The European Monetary System (EMS): Origin and Working

In this article we will discuss about the origin and working of the European Monetary System (EMS).

Origin of the European Monetary System:

The dollar crises which led to the breakdown of the Bretton Woods System prompted the EU countries to establish the “Snake in the tunnel” in 1972. Under this arrangement, the EU currencies were tied together and could fluctuate within narrow limits in relation to one another “(snake in the tunnel”) but jointly floating against other currencies of the world (“the snake out of the tunnel”). But this arrangement was brief and sporadic because countries moved into or out of the arrangement with changing circumstances.

After 1973, the “snake” was left to float against the dollar and the tunnel vanished. In the end, the “snake” became a German Mark currency area, with Germany the only large country of the EU. However, the “snake” was the forerunner of the more comprehensive European Monetary system.

At the initiative of France and Germany, by the Bremen Declaration of July 1978, the European Council decided to establish the European Monetary System (EMS). The EMS was formed in 1979 to coordinate or integrate monetary and fiscal policies and exchange rates among EU members.

Working of the European Monetary System:

The main elements in the EMU were:

(i) The exchange Rate Mechanism (ERM),

(ii) The European Currency Unit (ECU),

(iii) The European Monetary Cooperation Fund (EMCF), and

(iv) Financing facilities.

Their working is explained as under:

(i) The Exchange Rate Mechanism (ERM):

The ERM was established by the EU to replace the currency “snake” for the control of exchange rates. It was meant to keep the exchange rates of member countries within specified bands in relation to each other. Most exchange rates fixed by the EMS until August 1993 could fluctuate up or down between + 2.25 percent against any currency. To begin with, this applied to France, Germany, Belgium, Denmark, Luxembourg the Netherlands, Italy and Ireland. Spain joined in 1989, Britain in 1990 and Portugal in 1992 with 6 percent band. For some years’ the ERM seemed to be working well.

The bands had to be adjusted a numbers of times to stabilise exchange rates and control inflation in member countries. But after the unification of Germany in 1990, the ERM began to collapse when member were forced to follow different monetary policies.

In September 1992, Britain and Italy left it. In August 1993, all bands were widened to + 15 percent under speculative pressures, except for the German mark and the Dutch guilder. However, Austria joined the system in 1995, followed by Finland and Italy at 15 percent in 1996.

(ii) The European Currency Unit (ECU):

The ECU was introduced as a unit of account by the EU on the formation of EMS in 1979. Its value was equal to a weighted average of the currencies of member countries. The weight given to each currency was according to the relative size of a country’s GDP and its intra-community trade. By 1981, it had replaced all other units of accounts being used in the EU.

However, it was used very little by other financial markets. Despite this the ECU was a success. It was not only embraced by the member countries but also by the private sector which issued bonds and did bank transactions on a large scale in ECUs.

(iii) The European Monetary Cooperation Fund (EMCF):

The EMCF was an important part of the EMS. It acted as the clearing house for the central banks of the EMS. But, in practice, routine working of the system was carried out by the Bank for International Settlements. The central banks of the EMS were required to deposit 20% of their gold and foreign exchange reserves with the Fund on a short-term basis in exchange for ECUs.

On the basis of the above elements, the Working of the EMS was not smooth. During the early years of its operation, some members imposed exchange controls to reduce the possibility of speculation in their currencies by directly limiting the sale of domestic currencies for foreign currencies.

There were also periodic currency alignments in relation to the “bands.” There were eleven currency realignments between March 1979 and January 1987. Exchange controls helped the members to protect their foreign exchange reserves from speculators. From January 1987 to the end of 1992, exchange controls were removed by a number of EU countries. But the EMS continued with its fixed exchange rates.

The unification of Germany in 1990 led to differences in macro-economic policies of member countries which weakened the EMS. There was boom and high inflation in Germany which the Bundesbank (central bank) of Germany tried to control through high interest rates.

But major EMS countries like France, Britain and Italy were not prepared to raise interest rates so as to keep their currencies fixed against Germany. This policy conflict led to a crisis in the EMS exchange bunks which ended only when the bands were widened to + 15 percent for most countries by August 1993. These remained in-force until the introduction of the Euro in 1999.

(iv) Financing Facilities:

The members of the EMS had access to credit facilities which aimed at helping countries with public deficit to manage their transitory problems and defend their exchange rate parities. These facilities covered their very short-term, short-term and medium term requirements and were operated by their central banks.

Conclusion:

On the whole, the EMS worked well in bringing monetary cooperation among member countries. The success of the EMS encouraged the EU countries to have a single currency which led to the Maastricht Treaty.