EUROPEAN MONETARY SYSTEM

OVERVIEW OF THE PRESENTATIONThe background to the European monetary system

Features of the European monetary system

The exchange-rate mechanism and the European currency unit

An assessment of the European monetary system

Conclusion

BACKGROUND……!!! The Snake(1972)

Outcomes of Werner report on economic and monetary union 1972.

It is sometimes referred as mini Bretton Woods.

EMS owes much of its origin to the snake.

It was made up of six original EEC members(Belgium, France, Italy, Luxembourg, Netherlands, and West Germany ). Later UK and Denmark joined the system and Norway became an associate member.

CONTD…..Through this agreement the member currencies could vary by a maximum of +/-1.125%.

Against other currencies they could float by +/- 2.25(as permitted by the Smithsonian agreement).

The smaller margin of the fluctuation gave rise to the term ‘Snake in a tunnel’ which subsequently became the snake.

Snake system failed to produce the necessary results ( coordination of economic policies and convergence of economic performance).

THE EUROPEAN MONETARY SYSTEM

On 17th June 1978(Bremen conference) six of the European community countries committed themselves to set up European monetary system to replace the snake.

It aimed to provide “Zone of currency stability” bringing back into the fold the countries which had left the snake.

Objective of this initiative was to make the countries less dependent on unpredictable dollar and to provide a stable framework for the conduct of European trade.

THE EUROPEAN MONETARY SYSTEM

It commenced operation on 13th March 1979.

European Monetary System (EMS) was an arrangement where most nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations relative to one another.

 

After the collapse of the Bretton Woods system in 1971, most of the EEC countries agreed in 1972 to maintain stable exchange rates.

FEATURES OF THE EUROPEAN MONETARY SYSTEM

There are four main features of this system some of which were built upon the arrangements of the snake, they are:

An Exchange Rate Mechanism (ERM)

The ECU(European currency unit)

An extension of European credit facilities

The European Monetary Cooperation Fund

EXCHANGE RATE MECHANISMIt consists of two parts:

1. A grid of bilateral exchange rate bands between each of the member currencies which defines obligatory intervention.

2. An individual band of fluctuation for each currency against the ECU which if breached by a certain threshold will lead to the expectation that the authorities of that currency will take policy measures designed to bring it back within its ECU threshold.

BILATERAL EXCHANGE RATE PARITIES

This aspect of ERM consists of a grid of central exchange rate between each pair of currencies in the ERM.

Each currency can fluctuate a maximum of +/- 2.25% of its bilateral central rate against another member currency of the ERM.

Italy was allowed to join with a larger band of fluctuation of +/-6%(in January 1990 it narrowed its band of fluctuation to +/- 2.25%).

BILATERAL EXCHANGE RATE PARITIES

Obligatory Intervention

Authorities of each currency are obliged to intervene or take economic policy measures to keep the currencies within limit.

Any changes in the grid of central rates require mutual agreement between the countries.

THE EUROPEAN CURRENCY UNIT

ECU is a key component of ERM .It is a weighted basket of various EEC currencies.It acts as an ‘indicator’ of divergence.Once a currency crosses its divergence threshold against the ECU the alarm bell is triggered and the authorities of that currency are expected to take measures to bring its currency back into line.Unlike reaching a bilateral exchange rate limit triggering the ECU alarm bell does not lead to obligatory intervention.

THE EUROPEAN MONETARY COOPERATION

Each member of EMS deposits 20% of its gold and dollar reserves with the European monetary cooperation fund(EMCF) in exchange for the equivalent value in ECUs.

Each member have access to credit facilities enabling deficit countries to defend their exchange rate parities and manage transitory BOP problems.

THE EUROPEAN MONETARY COOPERATION

The credit facilities available are Very short term financing(VSTF) Short term monetary support(STMS) Medium term financial assistance

(MTFA)

The European investment bank(EIB) was given the authority to make loans available to the members of EMS at favourable interest rates.

THE EUROPEAN MONETARY FUNDUnder the agreement setting of the EMS it was planned to replace the EMCF which had been set up under the snake with a new European monetary fund in 1981.

It is empowered to receive monetary reserves from the central banks of the EEC member state and issue ECUs against these deposits.

It runs the ECU credit system and oversee the ERM.

Setting up of the EMF was delayed due to the controversies surrounding its powers and roles.

AN ASSESSMENT OF THE EMS

The European Monetary System was no longer a functional arrangement after May 1998 as the member countries fixed their mutual exchange rates when participating in the euro.

Unlike its predecessor ‘the snake’ ,no countries left EMS and was relatively successful.

The economic growth was generally lower for the ERM countries compared with the non-ERM countries.

ECONOMIC PERFORMANCE OF ERM AND NON-ERM COUNTRIES

ERM Countries

1979 1990

Belgium 2.2 3.5

Italy 6.0 2.0

West Germany 3.5 4.5

Non-ERM Countries

1979 1990

Austria 4.7 4.6

Japan 5.3 5.6

United Kingdom 2.8 0.6

SOURCE : WORLD ECONOMIC OUTLOOK

ERM 2

ERM 2 was launched on 1 January 1999.

In ERM 2 the ECU basket is being discarded and the new single currency euro has become an anchor for the other currencies participating in the ERM 2.

The EMS-2 is sometimes described as "waiting room" for joining the Economic and Monetary Union of the European Union.

CONCLUSION

The EMS confirmed the importance of the collective discipline framework which it helped to establish.

By obliging the countries, which were party to it, to comply with an explicit exchange rate discipline, it made a decisive contribution in the fight against inflation.

The lesson gained by the EMS was that monetary organisation was useful, but needed better mechanisms.

Thank you for your time…………….!!!!!