Tread carefully on one-way route to ERM revaluation

Talk of a revaluation of the pound's central ERM rate has been sweeping the markets for months now and is keeping the currency well underpinned. To that extent, the Central Bank has achieved its objective in stemming the heavy selling pressure on the pound it was facing until recently. For some time the authorities were quietly implying that revaluation was being considered and this, in itself, has helped to support the currency.

Only two months ago, the pound was heading inexorably down towards 2.41 deutschmarks, its central rate in the ERM. Now it is up at all-time highs against the deutschmark and has even breached DM2.70. But the pound is now becoming so strong that it is threatening to go higher than its permitted level above the weakest currency in the ERM band, although it still has some way to go before this problem becomes critical.

It is understood that in April and May senior Department of Finance officials believed that revaluation was the best option. Without such a move, they argued, inflation dangers would be rampant, as the currency seemed to be falling remorselessly against both the sterling and the D-mark. The key was the fall at the time in the trade weighted index, which is watched closely by both the Central Bank and Merrion Street.

Before the summer, the then Minister for Finance, Mr Ruairi Quinn, held out firmly against revaluation and was subsequently proved right. At the time it could have been argued that he did so purely for political reasons; a revaluation would have hurt farmers and exports.

The new Minister for Finance is also very aware of the revaluation issue, and the political risks. However, it is questionable whether he is coming under the same pressure as did Mr Quinn from his civil servants.

For the moment, the trade weighted index is not under such pressure. The fall in the value of the pound against sterling has been balanced out by our strength against core European currencies. So how close to its ERM limits is the pound? The technicalities of the band mean that, while it is officially the "15 per cent band", the limit actually translates into just over 16 per cent leeway for the stronger currency and just over 13 per cent in the opposite direction for the weaker currency.

Sources point out that it would not be difficult for the Central Bank to intervene to hold the currency down. After all it would be selling the pound and so its reserves would not be in any danger - the problem would be an increase in liquidity which could feed through to lower interest rates, again increasing inflationary pressures.

However, the ERM is actually an asymetrical system with most the pressure going on the weaker currency in the system. This means the Bank of France would be under an obligation to support the franc, although it has substantial reserves to do so.

What really counts is the so-called parity grid, which sets out precisely the upper and lower intervention rates for every currency pair in the system.

For example, the central rate for the pound and the French franc is 8.08631 francs, while the upper intervention rate is Ffr9.3895 and the lower rate Ffr6.946. Yesterday the pound was trading at Ffr9.0870, so it has some way to go before the Bank of France and the Central Bank are obliged to intervene. Nevertheless, the authorities are facing a dilemma between the short-term expediency of re-valuing against the long-term risk that sterling may fall sharply leaving us overvalued.

The other problem is that the pound may also be overvalued against the D-mark. The Central Bank's own definition of fundamental value is not known but it is understood to be close to the Goldman Sachs view of DM2.49 as a long-run equilibrium.

In addition, the problem is that while a revaluation is allowed under the single currency rules, devaluations are specifically ruled out. This means there would be no way back from a revaluation.