- •Introduction
- •Implications for Business
- •The Tragedy of the Congo (Zaire)
- •Introduction
- •The Gold Standard
- •Nature of the Gold Standard
- •The Strength of the Gold Standard
- •The Period between the Wars, 1918-1939
- •The Bretton Woods System
- •Flexibility
- •The Role of the World Bank
- •The Collapse of the Fixed Exchange Rate System
- •Exchange Rates since 1973
- •Figure 10.1
- •Speculation
- •Uncertainty
- •Who Is Right?
- •Exchange Rate Regimes in Practice
- •Pegged Exchange Rates and Currency Boards
- •Figure 10.2
- •Target Zones: The European Monetary System
- •Performance of the System
- •Recent Activities and the Future of the imf
- •Financial Crises in the Post-Bretton Woods Era
- •Third World Debt Crisis
- •Figure 10.3
- •Mexican Currency Crisis of 1995
- •The Asian Crisis
- •The Investment Boom
- •Excess Capacity
- •The Debt Bomb
- •Expanding Imports
- •The Crisis
- •Evaluating the imf's Policy Prescriptions
- •Implications for Business
- •Currency Management
- •Business Strategy
- •Corporate - Government Relations
- •Chapter Summary
- •Critical Discussion Questions
- •Case Discussion Questions
Target Zones: The European Monetary System
An exchange rate system based on target zones involves a group of countries trying to keep their currencies within a predetermined range, or zone, of other currencies in the group. The exchange rate mechanism (ERM) that was a central part of the European Monetary System (EMS) of the European Union between 1979 and 1999 is the most famous example of this kind of system.
In our discussion of the European Union (EU) in Chapter 8, we noted that the EU is committed to monetary union, including establishment of a single currency. The process began January 1, 1999, and it should be completed by January 1, 2002.10 A formal commitment to a common currency dates back only to the Maastricht Treaty in December 1991, but it has been an underlying theme in the EU and a subject of debate for some time. To establish a common currency, the EU needed to achieve convergence between the inflation rates and interest rates of its member states. The European Monetary System (EMS) was a mechanism for attaining this goal.11
When the EMS was created in March 1979, it was entrusted with three main objectives: (1) to create a zone of monetary stability in Europe by reducing exchange rate volatility and converging national interest rates; (2) to control inflation through the imposition of monetary discipline; (3) to coordinate exchange rate policies versus non-EU currencies such as the US dollar and the yen. In 1991, the objective of paving the way for introduction of a common currency in 1999 was added to this list. Two instruments were used to achieve these objectives, the European currency unit (ecu) and the exchange rate mechanism.
The Ecu and the ERM
The ecu was a basket of the EU currencies that served as the unit of account for the EMS. One ecu comprised a defined percentage of national currencies. The share of each country's currency in the ecu depended on the country's relative economic weight within the EC. Thus, for example, 30.1 percent of the ecu's value was established by the value of the German deutsche mark in 1989 because that was the estimate of Germany's relative strength and size within the EU economy at the time.
Until 1992, the exchange rate mechanism worked as follows: Each national currency in the EU was given a central rate vis-à-vis the ecu. For example, in September 1989, one ecu was equal to DM2.05853, to FFr6.90404, or to £0.739615. This central rate could be changed only by a commonly agreed realignment. From these central rates flowed a series of bilateral rates--the French franc against the Italian lira, the German deutsche mark against the British pound, and so on. For example, the given figures vis-à-vis the ecu indicate that the bilateral rate for exchanging deutsche marks into francs was DM1 = FFr3.3539 (i.e., FFr6.90404/DM2.05853). The bilateral rates formed a cat's cradle known as the ERM parity grid, which was the system's operational component. Before 1992, the rule was that a currency must not depart by more than 2.25 percent from its bilateral central rate with another ERM participating currency.
Intervention in the foreign exchange markets was compulsory whenever one currency hit its outer margin of fluctuation relative to another. The central banks of the countries issuing both currencies were supposed to intervene to keep their currencies within the 2.25 percent band. The central bank of the country with the stronger currency was supposed to buy the weaker currency, and vice versa. It tended to be left to the country with the weaker currency to take action.
To defend its currency against speculative pressure, each member could borrow almost unlimited amounts of foreign currency from other members for up to three months. A second line of defense included loans that could be extended for up to nine months, but the total amount available was limited to a pool of credit--originally about 14 billion ecus--and the size of the member's quota in the pool. Additional funds were available for maturities from two to five years from a second pool of about 11 billion ecus (originally). However, as a condition of using these funds, the borrowing member had to commit itself to correcting the economic policies causing its currency to deviate.