DRAMA within the European Exchange Rate Mechanism (ERM) reached new heights last week as speculators embarked on an all-out attack on the French franc, after the German Bundesbank failed to cut its key discount rate. On Friday, the system came perilously close to destruction when the franc and the Danish krone both hit their effective floor within the system. The Belgian franc, peseta and escudo also came close to their downward limit. Belgium and Denmark raised interest rates and central banks spent an estimated US$17.5 billion to try to alleviate pressure. Although this was successful in lifting the French franc back within its target range, market determination to smash the system remains intact. Interest rate hikes are unsustainable in countries like France and Spain where unemployment is running at 11.6 per cent and more than 22 per cent respectively. Central bank intervention of the magnitude as witnessed on Friday cannot continue either. One solution that has been proposed in the European financial press is that Germany should temporarily withdraw from the ERM to allow the other members to slash interest rates. This is not viable, however, because we believe there is insufficient central bank reserves among the remaining participants to fend off another bout of aggressive speculation. Only a realignment, which would devalue currencies against the deutschemark, Dutch guilder and the Irish punt, can save the system. At the time of writing, no official meeting has been called between European central bank chiefs and Finance Ministers. Meanwhile, currencies outside of the ERM continue to benefit. The dollar rocketed to a 23-month high against the deutschemark on Friday, before slipping back towards 1.74 deutschemark. The Swiss franc and sterling were also stronger. These safe-haven currencies will continue to post gains this week if the European drama drags on. Political reputations are on the line and this represents an extremely powerful argument for continuation of the ERM. As a result, we believe that the most likely outcome will be realignment couched in terms of a deutschemark revaluation. The next 24 hours will be crucial. Pauline Gately is head of research at BNP International Financial Services Ltd
