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Will Scotland take flight in UK independence referendum?

The people of Scotland will have the opportunity to vote on the country's independence from the rest of the UK in 2014. But while the decision will inevitably be an emotive one, the financial, business and political ramifications cannot be ignored, and it appears that there is still a great deal of uncertainty surrounding them.
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Will Scotland take flight in UK independence referendum?

Facing near bankruptcy following an ill-fated attempt to establish itself as global trading power by colonising the Isthmus of Panama in the closing years of the 17th century, the Kingdom of Scotland was left with little choice but to surrender its sovereignty. Accordingly it ratified the Treaty of Union with southern neighbours, England, in 1707, creating the United Kingdom of Great Britain. 

What began as something of a hostile takeover quickly developed into an alliance which was truly mutually beneficial. But now, more than 300 years later, many Scots feel going it alone might just be worth another shot. And come 2014, they will have the opportunity to put it to the vote.

Despite muddling along pretty well over the past three centuries, there is a deep-rooted history of petty acrimony and political point scoring on both sides of the border. It should not, then, be entirely surprising that the battle for Scottish independence is turning out to be something of an emotive issue. The pro-independence Scottish National Party (SNP) has long waged a political campaign based around appeals to national pride and stirring up of resentment against out-of-touch ruling factions in Westminster.

With a referendum in sight, things are getting heated. Nationalist factions have targeted business owners and members of the public over any inkling of a pro-Union stance in a manner, which, even by the standards of political discourse, is conspicuously extreme. Alistair Darling, the UK's former chancellor of the exchequer and member of parliament for Edinburgh South West, tells The Banker that when the pro-union 'Better Together' campaign, which he heads, was first unveiled, his office was inundated with hate mail for several hours.

Nevertheless, just as the motivation for finally pushing Scotland into union was financial, much of the dispute about its future has rested on economic considerations.

Holding its own

Few will seriously suggest that an independent Scotland would not be a viable state. However, whether it would be better off or not is a rather different question, and one that has, and will continue to be, the subject of fierce debate.

Extremes are voiced in both camps; the more condescending unionists characterise Scotland as a subsidy-hungry parasite on the rest of the UK, while nationalists suggest it would flourish unencumbered by oppressive Westminster rule. For now at least, neither are truly correct. It is true that public spending per capita is higher north of the border, standing at £10,165 ($16,029) for 2010-11, 14% above the UK average of £8884, according to UK Treasury figures. However, significant variation exists elsewhere, with £10,198 per head spent in London and £10,668 in Northern Ireland over the same period.

The Government Expenditure and Review Scotland (GERS) suggests that 9.3% of total public sector expenditure in the UK occurs in Scotland, despite it only having 8.4% of the population. However, it estimates that 9.6% of government revenues are generated there too, at least if a “geographical share” of North Sea revenue (85% to 95% based on approximations of territorial waters) is taken into account. Exclude oil and gas, and the figure falls to a less encouraging 8.3% of the UK total. Not that the nationalists have any intention of allowing that to happen. "It's Scotland's oil" has been a mantra for the SNP since supplies were first tapped in the 1970s, and Scottish first minister and SNP leader Alex Salmond has refused to countenance the possibility of anything but a geographical distribution of oil and gas revenues for an independent Scotland.

It is essential to his long promised strategy of cultivating a fossil fuel nest egg in a similar vein to Norway, which has amassed a $600bn sovereign wealth fund from oil revenues. Speaking at the London School of Economics in February, Mr Salmond outlined plans to hive off 10%, or around £10bn, of oil and gas revenues annually to create a fund which he said could be worth as much as £30bn over 20 years.

However, in a report issued in response to these claims, the Centre for Public Policy for Regions claimed that while the fund was viable, unless price and production were to far exceed forecasts, it would require budget cuts, as existing revenues are required to maintain levels of public spending. And while Mr Salmond said that a fund would only be implemented "once fiscal conditions allow", the report concluded: "There is little prospect of any surplus becoming available for an oil fund, and certainly not of the size being suggested." Moreover, the rate of growth proposed by Mr Salmond would be a considerably higher compound return rate than the 2% to 3% generated by the Norwegian fund.

Running low?

Oil, though, is not necessarily a stable base upon which to base an economy, especially given that North Sea oil production has already begun to decline; 40 billion barrels of oil equivalent (BOE) has already been recovered from the North Sea, according to Scottish Enterprise, with an estimated 12 billion to 24 billion BOE still to come.

These reserves have been estimated to be worth up to £1500bn, but the income they generate is already declining, according to the Office of Budget Responsibility, which predicts that UK oil and gas revenues will fall from a high of 0.9% of gross domestic product (GDP) in 2011-12 to 0.6% by 2015-16, and to between 0.1% and 0.2% in 2028.

Even while supplies last, some major variables exist. As a finite resource which has seen peak production come and go, oil values will likely maintain some sort of upward trajectory, but is likely to be an erratic one. Recent years have seen prices drop as low as about $9 a barrel in November 1998, and climb to almost $150 a barrel in July 2008. According to GERS figures, the amount of potential revenue generated from taxation of oil revenues in Scotland could range from £1bn to £13bn annually.

This is not a point that is lost on the unionists. “My argument is not that Scotland couldn’t go it alone, but that we would be very dependent on one source of revenue, namely oil,” says Mr Darling. “Yes there are supplies out there for some time, but by its nature it is not a renewable source and it will leave us very exposed to price fluctuations.”

Raising funds

Dealing with these fluctuations, as well as other fundraising needs, will require an independent Scotland to issue cash or debt instruments. The ease, and cost, of doing so, however, will depend on its sovereign credit rating. And this is currently something of an unknown quantity, given the lack of data available on national debt, currency reserves and the like.

However, while credit ratings agencies have been unwilling to publicly state what rating an independent Scotland might garner, the Financial Times reported earlier this year that at least one ratings agency – Moody’s – would mark down any country that did not have an established track record.

The Financial Times added that Moody’s, along with Standard & Poor’s and Fitch, had indicated that an independent Scotland would not automatically inherit the UK’s AAA rating, a fact that Stewart Hosie, member of parliament for Dundee East and deputy leader and chief whip of the SNP Group at Westminster, tacitly acknowledges. “The only conceivable reason for not having the same credit rating agency score would be the absence of history,” he says. However, he adds that there is not necessarily a direct relationship between credit rating and yield demanded on gilts. Indeed, when the UK’s rating came under threat in February this year, Canada had a secure AAA rating, but its five-year debt was more expensive. Meanwhile, Japan, rated at AA, enjoyed yields lower than either.

Separation from the UK requires taking a share in debt, as well as revenues however. Mr Hosie says the SNP “always said we’d take our full negotiated proportional share”. According to National Institute of Economic and Social Research calculations, this will amount to 70% of Scotland’s GDP, even if oil reserves are allocated on a per capita basis.

However, the complexities involved in these calculations make arriving at a definitive figure extremely hard, especially given that Scottish-headquartered Royal Bank of Scotland (RBS), and its £187bn of toxic assets, is now nationally owned, as is a large proportion of Lloyds Banking Group. RBS in particular is a mixed blessing. Ranking 12th in The Banker’s Top 1000 World Banks for 2012, it remains one of the world’s largest financial institutions. However, it also comes with a mountain of insured debt. Mr Salmond, has said that its failings were the fault of London-based regulators, so Scotland should not take a greater share than the rest of the UK population, telling Channel 4 News in January: "Obviously the people responsible for that, just as the people who took the corporation tax over the Royal Bank of Scotland, were the London Treasury, and unfortunately they were also responsible for misregulating the financial sector as well."

His position has been made harder, however, by the exposure of his enthusiastic support for RBS’s ill-fated takeover of ABN Amro, for which he offered “any assistance my office can provide” in a letter sent to RBS’s then-CEO, Fred Goodwin, in 2007.

Need to know

Despite the abundance of aspirational assertion and counter assertion on both sides of the debate, apportioning hypothetical shares of revenues and debt is unavoidably speculative, and, should the vote go the SNP’s way, will inevitably be the subject of extensive, and doubtless acrimonious, debate.

There are, however, some questions which “can, and should”, be answered before the referendum, says Owen Kelly, chief executive of Scottish Financial Enterprise (SFE). These, he says, include EU membership and the related issues of currency and regulation.

The SNP has said that an independent Scotland would wish to be a part of the EU, but even at the most basic level, it is not obvious precisely how this might come to pass. The membership process might, as nationalists appear to believe, proceed at a leisurely pace, without much in the way of negotiation. However, it may be that because Scotland is leaving the UK, it would have to initiate the joining process from scratch. “We don’t care what the answer is, but we want to know, because it has a lot of implications,” says Mr Kelly, questioning why the Scottish, or even UK, authorities have not sought a solid answer from Brussels over what the accession procedure would be, given that the terms of the referendum have been decided.

EU membership typically comes with some sizeable strings attached, not least when it comes to currency. SNP leader Alex Salmond has, in the past, suggested Scotland would join the euro as a matter of course to escape what he once described as the “millstone of the pound”. Recent events render that a policy bordering on political suicide, however, and Scottish finance secretary John Swinney has said he "cannot foresee the set of circumstances" which would lead to a referendum on joining the single currency.

Unfortunately for the SNP, signing up to the single monetary area is a condition of EU membership. It may be avoidable in the short term, however. Sweden, for example, has avoided joining thanks to a legal loophole.

A new pound?

With the euro a non-option, for a period, the SNP favoured the idea of a separate Scottish pound, which would be pegged to the pound sterling to avoid volatility, in a similar manner to which Panama uses the US dollar. When it became obvious that this would result in an interest rate set by a foreign country, over which Scotland would have no influence, plans changed to remaining part a fully realised currency union or 'sterling zone'.

Such an arrangement raises two issues, however; whether the rest of the UK would wish to enter into the arrangement, and even if it did, what commitments it might demand in return.

In the first instance, no one seems to have asked. Assent is certainly not assured, says Mr Darling, given that for the rest of the UK, currency union would effectively involve surrendering sole control over the pound to what would then be a foreign country.

Mr Hosie refuses to countenance the possibility of there being any objections, however, describing it as “inconceivable” that a UK government would refuse to continue with a sterling currency union. “Given the strength Scotland brings to the currency table in terms of net surplus and trade terms, it would be irrational, and very foolish for the rest of the UK in the future to say ‘no you can’t have that’,” he says.

Even if agreement were reached a stark warning across the channel of the potential ramifications of a poorly integrated currency union means that any UK government would likely expect an onerous degree of wider assimilation, including demands for tight control over Scottish budget, deficit levels, banking policy and levels of borrowing, says John Kay, a visiting professor of economics at the London School of Economics, fellow of St John’s College, Oxford, and former advisor to Mr Salmond. “I think if you spell out the kind of demands which the rest of the UK would make in that respect, you find yourself asking what independence would mean in the first place.“

As a result, he says, “one inevitably has to think of a separate Scottish currency”, although even this he describes as “not a brilliant option, but not an impossible one”. He suggests the SNP’s previous plan of pegging against the pound as likely the best course of action, although cautions that to do so requires sizeable foreign-exchange reserves – something which a newly independent Scotland may not have.

Last resort

Talk of currency inexorably leads to the crucial question of who would stand behind Scottish banking institutions – playing the role of lender of last resort and provider of liquidity to the financial system. It is not a frivolous query, especially when one considers the Royal Bank of Scotland had, in happier times, a balance sheet which exceeded £2200bn – even now, at £1500bn, it utterly dwarfs Scotland’s GDP.

Scottish deputy first minister Nicola Sturgeon has proposed that the Scottish government pay a fee to the Bank of England (BoE) to perform this function, but once again, it is unclear whether anyone outside of Scotland would welcome such an arrangement. Mr Hosie suggests Scotland should be able to expect the support it desires. “The BoE is Scotland’s central bank at the moment, it is English by name only,” he says. “Given the central bank is ours at the moment and would be in the future, we’d expect it to fulfil the obligations of a central bank.”

Many other institutions and controls that the SNP is keen to get rid of are also 'Scotland’s' at present, however, and a country wishing to leave the union might not find itself in a particularly strong bargaining position.

The SNP would like to remain subject to other London-based institutions too, specifically when it comes to financial regulation.

The topic is something of a sore point for Mr Salmond, who, in the past, has proposed that Scotland should emulate Iceland and Ireland’s economic strategy, and championed “light touch” regulation for the potentially lucrative financial sector.

Current SNP plans, though, suggest that the Scottish institutions sector would continue to be subject to oversight by banking regulators in Westminster. This would lead to a faintly unusual situation whereby regulatory powers lie with a foreign country with its own changeable domestic laws. It also begs the question, says Mr Kay, of why an independent Scottish parliament would willingly surrender the ability to make independent decisions, especially given Mr Salmond’s talk of mis-regulation. The difficulties may not end there either. Such an arrangement may not, in fact, be legal under EU law, which requires a national “competent authority” to regulate the financial sector.

Going full circle

Regardless, it seems the SNP currently has its heart set on sharing power in a number of areas, from monetary policy to defence. As a result, some question the point of the whole endeavour. As Mr Darling puts it: “If your entire argument is based on your being held back by the rest of the UK, what sense does it make to make an arrangement where as surely as you put a train on a set of tracks it will end up in the place in which you left.”

This is missing the point, says Mr Hosie. “This isn’t secession where we build a wall, it’s about political decision making. Which is why it’s sensible to have a shared currency, proper trade arrangements, free flow of people and movement of capital, as currently happens. If you’re in a currency union it doesn’t stop our government saying no our troops will not go to an illegal war in Iraq, or use tax allowances to grow sectors of the economy which are important to Scotland.”

These decisions will play a huge part in the future of the other big feather in Scotland’s economic cap – the financial sector, which employs nearly 100,000 people directly, a similar number indirectly, and accounts for 7% of Scottish GDP, according to the SFE.

Some, such as Ian Fraser, director and board member with Central Insurance, Scotland’s largest independent insurance broker, are open in their opposition to independence, although the financial sector is, for the most part, more guarded, characterising the referendum as a decision for the Scottish people. The overriding sentiment is a desire to nail down as many facts as possible.

Inability to do so is a huge concern. “Really, the challenge facing financial services firms is uncertainty regarding detail and information available,” says Catherine Burnet, head of financial services for KPMG in Scotland.“ George Renouf, director of investment strategy with Dundee-based investment trust Alliance Trust, is not optimistic about the chances of this being met, however. “I sometimes doubt whether we’ll get full clarity on many of these issues until the vote goes through,” he says.

Uncertainty almost inevitably leads to a more cautious business environment, and Scotland is no exception to this general principle of economic life, says Andy Fitzgerald, regional manager for Scotland and Northern Ireland with QBE Insurance. “People are putting off investment decisions because they don’t know the outcome.”

Despite a sense that political sentiment north of the border is somehow different – more communitarian, less red-blooded, tooth-and-claw capitalist – to the rest of the UK, there is, however, no reason to suggest that Scotland will be a less favourable place to do business. Certainly, the SNP has promised to welcome the financial sector and other parts of the business world

Ultimately though, no matter how important they may prove, financial regulation, debt shares and the nature of the lender of last resort will likely not be the stuff election campaign leaflets are made of. Instead, Scotland’s future sovereignty will inevitably be a decision made on the basis of national pride, culture, tradition and personal allegiances. However, the populous which will live with the consequences should be aware that going it alone will leave Scotland a smaller, more open economy, vulnerable to external shocks, investment appetite and fluctuations in pricing. As a result, it will require careful, and perhaps uncomfortable, financial management. Recreating the act of union due to economic necessity may not be an option in years to come.

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