Post-election chaos threatens to expose UK economic weaknesses

For the past two years, Britain has been an island of prosperity off a continent in turmoil.

The economy has expanded more than 10 times faster than the eurozone average and unemployment is less than half the level in the currency union. Living standards, which took a hit in the aftermath of the crisis, are finally back on the rise, thanks to upticking wages and falling inflation.

But clouds are hanging over the British recovery. In the first quarter of this year, growth has halved from 0.6 to 0.3 per cent, in spite of a joint boost from sliding oil prices and the incipient eurozone recovery.

Most importantly, after seven decades of almost continuous majority governments, a general election on May 7 looks set to produce a hung parliament. The risk is that neither the ruling Conservatives nor the opposition Labour - they are running neck and neck in the polls - will be able to cobble together a workable coalition, a situation that could shine an uncomfortable light on the economic weaknesses hidden underneath Britain's strong headline growth figures.

"The outcome of the UK general election remains exceptionally unpredictable . . . markets may be in for a very bumpy ride in the immediate aftermath of May 7," said Oliver Harvey, a macro strategist at Deutsche Bank.

Top of the list of potential concerns is a "twin" budget and current account deficit, which at over 10 per cent is double the level in the US.

"The number in itself is large," said Dean Turner, an economist at UBS. "When compared to other developed economies, it is even more startling".

Over the past five years, a coalition government formed of the Conservatives and their Liberal Democrats partners has succeeded in halving the budget deficit through an austerity programme. However, at 5.7 per cent of gross domestic product in 2014, it is still twice as high as in the EU as a whole.

Britain's main political parties have all committed themselves to cutting the deficit in the course of the next parliament. The Conservatives aim to run a surplus by 2020 while Labour and the Liberal Democrats are targeting a balanced budget, net of investment spending.

However, this nominal fiscal rectitude clashes with universal pledges not to increase most taxes, with the Conservatives going as far as promising to outlaw any rise in income or value added tax until 2020.

"The Conservative and Labour parties continue to bicker over whose fiscal plans are the most sensible," said Brian Hilliard, UK economist at Societe Generale. "The inescapable fact . . . is that the budget deficit is still too large."

Meanwhile, Britain's external balance has fallen deeper into the red, with the current account deficit plunging to 5.5 per cent of national income last year, the worst reading since records began in 1948.

Optimists, including the Bank of England's deputy governor, Ben Broadbent, point out that Britain's current account deficit is largely the result of poor returns from investment abroad. Since the assets held by foreigners in the UK have performed relatively well, the current account deficit can be seen as a measure of Britain's success.

However, this would matter little if a messy election outcome pushed investors to turn their back on sterling assets. The nightmare scenario is what happened in 1976, when a sterling crisis forced a Labour administration to seek help from the International Monetary Fund.

So far, markets have been relatively sanguine. While foreign investors have been net sellers of gilts in the first few months of the year, domestic demand has held up relatively well, meaning that interest rates on 10-year bonds are actually lower than at the start of January.

The UK is in substantially better shape than it was in the 1970s, thanks to a robust economic outlook and a strong institutional framework, which includes an independent BoE.

"Given the momentum of the recovery . . . and the UK's credible and independent institutions, we see the impact of the election as a modest drag," said Jacob Nell, an economist at Morgan Stanley.

Some even believe that a minority government could be less damaging than a majority administration, for example if it prevented the Conservatives from holding a referendum on Britain's EU membership as they have pledged in their programme.

"Given the potential adverse effect on the UK economy of 'Brexit' risk, in our view a minority Conservative-led government . . . might be less risky for the economy than a Conservative-led majority that can pass a referendum bill," said Michael Saunders, UK economist at Citigroup.

For others, however, the adjustment ahead is simply too large for an unstable government to manage.

"What happens when the reality of the huge fiscal challenge sets in? Or the (inevitable) adjustment of the unsustainable current account deficit starts?" says Erik Nielsen, chief economist at UniCredit.

"Given the political landscape the odds are not good that all this will happen smoothly via clever politics. A market-induced adjustment . . . seems on the horizon."

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