EUROPEAN ERM CRISIS EUROPEAN EXCHANGE RATE MECHANISM CRISIS
STUDENT: GABRIEL CALABRO’ (21319823) MODULE: GLOBAL FINANCIAL CRISIS MODULE LEADER: PIOTR KONWICKI
Table of Contents 1 Introduction…………………………………………………………………………………………………………….2 2 Type of Financial crisis …………………………………………………………………………………………..3 3 ERM Crisis Time-table and origins ……………………………………………………………………………3 4 The causes of currency crisis ……………………………………………………………………………………8 4.1 The causes of the European ERM crisis ………………………………………………………………………8
6 Policy options and Adopted solutions………………………………………………………………………10 7 Lessons learned……………………………………………………………………………………………………….12 8 Conclusions……………………………………………………………………………………………………………..14 8 Appendix………………………………………………………………………………………………………………….15 9 References……………………………………………………………………………………………………………….18
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1 INTRODUCTION
In this paper, will be documented and criticized divergent points of views regarding the European exchange rate mechanism crisis (ERM). In this regard the first section discuss the different type of financial crisis: bank, monetary and twin crisis. The second section will present and analyze the causes and the origins of the European ERM crisis in 1992. Moreover, in this section will be considered the three interpretations of the ERM crisis: Policy conflict, Speculation and self-fulfilling prophecies and Behaviour of fundamentals. In the third section of this paper there will be space to explain the current scenario in Europe and the adopted solutions by governments for the 1992/93 crises. In addition to this the Policy options will be considered and will be pointed out whether the European ERM collapse might be avoided. At the end, the last section will summarize the main ideas of this paper and it will give us an overview of the ERM and the lessons learned from it.
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2 Type of Financial crisis Although Finance is not merely prone to crises, it is shaped by them. Global Financial crisis is defined like a worldwide moment of market contraction. (Businessdictionary, 2017) Is possible to discern three different type of financial crisis: • • •
Bank Crisis (Sub-prime mortgages, 2008) Currency crisis (ERM, 1992) Twin crisis1 (Tequila crisis, 1994/95)
Systemic Bank crisis happen when a significant number of banks in one country are insolvent or they are facing liquidity problems at the same period. (The world bank, 2017) Currency crisis (or Balance-of-payment crisis) consist of a rapid devaluation of a currency which frequently finish with a speculative attack in the foreign exchange market. The third type is rarer than the other two and it consist of the verification of both, bank and currency crisis, at the same time.
3 ERM Crisis time-table and its origins The European Exchange Rate Mechanism (ERM) was part of the European Monetary System (EMS). It has been introduced by the European Economic Community on the 1979 to minimize the exchange rate volatility. This was fundamental to achieve the Economic and Monetary Union and the consequent introduction of one currency, the Euro. Since the beginning in 1979, the ERM permitted periodic realignments of the central parties. Through the whole 1980s member nations created mechanisms to protect the coordination of exchange rate policies. (Giavazzi and Giovannini, 1989) Before its introduction, when one nation or a set of nations decide a realignment, the size of devaluation was discussed in the Monetary Committee meetings with unanimous approval. The scheme of the ERM hence gave to its participants the opportunity to solve economic and financial issues by using coordinate policy responses, consequently berthing market forecasts of exchange rate realignment. In the meanwhile, the negotiation process forbade single participant nations from take unilateral realignments. The ERM is a mix between fix and variable rate system which adopt some margins. Thus, the exchange rates could just hang around that range. (semi-pegged system) Before the introduction of this system the exchange rates were based on the European Currency Unit (ECU), as soon as the ERM was introduced a Parity Grid of bilateral rates2 was formed based 1
Term in economics that refers to a simultaneous crises in banking and currency (also called a balance of payments crisis).
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The parity grid of bilateral rate was merely a table which state all the ranges of the ERM’s members
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on the ECU and the margin range was 2.25% for the clear majority of the countries and 6% for Italy, Spain, Portugal and UK. (European Community, 1979) However, since its instauration ERM has been the center of monetary policy strategies and the most complicated cooperation after the post Bretton-woods era. It is worth to notice that until the 1980 the ERM was a system of fixed but often flexible changes, while since the middle of the 80s it changed into the well-known “Hard ERM” characterized by a narrower range of volatility. Until the crash in the 1992 the new system worked well and this was the base for a harmonization and monetary unification, but a significant number of adverse events weaken the plans and the crisis among ’92 and ’93 is the cornerstone of the last monetary history in Europe. The explosion of the crisis in 1992, and the changes in market forecasts, showed that the coordination system was doomed to fail. To better understand the reasons of this failure is useful to start from the German reunification demand shock and the exchange rate tensions that came from it by the end of the 1991 and august 1992. (Buiter, Corsetti and Pesenti, 1998) Indeed, the unification of two countries totally different from the productive capacities and standards of living point of view, ends up with the implementation of a controversial monetaryfiscal policy mix. In fact, during the 1991, the movement of funds from west to east German was 139 billion of marks while the total amount of German private savings was 260 billion during the same year. (Bundesbank, 1992) The main issue was that the huge movement of funds was not financed by more taxes or less spending in the budget. Moreover, when the Economic and Social union was created in 1990 the ost marks exchange rate against the deutsche marks was 1-to-1 or 1-to-2 basis. Consequently, this had strong negative effects on the east German production level while the huge movement of funds increased the demand. (Collier and Akerlof, 1991) If most of this demand shock was faced through foreign goods, the inflationary pressure would have been restricted in the west side of the nation. But the hugest error has been in the wage policy. (S. Helmut, 1994) Indeed, the bad adjustments were expansive and the main cause of a restrictive line of monetary policy against inflation. (Sinn, 1992) By the end of 1991, the squeeze of monetary policy, witnessed a losing interest in accept salary inflation and in fiscal policy by the authorities. (Commission, 1993) During the 1992, was noticeable that without realignment in the ERM, the Bundesbank would follow the target of monetary stability using interest-rate tool with disregard for the repercussions for the domestic real economy and for the international environment.
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Imagine: 1
However, the domestic imbalances were spread all over the system. For instance, in Italy, during the 1990s, a shrink in economic activity plus a significant number of fiscal issues increased the desire of protection of the lira. (Froot and Rogoff, 1991) Moreover, the clear signs of shrinkage in the size of international reserves own by the Bank of Italy witnessed that the speculative attacks start in May 1992. (Goldstein, 1993)
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Portugal and Spain as well, were having a decrease in competitiveness. As regard with U.K. a diminution of British monetary policy, created internal tensions which infected the power of the pound. In overall for the European union the difference among deficit performance and actual public-debt and Maastricht requirement became increasingly bigger.
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Imagine: 3
In 1992, the outcome of the first Danish referendum3, made the actors of the market revue the negative effects of abandoning the “hard� ERM. Moreover, the French referendum4 on the 20 Sept 1992, confirmed a reduction in political support for Maastricht. During August 1992, these events (plus the Dollar crisis) arrested the pattern of increasing credibility that was the main feature of the ERM since its implementation. In September 1992, there has been a huge speculative attack against the lira. It increased after the 6 September 1992 (Euromeeting in Bath) where the tensions on exchange rate between European authorities was published on the newspapers. While Germany would have had a general ERM realignment, other countries without Italy did not want to even discuss about that.
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Danish referendum: held on the 2 of June 192 it regards the Maastricht Treaty and its rejection with 50.7% of voters was considered somewhat of a blow to the process of European integration. 4 French Referendum: held on 20 September 1992 it regards Maastricht Treaty and it was approved with 51% of the voters (le petit oui). Also, this considered to be signal of the end of the permissive consensus.
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Imagine: 4
During the ERM, Britain and Italy reached the bottom of their fluctuation areas and 12th September 1992 the Bank of Italy and the Bundesbank were obligated to admit that the current equality of the lira was not sustainable and Italian protection needed 24 billion deutsche marks in Frankfurt and roughly 60 billion all over Europe. (Bundesbank, 1992) Indeed, the EMR rules establish that the central bank of a powerful currency nation must take open-ended actions to help a weak currency. But the Bundesbank could not abandon the goal of internal price stability by taking several actions in the foreign exchange market. Indeed, since the 1978, aware of the interest conflict between German internal goal and ERM obligations, the Bundesbank president Otmar Emminger says that the government would protect the Bundesbank in case of intervention obligations. (Emminger, 1986) Although no European meeting Germany and Italy developed a proposal through bilateral consultations and on September 1992 a devaluation of 3.5% of the lira and a revaluation of 3.5% of the mark was established for a total of 7%. (European Community, 1992) The project should have included other member countries and it was ready on Sunday morning September 13 but British government did not want to devaluate its currency because they would have more time to see the results of the French referendum on the 20 September. Moreover, the Spanish government refuse as well, therefore, the lira has been the only currency to be devaluated. Roughly one day later the lira touched the floor of its new gap and this time the 7
pound followed. The sterling was sold all over the market and the Bank of England lost 15 billion dollars of reserves, roughly half of its savings. (Appendix 2) As regard with Spain the peseta fell under the band as well, although several attempts to protect it were done from the Bank of Spain. The 16 September 1992 is known in U.K. as “Black Wednesday”, indeed during the morning the bank of England increased the lending rate from 10% to 12% and later up to 15%. By the end of the day the sterling close under its minimum band level and England proclaimed the Exit from the ERM followed by Italy and Spain on September 19. (Bank of England, 1992) On September 20, all the currency that received speculative attacks were quoted near by the bottom of their gaps and the Bank of England decreased the lending rate back to 10%. In the meanwhile, in the French referendum, although the yes won, speculative attacks occurred against the Franc on September 23. Consequently, France lost in reserves 80 billion francs and the Banque de France increased the French repo to 13% and received help from the Bundesbank. Others strategies and policy helped to the end of the crisis such us: capital controls (Appendix 3) or implicit control of the lending rates.
4 The causes of the currency crisis The literature is divided into three different interpretation of the currency crisis based on two generations of model: 1. Focus on the importance of fundamentals (Krugman, 1979) (First generation) (appendix 4) 2. Focus on a change of investors sentiments (Obstfeld 1986, 1994) (Second generation) (appendix 5) 3. Usually focus on how problems on financial markets and banking systems can end up with a currency crisis (Third generation) (appendix 6)
4.2 The cause of the European ERM crisis The general cause of the ERM crisis has been a “co-ordination failure”; specifically, there was the rejection to admit that a general realignment was needed. (Buiter et al., 1998). However, the literature about the European ERM crisis is divided into two different interpretations based upon first and second generation models of currency crisis: 1. The most famous one consist of the policy conflict resulting from the reunification process in Germany and policy mix used in that country during the 1990s 2. The last theory blame self-fulfilling speculative attacks which lead to an expectations movement in the financial market.
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As regard with the first one, the focus is on the different performance between national prices and fiscal policies during the ERM period. Indeed, some nations did not understand this lesson. Consequently, the mismatch between prices and costs did not decrease enough while exchange rate did not follow. Hence, that mismatch carried on and it leads to a depreciation in real terms. (Tietmeyer, 1998) From this point of view, the crisis start as outcome of mounting divergence. In fact, the Bundesbank wrote “If success is not achieved in coping with the structural causes of inflation within a reasonable period, it will probably become increasingly difficult over the long term to avoid having recourse to exchange rate adjustments� (Deutsche Bundesbank, 1990) This show why a currency union not built upon durable progress will be always under pressure and tension. In 1993 a test on the Bundesbank showed that the divergent movement of prices and labor costs was not a fundamental cause of the ERM crisis. (Eichengreen and Wyplosz, 1993) This will lead us to the second interpretation which focus on the shift of credibility which lead to speculative attacks. But since the dilemma of fundamentals was well known the shift has been just on the expectations. Nevertheless, the interpretations above miss the key point: the ERM crisis derives from a strife among a center-country that did not want to deal with the inflationary effects of the unification and periphery-countries that did not want to sustain the drawbacks of a deflation but were against a co-ordinate nominal realignment. (Padoa-Schioppa, 1994) The main reason of that has been the obvious doubt if the rest of the periphery countries would have depreciated their currency as well. Indeed, whether to leave the peg or not is lastly a policy decision. This highlights the expectation game5 among the public and the private sector which as soon as discovered the effects of the new policy environment, a significant number of currencies, suddenly, seem to have a significant exposure to non-cooperative devaluations. Considering these observations, is important to note that the lira devaluation on September 14, 1992 was a crucial feature of the shock to the ERM fundamentals. Indeed, it transmitted signals about an eventual change in the equilibrium of the ERM monetary policy game from cooperative to non-cooperative behavior. Consequently, as soon as the private market reviewed its interpretation of the future level of EC-wide interest rates, it became clear that D-mark rate could only shrink as a reaction to big devaluations by other nations. The speculative attacks were the obvious consequence of such discoveries. Consequently, the ERM crisis would have been unpredictable since the macroeconomic indicators would not show any early signal that a moment of exchange rate volatility is coming. This is the most famous idea because to understand this enormous forecast mistake is not needed irrationality or financial market inefficiencies.
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Game Theory: is "the study of mathematical models of conflict and cooperation between intelligent rational decision-makers."
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5 Policy options and adopted solutions The 1992-93 ERM crisis has been the collapse of an Exchange rate system, instead of the crisis of plenty of unilateral pegs individually pursued by single countries. Consequently, is not convenient to focus on the representative country (Germany) dealing with an external shock that threat the stability of its current exchange rate. Indeed, the interpretations reached so far, do not take in consideration the structural policy spill overs6 between European countries and they are too focus on the effect of coordination of monetary and exchange rate policies among the periphery of the system. Instead, a systemic view might give us a better understanding of the ERM crisis. In the ERM system, a group of countries is supposed to peg their currencies against the currency of the price-stabilizing center country. In fact, considering the German unification scenario, the asymmetric disturbance in the system generate an appreciation of the D-mark which lead to a demand shock in the center.
Imagine: 5
Font: http://www.europarl.europa.eu
At this point the whole periphery would take advantage from a monetary expansion by the center, while the latter would benefit from a realignment by the periphery countries.
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Spill-over effect: In economics, spillover effects are economic events in one context that occur because of something else in a seemingly unrelated context
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As regard with the monetary expansion, it would absorb part of the demand and lead to lower interest rate but the level of inflation in the center country would be unacceptable since its goal consist of no inflationary bias. Consequently, whether there are no possible relations between the center and the periphery, the only option left consists of a realignment of the periphery countries which would absorb the demand shock and it might give credibility to their policy maker; which would benefit from a coordinate monetary policy between themselves by internalizing their spill-overs. Obviously, in reaction to a demand shock from the center, the periphery will not react in a coordinate way unless the price of defending its own exchange rate will compensate the collective political price of deny on the effort to peg. However, this require an enforcement mechanism not available to the periphery, indeed, single nations will always be tent to deny the coordination and play to pursue their own goal. In fact, coordination need a collective devaluation while governments might want to save their currency since just one currency depreciation would be enough to absorb the demand shock. In such scenario, a huge depreciation by a single country give clear evidence of no cooperation in the market, moreover there might be disagreement on how to share the costs and benefits from periphery-wide policy. The issue might be solved by inserting special weight to a principle of national equity7 which means that no country would have to support higher costs or take unfair benefits, even if it would be better for the whole system. Consequently, the only two options left would have been: • •
Periphery countries coordinate their exchange rate policies No cooperation and every country maximizes its own goal
By following the first point there would have been a set of small devaluations by many countries. Instead the periphery countries did not coordinate themselves and we have seen few large devaluations by a small number of countries. For instance, the devaluation of the lira against the D-mark, by 7% composed of 3.5% D-mark nominal revaluation and 3.5% Lira devaluation. (Bath European meeting, 1992) This did not lead to the optimal solution since loosened the ERM-wide monetary policy which decreased the interest rate and lead to an aggregate demand boost. Under these condition a coordinate policy reaction will need a realignment of the periphery with the centre, which will depend on the externalities, that being positive will push the periphery country in doing more. But from the point of view of a single country doing more does not means devaluation of its currency against the centre which might be reached through a coordinate response.
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Principle of national horizontal equity: The principle states that national authorities accept to cooperate only to the extent that no country would excessively benefit or lose from the common policy more — in relative terms— than the others.
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The reason of this policy makers’ commitment to exchange rate stability might also be explained trough the positive political effects coming from the participation in the ERM system. Indeed, price stability was the main goal since the credibility of governments’ anti-inflationary policies were based upon the skill to keep a stable exchange rate with the D-mark.
6 Lessons learned As said before the ERM crisis came from the incapacity to find a coordinate response to the demand external shock in Germany. (Buiter et al., 1998). In such scenario, would have been important: •
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Firstly, have a set of rules to follow to make sure that the cooperative mechanism works well. In fact, nowadays the debate regarding rules versus discretion has seen the rules based approach to win. Secondly, an efficient policy coordination to not lose credibility. Indeed, the shift of perception caused speculative attacks that would not occurred if the system would had shown more credibility. Thirdly, central bank independence and clear monetary objective function should be established. Consequently, the inflationary expectations can be kept down. This is fundamental for countries with an external anchor since central bank independence give the opportunity to increase credibility to the peg. In this prospective any change will occur just in response to exaggerate disturbance. Thus, to avoid speculative attacks solid monetary policy are needed. (Tietmeyer, 1998) Another important lesson focus on the importance of realignment. Consequently, a certain grade of flexibility would be needed in ERM system. Particularly relevant is the skill to not consider small price adjustment that are just realignments. Indeed, the ERM suffered a lot of issue when a significant number of small changes happened because they occur through changes in wage and price. Hence, if these are not flexible a general loss will result. Consequently, a revaluation will create money illusion that will lead to more painful changes in prices since they are less predictable. In fact, if labor markets do not react properly an Exchange rates system may only survive if nominal exchange adjustment and revaluations. (Jochimsen, 1993) Another important element to achieve a flexible exchange rates system consist of the introduction of Fluctuation margins and the related “honeymoon effect”. (Appendix 1) (Krugman, 1991) One more lesson should consist of including at the beginning a narrow subgroup of all EU participants. A set of Center-Periphery problems should be faced. Even through the issues included with a multi speed monetary union should pass soon. Finally, to sort the issue of the “unfair” competitive advantage taken by weak-currency nations against strong-currency one. The best would have been that these “competitive devaluations” implied some duties within the EU.
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During the 90s we have seen a change of sustainability, from exogenous to endogenous nominal limitations. This increased the academic discussion on its origins, which has been focusing on the inflation targeting, central bank independence and optimal contract, with losing interest on other kind of exchange rate mechanism as stabilization tools. However, a significant number of academics, still consider the ERM crisis as evidence of an unsustainable fixed exchange rate system. While, the mean cause of the ERM crisis has been a change in the monetary policy cooperation and the discovers of this change by market participants. Indeed, most currency crisis is generated from a lack of policy coordination. Thus, since the 1992-93 events clearly show the weakness of the European monetary system, what is supposed to replace the actual mechanism? Nowadays, the center should have the goal of monetary stability. Moreover, the classic discussion among monetarist and economist let us understand that the integration process is a target on its own instead of a tool to the monetary union. Indeed, the convergence-centered mechanism includes a view of monetary union as group of nations that are copies between themselves instead of unifications of divergent economies. Along these lines the monetary union could be achieved by adding integrate periphery countries to the existent center little by little. Moreover, some requirement (solvency, low inflation and financial stability) would be needed to join to the monetary union. But, they might make shift the focus from cooperation to domestic issues. One important lesson from the 1992-93 crisis consist of the lack of a system to absorb the policy spillovers. Indeed, nominal or real macroeconomic integration among Center and Periphery do not protect the mechanism from the collapse. Although, participants meet the Maastricht criteria perfectly, it might still be subject of speculative attacks. Moreover, the last events witness that, without coordination, nations that try to reach convergence might find themselves dealing with financial shocks beyond the control of a national government. Historically, political coordination has been font of progress in European economic. Political coordination is what has usually been taken with the reluctance of markets of the “experts�. The small and individual realignment of the lira in 1992 showed to either markets and experts that European governments did not want coherence and coordination response to monetary tensions. A new skill to do so will be the most important feature that the Maastricht system has not been forgot or ignored.
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7 Conclusions Studying the reasons of the crisis, it is possible to note that there were some characteristics that summed to the credibility of the Exchange rate system, and by developing a new system based on the lessons learned from ERM, it might be efficient nowadays. Obviously, a significant number of requirement should be met, moreover if the nations included have achieved the step of in which would be better to take off capital controls8. A significant quantity of willpower would be needed from all countries involved in creating a new exchange rate system, and most important the skill to include internal economics goals into the general goal of exchange rate stability. A key feature for any monetary agreement consist of to achieve the majority on policy preferences. Nowadays, is difficult imagine that nations could have the trust and the notions to adopt an exchange rate system and it would end up in a crisis. Consequently, nations should have a step by step system to achieve the monetary community. This would give the opportunity to better understand their collaborators and their policy preferences. For instance, the first step might consist of a regional integration and it would involve a sort of regional control system. After this, the integration might be extended to the whole countries and exchange rate bands might be imposed. Still one more option might consider the usage of parallel basket country such as those in the ECU, which may invoice currency for denomination of bonds or for trade.
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Capital control: represents any measure taken by a government, central bank or other regulatory body to limit the flow of foreign capital in and out of the domestic economy.
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Appendix: 1) If exchange rates are at least partly determined by the formation of expectations, he shows that the very existence of a target zone can have a stabilizing effect on the exchange rate. When the exchange rate approaches the upper or lower band, market participants will expect the central bank to intervene, so that the exchange rate will move away from the band. These expectations will then suffice to drive the exchange rate away from the band, without need for intervention by the central bank. This honeymoon effect, however, depends on the credibility of the target zone. If it lacks credibility, the market participants will at best take a wait-and-see approach, or otherwise launch an attack, in expectation of an overshooting of the exchange rate, in case that the peg is abandoned. The system could thus cause the crisis it was created to prevent. In this context, the width of the band is of great importance. Narrow bands allow for risk-free one-way bets, creating incentives for speculative attacks. Wider bands, in contrast, make currency speculations more risk-prone, since they allow for a reversal of exchange rate movements. While wider bands also reduce the stabilizing effects of target zones, they sharpen the awareness of the stability policy response to be borne by the countries themselves, by making convergence deficits in the member countries manifest more easily. To reduce the susceptibility of a target zone system, it is hence better to choose wide exchange rate bands than bands that are too narrow. 2) Theoretically, monetary authorities can infinitely defend the peg by reducing domestic high powered money supply and by contracting domestic credit. Even though an unconditional defense of a fixed exchange rate is always technically feasible, what is relevant for the stability of the exchange rate is not the technical feasibility, but rather the perceived costs of defending the parity. A sustained rise in short-term interest rates can have fatal consequences for the domestic banking sector and can sharply dampen aggregate demand and investment activity. As Buiter et al. (1998, p. 85) point out, ‘‘it is because the authorities care about the side-effects of drastic monetary tightening that speculators can prevail.’’ The only other means to defend the peg, besides capital controls, is the use of foreign reserves for intervention in the foreign exchange markets. Building up large amounts of foreign reserves can certainly help to increase the credibility of a peg. Having a ‘‘war chest’’ emphasizes a country’s ability to forcefully fend off speculative attacks. Holding reserves, however, is costly. Furthermore, even a country with a vast amount of reserves can reach its limits in the case of large speculative movements. Fortunately, in the case of a common exchange rate system, common support mechanisms are an additional way of ensuring markets that the peg can and will be defended. For this reason, and also as 15
a lesson from the experiences with the snake, the French secured a provision in the EMS Act of Foundation, authorizing weak governments to draw unlimited support from their strong-currency partners.18 In the conviction of Giscard, the French president, a European exchange rate system would only function if the burden was shared equally between the strong and weak currencies (Bernholz, 1999).19 The EMS was hence established with the VSTF, providing support that was ‘‘unlimited in amount’’. There is, however, a problem with central banks’ mutual assistance. Supporting the weak currency has monetary policy effects on the country with a strong currency. Irrespective of whether the central bank intervenes itself or makes its own currency available to other central banks for intervention purposes, bank liquidity is expanded and controlling monetary expansion is therefore made more difficult. It was exactly this reasoning that led the Bundesbank—with reference to the Emminger letter20—to curtail interventions during the EMS crisis. After heavy intervention in support of the attacked EMS currencies, it sensed that its internal monetary stability was under threat. By early September 1992, M3, the Bundesbank’s target money aggregate, was rising at an annual rate of almost 10%, far above its target of 3.5–5.5% (Eichengreen & Wyplosz, 1993, p. 110). It is therefore important to understand that while support mechanisms can be an important tool to increase the credibility of a regional exchange rate system, they cannot substitute for economic policies that are consistent with the external exchange rate objective. 3) A final point to be raised is the matter of capital controls. Capital controls, for obvious reasons, make things much easier for policymakers who have to guard a pegged exchange rate regime. There has been growing support for the view that EMS-like systems cannot survive in the absence of capital controls. Capital controls, it is argued, played an important role in the functioning of the EMS: ‘‘In the 10 years between its creation in 1979 and 1990, when capital accounts were freed, there were 12 realignments, most of them involving several currencies. With few exceptions, these realignments came in the wake of speculative attacks, yet the system survived. The first attack that occurred after capital liberalization was lethal’’ (Wyplosz, 2004, p. 262) It is out of question that the handling of the 1992/1993 crisis would have been facilitated and that authorities would have had more leeway to come up with solutions if there had still been capital controls. But one can also argue that once the avalanche had been set off, capital controls would not have changed much. As mentioned before, Ireland, Portugal, and Spain reintroduced capital controls during the crisis, but this did not prevent the punt, the escudo, and the peseta from remaining under speculative pressure and from facing devaluation in February (punt) and May (peseta and escudo). Also, as argued earlier, a better and more cooperative crisis management could have avoided the crisis, or at least limited its damages. And finally, speculative attacks do not occur entirely out of the blue. If the system is credible, it is also sustainable. 4) Krugman model is the easiest one, it is based on the inconsistencies between domestic macroeconomic policies, and a persistent government budget deficit. (balance-off payment problems). Consequently, Stable exchange rates must be related on economic conditions and governments must have policies coordinate with the requirement of a peg 16
to have a sustainable exchange rates system. Indeed, the presence of high inflation and rising labor costs reduced their competitiveness and generated balance off-payment issues. At this point, the government has two options: consume assets or borrow to finance the imbalance. However, the government cannot borrow or consume reserves for ever. Hence the only choice consisted of creating money. Since extra money leads to inflation, it is impossible to keep the fixed exchange rate. 5) Turning to the second-generation model, is based on the role of speculation and selffulfilling prophecies. Indeed, currency crisis can happen also without balance-of-payment issues. Because although the fundamentals are correct, market participants may speculate and threat monetary authorities up to the point that they could not avoid to use sternness policies that would suppress the internal banking sector. In fact, policymakers valuate benefits and drawbacks of defending a currency and they will give up the exchange rate if the pro to do so does not exceed the con. Consequently, speculative attack on the currency might happen and policies activated as a defense could reduce the economic activity flux and increase bank funding costs. Indeed, the private sector is aware that governments are dealing with other macroeconomic objectives such as the health of the banking system and the economy in general and consequently speculative attacks might pull monetary authorities down and let the currency float. From this point of view, the crisis has been the outcome of a shift in a market perception from credibility to vulnerability. (Eichengreen, 2001) Moreover, the wiliness to benefit from joining the European monetary union (EMU) make the policy maker accept slower growth and high level of unemployment as the cost for protecting the exchange rate. When surveys for the French referendum showed a collapse of the Maastricht treaty the EMU was not sure anymore and slowing economic growth and unemployment boost up the prices of protecting the peg. This environment made space for speculators 6) Finally, the third and last generation include few different models. One is based on an initial depreciation of the currency which will constrain the borrowing capacity of a country. Consequently, the demand for domestic currency will shrink and this will lead to a currency crisis. (Aghion et al. 2001) Another one consist of financial liberalization which mixed with deposit insurance might drive the banks to increase the landing by using foreign and domestic credit that may cause a currency crisis. (Mckinnon and Pill, 1995) The last theory is characterized by the self-fulfilling international liquidity crises in an open economy in which banks do not match long term illiquid investments with the need of cash in case of a bank run. (Chang and Vekasco, 2002)
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