Continuous heavy selling of the franc and other weak European currencies over the last few days has convinced economists there is no alternative for many countries but to cut interest rates. The foreign exchange markets believe that France, Spain and Portugal, whose currencies came under the strongest pressure, will only sink more deeply into recession if their rates remain at last week's levels.
By the end of last week most economists were agreed that the rate cuts would come whether or not the ERM survived the weekend. They argued that either the Bundesbank would be forced to reverse last Thursday's decision by its ruling council and cut the discount rate, or currencies would be released from the ERM, allowing their interest rates to move downwards.
'All the ERM pressure has been occurring because rates are having to go lower in France,' said Don Smith, economist at Midland Global Markets. 'We think that European rates will be very much lower by the year- end.'
Ruth Lea, chief economist at Mitsubishi Bank, said: 'Providing the French really cut rates, along with the Danish and the Spanish, you should see the European economies starting to recover. Lower rates should help growth in Europe generally.'
The fall in European interest rates should open the way for lower rates in Britain to preserve sterling's competitiveness against other currencies. Base rates are currently at 6 per cent. Midland Bank has already cut its forecast for UK rates from 5 to 4 per cent or lower by the end of this year. 'We haven't got an exchange rate crisis in Britain, we have an interest rate crisis,' Mr Smith said. 'Interest rates are just too high.'
British interest rates last touched 4 per cent in 1963.
Nicholas Parsons, chief economist at Canadian Imperial Bank of Commerce, also believes the Government would use the opportunity to cut rates. 'The need for cuts in British rates is in order to stimulate the domestic economy - that's the main worry of the CBI.'
Money markets remained cautious last week about a deep cut in rates in the near future but were clearly indicating they expected lower interest rates by the end of this year.
The three-month interbank rate - which most closely tracks bank base rates - ended the week slightly lower at 513 16 per cent.
Mr Smith refers to the latest CBI survey, which partly blames the strength of the pound for weak export growth in the UK. 'The government would like the export sector to be in the vanguard of the economic recovery but that hardly seems to the case at the moment.'
The pound continued to strengthen against other European currencies last week as investors used it as a refuge currency, safe from the storms within the ERM. It rose by nearly a pfennig on Friday to DM2.5850 and by four centimes against the franc to Fr8.8400.
The Government, for the time being, appears to be waiting to see how events on the Continent develop. Kenneth Clarke, the Chancellor, said in a BBC intervew: 'So far as our interest rates are concerned, I am glad to say at the moment we are detached from this. Our exchange rate is reasonably stable, we are relaxed spectators of events in the rest of the Continent.'
However, some analysts are more sceptical of an early UK interest rate reduction. Ruth Lea believes that although the pound may lose some competitive edge against the franc, this will be more than compensated for by a recovery in European economies, which will boost Britain's export sector.
European equity markets were already responding last week to the prospect of lower interest rates and the consequent boost to various European economies.
The FT-SE 100 ended the week at 2926.5, nearly 100 points up over the week, as cautious dealers began revising upwards their estimates of where the stock market will end the year.
Slaying the ERM, page 4
(Photograph omitted)Reuse content