MBA BOOK international banking

7 International Monetary System1.2 International Monetary System 1.3 System of Bretton Woods 1944-71 1.3.1 Main Characteristics of Bretton Woods System 1.4 International Monetary System

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Page No.

UNIT I

UNIT II

UNIT III

UNIT IV

UNIT V

CONTENTS

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INTERNATIONAL BANKING

SYLLABUS UNIT I

Introduction to International monetary system - International gold standard –fixedexchange regime - Flexible Exchange regime – Present system in IMS

-UNIT V

International networks for settlements - SWIFT - CHIPS-CHAPS-FEDFIRE.International Financial Institutions - IMF-IBRD-IFC-IDA-MIGA-ADB-ACU

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5 International Monetary System

UNIT 1

UNIT I

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International Banking

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International Banking

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1.2 International Monetary System

1.3 System of Bretton Woods (1944-71)

1.3.1 Main Characteristics of Bretton Woods System

1.4 International Monetary System Since 1971

1.5 International Monetary Fund

1.6 International Bank for Reconstruction and Development

1.7 Late Bretton Woods System

1.8 Structural Changes Underpinning the Decline of International

Monetary Management

1.8.1 Return to Convertibility

1.8.2 Growth of International Currency Markets

1.8.3 Decline of U.S Monetary Influence

1.9 "Floating" Bretton Woods (1968-72)

1.10 The "Nixon Shock"

1.11 The Gold Standard

1.11.1 Gold Specie Standard

1.11.2 Gold Bullion Standard

1.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to understand:

z The international monetary system and new forms of monetary interdependence

z Growth of international currency market and gold standards

1.1 INTRODUCTION

International monetary system addresses itself to provide mechanisms to solve the

problems of liquidity and foreign exchange transactions Since these cannot be solved

by any nation in isolation, it is desirable that all interacting nations agree to a certain

modus operandi to find solutions to common problems Adequate finances are to be

arranged (particularly for less developed/developing countries) so that international

transactions take place smoothly In the context of international trade, the problems

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International Banking that crop up relate to: (i) liquidity, (ii) adjustment, and (iii) stability Liquidity is

necessary to finance the transactions that are done on cash basis Adjustment is needed to bridge the gap that emanates because of imbalance between demand and supply at existing exchange rates Similarly, stability is necessary with intent to limit the degree of uncertainty in international business decisions

1.2 INTERNATIONAL MONETARY SYSTEM

Gold Exchange Standard was the first major step towards the establishment of an international monetary system This system was put into effect in 1850 The participants were the UK, France, Germany and the USA In this system, each currency was linked to a weight of gold The system was institutionalized at the Conference of Genes in 1922 Since gold was convertible into currencies of the major developed countries, central banks of different countries either held gold or the currency of these developed countries

1.3 SYSTEM OF BRETTON WOODS (1944-71)

The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states Preparing to rebuild the international economic system as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire for the United Nations Monetary and Financial Conference The delegates deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944 In the year 1946, the International Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF) were established

1.3.1 Main Characteristics of Bretton Woods System

z Fixed rates in terms of gold (i.e a system of gold standard), but only the US dollar was convertible into gold as the USA ensured convertibility of dollars into gold at international level

z A procedure for mutual international credits

z Creation of International Monetary Fund (IMF) to supervise and ensure smooth functioning of the system Countries were expected to pursue the economic and monetary policies in a manner so that fluctuations of currency remained within a permitted margin of + or - 1 per cent That is, the central bank at every country had to intervene to buy or sell foreign exchange, depending on the need

z Devaluations or reevaluations of more than 5 per cent had to be done with the permission of the IMF This measure was necessary to avoid chain & valuations like the ones which occurred before the Second World War

Check Your Progress 1

1 What do you understand by international gold exchange standard?

……… ………

2 What is Bretton Woods System?

……… ………

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1.4 INTERNATIONAL MONETARY SYSTEM

SINCE 1971

On 15 August 1971, President Nixon of the USA suspended the system of

convertibility of gold and dollar For some time, the system of fixed-rates with an

adjustment margin of + or –2.5 per cent was tried but did not work Finally, the fixed

rate system was abandoned and the floating rate system came into effect In December

1971, the Smithsonian Agreement was signed at Washington; its major features were:

z devaluation of the dollar and revaluation of other currencies; gold passed from

$ 35 per ounce to $ 38;

z new fluctuation margins: changing from ± 1 per cent to ± 2.25 per cent;

z non-convertibility of the dollar

In 1973, another devaluation of the dollar took place Petrol shock added to the

international monetary crisis Exchange rates became volatile

In 1976, Jamaica Agreements were signed focusing on the:

z Legalization of the floating exchange rate;

z Demonetization of gold as the currency of reserves

Thus, the part of quota which was hitherto required to be deposited in gold could be

deposited in foreign exchange At the same time, the IMP sold one-third of its gold

reserves In 1977 and 1978, in the wake of inflation in the USA, the dollar further

depreciated The Federal Reserve practiced a strict monetary policy Between 1980

and 1985, the dollar appreciated but at the same time the American BOP situation

deteriorated

1.5 INTERNATIONAL MONETARY FUND

IMF was established on December 27, 1945, when the 29 participating countries at the

conference of Bretton Woods signed its Articles of Agreement, the IMF was to be the

keeper of the rules and the main instrument of public international management The

Fund commenced its financial operations on March 1, 1947 IMF approval was

necessary for any change in exchange rates in excess of 10% It advised countries on

policies affecting the monetary system

1.6 INTERNATIONAL BANK FOR

RECONSTRUCTION AND DEVELOPMENT

The International Bank for Reconstruction and Development (IBRD) — now the most

important agency of the World Bank Group The IBRD had an authorized

capitalization of $10 billion and was expected to make loans of its own funds to

underwrite private loans and to issue securities to raise new funds to make possible a

speedy postwar recovery The IBRD was to be a specialized agency of the United

Nations charged with making loans for economic development purposes In 1956, the

World Bank created the International Finance Corporation and in 1960 it created the

International Development Association (IDA) Both have been controversial Critics

of the IDA argue that it was designed to head off a broader based system headed by

the United Nations, and that the IDA lends without consideration for the effectiveness

of the program Critics also point out that the pressure to keep developing economies

"open" has led to their having difficulties obtaining funds through ordinary channels,

and a continual cycle of asset buy up by foreign investors and capital flight by locals

Defenders of the IDA pointed to its ability to make large loans for agricultural

programs which aided the "Green Revolution" of the 1960s, and its functioning to

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International Banking stabilize and occasionally subsidize Third World governments, particularly in Latin

America

Match the following:

1 Gold Exchange Standard December 27, 1945

2 IMF 1946

3 International Bank for Reconstruction and Development 1960

4 International Development Association 1850

1.7 LATE BRETTON WOODS SYSTEM

After the end of World War II, the U.S held $26 billion in gold reserves, of an estimated total of $40 billion (approx 65%) As world trade increased rapidly through the 1950s, the size of the gold base increased by only a few percent In 1958, the U.S

balance of payments swung negative The first U.S response to the crisis was in the late 1950s when the Eisenhower administration placed import quotas on oil and other restrictions on trade outflows More drastic measures were proposed, but not acted on

However, with a mounting recession that began in 1959, this response alone was not sustainable In 1960, with Kennedy's election, a decade-long effort to maintain the Bretton Woods System at the $35/ounce price was begun The design of the Bretton Woods System was that nations could only enforce gold convertibility on the anchor currency—the United States’ dollar Gold convertibility enforcement was not required, but instead, allowed Nations could forgo converting dollars to gold, and instead hold dollars Rather than full convertibility, it provided a fixed price for sales between central banks However, there was still an open gold market, 80% of which was traded through London, which issued a morning "gold fix," which was the price

of gold on the open market For the Bretton Woods system to remain workable, it would either have to alter the peg of the dollar to gold, or it would have to maintain the free market price for gold near the $35 per ounce official price The greater the gap between free market gold prices and central bank gold prices, the greater the temptation to deal with internal economic issues by buying gold at the Bretton Woods price and selling it on the open market

However, keeping the dollar was still more desirable than holding gold because of the dollar's ability to earn interest In 1960 Robert Triffin noticed that holding dollars was more valuable than gold was because constant U.S balance of payments deficits helped to keep the system liquid and fuel economic growth What would later come to

be known as Triffin's Dilemma was predicted when Triffin noted that if the U.S failed

to keep running deficits the system would lose its liquidity, not be able to keep up with the world's economic growth, and, thus, bring the system to a halt But incurring such payment deficits also meant that, over time, the deficits would erode confidence

in the dollar as the reserve currency created instability

The first effort was the creation of the "London Gold Pool." The theory behind the pool was that spikes in the free market price of gold, set by the "morning gold fix" in London, could be controlled by having a pool of gold to sell on the open market that would then be recovered when the price of gold dropped Gold's price spiked in response to events such as the Cuban Missile Crisis, and other smaller events, to as high as $40/ounce The Kennedy administration drafted a radical change of the tax system in order to spur more productive capacity, and thus encourage exports This culminated with his tax cut program of 1963, designed to maintain the $35 peg

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Describe, in brief, the following:

1.8 STRUCTURAL CHANGES UNDERPINNING THE

DECLINE OF INTERNATIONAL MONETARY

MANAGEMENT

1.8.1 Return to Convertibility

In the 1960s and 70s, important structural changes eventually led to the breakdown of

international monetary management One change was the development of a high level

of monetary interdependence The stage was set for monetary interdependence by the

return to convertibility of the Western European currencies at the end of 1958 and of

the Japanese yen in 1964 Convertibility facilitated the vast expansion of international

financial transactions, which deepened monetary interdependence

1.8.2 Growth of International Currency Markets

Another aspect of the internationalization of banking has been the emergence of

international banking consortia Since 1964 various banks had formed international

syndicates, and by 1971 over three quarters of the world's largest banks had become

shareholders in such syndicates Multinational banks can and do make huge

international transfers of capital not only for investment purposes but also for hedging

and speculating against exchange rate fluctuations

These new forms of monetary interdependence made possible huge capital flows

During the Bretton Woods era countries were reluctant to alter exchange rates

formally even in cases of structural disequilibria Because such changes had a direct

impact on certain domestic economic groups, they came to be seen as political risks

for leaders As a result official exchange rates often became unrealistic in market

terms, providing a virtually risk-free temptation for speculators They could move

from a weak to a strong currency hoping to reap profits when a revaluation occurred

If, however, monetary authorities managed to avoid revaluation, they could return to

other currencies with no loss The combination of risk-free speculation with the

availability of huge sums was highly destabilizing

1.8.3 Decline of U.S Monetary Influence

A second structural change that undermined monetary management was the decline of

U.S hegemony The U.S was no longer the dominant economic power it had been for

more than two decades By the mid-1960s, the E.E.C and Japan had become

international economic powers in their own right With total reserves exceeding those

of the U.S., with higher levels of growth and trade, and with per capita income

approaching that of the U.S., Europe and Japan were narrowing the gap between

themselves and the United States The shift toward a more pluralistic distribution of

economic power led to increasing dissatisfaction with the privileged role of the U.S

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International Banking dollar as the international currency As in effect the world's central banker, the U.S.,

through its deficit, determined the level of international liquidity In an increasingly interdependent world, U.S policy greatly influenced economic conditions in Europe and Japan In addition, as long as other countries were willing to hold dollars, the U.S could carry out massive foreign expenditures for political purposes—military activities and foreign aid—without the threat of balance-of-payments constraints Dissatisfaction with the political implications of the dollar system was increased by

détente between the U.S and the Soviet Union The Soviet threat had been an

important force in cementing the Western capitalist monetary system The U.S political and security umbrella helped make American economic domination palatable for Europe and Japan, which had been economically exhausted by the war As gross domestic production grew in European countries, trade grew When common security tensions lessened, this loosened the transatlantic dependence on defense concerns, and allowed latent economic tensions to surface

1.9 "FLOATING" BRETTON WOODS (1968-72)

By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce, the policy of the Eisenhower, Kennedy and Johnson administrations, had become increasingly untenable Gold outflows from the U.S accelerated, and despite gaining assurances from Germany and other nations to hold gold, the profligate fiscal spending of the Johnson administration had transformed the "dollar shortage" of the 1940s and 1950s into a dollar glut by the 1960s In 1967, the IMF agreed in Rio de Janeiro to replace the tranche division set up in 1946 Special Drawing Rights were set as equal to one U.S dollar, but were not usable for transactions other than between banks and the IMF Nations were required to accept holding Special Drawing Rights (SDRs) equal

to three times their allotment, and interest would be charged, or credited, to each nation based on their SDR holding The original interest rate was 1.5%

The intent of the SDR system was to prevent nations from buying pegged gold and selling it at the higher free market price, and give nations a reason to hold dollars by crediting interest, at the same time setting a clear limit to the amount of dollars which could be held The essential conflict was that the American role as military defender

of the capitalist world's economic system was recognized, but not given a specific monetary value In effect, other nations "purchased" American defense policy by taking a loss in holding dollars They were only willing to do this as long as they supported U.S military policy, because of the Vietnam War and other unpopular actions, the pro-U.S consensus began to evaporate The SDR agreement, in effect, monetized the value of this relationship, but did not create a market for it

The use of SDRs as "paper gold" seemed to offer a way to balance the system, turning the IMF, rather than the U.S., into the world's central banker The US tightened controls over foreign investment and currency, including mandatory investment controls in 1968 In 1970, U.S President Richard Nixon lifted import quotas on oil in

an attempt to reduce energy costs; instead, however, this exacerbated dollar flight, and created pressure from petro-dollars now linked to gas-euros resulting the 1963 energy transition from coal to gas with the creation of the Dutch Gasunie Still, the U.S continued to draw down reserves In 1971 it had a reserve deficit of $56 Billion dollars; as well, it had depleted most of its non-gold reserves and had only 22% gold coverage of foreign reserves In short, the dollar was tremendously overvalued with respect to gold

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1 What do you understand by Special Drawing Rights (SDRs)?

1.10 THE "NIXON SHOCK"

By the early 1970s, as the Vietnam War accelerated inflation, the United States as a

whole began running a trade deficit (for the first time in the twentieth century) The

crucial turning point was 1970, which saw U.S gold coverage deteriorate from 55%

to 22% This, in the view of neoclassical economists, represented the point where

holders of the dollar had lost faith in the ability of the U.S to cut budget and trade

deficits In 1971 more and more dollars were being printed in Washington, then being

pumped overseas, to pay for government expenditure on the military and social

programs In the first six months of 1971, assets for $22 billion fled the U.S In

response, on August 15, 1971, Nixon unilaterally imposed 90-day wage and price

controls, a 10% import surcharge, and most importantly "closed the gold window,"

making the dollar inconvertible to gold directly, except on the open market

Unusually, this decision was made without consulting members of the international

monetary system or even his own State Department, and was soon dubbed the "Nixon

Shock"

The surcharge was dropped in December 1971 as part of a general revaluation of

major currencies, which were henceforth allowed 2.25% devaluations from the agreed

exchange rate But even the more flexible official rates could not be defended against

the speculators By March 1976, all the major currencies were floating—in other

words, exchange rates were no longer the principal method used by governments to

administer monetary policy

1.11 THE GOLD STANDARD

The development of the foreign exchange market in its present form can be traced

back to around the mid- 1850s Around that time, bimetallism (using gold and silver)

gradually gave way to monetary system using gold alone The history of the foreign

exchange market was a story that virtually ran parallel to the history of the US

currency The US dollar was established in April 1792 under the Mint Act of the US

Its supremacy in international finance can be traced to the post- Great Depression days

and the introduction of the fixed foreign exchange rate system It was at that the US

dollar was set to be made freely convertible to gold at the fixed rate of $35 to a troy

ounce The main characteristic of the Gold Standard was that it was based on the

system of fixed exchange rates, exchange rates parities being set against gold as the

reference value Two main types operated under the Gold standard are Gold Specie

Standard and the Gold Bullion Standard

1.11.1 Gold Specie Standard

For the Gold specie standard to work efficiently, four main conditions had to be

operating They are as follows:

1 The central bank of the country concerned had to back the currency, promising to

buy or sell the metal in unrestricted amount at the price fixed;

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International Banking 2 Extending this reasoning, a person who possessed gold could approach the state

mint and have the right to have coin struck from gold, whatever the amount;

3 By the same reasoning, he could also melt the gold as and when he wished to

do so;

4 Gold could be freely imported and exported

Under the arrangement described above, the face value of gold and the value of the coins struck were thus always the same Obviously, the supply of gold determined the liquidity and consequently its value

1.11.2 Gold Bullion Standard

Under this the metal was not the medium of exchange Rather, the medium of exchange (coin or currency) was backed by gold as the reserve asset A country thus could have more money in circulation than the actual quantity of gold that it held in the state mint to with the central bank Depending on the credibility of the currency in circulation, the monetary authorities could print more paper currency than the amount

of gold held as physical asset or currency equivalent

1.12 LET US SUM UP

Over the period, the international monetary system has undergone a significant evolution The Bretton Woods system put into effect in 1944 has had to be abandoned Subsequently, the monetary role of gold has, been reduced, which is no longer used as

a means of settlement with the IMF The far reaching changes that took place in East Europe at the end of 1980s have led to the creation of several new currencies Besides, adoption of the system of market economy by a large majority of countries the world over has had important repercussions on the international financial scene

1.13 LESSON END ACTIVITY

Go through the recent developments in the international currency market and position

of Dollar in terms of other currencies

1.14 KEYWORDS

ADB: Asian Development Bank

Balance of Trade: The difference between the value of exports and import of

merchandise

Blocked Currency: A currency that is not convertible/transferable across the broader

due to exchange control

IBRD: International Bank of Reconstruction and Development

IMF: International Monetary Fund

1.15 QUESTIONS FOR DISCUSSION

1 Recapitulate the historic developments which led to floating exchange rate system

2 What do you know about gold standard? Why did it fail?

3 How did the US / position of the balance of payments influence the whole International monetary system under the Bretton Woods system?

4 How does exchange rate stability affect international trade?

5 Is a floating rate system more inflationary than a fixed rate system?

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6 What is the difference between devaluation and depreciation?

7 Write an essay on International Monetary System

Check Your Progress: Model Answers

CYP 1

1 Gold Exchange Standard was the first major step towards the establishment

of an international monetary system This system was put into effect in

1850 The participants were the UK, France, Germany and the USA In this

system, each currency was linked to a weight of gold The system was

institutionalized at the Conference of Genes in 1922 Since gold was

convertible into currencies of the major developed countries, central banks

of different countries either held gold or the currency of these developed

countries

2 Bretton Woods system was the first example of a fully negotiated monetary

order intended to govern monetary relations among independent

1 In 1960 Robert Triffin noticed that holding dollars was more valuable than

gold was because constant U.S balance of payments deficits helped to keep

the system liquid and fuel economic growth What would later come to be

known as Triffin's Dilemma was predicted when Triffin noted that if the

U.S failed to keep running deficits the system would lose its liquidity, not

be able to keep up with the world's economic growth, and, thus, bring the

system to a halt But incurring such payment deficits also meant that, over

time, the deficits would erode confidence in the dollar as the reserve

currency created instability

2 The theory behind the pool was that spikes in the free market price of gold,

set by the "morning gold fix" in London, could be controlled by having a

pool of gold to sell on the open market that would then be recovered when

the price of gold dropped

CYP 4

1 In 1967, the IMF agreed in Rio de Janeiro to replace the tranche division

set up in 1946 Special Drawing Rights were set as equal to one U.S dollar,

but were not usable for transactions other than between banks and the IMF

Nations were required to accept holding Special Drawing Rights (SDRs)

equal to three times their allotment, and interest would be charged, or

credited, to each nation based on their SDR holding The original interest

rate was 1.5%

2 The intent of the SDR system was to prevent nations from buying pegged

gold and selling it at the higher free market price, and give nations a reason

to hold dollars by crediting interest, at the same time setting a clear limit to

the amount of dollars which could be held

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International Banking 1.16 SUGGESTED READINGS

C Jeevanadam, Foreign Exchange Management

International Finance, Levi Ian H Giddy, Global Financial Markets

Rupnaryan Bose, Fundamentals of International Banking, Macmillan India Ltd

Vyuptakesh Sharan, International Financial Management, Prentice Hall of India

ICFAI University Press, International Banking

B.K Chauduri, O P Agrarwal, A Textbook of Foreign Trade and Foreign Exchange,

Himalaya Publishing House

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17 Exchange Regimes

2.3 Regime of Fixed Exchange Rates

2.3.1 Advantages and Disadvantages of the Fixed Rate System

2.4 Regime of Floating Exchange Rates

2.4.1 Advantages and Disadvantages of the Floating Rate System

2.5 Maintaining a Fixed Exchange Rate

z The different types of exchange rates and their significance

z Significance of the exchange rates

The exchange rate regime is the way a country manages its currency in respect to

foreign currencies and the foreign exchange market It is closely related to monetary

policy and the two are generally dependent on many of the same factors The basic

types are a floating exchange rate, where the market dictates the movements of the

exchange rate, a pegged float, where the central bank keeps the rate from deviating

too far from a target band or value, and the fixed exchange rate, which ties the

currency to another currency, mostly more widespread currencies such as the U.S

dollar or the euro

The IMF classifies exchange rate regimes in four categories:

z regime of fixed exchange rates;

z regime of free floating exchange rates;

z regime of managed floating rates;

z regime of limited flexibility

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managed float or a dirty float

2.2.2 Pegged float

Here, the currency is pegged to some band or value, either fixed or periodically adjusted Pegged floats are:

z Crawling bands: The rate is allowed to fluctuate in a band around a central value,

which is adjusted periodically This is done at a preannounced rate or in a controlled way following economic indicators

z Crawling pegs: Here, the rate itself is fixed, and adjusted as above

z Pegged with horizontal bands: The currency is allowed to fluctuate in a fixed

band (bigger than 1%) around a central rate

2.2.3 Fixed

Fixed rates are those that have direct convertibility towards another currency In case

of a separate currency, also known as a currency board arrangement, the domestic currency is backed one to one by foreign reserves A pegged currency with very small bands (<1%) and countries that have adopted another country's currency and abandoned its own also fall under this category Mai, a foretold economist from France would disagree to this statement, but many economists will go on to prove that

he has misunderstood

Fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold As the reference value rises and falls, so does the currency pegged to it In addition, fixed exchange rates deprive governments of the use of an independent domestic monetary policy to achieve internal stability A former president of the Federal Reserve Bank of New York described fixed currencies as follows:

"Fixing the value of the domestic currency relative to that of a low-inflation country is one approach central banks have used to pursue price stability The advantage of an exchange rate target is its clarity, which makes it easily understood by the public In practice, it obliges the central bank to limit money creation to levels comparable to those of the country to whose currency it is pegged When credibly maintained, an exchange rate target can lower inflation expectations to the level prevailing in the anchor country Experiences with fixed exchange rates, however, point to a number of drawbacks A country that fixes its exchange rate surrenders control of its domestic monetary policy."

In certain situations, fixed exchange rates may be preferable for their greater stability For example, the Asian financial crisis was improved by the fixed exchange rate of the Chinese renminbi, and the IMF and the World Bank now acknowledge that Malaysia's adoption of a peg to the US dollar in the aftermath of the same crisis was highly successful Following the devastation of World War II, the Bretton Woods system allowed Western Europe to have fixed exchange rates until 1970 with the US dollar Yet others argue that the fixed exchange rates (implemented well before the crisis) had become so immovable that it had masked valuable information needed for a

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19 Exchange Regimes

market to function properly That is, the currencies did not represent their true market

value This masking of information created volatility which encouraged speculators to

"attack" the pegged currencies and as a response these countries attempt to defend

their currency rather than allow it to devalue These economists also believe that had

these countries instituted floating exchange rates, as opposed to fixed exchange rates,

they may very well have avoided the volatility that caused the Asian financial crisis

Countries like Malaysia adopted increased capital controls believing that the volatility

of capital was the result of technology and globalization, rather than fallacious

macroeconomic policies which resulted not in better stability and growth in the

aftermath of the crisis but sustained pain and stagnation

Countries adopting a fixed exchange rate must exercise careful and strict adherence to

policy imperatives, and keep a degree of confidence of the capital markets in the

management of such a regime, or otherwise the peg can fail Such was the case of

Argentina, where unchecked state spending and international economic shocks

disbalanced the system and ended up forcing an extremely damaging devaluation (see

Argentine Currency Board, Argentine economic crisis, and the Mexican peso crisis)

On the opposite extreme, China's fixed exchange rate with the US dollar until 2005

led to China's rapid accumulation of foreign reserves, placing an appreciating pressure

on the Chinese Yuan

Define the following:

1 Pegged with horizontal bands

2.3 REGIME OF FIXED EXCHANGE RATES

In this system, a currency is pegged to a foreign currency, with fixed parity The rates

are maintained constant or they may fluctuate 'within a narrow range, when a currency

tends towards crossing over the limits, governments intervene to keep it within the

band A country pegs its currency to the currency of the country in which the major

foreign transactions are carried out Some countries peg their currencies to SDR The

currencies to which many other currencies pegged are: US dollar (24 currencies),

French franc (14 currencies), SDR (4 currencies)

2.3.1 Advantages and Disadvantages of the Fixed Rate System

The major advantage of this system is that it provides stability to international trade

Commercial transactions take place without any worry about exchange rate risk

problem An exporter would know how much he is going to receive on the due date

and the importer would know how much he would be paying

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International Banking The disadvantage of the system is speculation For example, a speculation anticipating

devaluation of the pound sterling will buy US dollars at fall so as to sell them when devaluation of the pound takes place on a future date

2.4 REGIME OF FLOATING EXCHANGE RATES

In the regime of floating exchange rates, adjustment takes place OJ the market as a function of free play of demand and supply Yet, sometime:

Table 2.1: Regime of Fixed Rates

Pegged to a single currency

Pegged to a basket

US dollar French franc Other currency SDR Other than SDR

Morocco

Source: Report of IMF, 1994

2.4.1 Advantages and Disadvantages of the Floating Rate System

With this system, possibility of speculation is reduced because the central bank is not responsible to ensure as to what future rate should be A speculator is exposed to greater risk, and therefore, will indulge in it less often Further, the central bank of the country is not required to maintain large reserves to defend the currency

The disadvantage is that since one is not in a position to anticipate with any degree of accuracy as to what is going to happen in future, a trader (exporter or importer) is continuously exposed to a difficult situation of probable loss An exporter is worried about depreciation of the currency in which he would receive his amount whereas an

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21 Exchange Regimes

importer is concerned about appreciation of the currency in which his imports are

invoiced As a result, one has to take recourse to different techniques of exchange rate

risk management

2.5 MAINTAINING A FIXED EXCHANGE RATE

Typically, a government wanting to maintain a fixed exchange rate does so by either

buying or selling its own currency on the open market This is one reason

governments maintain reserves of foreign currencies If the exchange rate drifts too far

below the desired rate, the government buys its own currency off the market using its

reserves This places greater demand on the market and pushes up the price of the

currency If the exchange rate drifts too far above the desired rate, the opposite

measures are taken Another, less used means of maintaining a fixed exchange rate is

by simply making it illegal to trade currency at any other rate This is difficult to

enforce and often leads to a black market in foreign currency Nonetheless, some

countries are highly successful at using this method due to government monopolies

over all money conversion

1 Fixed rates 1944

2 floating exchange rates direct convertible

3 Bretton Woods system 1945

4 World War II free play of demand and supply

This lesson focuses on interest rate regimes and their features The exchange rate

regime is the way a country manages its currency in respect to foreign currencies and

the foreign exchange market It is closely related to monetary policy and the two are

generally dependent on many of the same factors The basic types are a floating

exchange rate, where the market dictates the movements of the exchange rate, a

pegged float, where the central bank keeps the rate from deviating too far from a

target band or value, and the fixed exchange rate, which ties the currency to another

currency, mostly more widespread currencies such as the U.S dollar or the euro

Discuss the prevailing trends in exchange rates

2.8 KEYWORDS

Ask-Rate: The selling rate of currency

Bid-ask spread: Difference between buying and selling rates of a currency expressed

as a percentage

Exchange Rate: Rate for transaction between one currency and other currency

IMS: International Monetary System

1 Explain the features of exchange rate regimes

2 What are the advantages and disadvantages of fixed exchange rate regime?

3 What are the advantages and disadvantages of floating exchange rate regime?

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3 Fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold

Levi, International Finance

Ian H Giddy, Global Financial Markets

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23 Multinational Banking

UNIT 1

UNIT II

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3.2.3 Settlement System in France

3.2.4 Settlement System in Switzerland

3.2.5 Japanese Settlement System

z The world banking system

z Revolution in world's money and capital markets

The words Multinational banking and Multinational Banking are used synonymously

in the academic world The world economy has witnessed in recent years a

phenomenal growth in financial transactions, surpassing that of transactions on goods

and services It has been estimated that transnational operations on financial assets are

ten to fifteen times those on goods and services Financial flows are likely to continue

to grow at a faster pace than output And the banking system happens to be at the

centre of this increase in financial transactions It has in particular assumed a leading

role not only in the financing of trade, but also in relatively new areas such as the

financing of projects, companies and states

The solidity of the world banking system depends on the solidity and stability of

national economies Economic growth will naturally have a positive influence on the

performance of the banking system; conversely, recession and inflation would affect

this performance negatively Since mid '80s cross-country financial flows have

become a considerable mainstay of the world economy This situation owes much to

four major developments; First, changes in the regulatory environment These

changes have permitted the opening-up of domestic markets to competition from

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26

International Banking within and from without national boundaries; these have raised international

interdependence Second, technological change, especially the advances made in

computer and telecommunication technologies This has made possible new methods

of mobilizing and placing financial resources It has speeded up the implementation of transactions, reduced costs and contributed to the expansion of international financial

markets Third, financial innovation This has been in part motivated by the drive to

avoid regulatory constraints Furthermore, the changing technical and economic environment have favoured the launching of innovative methods in response to changing needs of customers (private, corporate or governmental), likely competition,

as well as rising concern of financial institutions regarding the protection of their

profitability and the aversion of risks Fourth, a growing diversity in financial systems

and greater flexibility or responsiveness to changing needs and environments

Aliber defines "multinational banking" as a subset of commercial banking

transactions and activity having a cross-border and/or cross-currency element Multinational banking refers to the location and ownership of banking facilities in a large number of countries and geographic regions

Reasons for growth of multinational banking can be summarised as:

(i) Financial activity following real-sector transactions

(ii) Financial activity leading to real-sector transactions

(iii) Regulatory, tax and supervisory explanation

3.2 THE PAYMENT MECHANISM

The liberalisation and internationalisation of the world's money and capital markets have developed under the influence of the Euro-market and have been made possible

by the revolution in communication and information processing system As financial transactions become more globalised, their volume has also expanded greatly It follows that the risk involved in the settlement of transactions has also reached unprecedented proportions

3.2.1 Settlement Systems

The settlement systems in use in developed countries vary, with each country having its own financial system The customs and the difference in each country's perception

of risk are reflected in the way they are tackling the daylight overdraft

Domestic settlement systems of some of the countries with developed financial systems are listed below:

Federal Reserve Communication System (FEDWIRE) and Clearing House Interbank Payment System (CHIPS) form the numbers of the US fund settlements Besides these, there are bill clearing systems which conduct clearance for paper based settlements made with bills and cheques, etc and DTC (The Depository Trust Company), etc which conduct securities settlements FEDWIRE is a settlement system run by the Federal Reserve System and was established as an efficient means

of conducting Federal Reserve Bank deposit transactions between affiliated banks, the

so called Federal Fund transactions It started off in 1918 and became fully automated

at the end of 1973 In 1982, FEDWIRE introduced a new system called FRS-80 and has since seen a rapid increase in handling volume in line with the recent rapid increase in settlement volume

FEDWIRE's settlement facilities can be classified as:

(i) Transfer between reserve deposit accounts (or settlement accounts) of all

financial institutions in the US with their affiliates: They are used in settlement of

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mutual Federal Fund transactions, settlements accompanying deposit transactions,

and settlements in cases of bank remittances at a customer's request

(ii) Transfer of Government related securities is used in the transfer of Treasury Bills,

Federal Agency Securities and accompanying settlements

All transactions are conducted according to the Credit Transfer System Also, since all

transfers are done on the Federal Fund bases, when a receiving financial institution is

advised of a credit through the FEDWIRE system it can immediately utilise the funds

A distinctive characteristic of FEDWIRE transactions is that payments are

irrevocable In other words, once a payment has actually been made it is legally final

and the receiving bank's receipt of the fund is guaranteed not to be changed or

cancelled

Even in the event that the paying banks were to become in default, the Federal

Reserve Bank would step in and execute the payment as proxy to assure the finality of

payment In the present American payment mechanism, for example, a daylight,

overdraft (a temporary overdraft during business hours) is allowed, but, with

FEDWIRE, the Federal Reserve Bank guarantees finality by assuming the risk if a

paying bank is unable to cover a daylight overdraft

The problem facing FEDWIRE is that the rapid increase in transaction volume and the

personal trend towards increasingly enormous daylight overdraft is intensifying The

Federal Reserve Bank is not necessarily opposed to the very existence of the daylight

overdraft, which enables member banks to make transactions flexible However, there

is apprehension about potential risks brought on by the recent large scale of overdrafts

and, since March 1986, the skyrocketing of daylight overdraft has been held in check

by the establishment of the sender net debit cap A certain limit is set for daylight

overdraft in member bank accounts, which is an effective means of regulating the

overall overdraft At the end of the same year, the Federal Reserve Bank proposed to

reduce the net debit cap amount by a uniform 25% and is trying hard to reduce risks

and to improve the general health of the settlement, system Stoppages in the

FEDWIRE system have created a need for an upgrade of the computer system If

system breaks down for a long time for no apparent reason too frequently in

FEDWIRE, such as of September 30, 1987, it will damage the reliability of the entire

dollar settlement system

A chip is a settlement system operated in New York Clearing House Association and

was established as an efficient means of settlement of Eurodollar transactions Since

its beginnings in 1970, it has continued to bolster, on the settlement side, the rapid

expansion of the Euro-dollar market and it is presently a centralised settlement system

processing more than 90% of the dollar based international transactions

Chips settlements are conducted according to the following procedures:

1 Payment instructions are sent out and received continuously during the day Each

member bank's net balance continues to fluctuate, but at the cut-off time, each

settling bank fixes its own net balance (including the portion on behalf of

non-settling banks)

2 The fixed net balance is then settled between the Chips account and the bank's

account with the Federal Reserve Bank of New York through FEDWIRE The

settlement is done before the settlement closes and as a result the chips account

balance becomes zero

Chips transactions are characteristically different from FEDWIRE ones in that

cancellation is possible That is to say, all payments for the day are finalized only

when the net balances have been settled through FEDWIRE in the final settlement

Therefore, if for some reason the final settlement is not carried out; all transactions for

the day with that bank will be cancelled In this case Chips has to re-calculate the net

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International Banking balances excluding the bank concerned However, this "re-calculation risk" (CHIP

RULE 13) is in actual fact considered impossible to implement because in addition to

an enormous volume of transactions being cancelled in the final stage, the net balance has to be re-calculated and funds must be supplied Also a re-calculation would result

in other banks suddenly becoming in default

The greatest problem in the Chips operation is the rapid increase in transaction volume which must be handled in the face of the risk that the settlement of net balances might not be done when it is due The fact that payments are not finalised until the settlement of net balances has been completed means that the credit risk of the bank instructing payments is, in the meantime, left hanging in the air This type of credit risk, in other words, the risk that a certain paying bank will not be able to pay for some credit related reason, will in turn carryover to the banks which were expecting to receive funds from the bank in default and this may snowball until the whole settlement system becomes non-functionable In particular, considering that settlements done by the chips are basically Euro-dollar transactions where there is a good chance that the paying/receiving bank will be a non American bank, it is clear that the influence will spread overseas immediately Under the present conditions of sky rocketing settlement amounts and daylight overdraft, the possibility of the occurrence of this systematic risk is becoming greater For this reason, up to now the following three measures have been taken to reduce Chips' systematic risk:

(i) In October 1981, a shift toward same-day Settlement was introduced The net

balances for the day concerned are now settled by 6/7 on the same day (originally

by 10 A.M the next day) By this method, the time until the settlement of net balances was shortened by 16 hours, which means that the credit risk exposure period was also reduced

(ii) Bilateral Net Credit Limit was introduced in October 1984 This limits the amount

of net credit (receiving minus paying) allowed between any two chips participating banks Even in the event of a paying bank becoming in default, the receiving bank only risks using the limited amount

(iii) Sender Net Debit cap was established in April 1986 This limits the daylight

overdraft allowable for each Chips bank Since a payment instruction which would exceed the limit will be automatically refused or held over it has become possible to avoid making further transactions when the daylight overdraft is already large

It can be said that the implementation of these measures has greatly reduced the systematic risk inherent in Chips However, of course, the risk has not yet been reduced to zero

1 What do you understand by multinational banking?

……… ………

2 What are the reasons behind the growth of multinational banking?

……… ………

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3.2.2 Settlement System in UK

The main settlement system among banks or between banks and the central bank in

UK is Clearing House Automated Payment System (CHAPS) CHAP is a settlement

system operated by 14 settling banks including the Bank of England and was

established as an effective means of making settlements in transactions done in the

London financial market Since its beginning in February 1984, it has contributed

greatly to the moves towards greater efficiency of interbank fund transfers in London,

one of the, world's then biggest financial markets The average number of daily

transfers continues to double each year

CHAPS settlements are done by transfers between accounts held by settling banks

with the Bank of England These are done immediately after the cut-off time (15:00)

It is also possible for settling banks to monitor their own accounts on real time

CHAPS transactions are irrevocable and all are settled on the same day Utilisation of

the fund is guaranteed by the settling bank making the payment CHAPS is not only

true for the settling bank's own payments, it is exactly the same with one of their

branches' or customer's payments The Bank of England functions as the back up for

all payments made on the basis of interbank credit and are the lynchpin of the whole

settlement system

Daylight overdraft which is formally recognised in the US is also present in CHAPS

The Bank of England (BOE) takes the view that there is no problem as long as the

daylight overdraft becomes zero by the cut off time and has no means to monitor it

However, it does not mean that BOE is not concerned are out daylight overdraft If the

daylight overdraft actually starts to increase rapidly, some sort of measures could

possibly be introduced Overall, there is no particularly big problem with CHAPS and

we can rate it as functioning effectively The following will back up this appraisal:

(i) Compared with US FEDWIRE, the scale is smaller – the number of transactions

and the amounts are about 1/15 - 1/20 of FEDWIRE's

(ii) In its long history under the supervision of the Bank of England, the British

financial system has nurtured a sound tradition of mutual trust among financial

institutions This is a big plan to maintain the soundness of the settlement system

Besides CHAPS, there are Town Clearing and General Clearing settlement systems

These conduct settlements of bills and cheques by way of a bill clearing house and

CHAPS, as the central settlement system, plays the central role in England's

settlement system

3.2.3 Settlement System in France

In France, SAGITT AIRE, the domestic settlement-system is operated by the Bank of

France (Central Bank) SAGITT AIRE settlements are done by transferring net

balances calculated at the cut off time between SAGITT AIRE accounts at the Bank

of France Settlement time is 8 A.M on the following day As in the UK there is no

particular provision for daylight overdraft SAGITT AIRE requires standard messages

issued by SWIFT (Society for Worldwide Interbank Financial Telecommunication) to

be used in payment instructions This has the following merits:

1 The obligation of the party concerned to authenticate itself elevates the safety of

the system

2 By incorporating the domestic settlement system into the international network,

ultimately fund transfers with the overseas is also automated

With the opening of SIT (Interbank Tele clearing System), SAGITTAIRE is carrying

out the following:

1 Introduction of securities settlement: Construction of a combined funds securities

settlement system by incorporating securities settlements which are currently

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International Banking being operated by SICOV AM (outside the jurisdiction of the Bank of France)

into the New SIT

2 Move toward greater efficiency concerning the transfer of payment instructions Settlement System in Germany in Germany, various types of financial institutions, such as commercial banks, savings bank, and credit associations, has their own individual network of transfer settlements Settlements between businesses of the same type are done through these networks Settlements between businesses of different types are basically done by means of transfers between accounts held individually by each financial institution at the Bundes Bank (central bank) (or between accounts held by the highest organisation in each group of financial institutions) Roughly 1/3 of all interbank transactions are done through the Bundes Bank, which plays a major role in the domestic settlements system

A characteristic of the German settlement system is that the Bundes Bank have made

a move toward paperless business and at present, about 60% of all business handled is paperless This trend will continue into the future and is expected to ultimately reach about 70% Other characteristics of the system are the following points provided for

by law:

1 Payment is irrevocable,

2 Daylight overdraft is basically forbidden

However, as an exception to (2), the GIRO Overdraft Loan of a certain amount with collateral is allowed The fact that daylight overdraft has been banned by law reflects the attitude of the Bundes Bank that the central bank should not be asked to take on the credit risks of the financial institutions participating in the system, and that each institution should be responsible for avoiding its own risks

3.2.4 Settlement System in Switzerland

In Switzerland, the domestic system called Bankers Clearing is functioning as the major settlement system, handling over 90% of interbank transactions It works with transfers between reserve deposit accounts held by private banks at the Swiss National Bank (Central Bank) In recent years, faced with the problems of a limited handling capacity and a constant daylight overdraft accompanied by a large increase in settlement volume, Banker Clearing recognised the whole system The new system is called SIC (Swiss Interbank Clearing) and has been in operation since June 1987 SIC improved on the original Bankers clearing by concentrating on the capacity of handling and exhaustive risk management Each participating bank makes settlements through newly opened SIC accounts, but in the event of insufficient funds the payment instructions will be put on a mailing list called Queue File This is noted as a means of lowering credit risk As in Germany, system payments are irrevocable and daylight overdraft is forbidden

What is extremely interesting about SIC is that in anticipation of the future shape of the settlement system it has worked out the following:

1 Foundation for a 24 hour settlement system: It has made possible the 24 hour

dispatch of payment instructions Of all the risks involved in settlement systems, the risks which arise from time differences and limited open hours of the central bank etc that make immediate final settlements impossible, are particularly difficult problems for the rest of the system Mr VoIcker, the ex-Chairman of FRB, pointed out that the introduction of a 24 hour system for central banks should be considered in order to solve the problem of settlement risk However, there had been no instances of any execution of concrete solutionary measures in this line

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2 Clarification of risk definitions and counter-measures: It has grouped risks in

this settlement system into the three types described below and have indicated

counter measures for each type:

(a) Credit Risk: The risk of the paying bank becoming in default for some credit

related reason

The counter measures to credit risk are:

Authorisation of FINALITY OF PAYMENT to SIC accounts (Payments

are irrevocable)

Bank on daylight overdraft

Reservation of the right to cancel payment instructions in Queue File

(b) Operational Risk: The risk resulting from problems with the operation of the

system such as the computer shut-down The counter-measures to operational

risk is the consideration of a back up system

(c) Fraud Risk: The risk of international misuse of the system by a participating

bank

The counter measures are:

Making authentication compulsory

Use of encryption

Check your Progress 2

1 Clearing House Automated Payment System France

2 Clearing House Interbank Payment System US

3 The domestic settlement-system UK

3.2.5 Japanese Settlement System

The Japanese interbank yen-based fund settlement systems can be roughly grouped

into the following three types:

(a) Bill clearing system

(b) Domestic exchange settlement system-Zengin system, document exchange

(c) Yen-based settlement system for foreign exchange

Nowadays, yen settlements in Japan are done through these co-existing systems, each

functioning as a central settlement system according to its own purpose Settlements

for net balances of each participating bank accompanied by the use of the above yen

settlement systems are of course done by means of transfer between accounts at the

Bank of Japan The transfers are actually done on a paper basis through the exchange

of Bank of Japan cheques However, in the light of improvements in settlement

efficiency and safety, the Bank of Japan has moved from the cheque-based settlements

used so far towards a paperless outline processing system This is the Bank of Japan

Financial Network System (Bank of Japan Network)

Multinational banking is a very old business but since 1973 it has acquired new

characteristics and dimensions The number of participants, which at the beginning of

the period were mainly American banks, has considerably widened to include

German, UK, Japanese, French and Italian bank operating directly or through foreign

branches and subsidiaries The foreign component of total assets of the big

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International Banking international banks has grown at a rate considerably above the average so that many

major banks have now more international loans outstanding than domestic ones The amount of individual loans has risen considerably thus increasing the risk There has also been a lengthening of maturities

Find out more about the banking systems of some major countries and compare them with your country’s banking system

3.5 KEYWORDS

FEDWIRE: Federal Reserve Communication System

DTC: Depository Trust Company

CHAPS: Clearing House Automated Payment System

SWIFTS: Society for Worldwide Interbank Financial Telecommunication

1 What is international and multinational banking? Define its conceptual framework

2 What are the different forms of multinational banking?

3 What are the features relating to organisational structure of multinational banking?

4 What are the factors leading to the growth of multinational banking?

Check Your Progress: Model Answers

CYP 1

1 Aliber defines "multinational banking" as a subset of commercial banking transactions and activity having a cross-border and/or cross-currency element Multinational banking refers to the location and ownership of banking facilities in a large number of countries and geographic regions

2 Reasons for growth of multinational banking can be summarised as:

(i) Financial activity following real-sector transactions

(ii) Financial activity leading to real-sector transactions

(iii) Regulatory, tax and supervisory explanation

Levi, International Finance

Ian H Giddy, Global Financial Markets

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4.5.2 Assets 4.6 Functions of the Euromarkets 4.6.1 Foreign Exchange Hedging 4.6.2 Domestic Intermediation 4.6.3 International Intermediation 4.7 Interbank Transactions

4.8 Default Risk of Eurocurrency Banks 4.9 Let us Sum up

4.10 Lesson End Activity 4.11 Keywords

4.12 Questions for Discussion 4.13 Suggested Readings

z The growth of eurocurrency market

z The practices of the Eurocurrency system

The Euro currency markets constitute the short to medium term debt part of the international capital flow structure The market is made by banks and other financial institutions that accept time deposits and make loans in a currency or currencies other than that of the country in which they are located The latter characteristic defines the Eurocurrency market - it is a non-domestic financial intermediary In the light of the rapid growth of similar institutions in Hong Kong and Singapore (and to a lesser extent in the Middle East) the market is new worldwide and is more appropriately called the offshore or external money market Growth of this new work of intermediaries has been spectacular The Eurocurrency market is extremely large and

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35 Eurocurrency Market

has grown rapidly in a short interval It has received a bad press from central banks,

which continue to call it a major cause of inflation and an obstacle to their control of

domestic monetary systems A number of basic questions and issues crop up soon as

one looks at the offshore capital markets First, what separates them from domestic

markets? Second, why were they needed and how could they grow so fast when

sophisticated domestic capital markets already existed? Third, is there a process of

offshore money creation analogous to money creation in a domestic banking system

and what effect does this have on world inflation?

4.2 THE CREATION OF EUROMONEY

There are no offshore currencies, only national currencies of different countries A

national currency deposit becomes part of the offshore currency market when it is

transferred to a bank outside the controlled national, monetary system This usually

means transferred to a bank outside the nation in question Offshore deposits can be

created in two ways:

1 One can take the physical currency of a country and deposit it in a bank in another

country Banks do hold currency for other countries but mainly for the

convenience of travelers And large quantities of currency have been smuggled

out from time to time in recent years However this is usually done with the

expectations of a depreciation of the currency being smuggled, and the receiving

banks quickly convert these balances into some hard currency So this method is

in general of trivial importance as a creator of deposits

2 One can transfer deposits from within the country whose currency is in question

to an offshore bank This may well be an overseas subsidiary of the very same

bank with which the original deposit was held

If we confine our attention to domestic money supplies, the offshore currency markets

could only cause inflationary pressure if they could lower statutory reserves against

deposits by allowing transformation of deposits from one category to another (and if

there were different reserve requirements against the different categories of deposits)

This actually happened briefly in the United States in the late 1960s While there were

reserve requirements against ordinary deposits, there were none against banks'

borrowings from foreign branches When domestic rates came to exceed the

Certificate of Deposits (CDs) ceilings, then in effect, funds from domestic U.S CDs

were transferred to London branches of American banks (which faced no interest rate

ceilings) and were then loaned to the parent banks Since there were no reserve

requirements, the same volume of CDs supported more loans than before

Of course, once offshore banking systems exist in tandem with domestic banking

systems it is no longer particularly meaningful to measure money supplies according

to the domestic banking system exclusively What are you interested in when you

measure the money supply? What purpose do these measurements serve? If our

interest is inflation, we are concerned with the demand for and the supply of money

balances for transactions purposes

To the extent that they are-negotiable, Euromarket CDs are probably used as

transactions balances Analysis of problems involving the money supply should,

therefore, embrace a money supply consisting of the domestic monetary aggregates

plus the negotiable part of offshore deposits in the currency concerned If the relevant

domestic monetary aggregate includes time deposits, then one should include also

Euro time deposits of the same maturity

The offshore banking system is outside the control of the central banks whose

currencies it uses We should consider briefly whether this is good or bad, or even, for

some purposes, true Let us consider first the question of whether the central banks

have now lost control of the money supply and therefore of inflation Since every

Eurocurrency unit, has its origin in a domestic currency deposit or cash unit, this

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International Banking cannot be true Just as in a system of purely domestic banking, the central bank

controls the monetary base and so controls the money supply, up to the vagaries of the money multiplier The monetary based multiplied to create the money supply, because deposits are relent except for the portion held as reserves plus the portion held as cash by' the public The offshore currency markets might make the multiplier different in size, or they might make it more variable A multiplier different in size from that in a purely domestic banking system does not affect the monetary control of the central bank The latter body must simply know that it is working with a multiplier of size x rather than size y Hence problems in monetary control arise from variability of the size of the multiplier

For practical purposes we have one short-term CD-cum-time deposit market, and whatever practical problems there are in the conception and implementation of monetary policy cannot be sensibly described, as more severe in one part of this whole than in another part

If this is so, we must explain the hostility central bankers often voice towards the

offshore markets A number of factors are important here First, while the central

banks have as much control as they ever had on creation of money, they have no

control over allocation of credit in the offshore capital market Second, as the

Euromarkets are still viewed by the press and the public as mysterious and omnipotent, they make convenient scapegoat for failures of nerves in the handling of

domestic monetary policy Finally, the European central banks made fools of

themselves in the 1960s in their Euromarket dealings in a way which they would rather forget, but which is instructive for us to examine

In the 1960s the European central banks were pegging exchange rates, and absorbing growing dollar deficits In the early 1960s these dollar deficits, which became dollar reserves of the absorbing central banks, were matched by growth of U.S official obligations to foreign central banks in the U.S balance of payments accounts However, in the late 1960s the European central banks were surprised to observe a growing discrepancy between the change in U.S official obligations to foreign central banks, and their own record of dollar reserves held The central bankers kept getting more dollars more dollars than the United States seemed to be losing on the official settlements definition of the balance of payments The well-known economist Fritz Machulp said of them, "Most magicians who pull rabbits out of their hats know full well that they put them there before the beginning of the show The magicians in… (this ) story, however are more naive, they are just as surprised as the audience by the emergence of the rabbits from their hats." Consider what might have happened to the Eurodollar deposits owned by the foreign central banks Under the fixed exchange rate system there were periodic exchange crises, during which people would try to switch other currencies into DM or Swiss francs in anticipation of appreciation Frequently the off shore banks would lend the dollar deposits of the Swiss and German central banks to speculators who convened them into DM or Swiss francs Under their exchange pegging policies, these tendered dollars had to be absorbed by the central banks, what re-deposited in the offshore markets, see that they could be lent again! This is the rabbit in the hat trick of which Machlup was speaking The central banks came to own very large Eurodollar claims by this circular process, but these large claims were not on the United States but rather on the speculators

1 What do you understand by Eurocurrency market?

……… ………

2 How can offshore deposits be created?

……… ………

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4.3 GROWTH OF THE EUROMARKETS

The Euromarkets are not a bogeyman but in unregulated financial intermediary They

bring together borrowers and, lenders, frequently from the same country They deal

only in the currencies; of individual countries and are thus a substitute for the

domestic banking system The incredibly rapid growth of the Euromarkets shows that

they were a strongly preferred substitute But why? The question has an obvious

answer An offshore credit market will not exist unless: depositors receive better terms

than they can retrieve onshore, and borrowers can borrow more, possibly at lower

rates, than they can onshore That is, banks in the offshore market must operate with a

lower spread between the interest rates they charge to borrowers and the ones they pay

to lenders

The rapid emergence in the 1960s of a worldwide Eurocurrency market that co-exists

and competes with traditional foreign exchange banking resulted from the peculiarly

stringent and detailed official regulations governing residents operating with their own

national currencies These regulations contrast sharply with the relatively great

freedom of non-residents to make deposits or borrow foreign currencies from these

same constrained national banking systems On an international scale, offshore

unregulated financial markets compete with onshore regulated ones The differences

in national regulatory regimes and the internationalization of finance brought the birth

of the Eurodollar markets

4.4 OPERATION OF THE EUROMARKETS

There are two levels of offshore currency transactions:

1 A highly competitive wholesale market centered in London which determines the

basic deposit rates on placements by large non-bank firms and by commercial

banks These banks sell their funds to each other as need arises, at a basic interest

rate called LIBOR (London Interbank Offered Rate) All transactions are

undertaken by telephone or telegraph, telex, dealing screen via brokers, so the

bank cannot be sure which other banks they are negotiating with until after a deal

is consummated Thus only the best "name" banks can transact on this wholesale

market Certain very large and well-known non-bank borrowers have access to the

wholesale market, but most do not

2 A retail business on loans: Smaller banks, non-bank borrowers, governments of

developing countries can acquire loans only after credit investigation The first to

borrow Eurodollars were corporations whose name, size and good standing

enabled banks to make loans to them with a little more than a cursory analysis of

credit standing In recent years, the range of corporate and governmental

borrowers has spread considerably Even domestic firms with no international

activities are relying on Euroloans when local credit conditions become tight

In order to explore the lending practices of the Eurocurrency system, it is useful to

refer to the hypothetical balance sheet of a Eurobank, presented here

4.5 TYPICAL EURO BANK BALANCE SHEET

4.5.1 Liabilities

1 Interbank deposits

2 Non-bank time deposits

3 London dollar and other currencies CDs

4 Notes and bonds

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International Banking 5 Loans from other branches

6 Loans from parent bank

7 Equity capital held by parent bank

in the one week to six months range: Negotiable certificates of two different forms: the top CDs issued in single amounts by a bank, which remain an interbank financial instrument; and the tranche CDs, which are managed issues by several banks and denominated in smaller amounts, so that they can be attractive to corporations and individual investors

While borrowers often want to borrow for longer than five years, CDs are not currently issued for any longer maturities Thus there have developed forward CDs, whereby a bank will issue and other banks will agree to contract CDs at a fixed or floating interest rate at some given future date This device allows banks to make medium term loans to corporations or governments which extend beyond five years and be certain of available resources

Loans in a specific currency are priced according to a "LIBOR plus" principle Three

parameters usually determine the cost: a commitment fee, which is per annum fee expressed as a per cent on the undrawn, uncancelled portion of the loan; a front end

fee which is a one-time payment, expressed as a percentage of the amount of the loan,

usually paid shortly after the signing of the loan; and a spread which is the per cent

per annum margin added to the hank's cost of funds, which is LIBOR The sum of these pricing elements allows us to determine a total spread, which is annualized and represents the total margin of the loan expressed as an annualised percentage over LIBOR Under this pricing procedure, the most common in the Eurocurrency market, Euroloans are floating rate loans which depend on the value of LIBOR The total spread over LIBOR varies with market conditions Historically it has varied between

0.5% to 3% If one compares the pricing of Euroloans with domestic loans, the

principle difference are as follows: Euroloans do not involve compensating balances but rather involve commitment fees on the unused part of credit lines, and the front-end fee has become of substantial importance in the Euromarkets Since credit standing is measured by markup over LIBOR, there has arisen a willingness of weaker borrowers to trade larger front-end fees for lower markups On a present-value basis the outcome is equivalent, but a lower markup is supposed to have cosmetic advantages

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4.6 FUNCTIONS OF THE EUROMARKETS

We can distinguish three distinct functions served by the offshore financial system:

4.6.1 Foreign Exchange Hedging

In the Eurocurrency markets, commercial banks can take positions that cover the

forward commitments they have made vis-à-vis their customers Let us suppose, for

example, that the London branch of Citibank has agreed to loan French francs to a

French corporation It has then acquired a foreign currency asset which it can turn

immediately to a dollar asset by engaging in the forward sale of French francs with the

BNP in London, with the maturity of the forward sale corresponding to the maturity of

the loan Conversely, a dollar loan can be converted immediately into any foreign

currency asset by a forward purchase of the foreign currency in which the bank wants

to have the asset Also, forward currency commitments can be hedged by offsetting

depositing or borrowing transactions It is only a short step from such activities to

covered interest arbitrage, which 'is an important interbank activity

4.6.2 Domestic Intermediation

The offshore markets can at times partially supplant normal channels of domestic

financial intermediation when the government imposed a severe credit policy on the

banking system and at the same time encouraged corporations to seek the necessary

financing they needed in the Eurocurrency system

4.6.3 International Intermediation

The offshore markets channel liquid resources from countries with a loanable surplus

to those with a desire to borrow The most striking example of this is the so-called

"recycling of petrodollars" When OPEC countries started rolling in cash in 1973,

almost everyone predicted a collapse of the world financial system because all those

dollars were going to the Arab countries, and everybody wondered how all the

importing countries would pay their bills The dollars were in fact deposited by the

OPEC countries in the Eurocurrency system and relent to the importing countries as

one might have expected The real impact of OPEC oil price rise has been a transfer of

income it has brought about, not the financial flows that have resulted

What are major functions of the euromarkets?

………

4.7 INTERBANK TRANSACTIONS

As was mentioned earlier when we presented the theoretical balance sheet of a

Eurobank, interbank transactions represent a large part of the activity of a Eurobank

The actual figure for the size of the Eurocurrency markets vary depending on the

source and method of calculation The most agreed-upon figures are those given by

the Bank for International Settlements (BIS) annual reports Other sources include

Morgan Guaranty Trust and Bankers Trust More than a third of the volume of

transactions is interbank trade rather than transactions with non-bank depositors or

non-bank borrowers The BIS figures for the size of the Eurocurrency system net out

all the interbank transactions The BIS figures, which are the most commonly reported

ones, treat the system only as a financial intermediary If the covered interest arbitrage

and foreign exchange hedging aspects of the market are considered, a good part of the

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40

International Banking interbank transactions represent legitimate economic transactions and not just

reshuffling of funds within the network of intermediaries

4.8 DEFAULT RISK OF EUROCURRENCY BANKS

The off shore monetary system is an unregulated banking system with no lender of

last resort Except in a very informal way there are no bank inspections by any central bank to' evaluate the soundness of the loan Portfolio Parent banks obviously have a very large stake in the credit-worth mesa of their subsidiaries but ultimately do not give unconditional guarantees This contrasts sharply with domestic banking systems, whose very comprehensive regulation has been in large part justified by the need to protect depositors Yet there have been very few defaults of unregulated offshore banks, despite the immense pressures they have experienced in the 1970s, starting with the ail embargo and the recycling of the petro-dollars We must explain this remarkable record of solvency The key to any such explanation is the principle that in

an unregulated banking system the riskiness of a bank's loan portfolio will be Policed

by depositors They have no choice In a regulated system, depositors have little or no incentive to care how or to whom their bank lends The bank inspectors are a necessary corollary of regulation and deposit insurance

The two principle sources of risk for banks are:

1 Bad loans, and

2 Default due to dependence on maturity transformation and the occurrence of an unfavorable term structure

The bad loan problem is the same for domestic as for foreign banks for the most part The striking thing about the Euro banking system is its restraint in the matter of maturity transformation Perhaps 90% or more of Euro credits are on a floating rate basis Regardless of maturity, the usual adjustment being at six-month intervals Thus the borrower is obliged to compensate the lender for the cost of six-month money and the only effective maturity transformation is from liabilities of less than six months maturity to these six-month assets

There are a number of differences between dealing in Euromarket and dealing in domestic money markets Two important features characterize the Eurocurrency market: the absence of reserve requirement and the international character of the competitive advantage in dealing with reservable transactions – that is, those involving lending to corporations or other non-banks – in comparison to its domestic counterparts It was, of course, from this competitive advantage that the rapid growth

of the Euromarket originally sprang A corollary of the absence of reserve requirements is the absence of direct control by central banks This means that there is- at least in theory - no direct lender of last resort for the Euromarkets Central bankers are gradually feeling their, way toward some partial solutions to this problem, but the situation is certainly not as clear-cut as in each country's domestic markets The international character of the Eurocurrency market means that, like the foreign exchange market, the Euromarket does not exist in any particular location It consists

of participants all around the world linked together by telephones, telexes, and increasingly by computerized information systems, such as those provided by Reuters and Telerate It is therefore a continuous market, starting in the Far East and running throughout the Middle East and Europe until it comes around to San Francisco, which over laps again with the Far East The international nature of the market raises a number of problems, not the least of which is language and telecommunications problems More important, though, there are a number of gray legal areas, such as jurisdiction, the acceptability of a freeze on deposits in one country by another country whose currency is being traded in the first country, the question of whether booking a loan in one centre rather than another is merely legitimate tax planning, or

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