What it means
Before the EMS, exchange rates between European currencies moved widely, which made trade and investment across borders harder to plan. A business that agreed a price in a foreign currency could find its profit wiped out by the time it was paid.
The EMS was designed to reduce that uncertainty. Its central mechanism was the Exchange Rate Mechanism, or ERM.
Each participating currency had a central rate, and it was allowed to move only within a set band around that rate. When a currency drifted towards the edge of its band, the central banks involved were expected to intervene by buying or selling currency, or by changing interest rates.
The system also introduced the European Currency Unit, or ECU, a basket currency made up of a weighted mix of member currencies. The ECU served as a reference point for the ERM and as an accounting unit, and it was a forerunner of the euro.
Countries that wanted to take part had to follow disciplined economic policies to keep their currencies aligned. The EMS was tested during the early 1990s, when several currencies came under heavy selling pressure and some countries left the mechanism.
This episode showed how hard it is to defend a fixed exchange rate when markets doubt it. Eventually the EMS was succeeded by Economic and Monetary Union and the introduction of the euro, with a later arrangement known as ERM II for countries preparing to join.
For a finance professional, the EMS is mostly a lesson in how exchange rate regimes work and why they sometimes fail. It also helps explain why the euro was created.
When you see EMS in a different context, always check whether it refers to electronic manufacturing services, emergency medical services or another meaning.
In practice
Real-world examples.
Example
A German machinery exporter signs a contract to sell equipment to a customer in another member country, payable in six months. Because the EMS keeps the exchange rate within a narrow band, the exporter can estimate its revenue with more confidence. It uses a modest hedge rather than an expensive full cover.
Example
A treasury analyst at a multinational reviews the history of the ERM to understand why a currency suddenly lost value. She learns that when markets doubted the central rate, selling pressure forced a devaluation. She uses the lesson to stress test the company's exposure to managed currencies.
Example
A finance professor builds a case on the ECU basket to teach how a composite currency is weighted. Students calculate how a change in one member currency changes the value of the basket. They see how a small economy's currency can matter less than a large economy's currency.
Formula
Calculation
Upper limit = Central rate x (1 + band percentage); Lower limit = Central rate x (1 - band percentage)
Suppose a currency had a central rate of 2.00 units per ECU and a permitted band of 2.25% either side. The upper limit is 2.00 x 1.0225 = 2.045 units. The lower limit is 2.00 x 0.9775 = 1.955 units. The currency could trade anywhere between 1.955 and 2.045 before central banks were expected to step in, a total range of 0.09 units.Case study
Seen in the real world.
Northgate Wines is a fictional importer used here as an illustration. In the early years of a managed exchange rate system, it bought wine from a supplier in a neighbouring country and paid in the supplier's currency. Because the currency was held within a narrow band, the importer's finance manager could set price lists for the full year with only a small safety margin.
When the system came under strain and the currency was allowed to move more widely, the importer's costs rose by around 8% in a few weeks. The company learned to hedge and to review its pricing more often, rather than relying on a central bank to hold the exchange rate. This is an illustrative story with invented figures.
Watch out
Common mistakes.
- Treating EMS as the same thing as the euro, when it was an earlier system that helped lead to the euro.
- Assuming a managed exchange rate removes all currency risk, when the band can be widened or abandoned.
- Reading EMS in a document without checking whether it means European Monetary System, electronic manufacturing services or something else.
Questions
People also ask.
What did the ECU do?
It acted as a basket currency and reference unit for the ERM, and it was replaced by the euro on a one-for-one basis.
Does the EMS still exist?
No, it was succeeded by Economic and Monetary Union, although ERM II continues to link some currencies to the euro.
Why did some countries leave the mechanism?
They could not defend their exchange rates against market pressure without interest rates or policies that were too costly at home.
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