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Western EuropeMay 25 2021

Currency concerns could derail Scotland’s independence bid

As Scotland inches closer to independence, it’s worth examining the immediate fiscal and monetary hurdles the fledgling country would face. 
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Currency concerns could derail Scotland’s independence bid

Scotland’s march towards independence is gathering pace. The leader of the Scottish National Party (SNP), Nicola Sturgeon, is pushing for a second referendum on the issue by the end of 2023. Her ambitions have been helped by the outcome of the Holyrood elections in May, in which the SNP and the Scottish Green Party secured a pro-independence majority. The dial of public opinion has, for most of the past 12 months, been consistently in favour of independence despite a dip in the first quarter of 2021, according to research from the Financial Times.

A game of constitutional chess between Downing Street and Bute House is now unfolding as London and Edinburgh jostle for position over a potential referendum. Yet, this will be a sideshow to a broader and more important debate playing out between the pro-independence and pro-union campaigns in Scotland. At the heart of this exchange will be one question: can Scotland afford to go it alone? 

Over the long term, there is no question that the country could prosper as an independent state. Reaching this end point, however, will be exceptionally difficult and involve heavy costs for the average citizen. To understand why, it is worth considering the SNP’s current blueprint for an independent Scottish economy and, in particular, its currency. If Scotland was to achieve independence, the SNP administration intends to use sterling — without any agreement from the UK government — during an “orderly transition period”, until a new currency can be established. 

A Scottish central bank operating in sterling is not an independent central bank

Dame DeAnne Julius

Known as “sterlingisation”, it would see Scotland using the pound outside of a formal monetary agreement with the Bank of England (BoE). This would be the case until the SNP’s “six tests of readiness” to launch a new currency were met and a new monetary architecture, including the launch of new institutions, was developed. At first glance, it seems like a reasonable strategy. For voters, the plan offers a continuation of the status quo until the Scottish government is ready for the complex task of launching its own currency and gaining full control over its monetary policy.

Unsustainable plans

Yet, the Scottish economy could not sustain this arrangement for the “period of years” that Ms Sturgeon has said that it would take. This is for two reasons. First, Scotland’s fiscal deficit — the difference between what the government spends and what it earns — is huge by developed-economy standards. In the 2017–2018 financial year, it was –7.4% before sinking further to –8.6% in 2019–2020. The Covid-19 pandemic has wrenched the deficit even wider, as it has in most other markets, to between –22% and –25% for 2020–2021, according to the Institute for Fiscal Studies. Looking ahead, an independent Scotland is expected to face a persistent budget deficit of close to 10% of gross domestic product (GDP) by the middle of the present decade, according to an analysis by the Financial Times

This situation is compounded by an even more challenging balance of payments position. Scotland’s current account, which is a measure of the value of a country’s exports and imports of goods and services, is persistently in a deficit of close to –10% of GDP (about £16bn), according to leading academics. This is where the picture darkens considerably — a persistent current account deficit is more manageable when a country has its own currency, but an independent Scotland would see billions of pounds flowing out of its banking system every year, without a central bank able to generate and provide liquidity support in sterling.

ronald macdonald

Ronald MacDonald, Glasgow University

“A Scottish central bank operating in sterling is not an independent central bank,” says Dame DeAnne Julius, a distinguished fellow at Chatham House and a founder member of the Monetary Policy Committee of the BoE. “It cannot print its own currency, nor provide large-scale deposit protection, liquidity support to Scottish banks, or be a lender of last resort without a very generous — and politically unlikely — backstop from the UK government and the BoE.”  

As a result, the government in Edinburgh would be forced to lean almost exclusively on its fiscal policy regime as a stabilisation mechanism. Fiscal imbalances and lack of currency reserves would constrain this policy option, forcing the government to turn to debt issuance to raise funds just to keep itself and the banking system afloat. Investors eyeing a newly independent country running twin fiscal and current account deficits would demand a high interest rate to cover their risk, only adding to the Scottish government’s financial burdens. 

“Debt issued by [an independent Scotland] in sterling would not be attractive to investors unless it were sold at a higher interest rate than sterling debt issued by the BoE. Scotland has no credit history and an unstable macroeconomic situation, [so any debt that it issues] would be high risk for investors,” says Ms Julius. 

Macroeconomic instability

This picture would be worsened by other distortions in the economy. The total assets of Scotland’s banking sector, for instance, are equivalent to about 1250% of GDP, putting it well beyond the ability of the government to offer assistance in case a banking crisis erupted. To put this figure into context, the same banking sector assets-to-GDP ratio in Iceland was 880% during its own financial crisis, while that of Cyprus was 700% when it endured a banking crisis in 2012 and 2013, according to research from the UK Treasury. 

As a result, independence would likely trigger capital flight from Scotland, as well as the relocation of banks and asset management groups south of the border, feeding into its already challenging balance of payments position. “I can’t see the banking sector wanting to stay in Scotland [after independence]. So, there would be capital flight which would of course worsen the balance of payments situation. And if you have all of these profitable companies moving, that situation is going to get a lot worse. I don’t think that’s been thought through,” says Ronald MacDonald, research professor of macroeconomics and finance at Glasgow University’s Adam Smith Business School.

Scotland’s big lenders are already preparing for this scenario. In April 2021, Allison Rose, chief executive of NatWest, noted that the institution would have to move its headquarters to London in the event of a vote for independence, simply because its balance sheet was too large for an independent Scotland. Ms Sturgeon, when questioned about this announcement during an interview on BBC Radio 4, said that she “[didn’t] necessarily accept that rationale”. 

These conditions would force an independent Scotland to abandon the use of sterling. “The external position — the 10% current account deficit, which is more than double the deficit percentage of the UK — implies that the sterling exchange rate vis-a-vis the rest of the UK is too strong for the Scottish economy to succeed by itself in world markets. Yet a devaluation against the rest of the UK is impossible without a separate currency,” says Ms Julius. 

Fundamental dilemma

Herein lies the SNP’s fundamental dilemma: if Scotland votes for independence, there will be no choice but to introduce a new currency with a floating exchange rate regime. This new currency will be devalued relative to the UK pound by a considerable margin. “The logic of such a big current account deficit is that you would need to take a pretty big hit on the currency — I’ve estimated it would be up to 30%. That’s a very large depreciation and it would have to be handled very carefully in terms of its potential inflationary implications,” says Mr MacDonald. 

I can’t see the banking sector wanting to stay in Scotland [after independence]

Ronald MacDonald

Overnight, Scots would find themselves servicing historical debt with a new currency worth up to 30% less than sterling. “If you were unfortunate to have a mortgage denominated in sterling, you would be paying a lot more for that in [a new] Scottish pound. [In addition], it would have big implications for pensions if they were redenominated into the new currency. So there are major issues there for working people,” says Mr MacDonald. 

These difficulties would be accompanied by a brutal regime of fiscal austerity, which the SNP has conceded would be necessary, irrespective of the country’s post-independence currency situation. This perhaps explains why, on the currency question, the SNP is keen to avoid disclosing that a shift away from sterling will be required for an independent Scotland. 

“Obviously, the political economy of all of this is very important — that’s why the SNP wants to keep using sterling for as long as possible. So my feeling is that they would probably go into an independence referendum with that mantra continued, but once they were on the other side of a ‘yes’ vote, then they would very clearly have to change their policies,” says Mr MacDonald. 

“The SNP will just describe all of this as ‘Project Fear’, but it’s project reality in a sense. I don’t think any self-respecting macroeconomist could sign up to what they’re proposing at the moment,” he notes.

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