THE IMPORTANCE OF THE EURO-DOLLAR MARKET TO THE MANAGEMENT OF STERLING
A. Introduction
Throughout the 1960s, the management of sterling had been a central preoccupation of British governments. This preoccupation largely determined the way Britain viewed the Euro-dollar market*, as the government was constantly hit by the pressures which the international use of sterling placed on the British economy. The principal objective of British governments was to prevent a financial crisis by whatever means possible, in which the management of sterling was to be at the heart of governing Britain. In other words, the strain of the entire sterling area coincided with the governments strategy to achieving economic growth.
B. Government policies and the pressures of sterling
The pressure on sterling stemmed from the UKs underlying deficit in its balance of payments. This was reinforced, by the flow of funds that had arisen from an increase in foreign interest rates, which acted on the UKs reserves by encouraging an outflow of non-sterling area commercial balances, and some switching of funds into the Euro-dollar market out of sterling. In other words, a fixed exchange rate regime. If confidence in the sterling system as an important reserve and trading currency was to improve, it had to evolve as the world monetary system developed.
The sterling area had been changing throughout the 1960s. Greater independence in political, economic and financial affairs had led to a questioning of traditions and, in particular, the traditional links with sterling. The notion of devaluation, emphasised how far these changes had gone, when many of the independent territories preferred to retain the value of their currencies rather than to follow sterling. There was a situation in which there was an underlying lack of confidence in sterling with the result that many sterling area traders were reluctant to continue to use sterling as their trading currency, unless they could cover the exchange risk. There was stronger pressure than ever for the diversification of official reserves, either positively by a switch out of existing balances or negatively by retaining trading earnings in foreign currencies. No longer was there any assurance that sterling area rates of exchange would keep in line with sterling, with the consequence that: it became necessary for forward markets to be developed in the sterling area. In general, the legal framework within which the parities of the various currencies of the sterling area were fixed was very different in the late 1960s compared to the 1940s. There were very few territories whose currencies were legally tied to sterling and even where they were, it was still possible for the necessary action to be taken to sever the link, if at the risk of disrupting normal commercial business while the necessary legislation was pushed through. Most of the independent O.S.A. belonged to the IMF, and some of them had their exchange rates critically examined by the Fund; some had altered their parities without any particular reference to the sterling area (India and Ghana).
The fact of political independence almost certainly gave some countries, a bias in favour of not following Britains devaluation, if an apparently reasonable case could be made on economic grounds. The most important economic consideration was the effect on the countries trading position of each of the alternatives. Countries for which trade with the UKs is paramount were more inclined to change their exchange rates than those which rely more on other markets or sources of supply. None wanted to see the local prices of imported goods rise but neither did they want to see local currencies proceeds of their exports to the UK fall. Countries with a heavy reliance on UK aid would not have liked to see any drop in its value in local currency terms. But for countries with a heavy burden of dollar debt, uncovered by non-sterling assets, or whose exports to major markets outside the UK would receive no boost from devaluation, the balance of advantage will have appeared differently. The uncovered exchange position of the banks and of traders may have had an influence in some cases, although it seems that the impacts of policy decisions were taken.
In 1968, the Overseas Finance Division of the Treasury advocated several schemes, in order to freeze the sterling holdings, official and private, of persons resident outside the UK, (so-called Operation Brutus , Operation Brandon , and Operation Cranmer ). The freezing was a means of an exchange control operation, in which import controls were an essential additional feature of the scheme. Operation Cranmer was chosen as the most viable scheme to consider.
The object of Operation Brutus was to take control of the sterling holdings of non-UK residents (official and private), and to prevent them being run down, or to provide for this only slowly and at a controlled rate .
Operation Brandon was the code-name for plans to extend exchange control to transactions between UK residents and all or most of the countries of the present sterling area. The first object of Brandon was to obtain substantial continuing savings on the UK balance of payments. How much might be saved depended upon the regime implemented. The need for fresh savings had been emphasised by the delay in the development of the hoped for post devaluation surplus, and by the concern expressed by OSA countries concerned in the Basle Arrangements, that in the UK. Rawlinson believed that Brandon was a feasible measure that would make a useful contribution, and a way to achieve a satisfactory balance of payments performance. The second objective was to protect against speculative movements of funds to sterling area countries whenever sterling was under suspicion. This was a new problem for which the present UK exchange rate (at the time) made no provision. The problem resulted from the demonstration in November 1967, that other sterling area countries would not necessarily follow sterling in a change of parity. Generally, Brandon was a necessary adoption of the UKs control system in order to make it apt to changing circumstances. As it stood, the limited exchange control system operated only in respect of the NSA fails to protect against pressure that arises for any reason to shift funds to the sterling area. Thus, in the present circumstances, Rawlinson stated that it fails to protect against the outflow of private portfolio capital to e.g. Australia, and fails to protect against speculative or hedging investment in land or property in e.g. Australia. A third objective was to consider mobilising part of the private portfolio of overseas securities, in order to give some creditability to the UKs guarantees and to provide funds to repay debts. Brandon was necessary for this option to be kept open .
Operation Cranmer was a contingency plan in which the government freezes the sterling holdings, official and private, of persons resident outside the UK. This scheme introduces the import controls which become necessary, and the initiation of the mobilisation of private portfolio holdings of overseas securities in order to help to meet national liabilities .
C. The importance of the Euro-dollar Market
Although certain schemes were developed to overcome the pressure of sterling, it appeared that a new market was developing. The Bank of England, noted that the Euro-dollar market was having an impact in 1968 to the UK market . That market was operated by banks who accepted deposits at short-term in US dollars (and to a lesser extent in other currencies) and lent in the same currencies at short-term. It drew its funds from many sources, most notably from the banking systems of Germany, Italy and Switzerland which were the principal gatherers of dollars accruing from the US deficit; and its lent both to other banks and to non-bank borrowers in many countries. The report discussed further, that the market seemed to perform a useful function in redistributing surplus liquidity, in facilitating adjustment of internal liquidity in countries whose monetary systems rely on the import and export of short-term funds through banks as a major monetary regulator . An important point was that the Bank of England realised that the market also maintained world business activity at a high level by the ready availability of short-term working funds. It was estimated by the BIS in 1967, that the total of US dollars in the Euro-dollar market was of the order of $16 billion, but because a substantial part of this was several times on-lent the total of liabilities outstanding at any one time was much larger. In the UK, both the British and foreign banks operated in the marketplace.
By their participation in the market, the banks in the UK earned profits on the margins between their borrowing and lending rates and from time to time switched currency assets into sterling for lending in the UK (the dollar counterpart accrued to the UK reserves). British companies and firms made extensive use of the Euro-dollar financing for investment abroad, enabling foreign exchange earning capacity to increase without recourse to the reserves, and Euro-dollars were also utilised for domestic financing by British enterprises. London was a pioneer and remained a leader in the market. This business was useful. It earned profits. From time to time foreign currency was switched into sterling for lending in the UK. It provided a ready source of foreign currency for borrowing by British firms for direct investment outside the sterling area. It has always been understood that UK banks must keep their Euro-dollar business self-contained and that there is no question of falling back on the official reserves should they get into difficulties .
Clearly, this seemed to be a new concept not only in international finance but also to the British government itself. So important was the issue that a meeting was held between the Treasury and the Bank of England in June 1968 . Sir Douglas Allen, (the Chairman of the Treasury) decided on the 24th June 1968, that although there was no intention of blocking Euro-dollar accounts, fear of it in the Cranmer circumstances could lead to a run on British banks by depositors . It was argued that the UK government would take action in advance to ensure that British banks were not caught in an exposed position. The meeting concluded that these banks were in a much less exposed position than they had been previously; in particular they were in a more or less balanced position as far as standby arrangements were concerned. The Bank of England in the meeting concluded that any official action to curtail operations in the market would do more harm than good, though the Bank of England would continue to do all it could to encourage British banks not to get themselves into an exposed position. The Chairman further added that it should be clearly understood that there would be no question of using official reserves to bail out any banks which found themselves in difficulties following Cranmer .
The latest development in the Euro-dollar market, caused some discomfort to the British government, even to the question of what might happen in the Cranmer circumstances. Although, in 1968, the market had been reasonably stable, there had been mismatching of deposits and loans which was a concern, as there was no lender of last resort, and no real control either national or international. There had, in fact, been some intervention by the central banks, and the BIS were collecting information on a regular basis. It was however desirable, that some more systematic supervision by central banks or system of restraint by governments was developed. Any action that was specifically directed towards the mismatching problem had to be taken on a national basis by governments . Summing up the discussion, the Chairman stated that no action to curtail market operations was to be taken in the short-term, and that the Bank of England would continue to use their influence to require British banks to maintain a balanced position, and the wider doubts of the Euro-dollar market. Both parties and the Chancellor agreed that on the 19th October 1968, if Cranmer was to be implemented, difficulty would arise in respect of the Euro-dollar operations of banks in the UK. Also that, in order to minimise the risk, action had to be taken in the short-term in order to control or restrict Euro-dollar operations by banks in the UK .
The risk that the British government were worried about was this: in Cranmer, Euro-dollar accounts held with UK banks would not be blocked, but the fear of such blocking might provoke general withdrawals of Euro-dollar deposits from banks in the UK. This would lead to liquidity difficulties for the banks. Failures might only be avoidable if the banks were allowed to buy dollars from the official reserves to meet Euro-dollar liabilities. Rawlinson believed that this led to the following conclusions: Firstly, In the conditions postulated British banks might be exposed to the extent of some $840m in respect of quick Euro-dollar liabilities against which the corresponding assets are not equally quickly realisable. Secondly, if in the Cranmer situation a British bank is on the point of failure on this account the case for official help should be considered at the time. But the assumption must be that no assistance from the official reserves would be given. Thirdly, action should not be taken to curtail the Euro-dollar business of British banks at present . The business is useful, and to curtail it by official action now could have the adverse effect on confidence which it is hoped to avoid. But the Bank of England should continue to use its influence to minimise mismatching by British banks of Euro-dollar liabilities and assets. Fourthly, the Bank of England should keep in touch with the development of any international action to supervise Euro-dollar operations.
D. Blocking of Sterling Balances
However, there were dangers with Operation Brutus, to the sense that the blocking of sterling balances would arouse fears that the blocking of foreign currency balances would follow. This was a major point to the Treasury, as whether such fears were reasonable or not, they would be likely to be reflected in withdrawals of Euro-dollar balances from the UK .
To assess the impact of such withdrawals it was necessary to consider the maturity pattern of Euro-dollar borrowing and lending in London. Obviously if the maturities of loans exactly matched the terms of the deposits there would be less of a problem, though even in that case precipitate withdrawals might give rise to liquidity difficulties. In practical conditions of everyday banking, however, there is a continuous turnover of funds and, with the narrow margin earned between deposits and loans, a tendency to lend rather longer wherever possible; so that there is some mismatching both in particular cases and overall. A failure of confidence among Euro-dollar depositors, which caused a run on the banks, could leave them in the difficult position of having demand liabilities to meet from assets maturing at a later date and a chain of defaults could ensue. The banks had no legitimate grounds for expecting that they would be rescued in such circumstances by the use of the official reserves, but this will not have prevented exposure in certain cases which would warrant official attention if the stability of a British bank were threatened .
The extent of the resource was difficult to quantify not only because confidence movements themselves could not be precisely predicted but because a substantial part of the Euro-dollar lending is to other banks and affiliates. In normal times these might provide some temporary accommodation but their assistance in times of stress would be problematical. On the other hand, term depositors can normally expect to be able, at a price, to withdraw their deposits before the contractual date of maturity and failure to afford this facility would aggravate a declining confidence situation .
The foreign banks operating in London could, in such circumstances, be expected to shift their operations to other centres where they have offices or affiliates. The real problem centres on the position of the British banks, including British banks in the Other Overseas category, which were involved in the market. These had foreign currency liabilities to overseas residents of about $4,200m. of their overseas liabilities approximately 70% are on terms of up to three months whereas about 50% of their overseas assets mature in three months. Within the three months period there was also mismatching at various lengths of maturity. The mismatching was, however, less if lending to other banks in the UK was included. To the extent that these assets are held with foreign banks in the UK who can have recourse to their Head Offices, the British banks position was improved .
It should be noted that it was a common procedure where, the banks in the UK have entered into standby arrangements with clients to extend Euro-dollar credits amounting to some $2,160m and have standby arrangements to borrow $600m leaving them with a net liability of $1,560m contingent upon the credits being drawn. Within this total, however, the British banks have a more or less balanced position at around $340m. There are therefore indications that in the conditions of severe stress and disorder which Brutus would represent, British banks could be exposed to the extent of some $840m (i.e. 20% of $4,200m) subject on the one hand to possible mitigation by temporary accommodation from lending banks overseas (which would depend on the state of confidence at the time), and on the other to aggravation resulting from early calls on time deposits. The actual level of exposure is also further affected by the complexities of inter-bank lending. Nonetheless, it is clear that this could be a large and dangerous problem. The question has therefore been posed whether borrowing of Euro-dollars by UK residents should be deliberately reduced in some way .
If the UK interpret the term UK residents to include all banks in the UK operating in the Euro-dollar market, the means to affect their operations existed under Section 34 of the Exchange Control Act, which required Authorised Dealers in foreign exchange to comply with such directions as may be given to them by the Treasury on the way in which they may carry out their functions. It would theoretically be possible to place limits on either deposits or advances in Euro-dollars. The manner in which these powers could in fact be used would however be dictated by the practicalities of the banks situation. They could not be expected to reduce their deposits and advances at short notice. The wider implications of such a step, however, indicate that it would be undesirable. On the 10th June 1968 the Bank of England, official action at the present time to curtail operations in the market is likely to have just the effect on confidence that it is hoped to avoid and the consequences would be the same as have been described above in the event of a Euro-dollar run on the banks. There would also be permanent disadvantages in that the market would move to other centres with a consequent effect on invisibles, switching and the other indirect benefits derived from it. We conclude that official action could well result both in the loss of the market (and its attendant benefits) and in exposure of the British banks to default on their obligations, failing help from the reserves which we are in no position to give .
E. Operation Cranmer
Much of the contingency planning, Operation Brutus was renamed Operation Cranmer. The Cranmer plan was prepared and refined during the late summer of 1968. It was designed for an emergency, of the kind in which there was widespread pressure on sterling, little or no resources remain to meet it and further borrowing facilities are not satisfactorily obtainable . As, if no countervailing action were taken, the sterling exchange rate would have been forced to float under extremely unfavourable conditions. It would have been catstrophically low. As originally conceived, Cranmer might have been introduced when the exchange rate remained fixed, part of the intention being to protect the rate against the pressures arising from withdrawal of balances. The same general plan could, however, be put into operation after the introduction of a floating rate, with the modified intention in this respect of preventing the level from being pushed down unacceptably low.
The main features of the plan were: Firstly, Blocking of all sterling holdings, official and private, of countries outside the UK. Secondly, the mobilisation of private UK portfolio holdings of overseas securities in order to help meet national liabilities. This would be a lengthy process, which would involve legislation. Thirdly, the introduction of code-name ORESTES and ANDROCLES, to impose severe import restrictions . The scheme applied to all imports which could be controlled by using a quota system related to imports in a previous period involving: manufactured consumer goods, machinery, certain paper and iron and steel items and some manufactured foodstuff including drinks. Cranmer was not necessarily an alternative to a floating rate. The plan itself left open the question whether the official rate is floating or fixed; technically it was compatible with either. If the aim was to try to maintain a fixed rate, which assumes that some resources remain with which to defend it, the object of Cranmer was to conserve those resources by mitigating pressure on the rate. If it was decided to float, or floating, becomes necessary because there are no resources with which to defend a fixed rate, then the object of Cranmer was to mitigate pressure on the rate, in order to prevent a catastrophic fall .
Cranmer was an extreme measure for an extreme situation, as it was unlikely to be reversible for a long time. It would cause initial chaos in trade and payments, and probably lasting disruption of trade and of the international financial world. It would cause a violent outcry both abroad and at home, especially if the gravity of the crisis that precipitated it were not widely understood in advance. Cranmer was thus, a measure of last resort, when no other options were left open, and when the damage and hardship which Cranmer would cause are judged less than the damage and hardship resulting from uncontrolled floating under pressure. The UK during 1968 were suffering from a major monetary crisis, apart from the assistance received from many countries, the resources available to the UK were no longer adequate to maintain the present system. The government would take action itself to protect the essential interests of the country; and although this action would cause some difficulties for others, this action in the longer term would be in the interests of the UKs financial and trading partners. Operation Cranmer had three main objectives :
First, the UK government had to deal with the problem of the large sterling balances held by other countries . Some of these were official holdings, some private. The holders of these sterling balances could convert these sterling funds at will into foreign currency. Large conversions were made at the time, and the situation deepened for the UK government, as holders of sterling sought to cover themselves against the effects of precipitate action by the others. The UKs resources were no longer adequate to finance these continued conversions into foreign currency. In addition these sterling balances were banking liabilities of the UK which the UK government were in honour bound to meet. The governments firm intention was to meet these sterling liabilities in full eventually in a fair and equitable manner. But the UK government could only do this when it had the resources .
Secondly, the measure effects a large and rapid change for the better in the UKs balance of payments. In the first quarter of 1968, despite all the action taken, the balance of payments had remained unsatisfactory, and the action which the UK government were obliged to take in regard to non-residents sterling balances would in many ways create new pressures and difficulties. It was therefore imperative sharply to curtail the overseas expenditure of the whole nation. The improvements in the UKs balance of payments was one way in which the UK would accumulate the resources needed to discharge its overseas debts, including those represented by the sterling liabilities .
Thirdly, the UK government intended to take powers to modernise certain overseas assets which had always been regarded as second line reserves and which in the current emergency needed to be applied to the discharge of the UKs national liabilities .
F. The outcome
In response towards the Bank of England report, the main point here was a distinction between British Banks and other banks in the UK. To the sense that, it was the British banks that had a balanced position in regard to standby arrangements, while it was the overseas banks in the UK, that had the imbalance. This caused several questions, by Rawlinson (and the Treasury in specific) which needed answering : What are the implications for Cranmer? Any need for any generally action?
As far as Cranmer was concerned, the UK had to take the situation as it was. Even if it was decided on more general grounds to take some action to alter it, there was no possibility of doing this within the short-term. Therefore, in Cranmer, the choice was between: Firstly, doing nothing, and simply noting this as a risk, one of the many risks in Cranmer. Or secondly, blocking, as part of Cranmer, Euro-dollar liabilities in the same way as sterling liabilities .
The second point was technically feasible. It would mean that the authorities control the repayment of these dollar liabilities in the same way as they control that of sterling liabilities. The UK Government would avoid the problem of individual banks being unable to meet their liabilities by the rather drastic course of preventing any of them from doing so. On the first point attention was drawn to the sentence: The banks have no legitimate grounds for expecting that they would be rescued in such circumstances by the use of the official reserves, but this will not have prevented exposure in certain cases which would warrant official attention if the stability of a British bank were threatened .
If the UK adopted this course, there should be no question of using precious reserves to bail out banks unable to meet their liabilities. If these banks fail, the let them fail. Cranmer meant that the country as a whole was unable to meet its liabilities. There was no reason to give priority in the use of reserves to those who labelled their deposits as foreign currency deposits. This meant that the preferred choice was to: do nothing. The difficulties over Euro-dollars were then on a more objection to Cranmer. If Cranmer was forced upon the UK, then the UK would have to face them, and let these banks fail, if this was the outcome. The UK would add to the problems that, the UK have over repaying sterling liabilities by adding these dollar liabilities to them. This would be the implication of (b.); and if the authorities made it clear that, they were not going to intervene, then there was at least a chance that the foreign depositors would hold their hands until the mismatched assets mature, and so enable them to be paid off properly .
This then, led to the question of whether the Euro-dollar situation was all right generally, apart from Cramner? It could be argued that, action would be taken to stop these imbalances arising because, though the UK could not do this in time for Cranmer as envisaged, the UK might have wanted to do Cranmer at some future time. Also because of the risks to the reserves when something goes wrong with loans to which British banks commit Euro-dollars. An example of this was the Salad Oil Scandal, Ira Haupt affair, (explained in Case Study One).
However, against this, the business was profitable when it performed well, as it generally did, and it certainly helped out direct investment policy by providing a relatively painless source of funds for direct investments overseas. In general therefore, it was agreeable with the Bank of England, that no action would be taken to interfere with this business, either in the immediate future, for the reasons given, or in the longer term. Nevertheless, there was a cause for concern over the standby business. If a situation arose that, Euro-dollars were scarce, perhaps as a result of the American measures, and these standby credits are called, the price mechanism of interest rates may not be sufficient to prevent the calls exceeding the amount which the banks can raise. On such a situation, they would turn to the authorities, and to the reserves, in order to avoid default. However, the British banks were more or less balanced. The overseas banks would no doubt be referred to their head offices abroad. Nevertheless, it was questionable whether the authorities have sufficient control over this .
G. CONCLUSION
In a letter to the Treasury, Rawlinson estimated that, at the end of April 1968 that, approximately 70% of overseas liabilities were on terms of up to 3 months, whereas only 50% of overseas assets was maturing in three months, and there was mismatching within the three-month period at various lengths of shorter maturity . Taking this into account, along with the commitments of UK banks to stand-by arrangements in the Euro-dollar market, the indications were that, in conditions of severe stress and disorder, British banks could be exposed to the extent of some $840m in the absence of alleviating credit from overseas. The claims had arisen from the switching into the UK of funds obtained from Euro-dollar deposits. As, the authorities had been in some respects encouraging towards overseas borrowing although preferably on longer term easing the international debt management problem.
Operation Cranmer was an example of the governments policy on exchange controls to sterling. On the 18th December 1968, Lever with the intermediary of Rawlinson decided that if the UK were to operate particular regimes of restrictive exchange control (and it is necessary to specify what regime of postulated), the UK could over a period of time achieve large switches in the present pattern of gross claims and liabilities, but in the absence of other action, the net position would remain the same . The blocking of overseas claims against sterling was the proposed regime. As far as the Euro-dollar operation was concerned, the overall scale, the liquidity and general pattern of maturity dates were largely left to the market itself. However, the Bank of England had drawn the attention of the market to the dangers inherent in mismatching in terms between assets and liabilities.
ENDNOTE
* Here are two very similar definitions of the term Euro-dollars:
Robert Gilpin, (The Political Economy of International Relations, Princetown University Press, 1987, p. 314-315), states that: The Euro-dollar market received its name from American dollars on deposit in European (especially in London) banks yet remaining outside the domestic monetary system, and the stringent control of national monetary authorities.
Enzig and Quinn (The Euro-dollar System: practice and theory of international interest rates, MacMillan Press, 6th edition, 1977, p. 1) state that: the Euro-dollar system is a term used to describe the market in dollar deposits and credits which exists outside the United States of America.
This paper is based on the following Public Record Office files:
PRO T295/437: Future of the Sterling Area 1968, (31/10/1967 – 09/01/1968). File Number: 2 FEC 93/02 PART A
PRO T295/514: Operation Brandon (18/06/1968 – 02/12/1968). File Number: 2 FEC 391/01 PART A
PRO T295/605: Operation Cranmer, (Code-name for scheme to freeze sterling holdings), (03/04/1968 – 01/08/1968). File Number: 2 FEC 377/06 PART A
PRO T295/606: The Euro-dollar Market – Operation Cranmer, (Code-name for scheme to freeze sterling holdings), (11/06/1968 – 5/02/1969). File Number: 2 FEC 377/123/01