Formation of Exchange Rate Mechanism
Since 1960s, the trade among the European nations was increasing more rapidly than that with the rest of the world. By 1992, around 60% of the trade of the members of European Community (EC) was intra-EC. A single currency would not only reduce the cross border transaction costs but also increase the price transparency, boosting the intra-EC trade as a result. Under Maastricht treaty of 1991, conversion of EC to Economic and Monetary Union (EMU) required three stages: Stage 1 would entail removal of all trade barriers to financial flows; Stage 2 would require member states to meet fiscal and monetary convergence criteria and prepare for a new European Central Bank (ECB); Stage 3 would usher into a single currency, with monetary policy managed by ECB.
But the path was not going to be that smooth for all the participating nations….
To converge to a unified European currency, Exchange Rate Mechanism (ERM) was devised, under which twelve countries’ central banks would keep their respective currencies within agreed trading ranges or bands relative to deutschemarks (DM). Since the German economy was largest and its currency least prone to inflation since 1950s, the interest rates, in principle, would be guided by German central bank, Bundesbank. If EC members resembled an “optimal currency area”, with relatively synchronized performance, the system would be less likely to face significant issues. But if various countries had disparate growth rates, their central banks would not be free to modify their interest rates as required by their respective domestic markets; thereby placing higher priority on sustaining ERM bands than managing domestic demand and monetary policies. This system of fixed interest rates would come under strain if there were significant and persistent differences in the member states’ economic performance, be it inflation, labor costs, government finances or even the timing of the business cycle.
However, two players were resistant to the common currency formation. The first was the Bundesbank which ,unlike German government, was not too keen to make economic concessions for the sake of gaining political objectives. The central bank was less concerned about its role as the ERM’s anchor which a bad news for the other ERM members. Its mandate remained to control the German inflation. And then there was British politics. Prime Minister John Major wanted Britain to be “at the heart of Europe” and he had to face elections in another two months. Signing the Maastricht treaty, the British economy would be indirectly controlled by the Bundesbank. Political stakes were high.
Events leading to the Black Wednesday
All countries appeared, more or less, committed to make ERM a success. However the geopolitical realities of the region were causing a strain in the system. In 1989, with the fall of Berlin wall, there were massive investments in the East Germany to bring it up to the standards of West Germany. In 1991 alone, total Germany capital formation rose by 36% and government consumption by 27%. As a result, inflationary pressures began to surface. To counter the inflation, Bundesbank responded with an increase in the domestic interest rates.
On the other hand, UK during that time was experiencing recessionary economy with low growth and high unemployment rates. Furthermore, requests by member states to have Bundesbank decrease their interest rates or revalue the DMs met with a political deadlock.
The goal of achieving higher international economic integration while maintaining national policy independence is counteracted by what economists refer to as the “trilemma” or “the unholy trinity”. A country can, at any point in time, exercise control only on two of the three factors: 1) fixed exchange rate, 2) free international flows of capital, and 3) an independent monetary policy (control of interest rates).
By 1990, most of the EC members had eliminated all the restrictions on financial flows across the borders. Given an incentive, anyone would have preferred holding stable DMs to other currencies such as pounds, francs and lira among others. Higher interest rates in Germany, with unchanged interest rates in countries with weaker currencies, would create perfect condition for undertaking carry trades. However, if the interest rates of other countries or exchange rates could float freely, this could balance the exchange and interest rate parity. If UK, Italy, France and other EU members were not constrained by ERM, their interest rates would rise along with that of Germany’s, in which case investors would convert their funds from other currencies to DM. This would cause other EU currencies to depreciate relative to DMs. As a result, exports from Germany would be more expensive and goods from other nations would be cheaper for consumers. This would eventually result in an increase in exports of non-German counties, thereby priming demand for depreciated currencies to bring back the markets in equilibrium. However, this cycle would never set in place unless the currencies are allowed to depreciate in the place. EU nations could not depreciate their currencies as they were committed to the ERM.
Being a member to the ERM, the exchange rate of pound was fixed to DM within a prescribed band, the international flow of capital was unrestricted and the interest rates were required to balance the absence of forex adjustments. As the interest rates available in Germany were higher than those in UK, investors were incentivized to sell pounds and buy DM to invest at German interest rates. This caused a downward pressure on the value of Pound. While an increase in interest rates in UK was essential to ward off this imbalance, the domestic conditions demanded low interest rates to prime the economy. Additionally, the UK government was committed in sustaining pound’s ERM parity.
Currency speculators opined that the Bank of England will have to devalue pound in wake of market forces (Lira, a strong case point then, had already been devalued earlier that month). With this belief speculators took a position against the Bank of England, where they borrowed large quantities of pounds in the open market and sold them short to purchase DM.
Bank of England, on the other hand, made strong efforts to maintain low interest rates (to pump up the receding economy) and the peg to DM. It bought large amounts of pounds from the open market at the expense of depleting foreign currency reserves, primarily in U.S. dollar.
By 16th of September, 1992, UK was losing hundreds of million dollars every minute in supporting the pound’s value against DMs. The central bank ultimately resorted to increases in interest rates that went as high as 15%. However this proved futile in sustaining the peg. In the days to follow, pound fell by 15% against DM. Speculators bought back the shorted pound at the depreciated levels to repay their debt. The unused DM were the profit earned by the speculators. Bank of England’s reserves had depleted by $27billion.
George Soros had shorted $10 bn worth of pounds and traded it for DM only to buy them back when pound had depreciated. Soros took positions in interest rate futures, betting that the UK interest rates would increase in defense of the home currency. He made $1billion by shorting pound and another $1billion by participating in derivative markets. Soros was responsible for $10 billion of the total loss of $27billion suffered by the Bank of England, thereby known to be the person who broke the Bank of England !!
Since 1960s, the trade among the European nations was increasing more rapidly than that with the rest of the world. By 1992, around 60% of the trade of the members of European Community (EC) was intra-EC. A single currency would not only reduce the cross border transaction costs but also increase the price transparency, boosting the intra-EC trade as a result. Under Maastricht treaty of 1991, conversion of EC to Economic and Monetary Union (EMU) required three stages: Stage 1 would entail removal of all trade barriers to financial flows; Stage 2 would require member states to meet fiscal and monetary convergence criteria and prepare for a new European Central Bank (ECB); Stage 3 would usher into a single currency, with monetary policy managed by ECB.
But the path was not going to be that smooth for all the participating nations….
To converge to a unified European currency, Exchange Rate Mechanism (ERM) was devised, under which twelve countries’ central banks would keep their respective currencies within agreed trading ranges or bands relative to deutschemarks (DM). Since the German economy was largest and its currency least prone to inflation since 1950s, the interest rates, in principle, would be guided by German central bank, Bundesbank. If EC members resembled an “optimal currency area”, with relatively synchronized performance, the system would be less likely to face significant issues. But if various countries had disparate growth rates, their central banks would not be free to modify their interest rates as required by their respective domestic markets; thereby placing higher priority on sustaining ERM bands than managing domestic demand and monetary policies. This system of fixed interest rates would come under strain if there were significant and persistent differences in the member states’ economic performance, be it inflation, labor costs, government finances or even the timing of the business cycle.
However, two players were resistant to the common currency formation. The first was the Bundesbank which ,unlike German government, was not too keen to make economic concessions for the sake of gaining political objectives. The central bank was less concerned about its role as the ERM’s anchor which a bad news for the other ERM members. Its mandate remained to control the German inflation. And then there was British politics. Prime Minister John Major wanted Britain to be “at the heart of Europe” and he had to face elections in another two months. Signing the Maastricht treaty, the British economy would be indirectly controlled by the Bundesbank. Political stakes were high.
Events leading to the Black Wednesday
All countries appeared, more or less, committed to make ERM a success. However the geopolitical realities of the region were causing a strain in the system. In 1989, with the fall of Berlin wall, there were massive investments in the East Germany to bring it up to the standards of West Germany. In 1991 alone, total Germany capital formation rose by 36% and government consumption by 27%. As a result, inflationary pressures began to surface. To counter the inflation, Bundesbank responded with an increase in the domestic interest rates.
On the other hand, UK during that time was experiencing recessionary economy with low growth and high unemployment rates. Furthermore, requests by member states to have Bundesbank decrease their interest rates or revalue the DMs met with a political deadlock.
The goal of achieving higher international economic integration while maintaining national policy independence is counteracted by what economists refer to as the “trilemma” or “the unholy trinity”. A country can, at any point in time, exercise control only on two of the three factors: 1) fixed exchange rate, 2) free international flows of capital, and 3) an independent monetary policy (control of interest rates).
By 1990, most of the EC members had eliminated all the restrictions on financial flows across the borders. Given an incentive, anyone would have preferred holding stable DMs to other currencies such as pounds, francs and lira among others. Higher interest rates in Germany, with unchanged interest rates in countries with weaker currencies, would create perfect condition for undertaking carry trades. However, if the interest rates of other countries or exchange rates could float freely, this could balance the exchange and interest rate parity. If UK, Italy, France and other EU members were not constrained by ERM, their interest rates would rise along with that of Germany’s, in which case investors would convert their funds from other currencies to DM. This would cause other EU currencies to depreciate relative to DMs. As a result, exports from Germany would be more expensive and goods from other nations would be cheaper for consumers. This would eventually result in an increase in exports of non-German counties, thereby priming demand for depreciated currencies to bring back the markets in equilibrium. However, this cycle would never set in place unless the currencies are allowed to depreciate in the place. EU nations could not depreciate their currencies as they were committed to the ERM.
Being a member to the ERM, the exchange rate of pound was fixed to DM within a prescribed band, the international flow of capital was unrestricted and the interest rates were required to balance the absence of forex adjustments. As the interest rates available in Germany were higher than those in UK, investors were incentivized to sell pounds and buy DM to invest at German interest rates. This caused a downward pressure on the value of Pound. While an increase in interest rates in UK was essential to ward off this imbalance, the domestic conditions demanded low interest rates to prime the economy. Additionally, the UK government was committed in sustaining pound’s ERM parity.
Currency speculators opined that the Bank of England will have to devalue pound in wake of market forces (Lira, a strong case point then, had already been devalued earlier that month). With this belief speculators took a position against the Bank of England, where they borrowed large quantities of pounds in the open market and sold them short to purchase DM.
Bank of England, on the other hand, made strong efforts to maintain low interest rates (to pump up the receding economy) and the peg to DM. It bought large amounts of pounds from the open market at the expense of depleting foreign currency reserves, primarily in U.S. dollar.
By 16th of September, 1992, UK was losing hundreds of million dollars every minute in supporting the pound’s value against DMs. The central bank ultimately resorted to increases in interest rates that went as high as 15%. However this proved futile in sustaining the peg. In the days to follow, pound fell by 15% against DM. Speculators bought back the shorted pound at the depreciated levels to repay their debt. The unused DM were the profit earned by the speculators. Bank of England’s reserves had depleted by $27billion.
George Soros had shorted $10 bn worth of pounds and traded it for DM only to buy them back when pound had depreciated. Soros took positions in interest rate futures, betting that the UK interest rates would increase in defense of the home currency. He made $1billion by shorting pound and another $1billion by participating in derivative markets. Soros was responsible for $10 billion of the total loss of $27billion suffered by the Bank of England, thereby known to be the person who broke the Bank of England !!
