French Economy Strains Europe's Currency System

IF you believe foreign exchange dealers, the system that ties European currencies to each other is about to fly apart.

In practice this would mean the end, at least temporarily, of the European Exchange Rate Mechanism (ERM) - the foundation for trade within Europe.

By creating a system of stable exchange rates, the ERM has allowed European countries to trade among themselves without having to worry about major fluctuations in each others' currencies.

But many dealers in foreign exchange believe the ERM no longer reflects economic reality in Europe, especially French economic reality, and so they are rushing to sell francs.

Their action amounts to a bet that - just like in London and Rome last year - recession will force Paris to significantly lower interest rates to stimulate the economy. This would immediately weaken the franc, prompting its exit from the ERM, and leaving the lonely deutsche mark as the only major currency left in the fraying exchange rate system.

If you believe France's politicians, however, the ERM will survive and the French franc with it.

Recently, the French central bank intervened by buying massive numbers of francs to shore up the currency. Prime Minister Edouard Balladur, other French officials, and even former Prime Minister Jacques Chirac all say they want to continue this policy.

But the French cannot save the franc on their own, and that is why all eyes are on Germany's Bundesbank, or central bank.

On July 29, the Bundesbank council meets for its last session before breaking for the summer holidays. Currency traders are saying that the Bundesbank must drop interest rates significantly to allow other ERM members, especially France, to follow through with rate cuts of their own.

"The state of the exchange rate mechanism depends on the Bundesbank," says Kim Schoenholtz of Salomon Brothers in London.

Foreign exchange dealers are looking for a significant cut from the Bundesbank, along the lines of 0.5 percent to 1 percent, not the slight, gradual easing that has been the central bank's policy this year.

That size of a cut, however, "is not realistic," says Jurgen Pfister, head of economic research at Commerzbank in Frankfurt. This is because the bank's chief concerns, inflation and monetary growth, are still increasing beyond bank targets.

The best that can be hoped for, predicts Mr. Pfister, is a 0.25 percent cut. This, he says, may be enough to at least provide a "breather" from the current turmoil in the currency markets.

Neither the Bundesbank nor the French government want the ERM to fall apart.

A much lower franc would hurt German exports. And the French want to preserve their credibility as reliable monetary managers. Their vigilance in maintaining relatively high interest rates has at least paid off in the fact that France has only 1.9 percent inflation.

BEYOND this, there are the overarching goals of preserving the ERM simply to ensure smooth-flowing European trade and as a precursor to a single European currency.

"I think that Europe desperately needs a monetary system, without which the common market could disintegrate," wrote New York financier George Soros in the French daily Le Figaro.

Economists and market analysts are saying that the future of the franc largely depends on the degree of political will to shore up the sagging currency. "It's not so important what the economic data say - this is mostly a political decision," says Joachim Fels, economist for Goldman Sachs in Frankfurt.

German and French strategy appears to be that if they continue to work together they may be able to buy enough time until both their economies show signs of turning around. Then there would be less pressure on them to reduce interest rates.

But the currency market, at least, is betting that the economic outlook will not improve soon enough and that conditions such as a French unemployment rate of more than 11 percent will force Paris to lower rates.

"The market still regards the French as being French, and that they will chicken out," says a Paris-based analyst.

Indeed, it is tempting for the French to follow the British, who last September pulled their interest rates sharply down, and abandoned the ERM to let their currency float freely on the market. The weaker pound helped British exports and the lower interest rates contributed to the beginning of a British recovery.

For France, there would be short-term gains from a similar move, says Mr. Schoenholtz. But these gains do not appear to hold as much weight for the French as the longer-term goals of European integration, low inflation, and credibility, he says.