By Peter Apps, Political Risk Correspondent
LONDON, Jan 28 (Reuters) - Financial markets are worried Britain's election this year might produce the first hung parliament since the 1970s, with no single political party in overall control.
A poll of economists for Reuters on Thursday predicted a 20 percent chance of a hung parliament, up from 15 percent in a similar poll in October
Most opinion polls predict victory for the opposition Conservative party, but it would need a more than 9 percent lead to ensure a majority of parliamentary seats.
A lead of 6-9 percent would produce a hung parliament with the Conservatives as the largest party but with much depending on the actions of Britain's third party, the Liberal Democrats.
A Conservative lead of less than 6 percent would be likely to leave Gordon Brown's Labour party as the largest in parliament, but without an outright majority.
Following are potential scenarios:
CONSERVATIVE MINORITY GOVERNMENT
With the Conservatives ahead in opinion polls and Liberal Democrat leader Nick Clegg talking down the prospects for entering a coalition, this looks the most likely scenario in the event of a hung parliament.
Conservative leader David Cameron would avoid having to invite senior members of other parties into a cabinet, but would lack an overall parliamentary majority and so would need the support of other parties to push through legislation.
This could render it difficult or impossible for the Conservatives to enact significant public spending cuts, making policy-making unpredictable and raising the prospect of another election.
Cameron could call a new poll to ask for a stronger mandate and his government could be vulnerable to a no-confidence vote if enough opposition MPs join forces against them.
Potential impact on markets:
-- If opinion polls had reliably predicted a hung parliament in the weeks leading up to the election, the initial market reaction would be relatively muted but investors would swiftly look for signs on how policy would follow.
-- Any signs the Conservatives were holding back on cuts on expectation of a new election would be taken badly and could prompt warning comments from rating agencies.
-- Sterling and gilts market would likely be the most vulnerable, with the FTSE relatively more insulated with many companies -- from BP to Vodafone -- operating globally rather than simply exposed to Britain.
LABOUR MINORITY GOVERNMENT
Clegg has said whichever party has the strongest mandate should have the right to try to govern, which leaves open at least the small prospect of Labour minority rule.
Under these circumstances, pressure on Prime Minister Gordon Brown to step down -- both from within his own party and outside -- might prove overwhelming.
Other parties might feel they had a vested interest in forcing another election, making it all but impossible for Labour to find allies with whom to push through legislation.
This could render them vulnerable to a no-confidence vote, particularly if the electoral system and delivered a Labour minority but given the Conservatives a larger vote share.
Labour could potentially look to nationalist parties from Scotland, Wales and perhaps Northern Ireland for support, although in Scotland in particular long-running bad blood with the Scottish National Party might make them unstable bedfellows.
Potential impact on markets:
-- Broadly, most market players say they expect the Conservatives would cut the deficit faster than Labour, so a Labour minority government would be seen more negatively.
-- But the main concern would be the perceived much lower stability, survivability and ability to push through policy of a Labour minority.
COALITION GOVERNMENT
Probably the most likely alliance would be one between the Labour Party and the Liberal Democrats, although the Conservatives might also try to broker a similar deal.
The last ruling alliance in Britain was the 1977 pact between Labour and the then Liberal party, in which the Liberals provided parliamentary support to a Labour government. This stopped short of a full coalition, with the Liberals holding no seat in cabinet but having greater policy input.
The Lib-Dems say they would not enter a coalition unless partners signed up to their four priorities -- fairer taxation, a boost for primary education, a programme of infrastructure investment and political reform.
Expecting another party to embrace all Lib-Dem manifesto pledges is unlikely. What political price they might exact remains unclear.
Commitment to electoral reform, which would benefit smaller parties, would be one potential incitement. Clegg or Lib-Dem Treasury spokesman Vince Cable could enter cabinet or they could exact policy concessions on Afghanistan, the Trident nuclear weapons system or banking reform.
Potential impact on markets:
-- Opinions are mixed on whether a coalition would prove more or less stable than minority rule, but most market participants would prefer a Conservative minority to a coalition.
-- Most believe a coalition government would struggle to make cuts, although some point back to the 1930s to several coalition governments which were able to address spending while facing the Great Depression.
-- Some argue a Lib-Con coalition would be preferable for markets as they would cut faster, but others would prefer to see another Lib-Lab pact as they believe differences between the LibDems and Conservatives -- for example over Europe -- would render a Lib-Con partnership too unstable.
PROLONGED UNCERTAINTY
The worst outcome for markets would be if the major parties were unable to come to an agreement for days after the election.
Impact on markets:
-- At worst -- particularly if this coincided with a period of market uncertainty or worries over other sovereign borrowers such as Ukraine or Iceland -- this could spark a very sharp sell-off of sterling and British sovereign debt.
-- Similar crises in emerging countries in the last year prompted ratings agencies to swiftly cut outlooks and ratings, and the same could happen in Britain.
GOVERNMENT OF NATIONAL UNITY?
No government of national unity or grand coalition of all major parties has been formed in Britain since World War Two, although there were several earlier in the 20th century.
Arguably, a failure to form a government might put the country under so much pressure financially that it might again seem an option.
All the three major parties have committed to cut the deficit, so potentially they could work together. Alternatively, policymaking could be paralysed as the parties jockey for position ahead of an expected new election.
Potential impact on markets:
-- After days or weeks of uncertainty, the formation of a government -- any government -- would be viewed as positive by markets and might help put a floor under any crash. But investors would likely need to see a swift policy response. (Editing by Janet Lawrence and Ralph Boulton)