Pound falls on hope of lower interest rates

THE POUND fell sharply last night as French approval for the Maastricht treaty fuelled hopes of British interest rate cuts and Norman Lamont, the Chancellor, indicated that the sterling's return to the exchange rate mechanism could be years away, even if the system survives the current crisis.

The pound slid to around DM2.5650 in early trading in Tokyo and Sydney, according to NatWest Capital Markets. This was almost 5 pfennigs down on Friday's London close. Trading was active between ERM currencies, but relatively volatile.

While all EC states welcomed the French acceptance of the treaty, some delegations acknowledged for the first time that the European Monetary System had broken up into several tiers, with sterling in the bottom rank.

The City was hopeful that British interest rates could soon be cut, although the Chancellor did not indicate that an immediate reduction was in prospect. Economists believe that base rates could well fall to 8 per cent by the end of the year from their current 10 per cent, with the first cut possible this week. This would almost certainly trigger a wave of mortgage rate reductions and could help pull the economy out of recession.

The French franc was slightly stronger on the first indications of a 'yes' vote, but economists said it could well come under heavy selling pressure this morning. 'The markets will test the willingness of the Bundesbank to support the franc,' Alison Cottrell, of Midland Montagu, said. Pierro Barucci, the Italian treasury minister, also announced the lira would not return to the ERM tomorrow as planned 'to allow a further period of examination of the market'.

The US dollar slipped overnight, having been boosted late last week as currency dealers fled from the turmoil in the European markets.

The Chancellor announced that while outside the ERM Britain would judge its anti-inflationary policies by the growth in the amount of money circulating in the economy and asset prices, especially house prices. Nigel Richardson, an economist at Warburg Securities, said the new framework presented 'the danger of a return to the rudderless policies of the late 1980s'.

'The chance of Britain rejoining the ERM this year has been reduced, so the market is concentrating on the prospect of lower rates,' Avinash Persaud, of UBS Phillips & Drew, said.

Outlining conditions for sterling's resumed membership, Mr Lamont said at the International Monetary Fund meeting in Washington that the performance of the German and British economies must first converge, so that Britain was no longer buffeted by high German rates due to the inflationary pressures of unification. Offering a glimpse of how far away that may be, he said: 'It is not impossible to believe that the two countries can move towards a closer point in the (economic) cycle, once reunification comes to a successful conclusion.'

Theo Waigel, the German Finance Minister, rejected Britain's claim that the costs of unification were at the root of the crisis, arguing that Germany was paying for it itself. 'You know what the Chancellor of the Exchequer said and you know what I have said - I think you should believe what I said,' he added.

The Chancellor said that the other main condition for revived ERM membership was a reform of the system, in which strong currency countries were obliged to step into the foreign exchange markets as well as weak currency countries. This was something Germany signally failed to do before sterling left the ERM last Wednesday, he said.

Mr Lamont said that British interest rates were higher than justified by the progress against inflation. But the fall in sterling last week has produced 'some loosening' of monetary policy, he said.

The Chancellor echoed several colleagues in expressing hope that the vote would 'help ease tensions' in the currency markets today.

Mr Lamont went out of his way, however, to emphasise the obstacles still in the way of ratification of the Maastricht treaty, saying the narrowness of the French vote showed public support for it was still uncertain.

'Although this is the result that the French government has been looking for, plainly public opinion has to be taken into account in the development of Europe,' he said.

Wim Kok, the Dutch finance minister, said Europe was for now functioning with a multi-tiered monetary system, which had relegated to the bottom rung the pound, the lira and drachma. 'The differentiation in speeds is already visible and that in itself is not a disaster'.

Mr Lamont avoided answering directly a French television report last night that there was likely to be further realignment of the ERM today. 'There is no realignment', he said, without elaboration.