Leaving the ERM – A view from the Financial Sector

Manish Singh

Friday 22nd September: Theresa May’s Florence speech coincides with the 25th Anniversary of the UK leaving the Exchange Rate Mechanism (ERM), the precursor to the Euro, writes Manish Singh*. 16th September 1992 has since become known as “Black Wednesday” due to the market turmoil and the losses it caused to the UK Treasury. 

The decision to join the ERM was championed by John Major, then Chancellor of the Exchequer in Margaret Thatcher’s cabinet. As per the rules that governed the ERM, member countries agreed to fix their exchange rates with each other. Since Germany had the strongest economy in Europe, each country set its currency’s value in Deutschmarks (DM).  The exchange rate was allowed to fluctuate in an acceptable band of +/- 6% of the agreed upon rate.

In October 1990, Britain entered the ERM at an exchange rate of 2.95 DM/GBP and was obliged to keep the exchange rate in the 2.78 to 3.13 DM/GBP range. After, Major replaced Thatcher as Prime Minister the following month, the fixed exchange rate system was the centerpiece of his economic plan to combat inflation in the economy. With British monetary policy now tied by the exchange rate agreement, the government could not adjust the money supply and to a certain extent, the policy worked. Between 1990 and 1992, inflation decreased from +9.5% to +3.7%

In 1992, however, Britain started sliding into recession due to falling house prices. Unemployment spiked at +12.7% from just +7.7% two years prior.  If Britain were not part of the ERM it could have full control of its monetary policy and would cut interest rates to deal with the crisis. But in this case, doing so would push the currency’s value below the agreed upon ERM range. As economic conditions worsened, high inflation and deteriorating economic activity made sterling less attractive and it kept falling to the lower limit in the ERM. The British government was bound by the rules of the ERM to protect the value of the Pound from breaching the agreed upon limits. It had only two options:

  • Increase interest rates – attract money flow and get the GBP higher
  • Buy GBP with foreign exchange reserves.

However, both these policies, were further aggravating the UK’s already serious economic downturn. Interest rates reached +15% (albeit for less than 24 hours), with a worrying impact on the housing market. With rising rates, mortgage repayments became unaffordable and default rates increased.

Britain was left with no option but to leave the ERM, a decision that was hastened when GBP came under speculative attack by the likes of Hedge fund manager George Soros. By mid-morning on “Black Wednesday,” the selling of the Pound was so intense that the Bank of England (BoE) was buying £2 billion of its currency an hour. Jim Trott, former chief dealer for the Bank of England, described the day as “stunningly expensive.” The cost to the British taxpayer was estimated at roughly £3.3 billion.

Britain had stayed in the ERM for twenty-three months, the prime minister, apparently, determined to make a success of the policy. News was slower moving than today and few got to experience the real drama that surrounded Britain crashing out of the ERM. Six Days in September: Black Wednesday, Brexit and the Making of Europe by William Keegan, David Marsh and Richard Roberts is your opportunity to read a blow-by-blow account of how the fateful week in September of 1992 unfolded. Whether you are a historian or a student, Labour or Tory, Corbynista or Realist you will find the book a fascinating read.

In hindsight, joining the ERM proved to be a disaster for the UK.  For the financial sector, there were particular implications. Although the volatility in the FX market (and capital market in general) that staying in the ERM would create could initially benefit the financial markets that rely on trading volume, that would be a short term benefit. The fortunes of the financial sector are closely linked to the performance of the economy. Staying in the ERM would have constrained economic growth and hit the businesses in the city hard.  Leaving it started a decade and a half of growth and prosperity.

Britain was in control of its monetary policy once more; the pound was devalued, helping to pull the economy out of recession.

The ERM was a mechanism effectively run by the Bundesbank, in Germany, with interest rates set according to German needs. Member nations could not cut interest rates haphazardly to deal with an economic crisis. These problems have since then come to have particular resonance across the Eurozone.

The Prime Minister, Mrs Thatcher, who had long opposed entering the ERM, insisting that markets should set the price of the currency. Though enthusiasts claimed Thatcher was wrong in her reluctance to join the ERM and, said The Economist,   she was ‘wrong on the single currency’ (The Economist: 30 June 1990), the problems faced by many Eurozone econmies since then indicate that she was proven right.

The advocates of ERM – clever heads at The Financial Times, The Economist, John Major, Gordon Brown, Michael Heseltine, Neil Kinnock, to name a few –  are this time around opposed to Brexit.

*Manish Singh is Chief Investment Officer & Executive Director of Crossbridge Capital.