The mighty mark loses its grip: The currency's status as the kingpin of the ERM is under threat as doubts grow over Bundesbank policy

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A FEW months ago, a member of the Bundesbank council reassured a visiting dignitary that George Soros would not bet against the franc. The link between the French currency and the mark, safe from the depredations of the speculator who helped to break the Bank of England, would hold fast, he said.

Now the tables have turned. The link is under attack again, but this time it is the mighty mark that is feeble. Two weeks ago, Mr Soros set off a run in the German currency when he sharply criticised the Bundesbank's policy. As he thrust the knife in again last week during a speech in Budapest, the mark had dropped nearly eight pfennigs to DM1.70 against the dollar since he first spoke out.

Though Mr Soros cheerfully admitted he was talking his own book - having gone 'short' on marks by committing himself to selling them in future at what he hopes will be a higher price than he is able to buy them at in the market - he leads a growing band of market unbelievers who think the unchallenged reign of the mark is coming to an end. At the heart of his criticism is the charge that the Bundesbank, under Helmut Schlesinger, is being pulled in contradictory directions.

The Bundesbank is confronted with the highest inflation in Germany since the 1970s - at 4.2 per cent, it is also the highest in the Group of Seven, including Italy - which is a good reason for keeping interest rates up. High interest rates normally help to maintain a strong currency, holding down import prices and hence imported inflation.

But the Bundesbank is also faced with one of the worst German recessions since the Second World War. German industrial production has already fallen more than British industrial output, which explains the mounting pressure from politicians and industrialists for more interest rate reductions.

This dilemma between the needs of inflation and recession, Mr Soros said, meant the German central bank was on a hiding to nothing. It was in a similar position to the one confronting the British authorities last autumn. Whatever it said, everyone knew that German interest rates had to come down further and faster.

'The longer the Bundesbank persists in this policy, the bigger the recession in Germany, the worse it is for Europe and in the end the worse it is for what the Bundesbank is most concerned with: the value of the mark,' Mr Soros said.

Germany has deep-seated economic problems: a spiralling budget deficit worth 7 per cent of national income, brought on by the costs of supporting the east; high inflation driven up by runaway public spending and by the spending tax increases to curb the deficit; and a steep dive in international competitiveness. Germany's relative unit wage costs are now more than 40 per cent higher than they were in 1985.

If one exchange rate is falling, another must be rising. But the mark has suffered particularly from the renewed attractions of a recovery-boosted US dollar. The capital flows from Tokyo and Frankfurt into New York have weakened the mark against other currencies inside the European exchange rate mechanism. As a result, many have begun to question even the mark's role as the monetary kingpin or anchor of the ERM. Last week, for the first time in 26 years, France was able to take advantage of the strong franc to cut its interest rates below those in Germany.

'We shouldn't crow about this and start singing the Marseillaise,' said Jacques Delors, the European Commission President. The wave of ERM rate cuts led by France meant that 'not all decisions depend on the decision of a single country'.

Crowing was precisely what the French were doing, as Mr Delors, who has ambitions for the French presidency, well knew. German mark interest rates have traditionally been the floor to the rates of other currencies in the ERM, because international investors have always preferred to hold marks to other currencies if the interest rate rewards are the same. The franc, peseta and so on had to pay an interest rate premium on top of German interest rates to compensate for the risk of higher inflation and devaluation. Hence the mark's role as 'anchor' to the system.

Andre Icard, head of research at the Banque de France, said France and Germany were now 'sharing the duty' of anchoring the ERM, after France's successful cut in its intervention rate, taking it a quarter-point below Germany's discount rate to 7 per cent. The achievement was particularly sweet because the French had tried and failed to push their interest rates below German ones in 1991.

Just how sensitive the Germans were to this about-face in Europe's currency markets was revealed on Thursday. In a fit of pique, Theo Waigel, Bonn's Finance Minister, brusquely cancelled the planned top-level Franco-German council. Edmond Alphandery, the French Finance Minister, had hinted strongly on French radio that the talks would consider a co-ordinated rate cut, and had rubbed salt into German wounds.

Mr Alphandery boasted about the franc's new-found glory. 'We shall be able to talk as equals with the Germans. That was not the case a few weeks ago. Do you remember that the Germans supported the franc during the monetary storm of last September in very big proportions? Well now the franc is doing well, perhaps even better than the mark.'

Stung by these remarks, Mr Waigel hit back. He stressed that there was no question of any concerted monetary policy.

'We would like to draw attention to the fact that we know exactly what we are doing and what we should do and what we can do. We must also take care that the sovereignty and independence of the Bundesbank are not affected.' He would not take lectures from the French.

Mr Alphandery's remarks were as ill-judged in their impact on market sentiment as they were undiplomatic. Instead of maintaining its new-found strength in the ERM, the franc lost nearly a centime against the mark, closing on Friday at Fr3.3644.

'The fact that France wanted a co-ordinated rate cut at this meeting means they know they can't go on with unilateral rate cuts for ever. Alphandery's indiscretions may have cost the French a rate cut,' said Jim O'Neill, chief economist at Swiss Bank Corp.

But French interest rates still ended the week below German ones. Most impressively, they are below German interest rates not just for very short maturities - three months or a year - but for all maturities up to five years.

Even for 10-year government bonds, French interest rates (the yield on the bond) are only a sliver above the equivalent German ones. That means the market judges France to be almost as good an inflation risk as Germany, even in the medium term.

It is therefore no longer impossible that the franc could displace the mark as the 'anchor' to the system.

Traditionally, an anchor for a fixed or semi-fixed exchange rate system is a currency backed by a low and stable inflation rate (in the case of the post-war Bretton Woods system, gold assumed the formal role, but the mark and the Swiss franc were considered informal but acceptable alternatives).

On this basis, France now looks better suited to act as the anchor than Germany because its annual inflation rate is 2 per cent, more than two points lower. It may even be less prone to devaluation, since France has been gaining competitiveness against Germany because French prices have been rising less quickly than German ones. Although the mark has never been devalued within an exchange rate system since the monetary reform of 1948, there is little reason to suppose that the franc will be either.

The French economy is also contracting less sharply than Germany's, which may mean it is nearer to the higher interest rates that a recovery will eventually demand.

For cyclical reasons, too, the franc may be stronger than the mark. Independent forecasters think the French economy will shrink by 1 per cent this year, against more than 2 per cent for Germany. Nor does France face the prospect of the years of adjustment that German unification entails.

True, the anchor currency is also usually the reserve currency for the system. Central banks, citizens in the system, and even those outside, are willing holders of the anchor currency. Here the mark is indisputably much more qualified than the franc. Some 17 per cent of world currency reserves are held in marks, while external holders of French francs are far fewer. Even sterling's external role is greater than that of the French franc.

But the overseas holdings of the mark are a double-edged sword. In good times, they represent a vote of confidence in the currency. But a sudden switch into dollars or into yen can leave the mark reeling, as the Bundesbank has found in the past fortnight. Only last week, the bank's monthly report noted that foreigners bought a net DM94bn in German government bills and bonds in the four months to April. The cumulative sum is nearly 10 times larger.

But this is a cause of nervousness. Only a little of that glacier of foreign money has to melt to send the mark shooting down. Foreign exchange markets can react just like other asset markets in shares or property: they can push down currencies further than they deserve to go on the basis of underlying economic fundamentals (like trade surpluses and deficits, competitiveness and inflation).

No wonder the Bundesbank said it was 'all the more important to maintain confidence in the internal and external value of the mark'.

Yet the Frankfurt-based Bundesbank was much less sensitive to France's lower interest rates than Bonn. Indeed, it welcomed the fruits of other countries' own stability efforts. They should use every available space for rate reductions, said the Bundesbank. 'The DM rate must not set the floor for all ERM countries,' it wrote in its latest monthly report.

While obsessed with maintaining the stability of the mark, the Bundesbank is not wedded to being the sole anchor, something it sees as more of a burden than a bonus. 'To have several anchors in the ERM would suit us fine,' said a Bundesbank official.

But the notion that the mark will not be one of these anchor currencies is regarded as fantastic. An inflation-fighting reputation built up over five decades cannot be so lightly thrown away.

'What we are seeing at the moment is a balance of weakness,' said Herman Remsperger, chief economist of BHF-Bank in Frankfurt. 'No ERM economy is in great shape.'

Just as banks are telling their clients now to diversify their currency portfolios, so the anchors are diversifying too. 'But to talk of a dethroning of the mark is much too soon,' Mr Remsperger said. 'Just look at the way everyone, especially the French, are still focusing on the Bundesbank to cut rates. Frankfurt is still the place that counts.'

German economists see little immediate danger for the mark, and some respected analysts outside Frankfurt, like Jim O'Neill of Swiss Bank, share that view. At the beginning of the year, most banks forecast DM1.75-1.80 to the dollar by late 1993. 'Now exactly this is happening, and yet some claim to be unpleasantly surprised,' said Ulrich Beckmann, economist at Deutsche Bank. 'The talk in international markets of the fall of the mark is hugely over-dramatised,' added Dietrich Beier, chief economist at Berliner Bank. 'Whenever the dollar strengthens, the mark eases in the ERM. But this will be a slow process.'

(Photographs and graph omitted)