In recent days we hear a lot about “Brexit” i.e. the exit of Britain from the European Union(EU). But, Britain was never really a complete member of the EU. Unlike the rest of the members, Britain was/is not under the European Central Bank (ECB) and did/does not use the Euro as its currency unit. The reasons for the above take us back to September of 1992 or Black Wednesday.
Black Wednesday is the event which forced Britain out of the European Monetary Union. Due to the currency pegs which were required to be followed by the member nations, Britain’s Pound Sterling was driven far away from its true market value, causing the pound to be overvalued. On Black Wednesday, currency traders who spotted this anomaly forced the Pound back to its true valuation and hence created a situation where Britain could no longer remain in the monetary union.
Let us now look at a brief history of the events which led to Black Wednesday.
Entry of Britain into the ERM
In the year 1990, Britain entered the European Exchange Rate Mechanism (ERM). Entry into the ERM meant that the British pound sterling would be pegged to the Deutsch Mark (DM), the peg for all European countries in the ERM. This peg was advocated by the members of the European Economic Union to reduce exchange rate volatility among participant countries and hence boost overall trade in the region.
Thus, on 8th October 1990 Britain entered the ERM at 0.34 pounds per DM. Britain was allowed to let the pound fluctuate in a narrow band of plus or minus 6%. Thus, the British pound could appreciate to a maximum of 0.36 per DM, and depreciate to a minimum of 0.32 pounds per DM.
At the upper and lower limits of the band, the government of Britain was expected to intervene so as to bring the currency back within the range. Incase of currency markets, buying and selling of the domestic currency is an important tool used by governments to intervene incase of a positive or negative shock in the market. Thus, it was expected that the Bank of England, to stabilize the currency, would start buying pounds incase the pound depreciated to levels of 0.32 pounds per DM, and sell pounds incase the pound appreciated to levels of 0.36 pounds per DM.
The entry of Britain into the ERM meant that domestic factors no longer dictated the value of the Pound Sterling. Thus, for the value of the pound to appreciate, the German Deutsche Mark would have to appreciate.
Let us now turn to Germany to look at the reasons for the appreciation of the DM.
Reasons for the appreciation of the Deutsche Mark
- Fall of the Berlin wall
With the fall of the berlin wall and hence the reunification of Germany, the government of reunified Germany embarked upon a massive spending program. This was primarily undertaken to improve the economic scenario in erstwhile East Germany, which lagged erstwhile West Germany in-terms of economic prosperity.
This spending drive by the government caused the budget deficit of the government to rise sharply, rising from a near balanced budget before unification, to a deficit budget equivalent to 3% of GDP in 3% in 1991. This increase in money supply in the country led to high levels of inflation in the country.
- Inflation & Bundesbank
Thus, the Bundesbank to control inflation, increased interest rates sharply in the country, rising from 10% in January 1989 to 15.7% September in 1992.
This in a world where interest rates were relatively low led to a rush of money into Germany due to the interest rate differential. The flow of money into Germany caused the Deutsch Mark to appreciate from an average of 0.53 dollars per DM in 1989 to an average of 0.64 dollars per DM in 1992, or an appreciation of 21%.
Impact of the appreciation of the DM on the Pound Sterling and hence foreign trade
As per the terms of the ERM, the appreciation of the DM meant that the pound sterling also appreciated against the U.S. Dollar. Hence between 1989 and 1992, the British pound appreciated from 1.64 dollar per pound in 1989 to 1.82 dollars per pound in 1992, an appreciation of 11%.
This led a strange situation for the country, while the balance of payment deficit (i.e. more foreign currency flowed out of the country than into the country) was an average of 2% of GDP for the country between 1989 and 1992, the pound which should have depreciated in response to this deficit, continued to appreciate against its trading partners. Hence the country’s exports were rendered even more uncompetitive while imports became cheaper. Thus, worsening the already worrying trade deficit.
Recognizing this paradoxical situation, currency traders in financial markets had been gradually building up short positions to profit from the inevitable depreciation of the pound sterling.
A short position is taken when a trader expects the value of the asset to fall. In this case the underlying asset was the pound sterling. Thus, traders expected the value of the pound sterling vis-à-vis the US dollar to fall, i.e. they expected in future each pound would buy them lesser number of dollars. (in 1992, 1 pound bought them 1.82 dollars)
To put the short positions into perspective, the Bank of England had borrowed $14 billion to defend the currency in case of a sell off. This amount was equivalent to what Quantum fund (a Hedge Fund run by George Soros) alone aspired to sell.
September 1992: Black Wednesday
Recognizing that the pound sterling was overvalued, the British finance minister Norman Lamont urged the President of the Bundesbank Helmut Schlesinger to reduce interest rates so that the overvaluation of the pound could be corrected. This request fell upon deaf ears as on the 8th of September, the President of the Bundesbank made it clear that inflation in the German economy would be the Bundesbank’s first priority hence making no guarantees on interest rate reductions. Further, on the 14th of September, Mr. Schlesinger added that he believed a broader realignment of European currencies would be better than narrow readjustments. This was music to the ears of currency traders who took it as a signal for the breaking of the currency peg.
Upon reading hearing this, Stan Druckenmiller and George Soros decided to go for the jugular. Overnight in the United States the two built up short positions with anyone willing to buy pounds. Over the course of the next day the two of them had built up a position equivalent to $10 billion.
On the 15th of September when trading opened in London, the pound opened at the bottom of the band i.e. 0.32 Pounds per DM (or 2.778 DM per pound). By 8:40am, the Bank of England had bought 1.6 Billion pounds to try and support the currency markets. But these efforts were futile as the value of the pound refused to budge. Finally, at 11am the government agreed to increase interest rates by two percentage points. But, once again this had no impact on the value of the pound. For the rest of the day the Bank of England continued to buy pounds from currency traders, as it was obligated to do under the terms of the ERM and hence taking the losing side of the bet.
On the 16th of September as markets opened, the pound remained at the bottom of the band and the Bank of England was once again obligated to buy pounds from the market. In a last ditch attempt to boost the value of the pound, the government announced a three percentage point increase of the interest rate. This had no impact on the value of the pound.
Finally, at 7:30pm on the 16th of September, Norman Lamont called a press conference to announce that Britain was leaving the ERM.
As Britain left the ERM, the pound depreciated by a further 14% against the deutsche mark. This brought the overvaluation of the pound to an end and the currency was once again brought back inline with market prices.
By the end middle of September, when it quit the ERM, the Bank of England had spent $27 billion of its reserves to defend the currency. Further, by taking the losing side of the bet, the currency intervention had cost the British tax payers nearly $4 billion.
Black Wednesday shows us how excessive government control on the price of currency can lead to a situation where not only does the country lose out due to incorrect price signals, but also how taxpayers lose due to the costs of the readjustments. Thus, currency markets are one place where there should be minimal intervention by the government.