The Sterling Election

Have the improved prospects for a Conservative victory in the upcoming British election and the reduced chance of a hung parliament revived the sterling, or has the recovering British economy provided the boost? A little more than a week ago, the pound came within twenty points of its post crash low of 1.4781. By last Thursday it had regained 3.4% versus the dollar and 2.1% against the euro. Yet the reason probably has more to with Greek debt than resurgent manufacturing in the Midlands.

The British economy has recently been performing better. Fourth quarter GDP was unexpectedly revised 0.1% higher to 0.4% after six straight quarters of negative growth. Yearly manufacturing production turned positive in January for the first time in 21 months. The March Purchasing Mangers Index (PMI) in manufacturing at 57.2 was the highest since October 1994. Unemployment has been at stable within 0.1% of 7.8% since last June.

Britain's main continental currency trading partner, the EMU, has seen similar improvements in national figures. Euro zone GDP was positive in the fourth quarter rising 0.1% q/q; it had expanded 0.4% in the third. These are the first positive quarters since the beginning three months of 2008. EMU manufacturing PMI in March also pointed to higher growth ahead, at 56.6 it was the strongest since November 2006. Euro zone unemployment was 10.0% in February, which is substantially higher than in England but it has been unchanged by more than 0.1% for four months. The comparative advantage between the island economy and the continental has not altered in almost a year.

Economic figures in Britain and on the continent have seen the same order of gradual improvement over the past six months. If the British economy is slowly leaving the recession behind so are the Germans, the French and their EMU partners. In fact, the English GDP and unemployment numbers are better. Nevertheless, for the past six weeks the sterling has been weaker against the euro then at any period since the beginning of the year.

The same is true of the Sterling-US Dollar comparison. The American economy has been improving faster at least in GDP terms but its unemployment rate is worse and there is limited indication that its wholesale government revitalization plans will produce more substantial results than in the UK. As with the euro, the sterling has been punished against the dollar despite its rough equivalence in economic status.

According to a British Government website, Public sector net debt, expressed as a percentage of gross domestic products (GDP), was 60.3 per cent at the end of February 2010 compared with 50.5 per cent at end of February 2009. In 2009 the UK recorded a general government deficit of £159.2 billion, which was equivalent to 11.4 per cent of gross domestic product (GDP).

At 11.4%, the British government deficit is similar in magnitude to Greece and Spain. The source of recent sterling weakness is not the size of the deficit or the performance of its economy but the uncertainty surrounding the victor in the May election. Until the most recent polls, the possibility of a hung parliament rose with the decline of the Conservative lead over Labor. The Greek deficit and debt problems have a unique reflection in Britain.

In Europe, the problem of Greek debt is not ability but intention. No one doubts that the EMU members can create and fund a plan for the bail out of Greece when they decide to do so. In Britain, however, a hung parliament would throw up difficult political obstacles to a credible deficit control plan. Without a clear majority for either party in Commons, intention will matter less than the functional limits on government power. Even with the best intention, it may be difficult for any British Government presiding over a stalled parliament to enact an austerity budget.

In order for the UK to regain control of its finances, it must have, in the market view, a unitary government. A hung parliament would be the functional equivalent of the squabbling nations of the EMU, unable to agree on a policy though all agree something must be done to save the euro.

The currency markets clearly take the UK election more seriously than the bond markets. That is why the sterling rose on reports that the Tories had climbed several points in the most recent polls. A Tory Government has a chance to control the deficit, a split parliament has none Perhaps the bond markets will begin to pay attention to the British election, until now they been busy enjoying the Greece debacle.