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Unit 2: International Monetary System

2.3.1 Exchange Rate Mechanism (ERM) Notes

It refers to the procedure by which the EMS member countries collectively manage their exchange
rates. The ERM is based on a ‘parity grid mechanism’ that places an upper and lower limit on the
possible exchange rates between each pair of member currencies. In a parity grid mechanism
each country is obliged to intervene whenever its exchange rate reaches the upper or lower limit
against any other currency. The parity grid system, in the ERM, is in the form of a matrix
showing for each pair of currencies the par value in addition to the highest and lowest permitted
exchange rates. Thus there are specified bilateral exchange rates among all member countries
which, in fact, constitutes a grid. Each currency is then allowed to fluctuate 2¼ per cent above and
below the par rates. Each currency has hence got three exchange rates: the par value, an upper
limit and a lower limit. If an exchange rate is at either limit, ‘indicators of divergence’ are
encountered that mandate bilateral actions for the maintenance of the central rates by both the
countries.
The ERM has, thus, got three features – (1) A bilateral responsibility for the maintenance of
exchange rates (2) Availability of additional support mechanism that helps in maintaining the
parities; (3) If the currencies irretrievably diverge from parity a last resort or safety valve of
agreed upon realignments.

Example: If the Spanish peseta was at its lower support point vis-a-vis the German
mark, the Spanish authorities were required to buy Spanish peseta and the German authorities
were also supposed to sell marks. The fact that the Germans were also required to sell marks
made the ERM fundamentally different from the Bretton Woods System. In the Bretton Woods
System only one country had to undergo painful measures while the other country was not
required to cooperate.

2.3.2 European Currency Unit (ECU)

The ECU is a “basket” currency based on a weighted average of the currencies of member
countries of the European Union. The weights are based on each country’s relative size of GNP
and on each members’ share of intra-European Union trade. The ECU’s value varies over time as
the members currencies float jointly with respect to the US dollar and other non member
currencies. The ECU serves as the accounting unit of the EMS and helps in the working of the
exchange rate mechanism. In fact, the ECU since Jan 1, 1999 has evolved into the common
currency of the European union and is called the ‘Euro’.
Two kinds of mechanism were energised in the EMS. One mechanism was based on the parity
grid while the other was in terms of a divergence indicator defined with reference to the ECU.
In the divergence indicator mechanism, each country’s central rate against the ECU is determined
and the permissible margins of variations around this are specified. When the rate moves
outside these margins, the onus of adjustment is on the country concerned. For example, if the
German mark appreciates against all other currencies, it would also appreciate against the ECU
since the ECU is a basket of all the member countries. When the mark moves beyond the upper
limit, Germany will have to intervene and take appropriate action or explain to other EMS
members why it should not. Only as a last resort were par values realigned, although this
happened on several occasions.

2.3.3 European Monetary Cooperation Fund (EMCF)

Like the IMF, the EMS has its own institutional set up for monetary cooperation. Member
countries extend credit to each other for the purpose of carrying out exchange market intervention

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