THE EUROPEAN CURRENCY CRISIS---1992-1993

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THE EUROPEAN CURRENCY CRISIS---1992-1993

• Presented by
• Renee Wang
• Xintian Wu
• Yu-fa Chou

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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  withdrawn from ERM (European Exchange Rate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)

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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.

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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

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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.

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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.

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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

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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.

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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.

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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.

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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)

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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?

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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

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Stage Two

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

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Stage Three

• From the start of 1999, the euro is now a real
  currency.
• The national currencies have already ceased to
  exist.

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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.

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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

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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.

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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

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THANK  YOU!
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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.

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