US gloom imperils pound rescue

THE European exchange rate mechanism (ERM) came under severe strain yesterday, as unexpectedly dismal US employment figures triggered a slump in the dollar and undermined the Chancellor's pounds 7.25bn scheme to support the pound against the mark.

The Bank of Italy was forced to increase its key discount interest rate by 1.75 percentage points to 15 per cent, but the lira remained pinned to its floor in the system. Selling of marks for lire by both the Bundesbank and Bank of Italy earlier in the day failed to prop up the currency.

The turmoil in the ERM will top the agenda of EC finance ministers and central bank governors who meet in Bath today. Strains within the system are expected to worsen dramatically if the French referendum rejects the Maastricht treaty on European union in just over a fortnight. The meeting will aim to agree contingency plans for a French 'non', although it is expected to issue a robust defence of the ERM's existing rates.

The Italian rate rise fuelled speculation that the strong mark could yet force a realignment of ERM currencies, including a devaluation of the lira and, possibly, the pound. If the pound was devalued against the mark, hundreds of millions of pounds of taxpayers' money could be lost paying back the pounds 7.25bn of foreign currency loans announced by the Treasury on Thursday.

The dollar and the pound both began yesterday strongly, reflecting further market approval of Mr Lamont's move to borrow foreign currency, which would be used to support the pound and help meet the shortfall between the Government's spending and tax revenues. By mid-morning the pound had climbed above DM2.82 for the first time in nearly three weeks.

But the release of the US employment figures saw the dollar drop sharply, dragging the pound down in its wake. The dollar had been trading above DM1.42, but fell back to close in London at DM1.4045, 0.7 cents lower than Thursday's close.

The pound dropped back to DM2.8025, still up more than four-fifths of a pfennig on the day. and its highest close for a fortnight. The pound gained just over a cent against the dollar to close at dollars 1.9905.

The currency markets were also buffeted by a series of rumours. The Bundesbank denied reports that it was planning to announce an emergency cut in German interest rates at the Bath meeting.

The US Federal Reserve signalled a probable quarter-point cut in its key Fed Funds interest rate to 3 per cent, after the release of the employment figures. This would further widen the gap between German and US interest rates, increasing the attractiveness of the mark against the dollar. Analysts believe this could push the dollar to record lows next week. Employment in the US, excluding agricultural workers, fell by 83,000 in August, despite 100,000 temporary summer jobs being provided in an emergency federal scheme. Wall Street economists had expected employment to rise by 185,000 and saw the disappointing figures as evidence that President Bush could not expect good news on employment before November's election.

The Federal Reserve pumped dollars 2.5bn of funds into the US banking system yesterday, which most analysts interpreted as sanctioning a quarter-point interest rate cut. However, some dealers said the injection may just have reflected other central banks depositing dollars they had bought in recent weeks when intervening to support the US currency.

Despite the turbulence in the foreign exchange markets, the City does not believe a rise in UK base rates is a foregone conclusion, although the next move is likely to be up rather than down.