City fears devaluation or 2% rate rise is imminent: Prime Minister cancels Seville visit as pound dives on French referendum fears

THE THREAT of a sharp rise in interest rates hangs over millions of home owners and businesses today after the pound plunged to new lows in the exchange rate mechanism (ERM) yesterday.

Some City economists fear the Government will have to raise interest rates by at least 2 percentage points or be forced within days to announce the first formal devaluation of the pound for 25 years.

'We are staring a base rate rise in the face', said Nigel Richardson, economist at Warburg Securities.

The Prime Minister cancelled his intended trip today to Expo '92 in Seville, which the Labour Party seized on as 'an admission that the economy is in a grave state'. No 10 painted the move as a postponement because of Mr Major's domestic commitments and heavy workload.

Rumours in the financial markets that John Major and the Chancellor, Norman Lamont, had gone for discussions at the Bank of England were denied by the authorities, as were rumours of an emergency Cabinet meeting to agree an interest rate rise.

But the Bank did intervene in the currency markets during the day. It bought sterling to prevent the slide in the pound getting out of control, but made no serious attempt to prevent it falling below a particular level.

The pound fell throughout the day as international investors and currency market speculators fled from sterling into the German mark as they contemplated the prospect of a 'no' vote in Sunday's French referendum on the Maastricht treaty.

But economists said the pound was also falling for more fundamental reasons. 'The intellectual justification for some dealers is that the British economy will not recover with a central ERM rate of DM2.95 and high interest rates,' said David Simmonds, of Midland Montagu. The continued depressed state of the economy was reflected in official figures showing that factory gate prices rose at their slowest rate in more than 24 years in the 12 months to August.

The pound was trading at DM2.78 by late afternoon, just one-fifth of a pfennig above its ERM floor. Some dealers reported the pound hitting its floor, although there was no mandatory central bank buying of sterling at DM2.7780.

The pound ended the day at DM2.7842. The 2.95 pfennig fall on the day almost completely wiped out Monday's gains in the wake of the German interest rate cut and the 7 per cent devaluation of the Italian lira. The fall in the pound triggered a sharp decline on the stock market, which accelerated as the day wore on. Nearly pounds 10bn was wiped off the value of London shares by the close, reversing Monday's rise. The FT-SE index of 100 leading company shares closed 52.1 points lower at 2,370.

The markets were rife with rumours of a base rate increase as London trading ended. The key market interest rate, which tracks City base rate predictions, rose sharply and is already assuming an increase of at least half a point from the base rate of 10 per cent.

'This looks like the beginning of the end', said Keith Skeoch, chief economist at James Capel. 'The authorities have made tactical errors all along the way. They have said they will do whatever is necessary to defend the pound, but we are still waiting.'

He added that the Government would have to consider at least a one-point rise in base rates today or 'we are in real danger of a devaluation'.

But some economists were worried that a base rate rise could be counter-productive. 'Once they start raising rates, they are on the slippery road to disaster. Any rate rise is not going to be enough. A half or one per cent will merely cause the markets to look for more,' said Giles Keating, of Credit Suisse First Boston.

The renewal of tensions in the exchange rate mechanism began in Paris with rumours that a further 8 per cent devaluation of the Italian lira was planned if the French voted 'no' to Maastricht on Sunday. The lira dropped sharply, with the pound following suit on reports that the Bundesbank had argued last weekend for sterling to be devalued with the Italian currency.

The Italian and Spanish central banks both intervened to support their currencies against the mark, although the French franc was relatively calm.

Most of the mark buying came from elsewhere in Europe, but the dollar still fell just over a third of a pfennig to DM1.4840. The pound dropped by just over a cent and a half against the US currency to dollars 1.8765.

Adding to the Government's woes, the cancellation of Mr Major's Seville trip also prompted speculation about growing conflict between ministers over public spending.

Mr Lamont's new public spending committee - aimed at cutting pounds 14bn of extra bids for next year to hold public spending back to its planned pounds 244.5bn total - meets this week, with Michael Howard, Secretary of State for the Environment, already locked in a battle for extra cash to ease in the council tax, but with the Treasury trying to insist that any spending increases must be offset by cuts in other departments.

Letters, page 24

Interference denied, page 26

Commentary, page 27

Stock market report, page 29