I. Introduction and Background
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 2 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 3 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Abstract

This paper is concerned with developments in the European Monetary System (EMS) from its start in March 1979 through December 1982. Chapter I provides a summary of events leading up to the establishment of the EMS and a survey of its main features. Chapter II assesses the performance of the system by describing major exchange rate developments and examining the extent to which exchange rate stability and convergence of economic developments within the EMS have been achieved. Chapter III discusses the evolution of the system with special attention to various operational aspects and a summary of proposals for the institutional development of the system. Chapter IV considers the relationship between the EMS and the International Monetary Fund (IMF). The appendices contain statistical material and a bibliography.

This paper is concerned with developments in the European Monetary System (EMS) from its start in March 1979 through December 1982. Chapter I provides a summary of events leading up to the establishment of the EMS and a survey of its main features. Chapter II assesses the performance of the system by describing major exchange rate developments and examining the extent to which exchange rate stability and convergence of economic developments within the EMS have been achieved. Chapter III discusses the evolution of the system with special attention to various operational aspects and a summary of proposals for the institutional development of the system. Chapter IV considers the relationship between the EMS and the International Monetary Fund (IMF). The appendices contain statistical material and a bibliography.

History and Objectives

At its meeting in Bremen on July 6 and 7, 1978, the European Council, composed of the Heads of State and Government of the member countries of the European Community (EC),1 agreed that closer monetary cooperation between EC countries should be promoted through the creation of the European Monetary System, and an outline for the system was made public as an annex to the conclusions of the Presidency of that meeting. 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, 1978.2 The relevant legal texts, in particular the Agreement between the central banks of the member countries of the EC on the operating procedures for the EMS, were subsequently adopted. The system went into operation as of March 13, 1979, after difficulties relating to monetary aspects of the common agricultural policy of the European Community had been resolved. These difficulties had delayed the entry into force of the EMS from the originally envisaged date of January 1, 1979. At the same time, the European common margins arrangements (the “snake”) ceased to exist. All EC member countries but 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. Italy and Ireland, due to their particular economic circumstances, at first hesitated to join. However, for economic as well as political reasons, both countries decided in favor of participation. In the case of Italy, the decision to participate was facilitated by the flexibility provided by the possibility offered to EC countries with hitherto floating currencies (i.e., nonparticipants in the “snake”) to opt for temporarily wider fluctuation margins (of up to 6 percent instead of 2¼ percent). Ireland joined despite the fact that the United Kingdom decided not to participate in the exchange rate mechanism.

Because the United Kingdom does not participate in the exchange rate mechanism, the link between the British pound and the Irish pound was broken at the end of March 1979. The change encouraged Ireland to orient its economy more toward member countries in the EC other than the United Kingdom. Both Italy and Ireland also benefited from special financial measures for the less prosperous member countries fully participating in the EMS. Greece, which became a member of the European Community as of January 1, 1981, is at present not a member of the EMS.

The United Kingdom accepted general membership in the EMS but decided for the time being not to participate in the exchange rate mechanism; consequently, the Bank of England is not a partner in the very short-term financing facility serving to finance obligatory intervention at the margins in participating currencies. The pound sterling is included in the basket that forms the European Currency Unit (ECU), while the Greek drachma is not; the Treaty of Accession to the EC provides for the inclusion of the drachma, at the latest, by December 31, 1985, or earlier in the case of a revision of the ECU basket.

The predecessor of the EMS, the European common margins arrangements (the “snake”), was originally part of a broad effort of the EC countries, initiated in 1969, to create an Economic and Monetary Union by 1980. It aimed at the establishment of an autonomous exchange rate system among EC countries and at the gradual abolition of the fluctuation margins between EC currencies. However, adverse events such as the breakdown of the worldwide system of stable exchange rates in 1973 and the first round of oil price increases in 1973–74 (consequences of which differed from country to country) made it difficult for the “snake” to succeed in its original aims. In the end, it was a common exchange rate mechanism for a small group of EC countries (Belgium, Denmark, the Federal Republic of Germany, Luxembourg, and the Netherlands). Over the years, the other EC countries (France, Italy, and the United Kingdom), as well as the two non-EC countries participating in the arrangement, Norway and Sweden, decided to leave the arrangement. While in some aspects, such as the exchange rate mechanism or the financing of intervention, the EMS is broadly similar to the “snake,” it differs in other aspects, both technical and political. Above all, the EMS has a political dimension that makes adherence to the system not just a question of economic expediency. Features such as the ECU, the procedures to decide in common about exchange rate changes, and the general emphasis on the convergence of economic policies and developments underline the community aspect of the EMS and the mutual dependence and responsibility of its members.

The main objective of the EMS has been clearly stated by the European Council as a “zone of monetary stability in Europe” (paragraph 1.1 of the Resolution of December 5, 1978) and in the following quotation from the conclusions of the Presidency of the December 1978 meeting:

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….3

Main Features of the EMS4

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). These central rates determine a grid of bilateral central rates, around which fluctuation margins of ± 2.25 percent (6 percent for the Italian lira) have been established. At these margins, intervention by the participating central banks is obligatory and unlimited in amount. Intervention is, in principle, to be effected in participating currencies;5 intervention in other currencies (i.e., 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 other EMS currencies. The criterion used is the divergence of the actual daily rate of the EMS currency, expressed in ECUs, from its ECU central rate. If a currency crosses a “threshold of divergence,” set at 75 percent of the maximum divergence spread, this leads to a presumption that the authorities concerned will correct the situation by adequate measures, such as diversified intervention, measures of domestic monetary policy, changes in central rates, or other measures of economic policy.

The ECU plays a central role in the EMS. It serves as the numeraire for the exchange rate mechanism, as the denominator for operations in both the intervention and the credit mechanisms, as a reference point for the divergence indicator, and as a means of settlement and a reserve asset of EMS central banks.

For the financing of interventions in EMS currencies, there are mutual credit lines between 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,” which were established in 1970 and 1971, respectively, were substantially enlarged at the time of establishment of the EMS. They now provide ECU 25 billion6 of effectively available credit, compared with ECU 10 billion before. The two facilities are available to all members of the EC, including the United Kingdom and Greece. Designed for mutual financial assistance in cases of balance of payments difficulties, they have not been used since the EMS entered into force.

At the start of the EMS, the central banks participating in the exchange rate mechanism of the EMS received an initial supply of ECUs against “contributions” of 20 percent of both their gold holdings and gross U.S. dollar reserves (at market–related valuations) to the European Monetary Cooperation Fund (EMCF).7 These transactions took the form of revolving three-month swaps, which allow the necessary adjustments to keep contributions at the, level of 20 percent each of gold and U.S. dollar reserves, and to take account of any price or rate changes that may have occurred since the previous adjustment. It was agreed that the EMCF would leave the administration of the reserves transferred to it by the swaps to the contributing central banks. The EMCF was established as an institution of the EC in April 1973 and has served as the administrator for transactions under the “snake” and the EMS as well as the very short-term financing facility and the short-term monetary support.

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.”8

The Experience, 1979-82
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