Breaking the Bank of England: The Coming of George Soros
Stanley Druckenmiller, Chief Investment Officer, Soros Fund Management
Robert Johnson, Currency Expert, Soros Fund Management
Sir John Major, British Prime Minister
Norman Lamont, British Finance Minister
Helmut Schlesinger, President – Bundesbank
The European Exchange Rate Mechanism (ERM) was introduced as part of the European Monetary System to reduce exchange rate variability and achieve monetary stability in Europe and pave the way for the introduction of a common European currency we know today as the euro. In Oct 1990, Britain joined the ERM on the prodding of Sir John Major. The Pound was begged to the Deutsche Mark (DM) at 2.95DM per GBP, with a permitted limit of 2.778 DM per GBP. Thus, if the GBP ever feel to the bottom end of the range, the Government and HM’s Treasury along with the Bank of England would be forced to intervene by buying GBP.
Since 1979, the system worked well stabilizing currency fluctuations. The Bundesbank, Germany’s central bank, prided itself on its determination on fighting inflation. The unification of Germany created inflationary pressures, and the Bundesbank responded by raising interest rates. However, the other European economies were experiencing a recession, and their central banks responded by lowering interest rates. This combination led to a profitable ‘carry trade’ where money could be borrowed in Italy or England, converted to DM in Germany to earn a higher interest rate. The currency risk was effectively mitigated since currency rates were virtually guaranteed by the Governments. This pushed the Italian lira and the British pound, to the bottom of the permitted band.
From the Soros Fund offices in 7th Avenue, Druckenmiller observed this drama unfold with fascination. He knew that when the Bank of England raised rates, homeowners with mortgages would be specially pinched, and this would be extremely unpopular, especially during a recession. He felt that the British would rather devalue the pound than raise their own rates. At the same time, it was virtually unlikely for the Bundesbank to reduce its own rates to ebb the money flow into DM. He quickly shorted about 1.5 billion$ of the sterling, a small trade for the likes of Soros.
This was indeed a great trade. If devalued, the pound could fall by as much as 10-20%, bringing in a windfall profit. The currency was highly liquid, and it was easy to build or exit positions. Further, the chance of the trade going against Soros was very limited, so even if it didn’t work out, the loss would be limited. Like all currency trades, this could be leveraged, allowing Soros to take a huge position by putting in very little of his own money.
On 4 September 1992, central bank officials of various European nations met in the picturesque town of Bath, a few hours from London. Schlesinger was pressed to reduce interest rates in Germany, but in a speech on 8 September, rather than make a calming policy statement, he went on to declare that he could make ‘no guarantees’ about the future course of interest rates. Sitting in the audience, Soros realized that Germany would never accept a monetary union at any price, and would not trade its anti-inflation stance for the welfare of its neighbours. He had found his trigger.
The Big Short
Following Schlesinger’s speech, a wave of short selling spread across European currencies. Smart traders, armed with a globally connected network of computers, pressed into action, armed with the deadly combination of cash and leverage. The same day, the Finnish markka fell almost 15%, while the Italian lira was broken by the weekend, forcing it into devaluation.
Johnson told Soros and Druckenmiller than the Bank of England held about $44 billion in reserves, the maximum amount they could use to defend the sterling. Soros knew that that number could be overwhelmed by the force of global money, but the conditions had to be just right.
Following Italy’s devaluation, the Bundesbank had agreed to a rate cut of 25 bps, helping prop up the sterling pound. Further, Britain had announced it was borrowing a further $14 billion to expand its ability to defend the sterling. Soros was amused, Quantum alone was ready to sell short $15 billion; he felt, rightly as proved in hindsight, the amount wouldn’t do England much good.
Coming off the weekend, the Bank of England spent a few hundred million dollars supporting the sterling, and the currency rose, albeit slightly. But for men like Soros, battle-hardened heroes of trading floors, this minor loss was actually a sign of a greater movement: it emboldened them by signifying that their positions could move against them only slightly.
On Tuesday evening, the pound had taken a beating while Schlesinger went on to say that a ‘broad alignment’ of Europe’s currencies was better than a narrow adjustment of the lira. In the political world of euphemisms, this was as good as saying that the British pound should be expelled out of the ERM. Schlesinger’s office was bomarded with calls from HM Treasury office, but there would be no denials or clarifications issued till the morning.
In 888 Seventh Avenue New York, Druckenmiller read Schlesinger’s comment, without caring less if they were ‘authorised’ or not. He told Soros that now was the time to move in, and asked to build his position gradually. Soros, a man not averse to betting the farm, asked Druckenmiller to go for the jugular right then.
Through the night, Soros and Druckenmiller personally manned the phones, clamouring to sell sterling to anybody who will buy. At 11 am on Wednesday, Britain announced an interest rate increase of a full 200 bps, an unprecedented move. To Lamont’s frustration, the price line on the trading screen did not move with the announcement. In fact, it did not move at all, like the inactive heartbeat of a dead patient. The sky was falling, and it was costing Britain hundreds of millions of dollars by the hour. At 7:30 pm, in the Treasury’s central courtyard, the avalanche had crashed in and Lamont announced Britain’s exit from the ERM.
Britain had spent $27 billion defending its currency, and after the exit, the pound fell around 14% against the DM, effectively costing the taxpayers $3.8 billion. On the other side, Bruce Kovner and Paul Jones cleaned up hundreds of millions of dollars, but Druckenmiller and Soros went home with a $1 billion payoff. It was the first billion dollar trade, and it would be remembered forever as ‘Black Wednesday’. George Soros had arrived.
Today, the power of financial markets is unprecedented. They can correct Government actions, forcing leaders to change policies to market realities. They work 24X7 across the globe, unlimited by geography, reach or working hours. They are the ‘Masters of the Universe’, they are Adam Smith’s ‘invisible hand’. The same trade followed in East Asia in 1997-98, crashing the Indonesian rupiah, Thailand bath, Malaysian ringgit etc. When D. Subbarao, the RBI governor was confronted with a falling Indian rupee, he did not intervene aggressively, even as it fell from INR 44 to USD to 57, rightly learning from the fall of heroes past.