6 min read · Mar 19, 2020
The European Exchange Rate Mechanism (ERM) was a financial system originally introduced by the European Economic Community (EEC) in March 1979.
An integral part of the European Monetary System (EMS) founded around the same time, the mechanism’s primary mission was to promote financial stability across Europe, as well as align the currencies of the participating countries in preparation for the introduction of a single European currency further down the line.
This founding mission was ostensibly achieved — and the system thus rendered obsolete — by the time the Euro was rolled out around the turn of the millennium; nevertheless, the ERM had a profound effect on the global currency market of its era and its offshoots continue to play a role in the organisation of European financial politics to this day.
For this reason, it’s a subject that traders (particularly those who favour European instruments) would benefit from familiarising themselves with — so let’s start with the very basics:
What Does an Exchange Rate Mechanism Do?
Exchange rate mechanisms are used by central banks to influence the price of their respective national currencies within the financial markets in a manner that supports their economic goals.
Banks are only able to employ these types of mechanisms if their monetary system allows them to exert control over the currency in question. In practice, this is either achieved via establishing a fixed exchange rate or making sure their floating rate is nevertheless closely tied to a specific ‘peg’ instrument — usually another major currency or the price of a tangible asset such as gold.
These exchange rate mechanisms — sometimes known as ‘semi-pegged’ currency systems — grant the bank the ability to manipulate the pegged rate within a certain value range when needed, for example to ease trade conditions or influence the rate of inflation.
Banks commonly choose to set an upper and lower bound interval on their exchange rates in order to let the currency vary a little in response to supply/demand forces and other market events — as is natural and often desirable — without halting liquidity or rendering it vulnerable to excessive risk.
Further reading: https://www.thebalance.com/what-is-an-exchange-rate-mechanism-erm-1979093
A Brief Look at the European Currency Unit (or, the ‘Proto-Euro’)
When the ERM was brought in during the early months of 1979, it sought to normalise the exchange rates between European countries to minimise any problems that may arise from price discovery upon their absorption into the future Eurozone.
This was achieved through the establishment of the European Currency Unit (ECU), a standardised ‘unit of account’ that was measured as a weighted average of each participating currency — in a sense acting as a Frankenstein-esque, prototype version of the Euro. This weighted figure enabled each individual country to manipulate their exchange rate with other countries worldwide, while concurrently allowing for a central exchange rate to be put in place for each currency within Europe.
The mechanism worked by first calculating the equivalent value of its participating nations’ currencies in terms of ECUs. These bilateral rates were then expressed in a ‘parity grid’ and day-to-day fluctuations were closely monitored so they could only move within a 2.25% margin either side of the stipulated rate to prevent unwanted market volatility.
Exceptions to these restrictions included the British pound, Spanish pesata, Italian lira and Portuguese escudo, all of which were capable of fluctuating by a comparatively large margin of 6%. Further fluctuations either side of these constraints were prevented by loan arrangements or other determined intervention by the relevant financial institutions.
Contemporary Criticism of the ECU
The British Chancellor at the time of the ERM’s development, Labour’s Denis Healey, refused to let the UK join the ECU system; among other reasons, he posited that it gave Germany an unfair advantage by shielding the Deutschemark from appreciation at the expense of smaller economies.
This proved to be a controversial decision within many branches of government, especially given that Healey’s successor, the Conservative Geoffrey Howe — appointed only months later — was enthusiastically in favour of the European project; Britain would eventually join the system a decade later in 1990 at the behest of the equally pro-integration Chancellor John Major.
However, the UK’s involvement wasn’t to last, as it dramatically withdrew from the ERM treaty after less than two years in 1992 following a catastrophic crash in the price of the pound sterling — an infamous event now commonly referred to by economists as ‘Black Wednesday’.
Black Wednesday and Britain’s Withdrawal
Whilst the ERM had been seen to be successfully promoting economic stability throughout planned during much of the 1980s, by the turn of the 1990s the collective regulation and comparative weighting systems had begun to put serious strain on many of its member states.
The high German interest rates brought about by the country’s recent unification, as well as double deficits experienced by Britain and Italy — not to mention knock-on effects from the depreciation of the global reserve currency, the US dollar — ultimately ended up placing unfavourable economic conditions upon the UK in particular.
Tensions came to a peak when the UK, despite its best efforts — including an interest rate increase up to 15% and a massive buy-back initiative of the GBP across the global markets — failed to keep the pound sterling above the lower currency exchange limit required for inclusion in the ERM, prompting its abrupt departure from the mechanism on the evening of 16th September 1992.
Infamously, Hungarian currency investor George Soros had noticed the myriad factors working against Britain and began building up a considerable short sale portfolio of pound sterling in the months leading up to the crash, which he began rapidly selling off the day before Britain left the ERM.
He earned more than $1bn from this move — the most profitable forex trade ever, equivalent to £12 for each man, woman and child in Britain at that time — and was given the nickname ‘the man who broke the Bank of England’ by the media, a colloquial title he retains to this day!
Further reading: https://www.ig.com/uk/news-and-trade-ideas/forex-news/black-wednesday-explained-181217
ERM II and the Eurozone
The ERM in its original form was dissolved on 31st December 1998 in preparation for the Euro’s introduction on 1st January 1999. The exchange rates of its member nations were all frozen and the Euro was brought in at a value identical to where the weighted ECU left off as the new year rolled in — beginning at one Euro to 1.1743 US dollars.
Having fulfilled its function, the original ERM was dissolved; however, a successor known simply as the ERM II was soon brought in to foster alignment between the Euro and other EU member states that hadn’t adopted the single currency, a role it continues to play today.
The ERM II also now works as a sort of ‘holding area’ for future non-EU countries for a period of at least two years prior to their integration into the Eurozone, where they are subject to a number of financial regulations designed to ease their transition and facilitate convergence.
Countries typically agree upon a central exchange rate between their own currency and the Euro, pledging to keep their own rate within 15% of this figure (via intervention from both the European Central Bank (ECB) and the nation’s own central bank where required). Former members of the ERM II include Greece and Lithuania, while the only currently participating currency is the Danish kroner, which the mechanism allows to fluctuate within a band of ±2.25%.
Further reading: https://ec.europa.eu/info/business-economy-euro/euro-area/introducing-euro/adoption-fixed-euro-conversion-rate/erm-ii-eus-exchange-rate-mechanism_en
