On 5th May 2011, the first time since devolution in July 1999, the Scottish National Party won a majority of seats in the Scottish Parliament at Holyrood. One of the key manifesto promises of the party is to hold a referendum on Scottish independence before 2016. While political commentators have begun discussing the potential political ramifications of this – and how to stop it from happening, I’ve seen very little written on the financial and economic issues that will be raised as part of a break-up of the United Kingdom. Those pieces that do touch on economics tend to focus on the fact the UK Treasury currently receives Scottish oil revenues and Scotland receives higher per capita public spending than England. These two factors probably net-off to near zero. I believe that there are more important issues at hand.
The first of these is what will happen to the national debt? At present, the national debt of the United Kingdom is £921bn, which compares to FY10 GDP of £1,455bn, to give a debt to GDP ratio of 63%. So how will the national debt be split? Presumably Scotland will not be able to walk away from this debt and leave it with the rest of the United Kingdom (this would leave England, Wales & Northern Ireland with debt/GDP of 69%)? The most democratic way to split the national debt is on a per capita basis; however, this is unlikely to be popular with the Scots, as their lower GDP would leave the new country with debt/GDP of 67%. This leaves the most viable political strategy as splitting the national debt on a pro-rata basis to GDP (ie both Scotland & England/Wales/NI would have debt/GDP of 63%). However, there are other questions to be answered, such as: (1) how should nuclear decommissioning liabilities be calculated and assigned; (2) what about debt incurred by quasi-governmental organisations such as National Rail; and (3) how would public sector pension liabilities be shared-out? The political and economic calculations are highly complex. Regardless of the exact mechanics of this, people who have invested in Gilts – UK Government bonds – are going to find themselves holding two separate pieces of paper, one worth approximately 92% of par – a liability of England, Wales & Northern Ireland; and one worth ~8% of par – a liability of the new Scottish nation. Given the large number of different Gilts with their separate maturity dates and coupons, investors could find that their new Scottish securities are much less liquid than the Gilts that they used to hold. Would there be an immediate “flight-to-quality” (or liquidity) away from the new Scottish bonds and into English obligations? The extent to which this occurs will depend on the answer to the next question.
One of the first issues sitting in the in-tray of a hypothetical Scottish government will be to make a decision about what currency to use. As far as I can tell, they would have three possible options: (1) continue to use pound sterling issued by the Bank of England; (2) join the Euro-zone; and (3) issue a new Scottish currency. The first two have very similar problems, namely the arguments often regurgitated against the UK joining the Euro-zone. As a reminder of these, one major issue is that Scotland would lose control over its exchange rate and monetary policy, meaning that without significant convergence with the core of the Eurozone (ie Germany) or England, major imbalances could develop – either an investment boom and consequent bust (as in Ireland or Spain) or stagnation and gradual debt build-up (as in Greece, Italy and Portugal). While it could be argued that Scotland is “converged” with England today, that may well change should an independent Scotland begin to pursue its own fiscal policy and/or oil prices change materially, increasing (or reducing) the new Scottish government’s income from energy. This is particularly the case given Alex Salmond argues Scottish independence would lead to improved economic performance – effectively an acknowledgement that the economy would diverge from that of England. The second issue – closely linked to the first – is that the Scottish government would not be an issuer of its own currency. The result is that its bonds would be subject to default risk, which would likely require a higher interest rate than do Gilts at present. Governments that issue their own currencies can never default, as they can always print more currency if necessary. Such printing of banknotes does devalue the currency, but tends to be much less catastrophic than a liquidity-driven default. For example, the Pound has lost about 95% of its value since WWII, but the economy has grown many times over during the same period. Should the Scottish government decide to issue a new currency, the difficulty would be that with no track record, the new currency would likely immediately depreciate from an expected 1:1 exchange rate with pound sterling. This is because a new currency of a relatively small country would have no track record, and investors would demand a higher rate of interest to hold it as an alternative to pound sterling, a minor reserve currency. Therefore, the Scottish monetary authorities would be faced with the choice of hiking interest rates to maintain parity – thus strangling economic growth – or allowing the currency to depreciate, increasing the real value of debts denominated in pound sterling and increasing the cost of imports for Scottish consumers – thus reducing the standard of living. Not only is Scottish independence no economic free lunch, but it is likely to come at a cost.
Another key issue, in my opinion, is what would happen to the UK government holdings in Scottish domiciled and Edinburgh-headquartered Royal Bank of Scotland plc. At present the United Kingdom government owns 83% of the equity in the bank, has provided £222bn of credit insurance on risky assets via the Asset Protection Scheme and the Bank of England has made available approximately £16bn of debt-funding under the Special Liquidity Scheme. In my view, I don’t see how it would be politically feasible for a bank so systemically important to the English economy and owing such significant sums to the English taxpayer (as it would after Scottish independence) to be headquartered and domiciled in another country. Indeed, given the size of RBS in relation to the English economy, I would go as far as describing the bank having all its key decision-making functions located in another country as a major risk to English economic security. The solutions to this are two-fold: (1) RBS moves its domicile and all the key decision-making functions to England; or (2) The new independent Scotland buys-out the English government’s share of RBS’s equity and liabilities. At £16bn for the equity, £15bn for the Special Liquidity Scheme and a £200bn contingent liability under the Asset Protection Scheme I think the second option is unlikely given Scottish GDP is only £115bn (and therefore the upfront cash payment required from the new Scottish government would be 27% of GDP).
In summary, I believe that Scottish independence could have profound implications for the owners of gilts, and that those implications will depend very much upon the currency policy selected by the government of the newly-independent Scotland. An independent Scotland will have a major decision to make about which currency to use – none of the options look particularly attractive and all are likely to lead to higher public borrowing costs than the UK achieves on gilts at present. Finally, an independent Scotland is likely to lose RBS headquarters (a major employer in Edinburgh) to England, assuming of course that RBS hasn’t fully-paid back the UK government and Bank of England on its equity and liabilities. Therefore, there are some major issues for the Scottish people, politicians and UK government bond investors to consider during the next few years.