Black Wednesday 1992. Crisis Scenario around the British Pound and One-Way-Bet Scenario


Term Paper, 2013
12 Pages, Grade: 1,3

Excerpt

Contents

List of Figures

1 Introduction

2 Crisis Scenario around the British Pound
2.1 European Exchange Rate Mechanism
2.2 Economy of the UK
2.3 Impossible Trinity of the UK
2.4 Review of the British Pound Crisis

3 One-Way-Bet Scenario
3.1 Definition One-Way Bet
3.2 Application to the Pound Crisis

4 Perspective of German Central Bank

5 Description and Analysis George Soros’ Investment Strategy

6 Conclusion

References

List of Figures

1 Macroeconomic variables of United Kingdom 1980-1993
2 Impossible trinity in international economics
3 Exchange rates GBP/ DM in 1992
4 Macroeconomic variables of Germany 1980-1993
5 Interest rates of ERM countries from 1982-1993

1 Introduction

This paper deals with what is called Black Wednesday in politics and economics. The Black Wednes- day refers to the 16th September 1992 when the British government was forced to leave the European Exchange Rate Mechanism (ERM) after they had become unable to keep the currency above its agreed lower limit

In chapter 2 the scenario around the British pound is described. Macroeconomic variables are provided as well as a short introduction to the ERM. The theory of speculative attacks regarding the impossible trinity is applied to the British pound and a historical review of the crisis itself is given

In chapter 3 the question "Why did the British pound crisis represent a classical one-way-bet scenario?" is anwered

Chapter 4 deals with the perspective of the German central bank. Additional data, why speculants such as George Soros could be so confident about the German reluctance to support the British pound are provided.

In chapter 5 a description of the investment strategy of George Soros can be found as well as the downside risk related to this strategy.

2 Crisis Scenario around the British Pound

2.1 European Exchange Rate Mechanism

The ERM is part of the European Monetary System (EMS) established by the European Community in March 1979. One target of the ERM was the limitation of exchange rate fluctuations among the member countries while floating against other currencies and therefore monetary stability in Europe. From the very beginning eight countries fixed their currencies to one another. These countries were Belgium, Denmark, Germany, France, Ireland, Italy, Luxembourg and Netherlands. Later on further six european countries participated the ERM, such as United Kingdom (UK) in 1990.1

Usually until August 1993 each country had to maintain the value of its currency within a band of ± 2.25% of the specified target value. For newcomer countries, such as Britain, the bandwidth was increased to ± 6% to provide some flexibility and time to adjust2. Within the specified band the currencies were permitted to fluctuate relative to the other member currencies. The central exchange rate was based on the German mark (DM). The British pound was fixed to the German mark at a high level of 2.95 DM3 and the lowest acceptable limit of the British pound was 2.778 DM4.

It was the task of the central banks in the individual countries to guarantee the value of the own currency by buying and selling foreign currencies and adapting interest rates, respectively. This means, in case of a depreciation of the British pound the central bank of England could sell foreign currencies or raise interest rates. After UK joined the ERM, the British pound remained within the ± 6% band for a while, and after an appreciation of the currency, it stayed within the ± 2.25% band for more than a year.5

2.2 Economy of the UK

To describe the economic situation in the UK some macroeconomic variables6 are shown in figure 1.

illustration not visible in this excerpt

Figure 1: Macroeconomic variables of United Kingdom 1980-1993. Own diagram based on data from Trading Economics, http://www.tradingeconomics.com/united-kingdom/indicators.

Before entering the ERM and even before the crisis itself, UK had a relatively stable CPI (Con- sumer Price Index) inflation. However, compared to Germany the CPI inflation of UK in general is higher until the end of 1991. Furthermore, compared to the very low GDP growth of the UK the CPI inflation had to be assessed as high. The government debt, characterising the national debt in percent- age of the state’s Gross Domestic Product (GDP), was declining. This means the UK was more and more likely to pay its debt back. An indication of the level of international competitiveness of UK is the current account as percentage of GDP. During the years before the crisis the current account was negative. Usually, countries with a low current account have strong imports, low saving rates and a high consumption rate. Current account to GDP correlates with the trade balance, which had also been negative since 1986. This means, the rate of imports had been higher than the rate of exports since 1986. Furthermore the unemployment rate increased after entering the ERM.

2.3 Impossible Trinity of the UK

A currency crisis is an abrupt devaluation of a currency, which often goes along with speculative at- tack in the foreign exchange market. The British pound crisis in summer 1992 belongs to the Second- Generation-Models of a currency crisis7. A Second-Generation-Model additionally includes govern- ments’ and central banks’ decisions to domestic policies. Consequently these models differ from the first generation by the knowledge that currency crises are not necessarily caused by macroeconomic variables, but by a dilemma. Such a dilemma, in economics also called "impossible trinity", is il- lustrated in figure 2. The impossible trinity implies a country can not simultaneously take all three

Figure 2: Impossible trinity in international economics. Own graphic based on Salvatore (1996).

illustration not visible in this excerpt

aspects8. In case of the UK the government took position "a" to maintain a fixed exchange rate and free capital flow but lost monetary independence. As the British pound was linked to the German mark and the ERM provided foreign exchange bandwidths (see section 2.1), each change of German interest rates had a direct impact on the British currency. In case of an increase of German interest rates UK had two possibilities to react: Firstly, a depreciation of the British pound or secondly an increase of interest rates, which leads to a higher unemployment rate and/ or lower GDP growth9.

2.4 Review of the British Pound Crisis

In 1992 the British economy was faced with a recession (see section 2.2) and economic stagnation10. A possible solution was to lower interest rates in order to induce spending, but this had been rejected by the Central Bank of England11. In addition, both the high costs of the German reunification, being financed mainly by borrowing12 (see also section 4), and the British pound, being linked to the German mark at 2.95DM, and thus significantly overvalued, put pressure on the GBP/DM exchange rate13. The development of the exchange rates14 in 1992 is shown in figure 3 as well as the lowest acceptable limit of an exchange rate of 2.778DM/GBP.

Figure 3: Exchange rates GBP/ DM in 1992. Own diagram based on data from FXTop, http://fxtop.com/de/historische-wechselkurse.php

illustration not visible in this excerpt

Until the Black Wednesday, the main goal of Bristish Prime Minister John Major and Chancellor Norman Lamont was to defend the British pound, without realignment and to stay in the ERM15. On the other hand Helmut Schlesinger, president of the German Central Bank, did not intend to support the British pound by lowering German interest rates. Schlesingers’ main goal was not to undermine the German economy16.

At the end of August/ beginning of September the pressure on the exchange rates increased. The Bank of England started to buy 7.5 billion pounds in foreign currencies from international banks, with the goal to reanimate the pound. At the same time Chancellor Lamont further neglected to devalue the GBP and Prime Minister Major noted a devaluation as a possible softer option but considered it to be no government policy.17

An interview with Helmut Schlesinger, published in the Wall Street Journal, was interpreted as calling everyone to back out of the British pound18. At that time speculants, such as George Soros, started to bet on interest rates and on the security markets by selling short lended British pounds and purchasing German marks19.

At an exchange rate level of 2.80DM/GBP on 15th September the Bank of England bought fur- ther 3 billion British pounds but this intervention did not stop the falling exchange rate. Once again the German Central Bank refused to lower interest rates and a controversial interview with Helmut Schlesinger inspired traders to attack the British pound and other weak European currencies20.

On 16th September numerous companies, pension funds, insurance companies and British pound- dominated stock investors sold their shares21. With the Prime Ministers’ approval Chancellor Lamont increased interest rates from 10% to 12%. However, as the US market opened, the British pound was being sold there and the Bank of England was forced to raise interest rates further from 12% to 15%. It was understood that a the UK could not live with such high interest rates for a long time and the British pound kept decreasing under the allowed lowest limit of 2.778 DM. On that day Prime Minister Major took the UK out of the ERM.22

3 One-Way-Bet Scenario

3.1 Definition One-Way Bet

Since there is no official definition of a "One-Way Bet", I define the term as follows: In a perfect "One-Way-Bet" you have only one possibility of an ending. It is an obvious bet with no economic risk. This definition is congruent with the meaning in Slater (2009) on page 16923. According to Krugman in literature a "One-Way-Bet" is also called "One-Way-Option"24.

3.2 Application to the Pound Crisis

The highest loss of investment George Soros was faced with was to repay what he had borrowed. That was round about 4% interest and was judged by himself as a very little risk25. Furthermore the big tensions and growing disunity between the monetary authorities and the interview with Helmut Schlesinger (see section 2.4) published in the Wall Street Journal convinced Soros to take the risk.

Since Soros seemed to use a "Stop-Loss-Strategy" his risk management was well calculated. It was not a perfect One-Way-Bet Scenario but the publicly celebrated behaviour of relevant parties and the ratio of profit and loss was high enough to call it One-Way Bet.

4 Perspective of German Central Bank

In comparison to the macroeconomics variables of the UK presented in section 2.2 figure 4 illustrates the economic situation of Germany26 at that time.

Figure 4: Macroeconomic variables of Germany 1980-1993. Own diagram based on data from Trading Eco- nomics, http://www.tradingeconomics.com/germany/indicators.

Starting in November 1989, with the fall of the Berlin Wall, the German unification and the commitment of the West-German government to stimulate the East-German economy, an extraordinary shock happened to the ERM. One reason to look at the unification as an external shock to the ERM was the method of financing. The German government decided to finance the unification by an increase of the government debt (figure 4) rather than higher taxes27.

In addition, the economic recession of the rest of Europe and the US shifted demand for goods from Europe to the US and resulted in a decrease of German exports. The domestic demand in Ger- many increased whereby the trade balance declined (figure 4). Usually significant changes in the trade balance, as in the case of Germany in 1991, go along with significant changes in exchange rates. The German government suggested a realignment of the currencies of the main trading partners. Such a proposal is on the same level as a devaluation of these currencies and were rejected by the correspond- ing countries. Inflation rose by the expansionary fiscal policy (see figure 4), and the German Central Bank introduced a restrictive monetary policy. This led to an increase of German interest rates.28

Interest rates in Germany were no longer the lowest in the ERM29, e.g., interest rates of the Nether- lands were lower and interest rates of all other ERM countries approached (see figure 5)30. These

Figure 5: Interest rates of ERM countries from 1982-1993. Own diagram based on OECD data, http://stats.oecd.org.

illustration not visible in this excerpt

relatively high interest rates strengthened the German mark against other currencies, controlled inflation caused by the high cost of financing the unification and attracted investors (net capital inflow and therefore current account deficit).31

5 Description and Analysis George Soros’ Investment Strategy

George Soros was convinced that the breakdown of the ERM would lead to an essential realignment of the European currencies, a significant reduction of interest rates in Europe and a regression in European stock markets. Based on these three beliefs he developed a complex investment strategy of round about $10 billion.

Firstly, Soros borrowed to a high degree British pound (approx. $7 billion) because he expected it to depreciate. Immediately he changed these short British pounds in German marks at the ERM rate of 2.79 DM and to a smaller extent in French francs. With that step he hold strong German marks and increased the pressure on the exchange rate GBP/DM. Given that a country’s equities often rose after a depreciation of its currency, Soros secondly invested in British stocks approx. $500 million. He also expected an appreciation of the German mark and low German interest rates, which would strengthen

[...]


1 Wikipedia (a), http://de.wikipedia.org/wiki/Europäisches_Währungssystem

2 Zurlinden (2008), The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM, page 43

3 Slater (2009), Soros - The World’s Most Influential Investor, page 159

4 Ibid., page 162

5 Zurlinden (2008), The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM, page 44 6 TradingEconomics (b), http://www.tradingeconomics.com/united-kingdom/indicators

7 Kennedy and Irwin (1999), Harvard Business School - Note on Currency Crises, page 3

8 Salvatore (1996), The European Monetary System: Crisis and Future, page 606

9 Wikipedia (b), http://en.wikipedia.org/wiki/Impossible_trinity

10 Hamwi et al. (1995), The Exchange Rate Mechanism’s Role in the European Monetary System, page 215

11 Slater (2009), Soros - The World’s Most Influential Investor, page 160

12 Higgins (1993), Was the ERM Crisis Inevitable?, page 35

13 Slater (2009), Soros - The World’s Most Influential Investor, page 159

14 FXTop, http://fxtop.com/de/historische-wechselkurse.php

15 Slater (2009), Soros - The World’s Most Influential Investor, page 161 and 162

16 Ibid., page 162

17 Slater (2009), Soros - The World’s Most Influential Investor, page 163

18 Ibid., page 164

19 Ibid., page 165

20 Ibid., page 168

21 Ibid., page 169

22 Ibid., page 172-173

23 Ibid., page 169

24 Krugman, Currency Crisis

25 Slater (2009), Soros - The World’s Most Influential Investor, page 169

26 TradingEconomics (a), http://www.tradingeconomics.com/germany/indicators

27 Higgins (1993), Was the ERM Crisis Inevitable?, page 35

28 Higgins (1993), Was the ERM Crisis Inevitable?, page 35

29 Hamwi et al. (1995), The Exchange Rate Mechanism’s Role in the European Monetary System, page 215

30 OECD, http://stats.oecd.org

31 Salvatore (1996), The European Monetary System: Crisis and Future, page 606

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Details

Title
Black Wednesday 1992. Crisis Scenario around the British Pound and One-Way-Bet Scenario
College
German Graduate School of Management and Law gGmbH
Course
Economics
Grade
1,3
Author
Year
2013
Pages
12
Catalog Number
V300045
ISBN (eBook)
9783656964131
ISBN (Book)
9783656964148
File size
719 KB
Language
English
Tags
Black Wednesday, George Soros, Crisis, British Pound, 1992
Quote paper
Jacqueline Rausch (Author), 2013, Black Wednesday 1992. Crisis Scenario around the British Pound and One-Way-Bet Scenario, Munich, GRIN Verlag, https://www.grin.com/document/300045

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