THE EUROPEAN CURRENCY CRISIS---1992-1993

Presented by:

Renee Wang

Xintian Wu

Yu-fa Chou

INTRODUCTION

War in Europe: late September, 1992 Central Banks       vs       Investors Sell: Deutsche Mark        Sell: British Pound Buy: British Pound              Italian Lira

        Italian Lira      Buy: Deutsche Mark

Aim: To maintain/destroy the exchange rates between Mark/Pound and Mark/Lira

Result: Pound and Lira were forced to be withdrawn from ERM (European Exchange Rate Mechanism)

HISTORY BACKGROUND

What is EMS? Most members of the European Economic

Community (EEC) linked their currencies to prevent large fluctuations relative to anothers.

European Currency Unit (ECU): a basket of currencies, preventing movements around parity in bilateral exchange rates with other member countries above 2.25% (6% for Italy)

Deutsche Mark became the de facto "anchor" in the European Monetary System (EMS) due to Germany's strong economy after the merge of East and West Germany and the low-inflation policies of the Deutsche Bundesbank.

THE CATALYST OF THE CRISIS Germany:

– Economic strength increased – Concerned about domestic inflation, set high

interest rate The counties in recession:

– Want more stimulative policies to lift their economies out of sluggish growth

But– Those countries must keep their own rates high

to maintain the value of their currencies against the Deutsche Mark

The contradiction led to the crisis

THE FUNDAMENTAL CAUSE OF THE CRISIS

The relative economic strength of EEC members is not constant.

Change in economic strength of a country demands corresponding adjustment in the weight of its currency in ECU.

Although currency weights are set to adjust every 5 years, unsynchronized strength and weight could lead to crisis.

DEVELOPMENT OF THE CRISIS: PRELUDE Germany government increased money supply

and initiated many development projects to spur economic growth after the merge of East and West German. This, however, led to a greater possibility of inflation

Contrary to expectations, Germany increased its discount rate to 8.75% to ease inflation stress.

British and Italian economies were in trouble with

double digit deficits, forcing them to adopt a low interest rate policy.

DEVELOPMENT OF THE CRISIS: PRELUDE A prospect for a single European currency

was shadowed – Denmark's rejection of Maastricht Treaty in June

1992.– Reports projected voters in France might also

vote "no". Critical contradiction.

– pound/lira were overvalued– weak economic strength of UK and Italy.

Germany's rate increase intensified stresses on pound/lira

DEVELOPMENT OF THE CRISIS: SPREAD The EEC finance ministers Sep 5, 1992

– Equivocated on the currency realignment issue at their meeting in Bath, UK

Finland: on Sep 8– Finnish Markka no longer tied to Deutsche Mark – Failed to keep Markka/Mark exchange rate and

adopted a floating exchange rate Italy: on Sep 11

– Italian lira was hit by speculators and fell below its ERM  floor. 

– The Germans and the Italians met and opted for a 7% devaluation of the lira and modest cuts in short-term German interest rates.

DEVELOPMENT OF THE CRISIS: SPREAD UK: The Bundesbank made no attempt to

contact the British over the weekend about a broad realignment.

On Sep 15, sterling closed at 2.778 DM, only 1/5 pfennig above its ERM floor – As the French referendum (scheduled Sep 20)

approached, panic spread in the market.– Nervous investors sold massive amount of weak

currencies in ERM for DM.  On Sep 16 (Black Wednesday),

– Bank of England raised short-term interest rates from 10% to 12% and to 15% on the next day.

– Although an estimated 15 billion pound was poured into the market, the landslide of sterling could not be reversed.

DEVELOPMENT OF THE CRISIS: ANALYSIS

Why can't rate hikes stop investorsfrom selling sterling?

The market knew that the UK could not afford to keep interest rates high for long in the midst of a British recession.

The UK was not prepared to lose all of its currency reserves simply to stay in a seriously flawed ERM, either.

DEVELOPMENT OF THE CRISIS: RESULT

Sep 16,1992– Bank of England rescinded interest rate

increases.  – UK and Italy opted out of ERM. 

Sep 20, 1992– France approved the ratification of the

Maastricht Treaty.Yes: 13,165,475 (51.04%)No: 12,626,700 (48.96%)

A NEW WAY OUT

The development of Euro

– Stage One: July 1, 1990 to December 31, 1993

– Stage Two: January 1, 1994 to December 31, 1998 

– Stage Three:

January 1, 1999 and continuing

Stage One

Maastricht Treaty

– Signed on February 7, 1992 in Maastricht, Netherlands

– Setting a number of Maastricht convergence criteria

– Leading to the creation of the European Union

Stage Two

European Central Bank (ECB) is created . New currency (the euro) is created The duration of the transition periods are

decided

Stage Three

From the start of 1999, the euro is now a real currency.

The national currencies have already ceased to exist.

ADVANTAGE OF THE EURO

Produce a greater degree of European market integration than fixed exchange rates.  

More considerate of other countries’ problems – The European Central Bank would replace the

German Bundesbank under EMU 

Removing the cost of exchanging currency.

Convenience in transaction– Banks in the Euro-zone must charge the same for

intra-member cross-border transactions as purely domestic transactions for electronic payments.

DISADVANTAGE OF THE EURO

European countries vary in language, history and culture.

The level of fiscal federalism in the EU is too small to cushion member countries from adverse economic events.

Hard to handle through monetary policy. – Economic diversity in the Euro-zone– Euro-zone interest rates have to be set for both

low-growth and high-growth Euro members

CONCLUSION

Certainly, the fault of the crisis cannot all be attributed to Germany. However, although various economic contradictions among countries aggravated day by day, countries can be coordinated only in economic integration.

The international cooperation and policy coordination has already become the irreversible trend now. Therefore, economic policies of adopting coordination of various countries will promote the development of international economy.

REFERENCES

Treasury and Federal Reserve foreign exchange operations - Treasury Dept, Federal Reserve Bulletin, Jan 1993

The Search for Security: A U.S. Grand Strategy for the Twenty-First Century by Max G. Manwaring, Edwin G. Corr, Robert H. Dorff

THANK  YOU!

Maastricht convergence criteria The Maastricht convergence criteria for a

country to qualify for participation in EMU are: 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 normal band of the ERM without severe 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%. Back