An independent Scotland’s choice of sterling, the euro or a separate currency will have huge fiscal impact on a fledgling nation, writes Charles Goodhart
There are a range of challenges, depending on the precise nature of any constitutional change that might be considered, that a Scottish Government would face both in the direction of ofﬁcial ﬁnance and private ﬁnance.
What share of the prevailing UK debt stock would be transferred to a newly independent Scottish Government? What risk premia might an independent Scottish Government, or a government with greater debt-raising powers within the UK, face? Would Scotland be able to establish the Bank of England as its independent monetary authority, rather than set up a Central Bank of Scotland (CBoS)? What would be the implications for Scotland of adverse market sentiment on the capacity and the cost premia to issue Scottish debt?
For the purpose of this exercise, it is assumed that the share of the UK’s public sector net debt [PSND] to be allocated to Scotland in the event of independence would be approximately 8.5 per cent. The scale of UK PSND at that time, say at the end of 2014, is not predictable in advance, of course, but may amount to about £1.5 trillion, giving a Scottish share of £120 billion.
With expectations of continuing ﬁscal deﬁcits and, in the light of the travails of the eurozone periphery, the markets would apply some signiﬁcant credit risk differential to Scottish debt, whatever the new Scottish Government might say and however unfair that might seem to some. So, like the debt of the weaker, peripheral members of the eurozone, Scottish debt would probably require a signiﬁcantly higher interest rate than UK gilts. The present is hardly a propitious moment, from a market standpoint, to choose to become a small, peripheral member of a larger currency union, whether of sterling or the euro, and it is doubtful that this environment will change substantively over the next few years.
What the overall interest cost would be, relative to London, is impossible to predict with any accuracy. The Scottish debt market would also be significantly less liquid than that of UK gilts, which would further raise yields.
But in the present milieu of concern about such currency unions, it could easily be above 1 per cent even if economic events went quite well, potentially spiking far higher, as seen in the eurozone, if economic developments should deteriorate.
One of the obvious consequences of this conclusion is that the Scottish Government would be compelled to run a convincingly prudent ﬁscal position compared to the rest of the UK in order to maintain the conﬁdence of the markets.
As to the question of a Central Bank of Scotland, so long as Scotland remains within the sterling currency union (or in the eurozone), with its main banks being headquartered abroad, it would have relatively little to do, either in setting monetary policy or in maintaining ﬁnancial stability. Its main role might be in debt management.
Should Scottish adherence to that currency union come under question, however, its role would become much more vital, to use its balance sheet, currency reserves and market operations as far as it could to maintain conﬁdence in the maintenance of the currency union. As a small and newly established independent country with small foreign currency reserves, the power and ability of a CBoS to stem a speculative market attack on its own would be limited. It would need support from the larger members of its currency union or, if it had adopted a separate currency, from the IMF.
As has been shown in the eurozone, lack of conﬁdence in the maintenance of a currency union results in local depositors shifting funds into bank branches in the “stronger” part of the union. The CBoS would, therefore, be primarily dependent, should conﬁdence slip, on the banks, or in a real crisis the BoE (or ECB), recycling such funds. As with the eurozone now, such recycling would eventually be coupled with conditionality (probably austerity) to try to address the source of such a loss of conﬁdence. If that conditionality was not politically and socially acceptable, the only alternative remaining would be for Scotland to adopt an independent currency. It has neither been recommended nor proposed by any major group to date and would be a last resort. But, if that were to happen, the CBoS would then take a much more central role than is currently envisaged.
Another question relates to the position of Scotland’s banks. In the course of the 2008 ﬁnancial crisis, Royal Bank of Scotland was recapitalised by the British government, which now owns some 83 per cent of its equity. Halifax Bank of Scotland was merged with Lloyds TSB, and these joint banks were also recapitalised at a level of over 40 per cent of the equity. Both banks are now, and after Scottish independence would remain, owned and headquartered in London.
The cost to Scotland of seeking to buy a majority ownership of either RBS or Lloyds, by issuing more Scottish debt, would, we assume, be prohibitive. The cost of buying those parts of the business of RBS (and/or BoS) located in Scotland would be less astronomical, but having a commercial bank run by the public sector has drawbacks. While the intention might be to eventually sell back to the private sector, this would be a risky exercise, risks that a newly ﬂedged independent government might be wise to avoid. If Scotland becomes independent, it would seem anomalous to have a bank entitled Royal Bank of Scotland headquartered in London. Perhaps the most likely development would be for the main London bank to change its name – possibly back to the National Westminster.
But those parts of this bank located in Scotland would, almost certainly, retain the name RBS, as would BoS. Both the independent Scottish Government and these banks would want, we would expect, these Scottish parts to be separately capitalised subsidiaries rather than branches; largely because subsidiaries come, at least partially, under the control of the host state whereas branches remain wholly a part of the home bank. If RBS and BoS were to operate in Scotland as branches, not subsidiaries, Scotland would have virtually no banks that it could treat as Scottish. The Scottish authorities should have the power to require subsidiarisation in these two instances. There will be other cases of banks headquartered in London doing banking business in Scotland. Whether these should be put under pressure by the authorities to become subsidiaries, or be allowed to remain as branches should they so wish, is partly a question of relative size and could be decided on a case-by-case basis.
We would expect the credit rating of an independent Scotland might well be below, and its government debt interest rates above, those in the redeﬁned United Kingdom. The differential might become quite small if the currency union proved successful. But, given the doubts about the continuing success of the eurozone, the differential could be signiﬁcant at the outset and could increase further sharply if economic events disappointed. This differential in sovereign funding costs would, under normal circumstances, translate into differential funding costs for Scottish ﬁnancial intermediaries, relative to those in London.
This would be a (small) incentive to relocate headquarters to London, even if the bulk of operations remained physically in Scotland. Otherwise there would not seem to be any major detrimental (nor on the other hand positive) effects of Scottish independence on the role of ﬁnancial intermediation in the independent Scotland.
One of the speciﬁc claims that has been made is that, under independence, household mortgage payment rates would increase. However, provided there is a fully integrated ﬁnancial services sector, where products can be bought across any boundary between Scotland and the redeﬁned UK, and one common interest rate for the sterling zone, this is unlikely to be the case. Financial institutions may also be inﬂuenced by the relative long-term success of the Scottish economy – and therefore the creditworthiness of households in Scotland – but not the speciﬁc differential that may arise in government gilts.
• Charles Goodhart is Emeritus Professor at the London School of Economics, and former member of the Bank of England’s monetary policy committee.
This article is an extract from Scotland’s Future: the economics of constitutional change, a new economic commentary on constitutional options facing Scotland, edited by Prof Andrew Goudie of the University of Strathclyde. Readers of The Scotsman can buy Scotland’s Future for the special discount price of £13, at www.dundee.ac.uk/dup. The code is SCOT1.