In this essay we will discuss about Euro Currency Market. After reading this essay you will learn about:- 1. Meaning of Euro Currency Market 2. Origin and Growth of Euro Currency Market 3. Features 4. Functioning 5. Role in International Financial System 6. Effects.
- Meaning of Euro Currency Market
- Origin and Growth of Euro Currency Market
- Features of Euro Currency Market
- Functioning of Euro Currency Market
- Role of Euro Currency Market in International Financial System
- Effects of Euro Currency Market
Essay # 1. Meaning of Euro Currency Market:
Euro-currency is a currency held by individuals and institutions in a European country other than its country of origin. It is accumulated in European banks that deal in other currencies such as American dollar, Japanese Yen, Swiss Francs, etc.
This market is the largest market in the international monetary system. It has been playing a central role in short and medium term international borrowing and lending by large corporations and banks and for financing international trade.
Essay # 2. Origin and Growth of Euro Currency Market:
The origin of the Euro-currency market can be traced back to the 1920s when the US dollars were deposited in the European banks which converted them into their local currencies for lending purposes. But the real growth of the Euro-currency market began after the Second World War.
The following factors led to its growth:
1. Flow of US Aid:
The United States emerged as the most powerful nation in the post-war period which spent huge sums of money on the rehabilitation of Europe both in terms of economic and military aid. This led to the transfer of a large number of dollars in Euro-banks.
2. Cold War:
The cold war which started in the 1950s led the Soviet Union and the East European government to transfer their dollar deposits from America to Euro-banks for fear that they might be blocked by the American Government.
3. Decline in the Importance of Sterling:
In the post-war period Britain emerged as a debtor country. Consequently, the British sterling which had dominated the international financial market in the pre-war era gave place to the dollar in the post-war period. The importance of sterling further fell when the British Government placed severe restrictions on the grant of sterling to central banks outside the sterling area under the British Exchange Control Act in the early post-war period.
Regulation-Q of the US Federal Reserve System had been a major factor which gave rise to the Euro-currency market in the late 1960s. Under Regulation-Q, a ceiling was imposed on the interest rate payable on time deposits with the US banks and it prohibited the payment of any interest at all on deposits up to 30 days.
This encouraged the US banks to open branches in Europe and attract dollar deposits to be used for financing international trade. In particular, this happened in 1968 and 1969 and again from 1979 onwards when the Regulation-Q ceiling kept low interest rates on time deposits.
Consequently, both the US citizens and foreigners having dollars in excess of their transactions requirements transferred them in Euro-banks because they paid higher interest rate than the US banks. This also encouraged European lenders and borrowers to trade in dollars and their currencies in London and other European financial markets rather than in New York.
5. Other US Measures:
There were some other measures which hampered the capacity of US banks to compete for international business including curbs on the release of taxes on profits earned by foreigners in the United States, the introduction of the Interest Equalisation Tax in 1964, controls over the US direct investment abroad, and tight monetary policy to control inflationary pressures. These led to heavy borrowing by US banks from the Euro-currency market to meet the demand for dollars in the US.
6. BOP Deficits in US:
There have been large and persistent BOP deficits in the US thereby leading to the outflow of the US dollars to the Euro-banks in countries having surplus with it.
The increase in the oil prices since 1973 has resulted in the tremendous increase in the incomes of the oil producing countries of the world which are known as petro-dollars. These are deposited in Euro-banks. These have further expanded the Euro-currency market.
8. Innovative Banking:
Because of special circumstances that were present in the 1950s, there came into being a banking system distinct from but supplementary to the banking system of Europe. Like any other banking system, its elements consisted of reserves, deposits and loans, in US dollars and other currencies and recorded in Euro-banks.
Consequently, the Euro-currency market has grown rapidly, in which deposits are received and loans made in currencies other than that of the country in which the market is situated. Now the Eurocurrency market dominates international transactions and traditional foreign banking accounts of international banking.
Essay # 3. Features of Euro-Currency Market:
The Euro-currency market has the following features:
1. International Market:
The Euro-currency market is an international market which accepts deposits and gives credit in currencies from throughout the world.
2. Independent Market:
It is a free and independent market which does not function under the control of any monetary authority.
3. Wholesale Market:
It is a wholesale market in which different currencies are bought and sold usually above $ 1 million.
4. Competitive Market:
It is a highly competitive market in which the supply and demand for currencies depends on interest rate changes of Euro-banks.
5. Short-Term Market:
It is a short-term money market in which deposits in different currencies are usually accepted for a period ranging from a few days to a year and interest is paid on them.
6. Inter-Bank Market:
It is an inter-bank market in which the Euro-banks borrow and lend dollars and other Euro-currencies from each other.
Essay # 4. Functioning of Euro Currency Market:
The Euro-currency market is very extensive and complex. It is a means of transferring short-term and medium-term funds from one country to another. Euro-currency deposits and loans expand whenever funds flow into the Euro-banks as deposits from (i) commercial banks or residents of the United States; (ii) transfers by commercial banks or residents of other countries; and (iii) central banks, either directly or through the Bank for International Settlements.
The first type of flow from the United States can be caused by one or more of the following factors:
(1) A fall in US interest rates relative to Euro-currency rates;
(2) An increased desire for asset diversification;
(3) A fall in covered yield of foreign assets; or
(4) An expected appreciation of the US dollar.
The flow of Euro-currency from commercial banks or residents outside Europe involves a portfolio shift out of domestic currency assets into Euro-currency. Moreover, many central banks also redeposit a substantial proportion of their reserve gains in the Euro-market.
The Euro-market is connected closely to the foreign exchange market because banks are able to manage their foreign currency positions in two ways:
(1) They can buy and sell currencies outright in the spot and forward exchange markets.
(2) They can borrow and lend currencies in the interbank market. However, many Euro-currency loans are made to non-bank borrowers also, Let us analyse the functioning of the Euro-market.
Suppose that a bank in London acquires dollar-deposits on a New York bank. If the London bank simply keeps these deposits, no Euro-dollars are created. But if this bank lends these dollars to some individual at interest rate, it creates dollar deposit claims against itself.
These claims are Euro-dollars which the hank in London has created in excess of what it holds on a New York bank. Thus the ultimate increase in Euro-market aggregates will not be identical to initial deposit inflows because there are always subsequent flows induced by interest differentials and portfolio adjustments.
The above process of credit creation in the Euro-market has led economists to use the credit-multiplier analysis to explain its behaviour. Given the initial levels of US and foreign interest rates, this multiplier is always less than 1. This is because an initial deposit inflow of, say, $ 100 will encourage dollar rates to fall relative to foreign rates.
This will, in turn, lead to a leakage in the original inflow. Moreover, the Euro-market is very vast and unregulated. Therefore, it does not operate like the ordinary banking system. Last but not the least, the multiplier analysis is essentially a tool for examining a credit creation in a closed economy, whereas the Euro-market is an open market. This fact severely limits the usefulness of the credit multiplier as a method for expanding the growth of the Euro-currency market.
Essay # 5. Role of Euro Currency Market in International Financial System:
The Euro-currency market has been playing an important role in international financial system. Investing and borrowing US dollars is the core function of the Euro-currency market. It transfers short and medium terms funds throughout the world, thereby increasing international capital mobility. It not only enables individual banks to improve their portfolio allocation, but also provides important services to the non-bank private sector.
The Euro-currency market attracts funds because it offers higher interest rates, greater flexibility of maturities, and a wider range of investment qualities than other short-term capital markets. It attracts borrowers because it lends funds at relatively low interest rates.
It is competitive in the interest rates it charges and receives, both because of the economies of scale afforded by concentrating on wholesale transactions, and because the Euro-banks are not subject to the regulations which tend to raise costs in domestic banking. Commercial banks, central banks, government treasuries, international banks like the Bank of International Settlement, and multinational corporations are the borrowers and lenders in the Euro-currency market.
Essay # 6. Effects of Euro Currency Market:
The following have been the economic consequences of the Euro-currency market:
1. The expansion of the Euro-currency market has greatly increased international capital mobility and has helped in easing the global liquidity problem.
2. It has helped in integrating international capital markets.
3. It has played an effective role in recycling funds from countries having surplus balance of payments to those having deficit balance of payments.
4. International flows of Euro-currencies have improved economic efficiency by reducing interest differential among nations.
5. The Euro-currency market has also resolved the problems of countries whose policy objectives aim at controlling international capital movements by transferring their currencies from and to Euro-banks.
6. It has helped in financing BOP deficits and surpluses of countries through lending and borrowing their currencies in exchange for other currencies from the Euro-currency market.
However, these flows of Euro-currencies have three adverse effects:
First, when the monetary authority of a country is trying to curb inflation through a restrictive monetary policy, an inflow of short-term capital defeats such a policy. Again when there is an outflow of capital and the country is following an easy monetary policy to combat unemployment, such a policy again becomes ineffective. This is because the Euro-currency market does not operate under the regulations of any authority.
Second, Euro-currencies provide an enoromous fund of liquid resources which are used for speculative capital movements. These expose the economies of the concerned countries to severe strains of sudden and large withdrawals of credits. Such financial upheavals and disturbances also affect the international monetary system as a whole, especially when the countries involved are not protected by exchange controls or trade barriers.
Third, according to Milton Friedman, “The Euro-currency market has almost surely raised the world’s nominal money supply (expressed in dollar equivalents) and has thus made the world price level (expressed in dollar equivalents) higher than otherwise it would be.”