International Finance

European Monetary System,

EMU and Euro
 European Monetary System
• The European Monetary System (EMS) was the forerunner
of Economic and Monetary Union (EMU), which led to the
establishment of the Euro.
• It was a way of creating an area of currency stability
throughout the European Community by encouraging
countries to co-ordinate their monetary policies.
• It used an Exchange Rate Mechanism (ERM) to create stable
exchange rates in order to improve trade between EU
member states and thus help the development of the single
market.
• In 1979, nine members of the EEC established the European
Monetary System.
• After the collapse of the Bretton Woods system in 1971,
most of the European Economic Community countries
agreed in 1972 to maintain stable exchange rates by
preventing exchange fluctuations of more than 2.25%
(the European "currency snake"). In March 1979, this
system was replaced by the European Monetary System,
and the European Currency Unit (ECU) was defined.
• 4 components:
» Creating Exchange Rate Mechanism (ERM)
» Settling Central Exchange Rates
» Creation of European Currency Unit (ECU)
» Intervention by Governments of European Union
 Exchange rate mechanism (ERM)
• This is the process by which member countries maintain and
manage exchange rates.
• Only Greece and Portugal remain non-ERM participants.
• 3 Features:
» It stipulates that there is bilateral responsibility of member
countries for the maintenance of Exchange rates.
» The resources to support parities in ERM were to be made
available from a fund created for the purpose.
» As a last resort the realignment of currencies to be accepted by
the member countries when currencies irretrievably diverge
from path.
 Setting Central Exchange rates
• The central rates of EMS are specified-bilateral
exchange rates among member countries.
• The currency is allowed to fluctuate around the
central rate to the tune of 2.25% (6% for Italy).
• If currency fluctuations reached these bounds, then
the indictor of divergence is calculated.
• If indicator of divergence indicates 75% of deviation
in absolute value, the government is asked by
European Central Bank to intervene.
• Indicator of Divergence:-
DIj=(Dj/Max. Dj) X 100
 European Currency Unit (ECU)
• The ECU is basket or index currency.
• Each member currency is defined in terms of units per
ECU.
• The weights in the ECU are based on each member’s
share of intra-European trade and relative size of its
GNP.
• 2 basis of fluctuation of ECU against member
country’s currency:
» Change in weights due to changes in trade share or
growth of GNP
» Change in exchange rate against dollar
 Intervention by governments of
European union
• 2 types of interventions
» Short Term
» Medium Term
• Short Term Intervention:
» The central bank can intervene in the foreign exchange
market through a system of mutual credit.
» The members can borrow among themselves unlimited
amounts upto three months.
» Loans from the pool can also be provided to governments
upto nine months.
» Originally, the pool of credit is about 14 billion ECU’s.
• Medium Term Interventions:
» Additional funds are available for maturities upto five
years from second pool originally planned for 11 billion
ECU’s.
» This can only be used for the purpose of correcting
exchange rate misalignment.
• This was essentially an attempt to achieve greater
European monetary stability and mutual cohesion
among the members of European community.
• This would ultimately lead to the adoption of common
European Currency unit (ECU) and a common
monetary union.
 European Economic and Monetary
Union (EMU)
• A monetary union in Europe which succeeded the
European Monetary System.
• This union began to take effect in 1990, over a series
of three steps.
• The first step abolished individual member exchange
rate control.
• The second step established the European Central
Bank.
• The third step created the Euro as the common
currency.
 3 stages
• Stage One: 1 July 1990 to 31 December 1993
» On 1 July 1990, exchange controls were abolished, thus
capital movements were completely liberalised in the
European Economic Community.
» The Treaty of Maastricht in 1992 establishes the
completion of the EMU as a formal objective and sets a
number of economic convergence criteria, concerning
the inflation rate, public finances, interest rates and
exchange rate stability.
» The treaty enters into force on the 1 November 1993.
• Stage Two: 1 January 1994 to 31 December 1998
» The European Monetary Institute is established as the forerunner of
the European Central Bank, with the task of strengthening monetary
cooperation between the member states and their national banks, as
well as supervising ECU banknotes.
» On 16 December 1995, details such as the name of the new currency
(the euro) as well as the duration of the transition periods are
decided.
» On 16-17 June 1997, the European Council decides at Amsterdam to
adopt the Stability and Growth Pact, designed to ensure budgetary
discipline after creation of the euro, and a new exchange rate
mechanism (ERM II) is set up to provide stability above the euro and
the national currencies of countries that haven't yet entered the
eurozone.
» On 3 May 1998, at the European Council in Brussels, the 11 initial
countries that will participate in the third stage from 1 January 1999
are selected.
» On 1 June 1998, the European Central Bank (ECB) is created, and in
31 December 1998, the conversion rates between the 11 participating
national currencies and the euro are established.
• Stage Three: 1 January 1999 and continuing
» From the start of 1999, the euro is now a real currency,
and a single monetary policy is introduced under the
authority of the ECB. A three-year transition period
begins before the introduction of actual euro notes and
coins, but legally the national currencies have already
ceased to exist.
» On 1 January 2001, Greece joins the third stage of the
EMU.
» The euro notes and coins are introduced in January
2002.
» On 1 January 2007, Slovenia joins the third stage of the
EMU.
» On 1 January 2008, Cyprus and Malta join the third
stage of the EMU.
» On 1 January 2009, Slovakia joins the third stage of the
EMU.
 Road Blocks
• In early 1992, Danish voters in a referendum rejected
the Maastricht treaty.
• In September 1992, severe strains developed in the
ERM as UK and Italy found it increasingly difficult to
defend their parities against the deutschemark and
increase in interest rates.
• The sterling and the lira left the ERM after massive
intervention failed to shore up the currencies.
• The currency markets were plunged into a turmoil
when next, French franc came under pressure.
 Euro
• The euro (€) is the official currency of 16 of the 27 member states of
the European Union (EU).
• The states, known collectively as the Eurozone, are Austria,
Belgium, Cyprus, Finland, France, Germany, Greece, Ireland,
Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia,
Slovenia, and Spain.
• The euro was established by the provisions in the 1992 Maastricht
Treaty.
• In order to participate in the currency, member states are meant to
meet strict criteria such as:
» a budget deficit of less than three per cent of their GDP
» a debt ratio of less than sixty per cent of GDP
» low inflation
» interest rates close to the EU average.
• Euro came into existence on January 1. 1999 and
vigorous trading in it began on January 4, 1999.
• The parities of the eleven member currencies against
the Euro was fixed on December 31, 1998.
• During the transition period from 1999 to 2002, the
Euro co-existed with the national currencies of the
eleven countries.
• After 2002, their individual currencies ceased to exist.
 Thank You
Made By:- Rajshree Lodha 1212