A hung parliament will hang the pound

The rising risk of an inconclusive result in next year's British general election poses a real threat to the pound and British government debt.

A poll released by ComRes Ltd last Monday pointed towards a diminishing lead for the Conservative party in an election, which British Prime Minister Gordon Brown (above) must call by June.

Conservative support has fallen three percentage points to 37 per cent in the last month, according to the poll, with Labour steady at 27 per cent and the Liberal Democrats up two points to 20 per cent.

The upshot: a potentially hung parliament with the Conservatives left without enough votes to govern, leaving them dependent upon coalition support or forced to pursue a minority government.

With Britain facing a huge budget deficit and an uncertain economic outlook, this is one of the last things investors will wish to see.

"The risk of a hung parliament for the UK is very real," Citigroup economist Michael Saunders wrote in a note to clients. "A hung parliament would probably greatly reduce scope for sufficient fiscal consolidation to return the UK to fiscal sustainability, and raise risks of a fiscally driven currency crisis."

This could turn out to be an interesting trend in 2010. From the point of view of investors 2009 has been mostly about policy risk: the risk that central banks and governments won't do enough to overcome the crisis.

While you can argue that they have only stored up trouble for the future, you cannot argue that policy hasn't revived financial markets; liquidity has flooded and asset prices have responded.

But the sheer size of the problem facing the global economy meant that governments and central banks were given an enormously free hand to aggressively pursue solutions.

Next year, on the other hand, may be more heavily influenced by political risk; the risk that politics gets in the way of officialdom taking the steps needed to keep the circus in the air.

Britain could be a very good example if its election results in a hung parliament.

The ratings agencies are also likely to react badly to signs of political paralysis, though you can bet that the markets will downgrade Britain more quickly and brutally if in coming months the odds of a hung parliament rise.

Interestingly, this may not be all bad for British shares, at least in local currency terms. Morgan Stanley analysts point out that British-listed companies derive a great deal of their revenue from overseas, making a fall pound good for earnings.

Also, a devalued pound may prompt a shopping spree by foreign companies taking advantage of the rising purchasing power of the dollar, euro or yuan.