Tag: financial crisis

Almost 30 years ago, the European Exchange Rate Mechanism (ERM) was established to promote monetary stability among 12 members of the European Commission (EC). All participating states agreed to limit the variability of respective currency to 2.25% band on either side of a central rate. Later members were allowed to have their exchange rate to gyrate within a 6.00% band from a central rate. The ERM was a tool to converge the monetary policy of the 12 states and eventually, the adoption of a monetary union. Between 1992 and 1993, the ERM suffered a crisis that in a way, is similar to the Asian Financial Crisis that began exactly a decade ago.

In 1989, an EC committee laid out a plan to realize the European Monetary Union (EMU). The EMU would have an European central bank to manage a unified monetary policy for the EC. This ultimate convergence of a myriad of independent monetary policies would abolish all national currencies and eventually create an EC-wide currency.

Before the EMU could be established, all 12 members of the EC (namely, Germany, France, United Kingdom, the Netherlands, Belgium, Italy, Spain, Denmark, Portugal, Ireland, Luxembourg and Greece) had to approve the plan. In 1992, the Danish people almost rejected the EMU in a referendum while opinion poll in France was unconvincing. This brought the EMU into question, hurting confidence in the EMU and the ERM.

Currency speculators started to short sell various European currencies, betting for currencies devaluation. Regardless whether it was a self-fulfilled prophecy or a natural outcome, massive devaluation occurred and that forced many countries to drop out of the ERM band. Many fought but all lost. The British pound was one of them. The Malaysian central bank, the Bank Negara tried to defend the pound but it proved to be a USD4 billion futile adventure. In my opinion however, none other fought more valiantly mad than Sweden.

In effort to stop devaluation of the krona dead on its track as well as to teach the speculators a lesson, the Sveriges Riksbank, the central bank of Sweden, raised interest rate up to an astronomical 500%. This shocked a lot of people, including the speculators. The crazy monetary policy worked for awhile until the economy started to so a sign of stress. With a long run rate like that, not too many economy would survive long and so Sweden relented, quit the battle and forced to float the krona.

The story repeated itself in other European countries. The central banks of Portugal and Italy initially tried to defend their currencies only later to admit defeat. About five years later, similar story struck Southeast Asia.

On July 2 1997, after sustained pressure of devaluation, the Bank of Thailand gave up the battle to defend the baht. As history has recorded, the baht lost more than half of its value, from 26 baht to a US dollar in late June 1992 to 55 baht per US dollar in January 1993.

A professor of mine told my class that in late 1997, he did not understand what was going on but he did watch everything slipped away. He continued by saying nobody knew what exactly caused the crisis. But ten years after Camdessus looked on Suharto, we might have learned a thing or two from the crisis.

For me, it offers a real life example of the unholy trinity. The unholy trinity is the desire to have a pegged currency, free flow of capital and independence in monetary policy. One can only have two of them, not all three. When there is a violation of the rule, trouble looms.

In case of Sweden, the Sveriges Riksbank wanted all three. Under intense pressure and eager to move forward, the peg had to go. For Malaysia, in order to move on, free flow of capital had to go. Or rather, was chosen to be expendable. The Southeast Asian country imposed capital control in at the peak of the crisis and pegged its currency to the US dollar in 1998.

Of course, that is not the only lesson that could be learned from the era of irrational exuberance. But if the next currency crisis strikes, would anybody remember the lessons learned in the past?