History of the EuroTrader Homework: A History of the Euro - Part 1. Photo: dydcheung (Flickr). https://creativecommons.org/licenses/by/2.0/

Trader Homework: A History of the Euro (Part 1)

Our Trader Homework series provides key trading theory, history and analysis for traders to swot up on in their spare time. Following his excellent history of the British Pound (click to read it below), FX Trader Yvan Berthoux now follows that up with a detailed overview on the history of the Euro and Eurozone.

Trader Homework: A History of the British Pound (Part 1)

As with his history on the British Pound, Yvan's analysis of the Euro is split in two parts. The first focuses on the most important events and treaties that led to the adoption of the single currency. In the second part, he explains the trends and reversals of the single currency vis-à-vis the US Dollar in addition to stating what were the main drivers of the currency pair, before concluding with the current state of the currency.

Introduction

The Euro is part of the G3 currencies (with the Yen and the US Dollar) and is the second most traded currency with a daily average of 1,591 Billion Dollars according to BIS report on FX volumes in April 2016. If the Foreign Exchange market’s daily volume equals roughly 5 trillion USD, then the Euro’s percentage share of average daily turnover stands at 31% approximately, far below the USD Dollar and its 89%. Note that two currencies are involved in each transaction, therefore the sum of all the percentage share of individual currencies totals 200%.

PART I. The political face of the Euro

Even though the Euro came into existence on January 1st 1999, currencies of countries in the European Union (under the Exchange Rate Mechanism that we will see later on) were not allowed to float freely against each other between the early 1970s (end of Bretton Woods) and the Euro inception day (1999). Hence, it is hard to believe that European Leaders will let the currency down by accepting a country to leave the Euro Zone (i.e. Greece or Italy) for the main reason that it has been a political project for more than 60 years.

Although it would take me more than a lifetime to precisely study step-by-step the creation of European Union after WWII, this part will only focus on a few important political events that will be useful for a FX history research.

A. Introduction: Post WWII ‘cluster’

So the first international organisation to unify six Continental European countries after WWII was called the European Coal and Steel Community (ECSC) and was established in 1951 by the Treaty of Paris (signed by France, Belgium, West Germany, Italy, the Netherlands and Luxembourg).

In 1958, the Treaty of Rome came into place (signed by the same six countries in March 1957) and created the European Economic Community (ECC). It still remains one of the most important Treaties of the EU history; in short, it proposed the progressive reduction of customs duties, the establishment of customs union and the creation of a single market for goods, labour, services and capital.

Alongside the ECC, the European Atomic Energy Community was established by the Euratom Treaty, with the purpose of creating a specialist market for nuclear power in Europe in addition to energy development and distribution.

As you can see it on the ‘history map’ (Picture 1), between 1958 and the early 1970s, the European Union was ‘represented’ by three Communities (ECC, ECSC and Euratom), which eventually merged in 1967 (Brussels Treaty) to form a single institutional structure.

map of the European Treaties

Picture 1. History map of the European Treaties and Communities (Source: Wikipedia). CLICK TO ENLARGE

Until the early 1970s (end of Bretton Woods: 1971 – 1973), all the six countries were part of the Bretton Woods system, therefore there wasn’t any ‘action’ in the FX market then. You can see below at which rate the currencies were pegged to the US Dollar (table 1).

Exchange Rates versus the US Dollar during the three Communities

Table 1. Exchange Rates versus the US Dollar during the three Communities (Source: Bloomberg)

B. The 1970s: after the Nixon Shock.

The Nixon announcement – convertibility suspension of USD into gold – on August 15th 1971 was followed by the Smithsonian Agreements signed by the Group of Ten (or G-10) in December 1971.

In short, the countries accepted a US Dollar devaluation of roughly 8% against Gold (from $35 to $38 an ounce), wider trading bands of 2.25% (vs. 1% before) and some agreed to sharply appreciate their currency against the US Dollar (JPY + 16.9%, DEM and GBP +13.6%, FRF +8.6% and ITL +7.5%).

This agreement’s objective was to devalue the US Dollar in the time when the US was running negative balance of payments and important deficits as a consequence of the Vietnam War and the Great Society program (launched by President Johnson in the mid-60s, the aim was the elimination of poverty and radical justice).

However, under these new restrictions, the snake in the tunnel was adopted in attempt to limit fluctuations between EEC currencies. As a reminder, during the Smithsonian Agreement, EEC currencies were allowed to trade within a 2.25% band against the US Dollar. This means that if the Italian Lira started suddenly to depreciate from the low of its band to the high of its band, this would result in a total 4.5% depreciation against the US Dollar.

On the other hand, if the Deutsche Mark started to appreciate from the high to the low of its band, this would result in a total 4.5% appreciation. Therefore, if both happened simultaneously, the Deutsche Mark would appreciate by 9% against the Italian Lira. The Basel agreement (April 10th 1972) judged that the movement was too excessive and set a maximum change of 4.5% between two EEC currencies as well.

Even though it bought the US some time to regain some competiveness in the market after the Agreement, the US Dollar continued to fall dramatically in the 1970s (as a response to inflation rising from the two oil shocks) and countries were forced to quit the currency snake. For instance, the British Pound, which joined the snake in May 1972, left it a couple of months later. Italy left the snake in January 1973, followed by France in 1974 and again in 1976 after joining back.

By 1977, the currency snake became a ‘Deutsche Mark zone’ with four trackers: Belgium and Luxembourg Francs, the Dutch guilder and the Danish Krone (that joined the EEC on January 1st with Ireland and United Kingdom).

As we can see, depriving currencies to fluctuate freely between each other under the Currency Snake was a failure in the 1970s, but it didn’t stop the ECC officials to continue to work on a European Monetary System.

C. 1979: The European Monetary System

In March 1979, with the adoption of the European Monetary System (EMS) under the Jenkins European Commission, all nations of the EEC (Except United Kingdom) agreed to link their currencies under the Exchange Rate Mechanism in order to prevent large fluctuations and achieve monetary stability across in Europe. Picture 2 shows the historical exchange rate regimes for European Countries since 1979:

Exchange-rate regimes for EU members

Picture 2: Exchange-rate regimes for EU members starting 1979 (Source: Wikipedia). CLICK TO ENLARGE

  • The colour Grey represents members of the ERM (currency pegs to ECU)
  • The colour Blue represents the members of the Euro Zone ( 19 countries)
  • The colour Yellow represents countries members of the European Union, but outside of the ERM. For instance, Croatia joined the EU in 2013 but still has a ‘floating’ exchange rate (though it looks like the Croatian Monetary Authority has been trying to set the exchange rate at 7.6 HRK against the Euro with a trading band of roughly 2%)
  • The colour Green represents members of the EU, outside the ERM but with a currency pegged to the Euro (i.e. Bulgarian Lev BGN is set at 1.96 per unit of EUR)

Under the EMS arrangement, the European Currency Unit (ECU) – a basket of the currencies of the European Community members – was defined and used as the unit of account before becoming the Euro in 1999. Even though no currencies was designated as an anchor, the Deutsche Market (along with the Bundesbank) became the centre of the EMS very quickly (DEM had other 30% of currency weigh to the ECU between 1979 and 1999, followed by France with 20%).

Therefore, in the 1980s, the DEM, the GBP and the USD became three main currencies traded by market participants (an interesting documentary about currency trading called ‘Billion Dollar Day’ was produced by the BBC in 1985 and looks at one day – 24 hours – of FX trading).

As you can see it in picture 2, two countries had to withdraw from the ERM due to economic policies divergence and speculative: Italy withdrew from ERM on September 17th 1992 after a 7-percent devaluation 4 days earlier (re-entered in Q4 1996) and the UK withdrew from ERM on September 17th 1992 after Black Wednesday a day earlier (and never re-entered).

In addition, broad margins were also increase to 15% in August 1993 to allow currencies to accommodate speculation against other currencies (French Franc in 1992-1993).

D. The Maastricht Treaty

Before switching to Euro’s birth and the single currency potential drivers, another important Treaty signed on February 7th 1992 was the Maastricht Treaty, which created the European Union and led the creation of the Euro. It set the convergence criteria for a country to qualify for participation in EMU, which are the following ones:

  • Inflation within 1.5 percent of the best three countries of the EU for at least one year
  • Nominal long-term interest rates are required to be within 2% points of the best three in the EU for at least a year
  • Applicants countries have to be in the ‘narrow’ band of the ERM-II without tensions (and depreciation) for at least two years
  • Fiscal discipline: a budget deficit to GDP ratio of nor more than 3 percent and government debt-to-GDP ratio of no more than 60%

The treaty entered into force on November 1st 1993 and has been amended by the treaties of Amsterdam, Nice and Lisbon since then.

Stay tuned for PART II: Study of trends, reversals and main drivers of the single currency since Inception.

Yvan Berthoux is an FX Trader based in London. You can read more of his analysis at yvanberthoux.wordpress.com