Hints of rate rise to defend the mark

Last month's surge in optimism towards monetary union in the wake of the new French government's emergency measures to meet the 3 per cent Maastricht-inspired deficit target started to subside this week. The driver was the hint from the Bundesbank that it was ready to raise interest rates to defend the weakening German mark.

The markets are waiting for 12 August, when the German central bank will decide whether to roll-over the current 3 per cent "repo" rate, the rate at which it lends to the market, or raise it. Some are expecting a small increase of 0.2 per cent or less.

Coming as the first rise in money costs in Germany since 1992, that might be enough to give the foreign exchange markets a jolt, but Julian Jessop of Nikko Europe says the bank could jack up rates by 1 percentage point or more. That would test the weaker economies like Italy - and increasingly even France - which many in the Bundesbank would prefer not to be in the first wave of EMU.

But others are more sceptical. Robert Lind of ABN Amro suggests a rate rise would have little effect on the mark and would cause "near-hysteria" in France. Robert Prior of James Capel says such a move would not be justified by the still weak state of the domestic economy.