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The date September 16, 1992, is what we refer to as Black Wednesday. It saw the Pound Sterling crash and was one of the primary reasons why the UK could not adopt the Euro. The event ultimately forced Britain out of the European Exchange Rate Mechanism. The fall of the pound created immense wealth for investors like George Soros. Some estimates say that he made $1 billion on this day. It also caused tremendous turmoil in the political landscape of Britain. The reason being that they were spending taxpayer money in a bid to keep the pound afloat.
Three hundred traders had built up a short position on the pound, leading to a depreciation of the currency. It was a requirement of the European Exchange Rate Mechanism to keep the currency at a set value. This was to ensure a stable transition towards a common currency with Europe. Black Wednesday was a major obstacle to this development. The UK government was forced to resort to several measures to prevent the pound from collapsing. First, the interest rate in Britain rose to 10%. Next, foreign currency reserves were used to purchase pounds in the markets where there was a huge sell-off. Despite these measures, the UK government was unable to prevent the pound from falling further. The pound had depreciated by a significant margin. It became difficult for the UK to continue its membership in the European Exchange Rate Mechanism.
The result of Black Wednesday was investors like George Soros amassing disproportionate wealth at the expense of the UK Treasury. That is why Soros has a reputation for breaking the Bank of England by taking a short position. Speculators against the currency built up the short position and were creating hedges to account for the falling pound. The value of these positions was so high that the intervention of the UK government was not able to turn the situation around.
Many people also believe that Germany’s central bank’s lack of involvement was one of the reasons that aggravated the sell-off. The Deutsche Bundesbank could have used Deutschmarks to purchase pounds. If they did, that might have bolstered the efforts by its counterparts in the UK. However, it did not happen. This was one of the underlying reasons that encouraged speculators to go short on the pound.
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The buildup to Black Wednesday started when the UK government followed a semi-official policy of pegging the pound. You’ll find the various events leading to the crisis below:
In 1987 the UK pegged the pound with a tolerance level.
During the late 1980s, the British currency followed a semi-official policy that allowed it to fluctuate by +/- 6% against a basket of currencies. The goal was to shadow the German economy, which saw a low inflationary environment and strong economic conditions.
In 1990 the UK committed to the Exchange Rate Mechanism policy.
While the UK was still trying to follow a system of fixed exchange rates, it was only in 1990 that the country joined the ERM. It now became mandatory for the UK to ensure that the currency remained stable. The pound at that time was one of the weakest currencies in the ERM. That’s why many thought that joining it was a major blunder.
Next were the economic developments from 1990 to 1992.
The interest rates set forth by Germany were extremely high. This was in order to contain a high inflationary environment. The US dollar had also depreciated, and this did not fare well for the UK. The goods exported by the UK became more expensive in the US market. It became tough for the UK to keep up with Germany’s efforts. Being an ERM member also meant that they could not follow a free-floating mechanism that would have made their exports cheaper.
What followed was the depreciation of the pound.
The macroeconomic environment in the UK and Europe paved the way for a weakening of the pound. Traders, like Soros, looked to exploit this condition and decided to bet against the pound. Positions worth billions of dollars were taken with speculators adding to the volatility in the currency.
Intervention by the UK government.
The treasury had already started intervening in the foreign exchange market, thereby depleting its reserves. Without much help from other members of the ERM, the effort proved futile. Black Wednesday saw the UK treasury purchase pounds in the sum of 2 billion on an hourly basis but to no avail. The sterling weakened to the extent that prompted the UK to leave the ERM.
Black Wednesday saw the fortunes of Geroge Soros rise, and he earned the reputation of being an expert forex trader. Soros believed that it was unrealistic for the pound to maintain its level when the UK joined the ERM. He believed that the pound would have to be devalued at some point in time. This prompted him to take a short position on the currency. Through his Quantum fund, Soros started selling pounds worth almost 10 billion. The involvement of other traders and speculators also helped Soros It piled on the position that favored a devaluation.
We should note that Soros did advertise his opinion openly. This helped create a panic for investors who had a long position on the currency. Those investors bought into the idea that the pound could no longer be resilient at that level. The narrative did have a basis since the UK’s macroeconomic environment did not support the existing price level for the pound sterling.
Soros started building up a position in August. As the evidence of a weak UK economy emerged, he took a leveraged position, thereby amplifying his exposure. It was unlikely that such exposure would go undetected in the hedge fund industry, and others followed suit. It was certainly a risky position to take since it was the UK government was backing the pound. However, Soros did back up his analysis. He was aware of the lack of foreign exchange reserves that the UK government had. He also predicted that other economies would not be coming to the rescue. Some estimates say that Soros made profits worth 1 billion pounds in this period.
Being a part of the ERM was difficult for many countries, and there were breaches in the group’s tolerance level. Currencies like the Italian lira were also under pressure, but investors focused mainly on the pound sterling. Rules were relaxed, and member states were allowed to pursue monetary policies of their own.
For the UK, the short-term effects were profound. Their economy entered into a recession in the first half of the decade. The housing market crashed, and so did the business environment within the UK. One of the major fallouts of Black Wednesday was the decline in popularity of the Conservative Party or Tories. The party lost several by-elections after this event. Once the party of promoting economic reforms, the financial system’s failure changed the perception of the people towards them. In 1997, they suffered a landslide defeat and were not voted into power for quite some time after.
In terms of policymaking, the UK could now tackle economic instability with a more independent mindset. It was no longer subject to the constraints outlined in the ERM. The dependency on other economies was removed, and the pound was now under a free-floating exchange rate regime. For the first few years, the economy was still in a quagmire. However, Black Wednesday did set the tone for a more robust economic reform in the longer run. Policymakers were now in a position to set interest rates based on the inflationary environment back home. It no longer needed to base its rates on the interest rate regime in Germany. The perception of the masses also changed. The pro-Euro sentiment of the Conservative Party was no longer popular with the British public.
The new policies set by the government were more suitable for the economic environment in the UK. Within the next few years, the government was able to tackle inflation. By maintaining a floating exchange rate system, the economy managed to recover. The rising unemployment rate was also brought under control. Most importantly, the UK was able to maintain an independent status that resulted in a stronger economy.
Black Wednesday also showed the world the demerits of introducing a fixed rate system of exchange rates across Europe. It paved the way for more relaxed norms across countries. It further enabled a smoother transition towards a common currency in the region. The integration of economies within Europe was made possible after the reforms introduced in Black Wednesday’s aftermath. These policies gave more leeway to weaker countries to strengthen their economies. The rule imposing a cap of +/- 6% fluctuation in the exchange rate was also relaxed to enable a fairer movement of currency rates.
For the UK, many consider Black Wednesday a blessing in disguise. Since the sovereign debt crisis hit Europe in the late 2000s, billions of dollars were pumped in to bail out the weaker economies. Without the intervention of countries like Germany, the Eurozone would have fragmented. Meanwhile, Britain managed to keep itself on the sideline without almost any economic repercussions. Had the UK adopted the Euro, it would have contributed to bailing out countries like Greece. The economy of the UK performed comparatively better during this crisis. If we consider the implications of Black Wednesday in the longer run, the benefits seem to have outweighed the costs that the Treasury bore during the crash.
The terms of the ERM may have been unreasonable. It was difficult for many countries to keep their currencies fixed. Black Wednesday damaged the Bank of England’s reputation, and the UK government had to incur losses worth billions. The loss incurred was estimated to be over 3 billion pounds (a substantial amount back in the early 1990s). The semi-fixed structure also ensured that the pound could not be devalued, which hurt the business of exports. Other weak currencies like the Italian lira and Spanish peseta had to face similar problems. These currencies were overvalued when they entered the ERM, and their struggle continued even after the UK left the group.
Some of the repercussions of Black Wednesday are visible even today. The aftermath of the event resulted in a more integrated Europe. It paved the way for the formation of the Eurozone, although some of the problems it caused continued to exist. While there was a common currency in the region, countries were tied to a single currency, restricting their ability to act independently. Exchange rates used to be a tool to control economic policies, but this was no longer viable with the Euro.
For the UK, the impact was much more short-lived. Their economy went into a recession, and inflation became an increasing problem. It took the government a lot of effort to restore growth in the economy. High-interest rates meant borrowing became expensive, and housing markets collapsed. The newly elected Conservative Party’s term went downhill after Black Wednesday. The event also raised concerns about governments’ ability to control their economies, and the reputation of George Soros increased manyfold. It also necessitated the involvement of market participants in the development of policies.
Possible? Yes. Probable? No. During Black Wednesday, there were very few controls available to the Bank of England to check the falling pound. The forex reserves that the central bank had were insufficient to ward off investors from short selling. At that time, there were no IT systems to track the activity of market participants. This enabled the short position to build up without causing much of a concern.
Building up a currency position can be a much riskier move today, especially with central banks’ increasing powers. Soros at the time used foreign funds as leverage to take a position. Such moves are easy to curb now by imposing short-term capital controls on fund inflows. The reserves that the UK government has now are substantially higher. Their economy is also in a significantly better position. The monitoring of trades has also become easier with real-time IT systems. The government can also close Forex markets if they expect a session of highly volatile trading.
We cannot completely rule out the possibility of another Black Wednesday though. There have been numerous instances in the capital markets where prices have crashed immensely, even though numerous controls have been put in place. The pound saw its value erode due to Brexit. Stock prices have plummeted as the Covid-19 pandemic gripped the globe. The Asian currency crisis also happened after Black Wednesday. It saw the collapse of many currencies in Southeast Asia.
One important factor to consider is that George Soros was able to procure enough funds to rattle the Bank of England. In today’s context, the possibility of an investor taking on a central bank is unlikely. With information spreading rapidly, such moves can be preempted even if the fluctuation in exchange rates is small.
Black Wednesday was a lesson not only for the UK but also for governments across the globe. It demonstrated how a union could fail if not held together by sound economic principles. The crisis brought forth the disadvantages of a semi-fixed system of currencies, giving constituent countries little freedom in framing their own policies. It also demonstrated the weaknesses in the UK’s financial system and how investors like Soros could exploit it to amass huge wealth.
Black Wednesday was a lesson for central banks and a demonstration of how things could go out of hand if the financial system was not controlled properly. Since then, the central banks have been more vigilant and have been more proactive in tracking financial markets’ developments. It also highlighted the need for collaboration among economies. Had Germany intervened in the foreign currency market to strengthen the pound, the scenario could have differed. The realization crept in much later, but it acted as a catalyst in developing a common currency in Europe. The biggest beneficiary, in the end, was the UK. Black Wednesday was a wake-up call that made the economy more efficient and saved the treasury billions of pounds since it backed out of the union. Soros also managed to pocket about $1 billion from the bet and notoriety as one of the top foreign exchange experts worldwide.