Pound faces toughest test after EC bows to markets: German interest rate to fall as lira is devalued in ERM rescue

THE CREDIBILITY of John Major's commitment to defend the pound faces its severest test this morning after European Community governments yesterday caved in to pressure from the foreign currency markets to agree a 7 per cent devaluation of the Italian lira.

The Bundesbank also agreed to cut German interest rates to relieve pressure on the exchange rate mechanism (ERM). The move was welcomed across Europe as heralding the prospect of lower rates in other countries.

The Bank of England and the Treasury are hoping that the German rate cut will prevent a speculative attack on the pound, by making it more attractive relative to the German mark. But some City economists were fearful last night that sterling could come under irresistible pressure to follow the lira downwards in the ERM.

Severe pressure on the pound could force an increase of 2 percentage points or more in British interest rates to prop up the currency. That would push the economy deeper into recession and threaten higher mortgage rates for millions of homeowners.

Norman Lamont, the Chancellor, said last night that he was determined to resist any pressure for the pound to be devalued. 'The UK government has repeatedly made clear that there is no question of any change in the central parity of the pound against the German mark,' he said. The pound fell every day last week and closed on Friday less than a pfennig above its ERM floor.

City economists were divided on the likely impact of yesterday's moves. 'This could have a domino effect which could lead to the breakup of the system. Sterling could still come under pressure as the next weak link in the system,' said Bill Martin, economist at the City firm UBS Phillips and Drew. But David Simmonds, of Midland Montagu, said: 'This is very favourable news for sterling.'

The US dollar rose more than 5 pfennigs against the mark in early trade in Sydney and Tokyo today, with dealers waiting anxiously to discover the size of the German rate cut.

Yesterday's move was made at the instigation of the German authorities, said Giulio Amato, the Italian Prime Minister. 'In the last few days of last week, the German government had contacts aimed at appreciating the value of the mark and a cut in German interest rates and we thought this an extremely important signal,' Mr Amato said on Italian television.

The Bundesbank and the Italian and Belgian central banks have spent billions of marks in recent days in a fruitless attempt to lift the lira off its ERM floor. Its floor has now been lowered by 7 per cent, the first time this has happened to an ERM currency for five years.

Only a week ago, EC finance ministers meeting in Bath reiterated their commitment to existing rates in the ERM and said they had no plans to realign. The Bundesbank also refused to bow to pressure at the meeting to announce a cut in its interest rates. It seems the price of German agreement was for the lira to be devalued, the outcome the Bundesbank has privately long sought.

The Bundesbank's policy-making council will discuss the size of the cut in German interest rates at an emergency meeting this morning. The Bundesbank has kept rates high to counteract the inflationary impact of German unification.

The commitment by the Bundesbank to cut interest rates will give renewed hope that the European economy can start to pull out of its current low growth.

France welcomed the cut, saying that the opportunities it created were of 'considerable importance'. Michel Sapin, the French Finance Minister, said the Bundesbank decision showed the German authorities were prepared to take into account the economic situation elsewhere in Europe in deciding policy.

Yesterday's moves further exposed divisions among the Labour Party leadership on policy towards the ERM. Gordon Brown, the shadow Chancellor, yesterday called on Mr Lamont to follow Germany in cutting interest rates, combined with action on jobs and investment at home and in Europe that Labour has been urging.

But Bryan Gould, who has been arguing vigorously that the pound is over-valued - to the growing embarrassment of the Labour leadership - said that while the moves were welcome 'as everyone has foreseen, it leaves sterling in a further exposed position, particularly if there is a 'no' vote in the French referendum'. He said the welcome movement in the log-jam 'shows that the overwhelming necessity for realignment and a reduction in interest rates is now being acted upon'. However, it still left sterling over-valued against the mark, he argued.

Both the Confederation of British Industry and the Institute of Directors welcomed the German interest rate cut and said they hoped British interest rate cuts would now follow.

(Photograph omitted)