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.”