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The European Currency Crisis (1992-1993) Presented By: Garvey Ngo Nancy Ramirez.

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Presentation on theme: "The European Currency Crisis (1992-1993) Presented By: Garvey Ngo Nancy Ramirez."— Presentation transcript:

1 The European Currency Crisis ( ) Presented By: Garvey Ngo Nancy Ramirez

2 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).

3 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)

4 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.

5 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.

6 Factors Behind The Crisis and The Collapsed ERM Germany’s Role and Reunification Self-Fulfilling Speculative Attacks

7 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.

8 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%.

9 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 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.

10 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.

11 Black Wednesday and Speculative Attacks “Black Wednesday” refers to the events on September 16, 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.

12 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.

13 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.

14 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.

15 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.

16 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.

17 Stage One (July 1, 1990 – December 31, 1993) Maastricht Treaty (Treaty on European Union – TEU) Signed on February 7, 1992 in Maastricht, Netherlands Setting the convergence criteria for a country to qualify for participation in EMU 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.

18 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.

19 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.

20 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.

21 Thank You! Q & A


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