MOST of Europe - and those who do business with her - will have been applauding yesterday's cut in Germany's interest rates. For all her problems integrating with the former East Germany, the country still remains one of only three single economies whose performance can affect the rest of the world. Japan, the United States and Germany are the three locomotives which have the power to pull other economies behind them up the hill that leads out of the dark valley of recession. With the Japanese recovery looking more problematic, and America still struggling with the largest double deficit in the universe, any help that Germany can bring to Europe is increased in value. A large responsibility, but so is the domestic control of inflation. So the men of the Bundesbank will have thought deeply yesterday before nodding in half percentage point cuts in the Lombard and discount rate. They must have felt they had good reason to do so because this year they have shown that even the cause of harmony in the exchange-rate mechanism (ERM) had to take second place to the domestic requirement for sound money. Faced with huge borrowings to pay for the integration of the two Germanys, they were unwilling to allow the money supply pumps to run hot. The subsequent collapse of the ERM - disguised as a widening of the bands in which some currencies could be traded - was considered a fair price. Now the home-front is looking brighter. The recession which gripped Germany in such unfamiliar grasp appears to be loosening. Against the forecasts, second-quarter gross domestic product edged up by 0.5 per cent, the first quarter-on-quarter increase since the beginning of 1992. Retail sales have also begun to recover, from a worse-than-expected first quarter. It doesn't add up to much but like the first weak ray of spring which begin to soften the ice, the faint signs of hope appear to have raised even the dour spirits of the Bundesbank. The flurry of other rate cuts around Europe showed that despite the virtual abandonment of the ERM, it is Germany which still sets the pace. The Bundesbank has grown used to the incessant demands of its neighbours to unshackle them from interest rates which their industry and consumers cannot bear. Their other fear must be that the sleeping giant will itself awaken too fast. Falling interest rates could lower the mark, making the German market harder to crack, and at the same time opening up their own markets to cheaper German goods. This, say analysts, is not likely to happen. Instead, the mark will continue its upward momentum. After dipping initially when the German central bank announced 50 basis-point cuts in its official discount rates, the mark recovered as it began to dawn on dealers that the apparent good-will was not as deep as first thought. Against the 50-basis point cuts on the two most widely followed rates, money market rates were allowed to drop only 10 basis points. This marginal cut confirmed that the steel remained intact. Martin Wiedmann, analyst at Citibank, said the mark could climb to 1.55 or 1.50 per dollar by year-end and should make further headway against European currencies as well. ''It's not just the strength of the mark in this equation, but the weakness of the dollar as well,'' Mr Wiedmann said. ''The US economy has not fulfilled expectations.'' Alex Blinkhorn, chief trader at Bank of Tokyo, said investors' needs had shifted in the wake of the ERM's demise. ''The market has been belatedly freed from the old EMS [European Monetary System] way of looking at things,'' he said. ''People are looking for a combination of more attractive returns and currency stability. People want to optimise those two factors andthe mark has become the currency of choice.'' Mr Blinkhorn said the yen was stable but the returns were miserable, the dollar's returns were uninspiring and other European currencies offered high returns but were haunted by the fears of further devaluations. ''I don't think people really got a sense of how the market has changed until two weeks ago when the Bundesbank left rates unchanged despite the enormous pressure,'' Mr Blinkhorn said. ''Now it's obvious to even the blindest trader that the Bundesbank is not going to be herded into steep rate cuts.''
