Main developments in the European Monetary System 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 European Council, "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 currency 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 Belgium, Denmark, France, the promoted through the creation of the Euro- Federal Republic of Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, 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 currencies. 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 European Currency Unit 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 Italian lira). 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 franc (BF). deutsche mark (DM). Danish krone It serves as the unit of account for the ex- (DKr), French franc (F), Irish pound (£lr), Luxembourg franc 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 Bretton Woods system. 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.