Most analysts think the Bundesbank will have to cut rates on Thursday to save the ERM. However, the currency markets remain uncertain, and some dealers believe that bad regional inflation figures from some German states tomorrow may cause a terminal crisis before then.
The ERM barely managed to survive last week intact. If the franc - like the pound - was forced out of the ERM, this would probably spell the end of the system in its current form.
However, the Independent on Sunday has learned of a confidential study by Treasury economists, which concludes that sterling's own withdrawal from the ERM last year was crucial in stimulating economic recovery in Britain.
The study, which will come as a severe embarrassment to the Government, argues that Britain still would not have emerged decisively from recession by now had we stayed in the ERM, even if the Bank of England had matched German rate cuts. Intended for internal Treasury use only, it makes plain that the collapse of the Government's ERM policy was essential to the recovery.
The study undermines Government claims that recovery was under way before Black Wednesday and that devaluation only helped it on its way. It concludes that any early signs of recovery would have been wiped out if Britain had stayed in the ERM.
Rumours swirled in the foreign exchange markets last week that a meeting of the EC monetary committee over the weekend or early this week would agree that one of more of the weak currencies in the ERM would devalue or depart from the system altogether. Dealers believe the Bundesbank will have to show flexibility on Tuesday when it gives details of its 'repo' money market operations, if the ERM is to have much chance of survival.
It will then have to cut its key discount rate by at least half a point to 6.25 per cent on Thursday - the last meeting of its policy-making council before the summer recess - if speculators are not to rip the ERM apart.
The French franc and other weak ERM currencies came under severe selling pressure last week. The Bundesbank and the Bank of France were reported to have spent up to DM50bn ( pounds 19bn) in support buying of francs, only for the French currency to remain pinned within a whisker of its lowest permitted rate in the ERM.
Some intervention was carried out through swaps, to minimise its immediate effect on French foreign currency reserves. The franc ended the week at Fr3.4175 to the mark, 1.3 centimes above its ERM floor.
The Spanish peseta and Portuguese escudo were dragged from their positions at the top of the ERM grid as the speculators took easy pickings. The peseta was pulled below its central rate in the system for the first time since it was last devalued. The Belgian franc, a currency in the ERM's 'hard core', fell to its self-imposed floor against the mark, with the Danish krone ending the week as the ERM's weakest currency despite higher Danish interest rates.
Following a joint statement in support of the franc's parity by the French and German authorities, the Bank of France raised its overnight interest rate to 10 per cent on Friday to help make speculation more expensive. But the move failed to lift the franc further up the grid. The franc is suffering because France needs lower interest rates to pull its economy out of recession.
Recovery credited to ERM exit, page 4