The pound was volatile on Friday after the UK general election proved inconclusive but recovered as leaders pledged to form a government.Sterling traded 0.2% higher against the dollar at $1.4789 having hit a 13-month low of $1.4475.
It also clawed back some losses against the euro but was still 1.4% lower at 1.159 euros.
The markets are concerned that a weak government might be unable to reduce the UK's high budget deficit quickly.
However, ratings agency Moody's said the outcome of the election would have no bearing on the UK's credit rating.
The agency said it was assuming an incoming government would be able "to muster convincing parliamentary support for a fiscal adjustment that is no looser nor slower than was outlined by all three political parties" in the run-up to the election.
Another leading ratings agency, Standard & Poor's, also said it had not changed its view on the UK in light of the election result.
UK shares fell sharply, with the FTSE 100 closing down 2.6%, after stocks on Wall Street dropped in early trading.
The biggest UK fallers included the big banks. Shares fell by as much as 9% in afternoon trading before recovering slightly.
Barclays finished 6% lower, Lloyds fell 5.5% and RBS was down 5.7%.
The cost of government borrowing also increased.
Other European markets also fell as fears about the Greek debt crisis continued, with France's Cac 40 index down 4.6% and Germany's Dax index down 3.3%.
Leading Asian shares indexes had slipped overnight, with Japan's Nikkei closing down 3.1%.
High debts
"This messy [political] state of affairs is proving unsettling for the markets, with sterling sinking to a one-year low against the dollar and even losing ground against the euro, which has been torpedoed by the eurozone debt crisis," said Howard Archer at IHS Global Insight.
Investors are worried that a hung parliament will result in a weak government that will be unable to force through measures to reduce the UK's high borrowing levels.
"Strong leadership and consensus are required to deal with the serious threats still facing the economy," said Adam Marshall, director of policy at the British Chambers of Commerce.
Investors are also concerned that the parties will spend too long negotiating with each other over the formation of a new government.
Miles Templeman, director-general of the Institute of Directors, said: "It's vital that this political vacuum is filled as quickly as possible. The country simply can't afford an extended period of political horse-trading which delays much-needed action to tackle the deficit.
"Politicians have postponed the difficult decisions on public spending cuts for too long already. Further delay will only jeopardise the future of the UK economy."
Rescue package
The problem of high government debt has been brought into sharp focus by events in Greece, which has been forced to turn to its eurozone partners and the International Monetary Fund for rescue loans.
Although the UK has a much lower level of overall debt than Greece, its budget deficit is almost as high.
European leaders will meet later in Brussels to agree the final details of of a 110bn-euro ($139bn; £86bn) loan package to Greece, while the G7 finance ministers are also due to discuss the Greek debt crisis.
There are concerns that other European countries, particularly Spain and Portugal, may become engulfed in the crisis as investors shun government bonds.
On Friday, the cost of Greek and Portuguese government debt continued to rise, providing further evidence that investors remain unconvinced by the proposed rescue package for Greece.
(BBC)
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