Pound plunges as Government gives markets the jitters

The pound plunged on the foreign exchanges yesterday as worries about weakness in the Government hit the markets.

Sterling's exchange rate against the German mark reached its lowest value for nearly two years, closing at DM2.3585, despite unconfirmed Bank of England intervention to control the slide. Many analysts in the City predicted that it could pass its all-time low of DM2.3147 - which it reached after the exchange rate mechanism crisis in September 1992 - within the next few days.

Bill Martin, chief economist at international bank UBS in London, said: ``There is a deadly combination of political concern that the Government is weak and might be forced into an early election and economic concern that interest rates will need to rise so much to stop inflation that the economy will be hit."

Mr Martin said that even if both concerns were misplaced, the pound could fall even further.

Steven Bell, chief economist at the City merchant bank Morgan Grenfell, said: ``The crummy political situation has caused this. The pound might stop falling at about DM2.30.''

Concerned foreign investors focused at first on the Government split over the single European currency added to the mistaken view by Japanese investors that there would have to be a referendum on Europe.

But as the pound continued to tumble in value during the day, the currency market alarms grew over general political uncertainties.

However, despite market jitters, a majority of independent economists share the Bank of England and Treasury view that the economy is in reasonable shape. Mr Bell pointed out that although the pound's fall this year looks dramatic, the exchange rate had been remarkably stable since shortly after Britain's inelegant exit from the ERM.

Even so, a weaker pound is likely to bring forward the date of the next rise in base rates because of fears over inflation. Rates have been increased three times since September, and are widely expected to rise to between 7.5 and 8 per cent from the current level of 6.75 per cent.

Although the Bank of England is keen to avoid the impression that this is an old-fashioned sterling crisis that will force it into raising interest rates sharply, a weaker exchange rate will add to inflationary pressure. Import prices will be higher and exporters already running at high capacity will face even greater demand for their goods overseas. Figures on retail prices, retail sales, earnings and unemployment published today, will come under the spotlight as City analysts look for more evidence that inflation is already rising.

The Government published figures on Monday revealing that last month industry's raw material costs were rising at their fastest rate for nearly 13 years.

Sterling crisis, page 32