Without the pound, independent Scotland has more questions to answer
In ruling out the possibility of a shared Pound, the UK Parliament created a great deal of uncertainty for how financial markets will operate in an independent Scotland.
It is not often that all three major UK parties and a top civil servant at the Treasury are publicly in agreement, but recently they were: If Scotland votes to become independent in September, the remaining UK will not enter into a shared-currency agreement with the newly formed state. This is a major blow to Yes Scotland’s plan for a smooth transition to independence, which relied on continued use of the pound.
The decision by the UK government and the opposition is partly political, as they oppose having a divided country (with the North Sea oil ending up on Scotland’s side, nonetheless). But on a more pragmatic level, they would not stand to benefit from letting an independent Scotland piggyback on the pound’s sterling reputation in global markets. Assuming Scotland could not adopt the Euro immediately, it would have to create a new currency, which will have to address several key questions related to financial markets.
Debt and bonds
An intriguing twist to the UK shutting Scotland out of the pound-zone came from Scottish First Minister and Yes Scotland leader Alex Salmond, who asserted leaving the pound means Scotland is not required to take on any of the UK’s public debt. If this is more than simply hardball rhetoric, Scotland could be starting its independence without its estimated £15 billion share of UK public debt.
It is hard to tell if the UK would simply let Scotland walk away from that debt. Already it has shored up markets’ worries by assuring that it would take responsibility for the debt regardless. In this case, the only real history markets would have on Scottish debt is that the country walked away from the debt accumulated before 2014.
On a larger scale, the question of how Scotland would issue bonds is up in the air. A new country with a new currency, however stable its finances appear (which Yes Scotland claims are very stable), will face higher borrowing costs than Scotland currently has as part of the UK. Scotland may even have to issue sovereign bonds and cede the ability to ease its debt burden through monetary policy. The irony if Scotland issues sovereign bonds in pounds sterling would not be lost on the government and investors.
As a step to compel Scottish voters to remain in the UK, Westminster announced that if Scotland stayed in the UK it could issue its own Scottish bonds starting in 2015 to pay for duties already devolved to Scottish Parliament. Even if still in the UK, Scottish bonds could come with a higher price tag for Scotland.
Scotland’s large financial sector
Three of the UK’s largest banks – Royal Bank of Scotland (RBS), HBOS, and Lloyds – are headquartered in Scotland. Whether they will remain there if Scotland breaks from the UK is a hot political topic.
More so, it is a major question for financial stability. Scottish banks have assets 15 times as large as Scotland’s GDP. For comparison, Iceland’s three largest banks had assets only 11 times as large as Iceland’s GDP in 2008.
Also worrying is that the 2008 RBS bailout cost more than two years of Scottish economic activity, and the UK government still owns 80 percent of the bank. In the event of another financial crisis, Scotland could be hard-pressed to stabilize its banks (although it would depend on how assets are divided with a UK-based foreign subsidiary). Whether the UK would sell its stake in RBS to Scotland upon exit from the union, and whether Scotland could pay for it, is a further difficulty.
Even without a financial emergency, dividing and valuing assets would impose significant costs and require effort. Each of these banks has a presence in London – maybe even larger than their presence in Scotland – that would have to be split up. It is a doable but onerous task.
Valuing and converting Scottish assets to a new currency could be a nightmare. Depending on how the new currency is valued, Scotland could see large international capital flows that affect everything from personal savings to defaults. With 25 percent of Scotland’s economic activity in the financial sector, the adjustment will be large even if it goes smoothly.
As soon as an independent Scotland moves away from the pound, its central bank will be faced with a difficult proposition: manage a new currency in a relatively small European oil-producing country outside of the European Economic Area.
Scotland would at least initially have to peg its currency to the pound even if just for a one-time conversion of assets, retail prices, and outstanding cash. Finding the right peg value would involve balancing a number of factors, including optimizing the domestic value of oil exports, keeping imports from the UK affordable, and keeping the currency stable on the foreign exchange market.
An independent Scotland would be less insulated from shocks in the global oil supply. 13 percent of the Scottish economy comes from offshore oil in the North Sea, so the monetary authority would have to quickly adapt to world events. This, of course, would be on top of managing expectations and rates in a large, financial-centered economy. To run these operations, Scotland is fortunate to have several large prestigious universities to draw from.
Despite these risks, an independent currency for an independent Scotland could be a tool for the Scottish National Party to implement its fiscal policy goals of a more equal and green country. It would have complete control over its spending and attitudes towards regulation and redistribution, which it would not have with the pound or with the euro.
Without the pound, joining the euro may make the most sense for Scotland. As an established currency, it may save money on the bonds market and quell anxiety over investing in the country. Before it can join the Eurozone, however, Scotland must join the European Union.
Update: A reader inquired about whether the currently-available Scottish pound notes could serve as Scotland’s new currency. This is a difficult question to answer since these banknotes are issued by private banks, so legally they are only guarantees by the bank to repay a debt in that amount. Today these notes are in pound sterling, but conceivably would need to be denominated in a new Scottish currency if Scotland were to have control over its own monetary policy.