The Black Wednesday of 1992 refers to the momentous day when the British Pound was under attack by currency speculators. This day created history in the Foreign Exchange markets because of the fact that the Pound was considered to be one of the strongest fiat currencies in the world. In fact it was the reserve currency of the world before the dollar took over. Hence the notion that the British pound could be under attack from speculators in the foreign market was dismissed as being mere conspiracy theory without any substance.
Also, Black Wednesday was unprecedented in the fact that this was the day when open markets took on a powerful central bank with virtually unlimited access to money and the power to create more money if required and won! In this article, we will describe the events that lead to the Black Wednesday in detail.
England Joins European Exchange Rate Mechanism
The European Exchange Rate Mechanism was an exchange rate mechanism for European currencies which chose to be a part of the group. The idea was to reduce the variability of exchange rates between the European currencies. Hence, the European Exchange Rate Mechanism proposed that the currencies should be allowed to float freely. However, the range in which they float should be pre-decided. Thus, the European Exchange Rate Mechanism was a sort of a semi-pegged mechanism.
The rate of the British pound would be allowed to change in value relative to the German Deutschemark. However, this variability will only be allowed up to a certain extent. If the market took the rates beyond a given threshold, then the Central Banks would swing into action with their open market operations and ensure that the exchange rate is maintained as desired.
However, the problem was that England joined the European Exchange Rate Mechanism at an overvalued rate. This decision was taken by England unilaterally despite oppositions from German central bankers. Therefore, from the moment England joined the mechanism, there was a possibility that they could be under attack. However, the Prime Minister of England was more focused on bringing down inflation and hence continued to join the European Exchange Rate Mechanism at a higher rate despite several warnings!
Unification of Germany
The problem began in 1992 when West Germany united with East Germany. East Germany was less prosperous and therefore the cost of the unification was too high. The German economy as a whole suffered and inflation started running amok in Germany as well. To prevent this, the German central bankers changed their monetary policy.
What the Germans did was no different than what any other central banker would have done. One of the foremost responses to rising inflation is to raise interest rates. However, the problem was that the Deutschemark had become the base currency for European Exchange Rate Mechanism. All currency rates were semi-pegged to the mark. Hence by raising its own interest rates, Germany had fixed its own problem. However, it ended up creating massive problems for other member countries.
Fall of the Lira
The first casualty of the German interest rate rise was the Italian Lira. Like the British Pound, the Lira was also overvalued. The Italian economy was in dire straits and the Italian Central Bank was desperately taking action to preserve the value of the Lira. The German Bundesbank was also required to assist Germany in this market action as per the European Exchange Rate Mechanism agreement. The German central bank did help the Italians for a while. However, when it started affecting their domestic operations, the Germans gave up sending a very dangerous signal to the speculators in the market. The speculators now knew that the Bundesbank was only co-operating with other members to a certain extent and beyond that the members were on their own.
Attack on the Sterling
The markets as well as the British had pre-empted an attack on the British pound after the lira. It is for this reason that the British government officials were regularly in talks with Bundesbank officials asking them to lower interest rates. However, the Bundesbank officials did not respond to British pleas.
Speculators who were observing these developments began buying the Deutshemark and selling the Pound in the market. This widened the exchange rate gap between the two currencies. The British Central Bank began to intervene in the market. They were buying all the currency that was being sold by speculators and as a result maintaining the prices. However, the speed at which the market was selling pounds quickly left the Forex reserves of the Bank of England depleted. As a result, the Bank had to admit defeat. It had to exit the European Exchange Rate Mechanism and lower the value of the pound!
Thus, a bunch of speculators had forced the mighty Bank of England into admitting defeat. The pound fell much below the lower threshold of the European Exchange Rate Mechanism as it continued to free float after the attack. George Soros was one speculator who gained a lot of fame after the attack on the British Pound. “Quantum fund” i.e. the hedge fund managed by George Soros ended up making upwards of 1 billion dollars in profit from the fall of the British pound. Also, his influence over the currency markets was ascertained and he came to be known as the “man who broke the Bank of England”