Pound plunges as foreigners react to Tories' battle

DIANE COYLE

Economics Correspondent

The pound crashed to a record low on the foreign exchange markets yesterday as overseas investors stampeded out of sterling in reaction to the Conservative leadership battle.

The City described it as a sterling crisis but did not expect it to trigger an emergency rise in interest rates.

The pound's index against a range of other currencies touched its record low, set seven weeks ago, during the afternoon. Dealers predicted it would continue to fall until the leadership is decided.

"This is definitely a crisis," said Ifty Islam, currency strategist at investment bank Merrill Lynch. "We can only hope this is the point of maximum uncertainty."

The weakness of the pound will be high on the agenda at next Wednesday's monthly meeting between Kenneth Clarke, Chancellor of the Exchequer, and Eddie George, Governor of the Bank of England. Although a rise in base rates the day after the first round of the leadership election would astonish the City, financial markets have revised up their bets on the level of base rates by December.

The short sterling futures market now expects rates at 7.5 per cent by the end of the year.

The pound's fall reflected widespread selling by long-term overseas investors, shaken by the speculator-driven drop in the currency after John Redwood's announcement on Monday.

Rumours in the afternoon that Michael Portillo had resigned from the Cabinet to enter the first round, although promptly denied, ratcheted sterling down another notch. The switch from mainly speculative to mainly institutional selling occurred overnight in New York.

Paul Chertkow, chief currency economist at UBS, said: "Anything that brought the general election forward would now be seen as positive by overseas fund managers. It would end the uncertainty."

Nick Parsons at Standard Chartered agreed. "It is the only time I have known the need for a Labour government to rally sterling," he said.

The sterling index touched 82.7, the record low set on 9 May, on the Portillo rumours, before recovering to close at 82.9. Against the mark it fell to DM2.1860, less than a pfennig higher than the all-time low, closing at DM2.1889. The pound has fallen nearly five pfennigs since John Major's announcement last Thursday.

The dollar's weakness added to sterling's problems yesterday. As well as continuing worries about the trade war with Japan, a sharp fall in consumer confidence also hit the US currency.

The confidence index fell to its lowest level since last October, in the biggest decline since early 1992. One of the few economic indicators to be published before the Federal Reserve's policy meeting next week, it boosted chances of a cut in US interest rates. US bonds and shares rallied, while the dollar fell temporarily below DM1.37 and 84 yen.

Chris Turner, currency analyst at BZW, said: "If the dollar dives because trade sanctions are imposed, the pound will be in even bigger danger."

An additional hurdle this week is a big auction of gilt-edged stocks tomorrow, when the Bank of England has to sell pounds 2.5bn worth of gilts.

Mr Islam said: "The auction's success or otherwise will be an important signal of the state of confidence."

Most analysts agreed that the worst outcome for the pound next week would be for Mr Major to cling to power without a resounding victory. Investors were concerned about the uncertainty as well as the policies Mr Major or a successor might turn to before the election. Markets fear over-generous tax cuts and a more relaxed attitude to interest rates.

George Magnus, of SG Warburg, said there were also concerns that a Conservative government led by a Eurosceptic would undermine any interest in the pound's level against other European currencies. "Portents for the pound all look very bad. Its recovery might have to wait until we have a pro-European Labour government," he said.

Amid consternation about political developments, dealers speculated that the Bank of England had intervened secretly to smooth the pound's downward path. Some predicted open intervention to send a signal to the markets as the next step.

An increase in base rates was seen as a last resort, and one that could well be counter-productive. "Investors would see it as a panic measure," Neil MacKinnon, Citibank's chief economist, said. Past experience of the effect of higher base rates on the pound is not encouraging - a 3 percentage point jump in September 1992 could not stop the pound crashing from the exchange rate mechanism.