RECENT DEVELOPMENTS IN THE EUROBOND MARKET INTERNATIONAL FINANCE SERIES NO. 24

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85T00875R001600030139-5
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 13
• Document Creation Date: December 22, 2016
• Document Release Date: October 28, 2011
• Sequence Number: 139
• Publication Date: September 1, 1970
• Content Type: IM

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Confidential
INTELLIGENCE
DIRECTORATE;, OF
nteltgence Memorandum
Recent Developments In The Eurobond Market
International Finance Series No. 24
Confidential
ER IM 70-138
September 1970
Copy No.
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WARNING
This document contains information affecting the national
defense of the United States, within the meaning of Title
18, sections 793 and 794, of the US Code, as amended.
Its transmission or revelation of its contents to or re-
ceipt by an unauthorized person is prohibited by law.
I GROUP 1
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^ CONFIDENTIAL
CENTRAL INTELLIGENCE AGENCY
Directorate of Intelligence
September 1970
INTELLIGENCE MEMORANDUM
Recent Developments in The Eurobond Market
Introduction
The Eurobond market attained a position of
paramount importance among international bond
markets following new US restrictions on capital
outflows during the mid-1960s. The market grew at
an extraordinary pace from 1964 to 1969 and provided
about four times the combined total of long-term
funds generated by the older and more conventional
national markets for foreign bonds. In 1970, how-
ever, the Eurobond market has been facing its
severest test to date.
This memorandum reviews briefly the history and
significance of the Eurobond market, examines the
market's capacity for surviving periods of difficult
economic conditions through innovative adaptations,
and assesses the prospects for resumed growth.
Background - A Growth Market Through 1968
1. The Eurobond market has been an important
source of capital funds since 1963, when the US
Note: This memorandum was produced solely by CIA.
It was prepared by the Office of Economic Research.
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Interest Equalization Tax (IET)* effectively
rendered the previously dominant New York bond
market inaccessible to foreign borrowers. Ironi-
cally, nearly half of the funds borrowed by
foreigners in New York were foreign owned. Ac-
cordingly, alternative capital market machinery
was established in Europe to tap this lame pool
of US dollars. Thus the Eurobond market developed
strictly out of private commercial need and op-
portunity: borrowers obtained money unavailable
elsewhere at comparable terms, and investors were
given new opportunities to diversify their port-
folios. Both have benefited by freedom from various
forms of governmental control which apply to foreign
borrowings in local currencies.** For example, by
employing subsidiaries in countries with 1enient
tax laws and issuing regulations, such as Luxembourg,
interest can be paid without withholding taxes.
* With the objective of reducing foreign borrowing
in New York, the IET was designed to penalize
Americans who purchased foreign securities with a
tax that would equalize interest rates prevailing
in New York and the somewhat higher rates abroad.
In order to attract US investors, foreigners would
thus be forced to pay commensurately higher rates
in New York to compensate lenders for the tax.
** Subtle distinctions between Eurobonds and
foreign bonds permit significant differences in
taxation and regulation. Eurobonds are securities,
denominated in currencies that need not be of either
the borrower or lender, and that are issued,, quoted,
.and traded in several countries si?nuZtaneoueZy.
By contrast, foreign loans in Europe are issued by
a non-resident borrower in the domestic capital
market of a single country and are denominated in
the currency of that country. Most national capital
markets impose withholding taxes -- usually upward
of 20% -- on interest paid on foreign bonds to
non-residents. The fact that Eurobonds are also
issued in bearer form provides the investor with
additional means to avoid taxes.
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2. Whereas Eurobond funds are typically used
for investment purposes, Eurodollar borrowings --
their shorter term counterpart -- are employed for
shorter term purposes, such as financing foreign
trade. * Such Eurodollars are demand and time de-
posits, usually with maturities of one year or
less, which are held in banks outside the United
States. In mid-1970, Eurodollar deposits totaled
about $40 billion, compared with approximately
$12 billion of outstanding Eurobond issues. The
two markets, and their respective structures of
interest rates, are interrelated. For example,
when interest rates in the two markets are suf-
ficiently out of liuue, the Eurodollar market rep-
resents an important alternative to the Eurobond
market for both investors and borrowers.
3. In 1968 the United States imposed mandatory
foreign direct investment contro],:s** to improve its
deteriorating balance-of-payments position. This
induced an accelerated development of the Eurobond
market. US-based international companies, forced
to resort extensively to offshore sources of capital
to sustain their overseas growth, abruptly doubled
their share of Eurobond borrowings from about 30%
to 60%. This massive recourse to the Eurobond
market led to an increase in new issues from
$2.0 billion in 1967 to more than $3.5 billion in
1968 (see the table).
** These basically entailed a transformation of
the earlier voluntary program, effective since
1965, into a mandatory program. Three limitations
were imposed on direct investors (defined as in-
dividuals or companies in the United States who
own or acquire as much as a 10% interest in the
voting seeuritieb, capital, or earnings of a foreign
business venture) in their foreign direct invest-
ment transactions, particularly in the developed
countries of continental Western Europe. These in-
vestors were henceforth subject to (1) annual
limits on amounts of new direct investment, (2)
required repatriation of a specified share of total
earnings from their direct investments, and (3) a
reduction of their foreign balances of short-term
financial assets to an average of the level for
1965-66.
3 -
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4. The composition of new Eurobond issues also
shifted dramatically in 1968. A new appetite among
European investors for growth ?-- encouraged by the
aggressive salesmanship of groups like Investors
Overseas Services (IOS) -- began to assert itself at
this time. Convertible Eurobonds,* almost ex-
clusively American, provided an attractive combina-
tion of high yield and capital growth. As a result,
US companies were able to obtain substantially more
funds in the market at lower interest rates than
would have been available by means of :!.ssuing
straight debt bonds.
5. A sharp drop in dollar-denominated straight
debt issues in 1968 was more than offset by an un-
precedented demand for issues in denominated
Deutschemarks (DM). This shift reflected a higher
degree of confidence in the mark than in the dollar,
and the lower interest rates the DM bonds carried
compared with dollar issues. Investors were willing
to accept this lower rate of interest because of
their expectations that the par value for the under-
valued DM would soon be raised.
6. Meanwhile, the institutional structure of
the market continued to broaden. A greater variety
of maturities were offered, particularly in the
five- to ten-year medium-term range. US companies
operating in the United Kingdom adopted the practice
of issuing sterling bonds convertible into the
stock -- valued in dollars -- of the parent company.
An ever-widening clientele of borrowers and lenders
developed through a complex network of multinational
'underwriting syndicates. Although the major market
for Eurobonds was originally in London, others
emerged in Switzerland, Germany, and Belgium.
Significance of the Eurobond Market
7. The Eurobond market has benefited the US
economy in several ways. Overall, it has aided the
* While terms vary, these convertible bonds per-
mit the holder to exchange his bonds for common
stock at a conversion price, about 10% to 15% above
the stock price prevailing at the time of issue,
any time between a period of 6 to 18 months after
issue and the bond's final redemption date.
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US balance of payments by checking the outflow of
capital. This ha., been accomplished without in-
hibiting the international operations of US cor-
porations because a large part of the international
capital raising activities that had been concen-
trated in New York until the middle of 1963 spread
to other world financial centers. The Eurobond
market tends to strengthen the dollar's role as an
international currency. Moreover, it enhances the
potential of US companies for overseas expansion
by increasing their chances of obtaining long-term
capital. In times, this investment aids the US
balance of payments by generating a return flow of
profits.
8. The market has had ,vignificant efrects on
others as well. The new facilities make it easier
for borrowers to raise long-term capital as there
has been a mobilization of funds that might have
remained in official hands or in short-term invest-
ments. Borrowers have access to a usually cheaper
market and in the currency or currencies most
suitable to their purpose. Western Europe has
moved a step closer to the integration of its capi-
tal markets through the consolidation of Eurobond
issuing facilities. However, the greater freedom
of capital movement, demonstrated by an increased
volume of funds transiting national boundaries,
represents a potentially unsettling effect on
international equilibrium. in turn, participating
countries find it more difficult to manage their
domestic monetary policies. But attempts by
national governments to curtail the outflow of
domestic capital led to the creation of the Eurobond
market in the first place. All in all, the world
appears the gainer: facilities are provided through
which the excess capital of countries in balance-
of-payments surplus such as Germany and Switzerland
can be tapped more efficiently, thus contributing
to an increase of international liquidity.
1969: The End of an Era of Sustained Growth ...
9. The sustained expansion of the Eurobond
market ended in the spring of 1969. It has been
followed by a prolonged retrenchment, largely be-
cause of adverse economic conditions in the United
States and various actions by governments in Europe
and the United States. Rising US interest rates
were quickly reflected in higher Eurobond interest
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rates. Therefore, borrowers balked; at the same
time the appeal of convertible bonds -- the principal
form of Eurobonds at that time -- was greatly re-
duced by the fall of the faltering US stock market,
10. The governments of several major European
countries became increasingly concerned in early
1969 with the loss to the Eurobond market of scarce
funds required by domestic borrowers. Both Germany
and Italy effectively reduced this diversion by
limiting the participation of their domestic banks
in underwriting international bond issues. Similar
actions to reduce the amount of capital outflow
from their markets were taken in Switzerland and
Belgium. The restrictions imposed in some countries
on the sale of foreign mutual funds, which are
large investors in Eurobonds, also reduced the de-
mand for these securities.
11. At the same time, the US government eased
mandatory foreign direct investment controls, there-
by permitting US companies to rely more on both
capital transfers from the United States and retained
earnings for overseas investment. And because US
companies -- as a hedge -- in 1968 had borrowed
funds in the Eurobond market well in excess of in-
vestment needs for that year, considerable sums
were carried over. Accordingly, US companies in 1969
placed only $1 billion in Eurobonds, compared with
$2 billion in 1968. New US corporate Eurobond
issues were equivalent to only about 10% of total
expenditures for overseas plant and equipment in
1969, which contrasts with approximately 25% in 1968.
...and in 1970: A Threatened Breakdown
12. After a brief recovery in the fourth quarter
of 1969, Eurobond activity quickly resumed its
descent early in 1970. Among the principal con-
tributing factors to the dismal performance this
year have been a further fall in the US stock market,
a resurgence of US interest rates in the spring,
and German government restrictions on foreign access
to the DM capital market because of liquidity
problems following revaluation of the mark.
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13. The market for new Eurobond issues showed
unprecedented weakness during May-August 3,970.
The liquidity problems afflicting the IOS, and the
bankruptcies of the Penn Central Transportation
Co,apany and the Four Seasons Nursing Centers in the
United States further diminished confidence in the
US economy on the part of prospective European
investors. Accordingly, the prices of outstanding
Eurobond issues dropped sharply -- many by 25% to
50% --'causing prospective buyers of new issues to
become increasingly wary. Offerings of new con-
vertible bonds have been discontinued entirely since
April.
14. The already difficult situation for Eurobonds
was further complicated by renewed reservations
about the strength of the US dollar. Concerns were
provoked by Canada's decision in May to let its dol-
lar float. Investors feai'ed, despite official
denials, that other major currencies might subse-
quently follow suit.
15. The introduction of yet another innovation
rescued the Eurobond market from a threatened
collapse. Two large debentures featuring floating
interest rates* were issued in may and June 1970, for
$125 million by ENEL (the Italian National Elec-
tricity Agency) and for $75 million by the US Pepsi
Cola Company, respectively. Because investors are
largely protected against loss of capital, both of
these sizable issues were quickly oversubscribed at
a time when the market could g.:nerate only nominal
interest in other types of issues.
16. Nevertheless, the Eurobond doldrums persisted
throughout the summer. Borrowers were generally un-
willing to pay dearly for funds over a long fixed
period, =nd lenders feared capital losses at coupon
rates below 10%. A major shift in activity occurred
from the long-term capital market to short-term
Eurodollar financing, including bank lending and the
issuance of commercial paper by US overseas corpora-
tions.
* Floating rates are reset every six months
slightly above the current market rate for Euro-
doZZar deposits, thereby assuring that the value to
the holder will remain approximately unchanged.
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Prospects
17. Early signs have appeared of a likely re-
covery of the Eurobond market. Several US-based
companies announced plans to raise substantial sums
in the market during September. A strong investor
response to these announcements led the largest of
the borrowers, Esso Overseas Fii,ance, to cut the
rate of interest for its 15-year straight-debt de-
bentures from the original offering of 9.5% to 9%.
18. There are several reasons for expecting an
imminent resurgence of new Eurobond issues. An
increase in US economic activity this fall is
generally expected. The rate of US inflation may
decline and become slcaer than in other industrial
countries. Partly for this reason, short-term in-
terest rates should continue to fall.* An already
revived investor interest in convertibles should
gain momentum if recovery on Wall,Street continues.
Many companies that contracted short-term or medium-
term obligations are anxious to convert their hold-
ings into long-term obligations. The market for
Eurobonds denominated in iiiarks and Dutch guilders
has become more active, and should continue so.
And the recent scarcity of new issues has enabled
the market to absorb the large inventories carried
by dealers since early in the year.
19. In the long run, the Eurobond market will
flourish so long as controls continue to obstruct
the free movement of capital across national
boundaries. Restrictions on foreign issues in
European capital markets are not likely to be soon
removed. The maintenance of sovereignty, in eco-
nomic policies is jealously guarded by national
governments. Yet Eurobonds would not vanish even
should all fiscal restrictions be eliminated.**
* Eurodollar interest rates wer,." dampened by re-
duce.-? interest rates in the United States following
the b'ederaZ Reserves easing of credit in Zate sum-
mer -- by reduction in reserve requirements.
*'E In April 1969 the US government took the first
step toward elimination of the IET by reducing the
tax on the purchase of foreign securities from
1-1/4% to 3/4%.
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They would still offer the borrower and lender a
number of advantages. Unlike the New York bond
market, they are not subject to SEC regulations.
Because of the choice of currencies in which the
bonds are denominated, they provide a means of
minimizing exchange risks. Finally, there is less
likelihood of adverse government intervention in
the Eurobond market than in national markets.
19. The organization of trading in outstanding
Eurobonds is widely considered the Achilles heel
of the market. The viability of an active secondary
market depends on a speedy and safe system of clear-
ing transactions, involving participants geo-
graphically dispersed. Although many technical
problems remain, the institution of central clearing
systems, such as Euroclear and the Center of Delivery
(CEDEL),* and the growth of international brokerage
organizations add'greatly to the attractiveness of
the market for investors. Both Euroclear and CEDEL,
organized expressly tc clear and deliver Eurobonds,
will be computerized by early 1971.
Secondary market clearing is equally relevant to
a new form of international security that also is
expected to appear very shortly, the Euro-equity.
The establishment of this market will enable common
stocks of international companies to be traded any-
where in the ,,iorZd without restriction. Some initial
groundwork had been laid this past spring, but plans
wei,e temporarily abandoned as a result of the poor
showing of the US and other stock markets. However,
some European bankers believe that, as stoc, markets
demonstrate a renewed. vigor, the Euro-equities market
will emerge as an important international market to
rival that for Eurobonds.
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New Issues of International Bonds
Million US$
1965
1966'
1967
1968,- 1969
Jan-Mar
Apr-Jun
Jul
A
uc
Eurobonds
By borrower:
1,041
1,142
2,002
3,573
3,155
601
698
180
91
US companies
358
439
562
2,096
1,005
202
203
42
--
CC
Z
other
By currency:
683
703
1,440
1,477
2,150
399
495
138
91
US dollars
726
921
1,730
2,554
1,722
504
485
75
20
t-+
DM
203
147
171
914
1,338
104
55
55
Other
112
74
51
105
95
97
109
50
16
~..,
By type of issue :
Straight
931
900
1,742
1,663
2,024
484
663
180
91
Convertible
110
.242
260
1,910
1,131
117
35
--
--
Foreign bonds
376
378
403
-1,135
813
59
33
70
--
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