Günter Wittich and Masaki Shiratori
A long-term aim of the members of the European Economic Community (EEC) is to achieve a monetary union. One important feature of such a union would be either to adopt a common currency or to eliminate exchange rate fluctuations between the currencies of member states. The latter course of action had been suggested as early as 1962 by the EEC Commission but little was achieved in determining common exchange rate policies until, with the completion of the customs union, it seemed that a new impetus was needed for the further integration and development of the Community.
At a meeting of heads of state or of government in The Hague in December 1969, it was decided that the Council of Ministers, in cooperation with the Commission, would prepare a plan for the establishment of an economic and monetary union. A subsequent report (the Werner Report) concluded that monetary union, to be achieved in phases during the 1970s, would call for the reduction and eventual elimination of exchange rate fluctuations between currencies of member countries and complete liberalization of capital movements.
In the spring of 1971, the Council of Ministers agreed that member central banks should from June 15, 1971 reduce the margin of exchange rate fluctuation around a “Community level” for the US dollar from the then prevailing 0.75 per cent to 0.60 per cent, the Community level being agreed from time to time among member countries. The maximum potential spread between two Community currencies would thus have been narrowed from 1.5 per cent to 1.2 per cent. However, implementation of this plan was made impossible by exchange market developments during mid-1971.
In May 1971 the deutsche mark and the Netherlands guilder were permitted to float in the exchange markets. A few months later, the United States suspended the convertibility of the US dollar which led to all members of the Community (with the exception of France) permitting their currencies to float in the exchange markets. France continued to observe the previous margin of fluctuation against the U S dollar in commercial transactions but instituted a separate market for capital transactions. Moreover, the Benelux countries agreed to limit the spread between their currencies to the previously possible maximum, i.e., 1.5 per cent on either side of the cross-parity rate.
The Smithsonian Agreement reached in Washington in December 1971, while ending the temporary floating of exchange rates, also permitted currencies to fluctuate within margins of 2.25 per cent on either side of the central or parity rate in terms of the intervention currency, in contrast to the maximum of 1 per cent either side of parity under the Fund’s Articles of Agreement. This step widened the potential range of fluctuation between EEC currencies from 1.5 to 4.5 per cent on either side of the cross-parity so that quotations of EEC currencies could now vary up to 9 per cent (see box) in terms of each other, rather than 3 per cent possible before May 1971. This conflicted with the Community’s aim of progressing toward a monetary union and presented serious operational problems within the Community, especially for the administration of the common agricultural policy.
THE SNAKE IN THE TUNNEL
The black shaded area within the snake represents the maximum spread between Benelux currencies.
Under these circumstances, the Council of Ministers formally approved, on March 22, 1972, a plan to reduce the maximum spread between member currencies to 2.25 per cent by July 1, 1972.
The technical arrangements
Narrowing the spread between any two member states’ currencies to 2.25 per cent could have been achieved by limiting the range of fluctuation of member countries’ currencies against their intervention currency—the US dollar—to one half of the agreed maximum spread, or to 1.125 per cent above and below a Community level expressed in terms of US dollars, as had been planned in 1971. This procedure would have reduced exchange rate flexibility in terms of the dollar, would have been contrary to the intention of permitting increased flexibility of exchange rates among currencies in general, and would also have maintained the special role of the US dollar as the only effective intervention currency. A system was adopted, therefore, which called for intervention in US dollars only when the outer limits of ±2.25 per cent against the US dollar were reached; intervention within the margins to reduce the spread between Community currencies would take place in Community currencies. To implement the arrangement, the participating central banks indicated the rates at which they stood ready to buy or sell each other country’s currency.
In determining these intervention points, care had to be taken to ensure consistency between any pair of quotations, as it was intended that once the maximum agreed spread from the parity or central cross rate was reached, both central banks would be intervening simultaneously. As a premium of 2.25 per cent of currency A in terms of currency B is equivalent to a discount of 2.20 per cent of currency B in terms of currency A, responsibility for maintaining the reduced margins would have fallen exclusively on the central bank issuing the weakest currency if intervention quotations had been calculated uniformly at 2.25 per cent above and below official cross rates.
Suppose at a given time (T1), the US dollar is quoted at its lower limit against the deutsche mark in Frankfurt (a discount of the US dollar of 2.25 per cent from the central rate), while it is at the upper limit against the French franc in Paris (a premium of the US dollar of 2.25 per cent). Assuming that the market is working perfectly, the French franc will be quoted against the deutsche mark in Frankfurt at a discount of 4.40 per cent from the cross parity; the deutsche mark will stand at a premium of 4.60 per cent from cross parity in Paris. Now suppose further that over time the US dollar strengthens in Frankfurt, and weakens in Paris, to the opposite intervention points (time T2). Accordingly, the French franc will strengthen to a premium of 4.60 per cent in Frankfurt, and the deutsche mark weaken to a discount of 4.40 per cent in Paris. The range of fluctuation of a currency thus is 4.5 per cent (from a discount of 2.25 per cent to a premium of 2.25 per cent) in terms of its intervention currency, but 9 per cent in terms of another currency to which it is linked through the intervention currency.
To ensure bilateral intervention once the maximum spread was reached, announced buying rates of foreign currencies were therefore generally fixed at approximately 2.225 per cent below, and selling rates at 2.275 per cent above cross parities. As an exception, the Belgian National Bank and the Netherlands Bank decided to maintain the special arrangement adopted in August 1971 to restrict fluctuation between the Benelux currencies to 1.5 per cent on either side of the cross parity.
Intervention in the exchange markets as a rule was to take place only when quotations reached the outer limits of the band. In this way, conflicting exchange rate policies of individual central banks were to be avoided. Should it be found desirable by a particular central bank to intervene within the margins, it would do so only following prior consultation and agreement with its partner countries. As this rule applied to interventions in US dollars as well, central bank purchases and sales of dollars were in principle restricted to the observance of wider margins around the intervention currency as notified to the Fund.
Settlement of balances acquired by intervention
The agreement also contained provisions for the settlement of balances arising from central bank interventions in order to avoid continuous extension of credit by countries with the strongest currency to their partners. The resolution of the Council of Ministers invited central banks to settle such debts in the course of a one-month period, except when the Committee of Central Bank Governors agreed on different rules. The central bank of country A purchasing a partner bank’s—country B’s—currency in its own exchange markets will generally sell these balances forward to the central bank of country B, the maturity date being the last day of the following month. If, at the same time, the central bank of country B cannot satisfy the demand for currency A from its own holdings, it can obtain currency A from the central bank of country A through a similar swap transaction.
Chart 1.Range of Exchange Rate Fluctuations
Settlements were then to be made on the basis of the structure of the debtor country’s monetary reserves. For this purpose, reserves were classified into two categories: gold and gold-guaranteed assets (SDRs and reserve positions in the Fund) on the one hand, and foreign exchange on the other hand. Apart from claims settled by the use of the creditor’s currency, the debtor country redeems outstanding balances of its own currency by payment in reserve assets in proportion to the holdings of these two categories of assets, partly in order to facilitate a harmonization of the reserve compositions of member countries.
“The Snake in the Tunnel”
One of the important features of the arrangement to reduce intra-Community currency spreads is that it allows use of the full margins permitted against the intervention currency under the Fund’s decision on wider margins. This arrangement reduces the maximum spread at any time between dollar quotations of two Community currencies (popularly called the “snake”) while leaving quotations against the dollar free to move, according to the play of market forces, within the wider Smithsonian band of 4.5 per cent (the “tunnel” in the metaphor) formed by the maximum deviation from parity or central rates of ±2.25 per cent.
Suppose the Danish krone as the strongest Community currency in December 1972 was quoted at DKr 1 = $0.1465 (a premium of 2.23 per cent) in New York. The lowest level for the Italian lira against the US dollar can then be calculated on the basis of the announced selling rate for the Danish krone in Italy or DKr 100 = Lit 8,520 and is Lit 1 = $0.001719½ or a discount of the Italian lira of 0.01 per cent below the central rate. The Community band would therefore be 2.24 per cent, and its position between—0.01 per cent and +2.23 per cent of the dollar parity.
Discrepancies between the quotations in New York and the local markets would tend to be eliminated by “arbitrage”—i.e., transactions designed to profit from such discrepancies, and thus constantly tending to eliminate them. If, for example, the Danish krone and the Italian lira were quoted at a premium of 2.23 per cent and a premium of 0.05 per cent in New York, while the Danish krone is quoted at its upper limit against the Italian lira in Italy (and the lira is at its lower limit against the Danish krone in Denmark), then arbitragers will buy Italian lire in Italy and sell them against US dollars in New York until the difference between the actual and the calculated spread disappears.
It is the quotations in terms of US dollars which have given rise to the descriptive term “the snake in the tunnel.” The “walls” of the tunnel are formed by the maximum deviation from parity in terms of the intervention currency—the US dollar—and the “skin” of the snake is represented by the quotations in terms of US dollars of the strongest and weakest Community currencies, as can be seen in Chart 2.
Chart 2.Quotation of Community Currencies in Terms of the US Dollar
∗ The upper and lower limits of the Smithsonian band (the “tunnel”). A premium (discount) of 2.25 per cent of the spot rate in terms of currency units per US dollar corresponds to a premium of 2.30 per cent (a discount of 2.20 per cent) calculated in terms of U S dollars per currency unit.
In the absence of intramarginal intervention in dollars, the position of the snake in the tunnel and its width are determined by market forces within the agreed limit. The spread between the strongest and the weakest Community currency can become narrower or wider depending on strength of demand for individual currencies, and the position of the snake can be anywhere within the tunnel. When the maximum permissible spread is approached the position of the snake will not change as long as market forces working in opposite directions are of approximately the same strength, i.e., push the strongest currency upward and the weakest currency downward to the same degree. If, however, market forces work more strongly in one direction, the snake will move to that direction, pulling up or down the currency at the other extreme of the European band. During most of the time since the scheme came into effect, the width of the snake remained close to the agreed maximum and its position was generally determined by the demand for the strongest currency which indicated the level of quotations for the weakest Community currency. At particular times, however, the Community band was pulled downward by heavy sales of the weakest one—most markedly during the crisis that led to the floating of sterling in June 1972.
Developments in foreign exchange markets
The maximum spread between the strongest and the weakest EEC currencies narrowed sharply early in March 1972 when the agreement among Finance Ministers to reduce intra-European margins became known. Anticipating official action, market operators quickly bid the weakest Community currency—the Italian lira, which previously had been quoted at about 3.20 per cent below the strongest Community currencies, the Belgian franc and the Netherlands guilder—to within the prospective band in the days following the Finance Ministers’ meeting. The maximum agreed spread between European currencies had thus become established before the scheme was brought formally into operation on April 24, 1972.
Until mid-June the snake remained broadly stable in the upper half of the tunnel. The French and the Belgian francs, quoted near their upper intervention points against the US dollar, formed the upper limit, while the Italian lira and later sterling and the Danish krone represented the lower limit at around their central rates.
In the meantime, anxiety about the prospects for the British balance of payments increased and pressure on sterling brought the pound to the lower limit of the Community band. In the third week of June, the Bank of England and other central banks of the member countries had to purchase some £1,000 million to maintain the agreed spread.
To prevent a further loss of reserves, the British Government decided on June 23 temporarily to suspend the observance of exchange rate margins and permitted sterling to float against other currencies. When pressure on sterling mounted, the Italian lira and the Danish krone also declined sharply. Most of the funds from these countries, particularly the United Kingdom, flowed into the other stronger Community currencies, but some part was also switched into US dollars. As the three currencies depreciated against the US dollar, the other Community currencies also declined in terms of the dollar, pulling the snake lower in the tunnel.
Immediately after sterling was allowed to float, speculative attention shifted to the US dollar and the stronger Community currencies rose sharply, reflecting doubts whether the structure of exchange rates agreed at the Smithsonian would be maintained. A number of central banks intervened on a large scale in the exchange markets to prevent their currencies appreciating beyond the permitted margins. Faced with massive inflows of funds, the monetary authorities of most European countries officially closed the exchange markets on June 23 and most of the markets remained closed until June 28. The Community Finance Ministers held an emergency meeting on June 26-27 after which they confirmed their Governments’ resolve to defend both the Smithsonian exchange rate structure and the Community’s narrowed margins. However, it was agreed temporarily to modify intervention procedures for Italy; market operations in support of the lira could be carried out in US dollars until the end of 1972. Only the Danish authorities felt unable to continue adherence to the narrower band; for the time being, the krone would be allowed to move within the wider Smithsonian limits.
After the reopening of the European foreign exchange markets, speculative selling of US dollars against the strong Community currencies continued for a time despite new exchange control measures taken by a number of countries. The exchange markets became calmer in the latter part of July, particularly after the meeting in London of Community Finance Ministers on July 17-18, when market participants became convinced that other leading European currencies would not be set to float. A further tightening of exchange controls in Europe and the purchase of US dollars with the deutsche mark in New York by the Federal Reserve Bank of New York also contributed to quieten the markets.
Following these developments, speculative activity receded markedly and the U. S. dollar recovered gradually. However, some Community currencies—the Belgian and the French franc at the beginning and later the French franc alone—remained very firm, being quoted slightly below their upper limits, while the Italian lira, the weakest currency, remained slightly above its central rate. As a result, the position of the Community band remained rather stationary in the upper half of the tunnel for the period between the end of June and mid-September. Most other Community currencies fluctuated widely, on balance gradually easing against the dollar, as can be seen from the chart.
The dollar’s recovery was accelerated after the middle of September when short-term funds flowed back into dollar assets reflecting increased confidence among market participants in the Smithsonian exchange rate structure. The French franc, following the trend of other Community currencies, began to decline, which permitted the Italian authorities to let the lira ease and for the first time in nearly three months, the Community band itself began to move lower. After a temporary upward shift in mid-December, reflecting primarily capital inflows into Denmark which brought the Danish krone to form the ceiling, the Community band reached its lowest level within the tunnel in the middle of January 1973, when the Italian authorities resumed market intervention in Community currencies.
Until early in January 1973, official intervention in foreign exchange markets by Community central banks was reportedly on a comparatively small scale, apart from fairly frequent sales of US dollars by the Bank of Italy. However, the Netherlands Bank occasionally sold limited amounts of Belgian francs under the terms of the Benelux Agreement to restrict fluctuations among Benelux currencies to 1.5 per cent on either side of cross parity.
The calmer conditions in the exchange markets and the strengthening of the U S dollar ended abruptly when the leading markets turned nervous and hectic following the introduction of a two-tier exchange system in Italy and the decision of the Swiss authorities temporarily to refrain from intervening in the exchanges. Heavy sales of U S dollars in almost all major centers resulted in a sharp appreciation of Community currencies, and early in February massive central bank absorption of U S dollars again became necessary when quotations reached the outer limits of the Smithsonian band.
Nearly all major foreign exchange markets were closed on February 12-13. The U.S. Government announced that it was requesting Congress to authorize a 10 per cent reduction in the par value of the U S dollar, and new central or official exchange rates were announced by most members of the Community, reflecting a revaluation of currencies of 11.1 per cent in terms of the U S dollar. However, the Italian authorities decided to permit the lira to float in both the commercial and the financial markets, and the pound sterling continued to float in the exchanges.
The proposed devaluation of the U S dollar and the consequent appreciation of Community currencies did not lead to the expected unwinding of speculative positions on any substantial scale and failed to restore more normal conditions in foreign exchange markets. Speculative pressures shifted initially to the international gold markets, but toward the end of February a general distrust regarding the existing exchange system led to renewed massive sales of U S dollars on Continental markets. Under these circumstances, the Community countries decided not to intervene in their foreign exchange markets after March I while intensive consultations were begun to find a solution. However, foreign exchange dealings were permitted between domestic and foreign commercial banks and with customers. When the exchanges were officially reopened on March 19, six Community members—Belgium, Denmark, France, Germany, Luxembourg, and the Netherlands—permitted their currencies to float against the U S dollar while they agreed to maintain a maximum spread of 2.25 per cent between their currencies; for this purpose, they would continue to intervene in Community currencies. At the same time, the Deutsche mark was revalued by 3 per cent in terms of special drawing rights, and thus against partner currencies. Norway and Sweden also joined this agreement. Thus, the “snake” remained alive, but the “tunnel” ceased to exist.
In a meeting in Paris on October 19-20, the heads of state or of government of the enlarged Community decided to institute a European Monetary Cooperation Fund before April 1, 1973 to assist in the establishment of fixed but adjustable parities between the currencies of member countries. The idea of a common reserve fund for intervention and a central clearing account for the settlement of intra-Community debts had been under review for some time; indeed, such a fund was proposed by the Werner Report and the Council of Ministers’ Resolution of March 21, 1972 called for the submission of a report on it. The Fund is to be administered by the Committee of Governors of Central Banks within the context of general guidelines on economic policy laid down by the Council of Ministers. In the initial phase, the Fund will operate on the following bases:
concerted action among the central banks for the purpose of narrowing the margins of fluctuation between their currencies;
the multilateralization of positions resulting from interventions in Community currencies and the multilateralization of intra-Community settlements;
the use for this purpose of a European monetary unit of account;
the administration of the existing short-term support arrangement among the central banks;
the short-term financing based on the agreement of the narrowing margins and the above-mentioned short-term support will be reorganized in the Fund.
The Community countries have also continued to discuss modifications of procedures of the reduced margins agreement in the light of experience during the past months. Particular attention has been devoted to the intervention and settlement aspects of the agreement, related to the uncertainty with respect to the future role and official price of gold in the context of the world monetary reform. As the private price of gold increased markedly and the discrepancy between the official and private price of gold widened, countries generally have become hesitant to use their gold holdings valued at the official price for the settlement of international transactions.
It appears likely that ways will be found which, while maintaining the principle of using gold in settling accounts, will in effect provide for postponement of such settlements until the status of gold has been clarified in the context of the reform of the international monetary system. Furthermore, while central bank intervention will generally continue to be in Community currencies, greater flexibility in intra-marginal intervention, both within the Community band and under the Smithsonian Agreement, are presently under consideration.
After April 1972 the member countries of the European Community reduced the fluctuation of Community currencies against each other from the spread permitted under the Fund’s decision on wider margins. The narrowing of potential exchange rate fluctuations is the first experimental step in a unique attempt at forging a monetary union among countries of considerable economic disparity, with differing structural problems, and with diverging policy priorities to deal with these problems. It has often been emphasized in discussions of the Community’s progress toward economic integration that the feasibility and success of a monetary union is vitally dependent on a harmonization of economic policies among the constituent parts of the union. Differing economic policies leading to divergent trends in developments in member countries could not fail to affect the evaluation of relative currency strengths and put the arrangement to a severe test. Moreover, the movement toward a monetary union occurs at a time when changes in countries’ exchange rates have come to be considered more acceptable as a solution to economic maladjustments. Questions relating to the harmonization of economic policies and the use of exchange rate adjustments as a policy measure will continue to play an important role in the future development of the Community’s progress toward a monetary union.