Interaction between the euro-currency markets and the exchange markets

BIS Economic Papers No 15
May 1985

Introduction

This is an essay on a fairly technical subject: the interaction between the Euro-markets and the exchange markets. The possible justification for producing such a lengthy paper on this topic is twofold. Firstly, the important role international banking flows seem to have played recently in the rather exceptional exchange-market performance of the US dollar. And, secondly, the circumstance that, like its autonomous money and credit-creating potential, the exchange-market implications of the Euro-market appear still to be a highly controversial and much misunderstood subject. While in no way claiming to provide the ultimate answers, this essay seeks to present a broad analytical framework for approaching the question from various angles.

The paper is divided into three parts. The first explores the exchange-market implications of Euro-market transactions, starting from the assumption of a given pattern of international capital flows. The method used is that of partial equilibrium analysis, although in the concluding section an attempt is made to evaluate some of the broader implications of the existence of the Euro-currency market for the theory of exchange rate determination.

The second part, by contrast, discusses the influence the Euro-market may exert on exchange rate developments through its impact on the volume and geographical pattern of international capital flows. Apart from some general considerations, it examines in greater detail three specific issues: (a) the impact of the Euro-market on the exchange rates of the currencies which are used as the principal denominations in the Euro-currency market; (b) the exchange-market implications of the Euro-currency market in its role as an official reserve outlet; and (c) the potential role of the Euro-market in times of pronounced currency unrest.

The third part, which is rather more empirical in nature, briefly surveys the influence bank-related capital flows between the United States and the rest of the world may have had on the performance of the US dollar over the past ten years or so. It highlights, in particular, the important role bank-related capital flows have played in recent years in conjunction with the dramatic deterioration in the US current-account balance.