The Eurodollar Never Really Made Sense to Begin With

The Eurodollar Never Really Made Sense to Begin With
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In 1972, Ferdinand Marcos, President of the Philippines, declared martial law.  Out of economic necessity, he claimed, the government began to impose an economic modernization program which he believed would pull his nation out of what was then called third world status. To achieve this goal, along with political repression Marcos’ government would, as is usual in these cases, borrow heavily.  According to estimates published by the NBER, the investment share of GNP which had been 21.6% in 1972 climbed to 31% by 1979.  The part of overall “investment” contributed by the government surged from 2.1% of GNP to 7.3% at the close of the decade.

While outwardly the program appeared to have worked by 1980, it had only masked the great costs to achieve whatever gains were made.  The Philippines had a small current account surplus to start the 1970’s, rising to 5% in 1973 with the commodity price jump, but would fall to serious deficit for the remainder of the period.  By 1982, its size was figured to be 8.1%, but even at that level there was considerable doubt at the time as to whether that was a true figure.

With economic unrest came social unrest, as the former for any extended period of time will always lead to the latter.  The length of time required for the first to turn toward the second seems to be proportional to the political foundations at each instance. For Marcos, that would only mean trouble. Proclamation #1081, that which declared martial law, was formally lifted on January 17, 1981, after nearly nine years in place.  Two years later, in August 1983, former opposition leader Benigno “Ninoy” Aquino, Jr., who had been imprisoned during Marcos’ repression but had been given asylum in the US, attempted to return.  He was assassinated at the airport upon arrival.

Though it often seems straightforward, the means by which the Marcos’ government was able to finance massive cash deficits was not that at all.  There remains to this day considerable misunderstanding about what exactly happened in global finance during the 1970’s.  Bretton Woods officially ended in August 1971, removing all the final pieces of whatever had remained of the gold standard, but long before that point gold exchange had been functionally replaced by another system, the eurodollar system.  What followed Bretton Woods was not a dollar standard but a eurodollar one.

There are any number of functional differences that require more careful scrutiny so as to appreciate what that really meant, and still today means.  For the Philippines in the 1970’s, it meant banks like Citibank offering eurodollar financing in any number of ways, from the usual cross border transactions that accompany any economy’s day-to-day necessities of foreign trade to the more exotic. 

In 1983, Citibank’s Manila subsidiary reported $630 million in dollar deposits, not a small sum at that time and for this locale.  It was holding them on behalf of 50 financial institutions not of Philippine origin.  About half of that total balance was arrived at due to loans to firms and individuals inside the country, while the other half had been brokered from the eurodollar market.  One of those was a six-month eurodollar CD (Asiadollar fixed) arranged by finance broker Astley & Pearce, actually two $1 million transaction deposits borrowed from the Singapore branch of Wells Fargo Asia, Ltd.  The CD’s were arranged and confirmed by Astley & Pearce on June 10, 1983, for maturity on December 9 & 10 at 10% per annum interest (a very different time, if only in that respect).

Unfortunately, the assassination of Ninoy Aquino in between the settlement and maturity of those instruments had exacerbated the already shaky external position of the Philippines.   There were numerous credible rumors about possible capital controls flying around when Citigroup and Wells Fargo transacted.  On October 15, 1983, the Marcos government confirmed them when it imposed a Memorandum to Authorized Agent Banks (MAAB 47) stating that, among other things, foreign obligations to foreign institutions could not be paid down without official approval from the Central Bank of the Philippines. 

Unable to obtain it in time and in full, Citi defaulted on the deposits, leaving Wells Fargo to initiate suit on February 20, 1984, in the US Southern District of New York.  The Philippine Central Bank in March 1984 did finally give approval for Citi to repay part of the $2 million CD, only $934,000, leaving the lawsuit to continue through appeal all the way to the Supreme Court. 

The court case, as well as all levels of appeal, was a complete mess.  Even the Supreme Court ruling did little to clear up very serious matters of law.  Instead, the appellate court had affirmed the District court ruling but upon a separate legal basis, leaving the Supreme Court to remand back to the appellate court only to figure out how to harmonize the judicial disharmony.

Among the several issues of law, one was the primary consideration of “situs.”  This is an enormously important legal point as it establishes among other things applicable governing law.  Normally, this wouldn’t be much of an issue because banks and depositors are generally agreed upon where the bank and the deposit take place.  This case was importantly different, deciding how it might work in a eurodollar situation.  Further, the case never really did settle in law the true interbank eurodollar situation where the deposit is nothing more than the exchange of numbers on a computer screen. 

Wells Fargo had argued that the eurodollar deposit from among foreign subsidiaries of US banks attached to the parent banks; thus, the obligation of Citibank’s Philippines bank was an obligation that though blocked by foreign law on the local level could be repaid in the same means by Citibank in New York City.  In essence, a eurodollar liability was a dollar liability.  It seems uncontroversial to make such a declaration, but this fault-line is the initiation point for a great many others. 

There was legal precedence for this kind of contention, for one in the case of Vishipco Line v. Chase Manhattan Bank. Chase had removed its branch in Vietnam just days before Saigon fell to the North Vietnamese. The bank argued sovereign risk, meaning that as is usually the case in these situations its depositor bore the loss due to political activities in Vietnam according to Vietnamese law.  The courts ruled against Chase on the grounds that the liability followed Chase because it moved its operations before the actual sovereign action, even though barely a week and in anticipation of what came to pass, and therefore transferred the liability to its parent operations in New York. 

Though all the court decisions came down in favor of Wells Fargo, they did so on the narrowest of grounds, establishing findings of law on the specific merits of only that specific case.  The matter of “situs” as well as legal findings about eurodollar situations would continue to be at issue, just as they had been in the uneasy case of repurchase agreements which were often simultaneously, in law, repurchase agreements constituting legal sales back and forth as well as collateralized loans where no title passage occurred. 

The issues were not strictly “situs”, either.  The Libyan Arab Foreign Bank, a wholly-owned subsidiary of the Libyan Central Bank, had control and use of a eurodollar account with Bankers Trust in the UK throughout the early 1980’s.  On January 8, 1986, President Ronald Reagan announced the freezing of all Libyan government accounts, exactly the kind of scenario that was envisioned in the early days of the eurodollar system (which, in one origin myth, stated that the Soviet Union started up the eurodollar market as a means to avoid US confiscation of the dollars they acquired through a global system that worked on dollars). Libya sued in British court once Bankers Trust complied with the US Department of Treasury directive. 

Eurodollar deposits had up to that time lacked much documentation, one of the benefits of a largely unregulated offshore system.  However, in cases like these it left it up to the courts to decide matters of disagreement, particularly where exogenous, unplanned factors like sovereign risk would intrude.  This particular court decided that because the deposit contract failed to specify “situs”, it would be left as a matter of law in the place where the account was situated (London). 

Authorities in the US vehemently disagree with the finding, after all it was a matter of supposedly US currency at center.  In the Libyan case, the US government and its representative agencies argued against the ruling by taking the exact opposite position as the one they sought in the Wells Fargo Asia v. Citibank case.  In the latter, the US Federal Reserve filed in amicus curiae that the appellate court should uphold the ruling on the grounds of Philippine law.  In the case of Libyan Arab, the Treasury Department argued for the application of New York law. 

These kinds of technological revolutions are inherently messy in just these sorts of ways.  Something new is bound to challenge and strain existing and established standards and precedents, so it is not unexpected that the arising of a global currency regime might lead to very serious matters of property and appropriateness. In this particular topic, however, the manner in which it ultimately was settled, or at least for a time, was in standardization of contracts as well as more specific contract language.  Most eurodollar banks began, for example, requiring confirmation slips that specified the laws governing the contract. 

In many ways this resolution of sorts was in practice the Coase Theorem.  In 1960, economist Ronald Coase wrote the paper The Problem of Social Cost which suggested that in competitive markets with no transaction costs any conflict will be resolved efficiently regardless of the distribution of property rights.  He imagined a situation where a farmer wished to grow crops in the same general area a rancher wished to raise cattle. Does a court impose damages on the rancher for crop damages due to the cattle?  Or upon the farmer at the erection of some border? Coase argues that regardless of property rights the set of externalities will lead, absent transaction costs, to some set of cash or promises for cash where both the rancher and farmer will be efficiently compensated in a way that allows both to conduct their business interests.

In the situation of eurodollar banks conducting offshore currency business in every part of the world, the Coase Theorem would apply in the efficient management of disputes arising necessarily from the nature of that system’s ultimate lawlessness.  That is what ultimately is odd about it, meaning that typically an evolution leads to new definitions and standards; in the eurodollar it did not, only to ad hoc workarounds that left the most basic issues to remain undefined and untested.  If we didn’t know what a eurodollar was then, it certainly stands to reason the great difficulty in dealing with it in the middle 2000’s as it began to fail, remaining as it was still undefined.

The lack of transaction costs is, or was, instead merely a product of its extreme growth.  In other words, everyone had vested and great interest in allowing the system to expand exponentially, and therefore everyone had everything to gain by it doing so.  Further contests arising from property disputes or avenues of propriety would simply be set aside, left alone in economic considerations first and foremost.  If there was a dispute, and there would be, all parties would settle it for themselves as efficiently as possible so as to allow the system to get on with it even if it meant leaving unresolved major contradictions.

What happens, then, when transaction costs are imposed, or, more realistically, become relatively more significant even if just in perception?  I believe we are and have been for just about a decade now finding out that answer.  Without exponential growth, these inherently destabilizing factors of often direct contradiction become more paramount in the further consideration of participation within the system. It’s another way of looking at risk/return.  When growth was geometric and sustained, leading all participants to conclude and expect that growth to be sustained in perpetuity (an unreasonable expectation, of course, but this is finance, after all), there was very little perceived risk including those of unresolved externalities. 

Take away that growth, and what is left is only risk, incompatibility, and further uncertainty on any number of accounts including those that might sound eerily similar to the 1980’s eurodollar.  Much has been made of President Trump and the border wall with Mexico, including rhetoric about who might pay for it (and how).  The media, for what it’s worth, not much, has attributed post hoc ergo propter hoc the crash of the Mexican peso to what are characterized as threats. 

A quick glance of the peso’s path over more than just the time Trump has been a legitimate candidate shows that the peso has been falling since the middle of 2014, a concurrent victim of the “rising dollar” alongside so many other nations whose currencies haven’t been directly challenged by any US politician.  That means the peso, as the yuan or real, has been at issue with eurodollars not border walls. A separate check of banking statistics, especially those that do count cross border dollar transactions, shows very obviously that banks are and have been the real factor here.

The US Treasury Department prepares every month, several months in arrears, a vast array of data for its Treasury International Capital (TIC) report.  Most people know it for the top level estimates on foreign holdings of US Treasury securities (leading the media into another inappropriate and uneducated misidentification of Trump instead of “dollars”), but beneath all that are bank reports about cross border dollar holdings.  On both the incoming as well as outbound sides, foreign banks are either voluntarily withdrawing or being forced to withdraw from the dollar capacities.

The figures provided in this data set are by no means comprehensive, but they are corroborated by a number of separate sources including the balance sheets (particularly derivatives) of the major banks themselves.  What we find here is that the cross border dollar balances reported to and from US banks grew exponentially especially after 1995 until March 2008 – the month Bear Stearns fell, about a year after the first warnings from eurodollar futures and other market prices that something systemic was going on underneath all the unfortunate fixation on subprime.     

What the TIC data further shows is that the cross border dollar system began to rebuild after the panic but only partially to May 2011.  Since that point, including the more dramatic liquidity problems of late July/early August 2011, dollar balances have been reported variably lower.  On the outbound side, there was an immediate retrenchment (of US banks sending dollars abroad) after May 2011, and then more sideways since.  But in terms of US banks transactions with foreign banks, in dollars, there has only been a sharp decline since the middle of 2011.  The TIC figures show outbound dollar balances to foreign banks of $2.27 trillion in March 2008, falling to $2.08 trillion in the middle of 2009, and then rising again to $2.65 trillion in May 2011.  The latest update for December 2016 shows just $1.46 trillion, in a trend of nearly constant decay going back those five and a half years.

On the inbound side, things have been only a little different.  At the peak in May 2011, US banks had obtained just above $3 trillion in dollar funding (reported) from foreign banks.  That balance fell to $2.29 trillion by November 2012, in between QE3 and QE4, rebounding to $2.83 trillion by August 2014.  From there, coincident to this “rising dollar”, US bank payables in dollars to foreign banks have declined to just less than $2 trillion in December for the first time since March 2006.

Given, again, corroborative evidence elsewhere, it is reasonable to assume that if US banks are finding fewer dollars from foreign banks abroad that other foreign banks who would make the same transactions are left facing the same situation.  In other words, by every appearance there are fewer dollars abroad.  The degree to which the dollar situation has deteriorated isn’t perfectly clear, for one as the bank and interbank channel for dollar flow and fluidity isn’t exhaustive.  Other vehicles and cross border types have offset only somewhat the retreat of banks from the dollar system.

This is the problem that has unified the global economy in ongoing depression.  There is an enormous unsolved dollar degeneration, really “dollars” when including the more exotic elements of the offshore system in total, that can’t be met by other means.  When confronted with the overwhelming evidence to this effect, there is only unserious conjecture offered mostly for why it just can’t be the case (something about bank reserves and the Federal Reserve).  For the very few who might contemplate this huge intellectual chasm, they almost always look upon regulations as the primary if exclusive culprit (Dodd-Frank robbed banks of prop trading and forced costly inefficiencies, therefore if we get rid of Dodd-Frank then the eurodollar rises again). 

These are all false diagnoses that proceed from very false assumptions (gradation of the word “false” is warranted here).  What must be considered is that the eurodollar is itself simply unfixable.  In the general terms of this discussion, the inherent contradictions of the system are where this all fell apart, starting first with the definition of the eurodollar itself – none has ever really been established, as the court battles I have briefly summarized above confirm.  A dollar is a thing that requires no such conflict in legality; a eurodollar is much more and substantially different than simply an offshore deposit of dollars. At most, we can say a eurodollar is a promised liability denominated in dollars though settled not by dollars instead through other means based almost entirely on the instrument though which the liability is traded.

In the case of Lehman Brothers, questions over title to collateral ostensibly owned by the Lehman estate lingered for years.  In the case of MF Global, property and monetary issues were controversially handled with the offshore/onshore fracture prominently on display. 

I maintain the Coase Theorem but in reverse.  Prior to August 9, 2007, perhaps a few months earlier, these sorts of distinctions as well as a hundred other less extreme factors mattered very little because exponential growth created the liquidity for exponential growth simply because these eurodollar transactions could be settled in the various forms of exponential growth (it was just that circular).  After August 9, 2007, banks became more aware, and at times acutely aware, of the ambiguities and unsettled distinctions over exactly what a eurodollar is or was or might be at any point in the future.  If we didn’t fully define it thirty years ago when it was more so CD’s and time deposits, how might we run into problems with the basis in FX derivatives like basis swaps? Prior to the 2007 inflection, nobody much considered this; after, it may be all that is considered.

There are self-reinforcing aspects to the decay, as might be expected.  The more the offshore side has been destabilized by lack of capacity, the more participants might have to consider unsettled, and thus unsettling, scenarios like those of Wells Fargo Asia v. Citibank.  In other words, as foreign currencies are pressed the probability of further devaluations, sovereign responses, and even capital controls rise, meaning risk.  That has always been an enormous problem even under Bretton Woods and the classical gold standard, but it is more so under a eurodollar standard because there is nothing for any of this to reduce to; no tangible basis by which to solve and resolve the prospect for losses (losses of what?). 

Thus, banks don’t just pull “capital” out from these afflicted regions they pull out of “dollars” altogether.  Scrapping Dodd-Frank or even the repeal of Basel 3, or just Basel altogether, doesn’t solve this global imbalance. The problem isn’t regulations retroactively applied to make sure the system doesn’t succumb again to its inherent contradictions, it is instead that the system itself has been forced at long last to face up to those contradictions and has recoiled at the revealed asymmetry.  The eurodollar was always unstable, owing to the nature of its origins. 

The “dollar” shortage, then, isn’t really a shortage except as that might be the most visible symptom.  Fixing the global currency system can never be a matter of quantity, meaning that even if the Federal Reserve could do a QEE (QE Eurodollar), which it can’t in so many ways, it could still never accomplish a global recovery (which it, as noted last week, no longer believes is possible).  The solution is not to introduce more unstable currency, it is to understand the instability itself, even four and five decades too late, and then eradicate it.  That in all probability means eliminating the eurodollar altogether because, as any history of any of its wholesale parts shows, it never really made much sense to begin with. 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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