The Foreign Exchange Crisis of September 1992
In the aftermath of German reunification in October 1990, the German central bank, the Bundesbank, faced rising inflationary pressures, with inflation having accelerated from below 3% in 1990 to near 5% by 1992. To get monetary growth under control and to dampen inflation, the Bundesbank raised German interest rates to near double digit levels. Figure 16.3 shows the consequences of these actions by the Bundesbank in the foreign exchange market for British pounds. Note that in the diagram, the pound is the domestic currency and the German mark (deutsche mark, DM, Germany’s currency before the advent of the euro in 1999) is the foreign currency. The increase in German interest rates iF lowered the relative expected return of British pound assets and shifted the demand curve to D2 in Figure 16.3. The intersection of the supply and demand curves at point 2 was now below the lower exchange rate limit at that time (2.778 marks per pound, denoted Epar). To increase the value of the pound relative to the mark and to restore the mark/pound exchange rate to within the exchange rate mechanism limits, one of two things had to happen. The Bank of England would have to pursue a contractionary monetary policy, thereby raising British interest rates sufficiently to shift the demand curve back to D1 so that the equilibrium would remain at point 1, where the exchange rate would remain at Epar. Alternatively, the Bundesbank would have to pursue an expansionary monetary policy, thereby lowering German interest rates. Lower German interest rates would raise the relative expected return on British assets and shift the demand curve back to D1 so the exchange rate would be at Epar. The catch was that the Bundesbank, whose primary goal was fighting inflation, was unwilling to pursue an expansionary monetary policy, and the British, who were facing their worst recession in the postwar period, were unwilling to pursue a contractionary monetary policy to prop up the pound. This impasse became clear when in response to great pressure from other members of the EMS, the Bundesbank was willing to lower its lending rates by only a token amount on September 16 after a speculative attack was mounted on the currencies of the Scandinavian countries. So at some point in the near future, the value of the pound would have to decline to point 2. Speculators now knew that the depreciation of the pound was imminent. As a result, the relative expected return of the pound fell sharply, shifting the demand curve left to D3 in Figure 16.3. As a result of the large leftward shift of the demand curve, there was now a huge excess supply of pound assets at the par exchange rate Epar, which caused a massive sell off of pounds (and purchases of marks) by speculators. The need for the British central bank to intervene to raise the value of the pound now became much greater and required a huge rise in British interest rates. After a major intervention effort on the part of the Bank of England, which included a rise in its lending rate from 10% to 15%, which still wasn’t enough, the British were finally forced to give up on September 16: They pulled out of the ERM indefinitely and allowed the pound to depreciate by 10% against the mark. Speculative attacks on other currencies forced devaluation of the Spanish peseta by 5% and the Italian lira by 15%. To defend its currency, the Swedish central bank was forced to raise its daily lending rate to the astronomical level of 500%! By the time the crisis was over, the British, French, Italian, Spanish, and Swedish central banks had intervened to the tune of $100 billion; the Bundesbank alone had laid out $50 billion for foreign exchange intervention. Because foreign exchange crises lead to large changes in central banks’ holdings of international reserves and thus significantly affect the official reserve asset items in the balance of payments, these crises are also referred to as balance of payments crises. The attempt to prop up the European Monetary System was not cheap for these central banks. It is estimated that they lost $4 to $6 billion as a result of exchange rate intervention during the crisis