Transcript Chapter 9

International Financial Markets
Prices and Policies
Second Edition ©2001
Richard M. Levich
9

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The Eurocurrency Market
9-2
Overview
 Historical Overview
The Origins of Supply and Demand for Offshore
Banking
 Onshore Banking Regulations Boost the Offshore
Market
 The Offshore Markets Endure
 Growth of the Eurocurrency Market

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9-3
Overview
 Pricing Of Eurocurrency Deposits and Loans
Pricing in the Case of One Currency and Two
Financial Centers
 Can Offshore and Onshore Markets Coexist?
 The Impact of Capital Controls and Taxes
 Market Share and Pricing in Competing Offshore
Centers
 The General Case with Many Currencies and Many
Financial Centers

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9-4
Overview
 Policy Matters - Private Enterprises
Concerns of Depositors
 Concerns of Borrowers

 Policy Matters - Public Policymakers
Offshore Markets and Macroeconomic Stability
 Could the Offshore Markets Expand Indefinitely?
 Approaches to Regulating Offshore Markets
 Competing for Markets: U.S. Policy Initiatives
 Offshore Markets: European Policy Concerns

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9-5
The Eurocurrency Market
 The Eurocurrency market is the market for
deposits placed under a regulatory regime
different from the regulations applied to
deposits used to execute domestic transactions.
 It owes its existence to differences in national
financial regulation combined with declining
barriers to international capital movements.
 In effect, it is a parallel market in competition
with the traditional domestic market.
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9-6
Sectors of the International Money Markets
Currency Dimension
£
US$
Onshore
Regulatory
Dimension
Offshore
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U.S. bank deposit
U.S. Treasury bills
and bonds
U.S. corporate
bonds
U.K. bank deposit
U.K. government
bonds
U.K. corporate
bonds
Euro-$ deposit
Euro-$ bond
(corporate and
sovereign
issuers)
Euro-£ deposit
Euro-£ bond
(corporate and
sovereign
issuers)
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The Origins of Supply and Demand for
9-7
Offshore Banking
 The Eurocurrency market evolved through a
combination of forces.
 The supply and demand for Eurodollars had
always been present. The innovation came in
the mid-1950s when banks elected to lend these
funds within Europe rather than invest them in
the U.S. money market.
 The demand for Eurodollars further multiplied
when the Bank of England restricted the
external use of sterling in 1957.
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Onshore Banking Regulations
9-8
Boost the Offshore Market
 Under Regulation Q, the Federal Reserve
established ceilings on the interest rate that
banks could pay on deposits.
 To reduce the U.S. capital outflow, more
regulations were imposed in the 1960s:
The Interest Equalization Tax (IET) taxes U.S.
purchases of foreign securities.
 The Foreign Credit Restraint Program limits the
volume of bank lending with foreigners.

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Onshore Banking Regulations
9-9
Boost the Offshore Market
 However, these regulations only further
encouraged borrowers to investigate the
Eurocurrency markets.
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Onshore Banking Regulations
9 - 10
Boost the Offshore Market
 European governments also experimented with
capital controls in the 1970s.

Both Germany and Switzerland imposed regulations
to try to limit the nonresident demand for their
currencies.
 Similarly, these regulations helped to promote
the non-dollar segments of the Eurocurrency
market.
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9 - 11
The Offshore Markets Endure
 Even though many of the regulations that
initially fostered the market had since been
abolished, the Eurocurrency markets have
continued to grow and prosper.
 Today, we describe the innovation that permits
the Eurocurrency market to sustain its existence
as “unbundling” - taking the exchange risk of
one currency and combining it with the
regulatory climate and political risk of another
financial center.
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9 - 12
Growth of the Eurocurrency Market
 As in the onshore markets, funds are deposited,
lent, re-deposited, and re-lent in the
Eurocurrency market.
 The market has grown from essentially zero in
1960 to roughly $9.5 trillion on a gross basis
and $5.5 trillion on a net basis in 1999.
 The U.S. dollar is the main currency, while
Europe is the dominant region for Eurocurrency
deposits.
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Pricing of
9 - 13
Eurocurrency Deposits and Loans
 Consider the case of one currency (the U.S.
dollar) and two financial centers (New York and
London).
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9 - 14
Pricing of
Eurocurrency Deposits and Loans
In the onshore market ...
Interest
Rates
The demand (D ) for funds while the supply (S )
depends on the required rate of funds depends on
of return on available
individuals’ rates
projects,
of time preference.
RL
When banks incur costs X,
equilibrium deposit rate =
RD, lending rate = RL,
market size = Q.
RD
X
D
In the absence
of transaction costs,
the equilibrium is at A.
Q
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A
S
Quantity
of Funds
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Pricing of
9 - 15
Eurocurrency Deposits and Loans
In the offshore market ...
Since RD can be earned
in the onshore market,
Eurobanks incur cost X* < X , the supply curve to the
Interest resulting in offshore deposit offshore market (S* )
Rates
rate RD*, lending rate RL*,
will begin at RD.
market size Q*.
S*
RL
S
RL*
A
X
X*
RD*
D
RD
Similarly, the
D*
demand curve for
offshore funds (D*)
must begin at RL. Quantity
Q* Q
of Funds
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Pricing of
9 - 16
Eurocurrency Deposits and Loans
 The relationships among onshore and offshore
interest rates are : RL  RL*  RD*  RD
 In other words, for US$ :
London
London
New York
New York
lending rate > Interbank > Interbank > deposit rate
Offered Rate
Bid Rate
(“Prime”)
(LIBOR)
(LIBID)
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9 - 17
Pricing of
Eurocurrency Deposits and Loans
Onshore and Offshore Deposit and Borrowing Rates
Percentage per Annum as of June 20, 2000
Prime
Offshore
Offshore Onshore
Lending Borrowing
Deposit
Deposit
Rate
Rate: LIBOR Rate: LIBID Rate
*)
*)
(RL)
(RL
(RD
(RD)
Canada
Euro Area
Japan
Switzerland
United Kingdom
United States
7.50
NA
1.375
4.75
7.00
9.50
5.9063
4.5313
0.1875
3.4375
6.1875
6.8125
5.8125
4.4375
0.0938
3.3125
6.0313
6.6875
3.70
3.04
0.03
3.29
6.00
5.99
Note: Prime lending rates may not be comparable as lending practices may vary
across countries. LIBID, LIBOR, and deposit rates are for three-month maturities.
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9 - 18
Can Offshore and Onshore Markets Coexist?
 If the offshore market provides a similar service
at a lower cost, what prevents all onshore
transactions from migrating there?
Offshore depositors bear the additional risk of
exchange controls or taxes, plus the inconvenience
of having deposits outside their home country.
 For borrowers, size and credit quality may act as
barriers that restrict some firms from access to the
offshore market.

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9 - 19
The Impact of Capital Controls and Taxes
 When capital controls are present, the
inequality RL  RL*  RD*  RD may be affected.
 When there are controls on the movement of
funds into the onshore market, it is possible
*
that RD  RD .
 When interest rate ceilings or central bank
lending guidelines lead to a shortage of funds,
borrowers may be prepared to pay RL*  RL .
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Market Share and Pricing
9 - 20
in Competing Offshore Centers
 Consider the case of one currency (the U.S.
dollar) and several offshore centers (London,
Frankfurt, Singapore, and Beijing).
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Market Share and Pricing
9 - 21
in Competing Offshore Centers
Interest
Rates
*
SBeijing
RL
The supply of funds to each offshore
center depends on the assessed costs
and risk of using the center.
*
SSingapore
*
SFrankfurt
S*
London
8.25%
Then for London,
deposit rate = 8.00%,
lending rate = 8.25%,
market size = QA.
Once the most
D*
efficient and least
The demand for
risky center has set
offshore dollars
the price, the others
must follow suit.
X*
8.00%
RD
Suppose
each center
incur cost X*
= 0.25%.
QD QC QB
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QA
Quantity of Funds
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The General Case with Many Currencies
and Many Financial Centers
9 - 22
regulatory costs and political risk vary
United
States
NY US$
US$ NY IBF US$
UK£ NY IBF £
€
NY IBF €
SFr NY IBF SFr
S$
United
Kingdom Germany Switzerland Singapore
London
US$
London
£
London
€
London
SFr
London
S$
Frankfurt
US$
Frankfurt
£
Frankfurt
€
Frankfurt
SFr
Zurich
US$
Zurich
£
Zurich
€
Zurich
SFr
Zurich
S$
Singapore
US$
Singapore
£
Singapore exchange
€
risk vary
Singapore
SFr
Singapore
S$
Real
Rio Real
Onshore market
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Brazil
Offshore market
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9 - 23
Arbitrage and Interest Rate Parity
 The interest rate differential between an
onshore market and an offshore market has
been analyzed using a loanable funds approach.
 Arbitrage and regulatory competition should
keep the offshore interest rates for a single
currency nearly equal.
 The interest rate differential between offshore
instruments should conform to the interest rate
parity condition.
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9 - 24
Policy Matters - Private Enterprises
 Depositors are concerned about the riskiness of
offshore deposits.
If a dispute arises between the depositor and the
bank in a cross-border transaction, it is difficult to
know in advance which country will claim
jurisdiction and which legal precedents apply.
 A further complication concerns whether the
offshore bank is organized as a separate subsidiary
or a branch of the parent bank.

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9 - 25
Policy Matters - Private Enterprises

The simple distinction between assets and liabilities
in banking frequently offers a useful guide for
sorting out the complex legal issues that arise in a
cross-border banking dispute.
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9 - 26
Policy Matters - Private Enterprises
 Borrowers are primarily concerned about the
costs of borrowing onshore versus offshore.
Note that the reference rate (prime or LIBOR) is
only one element in the overall cost of bank
funding.
 Borrowers may need to post some form of collateral
(often in the form of compensating balances), pay a
multiple of the reference rate or an additional x %,
and/or put forward a lump-sum up-front fee.

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9 - 27
Policy Matters - Private Enterprises
 Borrowers also need to deal with the interest
rate risk that is associated with floating-rate
Eurocurrency loans.

Borrowers may choose to hedge this risk using
Eurodollar interest rate futures contracts or interest
rate swaps.
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9 - 28
Policy Matters - Public Policymakers
 For some offshore financial centers, the rise of
the Eurocurrency market has been an important
boost to employment and economic activity.
 For some major industrial countries, the rise
was perceived as a threat to their ability to
control macroeconomic conditions within their
borders, and perhaps even as a threat to the
fundamental safety and soundness of the
financial system.
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9 - 29
Policy Matters - Public Policymakers
 With the passage of time, most of these fears
have been put to rest, either through new policy
agreements or a better understanding of how the
Euromarkets operate.

Even though the Eurocurrency market has no
required reserves, the interaction of supply and
demand for funds means that “the specter of
uncontrolled credit expansion, made possible by an
infinite [deposit] multiplier, is illusory.”
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9 - 30
Policy Matters - Public Policymakers
 The Eurocurrency markets are now
acknowledged as being fully competitive with
the traditional onshore banking system.
 Policymakers have thus opted to factor in the
Euromarkets when setting domestic monetary
and financial policies.

Eurocurrency interest rates are closely linked to
those in the domestic money markets of the same
currency because the two kinds of deposits are
reasonably close substitutes for each other.
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9 - 31
Policy Matters - Public Policymakers
 In the Basle Concordat (1974), the United
States and 30 other countries agreed to assume
lender-of-last-resort responsibility for their
offshore banks.
 In 1980, the Bank for International Settlements
(BIS) announced an agreement among central
banks requiring commercial banks
headquartered within their territories to
consolidate their worldwide accounts.
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9 - 32
Policy Matters - Public Policymakers
 In some cases, policymakers have elected to
adapt their local regulations to compete head-on
with the Euromarkets too.
In 1981, the Federal Reserve Board amended its
regulations to allow the creation of International
Banking Facilities (IBFs).
 In effect, the IBF legislation creates an offshore
banking environment located physically within the
United states, although there are import restrictions
on their operations.

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9 - 33
Policy Matters - Public Policymakers
 To create a level playing field in financial
services, the European Union (EU) has sought
to harmonize rules on withholding taxes and the
disclosure of interest paid to depositors and
shareholders.

Such a policy will be detrimental to Luxembourg,
which generates 20% of its GDP from its attractive
financial services. But there can also be a wider
impact on the cost of capital for EU firms.
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