THE EUROPEAN CURRENCY CRISIS Presented by: Renee Wang Xintian Wu Yu-fa Chou

I NTRODUCTION 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Aim: To maintain/destroy the exchange rates between Mark/Pound and Mark/Lira Result: Pound and Lira were forced to be withdrawn from ERM (European Exchange Rate Mechanism)

H ISTORY B ACKGROUND 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.

T HE 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

T HE 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.

D EVELOPMENT OF THE C RISIS : P RELUDE 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.

D EVELOPMENT OF THE C RISIS : P RELUDE A prospect for a single European currency was shadowed – Denmark's rejection of Maastricht Treaty in June – 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

D EVELOPMENT OF THE C RISIS : S PREAD 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.

D EVELOPMENT OF THE C RISIS : S PREAD UK: The Bundesbank made no attempt to contact the British over the weekend about a broad realignment. On Sep 15, sterling closed at 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.

D EVELOPMENT OF THE C RISIS : A NALYSIS Why can't rate hikes stop investors from 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.

D EVELOPMENT OF THE C RISIS : R ESULT 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 N EW W AY O UT 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 criteriaMaastricht 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.

A DVANTAGE OF THE E URO 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.

D ISADVANTAGE OF THE E URO 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

C ONCLUSION 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.

R EFERENCES 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

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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