Interest rates await vote on Maastricht: Size of German cut disappoints City but pound and stocks rise despite a nervous market

THE GOVERNMENT held out the faint prospect of a cut in British interest rates yesterday after the Bundesbank cut German rates for the first time in five years. The long-awaited reduction in German borrowing costs - together with the 7 per cent devaluation of the Italian lira announced on Sunday - eased immediate pressures in the European exchange rate mechanism (ERM).

But the rate cut was smaller than the City expected and the financial markets remain nervous that a 'no' vote in Sunday's French referendum on the Maastricht treaty could plunge the ERM back into crisis. British interest rates might then have to rise to resist pressure for a devaluation of the pound.

After a lengthy and acrimonious meeting of the Bundesbank's policy-making council yesterday morning, the German central bank announced it was cutting its key Lombard interest rate by one quarter of a percentage point to 9.5 per cent.

The pound, the dollar and the stock market had already risen strongly in advance of the Bundesbank's announcement, but fell back in initial disappointment. Having fallen below DM2.80, the pound recovered to end the day at DM2.8137, up 2.9 pfennigs from Friday's close and nearly 3.5 pfennigs above its ERM floor. The dollar ended the day 4.45 pfennigs higher at DM1.4875, while the pound fell by 3.85 cents to dollars 1.8920.

The stock market's early-morning gains were cut in half after the Bundesbank's announcement, but the day still ended with nearly pounds 10bn added to the value of London shares. The FT-SE index of 100 leading shares closed 51.2 points higher at 2,422.1.

The Prime Minister's office last night put the best possible interpretation on the German rate cut, arguing that 'the direction is now clearly downwards'. It even departed from the normal practice of refusing to discuss British interest rate movements, to say that the time when rates here could fall had probably come closer.

Any reduction in German interest rates was always likely to be modest, Mr Major's officials said, but there had been a significant change of mood and the myth had been exploded that sterling would have to devalue with the lira.

Not all City economists were convinced. 'It has not been a very satisfactory day for the pound. Sterling is not out of the woods yet,' said Keith Skeoch, of James Capel. He said that it was disappointing that the pound had failed to rise as dramatically against the German mark as the rise in the dollar suggested it might.

Belgium, Holland, Austria and Switzerland announced interest rate cuts, following the Bundesbank. The French government also held out the prospect of a swift rate cut, but implied it was conditional on a 'yes' vote in Sunday's referendum.

The pound ended the day as the weakest currency in the ERM. The lira moved to the top of its newly lowered band as currency dealers cashed in their profits. That forced the Bank of England and Bank of Italy to buy sterling with lire.

Helmut Schlesinger, the Bundesbank president, last night rejected charges that the German central bank was 'bowing to pressure from foreign governments' in agreeing to cut rates. Bundesbank officials said the rate cut was the price it had to pay to secure a devaluation of the lira and end the need for expensive support buying of the currency.

More than DM24bn ( pounds 8.53bn) was spent last week supporting the embattled lira. This was increasing the number of marks circulating in the German economy further above the Bundesbank's money supply targets. Excessive money supply growth has been the main reason for the Bundesbank keeping rates high.

Because the mark is the anchor currency of the ERM, other ERM countries have had at least to match these high German interest rates in order to defend their currencies within the system.

The German interest rate cut was greeted with disappointment by many Conservative MPs. John Townend, chairman of the Conservative backbench finance committee said the reduction was 'very disappointing when we were led to believe it would be a minimum of 0.5 per cent and possibly 1 per cent'. Some of the party's opponents to Maastricht were even harsher, with Bill Cash, the MP for Stafford, describing it as 'cynical and cosmetic'.

John Smith, the Labour Party leader, who yesterday warned shadow Cabinet colleagues they will have to toe the party line on Europe, opposing devaluation and referendum, once the French have voted, said he hoped the Government would soon cut British rates.

Bryan Gould, Labour's heritage spokesman, continued to risk the Labour leadership's wrath by saying he still believed that the value of sterling needed to be cut.

Lira holidays, page 6

Leading article, page 22

How the ERM works, page 23

Euphoria punctured, page 24

Hamish McRae, page 25