Comment: Flirting on the borders of reason

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The Independent Online
Here are two deeply unfashionable propositions. One is that sterling might climb back to DM2.95 in the next 18 months; the other, that the pound will rejoin the European exchange rate mechanism before the end of 1993.

Unfashionable, and on a rational assessment perhaps less than an evens chance; but they are worth exploring. First, however, it is important to be clear that the propositions do not include the idea of sterling rejoining the ERM at its old central rate. Rather, the central rate might be around DM2.80, so that with 6 per cent bands on either side, the pound would be free to ride up to DM2.95, or down to DM2.65.

The first proposition: reaching DM2.95. For that to happen, several things need to turn out towards the extreme end of the likely range. The economy has to make a solid recovery next year, one more on the lines expected by the National Institute, with 2 per cent growth, rather than the more modest growth expected by the consensus. To expect 2 per cent growth is a little more credible now than it was a week or so ago, but it is asking a lot of exporters. Not only will home demand grow slowly over the next year, in the absence of a recovery in house prices; home demand cannot be allowed to grow quickly because of the fragility of the current account. So while it is now possible to be reasonably confident that the recession is over - that the economy will grow slowly from now on - it is not easy to be confident that the growth will be fast enough to start cutting the unemployment numbers.

At the moment each day brings new redundancy announcements, making it impossible to generate the confidence at home and abroad that would be needed to sustain a pound back in the DM2.80/2.90 region.

RATES MUST GO UP

Next, the British interest rate cycle needs to turn upwards. At the moment the question is always when the next base rate cut is coming, and whether rates will be down to 5 per cent next summer. That is fine as far as it goes. But at some stage in the next 18 months the Bank of England will feel the need to warn that the Government is in danger of missing its inflation target, and the markets will start to focus on rises in rates rather than falls. The US interest rate cycle must be close to a turning point already. The British economy is much weaker, but if there were 2 per cent growth next year, at least the markets would accept that no further falls were likely. That would be enough to start strengthening sterling, particularly if German rates were slipping.

The next factor determining the mark/pound exchange rate will be the course of the German economy, and mark interest rates. The new figures, showing a flat third quarter, are unsurprising, even though the markets took them as new evidence of weakness. The official forecasts are still for some very modest growth next year, but, given the way forecasts are being repeatedly downgraded, it is quite possible that Germany will be in recession. If that recession starts to look serious - worse than a 0.5 per cent fall in GDP - then the mark could fall quite sharply. Such a drop would be assisted were mark rates to come off in response (though no one should count on that).

If, a year from now, growth was running at 2 per cent and rising, UK base rates at 7 per cent and rising, while the German economy was contracting and mark rates were 7 per cent and falling, it would be quite reasonable to expect a mark/pound rate of DM2.70. That would be within the bands for a central rate of DM2.80, the sort of level at which the Bundesbank thought sterling should have joined the ERM in the first place. If Britain were then to rejoin and sterling moved to the top of the bands, it theoretically might move back to DM2.95.

And so to the second point: rejoining the ERM. This is a political, rather than a market, issue. Over the next year several things are likely to happen to the ERM. There will be further realignments, with the punt in particular being devalued. If in addition the franc is devalued, which is likely during the spring, the ERM will de facto have reverted to what it originally was - a system of fixed but adjustable exchange rates. It will then be a perfectly acceptable system for Britain to rejoin.

If, on the other hand, the franc and the mark are joined even more closely, which is being mooted, then it is very hard to see sterling going back in, unless the markets break apart the franc/mark union.

The paradox therefore is this: the greater the turmoil in the ERM the greater the chance that Britain will rejoin in the not-too-distant future.

GOLD PARALLELS

One final point. History students have been quick to draw parallels between the pound leaving the ERM and its coming off gold in 1931. If you look at the performance of sterling after leaving gold, it recovered all its dollar value in the next three years, and was rising even before the dollar itself came off gold in 1933. The initial devaluation lifted the economy, partly through the exchange rate, but more because it enabled a sustained fall in interest rates. But by 1934 the pound was trading at its 1930 level.

The Bank of England still believes that the pound was not seriously over-valued at DM2.95, and that the problem was the sterling/dollar rate. The dollar is now in the process of recovering and will climb further next year. To re-enter the ERM at a rate that could see the pound trading at DM2.95 would have obvious political attractions, particularly if the ERM had clearly become a more flexible entity. It would enable the Prime Minister to say that the policy was right all along, explaining the fact that the central rate had been dropped a little by reference to the revaluation of the mark against the franc. If you look at the history of sterling in the 1930s, there is a historical parallel too.

Of course this may not happen. What will certainly happen next year is a recovery of the Anglo-Saxon economies relative to continental Europe and to Japan. It would be odd if that recovery were not associated with some recovery of the Anglo-Saxon currencies - indeed the recovery of the dollar is already under way. Sterling's modest rehabilitation yesterday will probably be reversed, for there will be more bad news before the winter is out. But if one looks a year or 18 months ahead the rehabilitation should be secure.

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