ill

Ramon Moreno·

An empirical test confirms that, in the 1980s, eurodollar deposits held by U.S. residents were influenced slightly by the level ofinterest rates and the availability of monetary reserves available to the banking system. Total eurodollar deposits, however, do not appear to be sufficiently close substitutesfor money, or to have been sufficiently large in volume even at theirpeak in the early 1980s, to affect U. S. interest rates. For purposes of monetary cOlltrol, policymakers need not be concerned about the impact of domestic currency holdings of their nationals in the eurocurrency market.

The rapid development of international banking the size of eurodollar deposits held by U.S. resi­ and the euromarket that started in the late 1960s dents in comparison to narrow domestic money, generated extensive discussion about the implica­ make the U.S. financial market more susceptible to tions for monetary policy. While concern about the external influences by enhancing the substitutability inflationary implications of the euromarket has of euromarket assets for U.S. assets and hence the receded in the 1980s, the possibility that arbitrage activities of U. S. banks between the euromarket activity may limit the effectiveness of domestic market and the euromarket. The U.S. monetary instruments remains pertinent. experience may thus indicate the susceptibility of a The U.S. is at once more and less vulnerable than large economy to external influences when there are other economies to the external influence of the relatively few impediments to arbitrage between the euromarket. On the one hand, the U. S. is a "large" domestic financial market and the euromarket. economy, and the volume of euromarket transac­ Aside from promoting linkages between domes­ tions in which U.S. residents are engaged remains tic and foreign capital markets by stimulating capi­ small in comparison to domestic financial transac­ tal flows, it has been argued that the development of tions. This is particularly true with regard to the the euromarket may lead to the emigration of the eurodollar bank deposits ofU.S. nonbank residents. intermediation activities of domestic banks to the On the other hand, the few restrictions on capital euromarket. 1 Such emigration would have several movements, the use of the U.S. dollar as the major implications. For economies seeking to target mon­ currency of denomination in the euromarket, and etary aggregates, the appropriate definition of the aggregate may be complicated by the creation of * Economist, Federal Reserve Bank of San Fran­ potentially close substitutes in the euromarket. cisco. Thanks to John Duffy and Laura Shoe for Moreover, even an appropriately defined aggregate capable research assistance. may be less susceptible to direct control. The crea-

43 tion ofeuromarket substitutes for domestic money relevant foreconomiesthatareexpanding the scope may also weaken the ability of monetary policy to of their international banking actiVities .. The most influence interest rates or exchange rates, or·be notable exampleis Japan, Which today faces issues associated with disturbances to asset preferences similar to those the United States started to face in that increase the volatility of those rates. a result of the rapid growth of the The extent to which the eurodollar market affects eurodollar market. The growing internationaliza­ U.S. financial markets, and interest rates in particu­ tion of Japanese banking, the use of the yen in lar, has not been conclusively determined. The international transactions, and the possibility that earlierstructural models ofthe linkages between the Japanese residents may shift intermediation to an euromarket and domestic economies, such as Her­ incipienteuroyen market raise questions that may be ring and Marston (1977), assumed that U. S. interest clarified by the U.S. experience. rates are unaffected by foreign rates. This assump­ This paper will discuss the influences on the tion is supported by some recent evidence. For emigration of domestic banking activity to the example, an unpublished study using vector auto­ eurocurrency market, and assess the potential regressions by Genberg, Saidi and Swoboda (1982) implications of the emigration ofdomestic banking found that U.S. domestic interest rates were gener­ activity for domestic financial markets, specifically, ally not influenced by interest rates in foreign finan­ for interest rates. The next section discusses how cial markets, although U.S. rates did have a weak certain institutional features that characterize the influence on foreign rates. euromarket and international banking activity However, by applying a vector autoregression to explain the growth of these sectors, leading to the monthly data of the 3-month U.S. commercial emigration of U.S. banking activity to the eurodol­ paper and eurodollar deposits rates, Hartman lar market via the process of arbitrage. Section II (1984), found that while U. S. interest rates examines the determinants of equilibrium in the appeared to have been unaffected by foreign rates eurodollar market. Section III assesses the potential before 1975, between 115 to 2/3 of the variation in implications for domestic interest rates and mone­ domestic rates can be traced to foreign sources from tary policy of the shifting of domestic bank inter­ 1975 to 1978. 2 Using weekly data, Reinhart and mediation to the euromarket. Harmon (1986) found closer integration in the Using the framework developed in Section II, 1980s between the federal funds market and the Section IV examines the actual growth ofeurodollar overnight eurodollar market, and evidence. that deposits held by U.S. non-bank residents since the overnight eurodollar rates Granger caused the late 1970s. Section V contains an empirical test to federal funds rate. 3 ascertain the determinants of eurodollar deposit An understanding of the linkages between the creation and the influence of the euromarket on eurodollar market and domestic financial markets domestic interest rates. The conclusion follows in and the implications of the use of a national cur­ Section VI. rency in international transactions is particularly

44 I. International Banking andthe Eurodollar Market International banking can be described in several ment on eurodollar borrowing has been 3 percent, ways, but for ourpurposes, it will be useful to focus the same as that on domestic CDs. on two aspects: Banks operating in the eurodollar market gener­ I. The eurocurrency market, in which deposits ally do not issue checkable deposits, but they do and loans denominated in a given currency are issue a substantial volume of very short maturity offered outside the country where the currency is liabilities held by U.S. nonbank residents. In fur­ issued. The largest segment of the eurocurrency ther contrast to the domestic money market, where market is the eurodollar market, where transactions banks raise the bulk of their funds from nonbanks, are denominated in U.S. dollars. U.S. banks and interbank transactions account for about 70 percent U.S. nonbank residents are active participants in the of all eurodollar market transactions. eurodollar market. Although other currencies have gained some 2. The cross-border activities of banks based in a prominence in recent years, dollar-denominated given country, which form part of what is tradi­ deposits and loans offered outside the United States tionally understood to be international banking. or in International Banking Facilities in New York, This includes lending by domestic banks to foreign which are exempt from domestic banking regula­ residents, and foreign resident deposits in domestic tions, still represent the bulk of eurocurrency mar­ banks. ket activity.6 The settlement of dollar transactions Certain characteristics that historically have dis­ originated by U. S. or foreign banks operating in the tinguished banking in the eurodollar market from eurodollar market ultimately involves the transfer domestic banking account for the rapid growth of (using the Clearing House Interbank Payments Sys­ the former. Unlike domestic deposits, eurodollar tem, or CHIPS) of reserves (that is, claims on the deposits are not subject to FDIC premia orto reserve Federal Reserve) in the domestic U. S. banking requirements. For many years, eurodollar deposits market: Such reserve transfers typically involve also benefited from the absence of restrictions on U.S. banks, rather than the branches of foreign interest paid that applied to domestic banking. banks operating in the United States'? These institutional advantages encouraged demand Such close links between the domestic and the for eurodollar deposits, particularly during the infla­ eurodollar markets lead observers to treat the latter tionary I970s . as an extension of the U.S. banking system. 8 Since However, under certain conditions, borrowing by bank reserves are ultimately required in the settle­ U.S. residents from the eurodollar market is subject ment ofclaims originating in the eurodollar market, to reserve requirements ,4 and has affected the extent the availability ofreserves will tend to influence the to which U. S. residents have used the eurodollar volume of eurodollar deposit creation. In addition, market as a source of funds. In the early 1970s, efforts to tap the domestic and eurodollar markets to reserve requirements on eurodollar market borrow­ acquire reserves imply that the markets for federal ing were much higher than domestic reserve funds and overnight eurodollar deposits are closely requirements, effectively discouraging such bor­ connected by arbitrage, as are the markets for term rowing. In the mid-1970s, the reverse was true as domestic and eurodollar deposits. 9 These arbitrage the Federal Reserve sought to encourage borrowing activities are reflected in the eurodollar deposit from the eurodollar market to strengthen the value holdings of U.S. residents and the international of the dollar. 5 Since the implementation of the assets and liabilities of banks based in the U.S. Monetary Control Act of 1980, the reserve require-

45 n. Understanding Eurodollar Deposit Creation

Eurodollar Supply and Demand Chart 1 The arbitrage process described earlier is associ­ Eurodollar Market Equilibrium ated with the emigration of domestic banking Eurodollar Bid Rate Minus activity to the eurodollar market. U.S. CD Rate The extent to which intermediation will shift from the domestic to the eurodoUar market will depend on the interest rate paid on eurodollar deposits. At very high eurodollar deposit interest rates, the demand for eurodollar funds by banks will be small. As the differential between eurodollar rates and domestic U.S. rates approaches the difference in costs between dealing in the domestic and eurodol­ lar markets, banks will be increasingly indifferent Eo E2 E1 between operating in the domestic or eurodollar Eurodollar Deposits market, and the demand schedule will tend to flat­ ten. The slope of the demand curve is determined by matching the marginal revenue from lending against the marginal cost of raising funds in the eurodollar markets at any given eurodollar rate. 10 deposit rate is set by banks to reflect the higher cost Domestic residents may be indifferent between (reserve requirements and FDIC insurance premia) holding domestic and eurodollar deposits when of funds in the domestic deposit market. Banks are these deposits pay a premium over the domestic then indifferent between demanding funds from the deposit rate sufficient to compensate them for the eurodollar or domestic deposit market. The per­ perceived risk of acquiring eurodollar assets. fectly elastic demand for funds determines the Beyond a certain point, however, depositors may eurodollar rate, and a less than perfectly elastic require higher eurodollar rates to supply more funds supply of funds schedule is said to determine the to the eurodollar market, tracing an upward sloping volume ofeurodollar deposits. In Giddy's version of supply schedule for eurodollar funds. The slope of the cost of regulation view, the demand schedule in the supply curve reflects the rate at which asset­ Chart I would be a horizontal line. holders must be compensated for the perceived risk In the market price of risk view, derived from or inconvenience of banking in the eurodollar mar­ portfolio management theory, the differential ket. The equilibrium is shown by lines Sand D in between the eurodollar and domestic deposit rates is Chart 1. set by depositholders to compensate them for the perceived risk of placing funds in the eurodollar DelteriTlil1lents of Equilibrium market. Depositholders are then indifferent between In an illuminating discussion of the supply and placing funds in the eurodollar or domestic market. demand framework presented here, Giddy (1979), The perfectly elastic supply of funds determines the distinguished between two polar views of the eurodollar rate, and a less than perfectly elastic eurodollar market: the cost of regulation view, demand schedule is said to determine the volume of which reflects the behavior of banks that demand eurodollar deposits. According to this view, the eurodollar funds, and the market price ofrisk view, supply schedule in Chart 1 would be flat. which reflects the behavior of assetholders who Giddy argues that the cost of regulation and supply funds to the eurodollar market. market price ofrisk views are irreconcilable because According to the cost of regulation view, the market equilibrium cannot be determined when differential between the eurodollar and domestic both demand and supply are infinitely elastic. One

46 way around this disturbing conclusion, which sug­ In contrast, when the cost offunds in the eurodol­ gests that either banks or assetholders may not lar market (the eurodollar offer rate adjusted for the behave rationally, is that neither view need imply cost of reserve requirements applied that the demand or the supply of funds are every­ from the eurodollar market) is less than cost of where perfectly elastic." This reasoning underlies funds in the domestic market, there is an incentive the less than perfectly elastic segments illustrated in for obtaining funds in the eurodollar market to fund Chart 1. domestic lending. This case raises the possibility of The supply and demand framework introduced a "round trip", whereby domestic residents above does not explicitly state where the funds the funds in the eurodollar market and these funds raised in the eurodollar market will ultimately be are subsequently lent to domestic borrowers. Once placed. Kreicher (1982) analyzed this question more, the cost offunds in the domestic market, this under the cost of regulation framework by discuss­ time adjusted by the reserve requirements on ing the two choices available to banks, namely to eurodollar borrowing and the spread between the obtain funds from the domestic market to fund eurodollar bid and offer rates, places a floor on the lending abroad (outward arbitrage) or to obtain eurodollar bid rate. funds from the eurodollar market to fund lending in Between the two thresholds for inward or outward the U. S. (inward arbitrage). When the cost of arbitrage is an "arbitrage tunnel" within which domestic funds (the domestic CD rates adjusted for banks are largely indifferent between obtaining reserve requirements and FDIC premia) is less than funds in the domestic market and the eurodollar the return from depositing such funds in the market. When the differential between the eurodol­ eurodollar interbank market (the eurodollar bid lar rate and the domestic rate is sufficiently large, rate), there is an incentive for outward arbitrage. In the net foreign asset position of the U.S. banking the process of bidding for funds, the differential sector would tend to be positive; the reverse would between the domestic U.S. rate and the eurodollar be true when the eurodollar interest rate is low rate will narrow until the incentive for outward enough to create an incentive for inward arbitrage. arbitrage is eliminated. The cost of domestic funds The recent U.S. experience in this regard is ana­ thus imposes a ceiling on the eurodollar bid rate. lysed in section IV.

m. Implications of Intermediation via the Euromarket While the preceding analysis highlights some of induce the public to accept the new money supply. the key features of eurodollar market equilibrium, it For example, a policy that shrinks bank reserves is a partial analysis because it does not explicitly forces banks to reduce their deposit liabilities (and discuss the impact eurodollar market activities may therefore money creation) to satisfY reserve reaum~­ have on domestic interest rates. In general, the ments. The yield on assets that are alternatives to impact may be derived from mac­ money must then rise to eliminate the resulting roeconomic considerations. excess demand for money. In the analysis of monetary policy in a closed The extent to which interest rates will respond to economy, the existence of two assets, money and the monetary policy objectives of the central bank bonds, is typically assumed. Money here refers to depends ou(l) the existence of close substitutes for currency and checkable deposits (Ml) that pay a money and (2) the tightness of the link between fixed (possibly zero) rate ofinterest, and bonds refer reserve creation by the Federal Reserve and domes­ to a spectrum of interest-bearing assets. In this tic money creation by banks. If bonds were close framework, monetary policy affects interest rates by substitutes for money, a small increase in their yield changing the supply of money; changing the supply would suffice to eliminate the excess demand for of money, in tum, requires changes in the yield on money. The effect of a given change in reserves on bonds (and hence, the relative yield on money) to interest rates in that case would be small. In a closed

47 economy, the tightness and predictability of the link demand equation and the reduced form St. Louis between reserves and domestic money creation is equation) improved when eurodollar deposits of strengthened by reserve requirements. short maturity were included. 15 Goodman's results The growth of eurodollar deposits held by V.S. imply that shifting deposit activity to the eurodollar residents presents a potential problem for domestic market would create substitutes for domestic monetary policy because it tends to weaken the two money. conditions needed for an effective monetary policy cited above. Eurodollar deposits are believed by Tightness of Link to Monetary Reserves some observers to be close substitutes for domestic Giyen that eurodollar deposits are, to some money. Furthermore, because eurodollar deposits undetermined extent, SUbstitutes for domestic are not subject to reserve requirements, banks could money, the process by which eurodollar deposit potentially create a large volume ofsuch deposits in creation may offset the intention ofmonetary policy a manner that offsets the monetary policy objectives is best seen by example. Consider a deflationary of the Federal Reserve. monetary policy which induces a rise in domestic interest rates in relation to those in the euromarket. Money Substitutes Ifthis policy were to raise loan rates by more than it The argument that eurodollar deposits may be raises deposit rates, and thereby increase the profit close substitutes for domestic money is analogous to margins on lending, the rise in interest rates would arguments motivated by the financial innovation of create an incentive for banks to increase their inter­ the 19708, namely, that certain domestic assets may, mediation. At the same time, however, by raising in various ways, reduce the demand for transactions the cost of noninterest-bearing reserves, as well as balances. Because eurodollar deposits are of rela­ domestic CD rates, the rise in domestic rates would tively short maturity, they could be close substitutes tend to shift intermediation towards the eurodollar for domestic money. In addition, eurodollar market, where the marginal cost of funds is com­ deposits, particularly for the shortest maturities, paratively lower. In Chart I, these effects are illus­ may increase transactions efficiency (much like the trated by a rightward shift in the demand schedule domestic RP market), thus reducing the need for for eurodollar funds to D 1. cash balances. Although the link between eurodollar deposits While domestic assets that are potential money and monetary reserves may be weaker than the substitutes have generated an enormous literature, 12 corresponding link between domestic deposits and the evidence on the substitutability of eurodollar reserves, the rightward shift in demand for eurodol­ deposits for domestic money is thin. Studies of lar funds will still be limited by the following: interest parity suggest a high degree of sub­ (1) Liquidity Constraints: While eurodollar stitutability between assets of comparable maturity deposits are not subject to reserve requirements held in the V. S. and abroad,13 with very small risk (abstracting from reserve requirements on borrow­ premia imposed on the assets held in industrial ing from the eurodollar market), banks eventually countries. have to settle their eurodollar liabilities with dollar However, authors have generally not tested for the reserves. 16 When lending rates rise, a bank raising substitutability of eurodollar deposits for domestic funds in the eurodollar market trades off the money, limiting themselves instead to comparisons increased margins on lending these funds against of the size of eurodollar deposit holdings of resi­ the growing risk of illiquidity due to increasing dents with measures of narrow domestic money. 14 intermediation. This trade-off should tend to limit The comparison implicitly assumes a high degree of the volume ofloans and eurodollar deposit creation substitutability between eurodollar deposits and according to the availability of reserves created by domestic money but provides no direct evidence of the Federal Reserve, although the link is looser than such. An exception is Goodman (1984a), who found in the case of the domestic market where reserve that the forecasting performance of two standard requirements are binding. The extent to which equations using narrow money (the Goldfeld money

48 reserve availability limits eurodollar deposit crea­ for eurodollar deposits is not perfectly inelastic. tion depends partly on the substitutability of This conclusion may have implications for domestic eurodollar deposits for transactions balances and interest rates and monetary policy. partly on the extentofmaturity transformation in the Consider now a shift in the supply of funds from eurodollar market;17 domestic demand deposits to eurodollar deposits. (2) Loan Market Constraints. Higher interest The shift from reservable to non-reservable assets rates create adverse selection towards riskier bor­ should lower the demand for reserves, and tend to rowers and increase the probability of default. 18 lower domestic as well as eurodollar interest rates. These effects are generally associated with•credit A monetary authority seeking to stabilize output rationing, which limits the demand for funds on the must offset such disturbances to interest rates part of banks; caused by shifts in asset preferences. In general, the (3) Capital Constraints. Intermediation in the magnitude of shifts in the supply of funds between eurodollar market tends to reduce capital-asset domestic demand deposits and the eurodollar mar­ ratios. While the effect is reduced to the extent that ket may be greater the greater the substitutability such intermediation substitutes for intermediation between those two assets, or smaller depending on in the domestic market, capital constraints have the cost to assetholders of shifting to eurodollar been a matter ofgreat concern to banks in the 1980s. deposits. For any given rightward shift in demand, motivat­ ing non-banks to place their funds in the eurodollar Inward and Outward Arbitrage market bids up the eurodollar deposit rate. The rise The extent to which a shift from domestic money in the rate would tend to reduce the margins on towards eurodollar deposits will affect domestic lending. This sequence may be seen as a movement interest rates will also depend on the extent of from point b to point c in Chart 1(with the differen­ inward or outward arbitrage For example, ifa rise in tial increasing as the eurodollar rate rose). In fact, if domestic interest rates were to create an incentive the supply ofeurodollar market funds were inelastic for inward arbitrage, banks may demand eurodollar (for example, in times of great uncertainty abroad), deposit funds to lend at home. Such a "round trip" eurodollar deposit rates could rise so far as to would tend to lower domestic interest rates and thus eliminate any advantage in raising funds in the offset the impact of monetary policy. The effect on eurodollar market. 19 domestic interest rates would be attenuated if the Our example thus suggests that the volume of differential between eurodollar and domestic inter­ eurodollar deposits will rise during periods when est rates were instead to create incentives to lend interest rates are high as long as the supply schedule funds to the eurodollar market.

IV. U.S. Residents and the Eurodollar Market We may now use the preceding heuristic frame­ part of M2, and term eurodollar deposits are part of work to review the actual behavior ofthe eurodollar M3 in V.S. monetary statistics. market and the reasons explaining the emigration of Two features are apparent. First, after very rapid V.S. bank activity to the eurodollar market in the growth in the 1970s, total eurodollar deposits held late 1970s and 1980s. Two indicators ofthe emigra­ by nonbank V.S. residents peaked in 1984 at tion of V.S. banking activity to the eurodollar approximately $105 billion, and declined subse­ market are the eurodollar deposit holdings of V.S. quently. Overnight eurodollar deposits continued to nonbank residents and the external asset position of grow, although they accounted for only 18 percent V.S. banks compared to their foreign affiliates. 20 of total eurodollar deposits in 1986. Second, the Chart 2 shows the trend in the total, term, and size ofeurodollar deposits held by V.S. residents is overnight eurodollar deposit holdings ofV.S. non­ small in comparison to domestic monetary aggre­ banks with the foreign affiliates ofU.S. banks since gates. At their peak, total eurodollar deposits were 1977. Overnight eurodollar deposits are included as

49 associated with improved profit opportumttes in Chart 2 lending, and relative interest rates favored inter­ Eurodollar Deposits of U.S. Nonbank Residents mediation via theeurodollar market. The informa­ $ Billions tion in charts 4 and 5 tend to confirm this explana­ 125 tion,as well as clarifY the apparent absence of Total D~poSits inward arbitrage. 100 Chart 4 illustrates the behavior of the 3-month eurodollardeposit rate and domestic CD rate. In line 75 with~urhypothesis, the fastest growth ofeurodollar deposit holdings by nonbank residents occurred 50 when interest rates were rising or at their highest levels, and eurodollar growth peaked in 1983, Overnight Deposits 25 shortly after interest rate levels began their decline. ~ Chart 5 shows the difference between the 1977 1978 1979 1980 1981 1982 1983 1984 1985 1988 3-month eurodollar and the 3-month domestic CD rates. The top line, which is the unadjusted differen­ tial, represents the incentive to the nonbank sector to move deposits to the eurodollar market. It is remarkable that between 1979 and 1982, when the 20 percent as large as Ml and 3.7 percent as large as level of interest rates were at their highest, the M3. 21 spread between the eurodollar rate and the domestic Note also that, for most of this period, there was deposit rates also peaked. The fact that eurodollar little ifany evidence of inward arbitrage, or a round deposit growth continued at a fast pace over this trip in the form of eurocurrency market lending to period suggests that rising demand for eurodollar U. S. residents via the banking sector, associated funds, presumably due to profit opportunities in with these eurodollar deposits. Except for a brief lending, increased the unadjusted differentials episode between 1979 and 1980, U.S. banks have between the eurodollar and domestic deposit rates. been net lenders to their foreign affiliates since Since 1982, the spread between the eurodollar and 1977, as illustrated in Chart 3. 22 domestic deposit rate has fallen significantly, and The growth ofthe eurodollar market as a whole in contributed to the contraction in eurodollar deposits the 1970s is often explained as a supply phe­ held by U.S. residents. nomenon: sharp increases in oil prices provided oil producers with a large supply of dollar funds which they preferred to place in the eurodollar market. Chart 3 However, the rapid growth of eurodollar deposits Net Assets of U.S. Banks Versus Their Foreign Branches held by U.S. residents over the same period must $ Billions mean that the demand for eurodollar funds - asso­ 60 ciated with the explosion in international lending starting in the 1970s exceeded the increased supply of funds by oil producers. The growth trend was reversed by the 1982 debt crisis as declining expected returns on lending, and tightening capital constraints, lowered the demand for eurodollar funds. Our earlier discussion suggests that, given the more favorable regulatory treatment that applies to -20 I iii II Ii' i I the eurodollar market, eurodollar deposits must 1977197819791980198119821983198419851986 have grown in part because rising interst rates were

50 This timing roughly corresponds to the period when Chart 4 the. netforeign asset position of domestic banks in Three-Month Eurodollar Deposit Rate comparison to their foreign affiliates turned nega­ and U.S. CD Rate Percent tive (Chart 3). 20 To sum up, while the unadjusted.differential.of 18 the deposit rates paid to the nonbank sector in. the 16 late 1970s (top line ofChart 5) appeared to encour­ 14 age the shifting ofdepositsto the eurodollar market, the adjusted differential. (bottom line.of Chart 5), 12 which reflects the cost offunds to the banks, simul­ 10 taneouslyfavored .net lending abroad by the 8 banking sector rather than the use offunds raised in 6 the eurodollar market in the domestic market. Per­ haps even more surprising is that, while. the unad­ 4 +---,----,r--,--r--r-~-,----r----,,.----, 1977 1978 1979 1980 198, 1982 1983 1984 1985 1986 justed differential between the domestic and eurodollar rate narrowed significantly since 1983 when the U.S. began importing unprecedented amounts of capital, the adjusted differential still The reason that the funds raised in the eurodollar reflected an outward arbitrage incentive for banks. market were used for international rather than This is confirmed by the rising net foreign assets of domestic lending is suggested by the bottom line of U. S. banks versus their foreign affiliates over the Chart 5, which represents the differential between period. theeurodollar bid rate and the domestic CD rate While our discussion sheds some light on the adjusted for reserve requirements. This differential behavior of eurodollar deposits over the past ten reflects the incentive for banks to use the domestic years, the importance of the various interst rate market asa source of funds for lending to the effects for eurodollar deposit holdings of U. S. resi­ eurodollar market, or the outward arbitrage cited dents is still unclear, as is the ultimate impact of earlier.. When the differential is above zero, the eurodollar market on domestic interest rates. A eurodollar bid .rate exceeds. the tunnel ceiling dis­ more precise characterization of these effects cussed· earlier, and banks have an incentive for requires more formal analysis. outward arbitrage. When the differential is negative but sufficiently close to zero, b;mks-are indifferent betWeen using the eurodollaror the domestic market asa source of funds. When the differential is suffi­ Chart 5 Three-Month Eurodollar Deposit ciently low, the eurodollar bid rate falls below the Rate I U.S. CD Rate Differential tunnel f1oor,givingbanks a possible incentive for Percent8ge Points 2.0 inward. arbitrage. The period in which this last case 1.6 applied is illm,trated by the shaded areas in Chart ~ Unadjusted 23 5. 1.2 Chart 5 shows that, for most ofthe ten years since 1977,banks have either been indifferent between 0.8 tappin$ the domestic or eurodollarmarkets, or had an incentive for outward arbitrage. The exception is 1979, when the second oil price shock created a large. supply .ofeurodollar funds. At that time, eurodollar market· rates fell sufficiently below -0.8 1977197819791980 198119821983198419851986 domesticCD ratesto create an incentivefor banks to Shaded ar-eaindicates inward arbitrage opportunity use the eurodollar market to fund domestic loans.

51 v. Dynamic Relationships In the absence of an elaborate structural model, causality does not imply causality in the behavioral the determinants of the behavior of eurodollar sense understood in structural models (for example, deposits over time and the implications of the that an increase in interest rates would cause money eurolllarket for domestic interest rates (and there­ demand to fall), but does permit statements about fore monetary policy), can be examined more sys­ whether two variables appear to be connected in a tematically by performing a vector autoregression systematic way over time. While Granger causality (VAR). A VAR takes a set of variable and regresses tests are useful indicators, they do not show the them on the lagged values of the same set of extent to which lagged values of x will improve the variable, thus indicating whether the dynamic rela­ forecast of y. This information is provided by two tit.:mships in the data appear to be consistent with the other results obtained from VARs. relationships postulated by our understanding of 2. Variance Decompositions. These decomposi­ how the eurodollar market works. VARs may be tions indicate how much of the forecast error of a interpreted as reduced forms of complex structural particular variable results from innovations in each links, they assume limited knowledge ofthe precise variable included in the VAR. nature of these links. 3. Impulse Response Functions. Based on the Three useful results may be obtained with VARs: moving average representation of the VAR, impulse 1. Tests of Granger Causality. A variable x is response functions provide an explicit characteriza­ said to Granger cause another variable y if the tion of the dynamic response of a variable to an lagged values ofx improve the forecast ofy. Granger innovation to itself or other variables.

52 A four-variable VAR was estimated. The vari­ The data are monthly, the variables expressed in ables werenonborrowed reslerv~s(usledas a proxy differences oflogs andlagged 1 to3 months, and the for liquidity constraints that may affect deposit estimation period is 1979:1 to 1986:12. Short lags creation in the domestic and eurodollarmarkets), were chosen onthe beliefthatthearbitrage .relation­ the 3-month U.S~Treasury bill rate (as a proxy for ships we have been discussing take place over a very the level of domestic interest rates), the differential shortspan.of time. The estimation period Was between the unadjusted 3-month eurodollar and chosen to focus largely onthe behaviorofeurodollar domestic CD rates (representing the incentive for deposits inthe 1980s,. when. the strong variation in arbitrage between markets·and the influence of interest rates provides a good potential experiment eurodollar rates), and total eurodollar deposits held for the responsiveness of eurodollar deposits. 25 by U. S. residents (representingJhe shift in domestic The objective ofOUr VAR study is to shed some intermediation.towards the eurodollar market). 24 light on the potential impact of eurodollar deposit

53 creation on domestic interest rates and on whether such eurodoUar deposit creation could sys­ Chart 6 tematically offset the intention of monetary policy. Response of U.S. Treasury Bill Rate to Eurodollar deposit creation would do the latter if it One Standard Deviation Shock In: .12 were very responsive to interest rate behavior and relatively unfettered by the availability ofreserves in .10 tbe .U .S. banking system. The dynamic links .08 I Treasury Bill Rate between the price (interest rate) and quantity vari­ .06 ables should conform with the analysis presented .04 and may be interpreted as follows: Eurodollar Deposits 1. U.S. interest rates were affected by the .02 ~ Nonborrowed Reserves euromarket, eurodollar deposits as well as the O+-~=::::.... eurodollar/domestic CD rate differential should -.02

Granger cause the U. S. Treasury bill rate, and -.04 -l--r---.--r--r-,..-,.-..,.--,---.--r--r-,----, should explain a large portion of its variance. If 1 2 3 4 5 6 7 8 9 10 11 12 Months eurodollar deposits were to Granger cause the U. S. Treasury bill rate, one may infer that eurodollar deposits would be close substitutes for domestic money, and that, at the margin, such deposits would be large enough to have an impact on interest rates euromarket domestic CD rate differential are not that is pertinent to domestic monetary policy. significant. 2. If the volume of eurodollar deposit creation The variance decomposition and impulse were responsive to interest rates, the U.S. Treasury response functions characterize the specific contri­ bill rate, and the euromarket/domestic CD rate dif­ butions of innovations in the different variables to ferential would Granger cause eurodollar deposits, the variation ofeach variable in turn. Such a charac­ and explain an important proportion of the variance terization requires the innovations specific to each in such deposits. In this case, eurodollar deposit variable to be isolated. For example, the innovations creation may tend systematically to offset the direc­ in nonborrowed reserves must be treated separately tion intended by domestic monetary policy in the from innovations to the U. S. Treasury bill rate. This manner suggested earlier. In contrast, if eurodollar cannot be done by looking at the residuals of the deposits were subject to liquidity constraints, 'non­ vector autoregression equations because such borrowed reserves would Granger cause eurodollar residuals are typically correlated with each other. deposits, and the extent of the offsetting effects on The traditional procedure, in this case, is to con­ monetary policy will be correspondingly limited. struct a moving average representation of the vector Table I reports the results of the VAR, with autoregression that recovers innovations that are not columns 2 and 4 being of direct interest. As can be correlated with each other. 27 seen in the second column of Table I, under the The variance decompositions reported in Table 2 specification adopted here only the lagged Treasury show the percentage ofthe expected squared predic­ billrateis statistically significant in forecasting the tion error ofeach of the four variables in the system interest rate. In contrast to Hartman's results that is produced by an innovation in each of the forthe period 1975-1978, there is no evidence that variables in turn, for forecasts for I to 24 months the behavior ofeurodollar interest rates, reflected by ahead. The contribution of innovations in each the interest differential between eurodollar and variable is expressed as percentages. For example, Granger cause domestic U. S. in the last item under Nonborrowed Reserves, col­ 1980s. The fourth column of Table I umn I, the portion of the 24-month ahead forecast reveals that eurodollar deposits are Granger caused error in nonborrowed reserves that is attributed to bythe domestic Treasury bill rate and nonborrowed innovations in the eurodollar/domestic CD rate dif­ reserves. However, the lagged values of the ferential is divided by the total expected 24-month

54 ahead squared.prediction .error.of nonborrowed reservesconditionaLoninformation available at the Chart 7 time ·.theforecast isheing.made.i.Thistotal error will Response of Eurodollar Deposits to One Standard Deviation Shock In: depend oninnovations innonborrowedreserves, the .05 V.$. interest rate, and the vohnneofeuro4011ar deposits, as wellas on innovations in the.eurodollar/ .04 domestic CDrate·4ifferential (recall that these vari­ abies are expressed in log differences). As can be .03 seen ,after 24 months, 78 percent ofthe· errorin .02 nonborrowed reservesis due to innovations in non­ borrowe4 reserves, andneiU'ly 14 percentis due·to Eurodollar/CO[)ifferential, innovations in the eurodollar/domestic CD rate dif­ o +-/2::.~::"-::::::::::::::::::::::::::==:::::::=--- ferential. In general, Table 2 shows that innovations in -.01 -t-.,.--,---r---r-.-,---,---.,.--,---r---r-,,...... , other variables playa limited role in explaining the 1 2 3 4 5 6 7 6 9 10 11 12 Months standard error in the forecast of nonborrowed reserves, the V.S. interest rate, and the euromarketl domestic CD rate differential. The contribution of The impulse response functions presented in innovations in interest rates and nonborrowed Charts 6 and 7 illustrate the path of the response of reserves to the forecast error in totaleurodollar the levels ofthe V.S. Treasury bill rate and total deposits is also .small.28 After 24 months,. innova~ eurodollardeposits, respectively, toa Ist

55 eurodollar deposits. As indicated earlier, the effects source of observed dist~rbances.The present VAR of the last three are very small. assumes that disturbances to nonborrowed reserves Total eurodollar deposits rise in response to a 1 are the primary source, followed by disturbances to standard deviation innovation to the U. S. Treasury the U.S. Treasury bill rate, the euromarket/domestic bill rate and to nonborrowed reserves. This at least CD.·differential· and·eurodollar deposits.· The sen­ partly confirms our earlier suggestion that eurodol­ sitivityofthe impulse responSe and variance lar deposit creation is positively associated with decomposition results to the ordering adopted here changes in domestic interest rates, but it also indi­ depends on the covariation between the residuals of cates that such deposit creation will tend to be the equations, reported in Table 3. As can be seen, constrained by the availability of dollar reserves. the correlations between the· residuals are com­ In constructing a moving average representation paratively low, the highest being· - 32 percent for of a VAR, which is the basis for the variance nonborrowed reserves and the U. S. Treasury bill decompositions and impulse response functions, an rate. The results reported therefore are not very assumption needs to be made as to the original sensitive to the order assumed.

VI. Conclusions Since the late 1970s, disturbances to U.S. inter­ deposits do not appear to be sufficiently close sub­ est rates and nonborrowed reserves influence stitutes for money, or to be sufficiently large in eurodollar deposit creation. The effect ofU. S. inter­ volume even at their peak in the early 1980s, to have est rates implies that eurodollar deposits may be a strong influence on U.S. domestic rates. For created in a manner that offsets the intention of purposes of monetary control, U.S. policymakers monetary policy. The effect of nonborrowed need not be concerned about the impact ofdomestic reserves implies that the extent ofsuch offset will be currency holdings of their nationals in the eurocur­ curtailed by the availability ofreserves. It should be rency market. stressed that these two effects are small. Eurodollar This result may have implications for other large deposit holdings of U.S. residents are explained countries concerned about extending the scope of largely by the lagged values of those holdings. their international banking relationships. Ofcourse, In addition, any influence the euromarket has on the internationalization of banking has other domestic interest rates is negligible. Neither a proxy implications not fully explored here. Further for the effectof the euromarket interestrate nor the research should seek to identify the importance of volume of eurodollar deposits held by U.S. resi­ other channels that connect the euromarket to dents explains much of the variance in domestic domestic financial markets, particularly, the euro­ U.S. interest rates. Specifically, totaleurodollar bond market.

56 FOOTNOTES 1. See Mayer (1982). Similar reasoning underlies the theqeposits of offshore banks can be thought of as the framework used by Henderson and Waldo (1980, 1981). growth of the deposits of domestic branches not subject to 2, The apparentabsence of any inf.luence of foreign rates reserve requirements ... Banks do. not hold separate on US ratys reported by GenberQ,Saidiand Swoboda reserves against offshore deposits because the reserves may be caused by two factors: (a) changes in the return on heldagai~,st domestic deposits exceednormalliquiqity assetsqenominatedinforeigncurrencyaffectexchange ne.eds ..••. rate expectations in a way that diffuses the observed 9. The arbitrage between the federal funqs and overnight impact on U.S. rates, and (b) domestic interest rates and eurodollar market is discussed by Reinhart and Harmon the rates in financial markets abroad are subject to such a (1987). The arbitrage between dOmestic and eurodollar widevarietyofinfluencesthat no direct linkbetween them CDs is highlighted by Johnston (1979) and Kreicher may be apparent. (1982), The absence of direct linkages between national financial 10. The marginal conditions can be derived from the markets in the U.S. and abroad does not rule out the theory of the banking firm. The marginal revenue to be possibility that interest rates in national financial markets equated to marginal cost is the interest income from lend­ abroad may influence eurocurrency market interest rates, ing funds received by increasing eurodollar liabilities. For a which, in turn, may influence U.S. interest rates. Thus, the given level of domestic deposits and interest rates, the results of Genberg, Saidi and Swoboda may still be consis­ marginal cost depends on the extent to which increasing tent with Hartman's (1984) results. However, as indicated eurodollar liabilities will affect desired holdings of (nonin­ later, Hartman's results do not appear to apply for the terest-bearing) reserves, the interest cost of the additional 1980s. eurodollar liabilities, the expected penalty associated with 3. Overnight eurodollar rates Granger cause the federal the increased probability of becoming illiquid as eurodollar funds rate if. lagged values of the former improve the liabilities rise, and the marginal cost to the firm of an forecast of the latter. The test of Granger causality is increase in its size. In a profit-maximizing equilibrium, the discussed in a later section. size of the banking firm, the share of the domestic and eurodollar market in loans and deposits, and the quantity 4. The eurocurrency liabilities of U.S. residents subject to of desired reserves are all determined simultaneously. reserve requirements are defined as the net interbank liabilities of U.S.-based banks versus those of banks oper­ 11. Such an approach would explain why the differential ating in the euromarket and the borrowings of U.S. resi­ between the eurodollar deposit rate and domestic deposit dents from branches of U.S. banks operating in the rates of comparable maturity is not explained by the dif­ euromarket. AS discussed later, U.S. banks have been net ferential in the cost of funds in the two markets when there creditors compared to their foreign branches over are large disturbances to asset preferences (for example, extended periods, so the reserve requirements in many following the Herstatt Bank failure of June 1974). This cases do not apply. implies that for SUfficiently large changes in interest rates associated with shifts in the supply of eurodollar funds, the 5. In 1971, the reserve requirement on eurodollar borrow­ demand for eurodollar deposits is not perfectly elastic ing was doubled to 20 percent; it was then reduced to 8 either. percent in June 1973. Over this period, reserve require­ ments on eurodollar borrowing were higher than the 5-8 12. See Judd and Scadding (1982). percent reserve requirements on domestic CDs. From the 13. For a recent discussion, see Frankel (1985). last quarter of 1973 to 1978, the reserve requirement on 14. For example, see Mayor (1982). eurodollar borrowing was progressively reduced to 0 to encourage borrowing from the eurodollar market in order 15. Goodman's definition of eurodollar deposits of short to strengthen the value of the dollar, while the domestic CD maturity includes overnight eurodollar deposits and either requirement had risen to as high as 11 percent. 20 percent or 40 percent of term eurodollar deposits held by U.S. residents (the latter is taken as the upper limit on 6. The share of dollar-denominated transactions in the eurodollar deposits under 8 days). Her equations are euromarket has fallen in recent years. For example, lend­ estimated quarterly from 1959 to 1974 and then simulated ing denominated in U.S. dollars by banks in London ­ out-of-sample through the third quMer of 1982. which is the major euromarket center - has fallen from a peak of 80 percent in 1983 to 72 percent in 1985, while the 16. When foreign banks are involved, the settlement may shares of transactions denominated in yen and deutsche­ first involve bank deposits held with U.S. banks. This marks have risen (to 7 and 10 percent respectively). eventually will result in the transfer of reserves. 7. The reason is that foreign bank branch daylight over­ 17. Niehans and Hewson (1976) argued that banks drafts at the Federal Reserve are restricted, so foreign largely match the maturities of their assets and liabilities in banks prefer to settle using deposits held with U.S. banks the euromarket, suggesting that the extent of maturity rather than with the reserves they have been required to transformation, and therefore liquidity creation, is small. hold with the Federal Reserve since 1978. Originally, for­ However, more recently, Sneddon-Little (1979) found that eign banks were not allowed to run daylight overdrafts. At the extent of maturity transformation may be as large as for present, foreign bank overdrafts are limited to 5 percent of domestic banking. their U.S. liabilities. 8. For example, Aliber (1979), points out: "The growth of

57 18. See Stiglitz and Weiss (1981); or Sachs (1984). The tunnel floor is described by: f = [(i + p)(1 re)/(1 - rd)J 19.. One may also think ofa Ieftward shift in the supply of - s, Where re is the reserverequirement on borrowing from funds schedule caused by the rise in domestic lending the eurodollar market, and s is the spread between the rates'\lVhichmay or may not fully offset the rightward shift in eurodqllarbidand offer rates. Fora diScu$sion of how dema.nd. these values are derived, see Kreicher (1982). Unlike Kreicher, $latutoryFQ1Cpremia areu$edhere. 20. These two indicators do not provide a complete repre­ sentationaf ·eurodollaractivity·that may be •relevant .for 24 .. Jnstead oUaking the U.S. Treasury tJillJa.te andthe domesticmonetary policy because the arbitrage activities difference between theeuromarket and domestic CD of nonbank foreign residents between the domestic U.S. rates, we could have used a U.S. domestic rate and a rnarketand the .e(jrodqllar market .• are. not considered. comparableeuromarketrate. The two series would have However, a large portion ofthe foreign resident holdings of reflected both the effect o/the overall.leveloftherates as eurodollars is unconnected with U.S. economic activity (for well as the effect of the differential between them. Experi­ example, eurodollarentrepotoperations). Since .iUs diffi­ ments with this "Iternative specification gave similar cult, if not impossible, to ascertain thatproportion of for­ results. eigneurodollarholdings that should be included in the 25. Extending the estimation period to 1977 does not alter analysi$, we have confined our study to the emigration of the basic results. intermediation by U.S. residents. 26. Hartman estimates a two-variable vector autoregres­ 21. The analysis raises the question of whether it is appro­ sion with the 3-month U.S. commercial paper rate and the priate to compare total eurodollar deposits with M1. 3-month eurodollar deposit rate and finds evidence that Because of their short maturity, overnight eurodollar the 3-month eurodollar rate Granger caused domestic deposits are considered the closest substitutes for M1. rates for the period 1974-1978. Direct estimates performed However, a large proportion of eurodollar deposits are of by the author using a similar bivariate system in levels and very short maturity. Goodman (1984a), for example, rates of change confirmed this finding, but indicated that, assumes that up to 40 percent of eurodollar deposits after 1979, the eurodollar rates do not Granger cause mature in less than 8 days. domestic rates. This is consistent with the results in the 22. The pattern in the overall net foreign asset position of text. Reinhart and Harmon's (1986) finding that overnight U.S. banks appears to be consistent with the pattern eurodollar rates Granger cause the federal funds rate in shown in Chart 3. Although the U.S. economy as a whole the 1980s then indicates that the term structure relation­ has been a net creditor from early this century up to the ship of the euromarket and domestic interest rates has 1980s, total U.S. international banking liabilities typically changed. This warrants further investigation. exceeded assets up to the early 1970s. This was partly 27. In vector autoregressions, variables that are not because the role of the dollar as a reserve currency expected to have predictive values for other variables are resulted in the holding of significant dollar-denominated put last. This assumption is reflected in the ordering of the deposit holdings on the part of foreign governments. equations reported in Table 1. However, growing bank lending reversed this situation by The procedure for isolating the innovations in each vari­ the end of 1975. The net foreign assets of U.S. banks rose able follows naturally from this assumption. The innova­ from $1.1 billion in thatyeartoa peak of $130.2 billion in the tions to nonborrowed reserves were left unchanged. Any first quarter of 1983, before falling to $42.1 billion in the first systematic relationship between the residuals in the non­ quarter of 1986. The decline reflected the 1982 debt crisis, borrowed reserves equation and the U.S. Treasury bill which prompted U.S. banks to reduce the growth of their equation was then eliminated to obtain the innovations to external lending, particularly to less developed countries, be attributed to the U.S. Treasury bill rate. The innovations and that portion of growing U.S. borrowing that had been in the euromarket/domestic CD differential were then channeled through the banking sector. obtained by eliminating any systematic relationship with 23. The cost of domestic funds, which defines the tunnel the residuals of nonborrowed reserves and U.S. Treasury ceiling, may be described by the formula: c = bill equations. A similar process yielded the innovations in (i + p)/(1 - rd), where c is the cost, i is the interest paid on the eurodollar rate. As indicated later, the low correlation the domestic deposit, p is the FDIC premium, and r is the between the innovations suggests that the results are not reserve requirement on domestic deposits. very sensitive to the order assumed. 28. Recall that all variables are expressed in log dif­ ferences.

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59