Germany slays the ERM: Franc falls through floor as Bundesbank puts its own interests ahead of Europe's monetary ideal

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The Independent Online
ALREADY the French have named it 'jeudi noir', Black Thursday. While the franc did not devalue immediately, the likelihood of its removal from the exchange rate mechanism with a host of domestic and diplomatic consequences seemed to make the day as significant to France as 'Black Wednesday' was to Britain last September.

It had taken a surprisingly long time in France for the realisation to sink in that this really was a crisis.

It was only when Edouard Balladur, the Gaullist Prime Minister, met Edmond Alphandery, his centrist Finance Minister, Jacques de Larosiere, the governor of the Bank of France, and Jean- Claude Trichet, the head of the Treasury, for three hours that evening, that the seriousness of the situation struck most Frenchmen.

For 10 years, the exchange rate mechanism has been a stable fact of French life and the strong franc an article of faith among French politicians. Ironically, however, it was probably Mr Alphandery who raised the curtain on this latest act in the franc-mark drama in late June.

The franc was riding high and Germany's economy was in a mess. Mr Alphondery announced in a radio interview that he had called a meeting with Theo Waigel, his German counterpart, and Helmut Schlesinger, the Bundesbank president, to co-ordinate lowering interest rates. His words made the invitation sound like a summons and, a few hours later, Mr Waigel cancelled the meeting. It was a bad omen for the future.

Soon afterwards, however, it became clear that France's economy was in a worse state than anyone had thought, driven ever deeper into recession by the high interest rates forced on it by the ERM. The currency markets turned aganst the franc and began selling it aggressively. Concerned about the French economy, they wanted to see lower French interest rates. Everything depended on whether the Bundesbank would let them fall.

A week ago on Wednesday, the markets were confronted by two contradictory signals on prospects for German interest rates. One was a small cut in the German 'repo' rate, but hopes that this would lead to bigger cuts were counteracted by news that the German money supply was growing out of control.

Pressure on the French currency grew. There were hints that the French central bank had intervened in the franc's support. It closed at Fr3.4180 to the mark, just over one centime above its floor.

Seeing the determination of the French and German central banks to stand their ground, the speculators turned on easier game, dragging the Spanish peseta and Portuguese escudo from the top of the grid.

Last week began with the pressure lifting slightly. Inflation rates from the German states of Hesse, Baden Wurttemberg and North Rhine Westphalia contained no nasty surprises - the odds on a Thursday discount rate cut appeared increasingly good. 'In the end, the Bundesbank always acts to save the ERM. I am sure it will do so this time,' said a spokesman at Frankfurt's Bank Julius Baer.

The franc also received the support of George Soros, the man who made a dollars 1bn ( pounds 670m) betting on the demise of the pound. He wrote in the French newspaper Le Figaro: 'I am not speculating against the franc and I have no intention of doing so, because I do not wish to be accused of destroying the European Monetary System.'

On Wednesday, the Bundesbank's Frankfurt directorate appeared to put the matter beyond doubt when it allowed the repo rate to fall by a further fifth of a percentage point to 6.95 per cent. Surely, the markets reasoned, this was a prelude to at least a half point off the more important discount rate when the Bundesbank council met on Thursday.

The sight of the cavalry coming over the hill sent the franc briefly above Fr3.40 to the mark. It closed at Fr3.4045, a centime up on the day and 2.6 centimes above its ERM floor. The prospect of an imminent German rate cut even caused speculation that Kenneth Clarke, the Chancellor, might follow suit.

The trading floors of Europe's currency markets began Thursday in calm but expectant mood. No one expected the bombshell that landed at lunchtime: no rate cut. The Bundesbank's reputation for toughness soared as the European currency markets plunged into turmoil.

Passionate pleas from committed Europeans on the Bundesbank's central council, such as Horst Schulmann and Olaf Sievert, that the expected slowdown in inflation and monetary growth in the Autumn justified the rate cut that the ERM partners so desperately needed now, had failed to sway the hardliners. The decision to leave the discount rate unchanged was backed 'by a clear majority', Hans-Jurgen Koebenick, a council member, said afterwards.

A very senior Bundesbank official, speaking on condition of anonymity, explained the hardliners' thinking. 'From a domestic point of view, we believed that there was no change in the economic situation which could have justified a further easing in monetary policy,' he said.

From the German media came broad support for the Bundesbank's line. 'The Bank cannot be criticised for being brutal in imposing German interests through its monetary policy,' wrote Germany's most respected newspaper, the Frankfurter Allgemeine Zeitung.

But the Bundesbank's announcement caused panic. Traders rushed to their phones and selling orders soon had the franc and its weak ERM bretheren in a tailspin. The central banks were forced to start their defence, and by mid-afternoon were intervening constantly to keep the ERM afloat.

Any sellers of francs at Fr3.4180 to the mark found ready buyers in the central banks. Around DM20bn ( pounds 8bn) had been spent in the franc's defence by the end of European trading. The bank of France stepped out of the market as soon as it was no longer obliged to keep the franc in its ERM bands. But the markets had not had enough. Selling in New York pushed the franc down, and the Bank of France was soon forced back in.

Friday morning, and there was no mercy. As the speculative storm gathered intensity, the Bundesbank held firm, refusing to give the markets a clear signal that it was prepared to save the ERM. The Bank of France tried to hold the line but by 9.30am had been overwhelmed. The franc plummeted to its floor in the ERM of Fr3.4305, where it was to remain for the rest of the day. Some trading took place below the floor, on the few occasions when the central bank was not prepared to buy.

The Belgian franc, Danish krone, Spanish peseta and Portuguese escudo all hit or came close to their ERM floors. Belgium raised its official interest rates, while Denmark put upward pressure on market rates. Both were to no avail. By the end of the day, tens of billions of marks had been spent in intervention, but the pressure did not stop.

Even George Soros, who had pledged his support to the franc just days before, turned on the attack. He declared the defence of the franc to be hopeless, withdrawing his statement in Le Figaro that he would leave the franc alone. 'I do not expect the ERM to continue functioning. I do not expect the present arrangement to be operative Monday morning,' he said.

He spoke for the whole currency market. The truth behind the European currency system - that it could survive only as long as conditions in Germany allowed - had been revealed and the implications for the franc and the ERM seemed clear. And that may just have killed any hope of a single European currency ever emerging.

(Photograph omitted)

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