ERM at 'breaking point': Bundesbank refuses to rescue the franc by cutting interest rates, forcing central banks to spend billions

THE EUROPEAN exchange rate mechanism was pushed to the verge of collapse yesterday as an unexpected refusal by the Bundesbank to cut a key German interest rate triggered massive speculation against the system's weakest currencies.

The decision appeared to be a snub to France, which had earlier expressed confidence that the central bank was committed to defending the key link between the franc and mark. The strain on Franco-German relations could have far-reaching consequences for the EC and for the French government, within which there is a significant lobby against ERM membership.

Frantic trading saw investors and speculators fleeing from European currencies, forcing ERM central banks to spend billions of pounds propping them up in the system. About DM10bn-DM20bn (pounds 4bn-pounds 8bn) was thought to have been spent defending the French franc, but some dealers said the figure could have been ten times larger. That compares with about pounds 12.4bn spent defending sterling before its exit from the ERM.

Dealers said the franc, Spanish peseta, Portuguese escudo and Danish krone were in imminent danger of devaluation or - like the pound last September - expulsion from the system. Cracking the link between the franc and mark would probably destroy the ERM, which for 14 years has been the cornerstone of European economic co-operation and hopes for a single currency.

Edouard Balladur, the French Prime Minister, had crisis talks last night with his economic and finance ministers and the governor of the Bank of France. Officials in Brussels refused to discuss the possibility of any changes in the ERM, or to speculate on a meeting of the EC's powerful and secretive monetary committee.

'The ERM is at breaking point,' said Paul Chertkow, economist at the City firm UBS. 'We believe that the pressure will force the suspension of the system. No one seriously believes this level of intervention is sustainable or desirable.'

The Bundesbank left its key discount interest rate unchanged at 6.75 per cent, confounding expectations of a cut to 6.25 per cent.

Economists concluded that the heads of the Bundesbank's regional branches had resented being pushed towards a cut by the Frankfurt directorate, and had demanded that the central bank's anti-inflationary credibility be put before its support for the ERM. Money supply growth and inflation in Germany are running well above the Bundesbank's target rates.

The announcement of the Bundesbank council's decision sent the franc and other weak ERM currencies into a tailspin, forcing swift central bank intervention. The Bank of France and the Bundesbank later led concerted intervention in support of the franc, buying at Fr3.4180 to the mark until the end of European trading, when central banks no longer have to keep their currencies in ERM bands.

The Bank of France then stopped intervening, but was forced back into the market as New York trading pushed the franc below Fr3.42. Its floor in the system is Fr3.4305.

The dollar and the pound were beneficiaries, with sterling closing 1.32 pfennigs higher at DM2.5764 - compared with its old ERM floor of DM2.78 - and the dollar gaining over a pfennig and a half to close at DM1.7345. The stock market was also cheered by the prospect of an ERM collapse, which would herald a wave of interest rate reductions and revive Britain's export markets.

European rate cuts would also buoy the pound further, putting pressure on the Chancellor, Kenneth Clarke, to cut British interest rates from their current 6 per cent.

The ERM crisis has been triggered by the conflicting needs of France and Spain to cut interest rates to reduce record unemployment but match German rates to keep currencies above their lowest permitted rates against the mark. The markets increasingly conclude that they will have to cut interest rates, if necessary by leaving the ERM.

If a meeting of the monetary committee is triggered, the normal option - a realignment, involving devaluation by France, Denmark, Belgium and others - would by no means end the crisis. It would bring together angry and confused officials, since the Bundesbank's actions have blown a hole in the economic policies of virtually every EC state.

One option which has been considered is a rapid move to closer monetary union by Germany, France, Belgium, Luxembourg, the Netherlands and possibly Denmark. But this would cause grave political problems in Germany, where the idea of sacrificing the mark on the altar of European unity is deeply unpopular.

The EC's broader project of Economic and Monetary Union by the end of the century looks gravely wounded, if not dead. The single currency is the centrepiece of the Maastricht treaty.

The ERM crisis has revived fears in Brussels that co-operation across a broad range of areas is in jeopardy. The single market, the most tangible result of the EC, would be far harder to operate without the ERM.

The renewed pressure on the franc gives ammunition to French opponents of dependence on 'monetary purists' in Frankfurt. Most dissent is concentrated within the dominant Gaullist RPR party, behind the leadership of Philippe Seguin, the National Assembly president and main campaigner against ratification of Maastricht last year.

Leading article, page 19

Strain on alliance, page 23

View from City Road, page 24