Eurocurrencies: Interest Rates

Eurocurrencies

Eurocurrencies: Causes of Growth

Eurocurrencies: Size of Market

The Eurocurrency markets virtually pioneered the offering of long-term loans with floating interest rates. They ‘‘unbundled’’ the usual package, which fixed loan rates for the term of the loan. Eurocurrency deposits typically mature every 30 to 90 days; so to induce rollover of existing deposits, or to attract newdeposits, current deposit rates must be paid. Eurocurrency loan rates are usually revised every three to six months, based on current deposit rates. This protects banks from the interest rate risks of long-term maturity mismatching. More precisely, loan rates (in London) are based on the London Inter Bank Offered Rate (LIBOR), which is reset daily at the median rate that top-tier London-based Eurobanks offer to pay other banks for short-term deposits. Other offshore financial centers quote rates close to LIBOR. LIBOR is usually slightly above the rate paid on deposits from nonbank customers since interbank deposits can be acquired on demand, within minutes. In effect, Eurocurrency loans are based on banks’ marginal cost of raising new funds. The actual rates charged are LIBORþ, where the premium varies from borrower to borrower depending on credit risk. Very creditworthy customers can borrow at LIBOR or even, occasionally, slightly below. In this sense, LIBORis like the ‘‘prime’’ rate in the United States and other domestic markets, with themajor difference that it ismarked tomarket daily. Much of the Eurodeposit market is securitized: they are certificates of deposit that are traded continuously; hence their yield varies continuously. The practice of making long-term loans with variable rates was a key trigger for the so-called international banking crisis of 1982 89. In early 1980, the newly installed chairman of the U.S. Federal Reserve System, Paul Volcker, declared war on inflation, which had risen to double-digit levels in the United States and elsewhere. Hemore than doubled short-term interest rates, from about 10 percent to more than 20percent. Because of the tight linkages to Europe and the rest of the world via competition between New York and London for Eurodollar deposits, short-term rates, based on LIBOR, doubled worldwide. By 1982, middle-income countries in East Asia, Eastern Europe, and especially Latin America had borrowed heavily via syndicated loan packages put together in the Eurocurrency markets. They were paying LIBORþon their loans. By late 1981, their debt service burdens had doubled. This triggered a series of severe slowdowns and partial defaults, beginning with Mexico in August 1982.