16 September 1992 – A day of paramount importance in the history of finance. It was on this day that Bank of England failed in it’s duties and was forced to withdraw pound sterling from the European Exchange Rate Mechanism (ERM).
All the how? why? who? questions bubbling in your cerebrum will be answered here.
First and foremost, let me give you a brief description about 2 people:
George Soros: He managed the Quantum Fund (a hedge fund) along with his partner Jim Rodgers. They generated a return of 4200% (ie. multiplied the money 42 times) in about 10 years, while during the same time, S&P generated around 45%-50% return.
Jim Rodgers: He is Soro’s partner at Quantum fund. Jim Rodgers retired at an early age of 36 years and went on a world tour. In China he saw manufacturing scale. He, therefore, felt that commodity (raw materials) was going to pick up. So he started commodity fund which since 2003 grew at 165% a year for a period of five years. He Invested in countries rich in natural resources like Russia for oil, Brazil for Coffee, and so on. Rightly said, “If it rains in Brazil buy Starbucks.”
Soros and Rodgers separated after 10 years. Then George Soros took the hedge fund to an altogether a new level.
Britain Story:
Britain was facing huge inflation, zero growth rates, and skyrocketing unemployment. It was also adversely affects by Japan’s Asset Pricing Bubble. But it’s neighbor – Germany – was flourishing due to boom in it’s “automobile market.” Britain felt that by following German model of growth, it could alleviate the slump in it’s economy. Hence, Britain joined ERM.
What exactly is ERM pegging system?
In 1979, the European Exchange Rate Mechanism (ERM) was set up. This is a complex name for a complex system which dictates the exchanges rates for currencies of European countries. In layman’s words, ERM sets an upper and lower bound within which the exchange rates can fluctuate. It is a kind of semi-pegging system.
In the beginning, Britain stood back and refused to join the ERM but later, it adopted a semi-official pegging policy with German Deutsche Mark. In October 1990, when Britain’s economic and political conditions became unstable, it decided to join ERM.
1 pound = 2.95 Deutsche Marks
This preventing Britain’s currency from fluctuating more than 6 percent in either direction from the fixed rate. But how? It was actually Britain’s responsibility to ensure that this 6% bandwidth wasn’t breached by intervening in the currency markets with countertrades. Sounds complex… actually it isn’t!
Let’s take an example. Suppose the value of pound sterling depreciates so one will have to pay more pounds to buy the same amount of German Deutsche marks. This means, 1 pound < 2.95 deutsche marks. If it falls below 2.773 (falls more than 6%), then Britain will enter into the currency market and start buying sterling by utilizing its forex reserves. This props up the demand for sterling and thereby increasing it’s value. Britain keeps on buying till the time the value of pound sterling reaches the desired level.
Britain and the ERM:
Through ERM, Britain had outsourced its monetary policy to Germany, making its interest rate move in parallel to Germany’s interest rates (if it pegs its currency to German Deutsche Marks but doesn’t shadow Germany’s interest rate, then arbitrage opportunities will open up and an imbalance will be created).
In 1992, Germany was a growing economy whereas Britain’s growth was nearing the end. A lot of money was flowing into Germany causing inflation, high labor costs (much higher than required). Therefore, to combat inflation, German Bundesbank increased its interests rates. The last thing Britain wanted was to put undue pressure on the it’s own economy and Germany’s interest rate hike did exactly that.
BRAZIL:
Till the time China grew, Brazil also grew as it supplied raw materials, which backed china’s industrialization. China started faced a big demand for their currency, thereby, making its currency expensive.
China is an export driven economy and as it exports more and more, demand for Chinese Yuan increases resulting in appreciation of yuan. Of yuan appreciates, it would hamper the competitiveness of Chinese goods in foreign markets. China prevented it’s currency appreciation by placing countertrades in the currency market using it’s enormous forex reserves and by printing money. This earned China the title of “Currency Manipulator.”
Whereas Brazil, who exports raw materials, couldn’t keep the value of its currency suppressed. Hence, the Brazilian Real appreciated and became less competitive. It tried to reduce interest rate but it didn’t work successfully. It tried to print money but it brought inflation. Therefore, its was stuck. Brazil had faced maximum loss due to Quantitative Easing in US after the 2008 crash.
ITALY:
Italy’s economy was in a slow down phase. People started to take money out of their country. As a result Italian Lira further devalued. When it exceeded the limit for which currency was pegged, the government intervened and brought its own currency using Forex reserves by selling their Dollars. But they did not have enough Forex and if they continue doing so, they would not be able to perform foreign trade.
George Soros comes into the picture. Soros thought that the rate at which Britain was accepted into ERM was very high. It was facing problems due to Germany’s interest rate, rapid depreciation of USD (currency in which many British exports were prized), double deficit, etc.
British government was manipulating and keeping the currency high. Soros Short pounds.
George Soros also started dumping pound sterling, causing the price of pound sterling to plummet further.
BANK OF ENGLAND wanted to save it’s currency so they bought Pounds to maintained its value by using 5-6 billion out of the Forex reserves of 19 Billion Dollars. Further Britain thought that this method was not sustainable and increased interest rates from 10% – 12% in an emergency meeting, thinking that it will attract people to invest more in Britain.
But this created an inverse effect; the people felt that this is an harbinger that the economy will fail. On the same day government again increased its interests rates from 12% – 15% just after a few hours of the initial rise. People were convinced of a collapsing economy and started withdrawing money.
Government had to finally remove ERM and reduced its interests rates back to 12%. When removed from ERM,
Pounds fell massively.
Now Soros bought those pounds.
He made the value of his Quantum finds From 15 billion to 22 Billion Dollars. He made 1 Billion Dollars for himself. He broke the BANK OF ENGLAND!!!
Kashvi Gandhi 
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