Stiffer tests ahead for sterling amid uncertainty on rates

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THE POUND'S flirtation with its record low against the mark has encouraged talk of a sterling crisis. Analysts believe the Government's willingness to raise interest rates and to resist an irresponsible cut in taxes will be crucial to the currency's prospects.

The pound has fallen by about 10 per cent against the mark since the beginning of the year, reflecting greater optimism about the German economy and the perception that the turning point in German interest rates is approaching.

The pound's performance has also been affected by uncertainty about when the Bank of England will raise interest rates. The pound fell below DM2.40 on last week's good inflation figures. But it rose yesterday by 1.5 pfennigs to DM2.3901 after the Central Statistical Office said on Monday that recovery was stronger than had been thought.

Some analysts believe that a fall to below its record low of DM2.34 would convince the Bank of England to raise rates. But since Britain left the European exchange rate mechanism, the Bank has focused more on sterling's strength against a basket of currencies. The fall in its trade-weighted value has been only half as sharp as against the mark, as the pound has fallen in tandem with the weak dollar.

'The pound has been caught in the crossfire between the dollar and the mark,' said Neil Mackinnon of Citibank. He noted that the pound had also fallen below Sfr2 for the first time, which might not bode well for its future performance against the mark. 'Investors still regard sterling as a soft currency.'

Chris Turner of Barclays de Zoete Wedd warned that the biggest threat to the pound was the Treasury's reluctance to raise interest rates.

Sweden and Italy both raised rates recently, doing their currencies no good at all. But both have large budget deficits, which in the case of Italy meant that higher rates added L5,000bn ( pounds 2.5bn) to its debt-servicing costs. In Britain, government borrowing is falling fast and by more than expected, which means that a rate rise here should go down better with the currency markets.

But some analysts fear the Government could undo its good work in reducing borrowing by cutting taxes in next year's Budget in an attempt to win votes. Fear of this alone could keep sterling weak.

Jim O'Neill's team at Swiss Bank argues that the talk of tax cuts is potentially dangerous. 'The foreign exchange market is correct to be sceptical and if UK interest rates are not increased soon, the pound will suddenly look very vulnerable. A break of the DM2.38/39 area could see big sterling selling.'

The impact on the real economy of the pound's performance over the past few months is less clear. Kate Barker, of the Confederation of British Industry, argued that the move would have to be bigger and perceived as more likely to last before companies reacted by pursuing new international markets.

Robin Ebers, at the Institute of Export, said that in the German market in particular, demand for British goods was more dependent on quality and perceived value than on short-term price changes brought about by exchange rate moves. 'Changes in exchange rates make companies review their margins rather than change markets,' he added.

Analysts believe the real test for the pound will come if and when the dollar recovers. If the pound does not rise in tandem, this might be good news for exporters but it would be bad news for inflation as import prices rose. That might be enough of a sterling crisis to spur the Bank of England into action.

(Graphs omitted)