Does Eurodollar Borrowing Improve the Dollar’s Exehange Value? DAVID H. RESLEB “In a further move to improve the international position of the dollar, the Board of Governors on August 28, 1978, announced a change in reserve require. ments to make it more attractive for member banks to borrow funds in the Eurodollar market, ..The new action involves a reduction from 4 percent to zero in the reserve requirement on foreign borrowings of member banks, pri- marily Eurodollars, from their foreign branches and other foreign banks.” Federal Reserve BULLETIN, September 1978. - ABLY in 1978 the dollar began to decline sharply the dollar and thereby increase its foreign exchange in value in the foreign exchange markets. This dra- vaisse. This paper examines analytically the conditions matic decline, shown in Chart 1, precipitated several under which removal of these reserve requirements Federal Reserve policy actions, culminating in last would improve the dollar’s foreign exchange value. November’s comprehensive dollar rescue effort under- Available data relating to Eurodollar borrowing offer taken in cooperation with the Treasumy. This action little evidence that this policy initiative has fulfilled its consisted of a combination of dollar-supporting efforts intentions. including an expansion of both direct foreign exchange intervention and swap arrangements, and an an- nounced increase in the discount rate. While these ac- tions seem to have successfully abated the dollar’s decline, the desired improvement in the dollar’s inter- Eurodollars are simply dollar-denominated deposits national position has been modest. placed in a bank outside the United States. Anyone The action taken last November was the most may own Eurodollars and these owners may reside in dramatic of several actions taken to support the a foreign couutrv or in the United States. They may dollar.2 The quotation above identifies another such dollar-supporting move. By removing the reserve re- quirements against Eurodollar borrowing, the Fed in- As this article was published, the Federal Re- tended to encourage the use of this source of funds serve announced a comprehensive change in pol- in order to generate a net increase in the demand for icy that includes Eurodollar borrowing. Eurodol- mFederal Reserve Bulletin (September 1978), p. 777. The reg- lar borrowing will be included in the calculation ulations affected by this policy action are Regulations I) and of “managed liabilities,” Increases in the total of M. Regulation I) specifies the reserve requirements member these managed liabilities above a base level will banks must meet for various liability classificatiomms. Regsmlation Ni governs the Federal Reserve’s treatmemst of foreign branch be subject to an 8 percent marginal reserve re- banks. It is important to note that the computation of the quirement. This action, however, does not re- reserve requirement against “Eurodollar borrowimugs” was ac- tually on net ba/ances due to foreign branches. move the differential reserve requirement be- tm Imm addition to the action indicated fax the quotation, the Fed- tween large CDs and Eurodollar borrowing. In eral Reserve has increased the discount rate several times fact, the new policy action may further stimulate during the past )eam. For an assessmeiut of the effect of these discount rate changes em! tIme exchange rate, see Douglas R. the substitution of Eurodollars for large CDs that Mudd, “Did Discount Rate Changes Affect the Foreign Ex- this paper examines. charuge Value of the Dollar During 1978?” this Review (April 1979), pp. 20-26. Page 10 FEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1979 for a substantial volume of cxart i Eurodollar activity. Weighted Average Foreign Currency Value of the Dollard Regardless of their loca- Index Index March 1913=100 March 1973r100 tion, Eurodollar banks 100 100 (Eurobanks) perform an intermediary function simi- lar to that of other banks. 98 98 They issue liabilities (that is, they accept deposits) 96 96 which they use to acquire earniug assets, primarily loans to customers and fi- 94 94 nancial investments such as bonds, commercial paper, and so on. As with other 92 92 intermediaries, Eurobanks’ profits are the differential between earnings received 90 9 0 on their assets and the costs of their liabilities. 88 88 Eurodollar deposits dif- fer from domestic U.S. bank deposits in one often over- 86 86 looked but very important respect: Generally, liabili- 84 84 ties of Eurobanks are not JAN FEB. MAR. APR. MAY JUNE JULY AUG. SEP. OCT. NOV. DEC. JAN. FEB. MAR APR. MAY JUNE JULY AUG. uucheckable deposits.” Euro- 1978 1979 dollar depositors cannot Source, Federal Reserve Bulletin The countries ,ncluded in the weighted.overoge foreign interest rate and exchange rate series are Belgium, write drafts on their depos- Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, and the United Kingdom. rhe its. In other words, Euro- we,ghts and tormula used in constructing these series are from ‘‘Index of the Weigiled-Averoge Exchange Value of the U.S. Dollar, Revision,’’ Federal Reserve Bulletin August l978} dollars are not “money” in the same sense that demand deposits and U.S. currency he private citizens, nonfinancial corporations, other are money. Eurodollars are, instead, most comparable banks or flnarmcial intermedianes, or official instittmtions to various “near-monies” like large denomination cer- of forei gum governments. tificates of deposit (CDs) IViotives for holding Eurodollars are equally diverse. The prin’marv motive, however, is that Eurodollars are short—term dollar-denominated assets \vhich pay an at- tractive vmelcl. Those extensively engaged in interna- tional trade view the market as especialir’ convenient. \Vith a largc’ vOlmune of trade ultimately’ conducted in Thes-e are two important links between the Eurodol- dollars, the Eurodollar market provides a relatively lar maiket and the U.S. banking system. First, and high ~‘ielding outlet for dollar balances that obviates most important to this discussion, mans’ Eurodollar munch of the risk-and transactions costs associated banks aie branches or subsidiaries of U.S. commercial with converting them into a foreign asset or with in- banks. This means that U.S. parent banks have an aux- vesting then, directly in U.S. capital markets. I imt dc gt cc of Iuqtumdttm of I us odoll Sn sanes auth the tet us o si tat” nt>’ of time deps,sit. The us maturity of Eutodollar de— Despite the “Eurodollar” designation, time market is psmsits ranges frssns overnigist to, more typically, 30 days or not exclusivel located in Europe. Though the largest nsssre. ‘list- exteuut to which Eurodollars add to the worlds liquid balances aimd thereby represent a source of wcsricl immlla— part of the market’s activity takes place in London, tion is perhaps the smmtsst controvet-sial aspect of the market. the rest of Europe and such diverse locations as Sing- Fssr a s’cc-esmt chscsussion cmf this problem. see Adrian W. Throop, ‘‘Eurobam skis mg anci World luffati(sit, Voice of tim c’ apore, the Bahamas, and the Cay-man Islands account Federal Reserce Bank of Do//u.s ( Angnust 1979), pp. 8—23. Page 11 FEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1979 median’, a Eurohank maintains a stock of readily TabI 1 accessible funds (reserves) to meet day-to-day trans- Effective Cost of Bank Liabilities actions and clearing requirements. One of the most striking and controversial features of the Eurodollar (1) (2) Eurodollar Certificates (3) system is that, unlike domestic banks, the level of re- Borrowing of Deposit Difference serves held by Eurobanks is not regulated. This does 1977 August 656% 6.29% 27% not mean, however, that Eurobanks hold no reserves. Septeenbe 683 657 26 Profit-maximizing considerations determine the opti- October 7 44 6.64 80 mal level of precautionary reserves for Eurobanks, The special characteristics of this market result in very November 739 711 28 4 December 7 42 7 15 27 low levels of reserves relative to total deposit volume. Generally, Eurobanks’ deposits with U.S. banks serve 1978 Januoy 763 7.37 26 as precautionary reserves for the Eurodollar market. February 7.58 7 33 25 March 7 57 7.29 28 April 769 7,48 .21 May 815 789 26 June 8 68 8.32 .36 July 8 88 8.63 .25 August 8.83 8 56 27 As previously noted, U.S. banks often obtain liabil- S ptember 9.12 916 04 ities from the Eurodollar market by borrowing from October 10.12 10.02 .10 their own branches or from other Eurobanks. Like Novemb r 11.51 11.65 14 other forms of foreign borrowing, this practice in- December 1162 11.63 Cl creases U.S. liabilities to foreigners and lowers (raises) the short-term international capital account 1979 January it 16 11.41 .25 deficit (surplus). February 10.79 11 07 28 Mach 10.64 11.01 37 Falling deficits or rising surpluses generally indicate Apri 1060 10,92 32 an increasing demand for dollars which in turn implies May 1075 11.03 —.28 a rising value of the dollar in foreign exchange mar- 5 June 1052 1082 30 kets. This is the connection between Eurodollar bor- July 10.87 1099 12 rowing and the foreign exchange rate that the August Augutt 1153 1162 09 28, 1978 policy action attempted to exploit. lulntio Is o is epartddal rn tIC a mess The connection between the net liquidity deficit and 0 linil nelLh ph blere t 5 e’sns mat the foreign exchange rate, however, is more compli- 5)UTLCE-fd-nl s, Bulfnmndtls PS 111 nan Lots cated when Eurodollars are borrowed because such borrowing need not result in a currency conversion. iliari source of funds for th i domestic oper tions, To see this point more clearly, consider the following Specifically a .S.