THE EUROPEAN COMMUNITY'S 'SNAKE IN THE TUNNEL'

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85T00875R001700040021-3
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 14
• Document Creation Date: December 20, 2016
• Document Release Date: March 30, 2006
• Sequence Number: 21
• Publication Date: September 1, 1972
• Content Type: IM

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Confidential
DIRECTORATE OF'
INTELLIGENCE
Intelligence Memorandum
International Finance series
The European Community's "Snake in the Tunnel "
r Confidential
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~. ~ . ; ' ER IM 72-138
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CIA
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CENTRAL INTELLIGENCE AGENCY
Directorate of Intelligence
September 1972
INTELLIGENCE MEMORANDUM
TIIE EUROPEAN CUMii~1UNITY'S "SNAKE IN THE TUNNEL"
Summary and Conclusions
A. In an effort to rad;ice the role of the dollar within the European
Community (LC) and strengthen EC ties, EC members agreed in March
1972 to reduce the maximum deviation between EC currencies from 4.5%
to 2.25%. Unlike the procedures for central bank ir..tervention to support
the exchange rate limits under the Smithsonian agreement (tlie tunnel),
which involves only purchase and gale of dollars, the EC exchange rate
limits (tne snake) are maintained through transactions in EC currencies.
One of the objects of this agreement was to end the dollar's advantage
derived from its use as an intervention currency. The EC governments also
hoped that the new narrow band would reduce the impact of currency
disturbances on intra-regional trade relations and the operation of the
Common Agricultural Policy (CAP).
B. The system operated sr.~oothly when initially implemented on
24 April 1972, and no EC central bank intervention was necessary to
mai;tain the EC's 2.25% band until rumors of a possible sterling devaluation
in June 1972 led to a large speculative outflow from London. Despite heavy
central bank intervention by the United Kingdom, Germs-ny, and France
in the period 15-22 June, the British were forced to float the pou~-d
unilaterally on 23 June. The Italian lira then became the weak EC currency,
and Rome wished to withdraw from the scheme also. After considerable
intra-EC discussions, ~; was decided to maintain the 2.25% band, brit Italy
was granted an exception to the provision requiring that int%rventiori
obligations be repayed in the same proportion as a country', reserves.
C. The pound crisis reinforced the feeling of critics that the EC band
could be maintained only in a calm market and that F :;change crises are
probably magnified by the scheme. Pith narrower bands, weak currency
Note: This memorandum was prepared by the Office of Economic Research
and coordinated within the Directorate of Intelligence.
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countries are probably more inclined to bow to market pressures by
devaluing or floating because the potential gain for speculators is increased,
the flexibility central banks have Uefore intervention is required is reduced,
and intervention obligations have to Ue repayed in the same r~roportion
as the weak currency country's reserves.
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CON rIPEI~,'TIAL,
I. In March 1972 the finance ministers of the European Comnuuii:y
(EC) agreed to intervene in EC foreign exchange markets in order to keep
the dollar rates of their currencies within 2.25% of one another. This
coml?arcs with a 4.5?Io spread allowed by the December Smithsonian
agreemen*.. The EC sees this action as a first stem toward monetary
integration. This memorandwn examines the 4greement, describes the
system's operation, anr} :;onsiders the implications of the narrow band for
the international molteta~y system.
2. The EC's growing economic interdependence leas ;nc:eased the
need for Community-wi~1e coordination of exchange rate and incomes
policies. Witli the elimination of intra-EC tariffs and the implementation
of the Common Agricultural Policy (CAP), changes in exchange rates and
in national ecolomic policies have a more pronounced effect both on
members' trade balances and on the distribution of CAP costs and benefits.
The 1968 exchange crisis and the subsequent franc devaluation slid deutsche
mark appreciation lead a much greater impact on trade flows between France
and Germany than on French and German trade flows generally. Moreover,
Paris alid Bonn felt compelled, because of the parity realignment, to
introduce special border taxes and subsidies for agricultural products so
that the prices politically powerful German farmers received would not fall
in domestic currency terms, and the p~?ices that French farmers received
would not rise and further fuel French inflation.
3. At the Hague summit meeting in Decembel? 1969 it was agreed
i7 principle that the EC should :~ecome a monetary and economic w~ion.
The decision on the specific foul that this union would take was delayed,
however, by a basic disagreement between France and Germany over the
priority to be giveli monetary as opposed to economic union. Underlying
this were differences over the extent to which national economic policy
would be subject to review or coordination by Community institiltions.
4. The "monetarists" and "economists" finally compromised and in
October 1970 agreed to a second Werner Plan (named for the Luxembourg
delegate) providing for complete monetary and economic union by 1980.
The :.ompromise, however, spelled out only the first stage of
implementation. During the three-year first phase the maximum deviation
among EC currencies relative to their par value with the dollar was to be
reduced from 1.5% to 1.2%. The maximum swing would consequently be
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reduced from 3% to 2.4?~?.~ The need for economic coordination was also
explicitly recognized and the scheme would terminate if concrete progress
toward economic union was qot evident by 1975.
5. The currency crisis which began in early May 1971 prevented
the SEC from implementing the narrower bands on 15 June, as originally
intended. In the face of extremely heavy speculative capital inflows, West
German authorities unilaterally closed their foreign exchange market on
5 May and the Bundesbank withdrew its support for~the dollar. Although
the l;C Council on 9 May authorized the actions already taken by Bonn
and the subsequent currency floats by Brussels (in respect to capital
transactions) and the Hague, it was unable to agree on a progr~~m -- Stich
as a common float against the dollar -which would permit the Werner
Plan to be implemented. With the suspension of dollar convertibility on
15 August, EC attention was directed toward reaching agreement on
appropriate new parities, both within the EC and with the United States.
The Snake in the Tunnel
ti. The Et' r?Plieved that tangible progress toward monetary and
economic union was both necessary and possible once the currency crisis
had been resolved. A major provision of the December Smithsonian
agreement widened a currency's permissible band of fluctuation around its
central dollar rate from the previous 1.5?Jo to 4.5% - 2.25?,o above and
below the new central rate - (see Table 1). This wide bandy implemented
to allow currencies io better withstand speculative pressure, allowed the
cross rate between any two currencies other than the dollar to vary by
as much as 9%. The new 9?lo range of possible fluctuation between two
EC currencies, the EC thought, would disturb intra-regional trade relations
and further complicate CAP operations.
7. The EC members also believed that progress toward monetary
and economic union would be an important political gesture that would
strengthen the EC in negotiations with the United States on international
monetary reform and would reduce dependence on the US dollar both as
a transactions currency and as a reserve asset. In particular, the members
"` Under the system then existing, any Community currancy, such as the German
mark, could be at its dollar ceiling (G.75% above its dollar par value), while another
Community currency, such as the French franc, was at its dollar Hoar. [n this case
the deviation between the two currencies would be 1.5%. If conditions changed and
their positions were reversed, the mark would fall 1.5?Io, relative to the dollar, and the
franc would appreciate 1.5?S. The total swing in the value of the mark relative to the
franc, the variation in their cross rates, would thus be 3%. Under the Werner Plan the
deviation among EC currencies would be limited to 1.2?~? and their total swing would
consequently be limited to 2.4?!?.
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,summary of Currency Bands
Old dollar band
1.5
Smithsonian dollar band -- the "Tunnel"
4.5
EC band -- the "make"
2.25
Benelux band
1.5
Inter-country currency fluctuation ranges
Maximum Suing:
Range
Between the US dollar and an~~ other
~
currency
4.5
Between two currencies nc-t
ipating in the EC system
partic-
9.0
Between one EC currency and another
currency outside the EC
9.0
Between two EC currencies (except
Belgium and the Netherlands)
4.5
Between Belgium and the Netherlands
3.0
wished to end she discrimination m favor of the dollar that resuliec: from
the reduced exchange risk associated with dollar transactions (the
fluctuation of any currency relative to the dollar was limited to 4.5"/x) and
from the dollar's use as an intervention currency.
8. In March 1972 the CC again agreed to imple~aent thc; first phase
of a revised Werner Plan by limiting tae maximum deviation be+ween any
two EC currencies, initially '.0 2.25%, and eventually to perhaps 1.Si~. The
maximum swing between any two EC currencies was consequently reduced
from 9% to 4.5~%, or to the same sw:no permitted between any EC currency
and the dollar. Provision was also made for discussions on short-term
economic policy coordination and fora possible Community support fund.
The fund would be a partial pooling of Central Bank reeerves for the
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CONFIDENTIAL
purpose, in part, of supporting EC currencies within the EC. The plan went
into effect on `l4 April. Apparently reassured by the prevailing cahn in
tl~e exchange markets, the United Kingdom, Ireland, and Denmark joined
the scheme effective 2 May while Norway, the remaining EC applicant,
joined on 23 May.
9. Under the March agreement, EC central banks are committed to
maintain both the 4.5% Smithsonian band -the "tunnel" -- and the EC
band -the "snake." The Benelux countries, in a special arrangement, agreed
to maintain a narrower 1.5% band (sometimes called the "worm") for their
currencies.
10. The mechanics of intervention to support the EC agreement (tl:e
snake) differ from these to support the Smithsonian commitment (the
tunnel). Wt-ien an EC currency is at the floor of the Smithsonian twinel,
the central bank sells dollars or other reserve assets in exchange for its
ow,~ currency; when it is at the ceiling, the bank uses its own currency
to purchase dollars. But when intervention is required to keep EC currencies
wi?hin the 2.25% band, only the countries with the strongest and weakest
currencies enter the market, and they do so in EC currencies, not in dollars.
The EC country or countries whose currency is at the floor of the EC
band, or snake, sells the strong EC currency (which may have been acquired
by drawing on interbank swap lines) in exchange for its own currency;
the Community's strong country or countries uses its currency to purchase
the weak currency. Intervention thus lakes place only in the strongest
and weakest EC currencies; dollars are not us;,d in intervention.
11. In time of crisis, EC central banks are in constant contact through
a special "hot line." Intervention, how;;ver, is automatic. Tl~e EC central
banks have no discretion and intervene in the spot market to whatever
extent necessary when, and only when, the spread between any two E~
currencies widens to more than 2.25%.
12. The weak currency country loses reserves regardless of liow the
intervention is undertaken. If it intervenes directly, there is an immediate
reserve loss equal to file amount of strong currency used in the intervention,
including any strong currency reserves borrowed for that purpose. If the
~':rong currency country intervenes, the weak carte :cy country's reserve
loss is delayed until it must subsequently repurchase its currency from the
strong currency country. The elan provi~les that repurchase and repayment
of any borrowing takes place at the end of the month fallowing the
intervention. ~'he repurchase or repayment. i:, made in gold, dollars, EC
currencies, Special Drawing Rights, etc. i;i the same proportion as the weak
currency country's reserv~:s. Table 2 shows the composition of the
individual members' reserves as of June 1972.
CONFLD~~~.
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a. ~om~nunity applicant.
b. Data are for March 1972.
Experience
13. From 24 April until- the pound crisis in ~`: ne 1972, no EC central
bank intervention was required to introduce or maintain the EC's 2.25/
band. Because of a general mist' ust of th.e dollar, all the EC currencies
were grouped in the upper region of the dollar band (see the chart). For
the first month of oreration the French commercial franc* w, as at the top
of both the snake and the tunnel and the Italian lira was at the bottom
of the snake, hovering around its dollar central rate. In May the Belgian
* The French (as well as tltc Belgians) continueri to maintain their two-tier system
with separate mar;cets for trade and financial transactions. The financial franc was trading
at more than a 5% premium, relative to its dollar central rate.
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"The Snake in the Tunnel," i97Z
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24 April
23 June
agreement
British pound floated-
implamented
UK drops out
of the snake agreement
British
Pound
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French
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franc moved to the top of bath the EC ar,3 dollar bands, and the pounc!
replaced the lira at the bottom of the EC band, as the inflow of tourist
dollars into Italy buoyed that currency. Although no intervention was
necessary to maintain the EC's 2.25% band, the French did intervene in
May to prevent the franc from rising more than 2.2510 above its dollar
central rate.
14. The first test of the Werner Pls>> came in mid-June, when rumors
of a possible sterling devaluation led to a large speculative capital outflow
from London. On 15 June, sterling fell below it~~ dollar central rate, arrd,
with the French franc at its dollar ceiling, intervention was required to
maintain the EC's band. Because EC rules call for intervention only in EC
foreign exchange markets, the spr;;ad between sterling and the franc actually
exceeded the 2.251? band on 15 June in subseque;nt trading in New York.
In the period from 15 June to 22 June, about t1S $2.5 billion in sterling
are believed to have been purchased by the Bank of England and EC central
banks in an unsuccessful effort to maintain the 2.,25?,o band. The Germans
are believed to have taken in about $1 billion, and the French about $500
million. Finally, on 23 June, the British unilaterally floated the pound.
15. Following the pound float and the withdrawal of Denmark and
Ireland from the arrangement, the Italian lira was the weakest EC currency
and came under heavy speculative pressure. Rome wished to withdraw from
the scheme, but after considerable intra-EC discussion it was decided to
maintain the EC's 2.25% band. However, the Italians were allowed to repay
their intervention obligations in dollars. This proved to be a minor
concession. as total intervention on behalf of tl~e lira is believed to have
been less than $200 million. By August, both Rome and London had repaid
their intervention obligations.
16. Only modest additional central bank intervention has been
required since the pound float to maintain the EC's 2.25% band. Substa~rtial
intervention has been required, however, particularly in the period
immediately after the pound float, to prevent EC currencies from rising
more than 2.25% above their dollar central rates. The Belgians have also
recently been forced to intervene to maintain the 1.51? band for the Benelux
currencies.
Implications and Problems
17. The pound crisis reinforced the feeling of critics that the EC band
could be maintained only in a calm market. Although the pound was not
believed to be substantially overvalued, comparatively heavy intervention
was nevertheless required and the pound was eventual.'y forced to float.
Three members (tne United Kingdom, Denmark, ai;d Ireland) dropped out
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of the arrangement as a consequence of the crisis, and a major modification
was required to prevent Italy from withdrawing also.
18. Exchange crises are probably magnified by the EC's narrow band.
In the absence of the narrow band, speculators stand to gain only from
the change in the weak currency's exchange rate relative to the dollar --
the intervention currency. Under the EC's currency agreement, however,
the speculator stands to gain from both a weak currency's devaluation
relative to the dollar and from the subsequent apprecia~ion of other EC
currencies relative to the dollar. In the pou,~d crisis, for example, the pound,
once freed from its central rate, depre~ gated 3.7?~o relative to the dollar
in the period 23-28 June, while the French and Belgian francs, now freed
from the depressing influence of the pound, appreciated 1.3% relative to
the dollar. Speculators consequently stood to gain 5.0% rather that 3.7~%.
19. The agreement probably makes the governments of weak currency
countries more inclined to bow to exchange market pressures by devaluing
or floating. Because of the EC's 2.25% band, `he weak currency country
is unable to take full advantage of the v.ider dollar band when another
EC currency is above its dollar central rate. In the pound crisis, for example,
the strength of the other currencies participating in the monetary agreement
reduced the Bank of England's potential cushion by eliminating an
additional 2% in possible downward exchange rate adjustment before central
bank intervention was required.
20. The need to repay intervention obligations in the same proportion
as the weak currency country's reserves, including gold and SDRs, probably
further inhibits a country from defending its exchange rate. As demonstrated
by the exception that Italy was granted after the sterling float, the
proportionality feature is quite unattractive tc the debtor countries under
present conditions of dollar glut. The obligation to use gild in repayment
has also increased the pressures to increase the price of gold, at least for
monetary transactions within the EC, with the official gold price, $38 per
ounce, far below the free market price. The French leave s~~ggested that
gold be valued at $70 per ounce for intra-EC official settlements, but this
was not supported by the other EC members.
21. Strengthening the currency agreement i~: order to effectively deter
speculation will probably require both an increase in the amount of reserves
available for EC intervention and increased capital controls. Existing EC
inter-bank "swap lines" and standby credits are believed to total about $3.5
billion. Individual members' holdings of other EC currencies are relatively
small. These "swap lines" and holdings are likely to prove inadequate,
without additional controls on intra-EC capital movements, if the realism
of a particular EC exchange rate comesv~to serious questi~:i.
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CON1~ II)I;N'TIA~,
Pros ects
22. The future of the EC cr.rr?rency agreement is unclear. Its political
importance probably assures its continued existence in some torn;, but not
its success. The scheme failed to weather its first test intact, and the
exception granted to Italy has been prolonged and may be extended to
other co~~ntries, in part, to facilitate UIC reentry into tha arrangement.
Despite these early difficulties, tltc members are nevertheless considering
narrowing the EC band further, perhaps to 1.5%.
23. The EC is likely to try to strengthen the currency arrangement
at the EC Council meeting at the end of October. The Council is expected
to ratify at that time the recent agreement in principle to establish a
European monetary cooperation fund. Managed by the Central Sank
Governors' Conunittee under the general supervision of the Council, the
fund will coordinate EC central bank intervention to maintain the 2.25%
Uand as well as provide short-term foreign exchange credits. The agreement
also provides for a broader use of a European unit of account, a proxy
for the dollar now used exclusively under the CAP. Although the agreement
makes it appear that tfte EC is ahead of the schedule suggested in the Werner
Plan, it will not significantly change the existing systcrn.
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