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in January 1981, is at present not a member of regional disparities in the Community. This article reviews the EMS of the EMS.) The European Monetary System will facili- against the aims set out at its According to the , "the tate the convergence of economic devel- inception. purpose of the European Monetary System opment and give fresh impetus to the is to establish a greater measure of mone- process of European Union. The Council tary stability in the Community. It should expects the European Monetary System to be seen as a fundamental component of a have a stabilizing effect on international Horst Lingerer more comprehensive strategy aimed at last- economic and monetary relations." ing growth with stability, a progressive re- At the heart of the EMS is a system of At its meeting in Bremen in July 1978, the turn to full employment, the harmoniza- fixed but adjustable exchange rates. Each European Council, composed of the heads tion of living standards, and the lessening has a central rate expressed in of state and government of the member countries of the European Communities (EC), agreed that closer monetary cooper- ation between their countries should be The member countries of the European Communities are , , , the promoted through the creation of the - Federal Republic of , Greece, , , , the , and pean Monetary System (EMS). The main the United Kingdom. features of the EMS were set out in a reso- In the European Council's Resolution of December 1978, the intention was stated "to lution adopted by the European Council at consolidate, not later than two years after the start of the scheme, into a final system the its meeting in Brussels on December 4 provisions and procedures" of the initial phase. This second phase of the EMS was to and 5, 1978. The relevant legal texts, in par- entail—among other things—the creation of a European Monetary Fund. Work on the ticular the Agreement between the central second phase began soon after the start of the EMS. However, due in part to the worsening banks of the EC countries on the operating economic climate in the EC countries and the world at large, but mainly because of procedures for the EMS, were sub- significant differences of opinion on the major issues regarding the further development of sequently adopted, and the system went the system, the aim of limiting the initial phase to two years could not be observed. into operation on March 13, 1979. At the It became obvious that the economic, political, and legal problems would be formidable, same time, the European common margins going far beyond technical considerations. Subsequently, a more gradual approach arrangement (the "snake") ceased to exist. emerged, and, in early 1982, the EC Commission submitted to the Council of Ministers All EC countries, except the United King- a set of proposals that intended to further the step-by-step development of the EMS in dom, decided to participate in all aspects of certain key areas without waiting for a final, fully developed system. These proposals the EMS, in particular in the operational concentrated on certain operational and technical aspects that can more easily be for- heart of the system, the exchange rate malized but nevertheless might have important policy implications (for instance, the use mechanism. (Greece, which joined the EC and creation of ECLfe, and the scope and financing of intramarginal intervention), where- as they were less specific in other areas, such as the promotion of convergence in economic performance or the coordination of attitudes toward third . After thorough A longer version of this study by H. Ungerer, discussions in the competent bodies of the EC, no agreement on the package of proposals P. Nyberg, and O. Evans is published by the could be reached. However, there was a general consensus that one of the prime objectives Fund as Occasional Paper No. 19 and is obtain- for the countries participating in the EMS remained the pursuit of policies conducive to able from the Publications Unit. (See page 5 for greater convergence in economic performance. ordering information.)

16 Finance & Development / June 1983

©International Monetary Fund. Not for Redistribution terms of the participating in the exchange rate mech- 1 (ECU). The ECU consists of a basket of anism and the Commission." Realignments in the EMS fixed amounts of the nine currencies of all September 24, 1979—Upward shift in cross-rate EC countries (except, for the time being, Operation of the system between DM and DKr of 5 per cent. Shift in cross the Creek drachma). These central rates de- At the start of the EMS, contrasting ex- rate between DM and other EMS currencies o( 2 per cent. termine a grid of bilateral central rates with pectations and fears were raised about the fluctuation margins of plus or minus 2.25 consequences of strict adherence to a sys- November 30, 1979—Devaluation of DKr by 5 per cent against other EMS currencies (no com- per cent (6 per cent for the ). In- tem of fixed, though adjustable, exchange munique). rates on economic developments and poli- tervention by the participating central March 23, 1981—Devaluation of Lit by 6 per cent banks to keep the exchange rates of their cies of participating countries. There was against other EMS currencies. currencies within the margins is obligatory concern that the constraints of a fixed ex- October 5, 1981—Revaluation of DM and f. by and unlimited, in principle in EMS cur- change rate system would force countries 5.5 per cent against DKr. BF. LuxF, £lr. Deval rencies. Intervention in other currencies with higher inflation rates to turn to overly uation of F. Lit by 3 per cent against DKr, BF. fir (chiefly in U.S. dollars) is allowed and has restrictive policies in order to ward off ex- February 22, 1982—Devaluation of BF. LuxF by been undertaken on a substantial scale. cessive losses of reserves. On the other 8.5 per cent and of DKr by 3 per cent against other currencies. The grid of bilateral central rates and inter- hand, it was feared that fixed exchange June 14, 1982—Change in bilateral rates: be vention limits is supplemented by the rates and the consequent obligation to in- tween F and DM, f. 10 per cent, between Lit and "divergence indicator," which shows the tervene would undermine the ability of the DM, f. 7 per cent; between DKr, BF. LuxF, £lr movement of the exchange rate of each more stability-conscious countries to con- and DM, f. 4.25 per cent EMS currency against the (weighted) aver- trol domestic monetary expansion so as to March 21, 1983—Change in central rates: re- age movement of the others. If a currency contain inflationary developments. The valuation of DM 5.5 per cent, f. 35 per cent. DK 2.5 per cent, BF and LuxF both 1.5 per cent: and crosses a "threshold of divergence," this EMS would become an engine for the cre- devaluation of the F and Lit 25 per cent and i'lr leads to a presumption that the authorities ation of more liquidity and inflation and 3.5 per cent concerned will correct the situation by ade- force the stability-conscious countries to Sources: Commission of the European Communities one; settle for a higher average rate of inflation. Fund staff. quate measures. Based on official communiques; there was no A third line of thinking was that the system communiqu1 e issued for the change on November 30, 1979 The ECU plays a central role in the EMS. The following currencies are abbreviated in this chart: would not be able to hold together for very Belgian (BF). (DM). It serves as the unit of account for the ex- (DKr), (F), (£lr), change rate mechanism and for the oper- long. It was unreasonable to expect coun- (LuxF), Netherlands guilder if.), and Italian lira (Lit) ations in both the intervention and the tries with highly divergent economic devel- credit mechanisms. It also serves as a refer- opments to be able to align their policies to ence point for the divergence indicator, the degree necessary to keep a system of flation decisively and from a worldwide cli- and as a means of settlement and a reserve fixed exchange rates functioning. As a con- mate of stagnation and the requirement to asset of EMS central banks. The central sequence, speculative capital movements secure overall external balance, rather than banks participating in the exchange rate would disrupt foreign exchange markets mechanism of the EMS received an initial and force authorities to make sudden and from measures introduced to maintain bal- supply of ECUs at the start of the EMS, substantial exchange rate changes. Hence, ance within the EMS. To be sure, at times against the deposit of 20 per cent of both the EMS would be faced with problems certain measures, in particular interest rate their gold holdings and gross U.S. dollar similar to those that occurred in the final actions, were taken in response to tempo- reserves (at market-related valuations) with phase of the . rary developments in the EMS. But in view the European Monetary Cooperation Fund, It appears now that many of these con- of the worldwide trend toward higher in- which was established as an institution of cerns were exaggerated. The EMS, in its terest rates and the general need for more the EC and has served as the agency for first years, worked quite smoothly in an restrictive policies in EMS countries, these operations under the "snake" and subse- operational sense. Through March 1983, measures may anyway have had to be in- quently the EMS. there were seven realignments of exchange troduced. rates (see the table). The first three realign- A number of distinct periods of strain To finance interventions in EMS curren- ments, in 1979 and early 1981, were not within the EMS can, however, be dis- cies, there are mutual credit lines among large enough to cause any disruptions in tinguished. During some of these, the the participating central banks (the "very markets. The situation, however, changed authorities attempted to resist changes in short-term financing facility"). Claims and somewhat between mid-1981 and the end central rates by substantial intervention or debts arising from such interventions are of 1982. Tension within the EMS increased, by measures of short-term monetary policy settled according to certain rules govern- and at times large interventions were nec- directly motivated by exchange rate consid- ing, among other things, the use of ECUs essary to safeguard existing central rates. erations. In each case, after renewed pres- for such purposes. The "short-term mon- Four realignments took place from October sures, there was an adjustment of central etary support" and the "medium-term fi- 1981 through March 1983. In each, the larg- rates. During other periods of strain, the nancial assistance" mechanisms that had est bilateral change of central rates went authorities acted quickly, without a lengthy been established in 1970 and 1971, respec- beyond any previous realignment in the period of intervention (as when the Danish tively, were substantially enlarged. De- EMS or under the "snake." krone was devalued in November 1979), signed for mutual financial assistance in In general terms, there is little evidence and market pressures were successfully re- cases of balance of payments difficulties, that the EMS caused inflation to be trans- sisted (as when the deutsche mark was they have not been used since the EMS mitted from one participant to another to a weak in October 1980 and February 1981). entered into force. greater extent than would have been the A variety of policy measures accorn Under the provisions governing the case otherwise. Equally, it appears that in panied EMS realignments, but only at the EMS, adjustments of central rates are "sub- virtually all EMS countries the impedi- realignment in June 1982 did the commu- ject to mutual agreement by a common pro- ments to growth stemmed essentially from nique announcing the realignment make cedure which will comprise all countries a recognized need to curb domestic in- explicit reference to measures that France

finance iy [)nvlofnnent /' }uni' 1933 17

©International Monetary Fund. Not for Redistribution Chart 1 Chart 2 Movement of EMS currency exchange rates Variability of nominal effective exchange rates, 1974-82' against the ECU, 1979-82 (Monthly averages, March 1979=100)

Sources: Commission of the European Communities and Fund staff calculations. Sources: IMF, International Financial Statistics and Fund staff calculations 'Excluding the component. 'Variability is measured by the coefficient of variation (standard deviation divided by the average) multiplied by 1000, of the nominal effective exchange rate 2EMS currencies measured by simple average of variability of nominal effective ex- change rates of participants. and Italy, which had devalued their cur- EMS currencies, except the Danish krone, as domestic monetary developments con- rencies, would adopt. Other realignments, average variability in 1979-81 was less than sistent with stable domestic costs and however, were also supported by economic in 1974-78 (Chart 2). The average variability prices. The stability of exchange rates, as measures. The devaluation of the Danish of the nominal effective exchange rates of a well as of costs and prices, is seen as an krone in November 1979 was part of a number of European non-EMS currencies essential precondition for further economic larger package of policy measures, as was also declined considerably over 1979-81, integration among EC countries, for eco- the case with the devaluations of the Italian compared to 1974-78. This is not surpris- nomic growth, and for the narrowing of lira, the French franc, and the ing, given the close economic and financial differences in living standards. during 1981 and 1982. In March 1983, fol- ties between many European countries, The hopes that the EMS would promote lowing the realignment, France adopted a and the formal links in the exchange rate greater convergence of economic policies package of restrictive budgetary and mon- regimes of some of the countries con- and developments and eventually facilitate etary measures as well as restrictions on cerned. The rate is economic integration have, so far, not been expenditure for foreign travel. closely associated with the EMS currencies, fulfilled. The convergence of policies has in particular the deutsche mark, and the been insufficient to achieve convergence of Exchange rate variability rate, although largely market economic performance and, in particular, determined, is heavily influenced by devel- of cost and price developments. This, in Foremost among the objectives of the opments in the EMS. Both Norway and turn, made it difficult to maintain a high EMS is the achievement of a high degree of Sweden peg their exchange rates to baskets degree of exchange rate stability. An opin- exchange rate stability as a basis for further of currencies in which the combined ion held by many, however, is that the exis- economic integration within the EC. The weight of EMS currencies is large. tence of and the constraints imposed by the institutional arrangements of the EMS are It appears that the operations of the EMS EMS helped to prevent a greater diver- chiefly geared toward this objective. Cen- have had a moderating effect on the ex- gence of economic developments in the tral rate changes are subject to a multilevel change rate variability of the participating participating countries. consultation and decisionmaking process; currencies, with this influence spreading to In 1979, the preconditions for conver- furthermore, the implications of such those European currencies outside the sys- gence appeared to be improving both with- changes on other aspects of EC policies tem that have close economic and financial in and outside the EC. Inflation rates had need to be taken into account. At the begin- ties with the participants. In contrast, the been dropping or stabilizing since 1975, ning of the EMS, all this had led to the fear variability of nominal effective exchange and differences in inflation rates between that the necessary exchange rate changes rates of the U.S. dollar, the Japanese yen, member countries reached a minimum in might not be undertaken in time nor to the and the pound sterling has risen sharply 1978. The launching of the EMS roughly extent required. The danger of competitive since 1979. coincided with the second major oil price devaluations, on the other hand, was seen increases, which caused an increase of in- Convergence as remote. The exchange rate system of the flationary pressures. Differences in infla- EMS proved to be less rigid than initially The EMS has as its specific aim the crea- tion levels widened (Chart 3); consumer feared. tion of "a zone of monetary stability in Eu- prices in the Federal Republic of Germany At the same time, the variability of EMS rope," encompassing "greater stability at rose by 16 per cent from 1978 to 1981, but exchange rates appears to have declined home and abroad." "Stability abroad" is by 42 per cent in France and 64 per cent in since the system was introduced, com- equivalent to exchange rate stability, and Italy, for instance. By the end of 1982 a pared with a number of non-EMS cur- many official references imply that "mon- major convergence of inflation rates was rencies inside and outside Europe. For all etary stability at home" is to be interpreted not yet in sight, although inflation differ-

18 Finance & Development I June 1983

©International Monetary Fund. Not for Redistribution entials had fallen somewhat from their 1980 Chart 3 levels. Consumer prices, 1979-82 In the monetary field, the EMS period (Second quarter 1973 100! saw a certain convergence of interest rate EMS participants movements in participating countries. While interest rate developments in the United States played a significant role, a substantial part of the convergence can be attributed to the establishment of the EMS and to monetary measures taken in this context. Larger EMS countries, especially Germany, use the rate of growth of mon- etary aggregates as normative, intermedi- ate goals of monetary policy. As stability of Source: IMF, International the exchange rate is especially important financial Statistics. for the smaller EMS countries with very was the deterioration of the German cur- (such as interest rate changes or foreign open economies, monetary policy in these rent account from the second quarter of borrowing) may become more difficult. As countries has often been geared to achieve 1979. The impact of current account devel- a result, it might well be that tensions with- external stability. While this has resulted in opments on exchange rates was exacer- in the EMS will increase. In principle, a a tendency to equalize interest rate devel- bated by developments in the capital number of options remain open to author- opments within the EMS, monetary expan- account. The reputation of the deutsche ities in EMS countries, short of abandoning sion within the smaller countries has mark as a steadily appreciating currency, the EMS in its present form. Further remained partly outside the control of the and thus as a safe alternate reserve and changes in EMS central rates may have to authorities. investment currency, was undermined. be made. Or more substantial domestic ad- The medium-term rise in interest rates in Lower German interest rates contributed to justment programs may have to be put in most countries was accompanied by a pressure on the mark. Lastly, there were place by the countries with less stable cur- slower nominal money supply growth, al- political developments that adversely af- rencies and with serious payments prob- though the change in the growth rate of fected the deutsche mark and favored the lems, as it seems difficult to imagine that both narrow and broad money was very dollar as well as, temporarily, the French the more stability-oriented countries will be different in individual countries. The rate franc. prepared to compromise their policy stance of domestic credit expansion is of con- The authorities in various EMS countries and agree to an "average" degree of con- siderable interest as an indicator of the de- have also on several occasions taken exter- vergence in terms of monetary expansion termination and success of the authorities nal or domestic measures designed to cope and inflation. The countries under pressure in controlling domestic monetary develop- with the consequences of divergence. The could combine medium-term programs for ments. This rate was, like those for other existence of the EMS and the resulting ex- stabilizing and restructuring their econo- monetary aggregates, quite different in the change rate constraints in some countries mies with recourse to longer term external various participating countries. Devel- have induced (and have been used in the financing. It is also obvious that the first opments appear, however, to have con- public debate as an argument for) stronger option, more frequent exchange rate ac- verged somewhat during the first years of domestic adjustment efforts by modifying tion, would nevertheless require support- the EMS. In all participating countries wage indexation provisions (Belgium, Den- ive domestic measures to ensure success. (with the exception of Denmark), the rate mark, and, lately, Italy), or by introducing From the beginning, the operation of the of domestic credit expansion in 1979-81 more restrictive budget policies (Belgium, EMS has been characterized by efficient was, on average, slower than or about the Denmark, and France). and smooth management by the par- same as that experienced in 1974-78, and The initial moderating effects that con- ticipating central banks and a high degree generally decreased more for countries tributed to a smooth beginning of the EMS of flexibility. The provisions of the Central with a high rate of expansion in the period have dissipated, however; no clear signs of Bank Agreement in some important as- preceding the introduction of the EMS. a significant convergence of economic poli- pects of the system (such as currency of Factors influencing performance cies and developments could be detected; intervention, maturity of credits, or means and recourse to measures to temporarily for settlement of such credits) apply only As shown above, the trend toward con- mitigate balance of payments difficulties "in principle," thus allowing for a gradual vergence in economic performance among evolution of the system over time as experi- EMS countries, which was evident mainly ence is gained. The flexibility of the system in price performance during the two years was seen as necessary because of varying prior to the establishment of the EMS, on institutional settings and different ap- balance reversed itself afterward. These Horst lingerer a German citizen, has a proaches to many common problems divergences would have been expected to among the participating central banks; it is create major tension within the EMS, but PhD from the University of Tubingen. He worked in workable because the central banks con- the EMS operated smoothly and tree of , the cerned are limited in number and have a major disruptions, at least up to mid-1981. and us an Alternate long-standing tradition of close cooper- A number of factors may account for this LxL'cutive Director of the ation in foreign exchange matters, stem- development. In particular, the deutsche Fund before joining the ming in particular from the operation of the mark weakened within the EMS after May , fund staff m 1970. He is "snake." In general, the EMS—as is true 1980, and somewhat later, in line with the now Advisor in the for many aspects of EC policies—is as European Department. EMS as a whole, also fell against the dollar. much an institution of a technical as of a One important factor in this development political nature. HD

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