The European Crisis: Only Bonn can save the franc

THE BATTLE between the foreign exchange markets and the French government makes last week's sterling crisis look like a skirmish. The selling pressure may be similar, but the political and economic investment which France's President, Francois Mitterrand, and his Prime Minister, Pierre Beregovoy, have made in the franc fort is incomparably greater than the British government's commitment to the ERM.

A strong franc which could hold its own against the mark has been the foundation stone of French policy since President Mitterrand's U-turn in 1982. This began as a determined and successful attempt to squeeze French inflation, but it became much more.

There has been no change in the franc-mark link since February 1987, and the Elysee firmly intends that there never shall be. The plan has been to establish a single European currency without any further change in the present exchange rate.

This political agenda has, though, coincided with the immense economic shock caused by the reunification of Germany. By pumping cash into east Germany, Bonn has supercharged the German economy. In order to stop demand racing ahead of supply, thus boosting inflation, the independent Bundesbank has raised interest rates to record levels.

Normally, this would pull up the mark, cut the price of German imports, and reduce inflation. But this could not happen, because the mark has been fixed against the currency of Germany's largest trading partner. So interest rates had to be even higher in Germany to curb spending at home.

Until now, politics has triumphed over economics, despite the strong case for a mark upvaluation against everyone else, including the franc. But the 'petit oui' in last Sunday's referendum in France on the Maastricht treaty has persuaded many in the markets that the franc is now as vulnerable as the Italian lira and the British pound. If the markets succeed in dislodging the franc, they will have carried off their most valuable scalp.

Yesterday's talks between President Mitterrand and Chancellor Helmut Kohl were unusually secretive, but they probably revolved around what could be done to hold the franc rate. The problem for the French is that their weapons are blunt: they may have spent as much as a third of their reserves in one day. We know from last week's sterling crisis that the speculative selling can become an 'avalanche'.

Nor will a rise in interest rates necessarily suffice to hold the line: once the markets believe that a 10 per cent devaluation will happen soon, they need an extra 10 per cent interest over a short period (not a whole year) to compensate for the risk of holding the weak currency. France's only hope is that the Germans can come to the rescue.

In principle, the Bundesbank could cut interest rates. It could print as many marks as it liked, thus meeting demand and stopping the fall of the franc. But it is fiercely independent and politically popular.

The Bonn government was roundly criticised for putting pressure on the Bundesbank to make a quarter point cut in interest rates last week, and may not dare to risk it again. But if the Bundesbank does not move, the franc may be doomed.

(Graphs omitted)