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Bundesbank may raise interest rates to defend DeutschmarkWHEN the dollar climbed to Dm1.65, Germany's Bundesbank remained unworried although its president, Hans Tietmeyer, did say the "correction" in the exchange rate was probably over. But the dollar's sprint since early June from Dm1.70 to Dm1.85 - up 36% from the low of 1995 - has brought a belated signal from the central bank that the markets have gone over the top. Last week the Bundesbank issued an unusual statement that it would pay great attention to the Deutschmark's exchange rate and activity in the financial markets in future interest rate decisions. While the key securities repurchase rate - at which the Bundesbank provides money to banks against the collateral of gilts - was left unchanged at 3%, that applies for only two weeks. As this covered only half the annual holiday period of the Bundesbank's central council, the move was "an implicit threat" that interest rates could be hoisted if the Deutschmark falls further, according to Salomon Brothers' European analyst Gernot Nerb. A dollar rate of Dm1.90 would probably trigger action. However, the real question in the financial market this week was: is the Bundesbank bluffing? Because of its reputation the mere hint was enough to prompt some buying of marks, paring the dollar rate back to just under Dm1.84 as speculators who had sold short took their profits. The Bundesbank's professed concern is that because the bulk of industrial raw material inputs plus fuel and energy are dollar-priced commodities, a weak Deutschmark brings the risk of imported inflation. That has yet to show - the two-year fall of the German currency has been accompanied by a decline in inflation to 1.5% from 2.4%. In any case, commodity costs are only some 15% the total in manufacturing where labour and capital are far more significant. Pressure on wages is weak, domestic consumer demand is not booming and the latest business survey showed the balance of companies likely to increase selling price in the next three months fell from 5% to 4% last month. The worst that might happen if the Deutschmark stays low is a half-point rise in the inflation rate to perhaps 2% next year, according to Stephen Schneider, chief economist with Banque Paribas. Meanwhile, exporters are rejoicing. About 20% of German foreign sales are to dollar markets and overall exports, which grew by 5% in volume terms last year, are heading for a 7% rise in 1997. Sportscar-maker Porsche, which sells 40% of output in the US, will break even on an exchange rate of Dm1.40 to the dollar. At $1.80 the firm which nearly sank during the last recession will be fully restored to prosperity. Paul Meggyessi, currency analyst with Deutsche Morgan Grenfell, told the Wall Street Journal that the "lesson of the past five years in other countries is that devaluation has led to substantial economic benefits without any lasting increase in inflation". On top of these factors the Bundesbank faces the problem of European monetary union (EMU). Any increase in interest rates would immediately cause trouble in France which would have to follow suit-- at a time when growth is low and unemployment high - or abandon its treasured policy of pegging the franc to the Deutschmark as joint anchors of the proposed single currency. Both Germany and France are running tight fiscal ships in order to bring down their budget deficits to 3% of gross domestic product as required for membership of the single currency. A further squeeze from monetary policy would reduce consumption and tax revenues, hobbling the recovery needed to reduce unemployment (running at 12.5% in France and 11.4% in Germany) and cut social security bills. According to Meggyessi: "The Bundesbank would have felt quite comfortable if the slide in the Deutschmark had been a moderate, gradual business. But the past four weeks have seen an acceleration and a crisis of confidence which has been excessive and unjustified. I think the Bundesbank suddenly recognised that its previous attitude of relative indifference was encouraging markets to sell Deutschmarks. So it has launched a verbal intervention. It would prefer markets not to call this bluff and it may be working for the time being. But even if the exchange rate stabilises we could still see people taking another crack at the mark." In a report headlined "Impotence before extinction", Stephen King at HSBC James Capel economics research argues that the Bundesbank is stuck. If monetary union goes ahead and includes Italy in the first wave he reckons the dollar will rise to Dm2. The Capel view reflects a growing tide of opinion that if the Bundesbank raises interest rates it will have a temporary effect only on the Deutschmark and rebound badly on France and weaker potential EMU members.
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