The fall was the largest since the abortive Soviet coup in August last year, with the FT-SE index of 100 leading shares dropping 54.6 points to close at 2,311.1. However, the market did end the day off its mid-afternoon low, when the FT- SE was down almost 60 points.
Share prices in New York also dropped, with the Dow Jones Industrial average losing 25.93 points to close at 3,228.17. Wall Street's weak start helped to pull the FT-SE lower during the afternoon, although London trading was relatively light.
The Bank of England gave an early signal that it had no intention of raising base rates during the day, by satisfying almost all of a pounds 2bn shortage of liquidity in the money market. It bought short-dated bills at existing rates, although it accommodated upward market pressure in the rates accepted on longer-dated bills.
None the less, the market ended the day discounting a rise of at least half a percentage point in base rates from their present 10 per cent. The three-month interbank lending rate - which tracks City base rate expectations - ended 3/8 of a percentage point higher than Friday's close at 10 3/4 per cent. The one-month interbank rate rose to 10 1/2 per cent.
The fears of higher base rates contrasted with the pound's survival, relatively unscathed, of a chaotic day on the foreign exchanges, as dealers' attention focused on the tumbling dollar.
The pound ended the day less than 1/5 pfennig lower than Friday's close at DM2.8010, its most depressed since before joining the exchange rate mechanism.
During the day the pound traded below the psychological level of DM2.80, but no serious attempt was made to push the currency to its floor in the ERM of DM2.7780. City analysts believe that is only a matter of time.
Dealers reported that the Bank of England had bought pounds for marks during early morning trading, before joining the Federal Reserve and other European central banks in their futile bid to prop up the dollar.
'I would have thought that the Bank would be thrilled by how well the pound had done,' said Steve Barrow, economist at Chemical Bank. He added that the pound was still likely to be pushed towards its floor, even though the market 'is not as bearish of sterling as it is of the dollar'.
Against the dollar the pound rose by 6.3 cents from Friday's close to end the day at dollars 1.9955, the highest rate since the allied land attack in the Gulf war last February. Dealers reported that the pound was being quoted a fraction above dollars 2 during mid-afternoon, but it has not closed above that level for more than a decade.
Keith Skeoch, economist at James Capel, said the market was loath to drive the pound decisively above dollars 2, where it was 'patently overvalued'.
The dollar fell by 4.3 pfennigs against the mark to close at DM1.4060, its lowest yet. During the day it traded below DM1.40, which analysts are confident will happen again. In New York it dropped 2.75pf to a record low of DM1.4015.
The Fed and European central banks - including the Bank of England - carried out two waves of heavy intervention during the morning, buying dollars for marks. The Fed then intervened three times during the afternoon. Some analysts speculated that the Europeans might be fed up with fighting a losing battle.
'Every time they come in they have less and less effect. They should give up,' said Mr Barrow. He added there was nothing to turn the market around until the Bundesbank cut German interest rates or the Fed raised US rates.
The prospect of lower German rates was not helped by unexpectedly high inflation figures for the German state of North Rhine-Westphalia, where the annual rate of increase in the cost of living was 3.4 per cent in August, from 3.3 per cent a month earlier.
The continued strength of the mark exacerbated strains throughout the ERM, with both the French franc and Italian lira falling toward the bottoms of their permitted bands in the system. The strains may worsen further tomorrow if a new opinion poll expected to be published in the French newspaper Le Figaro shows a majority in France intending to vote against ratification of the Maastricht treaty.
Commentary, page 19
Market report, page 21