Falling Franc Poses Threat to EC Rate System : Markets: Traders continue assault on France’s currency, and its central bank responds by raising interest rates. The U.S. dollar benefits from the disarray.

Western Europe’s fragile system of fixed exchange rates, severely battered in the past 12 months, approached the breaking point Friday as currency traders mercilessly drove down the value of the French franc.

France increased one of its overnight interest rates to 10% from 7.75% in a desperate effort to stem the sale of francs. “The franc will not be devalued,” Prime Minister Edouard Balladur told reporters in Paris.

Even that was not enough.

France’s central bank was forced to buy huge sums of francs in the currency markets to prevent the currency from falling below its minimum allowable level against the German mark.

The U.S. dollar was a winner by default in the disarray, as traders sought safer currencies. In New York trading, the franc closed at 5.874 to the dollar on Friday, up from 5.820 on Thursday. At the start of the month, a dollar bought just 5.720 francs.

The dollar also gained against the mark, rising to 1.719 marks in New York, up from 1.704 on Thursday.

Devaluation of the franc--or, more dramatic yet, a decision by France to pull the franc out of the European Community’s system of fixed exchange rates--could deal a mortal blow to the exchange rate system. Germany and France are the system’s key members. The only other participants are six of the EC’s smaller members.

The system was designed to increase Europe’s attractiveness by guaranteeing that the value of investments would not be eroded by currency fluctuations within the Continent. It has become a halfway house toward the single currency that EC members hope will replace their national currencies by the end of the decade.

France faces its next big turning point Thursday, when the Bundesbank, Germany’s central bank, holds its next regular meeting. The Bundesbank could reduce pressure on the franc by reducing German interest rates, thus making investments in French francs relatively more attractive than those in German marks.

“If the Bundesbank doesn’t act, the pressure on the franc will intensify,” said Marc Hendricks, a currency analyst with Swiss Bank in London.

The Bundesbank has been gradually reducing rates this year. But short-term rates remain between 7% and 8%, unusually high for a country in recession. Since the last rate reduction, the internal signals from the German economy--rapid money supply growth and a 4.3% inflation rate--weigh against a further rate reduction.

Yvonne Staeuble, a currency economist with the London office of the investment bank UBS, said the only pressure for a German rate reduction came from the instability of the European currency system. The Bundesbank, she said, does not want to be seen as letting international pressure dictate domestic monetary policy.

Staeuble said the speculative pressure against the franc was based on politics more than economics. In contrast with Germany, she said, France has lower inflation, a better trade balance and a shallower recession.

But France’s 11.5% unemployment rate is politically intolerable, she said. Consequently, France has no good options. With high interest rates, it faces higher unemployment; with lower rates comes further downward pressure on the franc.

Currency traders, Staeuble said, were betting that France would ultimately be forced to choose lower interest rates. They hope to profit by selling francs now and buying them later at a lower price, much as they did last year with the British pound.

The turmoil within the current system has caused concern that Europe remains years away from being able to impose the same currency--and the same monetary policy--on such diverse economies as Germany’s and Italy’s.

Britain and Italy were blown out of Europe’s exchange rate system last September, when traders lost confidence in the British pound and the Italian lira. Both currencies have lost some 15% to 20% of their value since then against the German mark.

In addition, the Spanish, Portuguese and Irish currencies, while remaining in the system, have all been devalued. Nor are the problems for those currencies over. All three, plus the Danish krone, have been the target of speculative sales this week.

Only the Dutch and Belgian currencies have remained firm since last September. And on Friday even Belgium had to raise interest rates.