Finland had almost exhausted its reserves of foreign currency attempting to peg the markka against the ecu, the weighted average of ERM currencies. In the face of large outflows of cash from Helsinki, the Bank of Finland yesterday gave up the struggle and announced it would temporarily float the markka and peg it at a lower rate against the ecu when the market had stabilised.
The markka promptly fell by 14 per cent, having been devalued by 12.3 per cent in November last year.
The Bank of Sweden immediately increased its key overnight interest rate by eight percentage points to a record 24 per cent in an attempt to ward off speculation about a devaluation of the Swedish krona.
The Scandinavian crisis prompted widespread buying of the 'safe haven' German mark on nervousness about an ERM realignment. The mark was also helped by Helmut Schlesinger, the Bundesbank president, denying he had made a commitment not to raise German interest rates at last weekend's meeting of EC finance ministers and central bank governors in Bath. The German federal statistics office also said yesterday that the economy of eastern Germany had shrunk by more than 11 per cent in the year to the second quarter of 1992.
The nervousness in the currency markets was exacerbated by two opinion polls showing only small majorities of French voters in favour of the Maastricht treaty on European union. They suggested that recent hopes that the tide of opinion had turned back in favour of Maastricht may have been premature.
The pound ended the day 0.9 of a pfennig lower at DM2.7878, less than a pfennig above its floor in the ERM and more than 16 pfennigs adrift of its central rate. The dollar fell through DM1.40 and closed more than a pfennig down on the day at DM1.3916. The pound ended a cent stronger against the dollar at dollars 2.0035, its highest for more than a decade.
The weakness of the dollar continues to reflect fears that the gap between German and US interest rates - nearly seven percentage points - could widen further if the Germans raise rates or, more likely, the Federal Reserve cuts its discount rate to give a pre-election boost to the struggling US recovery.
Gerard Lyons, economist at DKB International, said events in Scandinavia had underlined the dangers for the weaker ERM currencies. 'The Finnish devaluation shows that intervention cannot continue indefinitely, while the Swedish move shows that interest rates increases have to be big not to be counterproductive,' he said.
Although the mark was strong, the ERM escaped severe strains. The embattled Italian lira, which is seen as the first candidate for devaluation if the ERM is realigned, survived relatively unscathed. Dealers reported Italian overnight rates forced up to 25 per cent to keep pressure off the currency.
The weakness of the pound rekindled fears that the Government might be forced to raise interest rates in Britain to defend the currency. The three-month interbank lending rate - the market rate that tracks City base rate expectations - rose by one-eighth of a percentage point to 10 3/8 , more than a quarter point above the current 10 per cent base rate.
The stock market was also unnerved by sterling's weakness. The FT-SE index of leading shares fell 34.5 points to 2,337.7.
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