City fears hung parliament — but this is no need for a sterling panic

Hugo Duncan
16 Mar 2010

The prospect of a hung parliament for the first time in nearly four decades has sparked talk of a sterling crisis.

The narrowing of the opinion polls — the Conservative lead over Labour has dropped into single figures — suggests neither party will win an overall majority in the upcoming general election.

Investors are dumping the pound as a result. They hate the uncertainty and fear that a hung parliament would prevent or delay the action needed to slash Britain's crippling debts.

Failure to tackle the deficit run up by Gordon Brown — borrowing is set to hit a record £178 billion this year — would threaten Britain's prized AAA credit rating, raise interest rates, and hammer the pound.

The last hung parliament in 1974 was soon followed by an embarrassing bailout by the IMF and currency analysts at Japanese bank Nomura warn a similar result in this year's election “would be highly negative for sterling”.

Nomura's Alastair Newton says: “The Government would be considered guilty until proven innocent and could demonstrate an ability to push through difficult and contentious spending cuts and revenue enhancements. In this environment, we cannot dismiss the possibility of a sterling crisis, although we are hopeful that cooler heads will prevail and the UK will find a way to muddle through.”

Newton says the election, expected on 6 May, will be a “watershed moment” for the UK in terms of how it is viewed in the financial markets. He argues that it does not really matter which party wins so long as the election results in a Government with a working majority strong enough to mend the nation's battered finances.

It is a popular view. “There is a real fear over the budget deficit and whether it will be tackled with a hung parliament,” says Jane Foley, research director of online currency trader Forex.com. “There is no let-up for sterling.” Citigroup chief economist Willem Buiter, a former member of the Bank of England's monetary policy committee, adds: “All bets are off should there be a hung parliament. Fiscal tightening could be postponed. The markets would attack sterling.”

Indeed they might, and sterling would no doubt fall in the wake of a hung parliament.

But is there any justification for this? Cooler heads suggest not. Jonathan Loynes of Capital Economics says: “There are worries that a hung parliament could lead to higher interest rates and a lower credit rating — a nasty scenario for sterling assets. But with monetary policy set to remain extremely loose and a strong cross-party consensus for fiscal restraint, we suspect that the reality would not be so bad.”

Labour, the Tories and the Liberal Democrats all agree on the need to cut Britain's debts. Bank of England governor Mervyn King, who spent much of last year urging Gordon Brown and Alistair Darling to get to grips with Britain's debts, now talks of “a clear political consensus” among the three main parties to take action.

There are differences in policy. The Tories want to start cutting immediately, Labour and the Lib-Dems only once the economy is back on its feet. But the differences are probably not as big as the politicians claim or the markets fear. David Cameron and George Osborne have softened Tory rhetoric on spending cuts while Alistair Darling appears to have convinced a reluctant Gordon Brown that restraint is needed despite calls from the likes of Ed Balls to continue spending at will.

“Policy differences between Conservative and Labour on major economic issues do not appear to us to be as great as the two parties would have the electorate believe,” says Nomura's Newton.

“We think financial market perceptions exaggerate the likely differences between the two main parties and that fiscal policy is likely to be very tight whatever the election outcome.”

The Lib-Dems could play a major role in setting policy in the event of a hung parliament and they too are committed to cutting the deficit.

With such political consensus in place, a credible plan to cut Britain's debts is more likely than not to be agreed even if there is a hung parliament. A public sector pay freeze, the new 50% top rate of tax, and a further rise in VAT are among the policies likely to have cross-party support.

Rating agency Moody's agrees. “We suspect strongly that any Government elected, even a hung parliament, would be ready to make adjustments to reduce the deficit,” says Moody's senior vice president Kristin Lindow.

The pound will, of course, remain under pressure such is the desperate state of the public finances and the economy. But a hung parliament is no reason for a sterling crisis.