How does European Exchange Rate Mechanism (ERM II) work?
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The European Exchange Rate Mechanism is a system of related monetary policies across Europe that are designed to keep the exchange rates between different European currencies in line with each other. This makes the exchange rate easily predictable, thus facilitating easier trade between different economies in Europe. This is important for countries that are in the EU but have opted out of the euro such as Denmark or countries planning to join the eurozone relatively soon like Bulgaria. How it works is that the central banks of Denmark and Bulgaria are required to use monetary policies to keep the value of their currency relative to the euro within a certain range, or band. If the value of their domestic currency relative to the euro falls too low, they have to implement deflationary monetary policy to strengthen their currency. Likewise, if their domestic currency gets too valuable relative to the euro, they have to implement inflationary monetary policy to weaken their currency.
At the moment only Denmark and Bulgaria are part of ERM II.
The Danish kroner has been in the ERM since 1999, has a central rate of 7.46038 and a fluctuation band of ±2.25%.
This means that 1€ has to buy you somewhere between 7.29252 and 7.62823 Danish krone.
The Bulgarian lev has been in the ERM since 2020, with a central rate of 1.95583 and a fluctuation band of 15% (the standard one).
This means that 1€ has to buy you between 1.66245 and 2.24920 lev.
The best way to see how this works in practice is by looking at when it failed. Notably with the British pound on 16 September 1992 (or “[Black Wednesday](https://en.wikipedia.org/wiki/Black_Wednesday)”). The UK was in the ERM at the time, and the rate that was fixed in 1990 was £1 = 2.90 Deutsche Mark (the West German currency at the time), with a 6% fluctuation rate. In particular, the pound could not go below 2.773 DM.
Unfortunately European economies weren’t in a great place by 1992; West Germany had reunified with East Germany, and had introduced high interest rates to counteract inflation. The UK and Italy hadn’t done so to match, so their currencies were getting worth less against the DM (due to higher inflation), and the UK was in a pretty bad place in general. On international exchange markets the pound started dropping low, and that encouraged certain investors to take “short” positions against the pound (basically borrowing a load of £s in DM, selling them at low prices, in the hopes that they could then buy them back at even lower prices later and return them, making a profit).
The UK Government’s way of countering this was to promise to buy £s being sold for less than 2.773 DM. If someone tried to sell £1 for less than 2.773 DM, the UK Government would buy it, in order to keep the price artificially high.
On 15 September 1992 the President of the German Federal Bank made some comments (which he thought were off the record) about how he thought the various currencies needed realigning, and the next morning currency traders started selling off huge chunks of pounds, at low values, which the UK Government was required to buy.
It was basically a game of chicken. The UK Government insisted it would stay in the ERM, which meant it had to buy up £s no matter how cheaply people were selling them. The sellers were selling their £s at low prices in the hopes that the UK Government would give up, devalue the £, and then they could buy back their £s for even less than they were selling them and make a profit.
By 10.30am the Government increased their base interest rate from 10% to 12% to try to discourage this, and later to 15%. It didn’t work. At 7pm the Government gave up, announcing that the UK would leave the ERM and the pound would be devalued.
Overall the UK Government ended up spending over £3bn (about £7bn today) to keep the UK in the ERM, with various currency traders picking up a lot of that (notably George Soros, who made over $1bn by short-selling pounds). It also contributed to the downfall of the Conservative Government at the time.
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