Little hope of pound's early return to ERM

SENIOR ministers will sanction the pound's re-entry into the European exchange rate mechanism only if there is clear evidence of a recovery in the British economy.

Other conditions discussed by ministers include a fall in German interest rates and the reinforcement of the exchange rate mechanism to withstand what one policy maker described as the 'hurricane force' of the market pressure on sterling last week.

The list of preconditions will buttress the view in the City's financial markets that re-entry into the ERM is unlikely for the foreseeable future, even if the system survives the aftermath of today's French vote.

Hopes of a reduction in base rates from their current 10 per cent as early as this week added almost pounds 40bn to the value of London shares on Thursday and Friday, with the FT-SE index of 100 leading company shares rising by almost 200 points.

The pound closed on Friday at DM2.6107, nearly 17 pfennigs below its former floor in the ERM. Sterling has effectively been devalued by more than 11 per cent from its old DM2.95 central rate, and is now at an all-time low.

Ministers are determined that before sterling re-enters the ERM there should be stronger international co-operation - code for better behaviour on the part of the German Bundesbank, whose loose talk is blamed for triggering the sterling crisis.

One official said this might be reinforced by an explicit risk-sharing arrangement, whereby countries whose currencies are strengthening within the system are obliged to supply more of their currencies to meet demand.

Some UK officials want to resuscitate the so-called 'divergence indicator', which highlights the currency causing the most strains within the system. If it is a strong currency - such as the mark recently - there would be a presumption of action such as interest rate cuts to bring it back into line.

But the most practical precondition is that a UK recovery should be under way and German interest rates coming down. If a recovery is not under way, the Chancellor could be constrained by backbench opinion from raising interest rates, and this reluctance could make sterling vulnerable.

Finance ministers and central bankers of the Group of Seven leading industrial countries were yesterday set to issue an appeal for calm on the currency markets in the face of mounting concern that turmoil could break out afresh in trading this week.

But the talks, which were being held at Dunbarton House, an elegant mansion in the Georgetown suburb of Washington, were also expected to be the scene of a frosty face-to-face encounter between Norman Lamont and Helmut Schlesinger, the Bundesbank president, their first meeting since sterling was forced out of the system on Wednesday.

Treasury officials and ministers were seething last week about the remarks made by Mr Schlesinger in a newspaper interview, although they attribute the episode to carelessness rather than malice.

In addition to their public appeal for calm on the markets, the Seven were set privately to draw up contingency plans for dealing with further upheavals on the foreign exchanges this week. But it is privately admitted that it would be folly for the G7 to attempt to take on the markets after the savaging to which the EMS has been subjected.

With everything pinned on the outcome of the French referendum on Maastricht, provisional planning has begun in Brussels for establishment of a slimmed-down EMS, comprising the hard currency countries of Germany, the Netherlands, Belgium, Denmark and, if possible, France. In the event of a French rejection of Maastricht, it was being assumed that weaker currencies would have to leave the system.

The Chancellor has decided to return to London tomorrow, 24 hours earlier than planned. Other European ministers are also thought to be preparing to return to their capitals and leave the International Monetary Fund annual meetings early in case of renewed currency turbulence.

But there were fears in Washington yesterday that the US authorities, and even the IMF, may have to get involved if the crisis becomes prolonged.

The IMF's managing director, Michel Camdessus, has warned that the EMS crisis was triggered by deepening concern over the size of the Italian and German budget deficits. Mr Camdessus insists that Italy's deficit needed to be tackled with 'immense urgency'.

The Seven were also due to assess the progress of Russia's economic reforms, amid growing indications that a planned IMF loan of between dollars 3bn and dollars 4bn may have to be delayed, possibly until next year. But ministers were expected to give the green light to negotiations for a 10-year rescheduling of repayments on the roughly dollars 60bn of foreign debts owed by the states of the former Soviet Union.