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Sterling plummets on political worries

The pound dived sharply on the foreign exchanges yesterday. "Sterling stinks," said the head of currency trading at one big London bank, speaking for a majority in the market.

The reason traders gave for the pound's fall to its lowest value against the mark in nearly two years was political uncertainty. The Bank of England was believed to have intervened during the day to prevent the exchange rate falling too far, too fast.

The Government's Euro-turmoil came under the spotlight again after the Liberal Democrat's technical victory in a House of Commons vote on Monday calling for a referendum on Europe. Investors in the Far East began selling sterling assets early yesterday morning. Foreign investors fear the split in the Conservative Party or loss of Ulster Unionist support will bring an early election.

The pressure continued throughout the day as the exchange rate went below its 1994 low of DM2.3710, an important psychological barrier. It closed at DM2.3585. Many traders say the currency could soon pass its all-time low of 2.3147. Volumes traded in the foreign exchange market were above average.

Steven Bell, chief economist at Morgan Grenfell, said: "The pound is an easy target. We have an interest rate rise just behind us, so traders will push the currency down and keep on pushing."

This weakness would bring forward the neeed for another increase in base rates.

The Bank of England said at last week's briefing on its quarterly inflation report that the pound's decline since the new year was not a concern.

Although a lower exchange rate is inflationary, bringing higher import prices, the Bank said sterling had been relatively stable for two years. Mervyn King, the Bank's chief economist, said: "There is no mechanical reaction to an exchange rate change. We ask why it has happened."

A weaker currency would be one of the factors taken into account by the Chancellor and the Governor in their decisions on interest rates.

Economists say the Bank of England sees sterling's current weakness as a temporary difficulty. In its view there are no fundamental problems with the economy. However, the Bank did note last week that capacity constraints among exporters posed the risk of higher inflation, and this would get worse if a weaker pound gave another boost to exports.

Fears that inflation is on the rise could continue to undermine the pound. Figures released on Monday showed industry's costs are growing at the fastest rate in 13 years. The retail price index for January will be published today.

Steve Barrow, currency analyst at Chemical Bank, said: "If the inflation figures are disappointing, the market will look at Britain as another peripheral European economy. It will not give the Bank of England a lot of credit for pre-emptive interest rate rises."

Another pessimist about the pound's prospects was Adrian Cunningham, currency analyst at UBS. He said: "As far as international investors are concerned, the British Government is slipping on every banana skin it can find."

John Shepperd, Yamaichi's chief economist, said: "The pound will stay vulnerable. The economy is in good shape. Politics are undermining sterling."

Some analysts were more positive. Huw Roberts, at NatWest Markets, expects sterling to drift lower, but not to fall much more near-term.