European Monetary System

Summary of European Monetary System

A mechanism established by the European Communities to mitigate exchange rate fluctuations among the members and establish a zone of “monetary stability in Europe.”The EMS is, in part, a fulfillment of the 1970 Werner Report (read this and related legal terms for further details), which suggested adoption of a common European currency as a vehicle for full economic and political integration of the European Communities. More immediately, the EMS arose in response to the inadequacies of the European monetary Snake (read this and related legal terms for further details), which it superseded. The EMS was established by a resolution of the European Council on December 5, 1978, and came into being on March 13, 1979. All members of the European Communities are members of the EMS, although the United Kingdom elected not to participate in exchange rate and intervention arrangements at the outset, reserving the right to participate fully at a later date.

The EMS created the European currency unit (ECU) as the common denominator for exchange rate transactions. The ECU was established as equal to the European unit of account, which is composed of a basket of European Communities (EC) member currencies (including the “nonparticipating”pound sterling) in fixed proportion. The composition of the basket was examined six months after commencement of EMS operations and left unchanged; the mix is to be reviewed automatically every five years thereafter, or more frequently if the fluctuations in exchange rates alter the value of any component currency’s share by 25 percent and review is requested (see figure).

Each participant’s currency has a central rate established for it in terms of the ECU; this results in a series of bilateral ratios among all participating currencies. The ratios are also known as bilateral central rates, bilateral parities, or bilateral exchange rates. Initially, currencies are permitted to float within a margin of 2.25 percent above or below the parity; when this margin is penetrated, i.e., when a currency gains or loses 2.25 percent in relation to any participating currency, participating governments are obliged to intervene, buying or selling the troubled currencies, to whatever degree necessary, to restore equilibrium. It is an object of the EMS to narrow the margins to less than 2.25 percent over time. The central rates were the same as those under the Snake for those currencies that participated in that arrangement (Belgian franc, Luxembourg franc, Danish krone, Netherlands guilder, and deutsche mark). For EMS participants that were not involved with the Snake, central rates were equated with market rates against the former Snake as of March 12, 1979. Central rates, in terms of the ECU, can be adjusted by the EMS “by mutual arrangement.”A change in the central rate of any currency results in a countervailing adjustment of all participating currencies.

The purchase or sale of an EC currency by an EC member central bank results in a debit or credit on the accounts of the European Monetary Cooperation Fund (read this and related legal terms for further details), which serves as a clearing center for intracommunity settlements. As financial settlements come due, and member central banks have automatically offset obligations, a debtor central bank will accommodate balances due by (1) employing assets denominated in the currency of the creditor nation; (2) payment in ECUs (although no member is obliged to accept ECUs for more than 50 percent of sums due); or (3) using central bank reserves, other than gold.

ECUs are created by the EMCF collateralized by 20 percent of a member central bank’s gold holding, and 20 percent of its gross dollar reserves. Quarterly adjustments are made to ensure that each member’s contribution reflects 20 percent of its gold and dollar reserves. On September 30, 1984, one ECU consisted of currencies in the following proportions: .719 Deutschemark; 1.31 French franc; .078 pound sterling; 140 Italian lira; .256

Netherlands guilder; 3.71 Belgian franc; .219 Danish kroner; 1.15 Greek drachma; .00871 Irish pound; .14 Luxembourg franc. For purposes of valuing reserves, gold is valued at the average of the twice daily fixings over the past six months on the London market; dollars are valued at the market rate two days prior to the value date.

The EMS also provides three credit mechanisms to member central banks:

1. Very short-term financing: ECU-denominated loans, unlimited as to amount, for periods up to 45 days (which may be extended up to three months), to permit intervention on behalf of EC currencies. The interest rate is the current rate applicable to ECU assets.

2. Short-term monetary support to meet temporary balance of payment problems; a quota is established for each EC central bank.

3. Medium-term financial assistance: ECU-denominated loans for a period of two to five years to accommodate significant economic problems. In return for such financing, the recipient nation may be obliged to adopt corrective economic policies.

The percentage values of each member currency will be revised not later than December 31, 1985, at which time the Greek drachma will be included in the mix.

It is contemplated that, over time, the EMS may evolve into a true central bank, issuing a uniform currency for use in private as well as governmental transactions.

(Main Author: William J. Miller)