Players lay siege on weak krone

EUROPEAN Exchange Rate Mechanism (ERM) strife dominated trading towards the end of last week, as central banks intervened and manipulated interest rates to spare the Danish krone from devaluation. Although the French franc remains weak, currency speculators have switched to the Danish currency which is viewed as an easier target.

More is at stake, however, than the Danish krone. If the currency is forced out of the ERM, this will put intense pressure on the franc, which could herald the end of the system. The threat is not new. In the battle between market participants who are sceptical of fixed exchange rate bands and the European governments who want to impose them, Britain and Italy were forced out of the system 10 months ago.

Last week's events portend greater danger for the ERM, however, because the franc and the mark are core currencies within the system.

Deepening recession throughout Europe has left ERM members struggling to maintain the artificially high interest rates necessary to support their currencies within system. High interest rates in Europe are a direct result of the Bundesbank obligation to pursue a tight monetary strategy in the wake of the country's burgeoning budget deficit following reunification. Unless Germany substantially reduces interest rates, clearing a path for the struggling ERM currencies to follow, the system will break down.

The signals, so far, from Germany hold little promise. Key interest rates were left unchanged at Thursday's Bundesbank council meeting. With only one more Bundesbank meeting scheduled before the summer recess, the ERM is fast running out of time. If no intent to lower rates is forthcoming within the next week market speculators will increase the heat on the ERM.

It is difficult to forecast what the outcome will be. However, we would strongly urge that dollar based investors hedge their exposure to the ERM currencies. It is probably too late for the Danish krone because overnight interest rates have already catapulted to 35 per cent, but for French franc and the peseta denominated investments, this would be a prudent strategy.

Pauline Gately is head of research at BNP International Financial Services Ltd