black wednesday september 16th 1992 bank of england

29-Sep-10 SIIB, Pune - Batch of 2009-11 1

Lending Risk Management Term Presentation Semester Three

Batch of 2009/11 SIIB, Pune

Submitted to Mr. Sameer Jaiswal

Group 1

BLACK WEDNESDAY (SEPTEMBER 16TH 1992)

The Day the Bank of England Broke

Prologue

It is a story of how one wise man (George Soros)

outwitted Bank of England and made a profit of

$ 1 Billion in a single day (16th September 1992) at its

expense.

This cost Bank of England a whopping £3.4bn

“The man who broke Bank of England”

Agenda…

The story…

UK: 1979-late 80s.. Recession and Lawson’s Boom

UK: 1990…

Germany: 1989-92..

UK: until mid 1992..

The speculators are watching..

US $ vs Brit. Pound..

Speculator’s big idea..

The Game..

Who got what..

The Learning..

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Britain used the fixed exchange rate system

In 1979………

European Community: Hey Great Britain! Care to join the new ERM ?? Its our bid to reduce exchange rate variability and achieve monetary stability in Europe…

Britain: Naah.. I am fine. I am happy with my Fixed Exchange Rate System..

In 1979, UK’s inflation was at its peak- 27% and inefficient

industries and trade unions on rise.

In 1981 : UK govt. brought in deliberate recession to curb

inflation and inefficiencies by:

Increased interest rates

Tightening of Fiscal Policy to reduce the budget deficit.

Sticking to strict Money Supply targets

In 1985 : Unemployment was still over 2.5 million people

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1986-1989… Lawson’s Boom-an inflationary boom..

Lawson’s want for Unofficial Exchange Rate 3 DM to £1 to

prevent increase in interest rate.

Tax Cuts-consumer confidence, Aggregate Demand and

economic growth.

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In

flati

on

(1

0%

)

Late 1980s…

Gro

wth

(5

%)

Stock market crash-1987 (25%)

Housing boom (300%)

In 1990…

Britain decides to join ERM in a bid to

o Keep inflation low

o Provide stability for exporters encouraging trade

Under the powerful political influences of Lawson, ex-

chancellor; John Major, Chancellor and Douglas Hurd,

Foreign Secretary.

The Pound Sterling entered the market at

1 Pound: 2.95 Deutshe Mark

(This rate was despite that British inflation levels that were three times higher than that of Germany)

Consequently, Britain changes to semi-fixed exchange rate system with fluctuation band of ± 6%

Interest rates had to be set at a level consistent with keeping sterling within the agreed ERM bands (limits)

Elsewhere (Germany) Until mid-1992…

Printing more money

Inte

rest

Rate

Inflation

Participatory countries (like UK) in the ERM forced to raise interest rates to maintain the pegged currency exchange rate..

Rate hike led to severe repercussions in the UK

Large Mortgages

Inte

rest

Rate

Unaffordable mortgages

Defa

ult R

ate

In UK until mid 1992…

Economic situation was declining quickly. The UK was sliding

into recession.

High inflation and deteriorating economic activity was making

the Pound less attractive.

Therefore, the Pound kept falling to its lower limit in the

ERM.

With weak economy and high unemployment rate, maintaining high interest rates was not sustainable for U.K.

in the long term.

Hmmm… seems like time to make some quick bucks

!!

Forex speculators naturally picked this up, and anticipated an

eventual devaluation of the British pound against the Deutshe Mark

or exit from ERM

To add to the fortunate/unfortunate events…

In September 1992 the dollar was rapidly depreciating

against the deutschmark.

Tied as it was to the ERM, the pound was hence

appreciating to unsustainable levels against the US

currency.

With a large proportion of British exports priced in

dollars, a pound/dollar correction was well overdue….

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The Big Idea..

Contract debts for the pounds (GBP), and to sell them

for the Deutschemarks (DM), and invest them in the

German assets..

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1st to 16th of Sept 1992…

Speculators intensified the game and sold billions of Pounds hoping to buy them back at

a depreciated rate hence pocket the difference.

George Soros

Bank had only one strategy:

Defend the peg system whenever the rate gets below or hits

lower peg.

Speculators had two strategies :

Strategy 1 : Always attack after bank's defence

Strategy 2 : Attack even if bank has not

defended and exchange rate is above 3DM

September 16th 1992… Day Time.. An desperate attempt….

15 % 12 % 10 % In

tere

st

Rate

The intervention had little or no effect.

Government authorized expenditure of £27 billion to buy back the pounds that were being

frantically sold.

September 16th 1992…Evening… 19:00 Hrs

We hereby exit from ERM and will use free floating Pound sterling.

Interest rates however will remain at 12 %.

George Soros a HAPPY man!!

He made a $1bn profit at Britain's expense.

For UK…. Black Wednesday:: A white Wednesday???

Things turned out better than expected. The pound fell 15% versus the Deutschemark and by 25% versus the US dollar within 5 weeks ,but then rose again. And inflation rather benign.

The ERM helped set a low-inflation foundation for the subsequent decade, however the ERM did prolong the British slump, by preventing UK rates from being cut to the levels justified by the UK economy.

UK became a bit more sceptical about hitching itself to external currency systems.

Pro-and anti-euro campaigners agree the ERM was a mistake

LEARNINGS…..

The traders continued relentlessly shorting the Pound

despite government measures because they knew that at

the end of the day market forces would prevail.

Once these forces push a currency one way it is almost

impossible to intervene via central bank mechanisms,

government directives or otherwise

Black Wednesday reminds us of two things:

The size and power of the Foreign exchange markets

The amounts of money that can be made by well

capitalised, well informed, and pro risk traders.

Risk Associated-Endogenous Risk

Endogenous risk here is with regard to the policy

rule/regime set up by regulatory authorities that end up

causing the instability and risk that they were meant to

avert…

Failed Government Policy

If the UK had joined the ERM at a high level at the start of the boom, the anti inflationary impact would have helped moderate the boom, keep inflation low and prevent a painful readjustment.

But, they joined at the wrong rate at the wrong time.

Trying to keep the Pound artificially high caused a recession, deeper than any of their competitors.

The artificially high exchange rate just attracted financial speculators who saw the British government as a source of easy profit.

“Today, the currency market Forex is far more liquid

than at the beginning of the 90ies. Therefore, no

investor, even having a billion capital, will hardly be

able to influence on the currency rate for a long time.

“Black Wednesday” of September, 1992 is left far

behind, but the historic facts should not be ignored,

because the history has a tendency to recur”

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THANK YOU