How the Exchange Rate Mechanism attempts to control fluctuating currencies between its members.
The Single European Market.
Outcome 1.
Suzanne K Menzies.
Tutor: C Masterton.
Contents.
Introduction 3
Part 1
A brief description of the Exchange Rate Mechanism. 4 - 6
Part 2
How the Exchange Rate Mechanism attempts 7 - 8
to control fluctuating currencies between its members.
Part 3
The ECU's 'Basket' of currencies. 9 - 10
Part 4
The principle role of the ECU. 11 - 12
Part 5
The purpose of the European Monetary Co-operation Fund. 13
Conclusion 14
Bibliography 15
Appendices 1 - Basket Quantities 1991
& Composition of ECU 1979 - 1989 16
2 - Key events in the ECU's 1981 - 1999 17
3 - History of the Euro - BBC News 18
4 - Convergence Criteria - BBC News 19
Introduction.
A European Monetary Union has been high on the EU's agenda for some time. The belief is that full harmonisation of Europe has to be on an economic, social, political and monetary basis. Now, with the implementation of the Euro becoming legal tender last January (2002), this aspiration has been instated.
The Euro, established by its forerunners: the ERM and ECU, as it expands will offer vast provisions, in the aim of developing economic monetary, power, aid and achievements in the long run.
This assessment explores the European Monetary field, hopefully giving some coherence to it along the way.
Part 1- Give a brief description of the Exchange Rate Mechanism (ERM).
As with most economic and social provision in Europe, the early stages of monetary union stemmed from the establishing Treaty Of Rome. Although they were only minor provisions, the treaty did lay down fixed exchange rates, (and possibilities of adjustments to this). Bretton Woods devised this Dollar-based system: where currencies were set at an agreed par value on an adjustable peg scale against the US Dollar. In the 1960s, Members of the EEC were also members of the International Monetary Fund (IMF). The Fund applied Wood's theory, in that each of the participating currencies 'pegged' onto the Dollar by undertaking to keep the market value of its currency within a band: where the ceiling was 1% above its Dollar parity and the floor was 1% below. Implementation of the Wood theory was left to the decision of each individual country.
However, on 15th August 1971, this system ceased when the US Dollar's convertibility into gold decreased and the contributing factor of the floatation of currencies. This International Monetary System (IMS) was heading towards a complete collapse. Then, in 1969 the Hague Summit initiated the publication of the Werner Report: drawn up by the then Prime minister of Luxembourg: Pierre Werner (October 1970).
The aim of the Werner Report was to transform the monetary union. Its proposals came in three stages:
. To reduce the existing fluctuations margins between the currencies of Member States.
2. To achieve complete freedom of capital movements with integration of financial markets and particularly systems of banking.
3. An unalterable exchange rate fixing system of all currencies.
The 'Snake in the Tunnel' Scheme.
The Snake Scheme was a direct implementation of the so-called 'Werner Reforms' (Introductory To British Politics: Dearlove & Saunders). The idea was for currencies to keep within narrower limits of fluctuations, between the currencies of other member countries. The plan being that the narrower fluctuations margins were the 'Snake': of which one currency operated between others and the dollar: the 'Tunnel'.
The 1970s however, saw sharp and frequent fluctuations in exchange rates; partly caused by increased oil prices, saw inadequate working of the Snake mechanism. Originally, the Snake was designed as an agreement of Community possibilities. After the exchange rate fluctuations, the Snake had become a system where currencies were centralised around the German Deutsche Mark.
By the end of 1977, only half of the nine Member States: Germany, Luxembourg, Belgium, the Netherlands and Denmark, remained within the Snake. The other Member States had allowed the currencies to float freely. That same year, the Werner Plan was abandoned.
Europe now was sitting at an un-stable monetary stance. Head of State realised that they needed to create stability through the reduction of currency fluctuations. The Brussels summit of December 1978, initiated the European Monetary System (EMS): the succeedor to the Snake. The EMS was launched in March 1979 and all EU countries joined (: Germany, France, Italy, Belgium, Netherlands, Luxembourg, United Kingdom, Ireland and Denmark). The principal aim of the EMS was to pave the way for full European Monetary Union (D Swann).
The result of the EMS union was the establishment of the Exchange Rate Mechanism (ERM). Predictably, not all EU countries were initial ERM members. As the UK did not join until 1990, but by 1992 all EU Countries were members, apart from Greece.
The ERM was intended as a fixed-exchange rate system where together, the values of the EU currencies float against currencies of the rest of the world, e.g. the Dollar.
The ERM was founded with the aim of giving stability to fluctuating exchange rates: encouraging international trade with Europe and attempting to control inflation. It focussed on the incorporating the essential features of the Snake and IMF exchange rate arrangements with additional improvements. It therefore agreed on par values for each national currency.
The ERM's intention was to provide a short-term solution to stabilise fluctuating exchange rates. This was relatively successful, until the 90s.
Problems began to surface as some of the Member States economies had began to diverge instead of the intended convergence. The central ...
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The ERM was founded with the aim of giving stability to fluctuating exchange rates: encouraging international trade with Europe and attempting to control inflation. It focussed on the incorporating the essential features of the Snake and IMF exchange rate arrangements with additional improvements. It therefore agreed on par values for each national currency.
The ERM's intention was to provide a short-term solution to stabilise fluctuating exchange rates. This was relatively successful, until the 90s.
Problems began to surface as some of the Member States economies had began to diverge instead of the intended convergence. The central rate of the ERM was the ECU, (see part 3). As the strongest European currency, the German Mark linked all members together. The Mark was deemed the strongest due to its large economy and the strong commitment of the German Monetary Authorities to price stability. This in turn, guaranteed a relatively low inflation level, not only in Germany, but also in other countries that participated in the ERM.
However, fixed exchange rates can cause major problems for countries, as it can prove difficult for them to exercise their own economic policies. Consistent pressure of economic fundamentals on a currency can consequently cause devaluation of the Member State currency.
This was the problem for the United Kingdom.
UK & the ERM.
When the UK entered the ERM in 1990, it was widely thought that it was doing so when the central rate was perhaps too high for the British Pound. The ERM had been at the centre of the British Economy: tying the pound to the Mark. The UK was forced out of the ERM on 16th September 1992.
Evan Davis from BBC News describes the event: 'Black Wednesday', as:
"One of the most memorable failures of post-war British economic policy".
With the British Economy, the ERM had lowered inflation, but failed to stabilise it. It has been argued that The ERM may well of been much more of a success if the set interest rates had been established by 'Europe for Europe' instead of by Germany, (as the ERM pegged us to the Mark). Italy & Spain also found themselves forced out of the ERM in 1992.
Politics played a major part in their reluctance to join the ERM (as they did not join until 1990). The Conservative leader at the time: Margaret Thatcher, sat in opposition to Britain becoming members of the ERM. She saw the membership as another loss off British sovereignty to Europe. Thatcher was basically opposed to any development of European integration, especially not in favour to the ERM, as she knew that the system was heading the EMU's drive to a Single European Currency. Not all members of Thatcher's party shared her curbed views. Her Chancellor of the time: Nigel Lawson was in great belief that British involvement in the ERM would be of great results. Lawson's argument was that pegging the pound to the Mark would help control British inflation as Germany already had a high record of maintaining low inflation. However, Thatcher would not partake in his theories and a frustrated Lawson resigned.
John Major replaced Lawson. Thatcher's choice of Major was probably due to his seemed-agreement with her anti-Europe views. Later, major came into conflict with Thatcher as he began to favour the ERM. Then in October of 1990, Major entered the UK into the ERM. Low-standing opinion poles of Thatcher resulted in a vote of Conservative MPs, which saw Thatcher ousted and Major the new Conservative Leader and Prime Minister.
By 1993, the ERM's state of affaires had worsened. The French and Belgian Francs, Danish Krone all came under attack. This was due to different expectations, with respect to the interest rate policies of France, Belgium and Germany.
The system completely broke down after an attempt by EU finance ministers to widen the fluctuating margins, (from 2.25% to 15%). The system had to be abandoned as it became too economically unviable to keep currencies at the fixed exchange level. The demise of the ERM demonstrated that fixed exchange rates are unrealistic and unworkable if they are not fully backed by co-ordinated economic policies.
Part 2 - How does the Exchange Rate Mechanism attempt to control fluctuating currencies between its members?
Within the ERM, currencies were officially set into exchange rate parities: e.g. the French Franc and German Deutsche Mark. The market rates of these currencies had to be kept within narrow ranges of ±2.25% or the allowed wider band of ± 6% (for UK, Italy and Spain) around a central rate, each side of the official bilateral parities. The central rate is calculated on the basis of the ECU: a basket of EU currencies set at fixed quantities, (see Part 3). This meant that, for example, if the French franc should fall to a discount of 2.25% against its Deutsche Mark parity: both France and Germany must buy French Francs with Deutsche Marks (D Swann).
The fixed exchange level is usually compared to a strong currency's exchange rate, e.g. US Dollar or Gold. The ERM fixed all EU countries to the German Mark. Without the fixed exchange rate, it was the belief of the ERM that higher or lower exchange rates would undoubtedly influence a company's decision to trade in a particular country: in the case of the ERM, for example France and Spain, and with the Euro, either trade with Europe, the UK or the USA.
The ERM adopted a policy that meant the exchange rate was fixed and no matter what the supply or demand of the currency in the market was the rate of exchange would remain unadjusted.
For Example, if inflation rose in the UK compared to the rest of Europe, companies would favour the Euro-countries as they look for the cheapest currency or exchange country.
D1 S
D
P1 E1
P E Demand for €s
D1
S D
0 P P1 Q
S
D S1
P E Supply of £s
P1 E1
S S1 D
0 P P1 Q
The fixed exchange rate method, between narrow bands, was the ERM's initiative to control the fluctuation of currencies.
There are advantages and disadvantages of fixed exchange rates:
Advantages:
* It reduces any uncertainties of international trade; therefore long-term investment trade agreements, budgeting, and the pursuit of foreign contracts are all encouraged. Any anticipated exchange rate movements no longer cause threat to trade profit ability.
* Fixed exchange rates: such economic discipline is encouraged as exchange rates cannot then be changed to solve inflation problems.
Disadvantages:
* Fixed exchange rates can lock currencies into rates that are too high or too low for their country's economy. E.g. a too high rate of exchange for the pound may price UK goods out of export markets and artificially lower the price of imports in the UK. This making imports more attractive and exports less. This could be reversed and ultimately give UK exports an unfair price advantage and artificially lower the price of imports into the UK.
* There could be a dramatic reduction in sales as consumers may no longer be able to use finance facilities; they may have less disposable income due to higher costs of existing debts such as their mortgage; higher interest rates persuade the consumer to save rather than spend.
If a currency is inclined to cross Marginally set limitations, the Central Bank of the conflicting Member State are obliged to intervene in the currency markets. They do this by means of buying weaker currencies and selling stronger currencies.
Part 3 - Explain the ECU's 'basket' of currencies.
The European Currency Unit is an unusual type of currency as it was originally used mainly for the purpose of bookkeeping within EC institutions and the allocation of grants and subsidies.
The 'basket' is purely a metaphorical term used to describe a pool of fixed quantities of EU currencies.
The quantity of each specific currency depends on the economic weight: i.e. the country in concern's collective share of Gross National Product and its intra-EU trade. The amounts were calculated by multiplying the weight assigned to each currency by that particular currency's exchange rate. The value of each currency in the 'basket' depends on the state of the countries economy.
The table below shows the composition of the ECU's basket, as of September 1989 and also each country's central rate within the ERM:
(*See also Appendix 1).
Currency
Units in ECU 1
Central ECU Rate2
BELGIAN/LUXEMBOURG FRANC
3.431
39.39
DANISH KRONE
0.1976
7.28
DEUTSCHMARK
0.6242
.91
GREEK DRACHMA3
.440
(292.8)
SPANISH PESATA
6.885
62.5
FRENCH FRNAC
.332
6.4
IRISH PUNT
0.00852
0.79
ITALIAN LIRA4
51.8
(2106)
DUTCH GUILDER
0.2198
2.15
AUSTRIAN SCHILLING
3.7
PORTUGUESE ESCUDO
.393
92.8
UK POUND STERLING5
0.08784
(0.79)
(Table taken from The Single European Market & Beyond: D Swann).
The way, in which the basket theory works, is best explained if you imagine there really is a basket, into which you place the appropriate denomination of currency from each member country. From this, you could then say that the contents of the basket equalled 1ECU. This can be seen in the above table, as it shows each country's units in the ECU.
If one of the currencies in the basket's value were altered in anyway, this would directly alter the ECU's value. For example, if the value of the French Franc decreased, then the ECU would be exchanged for less of the other currency, i.e. if it were US Dollars you were buying, and then your ECU amount would buy you fewer Dollars. Thus, the value of the Dollar would rise against the value of the ECU and the Franc's value would fall, as more Francs would be needed to buy the necessary amount of currencies that make up the ECU.
The ECU in use was as a unit of account in banking transactions. The EU can then use the ECU to measure the value of a particular item. For example, the gain to the EU of creating the Single European Market from 1st January 1993 was measured as being between 70 and 90 Billion ECU's.
Only existing electronically, payments the ECU's was therefore mainly restricted as a medium of exchange of bank deposits for ECU's. However, the ECU was never legal tender.
Part 4 - What is the principle role of the ECU?
The ECU played a symbolic role in the road to a European Single Currency: European Monetary Union. However, the ECU also exercised its role as the denominator for Community transactions. The ECU was undoubtedly the European Union's first common currency. It's transaction purposes basically worked as a credit function. The body of the European Monetary Co-operation Fund (EMCF - see Part 5) had the job of issuing the initial supply of ECUs. This was an EMS provision that in return for Member State deposits, ECUs were released into the market. ECUS were then to be used as the settlement for any country-intervention debts. The European Monetary Fund later superseded this short and medium-termed credit facility.
By 1988, progression of a European Monetary Union was in great development. In June of that year, the European Council began to make proposals in the form of stages that was to be expected at certain points along the way to the achievement of EMU.
The proposals were made under a committee, which was chaired by the President of the Commission: Jacques Delors.
Delors' report was as follows:
"Progress towards union should be seen as a single process, that involves three stages:
. Greater convergence of economic and monetary policy.
2. The economic and institutional basis for EMU: including the instating of an economic and monetary economy (ECB).
3. ECU to become a single currency.
The Delors Report was furthered by the Treaty on European Union (signed in Maastricht, Netherlands), which covered points such as:
- The proposed date for monetary union;
- The name of the single currency;
- The timetable for the conversion process;
- And the measures proposed to create legal certainty in the changeover.
Inevitably, this meant that by the third stage: the official ECU basket will cease to exist. At the Madrid Summit, 1995, the decision was made to call the single currency the Euro. The participating EU countries (all except Britain, Sweden and Denmark), adopted the Euro on the 1st January 1999 and it worked on an electronic basis.
The ECU process was believed to be cumbersome and expensive, and therefore it was abolished, thereby converting the ECU into a separate, floating currency: the Euro (€).
The present situation of EMU is that the fixed-but-adjustable rate Euro, allows the pound to float against it resulting in the exchange rate being decided according to the free market forces of supply and demand.
This method of floating exchange rates was participated in after the demise of the ERM, as the exchange rate market value of many principal currencies, i.e. the pound, was established.
An advantage of floating exchange rates is that the country's government are free to manage their currency's value, often to their own advantage. A disadvantage is that any potential exchange rate movements make it difficult to tender a price for foreign contracts.
The Euro then became legal tender on 1st January 2002. The principals of the Euro are that each country will be tied to a fixed (but adjustable) exchange rate, where any margin of fluctuation would be around this fixed exchange rate.
It is thought that The Euro will be a much more convenient method as it does not entail the ERM transaction costs. Member States also had to reach a convergence criterion before entering into the Euro.
*See Appendices 2, 3 & 4.
Part 5 - What is the purpose of the European Monetary Co-operation Fund (EMCF).
Essentially, the European Monetary Co-operation Fund functioned, as a means of finance for needs of monetary invention.
The ECU, known as the European unit of Account, also expressed the operations of the European Monetary Co-operation Fund. This body was created in 1973, as a basis to ensure that the original 'Snake' proposals, (see Part 1) were effectively exercised.
The EMCF were authorised to receive part of the national monetary reserves as they gave they initial supply of ECUs into the market. The supply was given against country deposits of 20% of both the gold and dollar reserves of the respective countries. This was an EMS provision that all community members had to abide by. The supplies of ECUS were given to each country's Central Bank.
The following diagram demonstrates the operations of the EMCF.
UK CENTRAL BANK FRENCH CENTRAL BANK
ECU
GOLD RESERVES GOLD RESEVES GERMAN CENTRAL BANK
ECU
GOLD RESERVES
ECU
ECU
ECU GOLD RESEVES
GOLD RESERVES
ITALIAN CENTRAL BANK
CENTRAL BANKS OF
REMAINING EU
MEMBER STATES.
However, after the implementation of the Treaty on European Union (Maastricht), the EMCF ceased to exist. This was because The TEU established the European Monetary Institute (EMI), which seized the tasks of the EMCF.
Conclusion.
There have been a number of great achievements and equally a number of flaws in succeeding systems of monetary exchange. The ERM in theory was workable system, however it proved that fixing countries currencies inflicted problems of conflict with economic policies.
The ERM perhaps should not have been such a fixed-rate system but more of an adjustable one. Tied to the German mark meant that the economic policies of all Member States were not being met.
Whether the problem is a fixed exchange rate or a fluctuating currency, both can have a negative impact on the economic policies of countries and to international trade.
Nowadays, it is collectively agreed on that fixing exchange rates would not be plausible, as it would cause a huge cross-border flow of currencies, given that the EU has and will continue to expand. Thus, the only way forward for monetary union within Europe has been to adopt a free-floating currency that is commonly shared.
The ECU initialised proceedings for the Euro and it therefore was a milestone in European currency progression. All that remains to be seen now is the Euro working at its full potential and acting as a vice to European prosperity and growth.
Bibliography.
Books:
* European Union Economies, a Comparative Study.
Frans Somers.
* Introduction to British Politics
John Dearlove & Peter Saunders.
* The Single European Market and Beyond
Dennis Swann.
Internet:
BBC News http://news.bbc.co.uk
ECU Website www.ecu-activities.be
The Guardian http://politics.guardian.co.uk
European Union www.europa.eu.int
European Parliament www.europarl.eu.int
Toerien Financial Services www.toerien.com
History Of E Monetary http://homepages.uel.ac.uk/K.Bain/emustory.html
European Economic & Social Committee http://www.esc.eu.int
Other Materials:
* All College notes and handouts.
Appendix 1 - Basket Quantities - 1991
& Composition of ECU - 1979 - 1989.
*Tables taken from www.ecu-activites.be
Appendix 2 - Key Events in the ECU's History, 1981-99.
Figure 1. - Taken from www.ecu-activities.be.
ECU versus Basket - Key Dates
981
ECU Basket Born
987
Breaking of Basket/ECU Link
990-Jun 92
ECU Bond-Issuing Boom
Dec 91
Treaty of Maastricht Signed
Jun 92
Danish "No" in Referendum
Sep 92
ERM Crisis: Lira and Sterling Leave
Aug 93
ERM Crisis: Bands Widened to 15%
Oct 93
Introduction of Caps on Clearing Banks Exposure
995
ECU Bond Market in "Run-Off"
Mar 95
ERM Crisis: Peseta and Escudo Devalued
31 Dec 98
ECU Basket Ceases to Exist
Jan 99
Euro Scheduled to Begin:
Initial External Value Equals That of Basket
Appendix 3
- Taken from BBC News - Inside Europe.
The euro was launched on 1 January 1999 as an electronic currency and became legal tender on 1 January 2002, but attempts to create a single currency go back 20 years. This chart shows the value of the euro (before 1999 as a basket of the 11 legacy currencies) against the US dollar.
Hover or Click on the graphic below
History of the Euro
Twelve of the 15 EU countries (Germany, France, Italy, Spain, Portugal, Belgium, Luxembourg, the Netherlands, Austria, Finland, Greece and Ireland) are members of the Eurozone. On 1 January 2002 euro cash replaces the old national currencies. As the chart shows, European currencies have always fluctuated against the dollar, even as debates have raged about the euro.
(c) MMII | News Sources | Privacy
Appendix 4 - Taken from BBC News - Inside Europe.
Monday, 30 April, 2001, 11:03 GMT 12:03 UK
Convergence criteria
These are the tests that national economies had to pass in order to be eligible to join the final stage of economic and monetary union - the single currency.
They consist of five criteria, laid out in the Maastricht Treaty:
* The amount of money owed by a government - known as the budget deficit, has to be below 3% of Gross Domestic Product (GDP) - the total output of the economy.
* The total amount of money owed by a government, known as the public debt, has to be less than 60% of GDP. The public debt is the cumulative total of each year's budget deficit.
* Countries should have an inflation rate within 1.5% of the three EU countries with the lowest rate. This was supposed to push down inflation rates and lead to more stable prices.
* Long-term interest rates must be within 2% of the three lowest interest rates in EU.
* Exchange rates must be kept within "normal" fluctuation margins of Europe's exchange-rate mechanism.
There was a great deal of disagreement between countries about how strictly these criteria should be interpreted.
But when decision day eventually came, only Greece was told it was not ready to join the single currency with the first wave of countries in 1999. It joined Eurozone at the beginning of 2001.
Denmark, Sweden and the UK all opted to keep their national currencies.
Composition: as of 1st November 1993.
2 Central rates: as of 6th March 1995.
3 Notational central rate
4 Temporary notational central rate as from 17th September 1992
5 Notational central rate as from 17th September 1992, (suspension of sterling participation in ERM).
2
