Bank has plenty of firepower to defend pound: The Government can intervene before raising interest rates to prop up sterling, says Robert Chote

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THE BANK of England today stands ready to confront the most serious attack on the pound since it joined the exchange rate mechanism in October 1990. If it fails to prop up sterling, the Government may be forced to raise interest rates for the first time in nearly three years, almost certainly pushing the enfeebled British economy deeper into recession.

Financial markets are fickle creatures - the pound may yet escape unscathed. But if the markets do decide to savage sterling, the Bank has some impressive defences to call upon before a base rate hike becomes inevitable.

The pound is now weaker than at any other time during its ERM membership. It closed in London on Friday at DM2.8028, a 27- month low. But more worryingly, in late trading and in New York, the pound fell below the psychological level of DM2.80.

The ERM rules mean that the Bank must not allow the pound to fall below DM2.7780, 6 per cent below its central rate against the mark of DM2.95. The first line of defence is intervention - the Bank uses reserves of foreign currency to buy pounds and keep their price up.

The Bank must be prepared to buy an unlimited amount of sterling at the floor price of DM2.7780 and the Bundesbank must offer to sell marks to anyone who wants them for 36 pence. There is no point in currency dealers trying to sell pounds for, say, DM2.77. The Bank would always offer sellers a better price.

The markets might try to push below the floor if they thought the ERM was about to be realigned, in which case the pound's floor could be moved down. One reason for the tension is the fear that a 'no' vote in next month's French referendum on the Maastricht treaty could trigger just such a realignment. Realignments are normally agreed at a weekend meeting of all ERM finance ministers and central bank governors. The last was in 1987.

The Bank cannot buy sterling indefinitely, but its firepower is considerable. At the end of July its reserves of gold and foreign currency totalled dollars 45.8bn ( pounds 23bn).

The Bank can also borrow unlimited sums from other ERM members under the system's very short-term financing facility (VSTF). Borrowings must be paid back within three months, although a limited amount can be carried forward for another six. In practice, other ERM central banks are likely to intervene in concert with the Bank as well as lending money.

The Bank need not wait until sterling hits its floor before intervening. For example, in addition to joining Friday's unsuccessful international effort to prop up the dollar, the Bank also quietly bought pounds on Thursday, when it was still above DM2.80. To cover its tracks, the Bank may ask commercial banks to buy on its behalf.

If intervention fails to bounce the pound off the ERM floor, and dealers feel happy to sell ever larger amounts of sterling to the Bank for DM2.7780, the Government would consider raising interest rates. This should make the pound more attractive because sterling-denominated investments would offer a higher return. The Government may even raise rates pre-emptively if it believes intervention would be futile.

But a rise in rates might do more harm than good. The markets could conclude that the resulting damage to prospects for economic recovery might make the pound less - rather than more - attractive. Several rate rises might thus be needed to stabilise sterling, or the Government might have to ask its partners to consider a realignment.