Darling under pressure to avert meltdown of sterling

Alistair Darling will come under pressure this week to act to halt the dramatic slide in the value of the pound, which has tumbled to a six-year low against the dollar and all-time low against the euro.

The currency has taken a battering in the markets as investors have become increasingly nervous about the state of the UK economy, the Government's public spending plans and a widely anticipated programme of interest rate cuts by the Bank of England.

The Chancellor of the Exchequer, who is due to make a speech at City University in London on Wednesday evening, is expected to attempt to slow the fall of the pound, which slipped through the $1.60 mark on Thursday last week for the first time since 2003, by assuring the financial community that the Government has not abandoned its budgetary rules.

The pound closed at $1.59 on Friday, its lowest level for six years, and is also down to a record low against the euro, which appreciated to 83p last week.

Investors' nerves were not helped on Friday when the UK economy was shown to have contracted by 0.5 per cent in the last quarter, a bigger slowdown than expected, and after Gordon Brown and the Bank of England's Governor, Mervyn King, said that a recession, measured as two consecutive quarters of negative growth, was likely.

The markets are worried that the Monetary Policy Committee (MPC) of the Bank of England will be forced to rapidly cut interest rates in the coming months, starting at its next meeting on 6 November, to reflate the flagging economy. The consensus view among City economists is that the MPC will reduce rates by 0.75 percentage points. This, it is feared, will offer investors fewer incentives to hold the currency, leading to a more dramatic sell-off.

A number of analysts expect thatthe MPC will need to cut rates to just2 per cent by next year, a level that has not been seen in the UK since the 1950s.

It is not just falling interest rates that have put the pound under pressure. As the global economic downturn takes hold, investors are looking for what are traditionally considered to be safe havens, such as short-term US Treasury Bills, the Swiss franc and the yen.

The markets are also worried that as the economy enters a recessionary period the Government will be forced to increase borrowing, paid for largely by issuing government debt in the form of gilts. As the number of bonds floods the market, already saturated by securities from other countries attempting to raise money, so investors are worried that the Government will be forced to increase yields to attract buyers. Some also fear that the higher taxes needed to service the debt, which will soar as a result of the bank recapitalisation programme as well as the economic downturn, could hamper the MPC's ability to reduce base rates, slowing any economic recovery and, ironically, leading to inflationary pressure.

Ruth Lea, a former director of the Centre for Policy Studies and now economic adviser to the Arbuthnot Banking Group, said: "The worst case is that all this leads to a run on the pound: that is the meltdown scenario, and while I would not say it is a probability at this stage, it is certainly a possibility. Sterling has dropped rapidly in the last few days, and while some of that is due to investors rushing to the dollar, which is still the only currency people have to have, the speed of that drop is a concern. Given the amount of borrowing the Government has to do, there is a chance that foreigners will no longer be prepared to hold sterling, and if that happens, it is 1976 all over again and it is back to the IMF."

It is the rate of sterling's decline that has spooked the markets. The pound was worth nearly $2 earlier this year, with many now predicting that the pound could drop as low as the psychologically important $1.50. The currency has also devalued by more than 15 per cent in the last year against a trade-weighted basket of leading currencies.

The Treasury declined to comment on what Mr Darling would say this week, but it is understood that the Government will not take action to artificially stimulate sterling. The last time the UK actively supported the pound was in the early 1990s, when sterling was in the Exchange Rate Mechanism. Last Wednesday sterling fell 6.25 cents against the dollar, suffering its steepest fall since the aftermath of Black Wednesday in 1992, when the Major government had to abandon the ERM.

Instead, Mr Darling is likely to reassert the Government's commitment to its spending plans, saying that the Treasury will stick to its budgetary rules.

Many observers will be keen to see how far Mr Darling wants to go in bringing forward large public spending projects, such as Crossrail and the 2012 Olympics. The bailing out of the banks and reports that the Government will try to spend its way out of recession by using reflationary policies has undermined sterling, some analysts believe.