Economics: Markets sweat over French poll

The markets are right to be worried about a French 'non' to Maastricht in the referendum on 20 September. The Danish rejection at the beginning of June caused the first crisis within the European exchange rate mechanism since the last realignment in 1987, pushing Italian interest rates up to 18 per cent at one point. But its impact could be as nothing compared with a French rejection. Sterling and UK interest rates would be in the firing line.

The result is crucial for the markets, as the Japanese investment house Daiwa Securities showed last week when it commissioned one of the polls. With the 'no' vote creeping upwards, and with a large slice of 'don't knows', the chances of rejection may now be as high as 40 per cent. Even Gerard Depardieu is being thrown into the 'yes' campaign.

The French hold a special place in European monetary integration, since both the exchange rate mechanism and now the move towards European monetary union have been at their behest. If that motive force is removed, EMU will be dead for a long time. Many other Europeans - including many British MPs and ministers - would breathe a sigh of relief. But they underestimate the rollercoaster ride in store.

If EMU dies, so do the convergence conditions which countries are meant to meet. The most important of these, from a market point of view, is low inflation. To be able to join the EMU, countries must have inflation rates within 1.5 percentage points of the three best-performing nations in Europe. In other words, their inflation rate has to be very similar to the likely performance of Germany, Belgium and the Netherlands.

But if there is no prospect of any such EMU, the markets have to ask themselves which countries are likely to continue to cleave to low inflation, and which may decide to opt for higher inflation rates in an attempt to buy short-term relief from recession. This process of separating sheep from goats will affect all the principal financial markets.

Take currencies first. They are traditionally sensitive to speculative attack, particularly if they have been pegged at a rate which some analysts in the markets feel to be inconsistent with the long-term balance of supply and demand for the currency - determined in turn by relative inflation, competitiveness, the balance of trade, and likely long-run capital inflows or outflows.

After the Danish referendum, the doubts about Italy's ability to hold the lira at its present parities steadily mounted. By the middle of last month, money was flowing out of the lira and into the mark, perceived to be the most solid and non-inflationary of the European currencies. The Banca d'Italia had sharply raised interest rates to provide investors with a premium against the risk of devaluation.

This time, any crisis could also affect sterling. The pound was relatively unscathed by the Danish referendum, perhaps because there has been a presumption that the UK might be among a smaller number of countries proceeding to adopt a single currency in 1999 even if Italy and Spain - the Club Mediterranee - fail to qualify.

But a French rejection would mean no EMU at all, even with Germany and the Benelux. So the need for the British to aim for Teutonically low inflation would disappear. The markets might begin to ask questions about the British government's real inflation objectives: perhaps 4 or even 5 per cent inflation would not look so bad in exchange for a speedier end to the recession.

Another reason why the British government is unlikely to enjoy such an easy ride as it did after the Danish referendum is the growth of political opposition at home. At the beginning of June, there were still hopes on the Tory back benches of a post- election recovery. The troops are now much more restless, and the Government might face a revolt if it raised interest rates.

The Chancellor would no doubt hope that his EC colleagues might accommodate a flight of capital into the mark by allowing a rise in its official parity within the system. This might also encourage the Bundesbank to cut interest rates, on the grounds that a higher currency would reduce import prices and hence inflationary pressures.

But the French are highly unlikely to abandon their policy of the franc fort so easily. They will want to go up with the Germans, which would leave the British either struggling to keep up with the Germans or devaluing with the Italians and the Spanish.

The Chancellor might decide to tough it out, but it would be costly. With the pound at the bottom of its range, he would almost certainly have to raise interest rates if he wanted to stick with present parities. He would be wise to react quickly with a 1-percentage point rise in interest rates and possibly a move to the narrow 2.25 per cent ERM bands. If he blinks, capital flight could eject sterling from the system entirely.

The second option is a devaluation within the ERM, along with the Italians and the Spanish. It would provide some competitiveness but would not help cut interest rates, which would have to stay higher than Germany's to persuade the markets to hold sterling. But a devaluation might help to avoid an interest rate rise if the markets believed that the new rate would hold for some time.

There would, though, be long- term damage to the Government's credibility and finances. As soon as the markets became worried about another devaluation, interest rates would have to be a good deal higher than Germany's. The cost of financing the budget deficit would also rise. Bonds which pay fixed-interest rates are particularly sensitive to long-run inflation projections. If inflation is thought likely to be higher, the fixed interest on the bond is worth less, and the price falls to allow a higher yield. UK bonds avoided such a fate after the Danish referendum, as the graphs show, but a devaluation would have an effect.

The third option is to allow the pound to float outside the European Monetary System, but this is not as anodyne as it sounds. Sterling would fall. But the key question is how much? If the pound sagged by 10 per cent - to about DM2.50 - the knock-on effect on inflation (through rising import prices) might be as little as 2 per cent because of the depressed state of the economy. The Government might feel relaxed about cutting short-term interest rates to 7 per cent. There would be a tussle about bond yields. Higher inflation would spell higher bond yields, but less attractive returns on cash could mean lower bond yields. Share prices would probably rise in anticipation of a recovery.

A real run on sterling and a flight into the mark could make the calculations very different. With the pound down 20 per cent, the Government might decide that it had to keep up short-term interest rates or even raise them. The bond market could be in retreat, and share prices could be pummelled by high bond yields, high short-term interest rates and uncertainty about the recovery. Tory backbenchers who think a French 'no' would do Britain a favour may be in for a shock.