After the Second World War, European countries realized that if they had a union of some sort, they would be less likely to go to war with each other. Therefore, in 1979, they decided that they would link their currencies together at a fixed exchange rate under the Exchange Rate Mechanism (ERM). Because Germany had the strongest, countries in the ERM system agreed to fix their currencies to the Deutschmark within 6% of the agreed rate.
Although this system had benefits, one major problem was how vulnerable it made central banks. The central banks had to maintain the exchange rate by buying or selling their currencies and using their foreign reserves. The other option is to alter interest rates, but this affects the economy as a whole, which makes it extremely complicated.
In 1990, Britain joined that ERM system at an exchange rate of 2.95 Deutschmark to 1 GBP. The problem was that at the time Britain joined, they were already in a recession. Under normal circumstances, the Bank of England (BOE) would cut interest rates to stimulate the economy. But because the exchange rate was fixed, the BOE was not free to do that.
After a year and a half of joining the ERM system, GBP was trading at the lower end of the band. Traders recognized that this was not sustainable. The pound was overvalued and the only thing keeping it from dropping was the promise of the BOE to keep the rates fixed. George Soros saw an opportunity in this. He had been building a short position of GBP worth $1.5B.
On Wednesday, September 16, Soros increased his short position to $10B. Other hedge funds heard about his plan and decided that it would be a good idea to join in. When the markets opened, the pound was trading dangerously low. The BOE bought the pound using its foreign reserves, but that was not enough to contain the price drop. So, the BOE hiked interest rates by 200 bps on that same day. Despite all their efforts, they could not stop the pound’s fall. On that same day, Britain had to withdraw from the ERM system and let the pound float freely. Soros made around $1B that day, and his firm, Quantum Fund, increased in value from $15B to $19B.
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- Leena Othman
