Pound drops out of ERM: Second rate rise revoked after rout in money markets

The government last night suspended Britain's membership of the Exchange Rate Mechanism after a tidal wave of selling the pound on the foreign exchanges left it defenceless against international currency speculators.

Britain's decision pushed the ERM to the brink of collapse early today, with the EC monetary committee locked in crisis talks aimed at holding the system together.

The Government was seeking a total suspension of the ERM until after the French vote on the Maastricht treaty on Sunday and it appeared that at least one other country - Spain - would follow Britain's lead.

The Chancellor, Norman Lamont, announced that the Government could no longer hold the line at the end of a day of desperate and futile attempts at propping up sterling, which included spending what the City estimated as pounds 10 billion from Britain's reserves and a two-stage rise in interest rates to 15 per cent.

Mr Lamont later rescinded the second rise, and said interest rates would be pegged at 12 per cent today, two points above the rate on Monday night.

The announcement sent sterling tumbling in New York trading last night, hitting DM2.69 - nine pfennigs below its former permitted ERM floor against the German mark.

In Tokyo today, sterling dropped to DM 2.6680 in hectic trading within minutes of the markets opening. Market sources said dealers were taking their lead from New York where the pound weakened substantially after the day's events in London. Investors were also switching into a strengthened dollar which saw the sterling rate against the US currency drop to as low as Dollars 1.75 - eight cents lower than the price quoted at the close in London.

The decision to suspend membership of the ERM represents a humiliating reversal for the Chancellor and the Prime Minister, who have staked enormous credibility on being able to resist devaluation. Britain joined the ERM less than two years ago, and until last night's decision, membership has been the centrepiece of the Government's anti-inflation strategy.

However, the U-turn was tacit recognition of the awesome risks of precipitating a slump by inflicting base rates of 15 per cent or higher on an economy that is already deep in recession.

With a private poll last night showing 58 per cent planning to vote No in the French referendum on Maastricht, the Government was aware that it might have been engulfed by selling pressure on Monday and be in no position to lower rates from 15 per cent for some time. Yesterday's rate increase was the first since October 1989.

Treasury sources said last night the Government intended to rejoin the ERM eventually. However, it was far too early to say when.

Mr Lamont said in his statement outside the Treasury at 7.40 last night: 'As a result of uncertainties caused by the French referendum, massive speculative flows have continued to disrupt the functioning of the exchange rate mechanism.

'As Chairman of Ecofin (the European Community finance ministers' council) I have tonight called an urgent meeting of the EC's monetary committee to consider how stability might be restored to the markets over the next few days.

'In the meantime the Government has decided that Britain's best interests would be best secured by suspending our membership of the ERM with immediate effect.'

It was understood last night that the Government was furious with comments from the Bundesbank about the possible need for an ERM realignment involving sterling. Theo Waigel, the German finance minister, tried to repair some of the damage late last night when he said sterling could rejoin the ERM after a devaluation.

Mr Lamont's dramatic statement followed an unprecedented day of financial turmoil. Massive selling of the pound forced the Bank of England to raise rates to 12 per cent then 15 per cent until the second rise was revoked and sterling suspended from the ERM after the pressure continued unabated.

The Bank's emergency measures came after record intervention in the foreign exchanges to defend sterling's parity was brushed aside by dealers scenting blood.

In total, the City believed that 40 per cent of Britain's foreign exchange reserves were spent in frenetic trading. There were reports that the morning began with senior Bank of England officials clashing with Mr Major and Mr Lamont over the Government's insistence on wasting the reserves on what the Bank expected to be a lost cause.

During the day the Chancellor repeated his insistence that he was prepared to do whatever was necessary to defend the pound, but rumours of an impending devaluation gained ground as the day wore on.

After the formal commitment to keep sterling above its floor of DM2.7780 lapsed at 4pm, selling pressure on the pound sent it down to a low of DM2.73.

Although it then rallied, the pound remained well below its floor until the Chancellor's statement and then crashed.

Yesterday's confirmation that the president of the Bundesbank, Helmut Schlesinger, told newspapers that he believed a further ERM realignment was necessary led to intense pressure on the lira as well as sterling.

Last night's meeting of the EC monetary committee in Brussels was being held amid fears that the weaker currencies - the lira, the Portuguese escudo and the Spanish peseta - may be forced to leave the ERM with the pound.

During the day, business leaders warned that a prolonged period of even 12 per cent interest rates would be catastrophic for the economy, already suffering from the longest recession since the 1930s and an unprecedented slump in the housing market.

Howard Davies, director-general of the Confederation of British Industry, said: 'We are disappointed that the Government has been blown off course by the currency markets.

Building societies held fire on an increase in mortgage rates until after the weekend, but said dearer home loans would follow if base rates stayed at 12 per cent.