What is Exchange Rate Mechanism (ERM)?

Published by Thomas Herold in Economics, Laws & Regulations, Trading

'Exchange Rate Mechanism (ERM)' is explained in detail and with examples in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Exchange Rate Mechanisms are systems that were established to maintain a certain range of exchange for currencies as measured against other currencies. These ERMs can be run in three different ways. On one extreme they can float freely. This permits the systems to trade without the central banks and governments intervening.

The fixed Exchange rate mechanisms will do whatever it takes to maintain rates pegged at a specific value. In between these two extremes are the managed ERMs. The best known example of one of these is the European Exchange Rate Mechanism known as ERM II. It is in use today for those countries who wish to become a part of the EU monetary union.

The European Economic Community formally introduced the European ERM system to the world on March 13, 1979. It was a part of the EMS European Monetary System. The goal of this new system centered on attaining monetary stability throughout Europe by reducing the variable exchange rates. This was set up to prepare the way for the Economic and Monetary Union. It also paved the way for the Euro single currency introduction that formally occurred on January 1, 1999.

The Europeans changed their system once the Euro became adopted. They introduced ERM II as a way to link together those EU countries who were not a part of the eurozone with the euro. They did this to boost extra eurozone currencies’ stability. A second goal was to create a means of evaluating the countries who wished to join the eurozone. In 2016 only a single currency uses the ERM II. This is the Danish krone.

The European ERM ceased to exist in 1999. This was the point after the eurozone country European Currency Units exchange rates became frozen and the Euro began trading against them.  ERM II then replaced the initial ERM. At first the Greek drachma remained in the ERM II alongside the Danish currency. This changed when Greece adopted the Euro in 2001. Currencies within the newer system may float in a fairly tight range of plus or minus 15% of their central exchange rate versus the euro. Denmark does better than this. Its Danmarks Nationalbank maintains a 2.25% range versus the central rate of DKK 7.46038.

In order for other countries that wish to join the Euro to participate, they are required to be a part of the ERM II system for minimally two years before they can become members of the eurozone. This means that at some point, a number of currencies for member states that joined the EU will have to be in the system. This includes the Swedish krona, Polish zloty, Hungarian forint, Czech Republic koruna, the Romanian leu, Bulgarian lev, and Croatian kuna. Each of these is supposed to join the system according to their individual treaties of accession.

In the case of Sweden, the situation is more complicated. The country held a referendum on becoming a part of the mechanism to which the citizens voted no. The European Central Bank still expects that Sweden will join the system and eventually adopt the euro. This is because they did not negotiate for an opt out of the currency as did the U.K. and Denmark. The Maastricht Treaty requires that EU member states all eventually join the exchange rate mechanism.

Britain participated in the mechanism from 1990 until September of 1992. On September 16, 1992 the British famously crashed out of the system on what became known as Black Wednesday because of manipulation of the pound by currency speculators led by Hedge Fund Billionaire George Soros.

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The term 'Exchange Rate Mechanism (ERM)' is included in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.