Shortly after his arrival in Paris (late in 1992), Geoffrey Harrington was faced with a problem. He had recently joined the financial management staff of his company's French subsidiary. Glancing at a memo that he had just received from the subsidiary's manager, Pierre Le Cheffe, he reflected that it was proving tough to gain the confidence of the management of the subsidiary. They were naturally suspicious of a young British newcomer, even a graduate of le business school, INSEAD.

Perhaps, he thought, this memo will give me a chance to prove the value of a B-school education. But what can I tell Le Cheffe? He reread the memo carefully:

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TO:	Geoffrey Harrington
FROM:	M. Le Cheffe

According to the financial press, Italy's weak export performance, high inflation and dwindling reserves are leading people to believe that Italy might demand a realignment -- in other words, break out of the European "snake" limits and allow the lira to devalue. Could this happen under the rules of the European Monetary System? What are Italy's alternatives?

I would value your opinion of the possible consequences of this for our affiliate in Milan. In particular, could you give me a concise assessment of the effect of such an event on

(a) cost and prices, and the outlook for sales; and
(b) interest rates, including the prospects for monetary policy following the exchange rate change.

If its any help to you, I have attached a table showing Italy's position in the EMS and some interest rates in the European Community countries. I note that Italy's is the weakest currency, except for the pound, which (like Portugal) is presently permitted a 6% movement against any other currency. Italy's maximum move is 2¼%.

Exhibit I. The European Monetary System

	Ecu Central Rates	Currency Amounts vs. Ecu, Sep 14	% Change from Central Rate	% Spread Vs. Weakest Currency	Divergence Indicator	Official Interest Rates	Euro-currency Interest Rates
Portuguese Escudo Spanish Peseta Belgian Franc German mark Dutch Guilder Irish Punt French Franc Danish Krone Italian Lira Sterling	178.735 133.631 42.4032 2.05586 2.31643 0.76742 6.89509 7.84195 1538.24 0.69690	173.588 129.992 42.0440 2.04111 2.30134 0.76742 6.89298 7.85106 1541.57 0.71820	-2.88 -2.72 -0.85 -0.72 -0.65 -0.14 -0.03 0.12 0.22 3.06	6.11 5.94 3.94 3.80 3.73 3.20 3.09 2.94 2.83 0.00	47 46 28 29 19 -5 -13 -17 -23 -60	- - 8.5 8.75 8.5 - 10.25 9.5 13.75 -	- 13 3/8 9 7/8 9 7/8 9 11/16 - 10 3/8 11 15 1/8 10 7/16

Ecu central rates were set by the European Community at the time of the last EMS realignment. Currencies listed in decending strength. Percentage changes from central rate are for Ecu: a positive change denotes a weak currency. Divergence shows the percentage difference between two spreads: the % change of the actual market rate form the Ecu central rate, and the maximum percentage deviation of the currency's market rate from its Ecu central rate. Bank rate refers to central bank discount rate, where quoted. Eurocurrency rates are offered rates in the interbank market.

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What would your answer be?

(After you've tried to answer this, check out the suggested solution.)

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Adapted from Cases in International Finance, Second Edition by Ian Giddy and Gunter Dufey (Addison-Wesley, 1994)

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Ian H. Giddy, Professor of Finance New York University Salomon Center • Stern School of Business 44 West 4th Street, New York 10012 Tel 212 998-0704 • Fax 212 995-4220

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Go to Giddy's Web Portal • Contact Ian Giddy at ian.giddy@nyu.edu