: Chairman Burns
-5-
The cost of holding on to the base represented too large
an insurance premium, though the bank regards itself as taking a
calculated risk. One reason it is taking the risk is that it
regards its Eurodollar base as being rather higher relative to its
size. On the other hand the bank's "economic model" shows an easing
this year but a tightening of credit conditions next year. Hence,
there is hesitancy in giving up more of the Eurodollar base.
A "relaxation" of the rest of Regulation Q would be a
"plus factor" in leading the bank to repay more Eurodollars, but
it would not be an overriding influence. The bank wants to keep all
its options open.
Morgan Guaranty Trust Company of N.Y.
This bank is not ready to give up any of its Eurodollar
base but a growing minority on the bank committee responsible for
this policy is leaning in that direction. In a month or two, Morgan
may be ready to drop from its base of $1.25 billion to about $1
billion. Meanwhile, the bank is borrowing shorter and shorter-term
Eurodollars in order to maintain its base. It expects either that
the rest of the Regulation Q ceilings on large CD's will be suspended
or that market rates will make it possible to issue CD's in ample
volume. Furthermore, loan demand has been quite weak recently.
Among all the officials with whom I spoke, Mr. Leach of
Morgan Guaranty revealed the clearest understanding of the balance
-
FORD & LIBRARY GERALD
To: Chairman Burns
-6-
of payments problem associated with massive repayment of Eurodollars.
He wondered whether the banks could be given some incentive or
"subsidy" to induce them to hold on to Eurodollars- for example,
a credit to required reserves (which, I told him, is ruled out
by the Federal Reserve Act) or a special issue of Treasury securities
at a rate favorable enough to cover the cost of holding the Euro-
dollars (which, I told him, might be ruled out by Mr. Patman).
Mr. Leach also recommended that the banks be given greater
latitude in moving below (and above) their bases.
Irving Trust Company
This bank went below its base during the summer and is
in the process of giving up more of the base. For one thing, it
regarded its base as too large for its size. Also, it is unwilling
to pay insurance premiums for a contingency that cannot be specified.
In any event, a consensus exists that the Fed will not again use
Regulation Q as it did in 1969.
How far the bank will reduce its Eurodollar position is
unsure. Next week the bank is likely to decide to let its base drop
from $730 million to about $500 million. It will always be prepared
to hold on to Eurodollars if the differential cost (now between 1/2
and 1 per cent) narrows or disappears. At some point, between $200
million and $400 million, the bank would hold on to its Eurodollars
as a hedge against the possibility that its present judgment is wrong.
FORD & LIBRARY GERALD
To: Chairman Burns
-7-
One explanation for the difference in behavior among
banks, according to Mr. Stone, may lie in their differential
experience in 1969-70 in being required to hold reserves against
liabilities over the base. Irving had never gone much above its
base and did not therefore feel the 10 per cent reserve require-
ment very heavily.
Mr. Stone is the originator of a proposal that the banks
be permitted to let their Eurodollar liabilities fall to 75 per
cent of their bases without losing the base.
Chemical Bank
This bank has no present plan to go below its base.
If Regulation Q were suspended, it "would be tempted. " If the
management decides that the base must be preserved despite the
costs, Chemical might follow other banks in shortening the
maturity of its Eurodollar takings. But this might simply flatten
the yield curve.
RS
Attachment.
GERALD
FORD & LIBRARY
OFFICIALS VISITED
First National City Bank
Mr. John J. Larkin, Senior Vice President
Mr. G. A. Costanzo, Executive Vice President and
2 associates
Manufacturers Hanover Trust
Mr. David J. Barry, Vice President and Treasurer
The Chase Manhattan Bank
Mr. George Roeder, Vice Chairman of the Board
Mr. Robert Rivel, Executive Vice President
Mr. James Bergford, Senior Vice President
Mr. Roger Lyon, Senior Vice President
Bankers Trust Company
Mr. Edmund F. Ebert, Senior Vice President and
two associates
Morgan Guaranty Trust Company of N.Y.
Mr. Ralph F. Leach, Vice Chairman of the Board and
one associate
Irving Trust Company
Mr. Robert W. Stone, Senior Vice President
Chemical Bank
Mr. Duane Saunders, Vice President and
three associates
FORD & LIBRARY GERALD
From AMERICAN BANKER, October 15, 1970.
FED ENCOURAGING LARGE NEW YORK BANKS TO RETAIN A HIGH BASE OF
EURO-DOLLARS
By Ben Weberman
A Federal Reserve Board official last week visited the
money managers of all the New York City banks that have Euro-dollar
reserve-free bases to discuss the attitude of these banks toward
continuid use of the foreign foreign funds and succeeded in
reversing a planned reduction in dependence on this source, it has
been learned.
The trip was made by Robert Solomon, Adviser to the Federal
Reserve Board, who watches over the central banks' balance of payments
policies, among other duties.
As a result of his tour, there is no longer any willingness
among bankers to advocate a reduction in Euro-dollars used for domestic
operations.
Mr. Solomon scheduled his trip to New York after First National
City Bank of New York had decided to cut its base--but before he was
aware of such a change.
He did know, however, that two other New York banks previously
had trimmed their dependence on Euro-dollars substantially and that many
of the other banks were considering such a move.
The Solomon trip may well have stopped cold any further
contemplation of how to get along with fewer Euro-dollars.
FORD & LIBRARY 07V839
-2-
While policy officials currently give the huge balance of
payments deficit a lower order of priority than domestic considerations,
they are not indifferent to the growing size of the negative data.
All that Mr. Solomon asked was for a description of bankers'
ideas toward their Euro-dollar holdings.
But to the bankers who were interviewed- a routine procedure-
the inference was that the FRBoard would be unhappy to see abandonment
of Euro-dollars as a source of funds largely because of the adverse
balance of payments impact of such a development.
They agree that even if such a suggestion was not made by
Mr. Solomon, they believe the concept behind the visit was in that vein
and it will influence money market considerations in the future.
One factor came through in the informal talks: It could be
more costly over the long run to permit Euro-dollar rates to run down
for current rate savings if credit starts to tighten again in the next
year or two and there still is a 10 per cent reserve requirement on
Euro-dollars used here in excess of the reserve-free base.
The problem has arisen because domestic CD's now can be placed
GERALD LIBRATA FORD
in substantial amountSat an interest cost of 6-3/4% which rises to a
gross cost of 7-1/8%, while Euro-dollars cost 7-3/4% to 8-1/8%, net.
A. W. Klausen, President, Bank of America NT&SA, confirmed in
Florida at the ABA convention that his bank has no intention to permit
a drop in its reserve-free base of about $500 million.
Another source in the FRSystem who was not aware of the Solomon
tour declared that it would be worth while for bankers to take into account
the risk of running down the Euro-dollar baseif the economy revives
x and the market tightens as the result of greater demand for credit
and a concurrent shift towards restraint by the Fed.
-3-
It was suggested also that at some time in the future if
balance of payments pressures grow severe the Fed may wish to take
measures to force banks back to the Euro-dollar market.
Those with reserve-free bases would be in a much better
competitive position than those who must create a 10% reserve on
foreign funds used here.
The Fed, it was explained, could terminate the suspension
on Regulation Q ceilings for deposits maturing between 30 days and 89
days or it could make access to the commercial paper market more
difficult.
And a more subtle approach also could be taken directly
in policy decisions. Thus, if domestic policy considerations call
for possible tightening but not clearly so, a shift in priority
to place credit emphasis on balance of payments - needs would
swing the balance in favor of restraint.
It was noted on Wednesday that data used recently by Fed
Governor Andrew F. Brimmer in a speech in Canada, interpreted to show
e
that 6 of 24 banks with historic basis already had dropped some of
the reserve-free base were exaggerated.
While the numbers were correct, 5 of the 6 banks showed
small, insignificant cuts due largely to clerical errors or difficulties
in balancing out amounts at the end of a computation periodwhen the
goal was to end just above the base.
-
GERALD FORD LIBRARY
October 17, 1970.
A PROPOSAL
It is proposed that the Board amend Regulation D to
establish a special incentive for banks to retain Eurodollar
borrowings. The proposed amendment would permit banks to main-
tain reserves of 10 per cent (rather than 17-1/2 per cent) against
demand deposits, up to an amount of demand deposits equal to a
bank's Eurodollar borrowings, whether borrowed directly from foreign
banks or through foreign branches. The incentive to retain borrow-
ings would be increased if the special reserve requirement applied
only to borrowings up to the amount of a bank's reserve-free base
(either the historical base or the minimum bases under Regulations
M and D) and if banks expected the amendment to be a relatively
permanent feature.
The proposal would release 7-1/2 cents of reserves for
each dollar of Eurodollar borrowings covered; at the present cost
of reserves, a bank would save roughly 40-50 basis points on each
dollar of such borrowings. Thus, the cost of retaining Eurodollar
borrowings would be reduced by close to 1/2 percentage point. At
present most banks are probably paying 1/2-1 percentage point more
GERALD FORD LIBRARY
for Eurodollars than for domestic funds (CD's or Federal Funds).
Banks' decisions to repay Eurodollar borrowings are made on the basis
of projections of future costs, but it is probable that the proposed
incentive of close to 1/2 percentage point would represent a sig-
nificant saving in relation to either cost calculation.
(A Proposal)
-2-
If banks expected to be able to obtain the lower re-
serve requirement on future borrowings under the reserve-free
base (but not on other borrowings), there would be an additional
benefit from retention of the reserve-free base, equal to the
expected reserve savings (discounted) --e.g., something less than
1/2 percentage point.
The justification for the amendment is the balance of
payments benefit; for any given reduction in borrowings (bal-
ance-of-payments cost), there would result greater scope for
divergence in relative monetary conditions here and abroad. In
principle, there would be scope for greater monetary easing in this
country, should domestic conditions warrant.
Among the issues to be considered are the balance of payments
benefit, the precedent-setting nature of the amendment, and the potential
release of reserves involved.
FORD & LIBRARY GERALD
October 17, 1970.
Pros and Cons Regarding an Adjustment of Reserve Requirements
Based on the Volume of Eurodollar Liabilities
The proposal under discussion is to let banks hold a lower
percentage of required reserves against demand deposits to the ex-
tent of their liabilities to branches.
PRO
1. In a world of high mobile capital, many central banks
are seeking ways to preserve some autonomy for their monetary policies.
In other words, central banks would like to have greater leeway to use
their powers to affect domestic credit and monetary conditions without
large balance of payments repercussions that might be undesirable in
themselves and might undermine the intent of the domestic monetary
policy actions.
The Federal Reserve may find it useful to have a mechanism,
in addition to the existing 10 per cent marginal reserve requirement
on Eurodollar borrowings, to regulate Eurodollar flows to and from
U.S. banks. Even if Eurodollar flows have little undermining effect
on U.S. monetary policy, there is a strong case for providing some
insulation of the balance of payments from changes in U.S. monetary
conditions. Such insulation can be regarded as softening a balance
of payments constraint on domestic monetary policy or as softening the
balance of payments impact of changing monetary policies, or both.
LIBRARY GERALD R. FORD
-2-
2. In present circumstances continued or intensified ease
in U.S. monetary policy plus a suspension of Regulation Q ceilings
on large CD's could lead to a massive outflow of short-term funds
to the Eurodollar market. The case for avoiding this flow is dis-
cussed in another paper.
CON
1. Adoption of a selective reserve requirement based on
Eurodollar liabilities might make it more difficult for the Board to
resist proposals for special reserve requirements based on desirable
social purposes for example, a lower reserve requirement to the
extent that banks finance housing. The only answer to this is that
the present proposal applies only to the composition of bank liabilities
and has no effect on the composition of assets. Another point is that
the present proposal is designed, in part, to prevent deleterious bal-
ance of payments effects from a suspension of Regulation Q ceilings
and from a desirable easing of monetary policy and therefore should
not be looked at in the same way as proposals for special treatment
of bank assets.
2. The proposal looks a little gimmicky. The only answer
is that in today's complex world some degree of selectivity is necessary
if major objectives are to be met.
FORD is LIBRARY GERALD
October 17, 1970.
Relative Costs to Banks of Holding Eurodollars
Banks that are retaining Eurodollar borrowings in order to
preserve the reserve-free historical base (or for that reason to-
gether with a desire to act in the public interest) are at present
paying about 1/2 - 1 percentage points more than would be paid on
domestic funds.
A survey of the positions of the 17 banks using historical
bases indicates that if banks expected to have to pay 1/2 percentage
point more for Eurodollar borrowings than for domestic funds over
the coming year, and to pay this additional cost on borrowings equal
to 50 per cent of their historical bases, they would generally incur
net (after-tax) interest costs equal to about 1 or 2 per cent of net
operating earnings after-taxes (net operating earnings are earnings
before taking account of profits and losses on securities transactions).
The percentages vary, depending generally on the relative extent to
which the individual banks have relied on Eurodollars as compared to
other sources of funds. (The percentage would, of course, be doubled,
if one assumed a 1 percentage point differential.) It should be noted
that although the costs (except perhaps for Irving Trust Company) are
quite small as percentage of total profits of the banks, after taxes
but before security transactions, they may represent more significant
proportions of the profits generated by the banks' money desk operations.
FORD is LIBRARY GERALD
Relative Costs to Banks of
-2-
Holding Eurodollars
POSITIONS OF SEELECTED BANKS
Projected Cost of Eurodollar Borrowings
Bank
as Per Cent of Net Operating Earnings
Irving Trust Company
5.8
Marine Midland
2.5
Chase Manhattan
2.4
Bankers Trust
2.2
Morgan Guaranty
2.2
Chemical
2.0
First National City
1.4
Continental Illinois
1.6
Manufacturers Trust
1.1
First National Chicago
0.9
Bank of America
0.6
*/ After tax comparisons, assuming a net additional cost of Eurodollars
of 1/2 percentage point for one year on borrowings equal to 50 per cent of
historical base. (Fir st National City has projected a decline in its
borrowings to 50 per cent of its base.)
FORD & LIBRARY GERALD
October 17, 1970.
The Case for and against Increasing the Marginal Reserve
Requirement on Eurodollar borrowings above
10 per cent at the Present Time
1. The principal
advantage of that action would be
to indicate clearly to the banks that the reserve-free historical
base could be more valuable to the banks in the future; if banks
have been assuming a future marginal requirement of 10 per cent in
calculating the costs and benefits of retaining the reserve-free
base, Board action might change their calculations, and increase
incentives to retain the base.
2. Much, if not all, of this advantage might be achieved
through a speech by a Board Member, indicating current thinking of
the Board and the scope for Board action in this area.
3. Board action to increase the rate of marginal require-
ment would tend to induce repayment of Eurodollar borrowings on which
reserves were being maintained. In the computation period ending
September 30, 1970, banks were maintaining reserves against almost
$500 million of Eurodollar borrowings. Some of these borrowings may
have since been repaid, but it would appear likely that an increase
in the rate of requirement at the present time would induce repayment
of at least several hundred million dollars of borrowings.
FORD is LIBRARY 038470
The Case For and Against
-2-
4. Even if banks were at or below reserve-free bases,
there would still be a small balance-of-payments cost involved in
a higher rate of requirement. With a higher rate of requirement,
banks would increasingly manage their Eurodollar positions to en-
sure that any miscalculations would be on the side of reducing
borrowings. Thus, over time, there would occur some erosion of
the historical bases of banks that in principle planned to re-
tain such bases.
Conclusions: In the light of the probable balance-of-
payments costs, it would be preferable for the Board to indicate
its future intentions regarding the rate of requirement through a
speech rather than through an increase in the rate.
FORD & LIBRARY GERALD
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
admin- maring
CONFIDENTIAL (FR)
October 19, 1970.
To:
Chairman Burns
From:
Robert Solomon
Subject: Additional Views of Banks on
Eurodollar Positions.
I have spoken with officials of the two largest banks
in Chicago and the Bank of America. What is reported here supple-
ments the report in my memorandum of October 13 on this subject.
Continental Illinois National Bank
and Trust Company
This bank is still maintaining its base, despite the cost,
estimated by the bank on October 15 at 1 percentage point. The bank
is worried about a future squeeze under Regulation Q and is willing
to pay an insurance premium to maintain reserve-free access to the
Eurodollar market. But there is doubt that it is willing to bear
the existing cost for long.
The bank feels that it and other banks are playing a guessing
game regarding Federal Reserve intentions regarding both future
monetary policy actions and Eurodollar regulations. In particular,
the bank is concerned that the Fed might relax the Eurodollar
regulations in a way that penalized banks that decide to keep their
liabilities at the base level while giving an advantage to banks that
drop below the base.
FORD i LIBRARY GERALD
-2-
The First National Bank of Chicago
The bank is worried that the Board might reimpose Regula-
tion Q in order to stem the repayment of Eurodollars. This is one
reason it is holding on to its base. It figures the present net
cost of holding Eurodollars at between 1/4 and 1/2 per cent.
Another reason for holding on is that this bank regards its base
as being relatively low. It too feels that it was penalized for
having been cooperative in early 1969 and not building up its
Eurodollar borrowings on a large scale.
Concern was expressed that the Board might, at some point,
take an action that would be to the advantage of banks that go below
their base. The example used was the possibility that the 10 per
cent reserve requirement might be lowered so that banks giving up
their bases would not lose much.
FORD LIBRARY & GERALD
Bank of America
The official to whom I spoke is probably not the most
sophisticated of the bank's officers. He said that the bank is holding
its position but is concerned about the cost--which it figures at 1-1/2
percentage points. It feels in a dilemma because it is not sure that
the Fed will not revise the regulation so as to make the base less
valuable. The Fed's position is not clear, according to this official.
It might adjust the regulation so that banks that give up a part of their
bases do not lose much.
-3-
OFFICIALS CONTACTED BY PHONE
Continental Illinois National Bank
and Trust Company
Mr. Donald C. Miller, Senior Vice President
The First National Bank of Chicago
Mr. A. Robert Abboud, Senior Vice President
Bank of America
Mr. Chance
FORD is LIBRARY GERALD
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Draft
CONFIDENTIAL (FR)
October 20, 1970.
TO:
Board of Governors
FROM:
Robert Solomon
SUBJECT: Dealing with the Overhang of Eurodollar Liabilities:
Laissez-faire vs. Taking Action to Discourage Outflows.
The differential between U.S. and Eurodollar interest rates
has led some banks to decide to give up a part of their reserve-free
bases and is leading many other banks to think seriously about doing
the same.
The reserve-free base has value to a bank insofar as the
bank now believes that it may, in the future, wish to have recourse
to the Eurodollar market to meet some of its needs for funds in the
United States. From the bank's viewpoint this could come about as
the result of a future squeeze under Regulation Q ceilings or as the
result of higher costs of funds at home than in the Eurodollar mar-
ket. Thus the banks are willing to pay some cost--in the form of
holding Eurodollars at interest rates higher than those on domestic
liabilities (Federal funds, CD's, and commercial paper) --as an in-
surance premium to preserve all or part of the reserve-free base.
is
But a number of the banks have decided that the current
cost is too high and this is leading them to think seriously about
reducing the size of the insurance policy.
Consideration of whether or not the Board should do some-
thing to discourage the outflow of funds should be preceded by an
estimate of the likely magnitude of the outflow in the absence of
Board action.
-2-
Magnitude of Potential Outflow
The outlook for the U.S. economy is such that one must
expect declining short-term interest rates here for some period
of time; at the least, short-term rates, after falling further
from present levels, are unlikely to rise substantially for quite
a while. Meanwhile, short-term yields in Europe are considerably
higher than ours. Even if Europe has reached, or passed, the peak
of intensity in the use of tight money during this cyclical upswing,
the easing of monetary conditions there is likely to lag ours by a
substantial margin. Thus European countries (notably but not only
Germany and Italy) will be exerting a demand on the Eurodollar mar-
ket for some time. This is a major reason why the $5 billion of
Eurodollar repayments that has already occurred this year has not
eliminated the differential between U.S. and Eurodollar yields.
Whether further repayment of Eurodollar liabilities by
U.S. banks would be self-arresting, as the result of a decline in
Eurodollar rates, thus depends importantly on the strength of demand
for Eurodollar in other countries.
While no one can be sure about the duration of tight money
in Europe, it is not to be ruled out that a significant differential
in short-term interest rates between the United States and Europe would
persist for at least a year--and possibly much longer.
FORD & LIBRARY
-3-
A related question is this: assuming a persisting differ-
ential in interest costs between the United States and the Eurodollar
market, is there a level below which the banks would hesitate to re-
duce their liabilities to branches. and, correspondingly, their re-
serve-free bases?
One consideration here is that more and more banks are
likely to come to the view that Regulation Q will not be used in the
future as it was in 1966 and 1968-69. If the Board lifts the re-
maining ceilings on large CD's, and even if it uses the term "suspension,"
the view is more than likely to spread that the suspension is permanent.
As this happens, banks will reduce what they regard as a minimum
desirable reserve-free base.
On the other hand, banks are unlikely to reduce their Euro-
dollar liabilities to zero. For one thing, their branches need a
balance with the head office, and as the magnitude of Eurodollar
transactions grows, the size of this balance also grows. Furthermore,
the future is uncertain and banks will hedge their bets regarding the
probable reimposition of Regulation Q ceilings.
In 1967, when credit conditions eased here, banks reduced
their liabilities to branches-- which had grown from $1.7 billion in
January 1966 to $4 billion at the end of 1966--only moderately, from
a peak of $4 billion to $3 billion. On the other hand, that period
of ease was rather short-lived and it is therefore difficult to draw
reliable conclusions as to bank behavior from it.
FORD & LIBRARY DERALD
-4-
Even if there is an upward trend in the long run in
liabilities to branches, banks could temporarily dip below that
trend when interest rate differentials make that course profitable,
just as they went far above the trend in 1969.
All things considered, it is possible to imagine a potential
outflow of as much as $6 billion from the present level of $10 billion.
The term "potential" is used here for more than one reason: (1) to
denote a possible outer-limit, (2) to indicate what could happen in
the absence of an effect of this very outflow of U.S. funds on Eu-
ropean interest rates. It is possible that the outpouring of U.S.
funds, by flooding the Eurodollar market and in turn European
money markets, would drive down short-term rates abroad before $6
billion flows out. But one of the presumed U.S. objectives, as dis-
cussed below, is to avoid flooding European money markets in a way
that undermines the efforts of European central banks to combat
inflation.
Thus while a $6 billion outflow may not be the most likely
estimate, because European rates will decline more than European
central banks wish them to decline, it is a possible outflow that
U.S. banks might be willing to tolerate if the differential cost of
Eurodollars remains relatively high.
FORD j LIBRARY 0ERALD
Advantages and Disadvantages
Assuming a possible outflow over a period of 6 to 12 months
of, say $6 billion-- or even $4 billion what are the disadvantages to
-5-
the United States of permitting it to happen?
Disadvantages
The official settlements deficit has amounted to $7 billion
in the first 9 months of 1970. This is much larger than the official
settlements surplus in 1968 and 1969 combined ($4.3 billion). After
5 years. 1965-69 inclusive-- in which the official settlements deficit
averaged out at zero, we have suddenly provided reserves to the rest
of the world, in 9 months, at a rate equal to more than three-fourths
of the SDR creation agreed to for a three-year period.
If this enormous rate of deficit should go on for a con-
siderable period of time--another six months or a year--several un-
fortunate consequences can be foreseen.
1. Heavy conversions of foreign dollar accruals
into U.S. reserve assets (IMF position, SDR, gold)
which could in turn trigger off a burst of specula-
tion against the dollar. If this happened, the re-
flow of dollars to foreign official reserves from the
Eurodollar repayments would be magnified, since for-
ward discounts on the dollar would encourage greater
reconversions by Europeans out of Eurodollars into
their own currencies and since interest arbitrage
reflows would be supplemented by speculative inflows
into European currencies.
FORD is GERALD LIBRARY
-6-
2. The chances of getting agreement on further
creation of SDRs by January 1973 (which requires
negotiations in 1972) would become very slim. This
in turn would lead to a growing view that the SDR
experiment had failed and that an increase in the
price of gold is necessary--not only to let the United
States pay off its debts but also to put the monetary
system on a "sound" basis. The progress that has been
made in recent years in de-emphasizing gold and moving
the international monetary system toward a managed basis
might be lost.
Apart from these dire results, the United States
cannot turn its back on a commitment it accepted when
it promoted the SDR agreement: we accepted and, in fact,
supported the proposition that the international monetary
system should not depend heavily on further additions to
official dollar reserves. It was agreed that it is
neither in the U.S. interest nor in the interest of other
countries that our official dollar liabilities should
continue to increase rapidly.
3. Europeans already feel resentment at being buffeted
in a magnified way by U.S. monetary policy. In 1968-69, we
imposed pressures on them when we let our banks drive Euro-
FORD & DERALD LIBRARY
-7-
dollar interest rates up to as high as 13 per cent.
Now we will be pushing rates down, undermining their
tight money policies and adding to their holdings of
official dollar reserves.
This resentment has been a catalyst in the drive
toward European monetary integration. Whether or not
such integration is advantageous to the United States,
the anti-American impulses behind it are not.
There are many reasons why the United States should
make some effort to maintain cordial and cooperative re-
lations with Europe and Japan. If we sit by and per-
mit a further outflow of $4-6 billion without being seen
to have tried to stem it, there will be a growing acceptance
of the view, already held in Europe, that the United States
has adopted the Friedman-Haberler-Houthakker prescription
that our only duty is to try to contain inflation and
maintain full employment, while the rest of the world
adjusts to whatever volume of dollars flows out of the
United States.
One result of a deterioration in the cooperation
attitude of the Europeans which may occur anyway if the
Mills' bill gets through Congress and is signed by the
President- would be less willingness of European countries
to revalue their currencies when in substantial surplus.
FORD & GERALD LIBRARY
-8-
The balance, in European minds, would tend to be tipped
against such action and toward actions or non-actions
that put increasing pressure on the United States.
4. Finally, it can be argued that the medium-term
outlook for the U.S. balance of payments is rather favorable
(see my submission to the Commission on Trade and Investment)
One can imagine a gradual working down of the Eurodollar over-
hang over the next 2 or 3 years as the rest of our balance
of payments improves. Given this prospect, one can also
argue against letting the Eurodollars flow out now in
massive volume. Providing an incentive to hold does not
saddle us with these liabilities forever.
The very fact that the medium-term outlook is favorable
argues for preventing a crisis atmosphere from being created
now. After our poor domestic management in 1965-69, we may
be on the road back to a sounder domestic economy and a
stronger balance of payments. But we can't persuade the
Europeans and the markets of this. We can only demonstrate
it and that takes time. Between now and when the demonstra-
tion becomes evident there is something to be said for
temporary measures to hold things (including confidence
in R. FORD LIBRARY
the dollar) in place.
1/ Trade, Investment and the Balance of Payments Adjustment Process,
August 6, 1970, Washington, D. C.
-9-
Advantages
Is there a case in favor of doing nothing and letting
the Eurodollar liabilities run off?
1. It can be argued that, having accumulated the
overhang, we have to face repayment eventually and we
ought to get it behind us. A variant of this argument
is that we ought to get a part of the repayment behind
us, by standing still for a further outflow of, say
$2 billion or so, hoping meanwhile that this will
narrow the interest rate differential between U.S. and
Eurodollar rates.
2. Another consideration relates to the distribu-
tion of foreign official dollar gains resulting from
Eurodollar repayments by U.S. banks. A very large
proportion of the increase in U.S. liabilities to
foreign monetary authorities in 1970 is accounted
for by Germany and Canada. For a part of 1970 Germany
may have welcomed the additions to its reserves, follow-
ing the enormous decline in reserves it experienced
following the October 1969 revaluation. Even if Germany
no longer welcomes additions to its dollar holdings (and
FORD & LIBRARY GERALD
ignoring the undermining of the Bundesbank's policy re-
ferred to earlier) there is little that Germany can do
about it. Apart from buying back the $500 million of
gold that it sold to the United States in the fourth
-10-
quarter of 1969, Germany is bound by the Blessing
letter not to buy gold from the United States.
Given the touchiness of the problems regarding U.S.
troops in Europe, Germany is unlikely to ask for a
revision of the Blessing letter now.
Other European countries would also share in
the reserve gains reflecting a further massive out-
flow of Eurodollars. Belgium, Holland, Italy, Switzer-
land--even France and possibly Britain--could experience
sizable reserve increases if another few billion of
Eurodollars were repaid. But we do have reserve assets
and should be ready to use them.
Conclusions
A weighing of these arguments can lead to the following
judgments:
1. The concern about the undermining of
monetary policy abroad is not allayed by the fact
that Germany can do little about converting un-
wanted dollars into gold. In fact, if it became
evident that the U.S. was leaning heavily on this
constraint on Germany, that fact itself would
worsen our cooperative relations with the rest of
the world.
Numerous contacts with Bundesbank officials
indicate that they would be disturbed by a massive
outflow of Eurodollars from the United States,
which would provide financing to German companies
that find credit unavailable or too expensive in
Germany.
LIBRARY GERALD ? FORD
-11-
2. The argument that the United States should
be seen to be trying to moderate the impact that its
changing policies have on the rest of the world is
hard to challenge. When we finally announced the
Eurodollar reserve requirement in mid-1969 we gained
some good will and put an end to an acrimonious debate.
3. If a balance of payments crisis should occur--
for whatever reason--the United States will be in a
better position to deal with Europeans and therefore
to see to it that the outcome of the crisis favors
our long-run interests if we have a record of taking
actions within our power. No one abroad in a re-
sponsible position is asking the United States to
deflate excessively in order to strengthen our bal-
ance of payments. But neither European nor Japanese
officials regard restrictions on capital flows as
undesirable and in some circumstances they advocate
such restrictions. Absence of any action by the United
States to shore up a crumbling Eurodollar regulation
could lead officials of other countries to believe
that we think the world is on a dollar standard and
do not concern ourselves with our balance of payments.
If they come to this belief, they would be more likely
to follow those in Europe who would like to push the
continental countries back toward a gold bloc. This
would hardly be a congenial environment in which to
try to work out of a crisis--or, for that matter, to
work on a day-to-day basis even if there is no crisis.
4. The existing attitude toward the dollar is
hardly a healthy one. The improvement we see in the
underlying balance of payments. in its prospects--
is not evident yet to the rest of the world or to the
markets. Since we must expect some deficit next year
even if there is no repayment of Eurodollars--and the
deficit could be aggravated temporarily if Europe slumps
after its current boom--we have a good reason to re-
strain dollar outflows where and when possible. This
need not mean simply a delay in facing the music--if
we are right in our optimistic view of the medium-term
outlook. And even if we are wrong, the chances of
&
FORD
inducing revaluations by surplus countries in Europe
will be greater if we are seen to do what we can to
hold down our overall deficit.
GERALD
LIBRARY
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
CONFIDENTIAL (FR)
October 20, 1970.
TO:
Chairman Burns
FROM:
Robert Solomon
SUBJECT: Your meeting with the New York
Clearing House Bankers.
On the subject of Eurodollars, you may want to cover the
following points:
1. The pros and cons of letting the funds flow out
(discussed in my paper of October 17, entitled "Dealing
with the Overhang of Eurodollar Liabilities: Laisser-faire
vs. Taking Action to Discourage Outflows "). I should
think that you would want to leave the impression that there
is concern here about a massive outflow.
2. Leave them in continued doubt regarding the
possibility of a future squeeze, as a result of Regula-
tion Q ceilings or otherwise, in which they would want
to borrow Eurodollars again.
3. Let them know that the 10 per cent marginal
reserve requirement could be raised in the future,
FORDO & LIBRARY GERALD
making preservation of the reserve-free base more valuable.
You will probably be presented with proposals to make the
present Federal Reserve Eurodollar regulation more flexible--for example,
by letting the banks go some distance below their bases
-2-
without losing them. An objection to this proposal is that it would
accommodate the banks that have decided to reduce their Eurodollar
positions and penalize the banks that have held their positions.
On the underlying U.S. balance ofpayments, one can take
a relatively favorable view of the prospects, although the improve-
ment may be concealed by short-term capital outflow just as the
deterioration of 1968-69 was concealed by the inflow. This view of
balance of payments does not, unfortunately, relieve us of being
concerned about the outflow. If it had not been for the inflow
of Eurodollars, we might have had to deal with a crisis earlier.
But the favorable outlook in the medium-term provides some comfort,
in that it projects a situation in which we can gradually work off
these excess liabilities.
RS
FORD & GERALD LIBRARY
91st Congress
2d Session
}
JOINT COMMITTEE PRINT
ECONOMIC POLICIES AND PRACTICES
PAPER No. 12
THE EURO-DOLLAR MARKET AND ITS
PUBLIC POLICY IMPLICATIONS
MATERIALS PREPARED FOR THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
no
FEBRUARY 25, 1970
Printed for the use of the Joint Economic Committee
U.S. GOVERNMENT PRINTING OFFICE
34-494
WASHINGTON : 1970
For sale by the Superintendent of Documents, U.S. Government Printing Office
Washington, D.C. 20402 - Price 20 cents
LETTERS OF TRANSMITTAL
to
FEBRUARY 20, 1970.
To Members of the Joint Economic Committee:
JOINT ECONOMIC COMMITTEE
Transmitted herewith is a study presented as No. 12 in our series
[Created pursuant to sec. 5(a) of Public Law 304, 79th Cong.]
on economic policies and practices in industrial countries and en-
titled "The Euro-Dollar Market and Its Public Policy Implications."
WRIGHT PATMAN, Texas, Chairman
This analysis was prepared by Ira O. Scott, Jr., professor of finance
WILLIAM PROXMIRE, Wisconsin, Vice Chairman
and dean of the Arthur T. Roth School of Business Administration
HOUSE OF REPRESENTATIVES
SENATE
at the C. W. Post Center of Long Island University, Brookville, N.Y.
RICHARD BOLLING, Missouri
JOHN SPARKMAN, Alabama
HALE BOGGS, Louisiana
J. W. FULBRIGHT, Arkansas
As a nontechnical survey of the origins of the Euro-dollar market
HENRY S. REUSS, Wisconsin
HERMAN E. TALMADGE, Georgia
and its current operation and status, this study is relevant to any
MARTHA W. GRIFFITHS, Michigan
STUART SYMINGTON, Missouri
consideration of U.S. balance-of-payments problems and of how the
WILLIAM S. MOORHEAD, Pennsylvania
ABRAHAM RIBICOFF, Connecticut
U.S. banking system participates in the international transfer and
WILLIAM B. WIDNALL, New Jersey
JACOB K. JAVITS, New York
W. E. BROCK 3d, Tennessee
JACK MILLER, Iowa
utilization of internationally mobile capital.
BARBER B. CONABLE, JR., New York
LEN B. JORDAN, Idaho
The views expressed in this paper are, of course, exclusively those
CLARENCE J. BROWN, Ohio
CHARLES H. PERCY, Illinois
of the author and do not necessarily represent the views of the Joint
JOHN R. STARK, Executive Director
Economic Committee, individual members thereof, or its staff.
JAMES W. KNOWLES, Director of Research
Sincerely,
ECONOMISTS
WRIGHT PATMAN,
LOUGHLIN F. McHuGH
JOHN R. KARLIK
RICHARD F. KAUFMAN
Chairman, Joint Economic Committee.
COURTENAY M. SLATER
Minority: DOUGLAS C. FRECHTLING
GEORGE K. KRUMBHAAR
FEBRUARY 19, 1970.
Hon. WRIGHT PATMAN,
Chairman, Joint Economic Committee,
SUBCOMMITTEE ON INTERNATIONAL EXCHANGE AND PAYMENTS
U.S. Congress, Washington, D.C.
HENRY S. REUSS, Wisconsin, Chairman
DEAR MR. CHAIRMAN: Transmitted herewith is an analysis of
HOUSE OF REPRESENTATIVES
SENATE
"The Euro-Dollar Market and its Public Policy Implications."
RICHARD BOLLING, Missouri
WILLIAM PROXMIRE, Wisconsin
Recently the Euro-dollar market has expanded rapidly in size, and
HALE BOGGS, Louisiana
STUART SYMINGTON, Missouri
its impact on the U.S. balance of payments has grown correspond-
WILLIAM S. MOORHEAD, Pennsylvania
JACOB K. JAVITS, New York
CHARLES H. PERCY, Illinois
ingly. Deposits attracted by U.S. banks via the Euro-dollar market
WILLIAM B. WIDNALL, New Jersey
W. E. BROCK 3d, Tennessee
expanded SO rapidly in 1969 that the Federal Reserve came to view
(II)
the market as a mechanism for circumventing its stringent domestic
monetary policies. It consequently imposed reserve requirements on
deposits from abroad similar to those specified for deposits by U.S.
residents. Moreover, by attracting funds formerly held by official
foreigners, U.S. banks operating in the Euro-dollar market have at
least temporarily reduced our payments deficits. But a possible
reflux of the same funds might worsen the U.S. external position in
the future. Thus, this study of the Euro-dollar market is extremely
relevant to current economic issues.
The study has been prepared by Ira O. Scott, Jr., professor of
finance and dean of the Arthur T. Roth School of Business Adminis-
tration at the C. W. Post Center of Long Island University, Brookville,
N.Y. The paper is presented as prepared by Dean Scott and does not
necessarily represent the view of the committee, individual members
thereof, or of any staff member.
(III)
IV
At the request of the full Joint Economic Committee, this study
of the Euro-dollar market was commissioned by the Subcommittee
on International Exchange and Payments and is presented as No.
12 in the Committee's series on Economic Policies and Practices.
This series was instituted several years ago as a means of making
information on economic institutions in industrial countries more
easily available to Members of Congress and the general public.
Since Dean Scott's paper includes a nontechnical description of the
origins of the Euro-dollar market, how it operates, its current stage
of development, and the policy questions its existence has raised, his
CONTENTS
study is a logical addition to this series.
Sincerely,
Page
HENRY S. REUSS,
Letters of transmittal
III
Chairman, Subcommittee on International
I. Purpose and description of the study
1
to
II. Structure of the EURO-dollar market
2
to
Exchange and Payments.
1. A definition, and the element of risk
2
2. Origins of the market
3
to
3. Suppliers of funds
4
4. Demanders of funds
5
5. The size of the market
5
to
6. The market mechanism
6
(11
III. The role of the EURO-dollar market in U.S. commercial bank oper-
to
ations
11
1. Management of a commercial bank money desk
11
2. The effect of regulation "Q"
12
to
3. Role of the EURO-dollar market
13
thate
TO
IV. The integration of national money markets, through the market for
EURO-dollars
17
V. The EURO-dollar market and the U.S. balance of payments
27
1. The effect of the EURO-dollar market upon the U.S. balance
of payments
27
2. The effect of the U.S. balance of payments upon the EURO-
dollar market
29
VI. Policy implications of the EURO-dollar market
29
1. The challenge to monetary policy
29
2. Use of direct controls
30
3. Implications for external policy
31
(a) Balance-of-payments effects
31
to
TLB
ai
(b) The market and speculation in gold or foreign
currencies
31
bas
(c) The market and the pound sterling
31
(11 bebuaqze only
(d) The use of direct controls
32
and TO no
(e) The use of indirect policies
32
4. The policy mix and the flexibility of fiscal policy
32
01 De
Bibliographical appendix
35
B 80 192/2801
(V)
uo il
70 TOT OJ
vd
(11
#
ILE to
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FORD
to
GERALD
LIBRARY
THE EURO-DOLLAR MARKET AND ITS PUBLIC POLICY
IMPLICATIONS*
By IRA O. SCOTT, Jr.
I. PURPOSE AND DESCRIPTION OF THE STUDY
Financial capital crosses the geographical frontiers of national
political units whenever domestic or internationally accepted means
of payment pass from the hands of residents into those of nonresidents.
International capital flows occur in response to differentials in expected
rates of return whenever artificial impediments to such flows either are
absent or are reduced. When the redistribution of financial capital in
this way leads to a corresponding movement of capital in real form, the
overall productivity of real capital tends to increase and thus to con-
tribute to the growth of real income.
In addition to the possibility of having favorable effects upon the
output of goods and services, international capital flows may affect
a country's balance of payments and the level of the domestic money
supply. From these possible effects stem the public policy implications
of freeing international capital movements.
In 1958, with the widespread return to currency covertibility,¹
the Western World emerged from an era of exchange restrictions
imposed during the Second World War and its aftermath. The past
decade, therefore, has witnessed an increased mobility of financial
capital. Domestic liquidity and the balance of payments have been
affected by these capital flows. Important public policy issues have
grown out of these events and developments.
The present study is focused upon the foreign market for U.S.
dollars, generally known as the EURO-dollar market. This market has
been an important outgrowth of the liberalization of capital move-
ments. The market has affected the balance of payments position of
the United States. It has influenced the U.S. money supply. Since the
Congress of the United States is the final arbiter of public policies
affecting the balance of payments and the money supply, the purpose
of the present study is to provide Members of Congress with a review
of the developments and structure of the EURO-dollar market and an
analysis of its implications.
The next section of the study is devoted to the structure of the
market. Sources and uses of funds will be identified, the volume of
transactions estimated, and the market mechanism described.
*See the Bibliographical Appendix (p. 35) for a number of references to the
EURO-dollar market.
**With the caveat that the author accepts full responsibility for the views
expressed in this paper, he wishes to acknowledge his debt to the following readers:
Geoffrey L. Bell, Sir George Bolton, Lawrence Chimerine, Emilio G. Collado,
Julie C. Esrey, John B. Henderson, Bernd E. Karl, John Karlik, Fred H. Klop-
stock, Warren D. McClam, Donald H. MacDonald, Helmut Meyer, Thomas
Roche, Robert L. Sammons, and Sir John Stevens.
1 For current transactions mainly, and often for non-residents only.
(1)
2
3
In the third section of the study, the special role of U.S. commercial
banks in the market is examined in greater detail. Also considered are
2.
ORIGINS
OF
THE
MARKET
the implications of the growth of the market for international capital
flows, the U.S. balance of payments, and the U.S. monetary policy.
The EURO-dollar market is, by any standard, the freest sector of the
Finally, policy issues growing out of the study's findings are
international money market. It is ironical, therefore, that the origin
examined.
of the market is attributed by some to the placement by various State
banks in the Soviet Union and elsewhere in Eastern Europe of U.S.
II. STRUCTURE OF THE EURO-DOLLAR MARKET
dollars with two Soviet-owned banks, the Moscow Narodny Bank, of
London, and the Banque Commerciale pour L'Europe du Nord, of
1. A DEFINITION, AND THE ELEMENT OF RISK
Paris. These State banks apparently preferred to place their holdings
of U.S. dollars with the Soviet-owned banks as a means of reducing the
Like the Holy Roman Empire, which was neither holy, Roman,
risk of having their funds blocked. In any case, a number of factors
nor an empire, the so-called EURO-dollar market is neither European
may be cited as contributing to the development of the EURO-dollar
nor a market for dollars. It is, rather, the market for bank deposits
market.
which are denominated in foreign currencies. In other words, the
The fundamental economic reason for the emergence and growth of
deposits are in the form of currencies other than that of the country
the EURO-dollar market is that the participating European banks
in which the bank is located.² The list of foreign, or "guest", cur-
have been able to establish competitive spreads between creditor and
rencies include the pound sterling, the Swiss franc, the German mark,
debtor rates of interest. On the creditor side,⁶ European banks have
the Dutch florin, the French franc, and the Italian lira. The basis
been able to offer competitive rates of interest because-unlike their
for the appelation, "Euro-dollar," lies in two factual aspects of the
U.S. counterparts-they are not subject to cash reserve requirements,
market.
deposit insurance assessments, regulation Q,⁷or to a prohibition on the
First, most of the banks who accept these nonresident funds in the
payment of interest on demand deposits with a maturity of less than
form of foreign currency deposits are located in Europe. Second, the
30 days.⁸ They have also been able to compete with nonbank invest-
great preponderance of such deposits is denominated in U.S. dollars.
ment media in the New York money market.
Consequently, transactions in the EURO-dollar market consist pri-
On the debtor side,⁹ European banks have often been in a position
marily of purchases and sales by European banks of the demand
to undercut, in their dollar loan operations, interest-rate floors estab-
liabilities of U.S. banks.³ The present study will, in any case, focus
lished by local cartels or official bodies which govern accommodations
on the U.S. dollar sector of the market.
in domestic currencies.
The element of risk permeates any money market, and the EURO-
Restrictive covenants growing out of the U.S. balance-of-payments
dollar market is no exception. It was born of the fear that dollars
control program and which apply to the overseas lending operations
owned in Eastern Europe but left on deposit in the United States
of banks in the United States also account in part for the advantageous
might be attached by U.S. residents with claims against Eastern
position of the European banks.
European governments. It is nurtured by differentials in rates of
Dollar lending operations outside the United States were made
return that take account of the risk of potential currency restrictions.
feasible by the general return to currency convertibility in 1958.
Thus, a EURO-dollar deposit must be distinguished from the deposit
Toward the end of 1958, the United Kingdom merged American-
liability of a U.S. bank. This is because of the risk that exchange
account and transferable-account sterling. Simultaneously, Austria,
restrictions might be imposed by the "host" country impairing the
Belgium, Denmark, France, Germany, Italy, the Netherlands, Nor-
owner's control over the disposition of the "guest" currency. This risk
way, and Portugal moved toward current account convertibility for
is presumed to be greater than that created by the possibility of ex-
nonresidents. Increasing prestige and authority enjoyed by the
change controls in the United States. In any case, the former risk
International Monetary Fund (IMF) and the European Economic
would probably be compounded by the latter.⁴
Community (EEC) instilled increasing confidence in the viability of
2 Some analysts, on the other hand, do carefully restrict the use of the phrase, "EURO-dollar market,"
the fixed exchange rate system.
to the market for U.S. dollars centered in Europe.
Technical leadership of the EURO-dollar market was easily captured
3 Thus, acceptance by a foreign bank of dollar deposits in a U.S. bank at a certain rate of interest may be
thought of as a purchase, while the placement of funds in the market may be considered a sale of dollar
by the British overseas, foreign, and merchant banking houses of the
deposits. The repayment or withdrawal of funds might then be treated as a repurchase.
A foreign bank which receives funds has a dollar liability to the depositor or seller. Since the funds received
city of London. This role was assured by their longstanding position
or purchased are the deposit liabilities of a U.S. bank, the receiving bank counts among its new assets a
of dominance in the international money market. It was also pro-
claim on a U.S. bank. The receiving bank may then place the funds with another foreign bank. Afterwards,
the original receiving bank has a liability to the depositor and a claim on another foreign bank. The latter
moted by the British restrictions of 1957. At that time, sterling loans
bank. in turn, now owns the claim on the U.S. bank.
4 The EURO-dollar market thus presents an enigma-an exception to the Schumpeterian dictum that
in the form of trade credits beyond the normal financing periods and
"a dollar is a dollar is a dollar?"
to finance third party trading activities were prohibited. Shut out of
Indeed, a distinction must even be made between U.S. bank deposit liabilities to residents and non-
residents. That is, the odds in favor of exchange controls are presumably greater than those in favor of a
5 These include the overseas branches of U.S banks.
bank holiday at home. And, again, the former risk is likely to be compounded by the latter.
6 That is, in attracting deposits.
7 This regulation, promulgated by the Board of Governors of the Federal Reserve System, places ceiling
limitations on the rates of interest which U.S. banks may pay on time and savings deposits liabilities to
U.S. residents.
8 These European banks, are, of course, subject to various controls imposed by the governments of the
countries in which they operate.
9 That is, in making loans.
FORD
34-494-69-2
CERALD
LIBRARY
4
5
a traditional area of operation, the international deposit-taking banks
4. DEMANDERS OF FUNDS
in London eagerly developed the EURO-dollar market as a substitute
financing mechanism.
The final users of funds in the Euro-dollar market include com-
With its economic basis, feasibility, and technical aspects provided
mercial banks, securities brokers and dealers, exporters and importers,
for, the market mechanism lacked only the fuel, which was to be
finance companies, governmental units, and international corporations.
liberally supplied by continued deficits in the U.S. balance of pay-
The foreign branches of U.S. commercial banks have transferred
ments.
10
dollar deposits to their head offices as a means of shoring up the latters'
3. SUPPLIERS OF FUNDS
cash positions. Canadian commercial banks have used the proceeds
of U.S. dollar deposits to make "street" loans in New York. 12 Com-
The primary suppliers of funds to the Euro-dollar market have
mercial banks generally have used dollars to make loans to exporters,
been commercial banks, central banks, international monetary insti-
importers, and to local customers.
tutions, nonfinancial institutions, and individual investors. Com-
London banks have channeled funds raised in the EURO-dollar
mercial bank recipients of dollar deposits in countries without or-
market, and swapped into sterling, to the U.K. hire-purchase com-
ganized money markets utilize the Euro-dollar market as an outlet
panies and local governmental authorities. The former supply con-
for short-term funds. Those in countries having some semblance of a
sumer credit. The latter finance the construction of housing, schools,
money market are still attracted to the Euro-dollar market when rates
sewers, and waterworks. Belgian banks have raised funds in the market
of return there are high relative to those obtainable from investment
to be used in financing the budget deficit of the Belgian central
in domestic money market instruments.
government.
Central banks have also been important suppliers of dollars to the
International corporations-especially those in petroleum, chemi-
market. When they receive dollars through their normal foreign ex-
cals, minerals, and other commodities widely traded internationally-
change operations, these dollars may be placed in the market in
are among the major borrowers of Euro-dollars. The Norwegian
several ways. First, they may be loaned to commercial banks in the
shipping industry, Japanese companies, Italian concerns and German
central bank's own country, or the dollars may be sold to these banks
industrial houses have all received loans originating in the EURO-
against domestic funds. 11 The same dollars might then enter the
dollar market. American companies doing business abroad rely on the
EURO-dollar market through commercial bank placement.
market as a means of complying with the provisions of the U.S.
Second, a central bank may place the dollars indirectly in the
balance-of-payments control program.
market through the Bank for International Settlements (BIS).
Finally, a central bank may place the dollars directly in the market
5. THE SIZE OF THE MARKET
through their deposit with a foreign, non-U.S. commercial bank.
International monetary institutions, such as the BIS and the
There are no available statistics which measure the volume of
European Investment Bank (EIB), make short-term foreign currency
transactions in the EURO-dollar market. An indication of the size,
deposits with participating commercial banks. The BIS is reportedly
relative importance, and growth of the market may, however, be
a major market operator in disposing of dollars deposited with it by
gained from figures for assets and liabilities of European banks which
member central banks.
are denominated in foreign currencies. Such figures are gathered by
The large American nonfinancial corporation with important foreign
the BIS from banks in Belgium-Luxembourg, France, Germany, Italy,
operations quickly grasped the opportunities afforded by the EURO-
the Netherlands, Sweden, Switzerland, and the United Kingdom. The
dollar market as a substitute for the investment of short-term funds
assets and liabilities reported are denominated in U.S. dollars, British
in New York. The market appealed similarly to multinational corpo-
sterling, Swiss francs, Deutsche marks, French francs, Dutch
rations based in other countries and to wealthy individual investors
florins, and Italian lire. These asset and liability figures are inflated
in disparate parts of the globe.
both by a substantial amount of redepositing between banks and by
U.S. companies that float foreign dollar bonds through their
certain positions which are not related to EURO-dollar market trans-
Delaware subsidiaries are forced for tax reasons to keep the proceeds
actions. At the same time, they do not include positions vis-a-vis
of these issues outside the United States until used to finance overseas
residents nor the intake or placement of dollars in the form of swaps.
investments. The proceeds are thus regularly placed in the EURO-
In table 1, an allowance is made for these various factors. These
dollar market.
figures represent BIS estimates of the scale of activity in the market
Finally, from varied sources, the market is, on occasion, deluged
on the basis of the principal sources and uses of funds for the eight
by short-dated funds of a speculative character.
reporting European countries.
The market has, as well, long been a haven for expatriate wealth
12 This particular type of transaction was common before the development of the EURO-dollar market.
seeking refuge from local political risks and tax exposure.
10 The relationship between the EURO-dollar market and the U.S. balance of payments will be discussed
to
in greater detail later.
11 Preferential swap facilities have been offered to their banks by central banks in Germany, Italy, the
Netherlands and Switzerland.
tiboro lo lo
gaizhow lo ni extrad
B lo toxtom
7
6
TABLE 1.-ESTIMATED SIZE OF THE EURO-DOLLAR MARKET
of the EURO-dollar market, they are excluded, on the basis of rough
estimates, from the figures presented in table 13
[Yearend figures in billions of U.S. dollars]
According to the BIS estimates, the EURO-dollar market has ex-
Items
1964
1965
1966
1967
1968
panded from about $9.0 billion in 1964 to $25.0 billion in 1968 14
During this period, a marked change occurred in the structure of the
Sources:
market. At the beginning of the period, the United States and Canada,
Outside area:
United States and Canada
1.5
1.3
1.7
2.6
4.5
Japan, Eastern Europe, and the reporting European area were all net
Japan
.1
users of funds. The "other outside area" was the only net supplier.
Eastern Europe
.3
.3
.4
.5
6
Other
2.8
3.3
4.0
4.8
6.6
This area consists mainly of the Middle East, Latin America, and
Total
4.6
4.9
6.1
7.9
11.8
"other Western Europe."
By the end of the period, the relative importance of the "other out-
Inside area:
Nonbanks
1.8
2.2
2.8
3.9
5.2
side area" as a net supplier had decreased; while the reporting area
Banks
2.6
4.4
5.6
5.7
8.0
itself had become the chief supplier of Euro-dollar funds. At the same
Total
4.4
6.6
8.4
9.6
13.2
time, the importance of North America as a user of funds had in-
Grand total
9.0
11.5
14.5
17.5
25.0
creased dramatically.
Uses:
Looking to the sources side of the market, EURO-dollar funds sup-
Outside area:
plied by North America have expanded significantly. This has been
United States and Canada
2.2
2.7
5.0
5.8
10.2
Japan
.4
.5
.6
1.0
1.7
the case in spite of the U.S. balance of payments control program.
Eastern Europe
.5
.5
.7
.8
.9
Other
.9
1.5
1.9
There was a $0.2 billion decline in 1965, the year the program was
3.0
4.2
introduced. But by 1968, supplies from North America had risen to
Total
4.0
5.2
8.2
10.6
17.0
$4.5 billion. About $2.5 billion of this increase was vis-a-vis the United
Inside area:
Nonbanks
2.3
3.3
3.7
4.1
4.7
States and largely reflected the deposits by U.S. companies of funds
Banks
2.7
3.0
2.6
2.8
3.3
raised in European financial markets.
Total
5.0
6.3
6.3
6.9
8.0
On the uses side, North America accounted for an increase of $8.0
billion, or roughly half of the growth of the market since 1964. These
Grand total
9.0
11.5
14.5
17.5
25.0
increased takings were particularly pronounced in 1966 and 1968 as a
Net: 1
Outside area:
result of borrowing by U.S. banks. In 1968, moreover, direct EURO-
United States and Canada
+.7
+1.4
+3.3
+3.2
+5.7
Japan
+.4
+.6
+1.0
dollar borrowing by U.S. companies appears to have achieved con-
+.5
+1.6
Eastern Europe
+.2
+.2
+.3
+.3
+.3
siderable importance.
Other
-1.9
-1.8
-2.1
-1.8
-2.4
Total
-.6
+.3
+2.1
+2.7
+5.2
6. THE MARKET MECHANISM
Inside area:
Nonbanks
+.5
+1.1
+.9
+.2
-.5
A number of parallels may be drawn between the EURO-dollar
Banks
+.1
-1.4
-3.0
-2.9
-4.7
market and the market for Federal funds in the United States. In the
Total
+.6
-.3
-2.1
-2.7
-5.2
Federal funds market, commercial banks which are members of the
Federal Reserve System trade demand deposits held with the Federal
1 A plus sign indicates that the area or grouping in question is a net user of Euro-dollar funds, whereas a minus sign
indicates that it is a net supplier.
Reserve banks. These deposits serve as legal reserves, but also as
Source: Bank for International Settlements, 39th Annual Report, Apr. 1, 1968-Mar. 31, 1969 (Basle, June 9, 1969), p. 149.
working balances which may be converted into earning assets through
placement with other member banks or through conversion into
The BIS divides the sources and uses of EURO-dollars between
loans or investments. The Federal funds market is an over-the-
those inside and those outside the eight reporting countries. The
telephone market 15 Transactions are noncollateralized. Transactors
"outside" components, in turn, are divided between those in the
are mainly banks. Some of these banks make a market by taking
United States and Canada, Japan, Eastern Europe, and those located
positions. Others enter the market only to serve their own imme-
elsewhere outside the reporting area. "Inside" sources and uses are
diate needs. Transactions are large-in million dollar blocks for the
classified according to whether the reporting bank has (1) received
most part.
dollars from, or loaned them to individuals or nonbank institutions
Responsibility for these market decisions falls upon the shoulders
located within the reporting area, or (2) received dollars, or loaned
of the officer who manages his bank's money desk. Money brokers
them to banking institutions within the reporting area.
serve on a commission basis, as go-betweens for buying and selling
Certain conceptual difficulties hamper any attempt to quantify the
banks.
size and structure of the Euro-dollar market. One difficulty con-
13 For a discussion of these and other conceptual and statistical difficulties, see Bank for International
cerns the treatment of dollar positions vis-a-vis the United States.
Settlements, 39th Annual Report, Apr. 1, 1968-Mar. 21, 1969, pp. 147-149.
Long before the market was established, foreign banks had dollar
14 On June 19, 1969, BIS Manager D. H. MacDonald put the size of the market at $30 billion. (See The
New York Times, June 20, 1969.)
liabilities arising out of the use of credit lines established with U.S.
15 Teletype facilities are also used.
banks and dollar assets in the form of working balances and money
market media of various kinds. Since these items do not form a part
8
9
In the EURO-dollar market, foreign commercial banks, for the most
EURO-dollars may be borrowed to finance long positions in other
part, are trading demand deposits held with commercial banks in the
foreign currencies or in gold.¹⁷
United States. These deposits are converted into earning assets
A commercial bank may borrow EURO-dollars, convert them to the
through interest arbitrage operations with other foreign banks or
domestic or a third currency, and make a customer loan. To avoid
through direct conversion into loans or investments. The EURO-dollar
the exchange risk in such a transaction, the bank will buy dollars
market is an over-the-telephone market. Deposits are received without
forward at the same time it sells them spot.
the pledge of collateral. Trading units are usually in blocks of $1 million
The New York agencies of Canadian banks invest funds in the
or more. Some banking participants play an accommodating role as
New York money market which have been deposited with their
intermediaries, bridging the gap between the supply and demand
European branches or with their head offices in Canada.
sides of the market. Some banks are mainly users of deposits, con-
In addition to accepting EURO-dollar demand and time deposits,
verting them immediately into end-use loans. The manager of the
some foreign branches of U.S. banks issue CD's to foreign banks,
bank's money position determines his bank's position in the EURO-
companies, and individuals. These CD's are offered in denominations
dollar market.
of $25,000 or greater, for minimum maturities of 30 days, and at rates
Whereas the Federal funds market is an overnight or over-the-
of interest sometimes below the EURO-dollar rates on deposits of
weekend market, EURO-dollar commitments vary from call to 7 days,
corresponding maturities. Unlike their domestic counterparts, EURO-
to 1 month, 3 months, and longer.
dollar CD's are not subject to regulation Q; they are not sold to U.S.
Negotiable time certificates of deposit (CD's) are also issued in
citizens; and they are not redeemable in New York. There is, how-
EURO-dollars, usually for maturities of 30 days or longer.
ever, a secondary market for them in London. This market enhances
The international character of the EURO-dollar market is accen-
the liquidity of the CD as a money market instrument and accounts
tuated by the integral role played by the foreign exchange market in
for the fact that they may be issued at rates of interest less than
the transformation of EURO-dollar deposits into loans of a domestic
those available on EURO-dollars.
currency. The efficiency of the EURO-dollar market depends, in large
The interest arbitrage operations of EURO-dollar banks give rise to
measure, upon the existence of an efficient forward exchange market.
a pyramiding of interbank deposits. In virtually every instance of an
Whenever a holder of dollars converts them into another currency-
interbank EURO-dollar deposit, there is a transfer on the books of a
to finance a loan, an investment, or a transaction in international
bank in the United States. The account of the depositing bank is
trade-the forward exchange market provides the means of eliminat-
debited; that of the accepting bank credited. There may, therefore,
ing the exchange risk. The manager of the money desk of a large
be a pyramiding of a number of interbank deposits on the basis of a
European bank may, therefore, serve also as the bank's chief foreign
given dollar deposit in a bank which is located in the United States.
exchange trader.
The European banks which form the interbank deposit chains tend
The simplest form of a EURO-dollar transaction consists of an inter-
to maintain the same, or nearly the same, dollar asset and liability
est arbitrage operation on the part of a European bank which pays one
maturities. This correspondence of maturities reduces the need to
interest rate for a deposit and puts the funds received on deposit with
maintain a precautionary cash reserve with a U.S. bank. Those
another bank at a slightly higher rate of interest. 16 Such a sequence of
banks, however, which are actively engaged in EURO-dollar trading
interbank deposits may involve a number of banks before the chain is
operations do carry small balances with their American correspondents.
broken by a loan to a nonbank borrower.
These are compensating balances which serve to defray the cost of
EURO-dollar loans by European banks to nonbank borrowers may
clearing the deposit transfers that are the U.S. counterparts of the
take several forms. EURO-dollars may be borrowed to finance imports
Euro-dollar chains. Interest rate margins earned on these arbitrage
from the United States when this method of financing is cheaper than
operations are narrow. Hence, they would be rendered unprofitable
drawing bankers' or trade acceptances, borrowing from an American
by anything more than minimal deposit balances in the United States.
bank, or obtaining a foreign currency Joan, the proceeds of which are
The potential expansion of interbank deposits on a given U.S.
converted into dollars through the foreign exchange market. Eventu-
deposit base is virtually unlimited. However, a chain may, at any
ally, the dollar obligation will be liquidated through the acquisition of
point, be broken by a bank which finds it more profitable to lend the
dollars in the foreign exchange market.
funds to a nonbank borrower rather than redeposit them with another
EURo-dollars may be borrowed to finance imports from countries
bank. Moreover, some banks will accept funds only if they can serve
other than the United States. Settlement may be made in dollars, or
end-use purposes.
the borrowed dollars may be converted into the third country's
The interest rate margin earned by the deposit-placing bank
currency.
presumably includes a risk premium. This risk premium may be due
Exporters to the United States may borrow EURO-dollars and buy
to the relatively small size of the receiving bank's aggregate resources,
their domestic currency in the spot market. Given a deep discount
or it may reflect the relative weakness in its local currency. The risk
on the forward dollar, this may be less expensive than borrowing the
element may grow at each successive stage. At the point it fully absorbs
domestic currency and selling dollars forward.
the profit margin, the pyramiding process comes to an end.
16 The existence of an interest rate differential that permits such an arbitage operation may stem from
17 Cf. James R. Hambleton, "Gold Rush Financing Debt-and Dangerous," American Banker, March 22
the risk of exchange control, a lower credit standing of the second bank, or from the fact that the second
1968.
bank has an opportunity to use the funds more profitably than the first.
FORD & LIBRARY GERALD
10
11
These redeposit chains probably enhance the efficiency with which
On the basis of such an expansion process, Bell estimates the multi-
capital is allocated by the international banking system. Interbank
plier to be well in excess of 1.22 Klopstock, on the other hand, puts
time-deposit assets do not, however, contribute directly to the financ-
the Euro-dollar multiplier in the 0.50 to 0.90 range. 23 Klopstock argues
ing of expenditures. Only when a loan is made to a nonbank borrower
that leakages from the system are large. As noted before, the borrower
are total expenditures and the level of economic activity affected. 18
may immediately convert the proceeds of his dollar loan into another
The EURO-dollar loan mechanism must be distinguished from the
currency. If dollars are actually paid out by the borrower, the recipient
interbank deposit pyramid. A loan to a nonbank borrower will be
of the funds may well be a resident of the United States who deposits
made, for example, either through a credit to the borrower's account,
funds in his U.S. bank account rather than in an account with a
an overdraft facility, or through a credit to the borrower's account
European bank. If the recipient of the funds is a foreigner, he more
in the United States. To use the funds, the borrower may draw checks
than likely will immediately convert the dollars into another currency.
on his dollar account or instruct the lending bank to convert the
It is true that dollars which are sold against a European currency
proceeds of the loan into specified foreign currencies. If the dollars
may end up in the hands of a European central bank which puts the
which have been borrowed and spent are redeposited with a European
dollars back, directly or indirectly, into the EURO-dollar market.
bank, they may be re-lent again; and the cycle repeats itself.
On the other hand, the European central bank may convert the dollars
The loan deposit sequence described above has been likened by
into gold or invest them in the New York money market. The existence
Geoffrey Bell 19 and others to the money expansion process char-
of such leakages, of course, limits the size of the expansion multiplier.
acteristic of the United States and other banking systems. The
The impact of the Euro-dollar market upon world liquidity is not re-
EURO-dollar expansion multiplier is potentially large, because many
stricted, however, to the multiplier process. EURO-dollar deposits have
European banks are not required to hold dollar cash reserves with
a remarkable growth record. But much of this growth is due to the
their central banks.² Nor do the European banks have more than a
strong competitive position of the European banks. They do not have
minimal need for contingency reserves. The multiplier concept is, in
to maintain cash reserve requirements or pay deposit insurance fees on
any case, useful only as an explanatory device and in an ex post
deposit liabilities. They may pay interest on deposits with a maturity
sense. There is no theoretical limit to the multiplier in an open system.
of less than 30 days. They are usually not subject to ceiling limitations
For time deposits, the need for reserves is virtually nil, because the
on interest rates paid on foreign currency deposits with a maturity of
maturity dates of the deposits are, for the most part, known in
30 days or more. They have often benefited from advantageous terms
advance. For call or current account balances, a number of substitutes
in swap arrangements with central banks. Regardless, therefore, of
for dollar cash reserves may be used. Local currency cash balances
leakages in the multiplier process, European banks have been able to
may be converted into dollars should the need arise. Credit lines
replenish and expand their dollar liabilities with great success.
may be maintained with American banks. Finally, contingency bal-
ances are typically placed at call with the overseas branches of
III. THE ROLE OF THE EURO-DOLLAR MARKET IN U.S. COMMERCIAL
American banks, Canadian banks, or other foreign banks with agencies
BANK OPERATIONS
or branches in the United States. 21
The expansion process may be fueled in several ways. Multinational
1. MANAGEMENT OF A COMMERCIAL BANK MONEY DESK
companies, foreign affiliates of American corporations, and nonbank
financial institutions abroad may maintain EURO-dollar accounts,
The manager of the money position of a commercial bank in the
from which disbursements are made and into which some of the
United States is responsible for maintaining a legal reserve position for
proceeds of EURO-dollar loans may well be paid. The proceeds of
his bank. Depending upon the structure of interest rates, the bank's
medium-term dollar loans may be placed in the EURO-dollar market.
size, and the past and present policies of its management, this officer
Finally, some of the dollars put into the market by central banks may
will select one or more sources to satisfy a need for cash. These sources
have originated in EURO-dollar loans.
of funds include the Federal funds market, the Federal Reserve dis-
count window, the issuance of CD's, the purchase of EURO-dollars, the
18 Even in this case, economic aggregates would be affected only if the loan would not otherwise have
been made. Ifit were not for the availability of a credit in the EURO-dollar market, central banks might have
sale of securities, borrowing from a correspondent, the sale of commer-
provided easier domestic monetary policies.
cial paper through one-bank holding companies, the sale of Joan
19 Cf. Geoffrey L. Bell, "Credit Creation Through EURO-dollars?" The Banker, August 1964, pp. 2-8.
20 There may, of course, be reserve requirements of a conventional sort.
participations, the arrangement of repurchase agreements, and the
21 American banks with overseas branches mingle these funds with their other short-dated assets, including
those obtained in the Federal funds market. Canadian and other foreign banks with agencies or branches in
curtailment of loans. The maturity of the funds acquired will be de-
New York may place these balances in the call loan market in New York, usually for the purpose of financing
termined, in part, by official regulations, market rates of interest, and
securities brokers and dealers.
the length of time it is anticipated the funds will be needed. The com-
mercial bank thus provides a key link between the markets for these
to
various sources of funds. In turn, the EURO-dollar market, among
others, may play a key role in the money position management o a
commercial bank.
titorq
22 See Bell, op. cit. In other words, according to the Bell estimate, the initial deposit of a dollar in the
Euro-dollar market would eventually give rise to more than a dollar in EURO-dollar deposits as a result O
the redeposit of the proceeds of EURO-dollar loans.
23 Cf. Fred H. Klopstock, The EURO-dollar Market: Some Unresolved Issues, Essays in International
Finance, Princeton University, No. 65 (March 1968).
12
13
2. THE EFFECT OF REGULATION "Q"
TABLE 3.-MATURITY DISTRIBUTION OF OUTSTANDING NEGOTIABLE TIME CERTIFICATES OF DEPOSIT
The Federal Reserve System has, in recent years, effectively
Total
Percentage
Total
Percentage
employed the ceiling limitation on time deposits as an instrument of
outstanding
maturity
outstanding
maturity
(in millions
within
(in millions
within
anti-inflationary monetary policy. First, through the open market
Date
of dollars)
5 months
Date
of dollars)
5 months
account, money market rates of interest are driven above the ceiling
on interest rates which banks may pay on CD's. As a result, investors
May 20, 1964
11,736
72
Aug. 30, 1967
20,741
78
Aug. 19, 1964
12,193
77
Sept. 27, 1967
19,899
78
may permit their CD's to mature and invest the proceeds in higher
Nov. 18, 1964
12,740
84
Oct. 25, 1967
20,108
79
Feb. 17, 1965
13,747
80
Nov. 29, 1967
21,132
82
yielding money market paper. The banking system thus finds a shift
May 19, 1965
15,058
76
Dec. 27, 1967
20,328
83
in its liabilities from the time to demand category. Since reserve
Aug. 18, 1965
16,009
79
Jan. 31, 1968
20,919
82
Nov. 17, 1965
16,368
82
Feb. 28, 1968
21,086
83
requirements for demand deposits are higher than those for time
Feb. 16, 1966
16,356
81
Mar. 27, 1968
20,554
84
May 18, 1966
17,724
75
Apr. 24, 1968
19,789
84
deposits, this shift is equivalent to raising the weighted, or effective,
June 29, 1966
17,898
73
May 29, 1968
19,453
80
cash reserve requirement which must be maintained by the banking
July 27, 1966
18,272
77
June 26, 1968
19.269
76
Aug. 31, 1966
18,192
80
July 31, 1968
21,449
70
system. As a result, the banks are forced into a deflationary posture.
Sept. 28, 1966
16,968
80
Aug. 28, 1968
22,306
77
Oct. 26, 1966
15,891
81
Sept. 25, 1968
22,258
78
A severe runoff in CD's of this kind occurred during the second
Nov. 30, 1966
15,460
82
Oct. 30, 1968
23,303
79
half of 1966. There was a 5½-percent ceiling on interest rates which
Dec. 28, 1966
15,633
80
Nov. 27, 1968
24,307
80
Jan. 25, 1967
17,850
74
Dec. 25, 1968
23,500
78
could be paid on large time deposits.
Feb. 22, 1967
18,553
75
Jan. 29, 1969
21,032
76
Mar. 29, 1967
19,300
73
Feb. 26, 1969
19,971
79
By September 1966, on the other hand, Treasury bills were yielding
Apr. 26, 1967
18,581
74
Mar. 26, 1969
18,787
79
5.36 percent, finance paper 5.67 percent, bankers' acceptance 5.75
May 31, 1967
19,076
74
Apr. 30, 1969
17,622
82
June 28, 1967
19,151
73
May 28, 1969
16,973
82
percent, and dealer paper 5.89 percent. The effective rate of return to
July 26, 1967
19,695
76
June 25, 1969
15,270
(1)
the investor on CD's is actually greater than the stated rate, because
the latter is computed on a 360-day, rather than a 365-day, basis.
Not available.
(See table 2.) However, given their risk characteristics, rates of
Source: Board of Governors, Federal Reserve System. These figures are based upon the maturity structure of CD's
in denominations of $100,000 or more outstanding at weekly reporting banks.
return on these money market instruments were competitive with the
5.576 percent effective return which could be realized on a 5½-percent
3. ROLE OF THE EURO-DOLLAR MARKET
CD. In view of the higher rates afforded by alternative investments,
corporate treasurers and other investors began shifting from time
It was this credit "crunch" of 1966 that projected the EURO-dollar
deposits to money market media. As a result, total CD's outstanding
market into the role of being a major source of funds for leading U.S.
fell from $18,272 million on July 27, 1966, to $15,460 million on
banks. These banks, primarily through their branches in London and
November 30, 1966. (See table 3.)
other major international financial centers, dramatically increased
their use of the market as a means of improving their reserve positions.
TABLE 2.-CERTIFICATE OF DEPOSIT RATE COMPARISON
On July 27, 1966, total liabilities of U.S. banks to their foreign branches
amounted to $2,786 million. (See table 4.) By December 28 of the same
Effective
Effective
Effective
Effective
Stated rate 1
rate 2
cost
Stated rate 1
rate 2
cost ³
year, these liabilities had reached a total of $4,036 million.
4½
4.562
4.879
5.30
374
5.730
4.55
4.613
4.931
5.35
424
5.790
4.60
664
4.986
5%.
5.450
817
4%
689
5.013
5.40
475
5.843
4.65
4.715
5.039
5. 45
5.526
5.897
4.70
4.765
5.097
51/2
5.576
5.951
43/4
4.816
5.147
5.55
5.627
6.004
4.80
4.867
5,201
5.60
677
6.058
4.85
4.917
5.254
55/8
703
6.085
47/2.
4.943
5.281
5.65
5.728
6.111
4.90
4.968
5.308
5.70
779
6. 166
4.95
019
5.362
5%
829
6.220
5.00
5.069
5.415
5.80
880
6.273
5.05
120
5.464
5.85
5. 931
6.327
5.10
5.171
512
57/8
956
6.354
51/8
196
5.549
5.90
981
6.380
5.15
5.222
5.575
5.95
6. 032
6.434
5.20
272
5.629
6.00
6. 083
487
5½1/4
5.323
5.683
1 Rate of interest paid on the CD.
2
Rate of interest received by the investor calculated on a 365-day basis.
3 Effective rate adjusted for FDIC assessments and a 6-percent reserve requirement.
Source: Chase Manhattan Bank. A 6-percent reserve requirement is assumed.
to
14
TABLE 4.-LIABILITIES OF U.S. BANKS TO THEIR FOREIGN BRANCHES
15
[In millions of dollars]
Amount
Amount
The 1966 experience was repeated during the latter part of 1968
1964:
1967
Jan. 29
1,040
Jan. 25
3,653
and the first half of 1969. (See tables 3 and 4.) On November 27, 1968,
Feb. 26
1,077
Feb. 22
3,396
outstanding CD's amounted to $24,307 million. By June 25, 1969,
Mar. 25
1,046
Mar. 29
3,412
Apr. 29
1,146
Apr. 26
3,047
this total had fallen to $15,270 million. During the same period, U.S.
May 27
1,132
May 31
2,776
June 24
917
June 28
3,166
bank liabilities to their foreign branches nearly doubled, going from
July 29
1,008
July 26
3,660
$7,273 million to $13,609 million.
Aug. 26
1,166
Aug. 30
3,976
Sept. 30
1,166
Sept. 27
4,059
Almost synonomous with the new role of the EURO-dollar market
Oct. 28
198
Oct. 25
4,322
Nov. 25
380
4,206
in U.S. banking operations has been the role of the city of London.
Nov. 29
Dec. 30
1,183
Dec. 27
4,241
This achievement has been realized in spite of one of the most severe
1935
1968
Jan. 27
358
Jan. 31
4.259
straitjackets-via United Kingdom exchange controls-ever to be
Feb. 24
592
Feb. 28
4,530
Mar. 31
1,431
Mar. 27
4,920
imposed upon a free market. But the City flourishes in the entrepôt
Apr. 28
433
Apr. 24
5,020
role.
May 26
432
May 29
5,888
June 30
436
June 26
6,241
Table 5 depicts the role of London in the EURO-dollar market. In
July 28
572
July 31
6,183
Aug. 25
1,792
Aug. 28
7,025
1965, United Kingdom banks accounted for 47 percent of the total
Sept. 29
1,611
Sept. 25 2
7,131
external liabilities in U.S. dollars incurred by the reporting European
Oct. 27
719
Oct. 30
7,080
Nov. 24
1,697
Nov. 27
7,273
banks. By 1968, the United Kingdom share had grown to 57 percent.
Dec. 29
1,345
Dec. 25
6,976
1966
1969:
8,725
TABLE 5.-ROLE OF LONDON IN THE EURO-DOLLAR MARKET
Jan. 26
1,688
Jan. 29
Feb. 23
1,902
Feb. 26
8,947
Mar. 30
1,879
Mar. 26
9,743
[Yearend figures for external liabilities denominated in U.S. dollars]
Apr. 27
1,909
Apr. 30
9,617
May 25
2,003
May 28
10,041
June 29
1,951
13,609
United States banks in the
June 25
July 27
2,786
July 23
14,522
United Kingdom banks
United Kingdom
Aug. 31
3,134
Reporting
Sept. 28
3,472
European
Percent of
banks 1
Percent of
Oct. 26
3,671
United Kingdom
£ millions
£
millions
Nov. 30
3,786
reporting banks
£ millions
banks
Dec. 28
4,036
1965
4, 107
21,879
47
849
44
1 Break in series occurred with December 28 figures of 4,050 and 4,036.
1968
11,196
36,408
57
43,766
59
2 Break in series occurred with September 18 figures of 7,599 and 7,610.
Source: Board of Governors, Federal Reserve System. The data shown in this table cover gross liabilies of U.S. banks
1
Source: Bank for International Settlements, 39th annual report, Apr. 1, 1968, to Mar. 31, 1969 (Basle, June 9, 1969)
to their branches in foreign countries. After December 1966 the data exclude military facility branches, but include certain
p. 143. The 8 European countries which report to the BIS are Belgium, Luxembourg, France, Germany, Italy, Netherlands,
overdrafts for the first time. The data are not directly comparable to the weekly series on assets and liabilities of large
Sweden, Switzerland, and the United Kingdom.
banks, primarily because the latter liabilities to foreign branches (included in "other liabilities") are on a net rather than
2 Bank of England, Quarterly Bulletin, vol. VI, No. 1 March 1966), table 84, p. 19.
gross basis. These data also differ from the monthly data on liquid liabilities to foreigners b ecause they include certain
3
Bank of England, Quarterly Bulletin, vol. 9, No. 1 (March 1969), table 19, p. 110.
liabilities that are classified as long-term or official in the monthly series.
4 Bank of England, Quarterly Bulletin, vol. 9, No. 1 (March 1969), table 10, p. 96. Figures are for currencies other than
sterling.
The attractiveness of the EURO-dollar market as a source of funds
for U.S. banks was enhanced by the fact that borrowings from foreign
Prominent in the city of London are the branches of U.S. commercial
branches were not subject to reserve requirements or assessments for
banks. In 1965, they accounted for 44 percent of the United Kingdom
deposit insurance. In addition, checks in the process of collection
banks' external liabilities in currencies other than sterling, mainly
which were issued in connection with Euro-dollar transactions could
U.S. dollars. (See table 5.) In 1968, the U.S. bank share had expanded
be deducted from gross demand deposits for reserve computation
to 59 percent.
purposes. Taking these savings into account, and depending upon the
The question of the importance of U.S. banks in the city may also
mixture of simultaneous sales and borrowings and the day of the
be considered the other way around, namely, the importance of the
week, U.S. banks might pay up to 250 basis points more for deposits
city to the U.S. banks. Table 6 shows the assets and liabilities of the
taken from their overseas branches than for domestic time deposits.
overseas branches of Federal Reserve member banks.25 There it may
An individual bank in the United States could thus increase its
be seen that the largest percentage expansion during 1968 in overseas
reserves by borrowing from an overseas branch. The reserves that one
branch assets occurred in the United Kingdom, with the number of
bank gained, of course, were lost by another. Therefore, such EURO-
United Kingdom branches increasing from 25 to 35.
dollar borrowings did not increase the level of reserves for the banking
25 Member banks account for more than four-fifths of total commercial bank assets in the United States.
system as a whole. But required reserves fell. Hence, the level of
excess, and, therefore, free reserves, was increased by this means. 24
24 Given member bank borrowings from the Federal Reserve System. That is, free reserves' excess
reserves minus member bank borrowings from the Fed. Excess reserves equal actual reserves minus re-
bns beed
quired reserves. The cost of Euro-dollar borrowings was, of course, increased with the institution of marginal
reserve requirements against net liabilities to foreign branches. The change in regulations also required
that checks issued by or on behalf of a foreign branch against its account with the home office be included
Istal
essitto basil au0
in gross demand deposits as is the case with ordinary official checks. Cf. "Euro-dollar Float," U.S. Banking
resuz
Developments, Chemical Bank, August 11, 1969. (See texts of amendments to Regulations D and M, Federal
Reserve Bulletin, pp. 656-657, August 1969.) U.S. bank demand for Euro-dollars, however, appears to be quite
inelastic. (Cf., e.g., "Trendsin the Euro-dollar Market," Continental Comment, Continental Illinois National
Bank and Trust Company, November 7, 1969; and "Euro Money Market Tight Again," Monthly Economic
Letter, Frankfurter Bank, December, 1969.)
16
17
1968
375
9,225
147
4,311
3,443
14,932
738
3,905
IV. THE INTEGRATION OF NATIONAL MONEY MARKETS THROUGH THE
MARKET FOR EURO-DOLLARS
Total
1967
295
045
2,665
15,658
2, 705
2,9, 9,767 767
536
2,650
15,658
The EURO-dollar market is an international money market-an
international market for dollar-denominated obligations at short term.
Confidence in the continued freedom of short-term capital movements
1968
9
53
137
7
87
284
100
166
284
and the fixity of exchange rates, plus the availability of efficient for-
ward exchange markets, have greatly reduced fears of losses on the
Other
part of short-term investors and permitted the expansion of the EURO-
1967
6
137
78
257
103
138
16
257
dollar market. The existence of such an international money market
should provide a communications link between national markets. This
B
link should be forged by the international flow of short-term capital.
1968
35
42
551
411
33
1, 037
294
505
223
15
Its effect would be manifested in the sympathy of movement of
U.S. overseas areas
and trust territories
1,037
national money market rates of interest. The purpose of this section is
to examine the evidence which might point to the existence of such
1967
31
43
500
965
245
492
213
965
an international linkage provided especially by the EURo-dollar
market. The evidence is presented in charts 1-7.
TABLE AND LIABILITIES OF OVERSEAS BRANCHES OF MEMBER BANKS OF THE FEDERAL RESERVE SYSTEM
1968
72
150
1,308
418
787
2,663
839
193
1,118
2,663
CHART 1*
CALL MONEY RATES
Far East
DOLLAR FUNDS
Weekly averages
Per cent per annum
1967
63
137
1,047
422
660
2,267
439
777
209
842
2,267
12
[Yearend figures in millions of U.S. dollars]
1968
178
251
880
97
508
1,736
570
638
152
376
1,736
10
v
Latin America
1967
133
212
591
119
348
1,270
511
372
53
334
1,270
8
CALL EURO-DOLLAR DEPOSITS
1968
34
441
1,120
359
801
2,721
569
1,454
28
669
2,721
6
Continental
Europe
1967
46
638
,416
923
1,144
4,121
283
105
1,110
1,121
4
FEDERAL FUNDS
1968
35
2,201
201
4,933
4,291
1,752
13,177
1,343
10,501
64
1,269
13, 177
2
England and
Ireland
1967
25
1,543
,155
712
768
8,178
838
6,534
32
774
8, 8,178
+
0
EURO-DOLLAR OVER FEDERAL FUNDS
1965
1966
1967
1968
1969
Number of branches.
Due from head offices and U.S. branches
Time
Due to head offices and U.S. branches
Source: Board of Governors, Federal Reserve System.
*Source: Board of Governors, Federal Reserve System. See Statistical Appendix for underlying figures.
Cash
Loans
Other.
Total
Deposits:
Demand
Assets:
Liabilities:
Other
Total
Items
LISA GERALD FORD
18
19
GHT нэлоянТ атнияли / 40 anT VI
CHART 2*
CHART 3*
NEW YORK, LONDON, HOT талял!!
LONDON: YIELDS FOR U.S. DOLLAR INVESTORS ON 3-MONTH FUNDS
YIELDS FOR U.S. DOLLAR INVESTORS ON 3-MONTH FUNDS
газязти:
EURO DOLLAR DEPOSIT RATES
DOLLAR DEPOSIT RATES: vsnom NEW YORK-LONDON DR ai textm willob-oauH adT
Friday figures
RA1100 ORUB av BTAR MAOJ ХИАДЕЗТИ Per per annum
Wednesdey figures
Hode due enoitagildo betanimonah rallob 101 Information 8
Indique mist- EURO DOLLAR DEPOSIT Bounition 91/- ni
ИМАВИЗТИТ
8'
-To) Insigifts to vilidaliave odd egrenoxe lo. vizit offt bate
30 DAY
silt no 298801 10 *TRST beaube 97ad atormam egnadoza braw
7
Foaud only loinoienaqze brie to
уэлот to
90 DAY
aidT In B abivorq bluode
-
180 DAY
6
woll
Indoitears
bluoda
dail
adi
90
bloow
tootle
at
venom
lanoited
5
to
U.S. CERTIFICATE OF DEPOSIT
111490
11114
4
tallob-oauH 7d vilsiondes bebivorq Innoitamenti 18
ni ai somehive adT
CALL
4
EURO-DOLLAR OVER U.S. CERTIFICATE OF DEPOSIT
23TAR YEMON CAFE
HIRE PURCHASE AND LOCAL AUTHORITY DEPOSIT RATES (covered)
TAX
Friday figures
Per cent per annum
РОИОТ
0
HIRE PURCHASE
$1
I
6
10-0003
1
EURO-DOLLAR DEPOSIT
FINANCE CO. PAPER RATES (covered) QUOTED IN NEW YORK
4
Friday figures
8
DIFFERENTIAL
1180930
1
FAVOR HIRE PURCHASE
+
U.K. HIRE PURCHASE
0
FAVOR EURO DOLLAR
7
1
CANADIAN FINANCE
COMPANY
6
EURO-DOLLAR DEPOSIT
6
LOCAL AUTHORITY DEPOSIT
5
4
гаиия JARBORR
U.S. FINANCE COMPANY
1
DIFFERENTIAL
4
FAVOR LOCAL AUTHORITY
0
FAVOR EURO DOLLAR
1
3
M
)
S
D
M
I
$
D
M
-
S
D
M
S
D
Mar.
Jun.
Sept
Dec
Mar
Jun
Sapt.
Dec.
Mar
Jun.
Sept.
Dac.
Mar
Jun.
Sept.
Dec
1965
1966
1967
1968
1965
1966
1967
1968
гаиия JARDOR R3V0 RAJJOG-0RU3
*See footnote to chart 1.
*See footnote to chart 1.
each
aaer
eaer
198 to brood
20
21
CHART 4*
CHART 5*
нтиом-с
no
глотазуит
RAJJOG
ROT
иосио
INTEREST ARBITRAGE: FRANKFURT/LONDON, ZURICH/LONDON
INTEREST ARBITRAGE, UNITED STATES/CANADA
WIN EDARTIONA
Friday Figures
Per cent per onnum
FRANKFURT INTERBANK LOAN RATE vs. LONDON EURO-DOLLAR RATE (COVERED)
Per cent per annum
3.MONTH TREASURY BILL RATES
8
IN TERMS OF DM
INTERBANK LOAN RATE
27120430 JA301
7
CAN. FIN. CO PAPER
6
MOONOJ
UNITED STATES
A0 00
4
5
EURO-DOLLAR
YAGIO81
CANADA
2
DIFFERENTIAL
FAVOR FRANKFURT
T.
3
2
BILL RATE DIFFERENTIAL AND FORWARD CANADIAN DOLLAR
PREMIUM
0
SPREAD IN FAVOR OF CANADA
1
FAVOR EURO-DOLLAR
ZURICH DEPOSIT RATE VS. LONDON EURO DOLLAR RATE (COVERED)
+
0
8
IN TERMS OF SWISS FRANCS
WOOM
FORWARD RATE
1
6
EURO-DOLLAR
DISCOUNT
3. MONTH COVERED RATE DIFFERENTIALS (NET INCENTIVES)
FAVOR CANADA
4
1
SWISS DEPOSIT RATE
TREASURY BILLS
+
FAVOR ZURICH
0
DIFFERENTIAL
+
0
2
2
PRIME FINANCE PAPER
FAVOR EURO-DOLLAR
FAVOR U.S.
FAVOR CANADA
1
II PRICE OF GOLD IN LONDON
U.S. dollar equivalent per fine ounce
35.3
+
0
XROY
FAVOR U.S.
35.0
1
M
D
M
0
M
S
D
M
D
1965
1966
1967
1968
1965
1966
1967
1968
*See footnote o chart 1.
*See footnote to chart 1.
FORD is LIBRARY GERALD
23
22
Hest
CHART 7*
по
CHART 6*
St.ORT-TERM INTEREST RATES' 678 vanom
Per
АОАИАО\23ТАТЕ азтіии ЗОАЯТІВЯА тезязтит
okola B to sonstaixe adm to
8
INTEREST ARBITRAGE, NEW YORK/LONDON
bad Form
3-MONTH TREASURY BILL RATES
BETAR
EURO-DOLLAR LONDON
to
7
;
ai
beneiros
boring
U.K. LOCAL AUTHORITY DEPOSITS
8
00
H17
MAD
1910912
add
judit
5
vd
6
LONDON
ado
RI
ER
viséols
OSTIMU
U.K.
6
-166 m TAI U.S.
*** SWITZERLAND
4
NEW YORK
4
(along
3
term vortom eda ningA (ID /
tibem aner to torgan edT breamsh
2
new.ted besiga egail odd mot inshaqqe RE beamU 2
RATE DIFFERENTIAL AND-3-MONTH FORWARD STERLING
ovode
amits
9
91/1 airld vd closed blaH Instrisc 20 to grilies ariest wen
SPREAD IN FAVOR OF LONDON
2
to consubai 192hm morl
STAR
8
JAPAN
111
919W
PREMIUM
mobgni
befinD
erlt
GERMANY
7
+
0
FORWARD RATE
DISCOUNT
III sain odi listano of guigled eibern text 6
].
whit
(loneq seviol S mide 000)
nobdod edit
2
CANADA
-79
N
bas olbbira arT
U.S.
4
RATE DIFFERENTIAL WITH FORWARD EXCHANGE COVER (NET INCENTIVE) 4.67
2.
SOURT
192mm
to
IN FAVOR OF LONDON
3
aid) JA
192/TAM
IN FAVOR OF NEW YORK
2
1963
1964
to
180011965
1966
1967
2.43
1st.
*See
footnote
to
chart
1.
to
of
$
C
M
$
0
M
S
2.33
M
$
*3-month treasury bill rates for all countries except Japan (average rate on bank loans and discounts),
1965
1966
1967
1968
Sw itzerland (3-month deposit rate), and Germany (Interbank Loan Rate).
3-month rate for U.S. dollar deposits in London.
to
beldnott
I hads of stontool
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24
25
In chart 1, there are presented interest rates on EURO-dollar call
Chart 5 depicts the close relationships which exist between money
money and Federal funds. These rates are both affected on the de-
market rates in Canada and the United States, while chart 6 presents
mand side by the U.S. money market banks, for which the respective
similar comparisons for the United States and the United Kingdom.
markets are alternative sources of reserves. The existence of a close
Clearly, there is not a full adjustment in the forward exchange markets
tie between the domestic Federal funds market and the international
to the interest rate differentials. However, the impact of market forces
EURO-dollar market is apparent in the narrow range of interest rate
plus official intervention account for the relatively narrow range of
differentials. On very few occasions during the period covered, is the
net investment incentive.
difference in excess of 100 basis points. It is evident that the greater
Finally, in chart 7, the raw interest rates of the countries considered,
spreads have occurred during the highs experienced by the EURO-
along with Japan, are shown. The periodic explosions in the United
dollar rate. The EURO-dollar rate is not tied as closely as is the Federal
Kingdom rate mark attacks on the pound and the desperate attempts
funds rate to the relatively rigid Federal Reserve discount rate, a
of the United Kingdom authorities to mount an effective defense.
fixed factor which may account for some of the variation in the dif-
The mirror-like reflection of United Kingdom and United States
ferential.
rates often displayed by the Swiss rate tells the story of Switzerland
The relationship between the Euro-dollar market and the New York
as a haven for flight capital. The Japanese pattern reflects
market is depicted further in chart 2 (upper and middle panels).
heavily administered rates. The remarkable seasonality which dom-
This chart shows the relationship between rates on 3-month money in
inates the German rate, reflects, to an important extent, the premium
the EURO-dollar and New York CD markets. Again, the money market
attached to year-end window-dressing by the German banks. 28 But,
banks are influential on the demand side. The impact of the 1966 credit
given the lack of fluidity in a number of markets and the existence of
crunch in the United States is apparent from the large spread between
various control policies, the sympathy of movement that does remain
the rates at that time. Market rates on outstanding CD's rose above
is impressive. And, much of the responsibility for this pattern, it
the new issue ceiling of 5½ percent. Held back by this rigidity, the
would seem, may be attributed to the EURO-dollar market.
banks borrowed funds from the EURO-dollar market. The influence of
The previous discussion has centered on the hypothesis that the
tightening credit conditions in the United States and the withdrawal
EURO-dollar market has provided a communications link between
of funds from the EURO-dollar market were reflected in the sympa-
national money markets. To test this hypothesis further, the behavior
thetic movement of finance company paper in the United Kingdom
over time of differentials between money market rates of interest in
and Canada. With CD's no longer competitive, U.S. companies
seven countries and the United States, as reported by the Inter-
moved into other money market media, helping to curtail the rise in
national Monetary Fund, have been examined. The 3-month Treasury
U.S. finance company obligations. (See chart 2, lower panel).
bill rate was used for Canada, the Netherlands, the United Kingdom,
In chart 3, upper panel, the structure of interest rates in the London
and the United States. Call money rates were employed in the case
EURO-dollar market is presented. The sympathetic movement ex-
of Belgium, France, Germany, and Switzerland. The test results are
pected from such homogenous market is apparent. 26 The middle and
presented in table 7. There it will be seen that the period 1948-68,
lower panels of chart 3 focus upon the relationships between the
has been divided on the basis of the general return to currency con-
EURO-dollar rates and two key United Kingdom money market rates.
vertibility in 1958.
Again, the influence of the demand side of the market is apparent.
Consumer credit concerns and the local authorities must keep their
TABLE 7.-DIFFERENTIALS BETWEEN MONEY MARKET RATES OF INTEREST IN THE UNITED STATES AND 7
COUNTRIES
rates competitive with those in the EURO-dollar market. At this point,
of course, the influence of the forward market comes into play. The
1948-58
1959-68
sterling rates are covered. During most of the period, the central
Coefficient
Coefficient
bank contributed effectively to the maintenance of interest-rate parity
of trend
Correlation
of trend
Correlation
through operations in the forward exchange market. During the
(percent)
coefficient
(percent)
coefficient
troubled times of late 1967, however, this was not the case.
Belgium
-4.3
0.881
-1.0
0.521
The four panels of chart 4 relate covered EURO-dollar rates to
Canada
11.6
.841
-1.4
.871
domestic rates of interest in Germany and Switzerland. Generally
United Kingdom
21.2
.786
-2.0
.740
Netherlands
1.0
.753
5.3
.926
sympathetic movements are discernible. However, neither country
Germany
28.9
2.188
-5.1
.290
Switzerland
2-1.5
2.843
2.5
.728
possesses a money market which is comparable in resiliency to those
France
(3)
(3)
-4.0
.916
in London and New York. Moreover, both countries have employed
various selective measures to impede the inflow, or promote the out-
1 These statistics were computed by my colleague, Lawrence Chimerine, whose assistance is gratefully ack nowledged.
2 Computed for 1950-58 only.
flow, of short-term capital.² The effect of these devices is especially
3 Data not available.
apparent in the case of Zurich.
26 There is also some evidence that short-term rates tend to be relatively high when rates are high gen-
The coefficients of trend were derived by regressing the percentage
erally. This pattern characteristic is consistent with the expectations theory of the term structure.
differential between the money market rate for each of the seven coun-
27 Cf. the concluding section of this paper for an enumeration of such techniques.
28 Based on correspondence with Franz Scholl. See also 'Recent Trends in Short and Medium-Term Inter-
bank Relations Classified by Banking Groups," Monthly Report of the Deutsche Bundesbank, Vol. 19, No. 12
(December 1967).
FORD
GERALD
LIBRARY
26
27
tries and the United States. The rate for the United States was sub-
Finally, correlation coefficients may be compared for the two
tracted from that of the other country, and the difference was divided
periods. For only three countries were the correlation coefficients higher
by the United States rate. Thus, for example, the -4.3 percent co-
in the postconvertibility period. For the other three 34 countries,
efficient of trend for Belgium means that during the period, 1948-58,
correlations with the U.S. rates were greater during the preconverti-
the Belgian rate less the United States rate, as a percentage of the
bility period. This result may seem inconsistent with the basic hypoth-
United States rate, declined by an average of 4.3 percent a year.
esis, since better linkage supposedly results in higher correlation. On
In general, if the level of interest rates in a foreign country is above
the other hand, a lower correlation may have been a necessary con-
that in the United States and the differential decreases, the trend
comitant of a negative trend differential in a case where the level of
coefficient will be negative. If the differential increases, the coefficient
foreign interest rates was higher than the U.S. level. That is, it would
of trend will be positive. On the other hand, the level of interest rates
have been necessary for foreign and U.S. rates to move in opposite
in the foreign country may be below that of the United States. In
directions in some years to reduce the differential, a rate pattern that
this case, if the differential increases, the trend coefficient will be
would also reduce the correlation. It follows that the comparison of
negative. If the differential decreases, the coefficient of trend will be
correlation coefficients is not a wholly satisfactory test.
positive. The correlation coefficients represent simple correlations between
A fundamental difficulty confronts any attempt to measure the
influence exerted by the EURO-dollar market upon international
the rates of each country and the United States during the indicated
interest rate differentials. This difficulty arises from the theory of
time periods.
interest rate parity, according to which national interest rates corrected
The development of the EURO-dollar market was, to say the least,
for foreign exchange risk will tend toward equality. In other words,
facilitated by the moves toward currency convertibility in 1958.
covered interest rates will tend toward equality. Inasmuch as forward
Consequently, the impact of the EURO-dollar market as a link between
exchange markets are subject to speculative movements and central
national money markets should have been greater during the 1959-
bank intervention, the extent to which uncovered rates of interest
68 period. The test results are in part consistent, and in part in-
will reflect the impact of international money flows may be limited.
consistent, with the thesis that the EURO-dollar market provided such
Hence, it was not unexpected to find that the econometrics produce
a national money market link.
less than fully satisfactory results. Indeed, it is surprising that the
Five of the seven trend coefficients estimated for the second period
results were as good as they were.
are negative. This result is consistent with the hypothesis being
tested. Moreover, the two countries with positive trends were the
V. THE EURO-DOLLAR MARKET AND THE U.S. BALANCE OF PAYMENTS
Netherlands and Switzerland, two countries which have generally
experienced lower interest rate levels than the United States.
1. THE EFFECT OF THE EURO-DOLLAR MARKET UPON THE U.S. BALANCE
In the five countries with negative trends, only Belgium has recorded
OF PAYMENTS
rates usually lower than those of the United States. In this instance,
the case of Belgium, the empirical result fails to support the theory
Since balance-of-payments equilibrium is an important policy ob-
being advanced. The empirical validation of the theory also is subject
jective, any consideration of U.S. policy vis-a-vis the EURO-dollar
to qualification because the results lack statistical significance.29
market must take into account the effects of the market upon the U.S.
In about one-half of the cases, the trend coefficients for the 1959-68
balance of payments. An attempt to assess these effects will be made
period are not significantly different from zero. Those for France and
next.
the Netherlands are clearly significant. Those for Germany and
Initially, the market probably induced an outflow of funds. During
Switzerland are of marginal significance. The statistics for the remain-
the market's formative years, rates of return on investment and in-
ing countries are not significantly different from zero.
terest rate levels were higher in most countries of Western Europe
With regard to differential behavior for the two periods, the results
than in the United States. Most European countries did not have
are also mixed. The United Kingdom pattern is a consistent one, since
money markets which facilitated international capital movements.
United Kingdom-United States differential tended to widen during
The development of the EURO-dollar market provided an outlet for
the earlier, and narrow during the later, period.³ The Swiss case is
short-term funds that responded to the higher rates of interest outside
also consistent. Swiss money rates have usually been below those in
the United States but did not involve the illiquidity of poorly struc-
the United States; and differentials widened during the former,⁸²
tured money markets, such as those found in many foreign countries.
and narrowed during the latter, period. 33 The Canadian result also
Once established, however, the market absorbed funds that might
tends to favor the hypothesis. For the other countries, however, the
otherwise have fallen into official hands. As official holdings rise, some
foreign central banks are increasingly subject to political pressures at
theory fails the test.
home to convert all but a working balance into gold. However, the
29 This statement is based upon the 0.05 level of significance. That is, given the number of observations,
amount of dollar balances which fall into the hands of official institu-
the correlations were SO low that they could have occurred more than 5 times in 100 samples drawn from an
uncorrelated population. The inference is drawn, therefore, that there is little, if any, correlation.
tions may be reduced in a number of ways and for a variety of reasons:
30 Becoming more positive.
31 Becoming less positive.
34 French data were not available for the earlier period.
32 Becoming more negative.
33 Becoming less negative. In other words, since Swiss rates were less than those in the United States, a
narrowing of the differential would reduce the negative difference.
28
29
(a) U.S. commercial banks may borrow EURO-dollars through
2. THE EFFECT OF THE U.S. BALANCE OF PAYMENTS UPON THE EURO-
foreign branches and other foreign banks to help satisfy legal re-
DOLLAR MARKET
serve requirements.
(b) Foreign banks may acquire EURO-dollars and relend them
Since the policies designed to bring the U.S. balance of payments
in the New York money market. Klopstock has estimated that
into equilibrium have an impact upon European money and capital
outstanding foreign agency and branch securities' loans in New
markets, their specific impact upon the EURO-dollar market should also
York have been in the $700 million to $1 billion range in recent
be considered. All would agree, presumably, that the supply of dollars
to foreigners through past deficits in the U.S. balance of payments has
years.³
(c) Foreign banks have borrowed Euro-dollars and reloaned
made an important contribution to the development and growth of the
them at long term, as well as short term, to companies in the
EURO-dollar market.³ These deficits have led to a sharp rise in U.S.
United States. Klopstock has estimated that about $500 million,
banks' liabilities to nonresidents, including foreign central banks,
of such loans were outstanding at year-end 1967.³⁶
commercial banks, nonfinancial corporations, and individuals. Whether
U.S. balance of payments equilibrium would lead to the drying up of
(d) Foreign banks with branches and agencies in New York
the market is, however, problematical.
have employed EURO-dollars as operating funds rather than draw-
The answer to the latter question depends upon the structure of the
ing upon their U.S. correspondents.
U.S. balance of payments as it reaches equilibrium. Suppose, for
(e) To some, though minor, extent, foreign banks have added
example, that there is a Vietnamese peace settlement combined with
to their working balances with U.S. banks to compensate the
an increase in the current-account surplus. Suppose further that these
latter for clearing services.
favorable developments result in the elimination of all direct controls
(f) Though the need for contingency reserves is a modest one
over capital movements. In these circumstances, and given relatively
foreign banks do hold some balances in the United States for
high interest rates in the EURO-dollar market, it is quite possible that
the market would flourish.
this purpose.
(g) Foreign banks and the foreign branches of U.S. banks
Even with a continuation of direct controls over capital move-
borrow in the EURO-dollar market and relend to European and
ments, a number of factors point to the viability of the market. The
other foreign companies and the European and other foreign
absorptive capacity of the market compares favorably with the
affiliates of American companies, thus reducing their own and
narrow money markets found in most countries. Foreign banks and
their customers' demand for bank loans in the United States.
corporations have few alternative outlets to the EURo-dollar market.
(h) Foreign monetary authorities may conduct dollar swap
And, in fact, a large proportion of placements in the EURO-dollar
operations with their commercial banks which bring downward
market are made by investors who acquire the necessary dollars in
pressures on the EURO-dollar rate structure through interest rate
the foreign exchange market. 40 Finally, American banks and com-
subsidies and increases in supply. Such interest rate effects will
panies would continue to utilize this recently developed and ex-
tend to increase private holdings in the United States and thus
panded source of funds.
It must be concluded, therefore, that equilibrium in the U.S.
reduce the level of official dollar balances.
balance of payments would not necessarily cause a contraction in-
Taking all of these factors into account, Klopstock has estimated
let alone destroy-the EURO-dollar market. It would most likely
that foreign private dollar holdings in the United States would be
remain in substantially its present form and size. Consequently,
about $3.5 billion less than their present level were it not for the
many of the policy implications of its existence would remain.
existence of the EURO-dollar market.37 In other words, if the EURO-
dollar market had not existed, these dollars might have found their
VI. POLICY IMPLICATIONS OF THE EURO-DOLLAR MARKET
way into official hands and thus affected adversely the U.S. balance
balance of payments on an official settlements basis.
1. THE CHALLENGE TO MONETARY POLICY
With regard to the impact of the market upon the balance of
payments on a liquidity basis, there is a certain asymmetry in the
The existence of the EURO-dollar market has greatly complicated
effect of inflows and outflows. When, for example, a U.S. company
the environment in which central banks operate. The market has had
transfers dollars from an account with a U.S. bank to an Italian
a direct impact upon the level of interest rates and the availability of
bank, the deficit on a liquidity basis increases. The deficit on this
credit in individual countries. Domestic banks may, for example,
basis is not affected if the Italian bank redeposits the funds with the
accept dollar deposits from the market, convert the proceeds of these
London branch of another U.S. bank. Nor is it reduced when the
deposits into the local currency, and make local currency loans to
London branch relends the dollars to its head office in New York. 38
domestic borrowers. Foreign banks may obtain funds from the EURO-
dollar market and make foreign or local currency loans to domestic
35 See Klopstock, op. cit.
companies. Domestic banks and corporations may liquidate existing
37 36 See ibid. ibid. Also see Fred H. Klopstock, "Impact of Euromarkets on the United States Balance of Pay-
ments," 38 The balance of payments on the official settlements basis is not changed by any of these transactions.
See Law and Contemporary Problems, vol. 34, No. 1 (winter, 1969), pp. 157-171.
39 It is true, of course, that the reverse would have been the case had U.S. deficits substantially dimmed
the long term prospects for the dollar.
40 Foreign investors could, of course, simply place these dollars in the United States. However, placing the
dollars in Europe has a certain, if illusory, appeal to many foreign lenders.
30
31
placements in the Euro-dollar market in much the same way as they
and direct controls on EURO-dollar placements by American companies
would liquidate short-term investments in order to provide funds for
are examples of the kinds of direct controls that may be used to prevent
expansion. As has been noted in some detail earlier, commercial banks in the
international capital flows which are facilitated by the existence of
the EURO-dollar market. These measures have been taken in this
United States have, from time to time, relied heavily upon the EURO-
country in an effort to reduce the balance of payments deficit. How-
dollar market as a source of funds. The acquisition of such funds by
ever, the same measures also affect the environment in which domestic
domestic banks may tend to offset the effect of a restrictive monetary
monetary policy operates.⁴²
policy. Similarly, in periods of expansionary monetary policy, domestic
banks and companies may absorb liquidity through the placement of
3. IMPLICATIONS FOR EXTERNAL POLICY
funds in the EURO-dollar market. Such placements counteract or
offset the effort of the central bank to expand liquidity at home. Thus,
(a) Balance-of-payments effects
the EURO-dollar market has added another dimension to the problem
The balance-of-payments effects of the EURO-dollar market are
of domestic monetary management.⁴
not easily assessed. However, the existence of the market may well
attract foreign dollar holders. Consequently, they may place dollars
USE OF DIRECT CONTROLS
in the market rather than converting them immediately into local
currencies. As has been seen in the earlier description of the market
Central banks in a number of countries have employed various
mechanism, the dollars may eventually be converted and fall into the
direct controls to prevent banks and nonfinancial corporations from
hands of a central bank.
pursuing policies that are inconsistent with central bank objectives.
Nevertheless, the postponement in time of the fact of conversion
Such policies, of course, have to some extent been employed or are
does result in the temporary absorption of U.S. dollars by a foreign
being employed in the United States. Others might be adapted for use
market. Hence, the balance-of-payments effect on an official settle-
in the United States. Some of the individual controls which may or
ments basis is favorable, and the threat to the U.S. gold stock is
are being used are as follows:
lessened. Otherwise, general shifts of funds into and out of the United
(a) Euro-dollar or foreign-currency loans by domestic com-
States are determined largely by expected rates of return. Relatively
panies may be prohibited outright, subjected to licensing arrange-
low interest rates in America may induce a general exodus, relatively
ments, or rationed administratively according to the type of
high rates of return a reverse flow.
borrower to be accommodated.
(b) The market and speculation in gold or foreign currencies
(b) Various kinds and degrees of restrictions may be placed
During attacks on the dollar, low-margin financing requirements
upon corporate borrowings from foreign banks.
for gold purchases have been met by EURO-dollar credit. The collateral
(c) The placement of dollars in the EURO-dollar market by
is high grade. It is not surprising, therefore, to find EURO-dollars
domestic banks or companies may be prohibited or subjected to
seeking such an outlet. As in the case of the Deutsche Mark, the EURO-
quotas.
dollar market has also been used as a vehicle for speculating in a
(d) Restrictions may be placed upon the conversion of EURO-
foreign currency. The basic problem has many ramifications. A direct
dollars into local currencies or an outright prohibition may be
approach, which has already been implemented to an important extent,
enforced. Such conversions may also be subjected to control
calls for the imposition of high margin requirements by national
through adjustments in the terms of swap arrangements with
monetary authorities upon this specific kind of lending activity.
domestic banks.
(c) The market and the pound sterling
(e) Domestic banks may be prohibited from incurring net
Monetary management on an international scale is affected by
liabilities in a foreign currency. Such a prohibition prevents the
movements into EURO-dollars from weak currencies. Such move-
bank from holding domestic currency loans as assets behind
ments, under the present regime of international surveillance and
EURO-dollar liabilities.
mutual support, add still another dimension to monetary manage-
These and other types of regulations and exchange controls have
ment. Thus, the 1966 credit crunch in the United States resulted in
been employed in a number of countries-notably the United Kingdom
the conversion of sterling investments into EURO-dollars, which were
and Italy-and have undoubtedly hindered to some extent the growth
then called home by U.S. banks. The Federal Reserve, in turn, was
of the EURO-dollar market. In the United States, present day restric-
asked to lend to the Bank of England. This cycle, to some degree at
tions upon foreign lending by banking and other financial institutions
least, meant that the Federal Reserve was replacing, through the
London circuit, the same dollars it was destroying through open
41 Given free international capital movements, similar problems would arise even without the existence
of a EURO-dollar market. Holders of EURO-dollar deposits would have the alternative of holding direct
market policy at home. The existence of such a cycle does not neces-
claims on the United States if the EURO-dollar market did not exist. Domestic banks would borrow money
from abroad-payable either in their own, the lender's, or a third currency-in order to cushion the effect of a
42 Congressman Reuss has called upon the Federal Reserve System to issue guidelines for a voluntary
restrictive monetary policy. Thus, the problems posed by the EURO-dollar market differ only in degree-
freeze on bank credit. See the New York Times, June 20, 1969.
not in kind-from those presented by the liberalization of international capital movements. That there is a
43 These include allowances for risks of various kinds including the risk of devaluation.
difference in degree is accounted for by institutional factors such as the key currency role of the dollar, the
relative liquidity of EURO-dollar investments, and the network of foreign branches of U.S. commercial
banks.
32
33
sarily completely vitiate domestic monetary policy. Policy impacts
of the fiscal instrument would, therefore, provide a necessary condi-
may be effective in a dynamic process, even though they would be
tion for the liberalization of capital movements.⁴
fully neutralized should a long-term static equilibrium ever come into
Even with fiscal policy flexibility, central bankers may fear the loss
being.
of control over the level of domestic interest rates. Interest rate policy
In any event, the existence of such a phenomenon is hardly more
at home will necessarily reflect, or be influenced by, monetary policies
than a present-day symptom of the closer ties between national capital
abroad, as a central bank protects its country's external position.
markets. The earlier discussion with regard to the related problem of
Finance ministers may be equally apprehensive if a restrictive mone-
monetary management at the domestic level has a bearing in the
tary policy, dictated by high interest rates in foreign money and
present context.
capital markets, makes politically costly inroads into the mortgage
(d) The use of direct controls
market and housing industry. Nevertheless, if fiscal policies in differ-
The widespread impact of the EURO-dollar market as a communica-
ent countries were generally flexible, central bankers would be free
tions link between national capital markets could be effectively
to concentrate upon the external position. They might, in turn,
eliminated through the reinstitution of a thorough-going system of
through cooperative efforts and effective coordination, be able to
exchange controls. As is patently clear from the historical record, the
keep interest rates at a relatively low level. Such a policy, generally
elimination of exchange controls on most short term capital move-
adhered to, would obviate the necessity for defensive monetary
ments was a basic ingredient in the inception and refinement of the
actions on as grand a scale as would be required in the absence of
Euro-dollar system. Their reinstitution could do much to destroy
such cooperation and coordination. Moreover, such policies of inter-
the institutional fabric of the market. The international position of the
national cooperation oriented toward coordinated efforts to keep
dollar and the benefits to be gained through the liberalization of inter-
interest rates relatively low would relieve pressures on the mortgage
national capital movements must, on the other hand, be weighed in the
market and construction industry.
balance.
Relatively low interest rates would also be conducive to higher
rates of growth, thus, compensating to some extent for the unfavorable
(e) The use of indirect policies
effect on growth of restrictive fiscal policies pursued during periods of
The effective employment of a high interest rate policy-combined,
strong inflationary pressures at home. Indeed, greater flexibility of the
if necessary, with an expansionary fiscal policy-would do much to
fiscal instrument and coordination of national monetary policies would
temper the need for direct controls on capital movements. Unilateral
reduce the need for some forms of cooperation, such as the use of
transfers, foreign aid, and military outlays must be considered. The
swap arrangements,¹⁷ which sometimes complicate the problem of
question of the parity relationships of the dollar is pertinent. Never-
domestic monetary management. The Federal Reserve has, for ex-
theless, the problem of capital flows, itself, could be handled largely
ample, done swaps with the Bank of England to buoy up the pound.
by a rational administration of the policy mix. Moreover, if the
It has entered into similar arrangements with the BIS to cool the
indirect policy approach were successfully implemented as far as the
EURo-dollar market and thus decrease its attractiveness to inter-
balance of payments is concerned, more rapid progress might be made
national investors. But, the existence of such arrangements is sympto-
in the area of international monetary reform, and longer run pressures
matic of a need for a greater degree of flexibility at the domestic
in the gold market 44 might be relieved.
policy level. Greater flexibility at that level would thus decrease the
importance of flexibility in international relationships.
4. THE POLICY MIX AND THE FLEXIBILITY OF FISCAL POLICY
Fiscal flexibility is, nevertheless, not a sufficient condition for the
elimination of the need for direct controls on capital movements. The
The key to further progress-perhaps, at this juncture, even the
spatial distribution of rates of return may be such that, in spite of
maintenance of the status quo-consists of the flexible administration
the coordination of monetary policies, private capital may be exported
of the policy mix. And the key ingredient in a flexible policy mix is
rather than flow into domestic uses which have been given high social
flexible fiscal policy. In the absence of fiscal policy flexibility and
priorities. In this event, the avoidance of direct controls may depend
given the view that the use of direct controls to regulate international
upon the willingness of the governments involved to adopt other selec-
capital movements is a lesser evil than employing them to achieve
tive devices, such as tax incentives, subsidies, and the like, to assure
domestic economic objectives, monetary policy is burdened with
the achievement of domestic resource allocation objectives. Only
domestic stabilization goals while controls direct over capital move-
ments are used to assure balance-of-payments equilibrium. Flexibility
46 As Katz has put it in his study of E.E.C. central banking:
the European central banks sought primarily to attain domestic economic goals, even when such
policies conflicted with the requirements of international balance. As a result, we find general tendencies,
44 In terms of dollars.
both in Europe and outside, toward the use of direct controls to check international flows of capital
45 This statement should not be construed as implying that if fiscal policy is flexible, monetary policy may
See Samuel I. Katz, External Surpluses, Capital Flows, and Credit Policy the European Economic Com-
thereby be flexible. Quite the contrary, it is precisely the condition of fiscal policy flexibility that permits the
munity, 1958to 1967, Princeton Studies in International Finance, No. 22 (1969), p. 44.
flexible use of monetary policy as an instrument of external equilibrium.
of Atlanta Monthly Review (December 1967).
47 Cf. "Central Bank Swaps-A Bulwark of International Monetary Cooperation," Federal Reserve Bank
Cf. Ira O. Scott, Jr., European Capital Markets, Office of the Comptroller of the Currency, Washington,
D.C., 1968, ch. 10.
48 Cf. Francesco Forte and Ira O. Scott, Jr., "The Use of Selective Taxes as a Means of Achieving
Balance of Payments Equilibrium," National Banking Review, Vol. 3, No. 4 (June 1966), pp. 439-447.
34
then can a rather heavy reliance upon direct controls in the area of
international capital movements be circumvented. 49
49 The "bard of economics" expresses his view of the matter as follows:
In cents and dollars, pounds and pence,
There is a Liquid Turbulence,
BIBLIOGRAPHICAL APPENDIX
And large financial integration
Leads to excessive speculation,
Whereas in Marks and Francs and Lire,
[CHRONOLOGICAL ARRANGEMENT]
The market's smaller, trade is dearer,
So European Gnomes or Elves
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Expend their savings on themselves-
Though people now are growing fond
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When Greeks and Arabs come with pay.
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(Humiliating Circumstance!)
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313-352;
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Because nobody can agree
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605-621;
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Trust Report, Special Series No. 2. pp. 1-10;
FORTE, FRANCESCO, and SCOTT, IRA O., Jr. "The Use of Selective Taxes as a
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International Finance, Princeton University, No. 64 (February 1968);
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National Banking Review, Vol. 4, No. 1 (September 1966), pp. 21-28;
the Seminar on Foreign Investment, National Association of Business Econ-
GOLDSTEIN, HENRY N. Some Analytical Aspects of the Euro-Dollar Market (un-
omists, Washington, D.C. (February 1968);
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KLOPSTOCK, FRED H. The Euro-dollar Market: Some Unresolved Issues, Essays in
McCLAM, WARREN. Interest Rates: Their International and Domestic Linkages
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EINZIG, PAUL. "London Dollar Certificates of Deposit," Banca Nazionale del
HAMBLETON, JAMES R. Gold Rush Financing Debt-and Dangerous," American
Banker, (March 22, 1968);
Lavoro Quarterly Review, No. 79 (December 1966), pp. 328-345;
BENNETT, ROBERT A. "U.S. Banks Find Eurodollars in the Bahamas.", American
VERNUCCI, ALFREDO, "The Impact of the U.S.A. Federal Funds Market on the
Banker, (April 18, 1968);
International Exchange Market," Banca Nazionale del Lavoro Quarterly Review,
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No. 79 (December 1966), pp. 346-361;
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No. 4 (April 1968);
(New York, 1966) p. 468;
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(January 1967), pp. 34-45;
(May 2, 1968);
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HOLTROP, MARIUS W. "Central Banking and Economic Integration," Per Jacobs-
Foreign Trade and Investment, an address before the 30th Chicago World Trade
son Foundation Lecture, Stockholm, Mav 16, 1968, Supplement to International
Conference (Chicago, Illinois, February 16, 1967);
Financial News Survey, Vol. XX, No. 19 (May 17, 1968);
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"Higher U.S. and Euro-dollar Interest Rates", World Financial Markets, Morgan
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March 1967);
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1968);
Case of the Dollar, a paper given at the Conference on the Foreign Exchange
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(April 1967);
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ment, Center for Advanced Management Studies, Arthur T. Roth Graduate
No. 495 (May 1967), pp. 411-417;
School of Business Administration, Long Island University, Montauk, Long
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Island, New York (June 14, 1968);
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pp. 138-152;
38
39
KLOPSTOCK, FRED H. "Euro-dollars in the Liquidity and Reserve Manage-
KLOPSTOCK, FRED H. "Impact of Euro Markets on the United States Balance of
ment of United States Banks", Federal Reserve Bank of New York Monthly
Payments," Law and Contemporary Problems, Vol. 34, No. 1 (Winter 1969),
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BRIMMER, ANDREW F. Monetary Policy Issues in 1969, an address before the
No. 8 (January 1970), pp. 22-31;
Fifty-Second Annual Meeting of the National Industrial Conference Board
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(New York, New York, September 19, 1968);
National City Bank (no date).
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(November 1968), pp. 251-257;
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"CD's, Euro-dollars, and Monetary Policy," Morgan Guaranty Survey (February
1969);
BRIMMER, ANDREW F. Euro-dollar Flows and the Efficiency of U.S. Monetary
Policy, an address before the Conference on Wall Street and the Economy '69,
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(March 1969), pp. 3-15;
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Federal Reserve Bank of Boston, New England Economic Review (May/June,
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Quarter, 1969);
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1969);
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BELL, GEOFFREY L. "The Forgetten Issues-Dollars and Gold," The Times
(October 29, 1969);
FRIEDMAN, MILTON. "The EuroDollar Market: Some First Principles," Morgan
Guaranty Survey (October 1969), pp. 4-14;
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1969), pp. 9-11;
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pp. 765-783;
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McCLAM, WARREN D. Present Relationships Between Money Markets and Foreign
Exchange Markets, an address before the Seminar on Impact and Organization
of Foreign Exchange and Money Markets, Association of Yugoslav Com-
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ber 14, 1969);
BRIMMER, ANDREW F. The Euro-Dollar Market and the U.S. Balance of Payments,
an address before a seminar at the London School of Economics, November 17,
1969, Bank for International Settlements, Press Review (Basle, November 24,
1969);
WILLES, MARK H. "Balance of Payments-In Deficit or Surplus," Federal
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BELL, GEOFFREY L. "Eurodollars," The Times (December 19, 1969);
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nomic Letter (December 1969), pp. 141-143;
FORD & LIBRARY GERALD
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
DATE 10/21
Chairman Burns
TO
FROM ROBERT SOLOMON
This message reports Ansiaux's
views on the need for the EEC to
"create a counterweight to the dollar."
RS
Attachment. )Airgram - A-478, Amembassy,
Brussels, 10/13/70)
I
FORD is LIBRARY 03RALD
DEPARTMENT OF STATE
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CT 16 8 15 AM 1970
RS/AN
ANALYSIS BRANCH
Ansiaux on the International Monetary Situation
4
CERP D
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NAVY
16
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In a speec given in Brussels on October 1, Baron Ansiaux, Governor
3
of the Banque Nationale de Belgique, commented sourly on the role of
the dollar in the international monetary system, pointed to SDR creation
as preferable to increased dollar holdings as the means for financing
trade expansion, and looked forward to the Common Market's creation
22 - PM 2
of a counterweight to the dollar.
COPYFLO-PBR
Ansiaux said that for the dollar to provide for the necessary expansion
of international reserves means that the United States must have a
perpetual balance of payments deficit. This has been the case since
1957-58 and the consequences have been the erosion of the dollar and of
confidence in it. But if the United States should reach equilibrium in its
balance of payments or run a surplus, how would other countries accumu-
FORD
late the needed increases in reserves? The answer has been the creation
LIBRARY
of SDRs. If, however, the United States balance of payments deficit
persists, there may be no need to increase SDR creation (after the initial
three year's issue) since increased dollar holdings abroad might cover
the need for additional reserves. The actual need for more SDRs should
therefore be carefully examined in 1973.
Ansiaux said that no country whose currency is a reserve instrument
should have a balance of payments current account debit; the role of such
a country is to distribute abroad its current account surplus. The
United States still has a modest current account surplus but not enough
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Page 2.
to finance the capital account deficit. An erall deficit is an important
failing for the United States. Nevertheless, it continues, for several
political reasons. The United States engages in financial operations
incompatible with its small current account surplus, it suffers from
excessive domestic demand, and its exports no longer attain the level
required for a healthy current account surplus. Ansiaux noted that
Europeans also have problems with inflation, made worse by that in the
United States, and that it has become very difficult to correct them.
The real solution for Europe, according to Ansiaux, is for the Common
Market, by the enlargement of its economic territory, the solidarity
of its members and the coordination of its national policies, to create
a counterweight to the dollar.
EISENHOWER
hn
FORD & LIBRARY GERALD
UNCLASSIFIED
DRAFT:RS:nss
10/21/70
The U.S. balance of payments is showing a deficit of
unprecedented size this year. As our monetary policy has eased,
our short-term interest rates have fallen relative to European
interest rates, and short-term funds have flowed to Europe in
enormous volume, enlarging our overall deficit.
In 1968-69, when our trade surplus declined and almost
disappeared because of inflationary pressures, the worsening of
our underlying balance of payments was masked by a large inflow
of short-term funds. This occurred as American banks borrowed
heavily in the Eurodollar market in an attempt to escape from the
Federal Reserve's restrictive monetary policies. Now that process
is being reversed. Although our trade surplus is growing again,
that improvement is more than offset as the banks repay the funds
they borrowed earlier.
The result is that dollars are flowing into the reserves
of foreign central banks very rapidly--$5 billion in the first
nine months of this year.
If this process continues, we face the possibility of
an international monetary crisis in the months ahead. But even if
a crisis is averted, the United States has a responsibility to get
control of its balance of payments and thereby to strengthen the
international standing of the dollar.
FORD is LIBRARY DERALD
-2-
The Persistent Balance of Payments Problem
Our balance of payments has been weak for more than a
decade. Whatever the reasons--and not all of them are our own
fault--this weakness has had an effect on the prestige and on
the foreign policy of the United States. For too long now,
American officials have been telling the world that a better
balance of payments is just around the corner. Meanwhile, the
U.S. Government has at times been forced to adopt policies that
are hardly in keeping with the position it would like to maintain
in the world.
There is one view--held by some in Washington and by
many economists in the universities--that the rest of the world
has no choice but to adjust to our balance of payments. It is
said that the special role of the dollar in the international monetary
system puts other countries in the position where they must either
accept the dollars that are generated by our payments deficits or
they must revalue their currencies enough to eliminate their sur-
FORD is LIBRARY 0ERALD
pluses (which are the counterpart of our deficits).
Quite apart from the technical aspects of this proposition,
it represents an attitude that can only breed poor relations--
economic and political- with other countries. It smacks of dollar
imperialism, and generates resentment and protective reactions
elsewhere. Certainly some of the anti-American (or at least anti-dollar)
impulses that lie behind the current efforts of the Continetal Europeans
to transform the Common Market into an economic and monetary union
-3-
can be traced to the widely-held view abroad that the United
States is concerned only about its domestic economy and is pre-
pared to ignore the effects it has on the rest of the world through
its balance of payments.
If we are to avoid a crisis and if we are to change
the view of other countries regarding our intentions, we need
a positive approach to the balance of payments.
What follows is the outline of such an approach.
Dealing with the Balance of Payments
1. The inflation that took hold in this country after
1964 had two related effects on our payments balance: it
raised the prices of our goods relative to prices abroad and
it drew in an econormous volume of imported goods (in 1968 alone
our imports increased by 23 per cent). Now that excess demand
has been eliminated from the economy, imports have levelled off.
Furthermore, inflation has broken out in other industrial
countries. With costs and prices rising rapidly abroad, we have
an opportunity to recapture some of the competitive ground we
lost earlier. But to do this, we must do something about the
strong upward thrust of wages. While our productivity is in-
creasing again, we cannot expect it to rise at a rate anywhere
near the current advance in wages as reflected in new wage
settlements.
GERALD R. FORD
-4-
Thus for international as well as domestic reasons, we
need a strong incomes policy that is designed to decelerate
the wage-price spiral as quickly as possible.
2. Although excess demand has been eliminated and the
immediate prospects for economic expansion are not strong, it
is essential to avoid a resumption of excess demand. This fiscal
year's budget deficit is not of serious concern in this respect,
since it reflects to a large degree the shortfall of revenues
that accompanies the shortfall in GNP. But the budget for
fiscal 1972 ought to be designed in a way that not only fits
domestic needs but also inspires confidence, at home and abroad,
that inflationary tinder will not be rekindled. This can best
be accomplished by limiting the increase in expenditures to
the amount of the normal increase in revenues of a fully-employed
economy.
3. The restraints on private capital outflows that your
administration inherited (the Interest Equalization Tax, the
Commerce Department's program on corporate direct investment
overseas, and the Federal Reserve program to restrain lending
abroad by banks and other financial institutions) were quite
FORD i LIBRARY GERALD
properly relaxed in the spring of 1969, that action not only
lightened the burden of these controls on the business and
financial community but also transmitted a message: that your
Administration wished to dismantle these controls as soon as
possible.
-5-
But one does not destroy a dam on the grounds that
one has not seen a flood since it was built. In the
present balance of payments circumstances, described in
the early part of this memorandum, I strongly recommend
that the restraints on capital outflow be held intact for
the year 1971 and that the announcement of this standstill
be coupled with an expression of your deep concern about
the balance of payments.
4. Finally, the Federal Reserve could take an action
to restrain the short-term capital outflow from American
banks to the Eurodollar market, without interfering
with our current domestic objective of encourage orderly,
non-inflationary expansion of the economy. This action
would make sense as part of a package designed to improve
the rest of the balance of payments. Furthermore, it would
be welcomed abroad as a cooperative act.
This program, parts of which are desirable on domestic grounds
anyway, could go a long way toward improving the international standing
of the dollar and, hence the international strength of the United States.
FORD & LIBEARY QERALD
-6-
The 1950's were the years of the so-called "dollar shortage,"
when the dollar was pre-eminent internationally. In the 1960's, the
dollar was generally weak. It is not at all unreasonable to think
that in the 1970's the dollar will once again be a strong currency.
A major pre-requisite to bring that about is to damp down the
wage-price spiral and to prevent the resurgence of excess demand in
the United States. Points 1 and 2 in the approach outlined above
are aimed at these goals. Points 3 and 4 are designed to protect
the balance of payments while the underlying elements of strength
in our payments position re-assert themselves.
FORD if LIBRARY 03RALD
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
Office Correspondence
Date October 21, 1970.
Chairman Burns
To
Subject:
Robert Solomon
From
The attached memorandum was written a week ago,
before we had thought of the reserve requirement inducement
to banks to hold their Eurodollars. It explores the proposal
to let banks go to 90 or 80 per cent of their bases.
I believe that one can exaggerate the power of an
amendment that permitted banks to go to 90 or 80 per cent
without loss of base but provided for loss of base if banks
went below the stated percentage. As compared with the present
situation, I see little additional incentive for the banks not
to go below 90 or 80 per cent. In either case, the base would
fall to the new level of borrowings. The only change is that
banks would feel free to go down to 90 or 80 per cent. At
FORD is LIBRARY
that level they might think twice but, having seen the Board
reduce the base once, they might feel more free to go below the
minimum percentage in the expectation that the Board would re-
duce it again.
RS
Attachment.
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
Office Correspondence
Date October 14, 1970
Mr. Robert Solomon
To
Subject: A Possible Amendment to the Lock-
From
Robert F. Gemmill
in Effect of Board's Euro-dollar Regulations
CONFIDENTIAL (FR)
This memorandum considers the feasibility of amending the Board's
Euro-dollar regulations to permit banks to reduce Euro-dollar borrowings
somewhat below the level of the historical base without any loss of that
reserve-free base. Two variants of the general amendment will be examined:
(1) Permitting borrowings to decline (in two
steps) to 90 per cent of the historical base during
1970, and to 80 per cent of the historical base by
mid-1971;
(2) Permitting borrowings to decline to 80 per
cent of the historical base by the end of 1970.
Either of these variants would be combined with an appeal to the banks
not to permit borrowings to go below the special levels established by
the Board. Either amendment would represent a quid pro quo for the
banks. In fact, the provision of a quid pro quo would appear to be the
main justification for the amendment, although as noted below there
would also be some shift involved in the cost benefit calculations
confronting an individual bank in determining the profitability of
retaining Euro-dollar borrowings.
The Broad Policy Issues. The rationale for the amendment
and for the accompanying appeal to the banks would be the need on
grounds of balance of payments policy to limit the reduction in Euro-
dollar borrowings over the next few months, and perhaps over the next
year. Moreover, it would appear likely that whatever effect the
amendment had in stemming repayments of Euro-dollar borrowings would
be a relatively short-term one. Avoidance of a crisis through short-
term measures can, of course, yield long-term benefits.
The potential costs of the amendment involve the uncertainty
as to its impact, and also the longer-term disadvantage of perpetuating
the special position of the large money market banks as the only banks
with significant amounts of reserve-free liabilities. The uncertainty
of the impact may cast doubt on the potential balance-of-payments
benefit, and it also raises a question as to the advisability of Board
adoption of a proposal that might be regarded as a "gimmick" if that
proposal were to prove ineffective.
These issues are considered in more detail below.
FORD i LIBRARY GERALD
Mr. Robert Solomon
-2-
CONFIDENTIAL (FR)
The Potential Balance-of-payments Impact
The balance-of-payments impact should be defined broadly,
to include not only the effect of Board measures on the net reduction
of Euro-dollar borrowings but also the effect of those measures and
of the resulting repayments on the policies of foreign authorities.
Large-scale repayments of borrowings would result in substantial
further reserve gains by foreign authorities, and in substantial
additions to domestic liquidity abroad. Failure of the United States
to take what were regarded abroad as strong measures to hold the re-
payments to manageable proportions would tend to undermine the cooper-
ation that is essential for successful functioning of the international
financial system.
The amendment of the lock-in effect would permit a reduction
in borrowings with no loss of historical base by the banks, in the
expectation of preventing an even larger reduction in borrowings through
a combination of changed financial incentives (a changed cost-benefit
calculation) and of moral suasion. Some illustrative calculations based
on simplified assumptions are presented below. They suggest that any
amendment of the lock-in effect that involved sanctioning a relatively
sizable reduction in borrowings (e.g. to 80 per cent of the historical
base) would produce foreign reserve gains sufficiently large to be
incompatible with our balance-of-payments objectives for the remainder
of 1970 and early 1971. If a very substantial further repayment of
Euro-dollar borrowings were to occur, it would be desirable that it
occur without specific sanction by Board action. Moreover, as demon-
strated in the section on cost-benefit calculations (pages 4 and 5 below)
there is clearly a risk that a Board-sanctioned reduction (through
amendment) could exceed the market-induced reduction of borrowings
that might occur if the Board maintained its regulations unchanged;
the nature of that risk depends upon assumptions concerning the effects
of repayment on Euro-dollar interest rates.
Illustrative calculations. Following are illustrative
calculations regarding potential repayments of borrowings under al-
GERALD FORD
ternative assumptions. The principal conclusion to be drawn is that
unless one assumes (1) that banks generally are planning very large-
scale repayments (Case #4 below) and (2) that such repayments would
occur without producing changes in Euro-dollar interest rates that
would change banks plans, there would be little or no balance-of-
payments gain realized from an amendment of the lock-in effect.
Moreover, even under these assumptions, much of the balance of
payments saving would disappear unless banks' plans could be changed
by a relatively modest amendment of the lock-in effect (Case #1 rather
than Case 2). Case #1 indicates that even a modest amendment to the
lock-in effect would involve a reduction in Euro-dollar borrowings
almost as large as might be expected to occur without the amendment
on what appear to be reasonable assumptions (Case 3).
Mr. Robert Solomon
-3-
CONFIDENTIAL (FR)
Case #1. If the Board permits banks using historical bases to
reduce average borrowings to 90 per cent of the current
historical base with no loss of historical base, there
would result a net reduction in borrowings of $1.3
billion by the 17 banks using historical bases.
(Aggregate historical bases were about $10.7 billion
in the computation period ending September 30, but
in that period some banks were still maintaining borrow-
ings above their bases.)
Case #2. If the Board permits banks using historical bases to
reduce borrowings to 80 per cent of those bases, the
aggregate decline in borrowings would be about $2.5
billion.
Case #3. If the Board takes no action, and repayments are made
according to schedule (a) by those four banks known
to have already scheduled them, and (b) by other banks
that have a ratio of Euro-dollar deposits to total de-
posits (net) of 15 per cent or more, in amounts suf-
ficient to reduce the ratio of borrowings to net
deposits to 15 per cent, there would be a net reduction
in Euro-dollar borrowings of $1.5 billion.
In this calculation, it is assumed that banks that have
announced no plans for change would hold to that view.
The assumptions for Case #3 are consistent with the
argument that use of high-cost Euro-dollars has a
larger impact on profits for banks making relatively
heavy use of Euro-dollars; of the four banks known to
have scheduled reductions in Euro-dollar borrowings,
three have relied very heavily on Euro-dollars. First
National City plans to reduce borrowings to 8 per cent
of net deposits from the present level of 16 per cent;
but other three banks planning reductions all have high
ratios of Euro-dollar borrowings to net deposits--
between 30 and 37 per cent--and plan to reduce borrow-
ings to roughly 25 per cent of net deposits.
Case #4. If the Board takes no
action and repayments are made by all banks using
historical bases, relinquishing 30 per cent of the
historical base (the average percentage reduction
scheduled by the four banks known to have planned
reductions), total borrowings would decline by $3.2
billion.
FORD is LIBRARY GERALD
Mr. Robert Solomon
-4-
CONFIDENTIAL (FR)
One may reasonably question whether, in the
light of the probability that such a large
repayment would reduce Euro-dollar rates to
some extent, and of the cost-benefit calcu-
lation confronting an individual bank (see
the following section), the plans of indi-
vidual banks would in fact be realized.
Changed Cost-Benefit Calculations. An amendment of the
lock-in effect would change the cost-benefit calculations of an indi-
vidual bank in two ways. These can best be illustrated by comparison
with the cost-benefit calculation associated with the lock-in effect
under the Board regulations as they now stand.
First, consider the effect on the calculation where the bank,
under present regulations, plans to reduce borrowings to a level below
that sanctioned by the amendment.
Bank A is assumed to have an historical base of $100 million
and borrowings of the same amount. If this bank expects that over the
next year Euro-dollar rates will average 1 percentage point higher than
the rate on alternative domestic liabilities, and if in the absence of
the lock-in effect, the bank would reduce its outstanding Euro-dollar
borrowings to $60 million in the coming year, the bank's expected cost
of retaining the historical base for the coming year would be $0.4 mil-
lion (1 per cent of $40 million). If the bank expects to have to resort
to Euro-dollar borrowing again in the second year, retention of the
historical base would save it roughly 1 percentage point (assuming
market rates on alternative sources of funds of roughly 10 per cent)
on those expected Euro-dollar borrowings of $40 million for a year--
that is, about $0.4 million.
Under these circumstances, the bank would doubtless decide
that the investment of $0.4 million to retain the historical base was
worthwhile, since the investment required to retain the historical
base might well yield returns beyond the second year as well as the
return of $0.4 million in that year. But, if the bank had only a
relatively remote expectation of using Euro-dollar borrowing in the
second year--perhaps only a 50 per cent chance--then the expected
return would be less: if the bank weighted the return by the proba-
bility, the return might be estimated at $0.2 million. Under these
circumstances, the bank might decide that the immediate cost of
retaining the historical base was too high.
&
FORD
GERALD
144.
Mr. Robert Solomon
-5-
CONFIDENTIAL (FR)
An amendment of the automatic downward adjustment feature
that would permit Bank A to reduce borrowings to 80 per cent of its
historical base, without loss of any part of that base, would reduce
the cost to the bank of retaining the full historical base. It thus
might induce the bank to cut its Euro-dollar borrowings to $80 mil-
lion, rather than going all the way down to $60 million. If the bank
reduced its borrowings to $80 million, the cost of retaining the
reserve-free historical base would be $0.2 million (1 percentage
point applied to the $20 million of Euro-dollar borrowings retained
for the purpose of holding the historical base.) The expected benefit
from possible future use of the historical base would be unaffected.
If one were sure that, in the absence of an amendment of
the automatic downward adjustment feature, bank A would reduce its
Euro-dollar borrowings to $60 million--and that other banks would
soon follow-there would probably be a balance of payments saving
to be obtained from amendment of the automatic downward adjustment.
In the above case, the saving would be $20 million for Bank A.
If the process of repayment of Euro-dollar borrowings in-
volved a reduction in Euro-dollar interest rates, as it would after
some point if banks generally were making repayments, the cost
calculation under both the present and the possible amended version
of the lock-in effect would be altered, but the changes would be
symmetrical in the two cases.
However, in the case where borrowings are not reduced to
the level sanctioned by an amended lock-in effect, the cost calcu-
lations confronting an individual bank are different. Declines in
Euro-dollar interest rates that might be sufficient to cause a bank
to cease making repayments under present regulations would not
necessarily cause it to cease repayments under an amended lock-in
effect. Thus, the potential repayment under an amended lock-in
effect could well be larger than that under present regulations if
the process of repayment resulted in relative declines in Euro-dollar
rates. An illustration follows:
Under present regulations, a relative decline in Euro-dollar
interest rates lowers the cost to Bank A of retaining part of its base,
without affecting the potential benefits of the reserve-free base. At
some point--e.g. a reduction to 1/2 percentage point in the margin of
Euro-dollar rates over alternative domestic rates--the expected cost
of retention of the base would be reduced sufficiently to cause the
bank to cease repayment.
FORD is LIBRARY QERALD
Mr. Robert Solomon
-6-
CONFIDENTIAL (FR)
However, under the possible amendment to the lock-in
effect, there is no benefit to the bank in maintaining Euro-dollar
borrowings above the lowest level to which they may be reduced
without loss of any part of the historical base. Hence Bank A
would cut its borrowings to 80 per cent of its base unless Euro-
dollars actually became cheaper than alternative sources of funds.
Its repayments could well be larger than under present regulations.
Moral suasion. Given uncertainty as to the significance
of the changed cost-benefit calculations resulting from a modest
amendment of the lock-in effect (sanctioning reductions of borrow-
ings to 90 per cent of the historical base) -and of the large balance
of payments impact of a substantial amendment (sanctioning reductions
to 80 per cent of base) it appears that the prospects for success of
an amendment of the lock-in effect would be greatest if coupled with
moral suasion. The amendment would represent a quid pro quo for bank
restraint in repaying borrowings.
It is hard to evaluate the prospects for success of moral
suasion under these conditions. Banks that have already scheduled
repayments (as well as other banks) might well argue that the quid
pro quo was inadequate. Banks might also take the fact that the
Board proposed an amendment (to 90 per cent of base) as an indication
that the Board might progressively reduce this percentage, and they
might try to force the Board's hand in this matter by continuing to
make repayments.
On the other hand, if banks viewed the process of relinquish-
ing reserve-free bases as a case of oligopolistic competition, they
might welcome the certainty provided by a Board amendment of the lock-
in effect accompanied by moral suasion. In the absence of Board
"supervision" of an orderly reduction in borrowings, many or most
individual banks may want to avoid leading the parade, in the process
reducing the costs to their competitors of maintaining their reserve-
free bases intact. If many banks take this view, Board action,
including moral suasion, might be successful in limiting a reduction
in borrowings to a specified amount--but that amount might be greater
than banks would in fact repay if the Board retained the present
version of the lock-in effect and the banks had to operate in a
climate of greater competitive uncertainty.
FORD & LIBRARY GERALD
Mr. Robert Solomon
-7-
CONFIDENTIAL (FR)
Other considerations
An amendment of the lock-in effect would involve some
potential costs, in addition to those that might arise as a result
of the balance-of-payments impact of the measure. The amendment
should be evaluated against a long-term objective of placing all banks
on the same footing with respect to reserve-free liabilities--and pro-
bably ultimately eliminating all reserve-free bases--as soon as this
could be achieved without sacrificing an important policy goal. The
Board has no reason to provide large money market banks with "permanent"
reserve-free bases, apart from balance-of-payments objectives. Thus, a
reduction in borrowings of $2 billion that resulted from failure of the
Board to take action (and that resulted in a corresponding reduction in
reserve-free bases of the banks involved) would clearly be preferable
to a reduction of $2 billion under an amended lock-in effect that left
the historical bases intact.
Because the amendment in question can be justified only by
its possible balance-of-payments impact--and is otherwise inconsistent
with long-term Board objectives-- the Board would want to be reasonably
sure that the amendment would be effective before proposing it.
BERALD R.FORD LIBRARY
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
DATE
10/22/70
Chairman Burns
TO
FROM ROBERT SOLOMON
Here is a more complete analysis
of the costs to banks of retaining
Eurodollar liabilities. Some of the
numbers in the earlier preliminary paper
I gave you have been revised.
RS
Attachment.
FORD is LIBRARY GERALT
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
Office Correspondence
Date October 19, 1970.
To
Mr. Robert Solomon
Subject: Estimates of Gross Interest Costs
From
Robert Bradshaw
to Banks of Retaining Historical Bases
Our intention here is to arrive at a rough approximation
of the amount by which the 17 banks may expect their total interest
expenses to be increased over the course of the next year under the
assumption that they retain their current historical bases (rather
than substituting lower cost domestic sources of funds for Euro-
dollars). Basically, the costs are calculated as the product of
a) various cost differentials (between Euro-dollars and domestic
sources of funds) which the banks might expect to prevail, on average,
over the course of a one year period and b) various amounts by which
the banks' might have expected to reduce their reserve-free bases in
the absence of loss-of-base considerations. For example, assume that
Bank A now has a reserve-free base of $1.0 billion and concludes (in
view of its expectations about various developments in foreign and
domestic money markets) that, were it not for the loss of base, it
FORDO is LIBRARY GERALD
would probably reduce its reserve-free base to $0.5 billion and esti-
mates that the average differential between the cost of Euro-dollars
and the cost of domestic alternatives during the year to come will
be 3/4 per cent. Under these assumptions the bank's estimate of the
marginal cost of retaining its reserve-free base would be equal to 3/4
per cent of $0.5 billion, or $3.75 million.
Which, of course, would influence the probable level of reserve-free
base calculation.
-2-
It should be emphasized that we are referring to expected
costs as of the present time. Whether or not these expected costs
will be realized is another matter, about which we can say very little.
We are not trying to predict what the banks will do -- we are only
trying to establish a reasonable range of estimates of the expected
costs, as seen by the banks at this time, of retaining their bases.
We do, however, compare various expected cost estimates with data on
individual bank net operating income to try to determine the order of
significance of these costs to the bank's overall profit picture.
These comparisons may give some indication which of the banks may
be likely to consider the cost of retaining their bases to be
excessive.
Some largely arbitrary judgments must be made about the
two elements in the cost calculation referred to above -- the amount
(or per cent) of Euro-dollar liabilities that the bank would expect to
replace with domestic funds were no loss of base incurred and the
expected average cost differential between the alternative sources of
funds.
The former we will refer to as "excess Euro-dollars" and the
latter simply as the "cost differential." In the examples given we assume
the banks' estimates of "excess Euro-dollars" to range from 50 per cent
of the current base to 25 per cent of the current base. The latter
We assume, in effect, dollar for dollar substitution of domestic
funds for Euro-dollars and no change in the size of total assets and
liabilities.
FORD & LIBRARY GERALD
-3-
percentage, we believe, is probably more realistic than the former.
First National City of New York, in confidence, "projected" a
50 per cent reduction, but the other banks with whom discussions
were held were speaking in the 15 per cent to 30 per cent
range. These projections, however, were only for the balance of this
year, and not a full year ahead. Moreover, these projections may not
be a good proxy for these banks' estimates of their "excess Euro-dollars"
in that they may still expect future benefits from retaining at least
part of their current bases.
Regarding the expected "cost differential", the cost
calculations (presented in the table) assume a 1/2 per cent differential
between expected Euro-dollar cost and domestic funds cost. Various
other differentials may be assumed; cost calculations for alternative
differentials can be readily made from the 1/2 per cent calculation.
The table shows, for example, that Bankers Trust Co. currently
has a reserve-free base of $0.8 billion. Assuming this bank to estimate
that 50 per cent of this amount ($0.4 billion) represents "excess Euro-
dollars" and that this bank expects the "cost differential" to average
1/2 per cent over the next year, then it's expected addition to total
costs (before taxes) of retaining its base is about $2.0 million. After
tax cost, assuming a 50 per cent tax bracket, would be about $1.0 million.
Bankers Trust Co. in 1969 had net operating earnings 1/ of about
1/ After taxes, but before adjustment for capital losses or gains
realized on security holdings.
FORD is LIBRARY GERALD
-4-
$42 million. Thus, in this example, this bank's estimated expected
cost of retaining its reserve-free base is about 2.4 per cent of
after tax profits.
Although a 1/2 per cent "cost differential" is
employed in the table we have no strong factural or a priori
basis for assuming this to be representative of the differential
the banks may expect over the course of the year to come. Expectations,
no doubt, differ considerably between the banks. The cost differential
between three-month Euro-dollars and 60-89 day CDs (adjusted for
the cost of reserve requirements against the latter) was about zero,
on average, in August, 1970. This differential widened to well over
100 basis points in late September and early October (primarily as a
result of rapidly declining CD offer rates, while Euro-dollar rates
remained fairly constant). But in recent days this differential has
narrowed to about 80 basis points, as Euro-dollar rates have eased
rather markedly.
The differential between shorter maturities of Euro-dollar
and domestic sources of funds has narrowed even moreso in recent days.
The one-month Euro-dollar rate is now under 7 per cent--roughly 1/4 per
cent above the (adjusted) cost of 30-59 day CD funds to U.S. banks;
and the excess of the call Euro-dollar rate over Federal funds has
vanished in the last couple of days. The recent narrowing of the above
differentials -- again, primarily a result of a rapid decline in
FORD & GERALD LIBRARY
-5-
Euro-dollar rates--may or may not be a temporary phenomena, depending
largely upon the reasons behind the decline in Euro-dollar rates.
There is evidence that a rather marked easing in conditions in certain
foreign money market has contributed to the decline, but this may
be a temporary development. If this decline in Euro-dollar rates also
reflects, or primarily reflects, a decision by U.S. banks to give up
part of their reserve-free bases the rate decline may be more permanent,
and the banks using historical bases may revise their expectations about
the costs of retaining these bases.
Attachment
cc: RFG, JER, Fred Dahl, BB, RWS.
LIBRARY GERALD R. FORD
Estimated Costsof Retaining the Current Reserve-free Historical Base,
for 17 Banks, Under Selected Assumptions
After tax cost 4/ as a
Net
percent of Net Operating
Reserve-
Per annum cost (millions of $)
Operating
Earnings at a 1/2% "cost
free Basel /
at a 1/2% "cost differential",
Earnings 3/
differential", at various
(millions
assuming various ratios of
(millions
ratios of "Excess Euro-
Bank
of dollars)
"Excess Euro-dollars" to current bases 2/
of dollars)
dollars' to current base.
50%
25%
50%
25%
First Natl., Boston
448
1.12
0.56
38.8
1.4
0.7
State Street Bank
25
0.07
0.04
9.6
0.4
0.2
Bank of New York
79
0.20
0.10
17.4
0.6
0.3
Bankers Trust
811
2.03
1.01
42.2
2.4
1.2
Chase Manhattan
2,239
5.60
2.80
119.5 /
2.3
1.2
Chemical
853
2.14
1.07
67.3 /
1.6
0.8
First Natl. City, N.Y.
1,453
3.63
1.82
112.8 **/
1.6
0.8
Irving Trust Co.
723
1.81
0.90
23.7
3.8
1.9
Mfg. Hanover
584
1.46
0.73
68.5 /
1.1
0.5
Marine Midland
270
0.68
0.34
13.8
2.5
1.2
Morgan Guaranty
1,250
3.13
1.56
78.1 /
2.0
1.0
Provident, Phil.
21 /
0.05
0.03
8.9 /
0.3
0.2
Mellon
176
0.44
0.22
46.9
0.5
0.2
Union Bk., L.A.
94 /
0.24
0.12
13.1
0.9
0.5
Bank of America
678 /
1.70
0.85
146.1
0.6
0.3
First Natl. Chicago
348
0.87
0.44
50.8 /
0.9
0.4
Continental I11.
670
1.68
0.84
52.7
1.6
0.8
Total
10,721
26.85
13.43
1/ In the computation period ended September 30, 1970,
After taxes but before gains or losses
except those footnoted which are for the previous
realized on security transactions; annual for
computation period.
1969 or 1968 (marked with an asterisk),
or
2/ The cost calculated for a 50% ratio of "Excess Euro-
1967 (marked with a double asterisk).
Source:
dollars" to current base, for example, assumes that the bank
Moody's Bank and Finance Manuel, April 1970.
expects that it would--were loss of base considerations not
relevant--replace 50% of its Euro-dollar reserve-free base
average, over the course of the next year. See text for a
FORD & LIBRARY GERALD
Data are for bank operations, rather than for
parent holding company.
with domestic sources of funds expected to cost 1/2% less, on
4/ Assuming a 50% tax bracket for simplicity.
more complete discussion.