Modern European Exchange Rate Systems

A highly significant event that occurred in the forex market over just the past decade or so has been the unification of many of the national currencies of Europe into a single consolidated currency known as the Euro. The following sections describe in greater detail the modern european exchange rate systems. For a short description of the European Monetary Union click here.

The Bretton Woods system of fixed exchange rates provided considerable stability among the exchange rates of the major European nations in the post World War II period.

Under this system, which was implemented after the Bretton Woods conference held in 1944, these major currencies were all pegged to the U.S. Dollar. The U.S. Dollar was in turn freely convertible to gold at the fixed price of $35 per ounce.

Nevertheless, the Bretton Woods system started to unravel in 1971 after the U.S. Dollar was unilaterally removed from the Gold Standard by then-U.S. President Richard Nixon.

The Snake Arises from Bretton Woods Ashes

The first replacement for the Bretton Woods system among the European currencies is now known as the “currency snake”.

The currency snake arose out of the 1972 Basle Agreement between the European Economic Community (EEC) members and its future members. The idea behind the snake was for EEC members to keep their currencies’ values within a tight 2.25% trading band.

This allowed the European countries, their corporations and individuals to carry on trading with each other with a certain degree of exchange rate stability, which was considered highly desirable for commerce.

Initially, the snake operated in a “tunnel” against the value of U.S. Dollar, so it was known as a “snake in the tunnel” regime. However, the tunnel aspect became untenable after the Dollar was allowed to float freely in 1973.

The currency snake exchange rate regime eventually fell apart by 1977 after several shake ups left the system with little more than a few relatively minor currencies tied to the powerful German Deutsche Mark.

The European Exchange Rate Mechanism or ERM

Many of the governments in Western Europe continued to feel the need to control exchange rates among their countries’ currencies after the snake unraveled in 1977.

This prompted the formation of the European Monetary System or EMS that arose in 1979 and was based on the currency snake.

This replacement had an Exchange Rate Mechanism or ERM that allowed exchange rates among participating currencies to trade within a narrow 2.25% range above and below central parity values.

When rates went outside this 2.25% band, relevant central banks were required to intervene in the forex market and/or adjust interest rates appropriately. This process was supposed to continue until any divergence was corrected and the currency pair returned to its desired range.

The ERM came under pressure resulting in the Pound Sterling and Italian Lira being forced out of the ERM by speculation in September of 1992. A number of other European currencies came under attack the following year that included the French Franc.

Some observers attribute this pressure on the ERM to the German unification that occurred in 1990. Eventually, it led to the widening of the trading bands in the ERM to 15% in August of 1993, with the central parity levels remaining unchanged. Yet another speculative crisis in March of 1995 also damaged the credibility of the system.

Currency Consolidation and the Euro

The official European solution after the ERM’s failure was to get as many major European nations as possible to adopt a single European consolidated currency known as the Euro.

The Euro received its name in 1995, but it was not introduced for accounting purposes until the start of 1999. The Euro was first introduced into global financial markets in the form of an electronic accounting currency on the first of January in 1999, and it replaced the former European Currency Unit or ECU at equal value. Paper and coins did not start circulating until early 2002. The value of the Euro was initially set at equality with that of the ECU or European Currency Unit.

Along with the Euro, the ERM II was introduced in 1999 for countries that were unwilling or unable to become part of the Eurozone. This system has a 15% trading band above and below a central parity level tied to the value of the Euro, and countries that join the E.U. need to participate in ERM II with their national currencies for two years before joining the Eurozone.

The Euro has now replaced national currencies in sixteen countries of the European Union that together make up the Eurozone. Although the Euro has come under pressure recently as a result of the Greek sovereign debt crisis, it continues to represent an extraordinary attempt to consolidate the national currencies of what are otherwise highly divergent neighboring countries within a geographically-based trading bloc.

The Euro as a Reserve Currency

Since the inception of the Euro as an accounting currency in 1999 and as a circulating currency in 2002, a growing number of central banks around the world have begun to turn to the Euro as a replacement for the U.S. Dollar as a reserve currency.

Furthermore, citing concerns over high U.S. government spending and seemingly never-ending overseas wars, as well as the intransigent U.S. trade deficit, central banks have increasingly begun turning to the Euro as the next best reserve currency.

The Euro currently holds second place only to the U.S. Dollar as a global reserve currency, accounting for 28.1% of global currency reserves in 2009 and up from just 17.9% at the introduction of the consolidated currency in 1999.

During the same period, U.S. Dollar reserves fell from 70.9% to 61.5% of global official currency reserves.

International Trade Increases the Euro’s Influence

Countries and their central banks will often hold the currencies of their major trading partners in reserve. This has made the U.S. Dollar an especially popular choice historically due to the United States’ active status in the international trading markets.

Nevertheless, as Europe consolidates further, it becomes an increasingly influential trade partner and so a number of non-European countries with strong trade ties to Europe are considering pegging their currencies to the Euro.

Furthermore, citing concerns over high U.S. government spending and seemingly never-ending overseas wars, as well as the intransigent U.S. trade deficit, central banks have increasingly begun turning to the Euro as the next best reserve currency.

Of course, the U.S. Dollar still benefits as the primary currency in which key commodities like oil and gold are denominated. Nevertheless, certain oil-producing nations have indicated their wish to switch to selling oil in Euros.

This would very likely hurt the Dollar’s status as a reserve currency even further in favor of the Euro, and would also tend to increase the Euro’s influence on global markets.

Further reading:

Fundamental analysis theory.

Popular European Currency Nicknames.

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