Economic Commentary: We are not out of the woods yet

It has been an unreservedly good week for the Chancellor, and it would be extremely pleasant to write that the corner has now been decisively turned for sterling, especially since the French are looking increasingly likely to vote 'yes'. But it remains hard for an analyst with anything other than a very short- term view to be so optimistic.

The two new 'events' of the past few days - the 10bn ecu borrowing facility to support sterling and the German pledge not to raise interest rates in present circumstances - both look much more impressive on the surface than they do on closer inspection.

Furthermore, the fundamental problem that underlies sterling's current troubles, the weakness of the domestic economy, shows every sign of getting worse at a somewhat alarming rate. The greater optimism in the UK financial markets that we can probably expect to see this week should therefore not be trusted.

Let us start by examining Britain's new borrowing facility. Last week, this column remarked that the Government's tactics for getting as far as the French referendum on 20 September would be based on a single word - intervention. The conclusion was that direct intervention in the currency markets was a legitimate tactic which would be sufficient to obviate the need for a base rate increase in the next few weeks, but that it would be foolish to expect intervention to provide a more permanent solution to the current policy dilemma.

The question now is whether this scepticism needs to be altered in the light of the Chancellor's bold and imaginative stroke last Thursday, when he announced a new 10bn ecu (or dollars 14bn) borrowing facility for the UK Government, all of which would be used to buy sterling over the remainder of this financial year.

The answer is that this does indeed increase the chances of avoiding a base rate rise in the rest of this year, since it enables the Bank of England to support sterling heavily without any loss of reserves. Furthermore, the knowledge that there is a forced buyer of dollars 14bn worth of sterling in the market will cause those speculators who have been selling sterling to think twice before acting again.

Political face

Finally, the arrangement involves a high-profile statement of intent by the Chancellor. He has always said that he will not devalue, but now he has put Britain's money where his mouth is (since any devaluation would involve making a significant foreign exchange loss on the new borrowing facility). Whether this makes any real difference to a government that was anyway facing a terminal loss of political face if it was forced to devalue is highly debatable. But every little bit helps in the game of bluff with the markets.

These are all significant plus points, which fully justify the Treasury's move. However, the basic fact remains that the Treasury's plan is simply one specific form of what is called 'sterilised' foreign exchange intervention, and the textbooks all tell us that such intervention has little permanent effect on the currency markets.

The new facility will work like this. The Government will borrow 5bn ecu immediately from a syndicate of banks, with the rest coming from longer-term capital market issues over several months. The foreign exchange so raised will then be used to buy sterling in the open market. If this were the end of the story, then the manoeuvre would be unequivocally good news for the UK currency.

However, consider what would happen in the UK's domestic money markets if this were the end of the story. Cash would be drained out of the system as the Bank of England bought sterling, and interest rates would inevitably rise sharply. The Treasury's scheme, far from being a way of avoiding an increase in interest rates, would directly cause a large increase in base rates within days.

This outcome will be avoided by the second part of the plan. The sterling purchased in the foreign exchange markets will not in fact be permanently drained from the UK system, but will be used to finance the Government's borrowing requirement, and will therefore enable fewer gilts to be sold.

This will re-inject the sterling back into the domestic money markets, thus offsetting the tendency for interest rates to rise. The second part of the plan will therefore 'sterilise' the impact of the currency intervention on interest rates - which is why it is unlikely to make any fundamental difference to the valuation of sterling.

But what about the weekend pledge from the Germans not to raise interest rates 'in present circumstances'? Is this not likely to underpin sterling in a more fundamental way? Perhaps it would if we could take the pledge at face value. But in fact it has all the hallmarks of a concession that has been wrought out of the German Finance Minister - not the Bundesbank - after much wrangling around a bleary-eyed EC bargaining table. And as such it does not amount to much more than a row of half-baked beans.

The backwoodsmen of the Bundesbank Central Council, when they meet in Frankfurt, are unlikely to take the view that their actions are bound by the Bath statement, which is in any case couched in highly hedged language.

Unfortunate effects

This is made more likely by the fact that Britain's new borrowing facility, and other central bank intervention to hold the exchange rate mechanism together, will have highly unfortunate effects in the German money markets.

Assume that Britain borrows marks to purchase sterling. In the same way as this intervention drains the UK money markets of sterling, and needs to be sterilised in order to prevent interest rates from rising, the opposite effect occurs in Germany. The Bundesbank will find that more marks are being injected into the system in London, and many of these are certain to find their way into the domestic German money markets in Frankfurt.

This will have two effects, both of which will be highly unwelcome to the Bundesbank. First, it will inflate the German money supply; second, it will put downwards pressure on German interest rates. Since this combination is wholly unacceptable to the Germans, they will certainly attempt to offset or sterilise both effects by directly draining money from their own system.

However, in similar circumstances in the past they have often found it difficult to retain full control over monetary growth. In fact, the Bundesbank has for this reason generally been highly uncomfortable whenever large-scale currency intervention has been holding the mark down 'artificially' as it would see it - and indeed, on this issue, it shares Margaret Thatcher's view that governments cannot expect to 'buck' the markets for very long.

This, I am afraid, is just another reason why the British government's intervention tactics will work at best for only a short period. Even if the French vote 'yes' to provide a temporary respite, the weakness of economic activity in the UK remains such that a spontaneous strengthening in sterling is not very likely, so more intervention will be necessary.

And sooner or later the backwoodsmen in Frankfurt, becoming uncomfortable with the effects of intervention on their domestic monetary aggregates, might well decide to bring matters to a head by tightening German monetary policy yet again. They have wanted to force an ERM realignment for two years now, and they will not quit easily with victory in sight.