Bank on alert after ERM shake-up

THE BANK of England is standing ready to defend the pound this morning in the wake of last night's devaluation of the Italian lira and Germany's announcement that it is to cut interest rates today.

The realignment of currencies within the exchange rate mechanism, which saw the value of the Italian currency lowered by 7 per cent, still leaves financial markets facing a nervous week in the run-up to Sunday's referendum in France on the Maastricht treaty.

The key question was whether last night's developments would be sufficient to steady the markets and re-assert the authority of the ERM or whether the lira would need to be devalued further and whether the pound would still come under attack from currency speculators, forcing John Major and his Chancellor, Norman Lamont, to follow suit and either devalue sterling or raise UK interest rates.

Economists and foreign exchange dealers were mixed in their interpretation of the developments. On the one hand Germany's decision to cut rates and Britain's commitment to maintain the pound at its central rate against the mark of DM2.95 were seen as positive steps by some.

Gavyn Davies, chief economist at Goldman Sachs, the US investment bank, said: 'The Bundesbank is clearly trying to help the French government ahead of next Sunday's referendum. But if they make a significant cut in interest rates today pressures on sterling could ease markedly for quite a while.'

David Simmonds, currency analyst at Midland Montagu, said: 'This is very favourable news for sterling. There was a fear that the pound would be swept along if the lira was devalued and that there would be a general realignment in which sterling would also be devalued.

'The markets will wait to see the extent of the German interest rate cut but I wouldn't be surprised if there are concerted cuts throughout Europe in its aftermath.'

However, Bill Martin, chief economist at UBS Philips & Drew, said: 'The devaluation of then lire is a dramatic reminder of the impermanence of fixed exchange rate systems.

'The finance ministers were saying only last weekend that there would be no realignment, and yet there has been one already, even before the French referendum.'

Peter Fellner of Natwest Capital Markets said: 'It has opened a Pandora's box, because officialdom said it wouldn't happen. The markets may worry that this adjustment is not sufficient, so sterling may still come under more pressure.'

He added that the foreign exchange markets would probably wait for the outcome of the French referendum before making a final judgement.

The French result is still evenly balanced, with the last public opinion polls suggesting that the vote could go either way. This is likely to be a cause for continuing concern in international capital markets nothwithstanding last night's dramatic intervention to steady the ERM.

Currency dealers will be looking for evidence that the large proportion of 'don't knows' among the French electorate are making up their minds how to vote. Although the publication of opinion polls is banned in France between now and Sunday, international banks and financial institutions have ordered their own surveys in an attempt to predict the result. Midland Montagu alone is conducting two polls this week.

Alan Davies, UK economist at Barclays Bank, said: 'The lira is a basket case, and if you exempt that, I think it's possible to get away with this action without damaging the system. If the Germans are saying (by lowering interest rates) that above all else they will not risk the durability of a fixed rate exchange system, that they are prepared to support that system, the auguries for the erm are great, whatever the result of the French referendum.'

The one thing most economists seemed to agree on was that Mr Lamont would have no leeway to cut UK interest rates.

Indeed, defending the pound against a serious speculative attack could involve a rise in interest rates of 2 percentage points or more to convince the markets that the Government is serious about avoiding devaluation. This would push the economy deeper into recession and could trigger a wave of mortgage rate increases from banks and building societies.

The pound avoided serious selling pressure last week, but every day slipped a little nearer to its floor of DM2.7780, closing on Friday at DM2.7847, barely two thirds of a pfennig from the floor.