European Exchange Rate Mechanism Totally Explained

Everything about The European Exchange Rate Mechanism totally explained

The European Exchange Rate Mechanism, ERM, was a system introduced by the European Community in March 1979, as part of the European Monetary System (EMS), to reduce exchange rate variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union and the introduction of a single currency, the euro, which took place on 1 January 1999.

Intent and operation of the ERM

The ERM is based on the concept of fixed currency exchange rate margins, but with exchange rates variable within those margins. Before the introduction of the euro, exchange rates were based on the ECU, the European unit of account, whose value was determined as a weighted average of the participating currencies.
A grid (known as the Parity Grid) of bilateral rates was calculated on the basis of these central rates expressed in ECUs, and currency fluctuations had to be contained within a margin of 2.25% on either side of the bilateral rates (with the exception of the Italian lira, which was allowed a margin of 6%). Determined intervention and loan arrangements protected the participating currencies from greater exchange rates fluctuations.

The Irish pound loses parity with pound sterling

Ireland's participation in ERM resulted in the Irish pound breaking parity with the pound sterling in 1979 as very shortly after the launch of the ERM the pound sterling, not at the time an ERM currency, appreciated against all ERM currencies and continued parity would have taken the Irish pound outside of its agreed band.

Pound sterling's forced withdrawal from the ERM

The United Kingdom entered the ERM in 1990, but was forced to exit the programme in 1992 after the pound sterling came under major pressure from currency speculators, including George Soros. The ensuing crash of 16 September 1992 was subsequently dubbed "Black Wednesday". There has been some revision of attitude towards this event given the UK's strong economic performance since 1992, with some commentators dubbing it "White Wednesday". Some commentators took to referring to ERM as an "Eternal Recession Mechanism", after the UK fell into recession during the early 1990s. The UK spent over £6bn trying to keep the currency within the narrow limits, spending the Gold reserves.

Increase of margins

In 1993, the margin had to be expanded to 15% to accommodate speculation against the French franc and other currencies.

Replacement with the euro and ERM II

On 31 December 1998, the ECU exchanges rates of the Eurozone countries were frozen and the value of the euro, which then superseded the ECU at par, was thus established.
In 1999, ERM II replaced the original ERM. The Greek and Danish currencies were part of the system, but when Greece joined the euro in 2001, the Danish krone was left as the only participant member. Currencies in ERM II are allowed to float within a range of ±15% with respect to a central rate against the euro. In the case of the krone, Danmarks Nationalbank keeps the exchange rate within the narrower range of ± 2.25% against the central rate of EUR 1 = DKK 7.460 38.

Current status of the ERM II

As of 1 May 2004, the ten National Central Banks (NCBs) of the new member countries became party to the ERM II Central Bank Agreement. The national currencies themselves will become part of the ERM II at different dates, as mutually agreed.
   The Estonian kroon, Lithuanian litas, and Slovenian tolar were included in the ERM II on 28 June 2004; the Cypriot pound, the Latvian lats and the Maltese lira on 2 May 2005; the Slovak koruna on 28 November 2005. The currencies of the three largest countries which joined the European Union on 1 May 2004 (the Polish zloty, the Czech koruna, and the Hungarian forint) are expected to follow eventually. Slovenia left the ERM II on January 1 2007 as the country entered the eurozone and Cyprus and Malta did the same on January 1 2008. Slovakia will leave the ERM II on January 1 2009 when the euro will be introduced.
   Plans for Bulgaria are to apply for ERM II membership in the end of 2008 or the beginning of 2009 and to commit to its rules regardless of the European Commission decision, while Romania plans to join ERM in 2010-2012.
   EU countries that have not adopted the euro are expected to participate for at least two years in the ERM II before joining the Eurozone. As Slovenia adopted the euro in 2007, the Slovenian tolar was removed from the ERM II and from circulation. The same happened to the Maltese lira and the Cypriot pound on 1 January 2008.
   Sweden is expected to participate in ERM II in order to meet the convergence criteria required for switching currency, but has deliberately chosen to stay out of the mechanism, thus maintaining their currency Swedish krona. This choice is currently tolerated by the ECB, but it has been warned it won't be tolerated for newer union members.

Exchange rate bands

In theory, most of the currencies are allowed to fluctuate as much as 15% from their assigned value. In practice, however, the currencies of the Baltic countries are pegged tightly to the central rate, and the others, except for the Slovak koruna, deviate very little (usually less than 1%) from it. In contrast, the Slovak koruna is allowed much leeway to float.

Date of entry	Country	Currency	€1=	Band		Notes
Date of entry	Country	Currency	€1=	Nominal	Actual	Notes
1 January 1999		Krone	7.46038	2.25%	<1%	The Danish krone entered the ERM II in 1999, when the euro was created.
28 June 2004		Kroon	15.6466	15%	0%	The Estonian kroon had been pegged to the German mark since its re-introduction on 20 June 1992, and then to the euro.
28 June 2004		Litas	3.45280	15%	0%	The Lithuanian litas was pegged to the US dollar until 2 February 2002, when it switched to a euro peg.
2 May 2005		Lats	0.702804	15%	1%	Latvia has a currency board arrangement whose anchor switched from the SDR to the euro on 1 January 2005.
28 November 2005		Koruna	35.4424	15%		The central rate was 38.4550 SKK before 17 March 2007.

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