The Sterling Crisis: Pound goes into free fall

THE GOVERNMENT last night abandoned its long struggle to keep the pound in the European exchange rate mechanism, leaving the foreign exchange markets free to push the currency down in a de facto devaluation.

Norman Lamont, the Chancellor, had vowed not to bow to market pressures. But, speaking from the Treasury courtyard yesterday evening, he said: 'The Government has concluded that Britain's best interests would be served by suspending our membership of the exchange rate mechanism.'

Mr Lamont's statement followed a day of desperate - but ultimately futile - measures to defend the pound. Massive support buying of the currency was estimated to have used up pounds 10bn, nearly half Britain's foreign currency reserves. The announcement of two interest rate increases in just over three hours shocked Westminster and the City, but still failed to lift the pound from its ERM floor.

The decision to float the pound sent the currency plunging in overnight trading. Within minutes of Mr Lamont's statement, sterling was quoted at DM2.68 in New York, almost 10 pfennigs below its former floor. The pound closed at DM2.69. But in Tokyo it began trading at DM2.6650.

Mr Lamont also announced the cancellation of the second of yesterday's interest rate rises. The first increase, from 10 to 12 per cent, remains in place. But the intended rise to 15 per cent this morning was abandoned when it was decided to float the pound.

City economists predicted the pound would fall to about DM2.60. If sterling re-entered the ERM at this level it would amount to a 10 per cent devaluation. But Bill Martin, of UBS Phillips and Drew, said it was 'crazy' to keep interest rates at 12 per cent while floating. He said base rates could be cut to 8 per cent, with the pound possibly as low as DM2.40. There is nothing to stop dealers selling the pound for as little as they wish, because the Bank of England is no longer committed to buy unlimited amounts of sterling at its previous floor level of DM2.7780.

Mr Lamont called a meeting of the European Community's monetary committee - consisting of senior central bank and finance ministry officials - which was held in Brussels late last night. It was understood that the British delegation - led by Nigel Wicks, the Treasury second permanent secretary - would attempt to secure the suspension of the entire ERM, but with little hope of achieving it.

The Treasury's intention appears to be to allow the pound to float for some days, even after the result of the French referendum on Maastricht is known on Sunday. The move was understood to have been taken unilaterally and without any quid pro quo from our European partners.

Official sources said the Government was not indifferent to sterling's level and would rejoin the ERM at an exchange rate consistent with market conditions and the pursuit of low inflation.

Economists had been convinced by the close of trading that a sharp cut in German interest rates was needed to restore stability to the ERM, in return for which the Bundesbank would demand devaluation of the pound, the lira and perhaps the Spanish peseta.

The announcement of two rate rises in one day was unprecedented but it failed to impress the markets. One dealer said that the markets 'scented blood'. The rises would have been the most rapid tightening in interest rates since the outbreak of the First World War.

A wave of mortgage rate increases and a slump in consumer confidence may still result if Mr Lamont is unable to reverse the rise in base rates to 12 per cent.

Yesterday's crisis was triggered on Tuesday evening by reports of an interview in Handelsblatt and the Wall Street Journal with Helmut Schlesinger, the Bundesbank president, in which he said the tensions in the ERM would have been eased more successfully had other currencies realigned with the lira last weekend. With the German central bank apparently uncommitted to defending the pound, sterling sank.

The pound was also sold on more fundamental grounds, with dealers increasingly convinced that the economy cannot make a meaningful recovery at current exchange rates and interest rates.

Share prices fell dramatically as the base rate announcements and support buying failed to lift the pound. But speculation during the afternoon about a devaluation, allowing a sharp lowering in interest rates, saw a stunning rally. Having been nearly 80 points down on the day in mid- morning, the FTSE index of 100 leading London shares rebounded to end the day 8.3 points up at 2,378.3.

(Photograph omitted)