Sterling 'at risk' outside the ERM

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The Independent Online
STERLING could face huge downward pressure, risking the rapid erosion of Britain's hard-won gains against inflation, unless the Government considers rejoining the European exchange rate mechanism, the Bank for International Settlements warned yesterday.

In its latest annual report, the central bankers' bank warned that the exchange rate situation in Europe is very unstable and crises similar to the upheaval of last September could reoccur.

The BIS said one possible solution to turbulence in the exchange market would be an acceleration towards monetary union. 'Some might find such a prospect acceptable, others not. But the alternative is to continue with the present set of potentially very unstable exchange rate arrangements, including the floating of two major currencies.'

The bank said 'the spectacular increase in capital mobility may also pose serious problems for floating currencies', such as the pound and the Italian lira. Market forces, combined with misguided policies, can lead to huge medium-term swings in real exchange rates. These could reappear, the BIS said, and would be particularly damaging for countries with close trade ties, such as Britain's links with the European Community.

Although the present environment makes it difficult for countries with floating currencies to curb these risks, the bank said the challenge would be greater outside the ERM than in it.

Countries with floating rates also need to stay on guard against inflationary risks and be ready to raise interest rates if a sharp depreciation in their currency threatens. 'The experience of asset price bubbles during the 1980s and the tendency of some floating exchange rates to overshoot in response to declines in interest rates are warnings to be heeded.'

The bank also said that the European recession and exchange market turmoil raised the question of whether tighter regulations were needed for the financial industry. It suggested that the deregulation of the 1980s had led to such problems that governments were now imposing even more regulations than were originally swept away. Obvious examples were the US reaction to the savings and loan crisis, and recent Japanese regulations introduced to cover crisis-hit non-financial institutions.

Hamish McRae, page 28