The Snake in the Tunnel

the snake in the tunnel Giinter Wittich and Masaki Shiratori rencies would thus have been narrowed from 1.5 per cent to 1.2 per cent. Ho- ever, implementation of this plan was made impossible by exchange market de- This vivid phrase has been adopted by the experts to denote velopments during mid-1971. the plan for reducing fluctuations among the currencies of the In May 1971 the deutsche mark and European Economic Community. The authors describe its the Netherlands guilder were permitted to operation until March of this year. float in the exchange markets. A few months later, the United States sus- pended the convertibility of the US dol- Background mission, would prepare a plan for the es- lar which led to all members of the Com- A long-term aim of the members of the tablishment of an economic and monetary munity (with the exception of France) European Economic Community (EEC) is union. A subsequent report (the Werner permitting their currencies to float in the to achieve a monetary union. One impor- Report) concluded that monetary union, exchange markets. France continued to tant feature of such a union would be to be achieved in phases during the 1970s, observe the previous margin of fluctuation either to adopt a common currency or to would call for the reduction and eventual against the U S dollar in commercial eliminate exchange rate fluctuations be- elimination of exchange rate fluctuations transactions but instituted a separate mar- tween the currencies of member states. between currencies of member countries ket for capital transactions. Moreover, the The latter course of action had been sug- and complete liberalization of capital Benelux countries agreed to limit the gested as early as 1962 by the EEC Com- movements. spread between their currencies to the pre- mission but little was achieved in deter- In the spring of 1971, the Council of viously possible maximum, i.e., 1.5 per mining common exchange rate policies Ministers agreed that member central cent on either side of the cross-parity rate. until, with the completion of the customs banks should from June 15, 1971 reduce The Smithsonian Agreement reached in union, it seemed that a new impetus was the margin of exchange rate fluctuation Washington in December 1971, while end- needed for the further integration and around a "Community level" for the US ing the temporary floating of exchange development of the Community. dollar from the then prevailing 0.75 per rates, also permitted currencies to fluctu- At a meeting of heads of state or of cent to 0.60 per cent, the Community level ate within margins of 2.25 per cent on government in The Hague in December being agreed from time to time among either side of the central or parity rate in 1969, it was decided that the Council of member countries. The maximum poten- terms of the intervention currency, in con- Ministers, in cooperation with the Com- tial spread between two Community cur- trast to the maximum of 1 per cent either THE SNAKE IN THE TUNNEL SPREAD FROM CENTRAL OR PARITY RATE BASED ON NOON QUOTATIONS IN NEW YORK JANUARY 2,1972 • FEBRUARY 9.1973 French Francs _ French Francs The black shaded area within the snake represents the maximum spread between Benelux currencies. 9 ©International Monetary Fund. Not for Redistribution side of parity under the Fund's Articles of Agreement. This step widened the po- tential range of fluctuation between EEC Suppose at a given time (Tj), the US dollar is quoted at its lower limit currencies from 1.5 to 4.5 per cent on against the deutsche mark in Frankfurt (a discount of the US dollar of either side of the cross-parity so that quo- 2.25 per cent from the central rate), while it is at the upper limit against tations of EEC currencies could now vary the French franc in Paris (a premium of the US dollar of 2.25 per cent). up to 9 per cent (see box) in terms of Assuming that the market is working perfectly, the French franc will be each other, rather than 3 per cent possible quoted against the deutsche mark in Frankfurt at a discount of 4.40 per before May 1971. This conflicted with the cent from the cross parity; the deutsche mark will stand at a premium of Community's aim of progressing toward 4.60 per cent from cross parity in Paris. Now suppose further that over time a monetary union and presented serious the US dollar strengthens in Frankfurt, and weakens in Paris, to the oppo- operational problems within the Commu- site intervention points (time T2). Accordingly, the French franc will nity, especially for the administration of strengthen to a premium of 4.60 per cent in Frankfurt, and the deutsche the common agricultural policy. mark weaken to a discount of 4.40 per cent in Paris. The range of fluctua- Under these circumstances, the Council tion of a currency thus is 4.5 per cent (from a discount of 2.25 per cent to of Ministers formally approved, on March a premium of 2.25 per cent) in terms of its intervention currency, but 9 per 22, 1972, a plan to reduce the maximum cent in terms of another currency to which it is linked through the inter- spread between member currencies to 2.25 vention currency. per cent by July 1, 1972. The technical arrangements maintaining the reduced margins would band. In this way, conflicting exchange Intervention have fallen exclusively on the central bank rate policies of individual central banks Narrowing the spread between any two issuing the weakest currency if interven- were to be avoided. Should it be found member states' currencies to 2.25 per cent tion quotations had been calculated uni- desirable by a particular central bank to could have been achieved.by limiting the formly at 2.25 per cent above and below intervene within the margins, it would do range of fluctuation of member countries' official cross rates. so only following prior consultation and currencies against their intervention cur- To ensure bilateral intervention once agreement with its partner countries. As rency—the US dollar—to one half of the the maximum spread was reached, an- this rule applied to interventions in US agreed maximum spread, or to 1.125 per nounced buying rates of foreign curren- dollars as well, central bank purchases and cent above and below a Community level cies were therefore generally fixed at ap- sales of dollars were in principle restricted expressed in terms of US dollars, as had proximately 2.225 per cent below, and to the observance of wider margins around been planned in 1971. This procedure selling rates at 2.275 per cent above cross the intervention currency as notified to the would have reduced exchange rate flexi- parities. As an exception, the Belgian Na- Fund. bility in terms of the dollar, would have tional Bank and the Netherlands Bank de- been contrary to the intention of permit- cided to maintain the special arrangement Settlement of balances acquired ting increased flexibility of exchange rates adopted in August 1971 to restrict fluctua- by intervention among currencies in general, and would tion between the Benelux currencies to 1.5 The agreement also contained provisions also have maintained the special role of per cent on either side of the cross parity. for the settlement of balances arising from the US dollar as the only effective inter- Intervention in the exchange markets central bank interventions in order to avoid vention currency. A system was adopted, as a rule was to take place only when quo- continuous extension of credit by coun- therefore, which called for intervention in tations reached the outer limits of the tries with the strongest currency to their US dollars only when the outer limits of ±2.25 per cent against the US dollar were reached; intervention within the margins to reduce the spread between Giinter Wittich Community currencies would take place a German citizen, is Chief of the Financial Relations in Community currencies. To implement Division in the Treasurer's Department of the Fund. the arrangement, the participating central Before joining the Treasurer's Department, he worked in banks indicated the rates at which they the Fund's Exchange and Trade Relations Department. He studied and lectured at the University of stood ready to buy or sell each other California at Berkeley where he received a Ph.D. country's currency. in Economics in 1966. In determining these intervention points, care had to be taken to ensure consistency Masaki Shiratori between any pair of quotations, as it was is an operations officer in the Treasurer's Department intended that once the maximum agreed of the Fund. He graduated from the Law School of spread from the parity or central cross the Tokyo University in 1960 and joined the Japanese Ministry of Finance. He studied economics at rate was reached, both central banks would Columbia University in 1964-66 and then returned to be intervening simultaneously. As a pre- Japan to work in the International Finance Bureau mium of 2.25 per cent of currency A in of the Ministry of Finance. In 1969 he joined the terms of currency B is equivalent to a Fund staff on a fixed-term appointment. discount of 2.20 per cent of currency B in terms of currency A, responsibility for 10 ©International Monetary Fund. Not for Redistribution Chart 1. debtor country redeems outstanding balances of its own currency by payment in Range of Exchange Rate Fluctuations reserve assets in proportion to the holdings This chart shows the extent to which two currencies—in this case the deutsche mark of these two categories of assets, partly and French franc—could, after the Smithsonian Agreement, fluctuate in terms of one in order to facilitate a harmonization of another.

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