David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

29.6 Antecedents of the eurozone
Table 29.4 ERM devaluations, 1992-98
Date Punt Peseta
Escudo lira Pound
Sept. 92 -5
left ERM
left ERM
Nov. 92 -6
-6
Feb. 93 -10
May 93 -8
-6.5
Mar. 95 -7
Dec. 96
rejoined ERM
After five years without any realignment during 1987-92, by mid-1992 several exchange rates appeared
overvalued. Germany proposed a general ERM realignment in August, but this was declined by other
countries. As speculative pressure continued, the Buba intervened heavily to support weaker currencies, as
did other central banks.
Speculation persisted. Sterling and the lira were forced out of the ERM and depreciated substantially. The
peseta, escudo and Irish punt were devalued but remained in the ERM. Table 29.4 shows ERM realignments
during 1992-97.
A new attack on the French franc in August 1993 led to a face-saving 'redesign' of the ERM to allow the franc
to survive within it. Previous narrow bands (2 1 /4 per cent each side of the parity) were replaced by very wide
bands (15 per cent each side of the parity). With such wide bands, the ERM survived thereafter.
Capital controls and the ERM
Initially, the ERM allowed high-inflation countries regular devaluations that largely shadowed
the nominal exchange rate depreciation they would have had under floating. After 1983
discipline increased, and realignments got less frequent. During 1983-85 inflation rates converged substantially
to the low German inflation rate.
In 1986 the Single European Act, a commitment to a single market, signalled the end of controls on capital flows.
Yet capital controls had underpinned the early ERM. For a high-inflation country, figure (a) shows the path ABDE
of nominal exchange rate depreciation to maintain real competitiveness. Initially, the exchange rate is pegged within
a band around central parity e0• When the exchange rate hits the bottom of the band at B, central banks intervene
to try to defend the band. As time elapses, the exchange rate moves along BC. With continuing inflation,
competitiveness is now being eroded. Eventually this prompts a devaluation of the central parity from e0 to e1,
so the whole band shifts down. The actual exchange rate jumps from C to D on the day of the realignment.
This is a one-way bet. As the exchange rate moves along BC nobody is expecting a sharp appreciation! Only
capital controls prevent a massive outflow on the financial account to avoid the imminent capital loss on
holding the currency. If capital controls had been removed in the early 1980s, there would have been an
immediate crisis. Figure (b) explains why this did not occur after 1986.
By the mid-1980s, inflation convergence within the ERM meant even Italian inflation was nearly down to
German levels. Slow depreciation of the lira could offset extra Italian inflation. The line is flatter in figure (b)
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