Hung parliament fears keep UK markets on edge

It is election time again in Britain and, for once, financial markets will be keeping a particularly keen eye on the likely outcome.

There's a simple reason for this: Britain is one of the most indebted countries in the developed West and firm government is needed to deal with that problem. Any sense that that is not going to happen is likely to result in a sharp, adverse reaction from financial markets.

Remember that Greece is thought to have done everyone a favour recently with its own sovereign debt crisis – the affair, which rumbles on, has corned Europe's politicians in that they now know they have to deal with extreme deficit problems, rather than just trying to ignore them. Otherwise, the markets will push them – mercilessly.

Britain is one of the first real tests of this theory. Sure, politicians from all the main UK political parties might be promising to reduce spending – but the resolve to implement those cuts is a political expedient.

In short, according to the latest polls of voters, there is a real chance that Britain ends up with a hung parliament – a situation where no one party has an absolute majority.

Minority governments are common elsewhere in Europe, but not in Britain, which is why observers are on edge. What's more, the first-past-the-post system in Britain makes it difficult to forecast with any accuracy what sort of majority either the Conservatives or Labour might manage. That means uncertainty and, for financial markets, uncertainty equals risk.

Melanie Baker, an analyst at Morgan Stanley in London, suspects that investors may be over estimating this risk. In a recent note to clients she declared:

"The economic implications in terms of spending cuts and deficit reduction may not be that different no matter who wins the election. The different parties' positions do not look vastly different to us, and we think some investors worry too much about a lack of fiscal tightening in a 'hung parliament'. In particular: 1) A hung parliament might increase the chances of cross-party agreement on the scale/method of deficit reduction. That might increase the chance of a successful deficit reduction. 2) If markets don't like the outcome of the election and fiscal policy proposals that emerge from this, they would likely force a more aggressive fiscal tightening on the government of the day."

So, the argument there is that whoever emerges victorious after May 6 in Britain, their hand will be forced by the markets.

As things currently stand, the main difference between the two major parties in terms of fiscal plans is that the Conservatives promise to begin consolidation sooner and cut deeper than Labour. Also, the Tories promise more spending cuts, as opposed to the tax measures favoured by Labour. Along with the Liberal Democrats, who may emerge as "king-makers" in a hung parliament, both Labour and the Tories have promised to protect some areas of spending, while also imposing limits on public sector pay.

The obvious threat is that a hung parliament leads to delays in terms of getting on with the required fiscal adjustment. But Baker at Morgan Stanley still thinks the market will press British politicians in to action. Indeed, the pressure might even be virtuous:

"Significant deficit reduction would benefit from broad support. In the event of a coalition or explicit multiparty support for a minority government's deficit proposals, this could make it more rather than less likely that we see significant and successful deficit reduction."

She believes that current plans for deficit reduction are attainable – especially when compared with holes Britain has dug itself out of in the past. Also, she notes that while the current British government's growth forecasts look optimistic when compared with Morgan Stanley's GDP expectations , it remains the case that economic conditions might turn out to be better than expected.

However, Baker is adamant that who ever forms the next government in the UK they will need more "wriggle room" in case of a weaker-than-expected economy. That translates into some very uncomfortable spending adjustments – the sort of adjustments that will require considerable political will to push them through.

What sort of measures? The table here provides some suggestions from the major British think-tanks, along with the possible fiscal impact. From slapping a five year freeze on public sector pay through to charging market rates on student loans, such measures will hurt.

Still, Morgan Stanley's central message is that the election, one way or another, will bring about clarity in terms of how Britain is going to deal with its problems. For that reason, the bank is actually upbeat on the prospects for Sterling – a currency that much of the foreign exchange world is currently betting against.

The Morgan Stanley analyst is at pains to stress that she does not dismiss the fact that Britain has significant public debt and that the economy is in a weak position. But she is convinced that Sterling's current weak state if not factoring in a clearing of the electoral air.

Let's see what happens on May 6.

The writer is associate editor of the Financial Times. The views expressed are his own


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