Exchange Rate Mechanism (ERM)

Refers to the methods for controlling a currency's exchange rate in relation to other currencies.

Author: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Reviewed By: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Last Updated:October 26, 2023

What Is an Exchange Rate Mechanism (ERM)?

ERMs, or exchange rate mechanisms, are methods for controlling a currency's exchange rate in relation to other currencies. They are a significant monetary tactic central banks employ to exert control over the economic value of a country.

Exchange rate mechanisms refer to a set of techniques governments use to manage the domestic currency's exchange rate against other currencies. ERMs are a key component of any economy's monetary policy, and central banks routinely employ them.

Maintaining tight controls over domestic currency is critical to promoting international trade. This is done by managing domestic currency in relation to international currencies traded on the foreign exchange market.

There are two types of ERMs: floating and fixed. Floating exchange rate mechanisms allow currencies to trade without any government or central bank intervention at their most extreme. 

Fixed, however, include required steps to keep rates at a specific level. ERMs that are managed fall somewhere in the middle.

Without intervention, the value of one country's currency will fluctuate naturally compared to that of another. However, these changes can be substantial or slight depending on various economic and sociopolitical factors. 

Any mechanisms put in place by a country to try to regulate these changes are called ERMs.

Exchange Rate Mechanism (ERM) History

Most currencies started on fixed ERMs, with prices tied to commodities such as gold. In fact, for around 90 years until 1976, when the U.S. government fully eliminated the peg, the U.S. dollar was, at least in some way, tied to gold prices.

The gold standard emerged as a result of the growth of fractional reserve banking as well as the development of international relations. 

In 1870, a large group of countries reached an agreement. The agreement stated they would use the gold standard to determine exchange rates.

To reduce volatility, some other countries began to peg their currencies to the U.S. dollar. This included China, the United States' largest trading partner, with this peg still partially in effect today. 

Many countries had adopted flexible mechanisms by the 1990s. However, retaining liquidity and limiting economic risks have remained the favored solution. Governments that use flexible mechanisms normally intervene to some extent, keeping exchange rates within specific ranges.

How Do Exchange Rate Mechanisms Work?

Originally, currencies were designed to track gold or other commodities and had a set exchange rate. However, central banks now use modern floating exchange rate mechanisms to influence domestic currency prices in foreign exchange markets.

Furthermore, it allows the central bank to significantly modify the currency value/peg to impact imports and exports. These changes can also attract foreign direct investment and foreign portfolio investment.

Tariffs and quotas, domestic interest rates, monetary and fiscal policy, and transitioning to a floating mechanism are the tools used to defend exchange rates. Depending on the situation, the effectiveness and reliability of various strategies can be combined.

Raising interest rates, for example, can be an efficient strategy to boost a currency's value, but it might be difficult if the economy is struggling.

Central banks can mint an endless number of domestic notes and coins. As a result, most traders generally respect the boundaries of fixed or semi-fixed mechanisms.

The exchange rate mechanism is crucial to preserve stable exchange rates and minimize market volatility. Furthermore, decreased currency volatility is essential since it improves market predictability for foreign investors.

What are Different Types of Exchange Rate Mechanisms?

Types are:

1. Fixed

A fixed exchange rate regime is one in which the value of a currency is set against the value of another currency, a basket of currencies, or a commodity like gold or silver.

A fixed exchange rate has several advantages and disadvantages. One significant advantage is that a normal fixed exchange rate does not fluctuate in response to market conditions. Improved international trade and investment are possible as a result of this. 

By restricting inflation, the fixed exchange rate system can be utilized to control currency behavior.

2. Floating or Crawling/Adjustable Peg Rate

An adjustable peg rate is a floating rate that fluctuates in response to economic factors. In most cases, the central bank will establish a range of flexibility tied to a fixed level or peg. It is then the obligation of the central bank to maintain the target exchange rate at the peg.

The Chinese central bank, which loosely pegs the Chinese yuan to the U.S. dollar, is the most famous user of the peg rate. China keeps the yuan's value low compared to the dollar. This makes its exports more appealing to foreign purchasers than similar items supplied by other countries.

Example of a Real-Life Use Case of an Exchange Rate Mechanism

A few of the examples are:

1. European Exchange Rate Mechanism

During the late 1970s, Europe's most notable exchange rate mechanism occurred. 

The European Economic Community (EEC) developed the ERM in 1979 as part of the European Monetary System (EMS) to reduce exchange rate volatility and promote stability before member countries adopted a unified currency.

It was created to prevent difficulties with price discovery by normalizing exchange rates between countries before they were integrated.

The European Economic Community (EEC) established the European exchange rate mechanism. The mechanism was developed as part of the European Monetary System to limit the exchange rate's overall fluctuation.

The ERM assists the European Union (E.U.) in maintaining the Euro's stability. Furthermore, it enables the E.U. to assess possible eurozone members based on their economic ideology/capabilities.

2. Soros and Black Wednesday

Legendary investor George Soros had built up a massive short position in the pound sterling in the months leading up to the 1992 catastrophe, Black Wednesday. This swap would become beneficial if the currency fell below the ERM's bottom band. 

Soros understood that Britain entered the pact under difficult circumstances, with a high-interest rate and shaky economic prospects. 

Soros sold off a large portion of his short position on Black Wednesday in September 1992, much to the chagrin of the Bank of England, which was fighting tooth and nail to keep the pound sterling afloat.

By the decade's end, the European exchange rate system had been decommissioned, but not before a successor had been established. 

In January 1999, the exchange rate mechanism II (ERM II) was established to ensure that exchange rate variations between the Euro and other E.U. currencies did not impair the single market's economic stability. 

It also aided non-eurozone countries in their preparations to join the eurozone.

Researched and authored by Rishav Toshniwal | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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