Theories of the growth of the euro-market: a review of the euro-currency deposit multiplier

May 1981

Introduction

One of the most controversial issues surrounding the development of Euro-currency banking concerns the ability of Euro-markets to expand autonomously the stock of money and credit outside the control of national authorities. The rapid expansion of international banking aggregates, which have grown by around 25 per cent, per annum, is said itself to provide evidence of monetary expansion in the Euro-markets. A short-hand name frequently used to describe this process is the Euro-currency credit or deposit multiplier.

Two important questions in this issue are: the ability of the Eurocurrency banking system to expand because a proportion of the funds the banks lend out is redeposited with them - endogenous money or credit creation and the Euro-currency multiplier proper; and second, the role of the Euro-markets in increasing the credit-creating or multiplier potential of the banking system as a whole, i.e. the domestic and international banking systems combined. When these effects are large they are said to undermine national monetary policies, in the first case because the monetary expansion is beyond the direct control of domestic authorities (unlike, for example, domestic bank deposits in Germany and the United States, Euro-currency deposits are not subject to legally imposed reserve ratios or direct credit controls); in the second, because the relationship between the domestic control variable - the supply of domestic bank reserves - and the stock of money is weakened when deposits are placed in the Euro-currency market.

This paper reviews the models that have been used to estimate and explain the size of these "multiplier" effects, and their implications for the rate of expansion of the Euro-market. Two distinct approaches have been adopted: one characterises the depositing and redepositing process by fixed coefficients (discussed in Section I), the other suggests that the size of any multiplier is variable and reflects general portfolio considerations and interest rate adjustments (Section II). Both depend on making "plausible" guesses at the likely size of the coefficients and interest rate adjustments in order to estimate the size of the multiplier. As estimates are, however, based on ex ante guesses without any ex post verification, the size of the monetary influence of Euro-banking remains an untested hypothesis. Some new approaches have therefore evolved to explain the growth and influence of the Euro-market in terms of empirically observed "institutional" links between the Euro-markets and national banking systems (Section III). These suggest that it is completely inappropriate lo treat the Euro-market as a closed or autonomous banking system and that the role of the Euro-markets in adding to the volume of credit can only he seen in the context of the world financial system as a whole. The paper concludes with a short summary of the main analytical conclusions.

Throughout, this paper, as with much of the literature on the subject, focuses on the role of Euro-banks in intermediating between private non-banks rather than between banks, although this latter activity is numerically the largest function of the Euro-market. The main issue of importance is the impact of the Euro-markets on the liquidity of the non-banking sector and whether this is significantly increased by the activities of Euro-banks outside the control of national authorities. By increasing the flow of liquidity between national money markets, Euro-markets might enhance the credit-creating ability of some national banking systems and thus the liquidity of the non-banking sector. The channelling of funds to domestic commercial or central banks may also provide balance-of-payments finance which can be used to sustain the level of world activity. To that extent, Euromarkets will have larger expansionary effects on the wealth and liquidity of private non-banks. But that is a separate issue and may be regarded as being caught by national policies. These effects would, however, be factors explaining any Euro-currency redepositing multiplier. Another issue which is briefly considered, because of its policy implications, is the role of central-bank deposits in explaining the size of any Euro-currency multiplier.