The financial markets

"A crucial element for the stability of the EMS is the perception on the part of the financial markets that the authorities are strongly committed to defending their exchange rates". Discuss this statement with reference to the roles that speculators and German reunification had in the EMS crisis of 1992/93. How did the crisis influence the future path of monetary integration? A fixed exchange rate regime operated in Europe in the post war period until the early 1970s. The European Monetary System replaced Bretton Woods; it begun in 1979 and ended on 31 December 1998, with the launch of the Euro. The EMS was an example of an 'incomplete' monetary union, and it had two principal components - the Ecu, and the Exchange Rate Mechanism (ERM).

The ERM was a predecessor to the Euro, but the first direction towards a common currency in Europe was the 1957 Treaty of Rome. Although its aim was a common market - not a monetary union - the Treaty did aspire towards the liberalisation of capital flows (which is a feature of a complete monetary union). But the defining event was the Werner Report of 1970, delivered by the Luxembourg Prime Minister. This Report was the first attempt to talk about monetary union, and concluded that it could be a reality by 1980. Although this date was missed by almost 20 years, the Report had no rigid timetable. The 3 stages set out were I) the voluntary reductions of fluctuation margins between the currencies of Member States 11) total liberalisation of the flow of capital, and iii) the irrevocable fixing of the exchange rates between different currencies.

The 1971 Smithsonian Agreement was an attempt to salvage Bretton Woods; each currency was allowed to fluctuate 2.25% either side of the existing $US exchange boundaries - giving EC currencies an effective margin of 9% - at the time, such a boundary was ineffective. An attempt to preserve a certain order in inter-European exchange movements was the 1972 Snake in the Tunnel - this narrowed intra-EC margins to 4.5%. This also enforced rules for joint intervention when a currency reached its band limit. The Ecu was a basket of EC (EU) currencies, and could be used as a unit of account for all EU transactions. Each currency's weighting in the Ecu was reviewed at 5-year intervals. Traditionally, the German Deutschmark (DM) had the largest weighting, followed by the French Franc (Ffr) then UK Sterling.

However, more critical to European monetary stability was the ERM. Like Bretton Woods, the ERM was an 'adjustable peg' system. Each currency was pegged at a central rate against the Deutschmark (DM), around which it could fluctuate freely so long as it remained within bands of -2.25% and +2.25%. Italy was an exception, whose bands were set at +6% and -6% until 1990. The UK, Spain and Portugal also enjoyed these wider bands. Significantly, the bands of the ERM were wider than the +/- 1% bands under Bretton Woods.

Under ERM, two things could happen when a currency hit its band limit. The first was the obligation of joint intervention of the Central Banks. Suppose that the Italian Lira reached its upper limit against the DM. This would require the central bank of the weakest and strongest currency within the system to intervene to in order to stabilize the currency. The second option - a country could request and seek a re-alignment. This was attractive to high inflation countries like Italy, for whom it was possible to change their exchange rates by regular, small increments without facing a large speculative crisis prior to the expected re-alignment.

Refer to diagram 1. Suppose Italy has higher inflation than Germany, and so wants to devalue the Lira by say 10% to offset this larger inflation. The new central rate would always fall between the previously prevailing upper and lower limits. Thus after realignment the market exchange rate would most likely not change, or even decline. Prior to realignment at date t1, the Lira hits the upper limit against the DM. AT this date the Lira is devalued against the DM by 10% reflecting Italy's inflation being higher than Germany's. The next day, the previous market rate will fall between the new limits. The change occurring at t1 will be minimal; the market exchange rate will fall the day after realignment, as speculators take their profits. However, a period of relative stability existed from 1987 to 1990, between which no country sought realignment.

Since the whole aim of the EMS was to create 'a zone of monetary stability' within Europe, the ERM needed credibility. The private sector could often ask; would the fixed exchange rates be maintained? Thus, the central bank of each participating nation was charged with maintaining the exchange rates. In other words, when a currency reached its margins, marginal intervention was required. This would be in the form of buying (or selling) the domestic currency, so as to push the currency back within its margins, or by altering interest rates. But this commitment wasn't absolute - a country could, as an alternative, request for and seek a parity re-alignment. In 1990, the EMS evolved into a truly fixed exchange rate system with (almost) perfect capital mobility.

For the EMS to be stable, it was essential that the financial markets perceived the authorities to be committed to defending their exchange rates. Credibility was essential. In general, the authorities possessed credibility in the money markets between 1987 and 1990. However, from 1990 onwards, this credibility was lost, and led to the whole collapse of ERM. Germany's Bundesbank had garnered a reputation as being 'hard-nosed' - tough on tackling inflation, which was its overriding priority. Thus, they felt the need to take action after the re-unification of East and West Germany in 1990 caused high inflationary pressures as a result of huge increases in government spending. A tighter, more restrictive monetary policy was needed to combat domestic inflation.

This created a conflict in the EMS. Whereas Germanys problems were inflation, Europe's second and third largest economies - the UK and France - were stuck in a recession and thus had deflationary pressures. It is clear that German re-unification put Germany, on the one hand, and France and the UK on the other, on separate agendas, and this contributed immensely to the 1992/93 crisis.

The role of speculators is to 'bet' on the movements of currencies, Speculators had observed the policy conflicts, and so believed that the UK and France were not committed to defending their exchange rates. It was believed that these two countries would cut their links to the DM, in order to be free to embark on expansionary monetary policies (reducing interest rates) and end their recessions. Therefore, speculators increasingly begun speculating against Sterling and Ffr, and this reached a climax in mid September 1992, with 'Black Wednesday' - the first leg of the ERM crisis. Speculators had 'bet' so much against Sterling that it was unable to maintain its central rate - despite the obligatory actions taken by the British government, Bank of England, and the Bundesbank.

Thus, it was initially German re-unification, and then as a result, speculation, that caused the 1992 crisis. A similar chain of events caused the 1993 crisis; this time there was heavy speculation against the Danish Kronor, Belgian franc and Ffr. The Ffr was only saved from expulsion by a combined, intense effort from the Bundesbank and the Banque de France. The irony in this is that the realisation of the speculators fears was caused principally by their own actions. Their speculation was self-fulfilled - and the blame lies squarely with them for the EMS crisis. Many critics claim that the crisis was caused because, relative to the speculators, the monetary authorities had very few mobile capital funds. But this is incorrect - EMS could have been saved had the Bundesbank supported the Ffr more than it did, and thrown all of its force into the battle.

But the only reason speculators were allowed to cause the crisis was because of the inherent faults within the ERM. For instance, the bands were too narrow, allowing for speculators to have the influence they did. Additionally, the elimination of the control of capital - in order to move toward a fully integrated internal market - at the end of the 1980s gave the speculators further power. Finally, and crucially, if the authorities possessed any credibility, the speculators would have had little reason to bet so much against the currency movements that happened.

The 1992/93 crises have indeed influenced the path of integration. The authorities in 1992/93 lost all credibility - since then, all further monetary integration has had credibility as a major issue. In August 1993, the EMS changed into a quasi-floating exchange rate regime, with bands at +/- 15%. This was to reduce the magnitude of influence that speculators could have. As the EU approached the launch of the Euro, one of the five convergence criteria necessary to gain entry was that a currency should not have been devalued in the previous two years.

Therefore, between 1997 and 1999, credibility became a major policy objective. Authorities were more committed to maintaining their exchange rates. The instability caused in 1992/93 was undesirable. Under EMU now, the stability & growth pact aims to stabilise the union by restricting government deficits to 3% of GDP, and the new European Central Bank has a strict mandate for stabilising inflation across the region.