Currency Substitution in European Financial Markets

Abstract

That currency substitution exists in European financial markets might, at one level, seem obvious. The Bank for International Settlements (BIS), in its International Banking and Financial Market Developments, regularly publishes data on the holdings of bank deposits by non-bank residents of European countries denominated in domestic currency but held abroad or denominated in foreign currency, whether held with domestic or with foreign-sited banks. Such "cross border deposits" may surely be regarded as potential "currency substitution" deposits. Expressed as a proportion of domestic money supplies, such deposits grew very fast for most of the major European countries during the period of the "New EMS", between the late '80s (as capital controls were phased out) and the early '90s. For example, in France, the proportion rose from 2.5% at the end of the first quarter of 1987 to 6.45% by the end of the second quarter of 1992; comparable figures for Germany, Italy and the Netherlands involve growth from 7.6 to 15.3%; from 1.92 to 7.82%; and from 33.61 to 54.93%, respectively. In the case of the United Kingdom there was a slight fall, from 16.83 to 15.04%. (The domestic money supply definitions used here are: M3 for France and Germany; M2 for Italy and the Netherlands; M4 for the United Kingdom). Of course, not all of these cross Border deposits could represent potential substitutions between European currencies of denomination - indeed a large, if not the greater part, of foreign currency-denominated deposits are in dollars; the published BIS data do not give the full details of currency of denomination which would allow us to determine what proportion represents intra-European currency substitution. Nevertheless, there is a clear presumption that the proportion of such deposits is both large and growing.