Transcript The European Currency Crisis (1992

The European Currency
Crisis (1992-1993)
Presented By:
Garvey Ngo
Nancy Ramirez
Background of European Union

In the 1970’s after the collapse of the Bretton Woods System,
European countries tried to limit intra-European exchange rate
fluctuations.

The European Economic Community (EEC), later becoming the
European Union (EU), consisted of several member countries
including: France, Germany, Italy, the Netherlands, Belgium, and
Luxembourg. It also added: Spain, Portugal, U.K., Ireland, Greece,
Austria, Denmark, Sweden, and Finland.

From the late 1970’s to the early 1990’s the EU member countries
formed the European Monetary System (EMS).
What Is the EMS?




The members of the EU wanted to reduce exchange rate variability
and achieve monetary stability in Europe.
The EMS has two components: the creation of an artificial unit of
account named the European Currency Unit (ECU), and a fixed
exchange rate system known as the Exchange Rate Mechanism
(ERM).
The ERM was essentially a managed float exchange rate system
where the currencies of participating countries were allowed to
fluctuate within pre-specified bands.
Only 11 countries of the 15 EU members were willing to commit to
the exchange rate bands becoming part of the ERM. (Austria, Finland,
Greece, Sweden)
Goals of EMS




Enhance the importance of Europe in the global economy. The EMS
was a way for the EU nations to handle some of their monetary
concerns amongst themselves rather than relying on a worldwide
system.
To create a unified Europe and eliminate all barriers to the movements
of trade and capital across the European countries.
To improve the functioning of the Common Agricultural Policy
(CAP). This basically ensured that exchange rate fluctuations would
not affect real income across ERM countries.
These were all steps along the way to establishing a full European
Monetary Union because it reduces the fluctuations of the currency
and improves the coordination of monetary policy decisions among
the member countries.
Effect of the EMS




Central exchange rates for each currency against the ECU were
established, allowing a fluctuation band of 2.25% for most currencies
against the central rate.
Member countries are required to intervene to make sure that their
currencies stayed within the prescribed band.
Since the ECU was an artificial accounting unit, the system effectively
turned into a system where the bands were maintained with respect to
the most stable currency of the group, which was the ‘German Mark’.
The Deutsche Mark (DM) became the unofficial reserve currency, so
the ERM had a built-in lending mechanism to prevent crises from
happening. The German Central Bank (Bundesbank) is suppose to
lend DM to the member country if the country needed support for its
currency.
Factors Behind The Crisis
and
The Collapsed ERM
 Germany’s
Role and Reunification
 Self-Fulfilling
Speculative Attacks
Germany’s Role



Germany becomes free to set monetary policy for itself while the
other countries have reduced control over monetary policy since they
have to hold reserves and intervene when the exchange rate got too
close to the edge of the band.
It was believed that other Central Banks were not very good at
keeping inflation under control, which is why they chose Germany
because they have made explicit mandates to root out inflation as its
primary goal after the World Wars.
This allowed people to make long-term decisions with more certainty
because the member countries fix their exchange rates to the DM,
which allows the Bundesbank to dictate the monetary policy
decisions.
The Reunification of East and
West Germany

The catalyst for the ERM crisis was the reunification of Germany in
1990 because the event was unprecedented in history for the merging
of a large and rich economy with a smaller economy with a much
lower standard of living.

In order to make the assimilation work, the West German government
spend an enormous amount of money.

Almost half of all West German savings were transferred to the East
and the government budget deficit rose from 5% to 13.2%.
Germany’s Accelerated Effects

By 1991, the Bundesbank was becoming very nervous about the
prospects of high inflation in Germany and started pursuing
contractionary monetary policy very seriously.

The combination of expansionary fiscal and contractionary monetary
policy caused German interest rates to rise dramatically, about 3% in
1991 and 1992.

The high interest rates of Germany made the situation for Britain,
France, Italy, and other European countries worse because they were
restrained from taking corrective monetary policy actions.
Initial Speculations

As the other European economies continued to deteriorate and
struggle, there was increasing pressures for the politicians in the
elections for Britain, France, and Italy to offer some policy solution.

As a result, some analysts speculated that these countries might soon
give up their support for the exchange rate peg against the German
Mark.

A currency devaluation would help the devaluing country boost
exports, and allow the country to regain the flexibility it needed to
stimulate its economy through interest rate cuts.
Black Wednesday and Speculative
Attacks





“Black Wednesday” refers to the events on September 16, 1992.
Due to major speculations and a weakening currency, the UK’s prime
minister and cabinet members tried all day to prop up the sinking
pound and avoid withdrawal from the ERM.
The British government raised the base interest rate from a high 10%
to 12% in order to tempt speculators to buy pounds.
During that same day, it promised to re-raise the interest rates to 15%,
but investors kept selling the pounds.
Even with the spending of billions of pounds to buy up the sterling
being frantically sold on the currency markets, Britain was eventually
forced to withdraw from the ERM because they were unable to keep
the sterling above its agreed lower limit.
Effect of Black Wednesday

The UK Treasury spent approximately ₤27 billion of reserves in trying
to defend the pound by selling Deutsche Mark and buying
pounds.

The market knew that the UK could not afford to keep interest rates
high for long.

The UK was not prepared to lose all of its currency reserves to simply
stay in a seriously flawed ERM.

One of the most high profile currency market investors, George
Sorros, made over $1 billion in profit by betting against the pound.
Speculative Attacks Continue




A similar situation took place with Italy, and eventually Italy pulled
the Italian Lira out of the European ERM.
The speculative assaults, which helped traders make billions at the
expense of European central banks, also prompted Spain and Portugal
to devalue their currencies against the German Mark.
The next major target for speculative attacks was the French Franc.
Elections for France were coming soon, and political pressure were
mounting for a cut in the French interest rates.
As with the other currencies, speculators were betting that France
would devaluate the franc or withdraw from the ERM rather than
maintain a high interest rate with slow growth and rising
unemployment.
The Fall of the French Franc (₣)





As part of the core currency link under the ERM, France and
Germany would do what they could to defend the franc.
As the Franc came under speculative attack, the central banks of
France and Germany intervened aggressively to hold their exchange
rate link by buying Francs and selling Marks.
The countries succeeded, but it was only momentarily; it was more
like a delay of the inevitable. France’s foreign currency reserves were
nearly depleted.
As expected, speculative attacks continued to hit the Franc because
speculators knew France needed lower interest rates to help stimulate
the economy and reduce unemployment.
Bank of France raised interest rates to defend the Franc, and both
France’s and Germany’s central bank continued to intervene directly
to support the Franc.
Root of the Problem Remains
Unsolved





Rising interest rates continue to hurt the French economy even more.
German interest rates were too high, and only a cut in German interest
rates could save the Franc.
Continued speculative attacks against the Franc proved to be
impossible to beat, so Germany and France gave up defending the
exchange rate link.
The EU finance ministers and central bankers decided to allow the
widening of the currency trading bands to fluctuate within 15%
around a central rate.
Once again the speculators won and locked in their profits by buying
back the devalued Franc. The German central bank spent about 60
billion Mark ($35 billion) trying to prop up the French currency.
The Road to A European Monetary
Union
 The
Signing of the Maastricht Treaty
 The
formation of the European
Economic and Monetary Union (EMU)
 The
creation of the Euro.
Stage One
(July 1, 1990 – December 31, 1993)

Maastricht Treaty (Treaty on European Union – TEU)


Setting the convergence criteria for a country to qualify for
participation in EMU





Signed on February 7, 1992 in Maastricht, Netherlands
Inflation within 1.5% of the best three of the European Union for at least
a year.
Long-term interest rates are required to be within 2% points of the best
three in the European Union for at least a year.
Being in the narrow band of the ERM ‘without tension’ and without
initiating a depreciation, for at least two years.
A budget deficit/GDP ratio of no more than 3% and a government
debt/GDP ratio of no more than 60%.
The treaty enters into force on November 1, 1993.
Stage Two
(January 1, 1994 – December 31, 1998)




The European Monetary Institute is established as the forerunner of
the European Central Bank, with the task of strengthening monetary
cooperation between the member states and their national banks, as
well as supervising ECU banknotes.
On December 16, 1995, the new currency, the Euro €, as well as the
duration of the transition periods are established.
The European Council, adopts the Stability and Growth pact to ensure
budgetary discipline, and also establishes a new Exchange Rate
Mechanism (ERM II) to provide stability with the Euro and other
national currencies.
On June 1, 1998, the European Central Bank (ECB) is created, and on
December 31, 1998, the conversion rates between the 11 participating
national currencies and the euro are established.
Stage Three
(January 1, 1999 – Continuing)

As of January 1, 1999, the Euro is now a real currency, and a single
monetary policy is introduced under the authority of the ECB.

A three-year transition period begins before the introduction of actual
euro notes and coins, but legally the national currencies have already
ceased to exist.

On January 1 of 2001, 2007, and 2008, Greece, Slovenia, and Cyprus,
join the third stage of the EMU, respectively.

Slovakia is to join the EMU on the first day of 2009.
Conclusion

The Euro produces a greater degree of European market integration
than fixed exchange rates.

Although Germany was the catalyst in the crisis, much of the fault can
be attributed to all those involved, including the member countries and
speculators.

The Eurozone is now one of the largest economies in the world.

Several countries like Hungary, Bulgaria, and Romania are
considering joining the new ERM II and possibly the Eurozone.
Thank You!
Q&A