The European Currency Crisis 1992-1993

1. The European Currency Crisis1992-1993 Cynthia Diaz Hazel Gonzalez Daniel Monge

2. Introduction of European Union • 1970’s, Collapse of the Bretton Woods System • The European Economic Community (EEC) (Germany, Italy, France Netherlands, Belgium and Luxembourg) • European Union • Added Portugal, Denmark, Spain, U.K., Finland Greece, Austria, Sweden, and Ireland,. • 30 yr Transition : European Monetary System (EMS).

3. European Monetary System • Exchange rate variability / Monetary stability • EMS: 1. European Currency Unit (ECU) 2. Exchange Rate Mechanism (ERM) • Floating the exchange rate.

4. What is the purpose for EMS? • Europe in the global economy. • Create Europe Bond • Common Agricultural Policy (CAP). • To control fluctuations of the currency and improve coordination of monetary policy decisions among countries apart of the union.

5. Effect of the EMS • EstablishedCentral exchange rates for each currency • Brought responsibility of countries in the EU to stay with band rates. • Stable currency of the group ‘German Mark’ • Unofficial reserve currency: The Deutsche Mark (DM) • German Central Bank (Bundesbank)

6. Factors Behind the Crisis • Deutsche Mark became the anchor in the European Monetary System (EMS) • Due to Germany's strong economy after the split of East and West Germany • Deutsche Bundesbank had low inflation • Germany Gained Economic Strength • Became free to set monetary policy for itself • Other countries had reduced control due to reserves needed to adjust to the edge band of the mark.

7. The Crisis • Reunification of Germany (East & West) • Merged large rich economy of the West with poor smaller economy of East • West Germany transferred savings to the East • Caused the government budget deficit to rise from 5% to 13.2% • Government increased money supply and initiated many development projects to gain economic growth • German interest rates rose about 3% in 1991 and 1992 to try to ease inflation

8. Germany’s Effects • Germany’s high interest rates made European countries worse • Britain, France, Italy and other countries were restrained from taking corrective monetary policy actions. • Britain, France, & Italy economies suffered such high deficits that they were forced to adopt a low interest rate policy • currency devaluation would help the devaluing country by boosting exports, and allowing the country to regain the flexibility it needed to stimulate its economy through interest rate cuts

9. Speculation • Analysts speculated that these countries might soon give up their support for the ERM • Due to speculations and a weakening currency • September 16, 1992 : Black Wednesday • UK’s prime minister and cabinet members tried all day to boost up the sinking pound and avoid withdrawal from the ERM

11. Black Wednesday Outcome • The British government raised the interest rate from 10% to 12% to try to get speculators to buy pounds • Market knew that the government could not afford to keep interest rates high for long • Investors kept selling the pounds and eventually Britain was forced to withdraw from ERM • Britain Treasury spent approximately ₤27 billion of reserves in trying to defend the pound by selling Deutsche Mark and buying pounds. • http://www.youtube.com/watch?v=AHDsO7gvXHQ&playnext=1&list=PLCDCB8FC42E6B0E3E

12. Speculative Attacks Continue • Speculative assaults • helped traders make billions at the expense of European central banks • caused Spain and Portugal devalue their currencies against the German Mark. • French Franc was a major target because they had • high interest rate, slow growth, & rising unemployment • political pressure before elections demanded a cut in the French interest rates • speculators betted that France would devalue the franc or withdraw from the ERM

13. The Fall of the French Franc (₣) • Speculative attack against the Franc • made the central banks of France and Germany intervened aggressively • central banks tried to hold their exchange rate • central banks kept buying Francs and selling Marks. • The countries succeeded momentarily but France’s foreign currency reserves were nearly depleted

14. The Fall of the French Franc (₣)Continued • Speculative attacks continued to hit the Franc • speculators knew France needed lower interest rates to help stimulate the economy and reduce unemployment. • France’s and Germany’s central bank continued to intervene directly to support the Franc • Interest rates were raised to defend the Franc • Germany and France gave up defending the exchange rate link.

15. After the Fall • Speculators won • They secured huge profits by buying back the devalued Franc • The EU finance ministers and central bankers • allowed the widening of the currency trading bands to fluctuate within 15% around a central rate • A total of about 60 billion Mark ($35 billion) was spent by the German trying to prop up the French currency

16. Maastricht Treaty • Signed on February 7, 1992 in Maastricht, Netherlands • Set 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 must not be more than 2% points higher than the lowest inflation member states • Being in the narrow band of the ERM ‘without tension’ and without initiating a depreciation, for at least two years • Government deficit to GDP must not be more than 3% and a government debt/GDP ratio of no more than 60% • The treaty entered into force on November 1, 1993.

17. European Monetary Institute • Established as the forerunner of the European Central Bank • intended to strengthen monetary cooperation between the member states and their national banks • supervise ECU banknotes. • European Council • adopts the Stability and Growth pact to ensure budgetary discipline • establishes a new Exchange Rate Mechanism (ERM II) to provide stability with the Euro and other national currencies. • European Central Bank (ECB) is created • Conversion rates between the 11 participating national currencies and the euro are established