At its meeting in Bremen in July 1978, the European Council, composed of the heads of state and government of the member countries of the European Communities (EC), agreed that closer monetary cooperation between their countries should be promoted through the creation of the European Monetary System (EMS). The main features of the EMS were set out in a resolution adopted by the European Council at its meeting in Brussels on December 4 and 5, 1978. The relevant legal texts, in particular the Agreement between the central banks of the EC countries on the operating procedures for the EMS, were subsequently adopted, and the system went into operation on March 13, 1979. At the same time, the European common margins arrangement (the “snake”) ceased to exist. All EC countries, except the United Kingdom, decided to participate in all aspects of the EMS, in particular in the operational heart of the system, the exchange rate mechanism. (Greece, which joined the EC in January 1981, is at present not a member of the EMS.)
A longer version of this study by H. Ungerer, P. Nyberg, and O. Evans is published by the Fund as Occasional Paper No. 19 and is obtainable from the Publications Unit. (See page 5 for ordering information.)
According to the European Council, “the purpose of the European Monetary System is to establish a greater measure of monetary stability in the Community. It should be seen as a fundamental component of a more comprehensive strategy aimed at lasting growth with stability, a progressive return to full employment, the harmonization of living standards, and the lessening of regional disparities in the Community. The European Monetary System will facilitate the convergence of economic development and give fresh impetus to the process of European Union. The Council expects the European Monetary System to have a stabilizing effect on international economic and monetary relations.”
At the heart of the EMS is a system of fixed but adjustable exchange rates. Each currency has a central rate expressed in terms of the European Currency Unit (ECU). The ECU consists of a basket of fixed amounts of the nine currencies of all EC countries (except, for the time being, the Creek drachma). These central rates determine a grid of bilateral central rates with fluctuation margins of plus or minus 2.25 per cent (6 per cent for the Italian lira). Intervention by the participating central banks to keep the exchange rates of their currencies within the margins is obligatory and unlimited, in principle in EMS currencies. Intervention in other currencies (chiefly in U.S. dollars) is allowed and has been undertaken on a substantial scale. The grid of bilateral central rates and intervention limits is supplemented by the “divergence indicator,” which shows the movement of the exchange rate of each EMS currency against the (weighted) average movement of the others. If a currency crosses a “threshold of divergence,” this leads to a presumption that the authorities concerned will correct the situation by adequate measures.
The member countries of the European Communities are Belgium, Denmark, France, the Federal Republic of Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, and the United Kingdom.
In the European Council’s Resolution of December 1978, the intention was stated “to consolidate, not later than two years after the start of the scheme, into a final system the provisions and procedures” of the initial phase. This second phase of the EMS was to entail—among other things—the creation of a European Monetary Fund. Work on the second phase began soon after the start of the EMS. However, due in part to the worsening economic climate in the EC countries and the world at large, but mainly because of significant differences of opinion on the major issues regarding the further development of the system, the aim of limiting the initial phase to two years could not be observed.
It became obvious that the economic, political, and legal problems would be formidable, going far beyond technical considerations. Subsequently, a more gradual approach emerged, and, in early 1982, the EC Commission submitted to the Council of Ministers a set of proposals that intended to further the step-by-step development of the EMS in certain key areas without waiting for a final, fully developed system. These proposals concentrated on certain operational and technical aspects that can more easily be formalized but nevertheless might have important policy implications (for instance, the use and creation of ECUs, and the scope and financing of intramarginal intervention), whereas they were less specific in other areas, such as the promotion of convergence in economic performance or the coordination of attitudes toward third currencies. After thorough discussions in the competent bodies of the EC, no agreement on the package of proposals could be reached. However, there was a general consensus that one of the prime objectives for the countries participating in the EMS remained the pursuit of policies conducive to greater convergence in economic performance.
The ECU plays a central role in the EMS. It serves as the unit of account for the exchange rate mechanism and for the operations in both the intervention and the credit mechanisms. It also serves as a reference point for the divergence indicator, and as a means of settlement and a reserve asset of EMS central banks. The central banks participating in the exchange rate mechanism of the EMS received an initial supply of ECUs at the start of the EMS, against the deposit of 20 per cent of both their gold holdings and gross U.S. dollar reserves (at market-related valuations) with the European Monetary Cooperation Fund, which was established as an institution of the EC and has served as the agency for operations under the “snake” and subsequently the EMS.
To finance interventions in EMS currencies, there are mutual credit lines among the participating central banks (the “very short-term financing facility”). Claims and debts arising from such interventions are settled according to certain rules governing, among other things, the use of ECUs for such purposes. The “short-term monetary support” and the “medium-term financial assistance” mechanisms that had been established in 1970 and 1971, respectively, were substantially enlarged. Designed for mutual financial assistance in cases of balance of payments difficulties, they have not been used since the EMS entered into force.
Under the provisions governing the EMS, adjustments of central rates are “subject to mutual agreement by a common procedure which will comprise all countries participating in the exchange rate mechanism and the Commission.”
Operation of the system
At the start of the EMS, contrasting expectations and fears were raised about the consequences of strict adherence to a system of fixed, though adjustable, exchange rates on economic developments and policies of participating countries. There was concern that the constraints of a fixed exchange rate system would force countries with higher inflation rates to turn to overly restrictive policies in order to ward off excessive losses of reserves. On the other hand, it was feared that fixed exchange rates and the consequent obligation to intervene would undermine the ability of the more stability-conscious countries to control domestic monetary expansion so as to contain inflationary developments. The EMS would become an engine for the creation of more liquidity and inflation and force the stability-conscious countries to settle for a higher average rate of inflation. A third line of thinking was that the system would not be able to hold together for very long. It was unreasonable to expect countries with highly divergent economic developments to be able to align their policies to the degree necessary to keep a system of fixed exchange rates functioning. As a consequence, speculative capital movements would disrupt foreign exchange markets and force authorities to make sudden and substantial exchange rate changes. Hence, the EMS would be faced with problems similar to those that occurred in the final phase of the Bretton Woods system.
It appears now that many of these concerns were exaggerated. The EMS, in its first years, worked quite smoothly in an operational sense. Through March 1983, there were seven realignments of exchange rates (see the table). The first three realignments, in 1979 and early 1981, were not large enough to cause any disruptions in markets. The situation, however, changed somewhat between mid-1981 and the end of 1982. Tension within the EMS increased, and at times large interventions were necessary to safeguard existing central rates. Four realignments took place from October 1981 through March 1983. In each, the largest bilateral change of central rates went beyond any previous realignment in the EMS or under the “snake.”
In general terms, there is little evidence that the EMS caused inflation to be transmitted from one participant to another to a greater extent than would have been the case otherwise. Equally, it appears that in virtually all EMS countries the impediments to growth stemmed essentially from a recognized need to curb domestic in flation decisively and from a worldwide climate of stagnation and the requirement to secure overall external balance, rather than from measures introduced to maintain balance within the EMS. To be sure, at times certain measures, in particular interest rate actions, were taken in response to temporary developments in the EMS. But in view of the worldwide trend toward higher interest rates and the general need for more restrictive policies in EMS countries, these measures may anyway have had to be in troduced.
Realignments in the EMS1
September 24, 1979—Upward shift in cross-rate between DM and DKr of 5 per cent. Shift in cross-rate between DM and other EMS currencies of 2 per cent.
November 30, 1979—Devaluation of DKr by 5 per cent against other EMS currencies (no communiqué).
March 23, 1981—Devaluation of Lit by 6 per cent against other EMS currencies.
October 5, 1981—Revaluation of DM and f. by 5.5 per cent against DKr, BF, LuxF, £lr. Devaluation of F, Lit by 3 per cent against DKr, BF, £lr.
February 22, 1982—Devaluation of BF, LuxF by 8.5 per cent and of DKr by 3 per cent against other currencies.
June 14, 1982—Change in bilateral rates: between F and DM, f. 10 per cent, between Lit and DM, f. 7 per cent; between DKr, BF, LuxF, £lr, and DM, f. 4.25 per cent.
March 21, 1983—Change in central rates: revaluation of DM 5.5 per cent, f. 3.5 per cent, DK 2.5 per cent, BF and LuxF both 1.5 per cent; and devaluation of the F and Lit 2.5 per cent and £lr 3.5 per cent.Sources: Commission of the European Communities and Fund staff.1 Based on official communiqués: there was no communiqué issued for the change on November 30, 1979. The following currencies are abbreviated in this chart: Belgian franc (BF), deutsche mark (DM), Danish krone (DKr), French franc (F), Irish pound (£lr), Luxembourg franc (LuxF), Netherlands guilder (f.), and Italian lira (Lit).
A number of distinct periods of strain within the EMS can, however, be distinguished. During some of these, the authorities attempted to resist changes in central rates by substantial intervention or by measures of short-term monetary policy directly motivated by exchange rate considerations. In each case, after renewed pressures, there was an adjustment of central rates. During other periods of strain, the authorities acted quickly, without a lengthy period of intervention (as when the Danish krone was devalued in November 1979), and market pressures were successfully resisted (as when the deutsche mark was weak in October 1980 and February 1981).
A variety of policy measures accompanied EMS realignments, but only at the realignment in June 1982 did the communiqué announcing the realignment make explicit reference to measures that France and Italy, which had devalued their currencies, would adopt. Other realignments, however, were also supported by economic measures. The devaluation of the Danish krone in November 1979 was part of a larger package of policy measures, as was the case with the devaluations of the Italian lira, the French franc, and the Belgian franc during 1981 and 1982. In March 1983, following the realignment, France adopted a package of restrictive budgetary and monetary measures as well as restrictions on expenditure for foreign travel.
Chart 1.Movement of EMS currency exchange rates against the ECU, 1979–82
Sources: Commission of the European Communities and Fund staff calculations.
1 Excluding the pound sterling component.
Exchange rate variability
Foremost among the objectives of the EMS is the achievement of a high degree of exchange rate stability as a basis for further economic integration within the EC. The institutional arrangements of the EMS are chiefly geared toward this objective. Central rate changes are subject to a multilevel consultation and decisionmaking process; furthermore, the implications of such changes on other aspects of EC policies need to be taken into account. At the beginning of the EMS, all this had led to the fear that the necessary exchange rate changes might not be undertaken in time nor to the extent required. The danger of competitive devaluations, on the other hand, was seen as remote. The exchange rate system of the EMS proved to be less rigid than initially feared.
At the same time, the variability of EMS exchange rates appears to have declined since the system was introduced, compared with a number of non-EMS currencies inside and outside Europe. For all EMS currencies, except the Danish krone, average variability in 1979-81 was less than in 1974-78 (Chart 2). The average variability of the nominal effective exchange rates of a number of European non-EMS currencies also declined considerably over 1979-81, compared to 1974-78. This is not surprising, given the close economic and financial ties between many European countries, and the formal links in the exchange rate regimes of some of the countries concerned. The Austrian schilling rate is closely associated with the EMS currencies, in particular the deutsche mark, and the Swiss franc rate, although largely market determined, is heavily influenced by developments in the EMS. Both Norway and Sweden peg their exchange rates to baskets of currencies in which the combined weight of EMS currencies is large.
Sources: IMF, International Financial Statistics and Fund staff calculations.
1 Variability is measured by the coefficient of variation (standard deviation divided by the average) multiplied by 1000, of the nominal effective exchange rate.
2 EMS currencies measured by simple average of variability of nominal effective exchange rates of participants.
It appears that the operations of the EMS have had a moderating effect on the exchange rate variability of the participating currencies, with this influence spreading to those European currencies outside the system that have close economic and financial ties with the participants. In contrast, the variability of nominal effective exchange rates of the U.S. dollar, the Japanese yen, and the pound sterling has risen sharply since 1979.
The EMS has as its specific aim the creation of “a zone of monetary stability in Europe,” encompassing “greater stability at home and abroad.” “Stability abroad” is equivalent to exchange rate stability, and many official references imply that “monetary stability at home” is to be interpreted as domestic monetary developments consistent with stable domestic costs and prices. The stability of exchange rates, as well as of costs and prices, is seen as an essential precondition for further economic integration among EC countries, for economic growth, and for the narrowing of differences in living standards.
The hopes that the EMS would promote greater convergence of economic policies and developments and eventually facilitate economic integration have, so far, not been fulfilled. The convergence of policies has been insufficient to achieve convergence of economic performance and, in particular, of cost and price developments. This, in turn, made it difficult to maintain a high degree of exchange rate stability. An opinion held by many, however, is that the existence of and the constraints imposed by the EMS helped to prevent a greater divergence of economic developments in the participating countries.
In 1979, the preconditions for convergence appeared to be improving both within and outside the EC. Inflation rates had been dropping or stabilizing since 1975, and differences in inflation rates between member countries reached a minimum in 1978. The launching of the EMS roughly coincided with the second major oil price increases, which caused an increase of inflationary pressures. Differences in inflation levels widened (Chart 3); consumer prices in the Federal Republic of Germany rose by 16 per cent from 1978 to 1981, but by 42 per cent in France and 64 per cent in Italy, for instance. By the end of 1982 a major convergence of inflation rates was not yet in sight, although inflation differentials had fallen somewhat from their 1980 levels.
Chart 3.Consumer prices, 1979-82
Source: IMF, International Financial Statistics.
In the monetary field, the EMS period saw a certain convergence of interest rate movements in participating countries. While interest rate developments in the United States played a significant role, a substantial part of the convergence can be attributed to the establishment of the EMS and to monetary measures taken in this context. Larger EMS countries, especially Germany, use the rate of growth of monetary aggregates as normative, intermediate goals of monetary policy. As stability of the exchange rate is especially important for the smaller EMS countries with very open economies, monetary policy in these countries has often been geared to achieve external stability. While this has resulted in a tendency to equalize interest rate developments within the EMS, monetary expansion within the smaller countries has remained partly outside the control of the authorities.
The medium-term rise in interest rates in most countries was accompanied by a slower nominal money supply growth, although the change in the growth rate of both narrow and broad money was very different in individual countries. The rate of domestic credit expansion is of considerable interest as an indicator of the determination and success of the authorities in controlling domestic monetary developments. This rate was, like those for other monetary aggregates, quite different in the various participating countries. Developments appear, however, to have converged somewhat during the first years of the EMS. In all participating countries (with the exception of Denmark), the rate of domestic credit expansion in 1979-81 was, on average, slower than or about the same as that experienced in 1974-78, and generally decreased more for countries with a high rate of expansion in the period preceding the introduction of the EMS.
Factors influencing performance
As shown above, the trend toward convergence in economic performance among EMS countries, which was evident mainly in price performance during the two years prior to the establishment of the EMS, on balance reversed itself afterward. These divergences would have been expected to create major tension within the EMS, but the EMS operated smoothly and free of major disruptions, at least up to mid-1981.
A number of factors may account for this development. In particular, the deutsche mark weakened within the EMS after May 1980, and somewhat later, in line with the EMS as a whole, also fell against the dollar. One important factor in this development was the deterioration of the German current account from the second quarter of 1979. The impact of current account developments on exchange rates was exacerbated by developments in the capital account. The reputation of the deutsche mark as a steadily appreciating currency, and thus as a safe alternate reserve and investment currency, was undermined. Lower German interest rates contributed to pressure on the mark. Lastly, there were political developments that adversely affected the deutsche mark and favored the dollar as well as, temporarily, the French franc.
The authorities in various EMS countries have also on several occasions taken external or domestic measures designed to cope with the consequences of divergence. The existence of the EMS and the resulting exchange rate constraints in some countries have induced (and have been used in the public debate as an argument for) stronger domestic adjustment efforts by modifying wage indexation provisions (Belgium, Denmark, and, lately, Italy), or by introducing more restrictive budget policies (Belgium, Denmark, and France).
The initial moderating effects that contributed to a smooth beginning of the EMS have dissipated, however; no clear signs of a significant convergence of economic policies and developments could be detected; and recourse to measures to temporarily mitigate balance of payments difficulties (such as interest rate changes or foreign borrowing) may become more difficult. As a result, it might well be that tensions within the EMS will increase. In principle, a number of options remain open to authorities in EMS countries, short of abandoning the EMS in its present form. Further changes in EMS central rates may have to be made. Or more substantial domestic adjustment programs may have to be put in place by the countries with less stable currencies and with serious payments problems, as it seems difficult to imagine that the more stability-oriented countries will be prepared to compromise their policy stance and agree to an “average” degree of convergence in terms of monetary expansion and inflation. The countries under pressure could combine medium-term programs for stabilizing and restructuring their economies with recourse to longer term external financing. It is also obvious that the first option, more frequent exchange rate action, would nevertheless require supportive domestic measures to ensure success.
From the beginning, the operation of the EMS has been characterized by efficient and smooth management by the participating central banks and a high degree of flexibility. The provisions of the Central Bank Agreement in some important aspects of the system (such as currency of intervention, maturity of credits, or means for settlement of such credits) apply only “in principle,” thus allowing for a gradual evolution of the system over time as experience is gained. The flexibility of the system was seen as necessary because of varying institutional settings and different approaches to many common problems among the participating central banks; it is workable because the central banks concerned are limited in number and have a long-standing tradition of close cooperation in foreign exchange matters, stemming in particular from the operation of the “snake.” In general, the EMS—as is true for many aspects of EC policies—is as much an institution of a technical as of a political nature.