Black Wednesday.
16 September 1992 is the day when speculators single-handedly broke the British pound. This costed the government and the taxpayers £3.3 billion dollars and threw the entire British financial system into chaos. Amidst the chaos with the British pound one man made 1 Billion pounds while taking advantage of this event. Some say he was the catalyst to this event. That man was George Soros.
Basics of Currencies and currency trading.
The most basic factor that influences the value of a currency like most assets and commodities is demand and supply. The higher the demand for a particular currency, the greater the value and vice versa. When there’s an excess supply of a particular currency while demand is unchanged, makes the currency less valuable.
Other factors that influence the value of a currency are inflation rates, interest rates, geopolitical conditions, government debt and etc. But the most important factor is the interest rate in the country. A higher interest rate for a country compared to other countries makes that country’s currency more valuable. This works the other way as well.
Currencies are usually traded in pairs. For example, USD and INR. If you expect the value of a currency to drop you would short sell that currency to profit off the drop in value. Let’s say we’re trading the currency pair USD and INR where the rate for $1 is ₹50. If we expect the value of INR to drop we would borrow rupees and sell it in a currency market and purchase dollars [under the assumption that the value of USD does not change]. When a currency’s value falls the rate will increase this simply implies it takes more of that particular currency to purchase another due to it being less valuable. Let’s say the value did fall and now the rate for $1 is ₹70 we will now buy back rupees to make a profit. The process of making a betting against an asset [expecting a reduction in its value’] is called shorting. All the speculators who took part in black Wednesday to break the British pound were shorting the British pound.
Events prior to Black Wednesday.
Two years before Black Wednesday the UK entered the European Exchange Rate Mechanism [ERM]. This was before the Euro came into existence and many countries did not want to give up on their native currencies. Hence, they entered into the ERM. The objective of the ERM was to fix the exchange rate for all the countries under the European Union [EU] artificially. This meant that the central banks of the member countries had to intervene and fix the price according to the guidelines issued by the EU. If the value of their currency was falling the banks will use their foreign reserves to buy it. If the value was increasing they would then sell the currency to bring it back to the fixed rate. This concept in itself was incredibly flawed due to many reasons. The buying and selling of various currencies by different entities had an effect of the prices and along with this a country would have to balance its inflation rate, interest rate, economic growth rate and other factors to keep the currency in like with the EU’s guidelines.
The previous government of UK were aware of these factors and did not want to enter the ERM. The following government however, entered into the ERM and the timing of the entry was not seen as optimal since the UK was going through a recession at that particular period and the inflation rate was 3 times more than the inflation rate of Germany whose currency [Deutsche Mark(DEM)] set the benchmark for the ERM. Due to the effects of the recession the exchange rates were very close to the lower bounds of the agreement. The central bank also had no power to cut interest rates to help improve the economy since this would force them under the bounds of the ERM. Many people including various economists and speculators noted this to be unsustainable and expected the UK to leave the ERM and devalue its currency.
The pound short.
Many speculators and currency traders knew a currency devaluation was going to come soon which makes this event more or less a self-fulfilling prophecy. Many currency traders including George Soros began building a large short position against the Pound. He did this by borrowing extremely large amounts of Pounds from various institutions. Helmut Schlesinger the president of the central bank of Germany in an interview stated that some currencies in the ERM may come under pressure some took this as a direct reference to the Pound which made this interview a direct catalyst to Black Wednesday. The night before 16 September 1992 Soros began shorting the Pound [The currency pair used was GBP and DEM]. Close to £10 billion was sold in the open market that night. The central bank of the UK tried using their forex reserves to buy pounds but it did not make a dent since most speculators were shorting the pound which overwhelmed the central bank. The UK then raised interest rates twice in a day from its base rate of 10% to 12% and from 12% to 15% which was devastating to the economy since it was already going through a recession. The central bank had purchased around £27 Billion but it could not contain the rate since most of the currency markets had been shorting the pound. Later that day, the UK accepted defeat and was forced to withdraw from the ERM. The following day the Pound fell by 15% against DEM and 25% against USD. Through this short Soros through his hedge fund [Quantum Fund] made around £1 Billion.
Since the UK left the ERM the central bank was once again able to control interest rates. This enabled the UK’s economy to recover and some see the events of Black Wednesday as a positive since it helped the economy recover and prevent the many problems that it would have encountered if it was a part of the ERM leaving its mechanisms unusable.