Layman's guide to pound's slump on currency market

How significant was the pound's fall yesterday?

It was quite a drop. The Irish currency started trading at well over 94p sterling and closed around 92.50p, having fallen to 91.50p at one stage. It also fell sharply against other currencies such as the deutschmark and the US dollar. Even by the volatile standards of the foreign exchange markets, it was a sharp decline. It is also significant that there was a large volume of trading in the pound yesterday.

Why did it happen?

International investors are betting that the Irish currency will enter monetary union at a lower value than it has been trading recently. They thus feel that it is ripe for a fall.

The planned move to EU monetary union is now a key influence on many currency transactions. Under monetary union, currencies are due to be fixed together irrevocably in January 1999; in other words the pound's exchange rate would be fixed at, say, 2.50 deutschmarks for ever more. In recent weeks speculation has grown that the pound will join at a much lower rate than where it has been trading recently against the other EU currencies. Investors thus hope to make money by betting on a weaker pound and selling the currency.

What does the Government think?

Comments a few weeks ago from Mr Ruairi Quinn, the Minister for Finance, quoted on the news wires, to the effect that he would prefer to see the pound trade lower in the ERM, turned attention to the Irish currency. While the Minister has said that there has been no change in policy, international investors believe the Government wants to see a weaker pound so that the pound does not enter monetary union at too high a rate. Entering at a high rate would make life hard for exporters.

But why the big fall yesterday?

In recent weeks the Central Bank has been stepping into the market when the pound has weakened. The Central Bank has bought the currency to stop it falling and this has supported it on the markets. Suddenly, yesterday morning, the Bank stopped buying pounds and the currency value fell sharply as a result.

Why did they make this decision?

As a politician would say, I'm glad you asked that question. Mr Quinn said there had been no change in policy but, as reported in The Irish Times a few weeks ago, it does appear a decision has been made at Government level that a weaker pound in the ERM would be preferable in the run up to monetary union.

Why precisely the Central Bank chose yesterday to let the currency fall is unclear, but it may reckon that, if the pound has to fall in the ERM over the next year or so, it is better to let it happen over a period of time, rather than have a really sharp sell off next year.

What are the dangers in a weakening pound?

The main risk is that, by pushing up import prices, it could lead to an increase in the rate of inflation. For this reason, the Central Bank is likely to try to stop the pound from falling too far too fast. The pound is now trading closer to the other currencies in the EU exchange rate mechanism, which may lessen the selling pressure. However, once international traders have the pound in their sights, further selling may be in prospect. It is important to realise that the selling is not a vote of "no confidence" in the economy; in fact it is in large part due to investors' views that we are healthy enough to join the single market.

What about interest rates?

Interest rates have risen on the money markets in recent days, although it is far too early yet to say that bank and building society rates are to increase. Market sources believe that a rate rise is unlikely, though much will depend on the market trend over the coming days. One of the main reasons there is upward pressure on interest rates is that international investors are borrowing Irish pounds so that they can then sell on the currency. They then hope to make a profit by buying pounds back at a cheaper rate than they sold.

What happens next?

Many highly paid analysts will be mulling this very question. By late yesterday the pound had stabilised a little, but much now depends on whether international investors decide to engage in further selling, on the response of the Central Bank and on whether EMU remains on track. Interesting times ahead.