General Election 2010: Who's right over pound, Ken Clarke or Goldman Sachs?
Views are split on what effect a hung parliament would have on sterling.

By Louise Armitstead, Chief City Correspondent
Published: 6:45AM BST 23 Apr 2010

Even for a veteran politician like Kenneth Clarke, this election campaign feels a little different. "I am trying to persuade people to vote for me who weren't born when I started," he mused.

Although he was referring to the youngsters in Rushcliffe, his Nottinghamshire constituency since 1970, the emphasis on his experience wasn't lost on traders in the City of London either.

At the same press conference on Wednesday, Mr Clarke issued a stark warning that a hung Parliament would result in financial chaos that would hit the pound so severely that a rescue mission from the International Monetary Fund (IMF) would be required.

That afternoon, Goldman Sachs published a note advising its clients to buy sterling. The hot-shot analysts at Wall Street's powerhouse argued that the UK's growth prospects were strong, that the European outlook was comparatively weak and, crucially, fears over a hung Parliament were already overblown and the election result would not have much of an impact.

Mr Clarke had warned: "Bond markets won't wait. Sterling will wobble. If the British don't decide to put in a government with a working majority, and the markets think that we can't tackle our debt and deficit problems, then the IMF will have to do it for us."

For the traders watching sterling strengthen against both the euro and the dollar, Mr Clarke's views seemed exaggerated. But they had to admit, unlike most of them, Mr Clarke can claim first-hand experience: he was actually in Westminster for the hung Parliament of 1974, the humiliation of going to the IMF in 1976 and the doomed Lib-Lab pact of 1977.

"[Sharing power] was a farce, it was a fiasco, it didn't save us from disaster," said Mr Clarke. "And I would be very, very alarmed if any prospect of that occurred on this occasion."

So who's right? Goldman Sachs or the Conservatives?

The politicians seem to have the strongest evidence so far. Sterling has already shown itself to be deeply sensitive to the prospect of a hung Parliament. Although the possibility of a coalition Government has been discussed since October last year, it wasn't until the polls in late February that a hung Parliament actually looked likely.

Thomas Stolper, chief foreign exchange strategist at Goldman Sachs, said: "The markets reacted violently. On February 25 the pound/euro rate was 0.88. Two days later this had fallen to 0.995. This was a 4.3pc drop in the value of the pound, probably the sharpest sell off we've ever seen."

Meanwhile, the ongoing debt crisis in Greece has served as a constant reminder of what happens when the markets take fright at the size of country's debt pile. And there are no shortage of opportunities to draw the comparison with Britain. On Wednesday, the IMF revised its growth forecast for the UK for next year from 2.7pc down to 2.5pc. Oliver Blanchard, economic counsellor at the IMF, added that countries running large deficits (he didn't need to mention the UK) were facing the threat of a "debt explosion".

Experts have warned that if the debt in not cut, Britain will lose its top-grade credit rating. Last month, Standard & Poor's, the rating agency, kept a negative outlook on the UK's AAA rating "in the absence of a strong fiscal consolidation plan".

Throw in political uncertainty – or worse paralysis – and the mix certainly looks flammable.

But, says Goldman Sachs, the uncertainty is overblown. Unlike the electorate, markets don't wait for polling day and the money has already moved. Mr Stopler said: "The currency markets reacted in February, there won't be any surprise now. The first TV debate gave the strongest signal yet that there will be a hung Parliament and yet this week the currency markets shrugged it off. If there's a hung Parliament on May 7, who in financial markets can realistically claim that they had no idea it could happen?"

He added: "Markets are global. In Britain, people might be surprised by a coalition but investors around the world are completely used it. They won't be fazed at all."

Moreover, between February and the TV debates, Alistair Darling delivered a Budget that reassured the City that the parties were united in restraining public spending.

Amit Kara, an economist at UBS, said: "The similarities between the political parties on the fiscal situation far outweigh their differences. All the parties have said they'll tackle the deficit in less than four years, so where the difference? The fears have been magnified and totally overblown because it's election time."

The Budget also showed that Government was not downplaying the debt problems - the figure of £163bn was better rather than worse that the £175bn forecast last year. The figures are big but, say the analysts, not frightening. Although Britain's borrowing as a percentage of GDP is high - at 11.5pc it is behind only Ireland and Greece - the Government's total debt to GDP is currently one of lowest at 68.1pc. The confidence in Britain compared to Greece is already reflected in bond prices. The yield on UK 10-year gilts on day 3.97pc. The equivalent bond in Greece was trading nearly 500 basis points higher at 8.7pc.

The analysts argue that Britain's outlook for growth is strong with the worse news already out. The view is being echoed by the Bank of England.

But the big unknown is still sentiment in the City on the day. As one senior trader said: "In untried situations, the herd mentality is the strongest mover of markets. You can rationalise all you like, but if enough people are running in one direct, it makes sense that you run too."