the

Giinter Wittich and Masaki Shiratori rencies would thus have been narrowed from 1.5 per 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 of the In the deutsche 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 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 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 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 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 _ 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 in (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 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 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 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 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 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 dol- lar 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 bal- ances 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. the reserve compositions of member coun- tries.

"The Snake in the Tunnel" One of the important features of the arrangement to reduce intra-Community currency spreads is that it allows use of the full margins permitted against the in- tervention currency under the Fund's deci- sion on wider margins. This arrangement reduces the maximum spread at any time between dollar quotations of two Com- munity currencies (popularly called the "snake") while leaving quotations against the dollar free to move, according to the play of market forces, within the wider Smithsonian band of 4.5 per cent (the "tunnel" in the metaphor) formed by the maximum deviation from parity or central rates of ±2.25 per cent. Suppose the as the strong- est Community currency in December 1972 was quoted at DKr 1 = $0.1465 (a premium of 2.23 per cent) in New York. The lowest level for the Italian against the US dollar can then be cal- culated on the basis of the announced selling rate for the Danish krone in Italy or DKr 100 = Lit 8,520 and is Lit 1 = $0.001719V£, or a discount of the Ital- ian lira of 0,01 per cent below the central rate. The Community band would there- fore be 2.24 per cent, and its position between —0.01 per cent and +2.23 per cent of the dollar parity. Discrepancies between the quotations in New York and the local markets would tend to be eliminated by "arbitrage"—i.e., transactions designed to profit from such discrepancies, and thus constantly tending to eliminate them. If, for example, the Danish krone and the were quoted at a premium of 2.23 per cent and a premium of 0.05 per cent in New York, while the Danish krone is quoted at its upper limit against the Italian lira in Italy partners. The resolution of the Council of demand for currency A from its own hold- (and the lira is at its lower limit against Ministers invited central banks to settle ings, it can obtain currency A from the the Danish krone in Denmark), then arbi- such debts in the course of a one-month central bank of country A through a simi- tragers will buy Italian lire in Italy and period, except when the Committee of lar swap transaction. sell them against US dollars in New Central Bank Governors agreed on dif- Settlements were then to be made on the York until the difference between the ac- ferent rules. The central bank of country A basis of the structure of the debtor coun- tual and the calculated spread disappears. purchasing a partner bank's — country B's try's monetary reserves. For this purpose, It is the quotations in terms of US dol- —currency in its own exchange markets reserves were classified into two categories: lars which have given rise to the descrip- will generally sell these balances forward gold and gold-guaranteed assets (SDRs tive term "the snake in the tunnel." The to the central bank of country B, the ma- and reserve positions in the Fund) on the "walls" of the tunnel are formed by the turity date being the last day of the follow- one hand, and foreign exchange on the maximum deviation from parity in terms ing month. If, at the same time, the cen- other hand. Apart from claims settled by of the intervention currency—the US tral bank of country B cannot satisfy the the use of the creditor's currency, the dollar—and the "skin" of the snake is rep-

11

©International Monetary Fund. Not for Redistribution resented by the quotations in terms of US dollars of the strongest and weakest Chart 2. Community currencies, as can be seen in Quotation of Community Currencies in Terms of .the US Dollar Chart 2. (Spread from central or parity rate) In the absence of intramarginal inter- vention in dollars, the position of the snake in the tunnel and its width are determined by market forces within the agreed limit. The spread between the strongest and the weakest Community currency can become narrower or wider depending on strength of demand for individual currencies, and the position of the snake can be anywhere within the tunnel. When the maximum permissible spread is approached the posi- tion of the snake will not change as long as market forces working in opposite di- rections are of approximately the same strength, i.e., push the strongest currency upward and the weakest currency down- ward to the same degree. If, however, mar- ket forces work more strongly in one direction, the snake will move to that di- rection, pulling up or down the currency at the other extreme of the European band. During most of the time since the scheme came into effect, the width of the snake remained close to the agreed maxi- mum and its position was generally deter- mined by the demand for the strongest currency which indicated the level of quo- tations for the weakest Community cur- rency. At particular times, however, the <: The upper and lower limits of the Smithsonian band (the "tunnel"). A premium Community band was pulled downward by (discount) of 2.25 per cent of the spot rate in terms of currency units per US dollar corresponds to a premium of 2.30 per cent (a discount, of 2.20 per cent) calculated in heavy sales of the weakest one—most terms of U S dollars per currency unit. markedly during the crisis that led to the floating of sterling in June 1972. ling and the Danish krone represented the Immediately after sterling was allowed Developments in foreign exchange lower limit at around their central rates. to float, speculative attention shifted to the markets In the meantime, anxiety about the pros- US dollar and the stronger Community The maximum spread between the pects for the British currencies rose sharply, reflecting doubts strongest and the weakest EEC currencies increased and pressure on sterling brought whether the structure of exchange rates narrowed sharply early in March 1972 the pound to the lower limit of the Com- agreed at the Smithsonian would be main- when the agreement among Finance Min- munity band. In the third week of June, tained. A number of central banks inter- isters to reduce intra-European margins the and other central vened on a large scale in the exchange became known. Anticipating official ac- banks of the member countries had to pur- markets to prevent their currencies appre- tion, market operators quickly bid the chase some £1,000 million to maintain ciating beyond the permitted margins. weakest Community currency—the Italian the agreed spread. Faced with massive inflows of funds, the lira, which previously had been quoted at To prevent a further loss of reserves, monetary authorities of most European about 3.20 per cent below the strongest the British Government decided on June 23 countries officially closed the exchange Community currencies, the temporarily to suspend the observance markets on June 23 and most of the mar- and the Netherlands guilder—to within of exchange rate margins and permitted kets remained closed until June 28. The the prospective band in the days following sterling to float against other currencies. Community Finance Ministers held an the Finance Ministers' meeting. The maxi- When pressure on sterling mounted, the emergency meeting on June 26-27 after mum agreed spread between European cur- Italian lira and the Danish krone also de- which they confirmed their Governments' rencies had thus become established before clined sharply. Most of the funds from resolve to defend both the Smithsonian the scheme was brought formally into op- these countries, particularly the United exchange rate structure and the Commu- eration on April 24, 1972. Kingdom, flowed into the other stronger nity's narrowed margins. However, it was Until mid-June the snake remained Community currencies, but some part was agreed temporarily to modify intervention broadly stable in the upper half of the tun- also switched into US dollars. As the procedures for Italy; market operations in nel. The French and the Belgian francs, three currencies depreciated against the support of the lira could be carried out quoted near their upper intervention points US dollar, the other Community curren- in US dollars until the end of 1972. Only against the , US dollar, formed the upper cies also declined in terms of the dollar, the Danish authorities felt unable to con- limit, while the Italian lira and later ster- pulling the snake lower in the tunnel. tinue adherence to the narrower band; for 12

©International Monetary Fund. Not for Redistribution the time being, the krone would be allowed Bank occasionally sold limited amounts of Deutsche mark was revalued by 3 per to move within the wider Smithsonian Belgian francs under the terms of the cent in terms of , limits. Benelux Agreement to restrict fluctuations and thus against partner currencies. Nor- After the reopening of the European among Benelux currencies to 1.5 per cent way and Sweden also joined this agree- foreign exchange markets, speculative sell- on either side of cross parity. ment. Thus, the "snake" remained alive, ing of US dollars against the strong Com- The calmer conditions in the exchange but the "tunnel" ceased to exist. munity currencies continued for a time markets and the strengthening of the U S despite new exchange control measures dollar ended abruptly when the leading Further steps taken by a number of countries. The ex- markets turned nervous and hectic follow- In a meeting in Paris on October 19—20, change markets became calmer in the lat- ing the introduction of a two-tier exchange the heads of state or of government of the ter part of July, particularly after the system in Italy and the decision of the enlarged Community decided to institute meeting in London of Community Finance Swiss authorities temporarily to refrain a European Monetary Cooperation Fund Ministers on July 17—18, when market par- from intervening in the exchanges. Heavy before April 1, 1973 to assist in the estab- ticipants became convinced that other lead- sales of U S dollars in almost all major lishment of fixed but adjustable parities be- ing European currencies would not be set centers resulted in a sharp appreciation tween the currencies of member countries. to float. A further tightening of exchange of Community currencies, and early in The idea of a common reserve fund for controls in Europe and the purchase of February massive central bank absorption intervention and a central clearing account US dollars with the deutsche mark in of U S dollars again became necessary for the settlement of intra-Community New York by the Bank when quotations reached the outer limits debts had been under review for some of New York also contributed to quieten of the Smithsonian band. time; indeed, such a fund was proposed by the markets. Nearly all major foreign exchange mar- the Werner Report and the Council of Following these developments, specula- kets were closed on February 12-13. The Ministers' Resolution of March 21, 1972 tive activity receded markedly and the U. S. U.S. Government announced that it was called for the submission of a report on dollar recovered gradually. However, some requesting Congress to authorize a 10 per it. The Fund is to be administered by the Community currencies—the Belgian and cent reduction in the par value of the U S Committee of Governors of Central Banks the French franc at the beginning and later dollar, and new central or official exchange within the context of general guidelines on the French franc alone—remained very rates were announced by most members economic policy laid down by the Council firm, being quoted slightly below their of the Community, reflecting a of Ministers. In the initial phase, the Fund upper limits, while the Italian lira, the of currencies of 11.1 per cent in terms of will operate on the following bases: weakest currency, remained slightly above the U S dollar. However, the Italian au- • concerted action among the central its central rate. As a result, the position thorities decided to permit the lira to float banks for the purpose of narrowing of the Community band remained rather in both the commercial and the financial the margins of fluctuation between stationary in the upper half of the tunnel markets, and the continued their currencies; for the period between the end of June to float in the exchanges. • the multilateralization of positions and mid-September. Most other Commu- The proposed of the U S resulting from interventions in Com- nity currencies fluctuated widely, on bal- dollar and the consequent appreciation of munity currencies and the multilat- ance gradually easing against the dollar, Community currencies did not lead to the eralization of intra-Community settle- as can be seen from the chart. expected unwinding of speculative posi- ments; The dollar's recovery was accelerated tions on any substantial scale and failed • the use for this purpose of a European after the middle of September when short- to restore .more normal conditions in for- monetary ; term funds flowed back into dollar assets eign exchange markets. Speculative pres- • the administration of the existing short- reflecting increased confidence among mar- sures shifted initially to the international term support arrangement among the ket participants in the Smithsonian ex- gold markets, but toward the end of Febru- central banks; change rate structure. The French franc, ary a general distrust regarding the existing • the short-term financing based on the following the trend of other Community exchange system led to renewed massive agreement of the narrowing margins currencies, began to decline, which per- sales of U S dollars on Continental mar- and the above-mentioned short-term mitted the Italian authorities to let the lira kets. Under these circumstances, the Com- support will be reorganized in the ease and for the first time in nearly three munity countries decided not to intervene Fund. months, the Community band itself began in their foreign exchange markets after The Community countries have also to move lower. After a temporary upward March I while intensive consultations continued to discuss modifications of pro- shift in mid-December, reflecting primar- were begun to find a solution. However, cedures of the reduced margins agreement ily capital inflows into Denmark which foreign exchange dealings were permitted in the light of experience during the past brought the Danish krone to form the ceil- between domestic and foreign commer- months. Particular attention has been de- ing, the Community band reached its low- cial banks and with customers. When the voted to the intervention and settlement est level within the tunnel in the middle exchanges were officially reopened on aspects of the agreement, related to the of January 1973, when the Italian authori- March 19, six Community members—Bel- uncertainty with respect to the future role ties resumed market intervention in Com- gium, Denmark, France, , Lux- and official price of gold in the context of munity currencies. embourg, and the Netherlands—permitted the world monetary reform. As the pri- Until early in January 1973, official in- their currencies to float against the U S vate price of gold increased markedly and tervention in foreign exchange markets by dollar while they agreed to maintain a the discrepancy between the official and Community central banks was reportedly maximum spread of 2.25 per cent between private price of gold widened, countries on a comparatively small scale, apart from their currencies; for this purpose, they generally have become hesitant to use their fairly frequent sales of US ;dollars by the would continue to intervene in Commu- gold holdings valued at the official price Bank of Italy. However, the Netherlands nity currencies. At the same time, the continued on page 38 13

©International Monetary Fund. Not for Redistribution