More currency mayhem will put ERM to the test

THE MAYHEM in foreign exchange markets is expected to continue this week, after a tumultuous close last week for European currencies.

Analysts believe that without co-ordinated government action, investors will continue to flee to the safe havens of the mark and yen.

Neil MacKinnon, chief economist at Citibank, said: ``We haven't seen anything yet.'' He said international investors were uncertain about interest- rate moves and political developments in the weak-currency countries, and saw no reason to reverse flows of capital out of these markets.

James Montier, currency economist at Kleinwort Benson, said: ``There does not seem to be anything that will pull the currency markets out of this quagmire. It would take some quite dramatic action by governments.''

One rumour sweeping London and Madrid on Friday was that the Spanish government would withdraw from the exchange rate mechanism this weekend. The Spanish Ministry of Economy strongly denied the rumour and said it would not be asking for a meeting of the European Monetary Committee.

A spokesman for the ministry said: ``The peseta is not going to leave the system.'' Dealers were unconvinced by the denial, however, and reported signs of intervention by the Bank of Spain.

The mark has set repeated new highs against other European currencies and the dollar in recent weeks. On Friday, it was the turn of the pound, the Italian lira and the Irish punt to hit new record lows. The lira fell to 1,275 to the mark, while the pound and punt fell to DM2.19.

The dramatic exchange rate moves were given new impetus by the failure of the Bundesbank to cut German interest rates on Thursday, despite earlier hints by president Hans Tietmeyer that it might do so. Mr Tietmeyer repeated his comments on Friday, the day after the Bundesbank council meeting, saying the mark was ``slightly overvalued''.

But most analysts thought the same tease would not work twice and that the chance to orchestrate a co-ordinated cut in German rates and simultaneous rise in US and UK interest rates had been lost.

A second factor was the close margin by which the Italian government passed its confidence vote and mini-budget. The media magnate Silvio Berlusconi has warned that his Freedom Alliance will continue to oppose the economic reform plans of Mr Dini's technocratic government. Observers are gloomy on the lira's prospects. Stephen Hannah, director of research at IBJ International, said: ``All the authorities can do is demonstrate their commitment to long-term reforms. Italy needs some very tough austerity measures, but it is likely to get fresh elections.''

Important economic statistics will be thin on the ground this week. In Britain, a CBI survey and the retail prices index for February will provide more evidence on growth and inflation, but the main focus of attention will be Wednesday's monthly meeting between the Chancellor and the Governor of the Bank of England.

Although no immediate rise in base rates is expected, the economist Adam Cole at James Capel points out that the fall in sterling so far this year has more than counteracted the effect of the half-point rise in base rates last month.

Mr Cole said a rise in interest rates of half a point would be needed to keep monetary policy as tough as it was at the beginning of this year.

There are few figures due out in the US either, where recent economic evidence has suggested that growth is slowing. Dealers will focus on the 28 March meeting of the Federal Reserve's policy committee. Although the Wall Street consensus is that domestic considerations will win, and the Fed will keep interest rates on hold, there is growing doubt about how much longer it can ignore the dollar's weakness.

William Sterling, international economist at Merrill Lynch in New York, said: ``The days of setting US interest rates primarily on domestic considerations may be drawing to a close."

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