Comprehensive Essay on Euro-Dollar Market in the International Financial System

1. Prelude :

Though, the emergence of Euro-dollar in the international financial system is of recent origin, late in the sixties, it has caused a profound influence upon the money and capital markets of the Western World. Presently, however, the Euro-dollar Market has become a permanent integral part of the international monetary system.

2. The Meaning of Euro-dollar :

By Euro-dollars is meant all U.S. dollar deposits in banks outside the United States, including the foreign branches of U.S. banks. A Euro-dollar is, however, not a special type of dollar. It bears the same exchange rate as an ordinary U.S. dollar has in terms of other currencies.

Euro-dollar transactions are conducted by banks not resident in the United States. For instance, when an American citizen deposits (lends) his funds with a U.S. Bank in London, which may again be used to make advances to a business enterprise in the U.S., then such transactions are referred to as Euro-dollar transactions. All Euro-dollar transactions are, however, unsecured credits.

Euro-dollars have come into existence on account of the Regulation issued by the Board of Governors of the U.S. Federal Reserve System, which does not permit the banks to pay interest to the depositors above a certain limit. As such, banks outside the United States tend to expand their dollar business by offering higher deposit rates and charging lower lending rates, as compared to the banks inside the U.S. Increase or decrease in the potential for Euro-dollar holdings, however, depends directly upon U.S. deficits and surpluses, respectively.

3. Euro-dollar Market :

Euro-dollar market is the creation of the international bankers. It is simply a short term money market facilitating banks’ borrowings and lendings of U.S. dollars. The Euro-dollar market is principally located in Europe and basically deals in U.S. dollars. But, in a wider sense, Euro-dollar market is confined to the external lending and borrowing of the world’s most important convertible currencies like dollar, pound, sterling, Swiss franc, french Franc, Deutsche mark and Netherlands guilder.

In short, the term Euro-dollar is used as a common term to include the external markets in all the major convertible currencies.

Euro-dollar operations are unique in character, since the transactions in each currency are made outside the country where that currency originates.

The Euro-dollar market attracts funds by offering high rates of interest, greater flexibility of maturities and a wider range of investment qualities.

Though, Euro-dollar market is wholly unofficial in character, it has become an indispensable | part of the international monetary system. It is one of the largest markets for short-term funds.

The Euro-dollar market has the following characteristics:

1. It has emerged as a truly international short-term money market.

2. It is unofficial but profound.

3. It is free.

4. It is competitive.

5. It is a more flexible capital market.

Original customers of the Euro-dollar market were the business firms in Europe and the Far East which found Euro-dollars cheaper way of financing their imports from the United States, since the lending rates of dollars in the Euro-dollar market were relatively less.

The Euro-dollar market has two facets:

(i) It is a market which accepts dollar deposits from the non-banking public and gives credit in dollars to the needy non-banking public.

(ii) It is an inter-bank market in which the commercial banks can adjust their foreign currency position through inter-bank lending and borrowing.

The existence of Euro-dollar market in a country, however, depends on the freedom given to the commerical banks to hold, borrow and lend foreign currencies – especially dollars – and to exchange them at fixed official exchange rate.

4. Benefits of the Euro-dollar Market :

Following benefits seem to have accrued to the countries involved in the Euro-dollar market:

1. It has provided a truly international short-term capital market, owing to a high degree of mobility of the Euro-dollars.

2. Euro-dollars are useful the financing of foreign trade.

3. It has enabled the financial institutions to have greater flexibility in adjusting their cash and liquidity positions.

4. It has enabled importers and exporters to borrow dollars for financing trade, at cheaper rates than otherwise obtainable.

5. It has helped in reducing the profit margins between deposit rates and lending rates.

6. It has enhanced the quantum of funds available for arbitrage.

7. It has enabled monetary authorities with inadequate reserves to increase their reserves by borrowing Euro-dollar deposits.

8. It has enlarged the facilities available for short-term investment.

9. It has caused the levels of national interest rates more akin to international influences.

5. Effects of Euro-dollar Market on International Financial System:

Euro-dollar market has affected the international financial system in the following ways:

1. The position of dollar has been strengthened temporarily, since its operations of borrowing of dollars has become more profitable rather than its holdings.

2. It facilitates the financing of balance of payments surpluses and deficits. Especially, countries having deficit balance of payments tend to borrow funds from the Euro-dollar Market, thereby, lightening the pressure of their foreign exchange reserves.

3. It has promoted international monetary cooperation.

4. Over the last decade, the growth of Euro-dollar has helped in easing of the world liquidity problem.

6. Shortcomings of the Euro-dollar Market :

The Major drawbacks of the Euro-dollar market may be mentioned as under;

1. It may lead banks and business firms to over-trade.

2. It may weaken discipline within the banking communities.

3. It involves a grave danger of sudden large-scale withdrawal of credits to a country.

4. It has rendered official monetary policies less effective for the countries involved.

In fact, the Euro-dollar market has created two major problems for an individual country dealing in it. Firstly, there is the danger of over-extension of the dollar credit by domestic banks of the country; consequently, high demand pressure on the official foreign exchange may take place. Secondly, the Euro-dollar market appears as another channel for the short-term international capital movement for the country, so that, the country’s volume of outflow or inflow of capital may increase which may again endanger the foreign exchange reserves and the effectiveness of domestic economic policies.

It has destabilisation effect. It increases the pressure on exchange rate and official foreign exchange reserves. This may require additional liquidity. If such additional reserves are not provided, it may endanger the existence of the present gold-exchange standard.

Above, all, the Euro-dollar market has caused the growth of semi-independent international interest rates, on which there can be no effective control by a single country or an institution.

7. The Euro-dollar Multiplier (EDM):

The Euro- dollar market expansionary capacity, that is to say its ability to create deposits in the Eurodollar banking system is measured in terms of the Euro-dollar multiplier.

The Euro-dollar multiplier is worked our as under:

MSUSD = MSUS + EUROD – R

1. Indian would be in a better position to enforce its rights.

Where,

MSUSD = Total supply of American Dollar

MSUS = the US money supply, i.e., amount of dollar currency + deposits

EUROD = Euro-dollars deposits RD = bank’s reserves deposit ratio

RD is measured as: RD = r. ED and r = RD/EUROD

[r stands for banks reserves deposit ratio. Its value is significant in determining the multiplier | effect]

Further, MSUS + EUROD = world supply of dollar.

RD is subtracted from world dollar supply, to avoid double counting, Eurobanks deposit their reserves in the United States banks. Here it is assumed that all dollar reserves deposits are held with the US banks.

Euro- dollar money multiplier is measured thus:

Where, inverse of k, i.e., 1/k represents the Eurodeposit leakages. Leakages refer to deposits of money away from Euromarket.

It follows that when the value of k increases the coefficient of the multiplier (EM) increases and vice versa. Similarly the value EM increases when RD (reserve deposit) ratio increases and vice versa.

Hence, when US money supply increases by 2%, the actual rise in money supply of dollar through Eurodollar market tends to be increasing by 2.66%, i.e., greater than the domestic rise of dollar money supply.

8. European Monetary Union (EMU):

The European Monetary Union (EMU) was established in March 1979 for the monetary transactions among the member countries of the European Union (EU). It is to serve as the foundation for single currency.

Following are the main features of the EMU:

1. European Currency Unit:

It is regarded to the means for settlement of payments among the central banks of the member nations. The 13^th January 2002, Euro currency was introduced, which was adopted by the 12 member countries initially. Today, all 15 countries except Great Britain are using Euro as the common currency.

2. Exchange Rate Mechanism:

It facilitated the mechanism for the exchange rates of the currencies of the member countries such as to prevent wide fluctuations in their values, thus, assist them to regulate interest rates and contain inflation

3. European Monetary Co-operation Fund:

This is established to act as the cleaning house of the central banks of the member nations.

4. European Investment Banks:

The Bank is recognised as part of EMU. Its major function is to provide loans and guarantees for the loans raised by the member countries.

5. European Regional Development Fund:

This is meant to provide financial assistance for development of background areas of the EU.

6. European Central Bank:

It was set up in 1998. Its major function is to maintain price stability and operate single monetary policy for the EU. The ECB and national central banks of the EU together constitute the European System of the central Banks for a better monetary ordering. Its main objects and functions include:

(a) Determination and implementat ion of common monetary policy for the EU.

(b) Conduct of foreign exchange operations.

(c) Management of payment system

(d) Promoting Euro System

(e) Management of changeover from national currencies to Euro

(f) Advising on monetary issues.