5. – German spending increases German inflation rates increase British inflation levels still three times higher than that of Germany US Dollar rapidly depreciates – many UK exports priced in USD UK and Italy have double deficits Interest rates at 15%, “Lawson Boom” about to bust
8. Traders’ Assumptions Currency must revert to ERM boundaries Britain is reluctant to raise interest rates Interest rates UP – currency rates UP Currency rates UP – equity prices DOWN Currency rates UP – bond prices UP
9. Soros’ Positions SHORT British Currency – 7bn SHORT Italian Currency LONG British Equities – 500m LONG German Currency – 6bn LONG German and French Bonds SHORT German and French Equities
10. UK Treasury Response Raising interest rates to 10% - 12% - 15% Spent £27B of foreign reserves in propping up (buying) the pound
11. £3.4 BILLION Estimated total cost of Black Wednesday [1997] £800 MILLION Estimated Black Wednesday trading losses [1997]
12.
13. Aftermath Conservative Party blamed for crisis; loses 1997 election, Prime Minister John Major succeeded by Tony Blair UK leaves ERM Italy and Spain widen ERM bands ECU replaced by euro in 1998 ERM-II established in 1999
Editor's Notes
TRAVERS’ INSTRUCTIONS: “In particular, all of these crises were caused by a shock of illiquidity in a derivatives market (or several), as opposed to insolvency. I would like you to summarise the lead-up to the crisis, what caused the meltdown, and what the resulting impact was on the markets. For example, if a trading firm (Soros, LTCM, Enron) were to blame, explain what types of trades they had on that led to the market instabilities. You are welcome to include an explanation of a trading strategy that we have not yet covered in class, if relevent to your story.”
ERM, the Exchange Rate Mechanism, was effectively the precursor to the European single currency, the euro.It was a mechanism which required member countries to keep their national currencies, like the pound, within defined and fairly narrow levels against each other.Bands were set 2.5%-6% apart from a central line/entry point; when the fx rate hit those bands, the banks would intervenethe key perceived advantage was that it avoided wide fluctuations in currencies in value against each other. + precusor to euro If you’ve got wide movements in exchange rates it is difficult for people engaged in international trade. Keeping exchange rates more closely aligned was a way of getting round that difficulty.
Breakdown of ECU component countriesEmphasise huge share of Germany and France; Germany, for the most part, set the pace for the ERMMark the most stable- all currencies pegged against it
East+WestRich, big economy + small, poor economyDeficit as % of GDP 5%-13.2%West German Savings transferred to East Germany; East Germany consumesEast German Mark was converted to the West Mark at a huge rate 1.8:1 (before that, pegged to 1) – far exceeding its value; East German economic shutdown, more DMBurdesbank pumps money in, inflation – interest rates go up 3%Money away from GBP to invest in DMUnemployment at 10%+WorstRecession since WWIILess german money – less germans buy UK things, GBP fallsAbsolute aoppreciatonopfamrkHigher interest artesIf GBP falls with no ERM, less absolute money outflow;
George Soros, famous for winning $980 mil+ on falling GBP for his hedge fund; a third was his shareAlso, major banks that won out
Sample BB chart, showing the ERM breakdown in action
Review of currency/equity/bond price relationships
Not a hedge strategy – all trades flow from same assumption (GBP devaluation)
Aftermath - effects
Three graphs:Negative effectsPie chart – foreign reserves used upFirst bar chart – severe currency devaluationPositive effectsSecond bar charts – UK shows amazing GDP growth despite ERM crisis