Abstract
To understand why the sales of certain ERM currencies in the summer and fall of 1992 were so huge, the story has to go back at least five years. Specifically, over 1987-91, large, cumulative inflows of capital into the higher-yielding ERM currencies occurred (see Table 4). These inflows are examined in more detail in Annex VI. One of the important factors motivating these inflows was the growing perception by international investors that the member countries of the EMS were on a continuous convergence path toward European Monetary Union (EMU), under which interest rate differentials in favor of the high-yielding ERM currencies would increasingly overestimate the actual risk of exchange rate depreciation. As one portfolio manager recalled the prevailing view, “why settle for the yield on a deutsche mark bond when you can get the higher yield on a peseta or lira bond without a compensating exchange risk?” This came to be known in major financial centers as the “convergence play.”
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