The Eurocurrency market and exchange rate adjustme...
Thus, while Eurocurrency transactions in themselves have no effect on any country’s balance of payments, they act as the conduit for the forces that determine the magnitude and direction of trade and capital flows.Given the relation between a country’s balance of payments and its exchange rate, it follows that they also act as the conduit for the forces that determine a country’s exchange rate.
First let’s consider a country whose currency is used on the Euromarkets.In Transaction 6 Honda sells its US dollar deposit to Sumitomo for a sterling deposit.Because both Honda and Sumitomo are Japanese residents, the Japanese balance of payments and exchange rate are not affected by the sale of dollars.The transaction does not affect the US or UK balance of payments directly either.However, it does affect the dollar/sterling exchange rate by putting downward pressure on the dollar.If the initial sale is followed by Sumitomo balancing its foreign exchange position by selling dollars, the dollar will undergo further downward pressure.Furthermore, Swiss Bank Corp.will have an unbalanced position with a liability in sterling and an asset in dollars.If it decides to balance its position, the dollar will fall further.In fact, every dollar that has been created in the Eurocurrency system can be sold (or bought)and it will have the same effect on the exchange rate as if a dollar created in the United States had been sold (or bought).
This has some interesting implications for the domestic monetary policy of a country whose currency is used on the Euromarkets.Notice that the downward pressure on the dollar was not generated by a change in the US price level or balance of payments.In fact, nothing connected with the US economy or financial system was involved.It was generated by a preference for sterling over dollars.This means that a disequilibrium between the supply and demand of a currency used on the Euromarkets can be reflected in the exchange rate before it is reflected in domestic prices or the balance of payments.
The situation is somewhat different for a country whose currency is not used on the Euromarkets.Since the currency is not borrowed and lent outside the domestic market, most transactions with the Eurocurrency market involve a foreign currency transaction and affect either the balance of payments or the exchange rate.Consider a bank that borrows on the Eurocurrency market and lends to a firm to pay for imports.There is no sale of foreign exchange but the balance of trade is affected.If a firm borrows on the Eurocurrency market to finance domestic operations, there is a sale of foreign exchange and the exchange rate is affected.If a firm buys foreign currency to lend on the Eurocurrency market, the exchange rate is affected.As we mentioned before, when the central bank borrows on the Eurocurrency markets, the balance of payments is affected because foreign reserves increase.However, if the central bank transfers a part of its reserves from a domestic market like the United States to the Eurocurrency market, neither the balance of payments nor the exchange rate is affected.