Forex: The Eurodollar in Foreign Exchange
An international capital market developed in the 1960s, dealing in what are known as Eurocurrencies, of which much the most important is the Eurodollar.
The prefix Euro is used because initially the market largely centered on the countries of Europe, but it has by no means been confined to them. Japan and Middle Eastern Oil states have been important dealers. While these short-term lending normally moves across national frontiers, they do not enter directly into balances of payments as they do not directly involve foreign exchange transactions. They may, however, indirectly cause such transactions to take place.
The nature of the market is as follows: In the ordinary course of affairs, and Italian, for example, acquiring dollars--- say, from exports or from a legacy--- would sell these dollars for his own currency. But he may decide to deposit the dollars at his bank instead, with an instruction not to sell them for cash but to repay him in dollars at a later date. Thus the bank has dollars in hand and a commitment to pay them out in, say, three months. It may then proceed to lend these dollars to another bank, anywhere in the world. Since the lending and borrowing is done in dollars, no foreign exchange transaction is directly involved. The sum total of all operations of this sort is the Eurodollar market. It is not centered on any particular place and has no formal rules of procedure or constitution. It consists of a network of deals conducted by telephone and telex around the world. U.S. residents themselves lend and borrow from this market.
One may ask why lenders and borrowers use this market in preference to more conventional methods of lending and borrowing. Ordinarily the answer is because they can get more favorable terms, since the market works on very narrow margins between lending and borrowing rates. This involves expertise; London has played the most important part in the creation of the market. The lender hopes to get a better rate of interest than he would on a time deposit in the U.S. (restrictions limiting interest payable on U.S. time deposits are said to have been a contributing cause of the growth of the market). At the same time, normally, the borrower will find that he has to pay a lower rate than he would on a loan from a commercial bank in the U.S.
This has not always been the case, though. In 1969, Eurodollar interest rate went to very high levels. One reason for this was the set of restrictions imposed by the U.S. on its commercial banks lending abroad. The second was that although the prime lending rates of the principal U.S. banks might be below Eurodollar rates, many individuals, including U.S citizens, found that they could not get loans from their banks because of the 'credit squeeze'.
