Mexico spells ERM trouble

After a week of panic in world currency markets, fears are growing among foreign exchange dealers that the European Exchange Rate Mechanism may be heading for the most damaging crisis in its history.

Several European currencies, including the Spanish peseta, the French franc, the Italian lira and the Swedish kronor, are likely to come under further intense downward pressure this week. In recent days they have been victims of the "flight to quality" triggered by the collapse of the Mexican peso two weeks ago as investors rushed to put their money into the German mark, regarded as the only safe haven in Europe.

Turmoil is also expected in East Asia, where the currencies of countries including Thailand, Malaysia, Indonesia and Singapore are likely to weaken further after heavy falls last week. "Mexico's problems have focused people on the risks of certain countries, and it's far too soon to say if the trouble in Mexico is over," said Bill Dudley, economist at the US investment bank Goldman Sachs.

Already this year, the Spanish currency has lost 5 per cent of its value, falling to Ptas91.9 against the mark - within 5 per cent of its ERM floor of Ptas87.15. The franc fell to Fr3.45 - a14-month low - on Friday while the lira also weakened significantly against the mark to L1,055.10.

Pedro Soldes, the Spanish economics minister, said on Friday that the weakness of the peseta was "part of a much wider currency crisis".

"I would be very surprised if there was not trouble in the ERM before the end of the first quarter," said Michael Burke, economist and currency analyst at Citibank. "The catalyst is likely to be the next German interest rate hike, probably before the endof March." Another dealer said: "The mark will continue to strengthen while the peseta and franc will weaken. I am not predicting the end of the ERM just yet, but the floors of the ERM bands are close now."

Many analysts believe that for any currency to breach its ERM divergence limits would seriously undermine the credibility of the system when European politicians are struggling to keep alive the goal of a single currency. After the last crisis in 1992, the permitted divergence of most ERM currencies from their central rate was dramatically widened from 2.25 to 15 per cent in the belief that such wide bands could never be breached. That now looks ill-founded.

If foreign exchange market sentiment turns strongly against the most vulnerable currencies, there could be concerted speculative action of the kind that nearly destroyed the ERM and forced sterling out of the system more than two years ago.

The market is concerned that, with inflationary pressures growing, Germany will raise its interest rates, which would strengthen the mark still further at the expense of other European currencies. "This would be grim news for the French and Spanish, who might not be able to follow without damaging their own economy," Mr Burke said.

Sterling, however, has been relatively untouched by the currency drama thanks to the strength of Britain's economic recovery. It has held its value against the mark during the week at around DM2.40.

While the flight to the "safe" currencies of the mark and yen continues, there were signs on Friday that the dollar was stabilising. Most analysts believe it is undervalued and should start rising in the longer term.