The European Exchange Rate Mechanism (or ERM) was a system introduced by the European Community in March 1979, as part of the European Monetary System (EMS), to reduce euro foreign exchange variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union and the introduction of a single currency, the euro, which took place on 1 January 1999.
The ERM is based on the concept of fixed currency exchange rate margins, but with euro foreign exchange variable within those margins. Before the introduction of the euro, euro foreign exchange was based on the ECU, the European unit of account, whose value was determined as a weighted average of the participating currencies and euro pound exchange rate appeared.
A grid (known as the Parity Grid) of bilateral rates was calculated on the basis of the euro foreign exchange expressed in ECUs, and currency fluctuations had to be contained within a margin of 2.25% on either side of the bilateral rates (with the exception of the Italian lira, which was allowed a margin of 6%). Determined intervention and loan arrangements protected the participating currencies from greater exchange rates fluctuations.
Ireland's participation in ERM resulted in the Irish pound breaking parity with the Pound Sterling in 1979 as very shortly after the launch of the ERM the Pound Sterling, not at the time an ERM currency, appreciated against all ERM currencies and continued parity would have taken the Irish pound outside of its agreed band.
In 1990, the United Kingdom participated but was forced to exit the programme after the Pound Sterling came under major pressure from currency speculators led by George Soros. The ensuing crash of 16 September 1992, was subsequently dubbed "Black Wednesday". In 1993, the margin had to be expanded to 15% to accommodate monetary problems with the Italian lira and the Pound Sterling. On December 31, 1998, the ECU exchanges rates of the Eurozone countries were frozen and the value of the euro, which then superseded the ECU on a 1:1 basis, was thus established.
In 1999, ERM II replaced the original ERM. The Greek and Danish currencies were part of the system, but as Greece joined the euro in 2001, the Danish krone was left as the only participant member. Currencies in ERM II are allowed to float within a range of ±15% with respect to a central rate against the euro. In the case of the krone, the Danish Central Bank keeps the exchange rate within the narrower range of ± 2.25% against the central rate of EUR 1 = DKK 7.460 38.
As of 1 May 2004, the ten National Central Banks (NCBs) of the new member countries became party to the ERM II Central Bank Agreement. The national currencies themselves will become part of the ERM II at different dates, as mutually agreed.
The Estonian kroon, Lithuanian litas, and Slovenian tolar were included in the ERM II on 28 June 2004; the Cypriot pound, the Latvian lat and the Maltese lira on 2 May 2005; the Slovak koruna on 25 November 2005. The currencies of the three largest countries which joined the European Union on 1 May 2004 (the Polish zloty, the Czech koruna, and the Hungarian forint) are expected to follow eventually.
EU countries that have not adopted the euro must participate for at least two years in the ERM II before joining the Eurozone.