Marching with the mark: All you need to know about the Bundesbank and its power: Christopher Huhne analyses the European Monetary System

Who buys and sells currencies?

Everybody from tourists, trading companies and banks buy and sell currencies. Exporters earn francs, marks and dollars, then switch them into pounds to pay their wage bills and so forth. At the same time, importers buy foreign currency with their sterling.

Investors also buy and sell currencies when they sell or buy up shares or other investments overseas. In London alone, the amount of currencies traded every day in the dealing rooms was dollars 187bn when the Bank of England last conducted a survey in 1989.

What is the European Monetary System?

The EMS - also known in Britain as the exchange rate mechanism - was set up in 1979 to establish a 'zone of monetary stability' in Europe. Because the European economies are individually much smaller than those of the United States or Japan, they do much more trade with each other. A sharp rise in a currency can be particularly painful for exporters, and a sharp fall can add a lot to the price of imports, and hence inflation. So the Europeans have always been keen to limit the fluctuations in their currencies.

Under the EMS rules, each currency is allowed to stray just 2.25 per cent away from its central (or target) rate against each of the other 10 currencies in the system. The only exceptions are the pound, the Portuguese escudo and the Spanish peseta. These have the special wider limit of 6 per cent to make allowances for their greater volatility. Their governments are committed to narrowing the limit to 2.25 per cent.

How can governments and their central banks maintain their exchange rates?

The first line of defence is intervention: the purchase of your own currency to keep its price up, by using official reserves of foreign currency. Britain has some dollars 44bn ( pounds 22.8bn) of reserves. Another defence is borrowing yet more foreign currency that can be used to buy sterling, such as the Chancellor's dollars 7.3bn borrowing, mainly of German marks. Borrowing also acts as a signal of how serious the Chancellor is about defending the pound, since any devaluation would mean that more pounds would be necessary to service and repay the foreign currency debt. When the currency is at its limits in the EMS, the Goverment has access to unlimited credit from other EMS central banks, but this must be repaid within some three months. A limited amount of credit is available for a further three months.

If intervention does not work, governments can raise interest rates to persuade investors to hold the currency. If that does not work, they must let the currency sink, as the Italians did on Sunday.

Why is the German Bundesbank so important in setting other country's interest rates as well as Germany's?

Germany has never devalued the mark against any other currency in the EMS, partly because its central bank, the Bundesbank, is independent, and proud of its inflation-fighting reputation. Investors know and like this. They therefore insist on higher interest rates on other currencies to compensate them for what they perceive as the extra risk involved in not holding marks.

The only way that currencies can have lower interest rates than those in Germany is if they have fallen so far that the markets believe they will now rise, even against the mark. But most European countries are not prepared to let their currencies go into such a free fall because of the impact that would have on import prices and inflation.

Why are Germany's interest rates so high?

Unification with the eastern Germany involved a large increase in government spending on benefits and investment projects. As the economy grew rapidly, inflation rose, and the Bundesbank raised interest rates to stem price rises. Interest rates elsewhere in Europe had to stay high, even though other countries were not experiencing the unification-led boom.

Why have the Germans agreed to cut interest rates now?

The flood of German marks spent by the Italians, British and others to buy up their weakening currencies were put on deposit in Frankfurt to earn interest. These marks boost the money supply, and help to drive down German interest rates. In principle, the Bundesbank can neutralise these flows by borrowing the mark itself. But last week it was forced to take 17bn marks (some pounds 6bn) out of the Frankfurt money markets. It agreed to cut interest rates in exchange for a lira devaluation that might staunch the need for such

intervention.

Why do movements in the US dollar affect the EMS?

When investors desert the dollar, they prefer strong currencies, such as the mark. As the mark rises, other European currencies linked with it have to struggle to keep up, if necessary by raising interest rates. The French, British and Italians are all praying that the dollar rebound is for real. A weak mark makes life easier.

Why does the French referendum on Sunday matter for the British interest rates?

The Maastricht treaty sets out conditions that European countries have to meet in order to participate in a single currency, such as low inflation, debt, deficits and interest rates. Without those commitments, the markets fear that some countries - notably Italy - may stray from what they see as virtue.

So a vote against Maastricht may cause investors to insist on a higher interest rate as an extra risk premium over and above German interest rates. The alternative is to succumb to the pressure - and

devalue.

Should we devalue the pound within the EMS?

Few businesses are complaining that the pound is too high for them to compete against other European companies. True, the fall of the dollar has made the Americans super-competitive, but history suggests that it will bounce back. The argument is therefore whether devaluation would allow us to have lower interest rates, and the answer is no. After one devaluation, the markets would expect us to have another before long, and would require higher, not lower, interest rates to compensate for the risk of capital loss.

Would we be able to cut our interest rates if we left the EMS?

In principle, yes. The Americans have interest rates at just 3 per cent, but they have also been prepared to see the dollar fall by a fifth in a year. No British government could put up with the impact that such a drop would have on import prices and inflation, inside or outside the EMS. In January 1985, Mrs Thatcher was forced to raise interest rates to 14 per cent, even though we were free to let the pound fall, and unemployment was rising steeply.

Would we avoid these problems if we had a single currency?

Yes. The problem today is that the Bundesbank is setting German interest rates largely according to German conditions. A European central bank would take account of the recessions in France and Britain as well. Interest rates on a single currency, the Ecu, would now be lower. That is why the French government is so keen on the Ecu.