Factbox: Key risks to watch in coalition-era Britain

By Peter Apps, Political Risk Correspondent

LONDON (BestGrowthStock) – Britain’s inconclusive May 6 general election has produced its first coalition government since 1945, with the new Conservative Prime Minister David Cameron in partnership with third-placed Liberal Democrats.

Investors will be relieved that at least some clarity has emerged, but will be looking keenly at how it will tackle a budget deficit forecast at 11.1 percent of output this year.

Sterling, gilts and stocks all suffered after the election gave no one party in overall control.

Markets broadly welcomed Tuesday night’s coalition agreement, with gilts futures and sterling enjoying a steady performance overnight but losing some ground later to trade broadly steady versus the dollar.

Below are the key political risks to watch in the coming days and months.

GOVERNMENT MAKE-UP, POLICY

Among key nominations announced so far are Lib Dem leader Nick Clegg as deputy prime minister and Conservative finance spokesman George Osborne as chancellor.

The LibDems will get five cabinet positions as well as a host of junior minister posts. Markets will watch how much influence will be given to populist Lib Dem finance spokesman Vince Cable, who was nominated UK business secretary.

Conservative and Lib Dem frontbenchers have been hammering out policy details for days, with some details already emerging late on Tuesday and early on Wednesday [ID:nLDE64B072].

What to watch:

— Markets would like stable government for at least a couple of years to address the deficit, and will be wary of signs of disputes over issues such as Europe.

— What happens to the ousted Labour party? Former Prime Minister Gordon Brown is standing down as party leader, ushering in a leadership battle expected to be between former Foreign Secretary David Milliband, his brother Ed and perceived more leftist contender Ed Balls amongst others. How quickly Labour can reassert itself as a credible opposition or possible government could also impact market expectations of how long the current government will last.

ADDRESSING THE DEFICIT

The Conservatives had pledged an emergency budget within 50 days if they defeated Labour Prime Minister Gordon Brown, and can be expected to push ahead with one with their new coalition partners.

That will be key to credibility with both investors and credit ratings agencies, who have threatened to strip the UK of its AAA credit rating if public debt is not reined in. The Conservatives had periodically made explicit comparisons to Greece — something they can be expected to stop doing now they are in office.

The LibDems appear to have agreed with the Conservative plan to begin cutting immediately, with 6 billion pounds in cuts to normal frontline services this financial year subject to advice from the Treasury and Bank of England.

The tax picture appears mixed, with the Conservatives abandoning their commitment to raise the death tax threshold to 1 million pounds ($1.48 million) from 325,000 pounds and moving toward Lib Dem proposals to raise the personal tax allowance to 10,000 pounds as a long-term goal.

What to watch:

— Investors will want to see a properly costed tax plan, detailed spending proposals and a clear strategy to reduce the deficit.

— Credit rating agencies have held off any moves until after the election, but any downgrade or outlook change could seriously hurt sterling, gilts and filter through to stocks.

— What divisions emerge within the ruling coalition as a consequence of the cuts? Backbench rebellions could also threaten policy-making — albeit much less than they would have in a minority Conservative administration.

TACKLING THE BANKS

Equities markets in particular watching closely to see what line the new government takes with Britain’s banking sector.

According to a Conservative source, the two parties have agreed to introduce a banking levy, tackle bonuses and create a more competitive banking industry (Read more about the banking industry recovery.), but there are no details yet.

What to watch:

— what happens with suggestions by Cable and the LibDems to break large banks up into retail and investment banking arms. The coalition deal will examine this option, producing an interim report within a year. This would be extremely negative for shares in banks such as Barclays and HSBC.

— Can the new government get credit flowing again? The government will look at both the Conservative proposal for a loan guarantee scheme and a LibDem proposal for net lending targets for nationalized banks and decide which to follow.

EXTERNAL, INTERNAL STRAINS

Cameron’s government takes over a country fighting a war in Afghanistan, an issue which could become a key dividing point within the coalition. The LibDems are much less enthusiastic about the war and might oppose any further increase in troop numbers.

It might also face an upsurge in dissident republican violence in Northern Ireland, with several attempted bombings so far this year — although he has much more freedom on Northern Ireland policy than if he was locked in a minority government dependent on Ulster Unionists for support.

Social and labor unrest is also a worry, given the scale of austerity measures facing Britain. Companies such as British Airways are already facing industrial action, which could spread to the public sector.

The relatively Eurosceptic Conservatives and more Europe-friendly LibDems could also fracture over relations with the EU.

What to watch:

— Does the EU agree further bailout packages for troubled fringe euro economies? The outgoing Labour government largely refused to contribute funding, arguing the problem was one for the euro zone rather than the EU. Cameron would likely do the same. But any worsening in relations with the EU could imperil Lib Dem support for the coalition.

— Does NATO request more troops for Afghanistan?

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(Editing by Philippa Fletcher)

Factbox: Key risks to watch in coalition-era Britain