International bank lending in perspective

International lending by commercial banks has risen very rapidly more slowly and with less disruption of since 1971. The authors of this article examine the implications of their economies. this growth for international inflation and for the conduct of Nevertheless, many questions about the monetary policy in the major industrial countries. ultimate macroeconomic implications of the expansion of international bank credit still await a satisfactory answer. In particular Andrew Crockett and Malcolm Knight there is the question whether the growth of Eurocredit leads to uncontrolled liquid- The past few years have witnessed a spec- countries in 1972-73, the large current ac- ity expansion. Do commercial banks, tacular growth in international credit mar- count deficits of the non oil-countries after through their international borrowing and kets. Total international bank claims on 1973, and the depressed level of domestic lending activities, act as an independent nonbanks rose from $61 billion at the end loan demand in the industrialized coun- cause of inflation in the sense that they can of 1970 to $405 billion in December 1977 tries which has persisted since late in 1974. increase world liquidity independently of (see the table). The average annual rate of It seems clear that the commercial bank- domestic money supply growth in the ma- increase during the seven-year period was ing system has played a most important jor industrial countries? To answer this, it just over 31 per cent, although the growth role in recycling surplus funds from mem- is necessary to understand the factors which rate was far from constant from year to bers of the Organization of Petroleum Ex- lead to growth in Eurocredit markets. year. porting Countries (OPEC) and several in- The major factors which contributed to dustrial countries to non-oil exporting Factors affecting growth the expansion were the relative ease of countries. This has financed a substantial International banking encompasses two domestic monetary policies in the major segment of balance of payments deficits distinct types of activity. The first occurs industrial countries during the early 1970s, and has permitted the subsequent adjust- when a bank in a particular country en- the overoptimistic projections for the ments in the borrowing countries' domes- gages in domestic currency borrowing or growth prospects of primary producing tic output and absorption to take place lending vis-a-vis nonresidents. The second

Estimated total external bank claims on nonbanks as reported for major financial markets, 1970-77 (In billions of U.S. dollars)

1970 1971 1972 1973 1974 1975 1976 1?ZZ Dec. Dec. Dec. Dec. Dec. Dec. Dec. March June Sept. Dec.

U.S. banks 24 33 41 56 83 98 123 123 129 134 142

Head offices1 12 14 16 20 32 38 48 45 47 49 52 Branches2 12 19 25 36 51 60 75 78 82 85 90 Of which: In the United Kingdom (7) (9) (11) (15) (19) (17) (18) (19) (19) (20) (22) In the Bahamas and Caymans (2) (4) (5) (9) (14) (19) (29) (30) (33) (33) (32) Banks3 in Western Europe,4 Canada, and Japan 37 44 60 98 137 162 207 217 231 241 263 Total 61 77 101 154 220 260 330 340 360 375 405 U.S. banks'share of total (39) (43) (41) (36) (38) (38) (37) (35)

Source: Bank for International Settlements, U.S. Federal Reserve, and Exchange and Trade Relations Department, IMF. ' Short-term and long-term external claims excluding claims on banks and their branches, as measured by the latter s liabilities to parent banks. 2 Claims on foreign (non-U.S.) official institutions and nonbanks. 3 Excluding branches of U.S. banks. ' Belgium-Luxembourg, the Federal Republic of Germany, France, Italy, the Netherlands, Sweden, Switzerland, and the United Kingdom.

Finance b Development I December, 197S 45

©International Monetary Fund. Not for Redistribution involves a Eurocurrency (foreign currency) these deposits have an expansionary im- and thereby induce a "leakage" of part of transaction, when a bank in one country pact on Euromarket aggregates. If a coun- the original inflow. But the Eurocurrency issues liabilities or purchases assets which try which holds its official foreign ex- markets are so vast that domestic interest are denominated in the currency of some change reserves in the United States has a rates and financial conditions, even in the other country. Thus, a dollar-denominated deficit with another country which keeps United States, cannot be taken as given loan made to Brazil by a New York bank is its reserves in the Euromarket, official and may be altered by deposit transfers classified as a foreign credit, while a similar monetary movements between the two will vis-a-vis Eurobanks. This fact severely lim- loan granted by a bank in London would inject reserves into the Euromarket, per- its the usefulness of the deposit multiplier be regarded as a Eurodollar credit. For some mitting an expansion of deposits and loans. concept as a method for mechanically pre- purposes, it is important to distinguish Given this pattern of initial inflows, how dicting the growth of Eurocurrency aggre- these transactions clearly: in most coun- is the expansion of the market determined? gates. tries, for example, foreign lending and bor- The ultimate increase in Euromarket ag- These limitations of the multiplier ap- rowing in domestic currency are subject to gregates will not be identical to initial de- proach have led to an alternative view of stricter banking regulation than are Euro- posit inflows because there are always international credit expansion: that, since currency transactions. As our concern is subsequent flows induced by interest Eurobanking is largely unregulated, there with the overall growth of international differentials and portfolio adjustments. is no limit to the potential expansion of the bank lending, however, we will include This, together with the fact that Eurobanks market as long as creditworthy borrowers both types of activity under Euromarkets hold only a very small proportion of their are willing to use it. At first glance this or off-shore markets. assets in the form of prudential reserves, view that Eurocredit is demand deter- Eurocurrency deposits and loans expand has encouraged some economists to at- mined may seem appealing. But it is tena- whenever funds flow into the Eurobanking tempt to analyze the behavior of the mar- ble only if it is assumed that central banks system, as deposits with Eurobanks, either ket by using money multiplier concepts. in the major industrial countries always from private sources or from central banks. The concept most commonly used—the pursue an accommodating credit policy that For example, in the case of Eurodollar de- initial deposit multiplier—attempts to cal- allows the Eurobanks to obtain all the de- posits, which make up the largest part of culate the ultimate increase in Eurocur- posits they want at constant cost (that is, at the market, there are three types of trans- rency aggregates on the basis of a given in- stable money interest rates). Although in actions causing such flows: (1) transfers of flow of deposits. With given initial levels of the 1960s central banks often had a policy funds to the Eurodollar market by banks or U.S. and foreign interest rates, this multi- of stabilizing nominal interest rates, it is other private residents of the United States; plier is obviously less than 1, since a $100 now generally recognized that such a pol- (2) transfers by private residents (banks or initial deposit inflow will encourage Euro- icy would quickly lead to inflation, even in nonbanks) of other countries; and (3) cen- dollar rates to fall relative to foreign rates a world without Eurocurrencies. As a re- tral bank placements of reserve accruals in sult, monetary authorities in the major in- the Euromarket, either directly or via the dustrial countries have shifted the focus of intermediation of the Bank for Interna- Andrew D. Crockett their policies from nominal interest rates to tional Settlements. The first type of flow, monetary growth targets. Because Euro- which is the result of the portfolio behavior banks can attract additional funds only by of private U.S. residents, can be caused by bidding them away from domestic finan- one or more of the following factors: (1) a cial institutions, such deposit transfers must fall in U.S. interest rates relative to Euro- a citizen of the United act to tighten credit conditions in national dollar rates; (2) an increased desire for as- Kingdom, is a graduate of money markets, thus tending to slow down set diversification; (3) a fall in the covered Cambridge University the shift of funds to the Euromarkets. yield on foreign assets or (4) an expected (U.K.) and Yale University As explanations of the growth in inter- appreciation of the U.S. dollar. (U.S.A.). He was a national bank lending, both the multiplier Eurodollar inflows initiated by banks or member of the staff of the and demand-determined approaches are nonbanks outside the United States in- Bank of England from 1966 until 1972, when he unconvincing. In our judgment, a more joined the Fund staff. He is presently Advisor, volve a portfolio shift out of domestic cur- balanced view may be derived from the ar- , Middle Eastern Department. rency assets and into dollars. These shifts guments which lead us to reject them. occur for reasons comparable to those listed While weak domestic loan demand in the above. If central banks are intervening to Malcolm Knight industrial countries and the appearance of prevent their exchange rates from depre- the OPEC surplus have been important ciating by buying domestic currency with contributing factors, it is not possible to dollars, there will be a fall in their official pinpoint a single cause for the rapid growth dollar reserves. In the absence of interven- of the international credit markets during tion, a new deposit inflow into the market a Canadian citizen, the past five years. Furthermore, there is can occur only to the extent that private received his M.Sc. and no doubt that under conditions of uncer- holders of dollar claims can be induced to Ph.D. in economics from tainty Eurocurrency aggregates can change exchange them for foreign currency (non- the University of London rapidly in the short run. But over the longer dollar) assets. Thus, other things being (U.K.). Between 1971 and time periods relevant for economic policy, equal, the growth of Eurocurrency markets 1975 he served on the unregulated international banking is un- tends to be more limited when exchange faculties of the London School of Economics (U.K.) likely to be an independent cause of world and the University of Toronto (Canada). He has rates are floating freely than it is when they inflation as long as monetary authorities— published articles in the fields of macroeconomics and are pegged by official intervention. Many international finance. Since 1975 he has been an especially in the industrial countries—are central banks redeposit a substantial pro- economist in the Research Department of the Fund. able to maintain firm control over the rate portion of any reserve gains in the Euro- of growth of domestic monetary aggre- markets, and it is generally assumed that gates. For, in the final analysis, the total

46 Finance & Development I December, 1978 ©International Monetary Fund. Not for Redistribution size of the Euromarket is determined by for the country's own domestic objectives These difficulties are less significant if conditions in the domestic financial mar- will not necessarily be the same as the pol- assets denominated in the same currency kets of the industrial countries. icies needed to promote suitable adjust- are readily substitutable between domestic ment in transactions abroad. Domestic credit and external markets and if a competitive The high mobility of capital that is asso- equilibrium exists between the two mar- In practice, international bank lending ciated with international bank lending re- kets. Then, monetary policy actions would has had consequences not foreseen by the quires central banks in the major countries affect not only domestic monetary aggre- monetary authorities—particularly because to take the international, as well as the gates but also the availability of credit in all international credit markets (such as the purely domestic demand for their curren- external markets where assets denomi- Euromarkets) are highly integrated and cies into account in formulating domestic nated in that currency are traded. Under unregulated. These characteristics consid- policies. But international credit markets these conditions, the existence of unregu- erably complicate the task of formulating are largely unregulated, and the effects of lated external banking would create no economic policy (particularly anti-infla- such policies on these markets are not eas- more serious problems of monetary control tionary policy) in those countries whose ily gauged in advance. A sudden increase than the existence of unregulated domestic currencies are widely used in international in the demand for international bank credit financial intermediaries. In the United credits. may make monetary conditions in an in- States, for example, more than a fourth of Whether international commercial bank dustrial country tighter than the authori- all bank deposits are held by banks that are lending takes place through domestic or ties had expected. At the same time, if gov- not members of the Federal Reserve Sys- offshore markets, the fact that credit is ernments outside the industrial world are tem. Because of the high degree of substi- switched between domestic and foreign able to borrow on the international market, tutability between the assets and liabilities borrowers clearly has implications for the they may maintain a more expansionary of member and nonmember banks, how- distribution of final demand among coun- credit policy than would otherwise be war- ever, the short-term behavior of nonmem- tries. However, the relationship between ranted by their underlying situation. bers' balance sheets reflects almost identi- the distribution of credit and the distribu- There is very little that can be done about cally that of member banks. tion of final demand is, at best, extremely this problem by the countries that issue in- The changing composition of lenders and loose. It obviously does not make much ternational currencies. They will naturally borrowers in financial markets also creates difference whether banks lend to domestic want to manage their monetary policy in problems. For example, the higher oil prices residents or to foreign residents if both ways consistent with domestic objectives. in 1974 had the effect of increasing in the want to borrow in order to buy the same Insofar as the supply of credit to other world economy the proportion of lenders domestically produced products: in that countries proves to be greater or less than and borrowers whose natural financial situation any effects on domestic money is appropriate for their current cyclical habitat was the offshore markets. Thus, supplies would be offset. Unfortunately, needs, it is the monetary authorities in the the surplus funds of the oil exporting this will not be the normal case. Foreign receiving countries who will face the ne- countries may be more likely to be shifted borrowers are less likely to spend the pro- cessity to take offsetting action. To the ex- between financial centers than the domes- ceeds of their loans in the domestic market tent that they do not take such corrective tic financial savings which they largely dis- of the country whose currency they bor- action at their own initiative, there may be placed. Similarly, the borrowers of these row. The authorities in lending countries a role for Fund surveillance to discourage funds—the governmental or quasigovern- may wish to counteract the first-round ef- over (or under) borrowing. mental agencies seeking balance of pay- fects of these loans to nonresidents on the ments financing—have also looked to in- distribution of demand. In addition, there Domestic monetary control ternational rather than to national financial are second-round and third-round effects markets. To the extent that this is true, a whose consequences are difficult to follow The difficulties of discriminating be- given rate of growth of monetary aggre- through. If Argentina borrows dollars to tween domestic and international objec- gates in domestic markets is likely to be spend in Germany, the deutsche mark is tives in formulating national monetary pol- more expansionary than it would be in likely to appreciate against the U.S. dollar, icy are exacerbated when the bulk of normal circumstances, because a smaller thus displacing some demand back to the lending takes place through offshore mar- proportion of the total demand for bank in- United States. When such subsequent ef- kets. In the longer term, these markets termediation is now directed to these on- fects are considered, it immediately be- have grown because depositors and lend- shore markets. comes clear that many other factors are ers have moved out of national money The existence of an unregulated market likely to come into play that cannot be pre- markets and into the international mar- which can be tapped fairly readily by large dicted with much precision. kets, a process which speeds up transfers lenders and borrowers tends to weaken the The basic analytical problem is clear: of local deposits and thereby causes a effectiveness of domestic monetary policy, credit markets in a given currency provide gradual rise in the velocity of circulation of particularly when this policy is one of re- finance not only for domestic commerce domestic money. Ideally, it would be de- straint. During the U.S. credit crunches of but, because of the mobility of capital, for sirable for the monetary authorities to rec- 1966 and 1969, for instance, there was a re- spending in the rest of the world as well. ognize such induced changes in velocity markable growth of the Euromarkets ow- This is, of course, not a new problem, but and to offset their effect on economic activ- ing to Eurodollar borrowing by U.S. banks it has been exacerbated by the growth of ity by varying the rate of domestic money for domestic U.S. credit needs. One reason offshore currency markets which has facil- creation. This, however, is not easy to do for this phenomenon was quite clear: the itated these international financial transac- because the rate of growth of these external existence of interest ceilings on deposit rates tions. If fluctuations in economic activity markets is not easy to forecast. Further- under Federal Reserve Regulation Q. As are imperfectly correlated over time be- more, there is no satisfactory theoretical or domestic interest rates rose above the crit- tween the country whose currency is used empirical measure of the effects of Euro- ical Regulation Q ceiling, depositors tended internationally and the borrowing coun- banking on the velocity of domestic bank not to renew interest-bearing deposits. tries, then the monetary policy appropriate deposits. Balance sheets of U.S. banks (and thus

Finance & Development I December, 1978 47 ©International Monetary Fund. Not for Redistribution their lending) would presumably have be at the same level in both markets. Thus, In sum, none of these points suggest contracted sharply had they not been able the degree of restraint that the authorities that international bank lending is an un- to borrow back from the Euromarkets the exercise over domestic monetary aggre- controlled engine of international inflation. interest-sensitive funds to replace their gates is bound to be reflected eventually in However, they do imply that international maturing certificates of deposit. The exis- credit conditions (and the rate of credit ex- lending reduces the predictability of the ef- tence of Regulation Q made the U.S. situ- pansion) in Euromarkets. fects of a given domestic monetary policy, ation a special case, however. In addition, In the short run, in contrast, domestic especially in a period of restraint. In addi- the fact that Regulation Q ceilings have banks may try to maintain customer good- tion, the greater capital mobility associated been eliminated on large deposits has fun- will by not increasing their lending rates with international lending may exaggerate damentally altered the situation in the rapidly and, instead, by limiting new credit the international disturbances that result United States. extensions. In turn, disappointed borrow- from disparities in cyclical phasing be- Apart from the effects of Regulation Q, ers might shift from domestic to offshore tween borrowing and lending countries. the existence of offshore markets could un- markets, which, being competitive and un- The high rate of international bank lend- dermine at least the timeliness of domestic regulated, may cause rates to rise some- ing, evident since 1970, has greatly facili- monetary restraint. When the Federal Re- what faster in response to underlying de- tated the international mobility of capital. serve System tightens domestic monetary mand and supply. This borrowing abroad In turn, capital mobility complicates the policy, the banks have, in one way or an- would tend to reduce the speed with which problems faced by national policymakers other, to cut back the volume of their lend- the authorities could make monetary re- seeking to stabilize their domestic econ- ing. But short-term effects may differ from straint effective at home. Such a leakage omies. This means, in particular, that long-run effects. In the long run, the ra- would occur at a time when it is particu- countries which issue international curren- tioning mechanism is based on price. As larly important for policy to be effective cies must attempt to take account of the we have pointed out, capital mobility be- quickly—that is, before inflation and asso- global demand for assets denominated in tween domestic and offshore markets ciated expectations have had a chance to their currencies when formulating domes- means that the price of credit will tend to gain a firm hold. tic monetary policy. HU

The international capital market and In Mr. Hoffmeyer's opinion, the alterna- Basically, Lord Roll also agreed with the international monetary system tive to the present system is not a fixed rate Mr. Hoffmeyer's diagnosis of the break- continued from page 9 system but a return to a world of restric- down of the Bretton Woods system and tions. said he too had no nostalgia for the old only if they are accompanied by appropri- fixed exchange rate system. In comment- Lord Roll as commentator ate economic policies. ing on the three main forces which Mr. Mr. Hoffmeyer identified three stages in Lord Roll suggested in his comments on Hoffmeyer found necessary for the stabil- the development of economic policy reac- the statements of the two speakers that ity of the present system, Lord Roll also tions: public declarations, followed by they tended to reflect opposing views: Mr. did not accept the suggestion that it was market intervention, and then by economic Hauge was, on the whole, slightly opti- too easy to borrow in the private markets; policy measures. In his opinion, declara- mistic about the future and Mr. Hoffmeyer on the contrary, he felt that the market had tions represented the easy way out and took a more reserved view. to date applied a sufficient degree of dis- were usually ineffectual. Market interven- He agreed with Mr. Hauge on the causes cipline. As regards exchange rates, how- tions were usually more effective but were of the breakdown of the Bretton Woods ever, he considered that exchange rate not sufficient by themselves. Economic system, on the growth of the world mar- movements affect the underlying economic policy measures, he thought, were always kets, and on their ability to react quickly situation too slowly and their effects were, necessary to influence market forces. He to the financing needs of countries. Even at times, perverse. While agreeing that regretted that authorities always seemed though he concurred with Mr. Hauge's changes in exchange rates had an impor- to be reluctant to take them: they were analysis of the major problems that the tant part to play, he considered that of late continually addressing market factors from markets face—that is, risk, liquidity and their role had been too great. last year and ignoring the new factors cur- uncontrolled credit creation, and exchange In the realm of economic policy, Lord rently taking place. He concluded that the rate destabilization, Lord Roll felt that Roll considered the practical effects of both current floating rate system cannot be doubts about these problems should not be declarations and market intervention really maintained unless the major countries take dismissed too lightly and should be stud- quite limited. Both speakers had also ar- more seriously the obligation to harmonize ied further. In his view, it would be a gross gued for the need to harmonize economic their economic policies. overreaction to attempt to regulate the policies, but he was somewhat skeptical In concluding, Mr. Hoffmeyer predicted market and, if regulations were imposed, about prospects for achieving such har- that, despite the teaching of the textbooks, they would be ineffectual since financial mony. He agreed with Mr. Hauge that the we could not expect to achieve economic transactions tend to take place where re- Schmidt-Giscard d'Estaing initiative was equilibrium. There was no short-cut road strictions are at a minimum. a step in the right direction but thought to stability. In his view, exchange rate fluc- Lord Roll welcomed the growing coop- that monetary matters should be resolved tuations should prompt economic policy eration between the World Bank and com- on a worldwide and not on a regional ba- reactions in the countries concerned. He mercial lenders. On the other hand, he was sis. felt that the fixed exchange rate system had doubtful of the feasibility or desirability of Lord Roll concluded that both speakers failed because leading countries relied too a more systematic and formal cooperation had detailed the shortcomings of the pres- much simply on public declarations and between the Fund and the commercial ent system but had not provided, and he market intervention. Because of this ex- banking system. He also agreed with felt could not be expected to provide, an- perience, it was misleading to put too Mr. Hauge's summarization of the neces- swers to the many questions raised about much hope on the capacity of Fund sur- sary steps to be taken to improve the eco- the workings of current monetary arrange- veillance to manage exchange-rate policies. nomic position of the United States. ments. ED

48 Finance & Development I December, 1978 ©International Monetary Fund. Not for Redistribution