Jeremy Peat & Lesley Sutton: Sharing the debt burden

Our previous David Hume Institute chairman of trustees, Sir Ian Byatt, suggested that it would be of interest to calculate what Scotland’s share of UK public debt might be in the event of Scottish independence. That seemed an interesting question, so we set about trying to answer it, leading to a recently published paper. That paper has attracted some interest and now the First Minister has set up a Financial Commission Working Group, made up of members of his Council of Economic Advisers, to “oversee work to establish a fiscal and macro-economic framework for Scotland”. Our paper should provide food for thought for that commission.

This is not a detective novel so it seems reasonable and helpful to provide the key conclusion from this investigation in advance of the complex plot unwinding – namely that there simply is no one “correct” answer to this particular question.

For reasons we set out, the likely extent of debt in an independent Scotland will certainly be relevant to and perhaps influence the evolving constitutional debate, but cannot be determined by careful analysis alone. It will be determined as much, if not more, by politics as by statistics. Our paper identified the key data and set out possible means by which UK debt in different categories might be sub-divided. But no one approach to such sub-division is intrinsically “right”. Each is a topic ripe for intense debate.

The extent of national debt in relation to national output – ie, the ratio of debt to Gross Domestic Product (GDP) – is seen by credit rating agencies and others as a critical aspect of assessing the health and credit-worthiness of a nation. In his recent Budget, the Chancellor cited data provided by the independent Office for Budget Responsibility (OBR) on the expected ratio of the annual deficit to GDP for the UK in each of the years ahead, and also the projected debt to GDP ratio going forward. The UK debt to GDP ratio is not now expected to peak until 2014-15, at a level of 76.3 per cent.

There is no straightforward answer as to what level of debt to GDP is acceptable and indicative of a healthy economy. For entry to the eurozone, the criterion was supposed to be below 60 per cent but several nations entered with ratios at 120 per cent or more. Gordon Brown saw a level of 40 per cent as reasonable for the UK in the “good old days”.

A great deal depends upon the maturity of the debt and of course on economic prospects – highly relevant to the ability to service debt. The more doubts there are about a nation’s ability to service debt, the lower the national credit rating and the higher the cost of government borrowing. This is a vicious circle – higher debt means higher borrowing costs, resulting in more revenue being required to service debt and hence more difficulties for the national treasury.

Before turning to the data we should enter one further caveat. This paper was completed in advance of both the Budget and the announcement that the UK government was taking over the pension liabilities of Royal Mail. Some of the data may consequently have changed, but not so as to challenge the broad thrust of the argument.

The best starting point is UK Public Sector Net Debt (PSND) – the basis for the Budget figures and for analysis by credit agencies. In January this year, excluding financial intervention, UK PSND stood at £988.7 billion – 63 per cent of UK GDP. Scotland’s share of this debt could be calculated on the basis of our share of UK population (8.4 per cent) or UK Gross Value Added (8.3 per cent) or Scotland’s share of UK public expenditure (9.5 per cent).

Some might argue that debt built up paying for activities which an independent Scotland would not support should be excluded altogether when calculating shares – on the occasion of Ireland’s negotiations in 1922, the Irish share of UK debt was set at zero as a quid pro quo for other elements in the negotiations (though this is probably not a valid precedent).

Applying, as an example, the 8.4 per cent population share, Scotland’s PSND comes to £83.1bn.

Next comes the issue of the appropriate measure of Scottish GDP. We have no ready measure but we can work around that. More substantively, should this GDP measure be based upon onshore activity alone or also include some measure – population-based share or a geographical-based share – of offshore activity? Using a methodology explained in the paper, comparable UK and Scottish measures have been produced. The UK debt/GDP ratio changes marginally to 64.6 per cent. Including a geographical share of offshore activity, Scottish GDP comes to £159bn and the debt-to-GDP ratio is 52.2 per cent. Using a population-based share, the ratio is 64.3 per cent and with only onshore activity included the ratio rises above the UK level to 66 per cent. Once again we take no view – the reader may pay their money and make their choice: Scotland’s debt to GDP ratio is well below the UK level or about the same or slightly greater.

However, PSND is a fairly narrow measure of debt. Last November, HM Treasury published Whole of Government Accounts (WGA) examining UK debt including, among other things, Private Finance Initiative (PFI) debt and some future public sector pension liabilities, but not including state pension liabilities, or Royal Mail liabilities. (Under the niceties of government accounting, £37bn of Royal Mail pension scheme assets were included as revenue in 2012-13, sharply reducing the deficit and the deficit-to-GDP ratio. The distinctly larger – even in present value terms – liabilities were not included in the PSND measure.)

These WGA data are for March 2010, so include a lower PSND figure than the data shown above for 2012. These data show overall gross UK debt as amounting to £2,033bn or a net figure of £1,212bn after taking account of assets. There are some serious liabilities here. Future public sector pension liabilities alone – NHS, teachers, police, firefighters and the civil service – amount to £1,132bn. After independence, some of these would fall to Scotland.

The paper considered Scotland’s possible share of these UK liabilities. An estimate of an equivalent gross liability figure – pro-rating PSND by population and using best estimates for other items from work by Audit Scotland and others – is £152.5bn. Allowing for Scotland’s share of assets takes this down to £83.5bn net.

As ever, there are grounds for debate. The PFI liabilities may be calculated on differing bases. Other liabilities include nuclear decommissioning – with five of the 19 stations geographically in Scotland, but with the Scottish Government opposing nuclear generation, how should these liabilities be shared?

Finally a further contentious topic: the debts related to banks. In the narrowest terms, the UK government bought equity in Royal Bank of Scotland and Lloyds Banking Group, which includes Bank of Scotland, amounting to £65.8bn. The extent to which this is recouped will depend upon the banks’ performance and the government’s ability to sell its equity stakes at an appropriate price at a suitable time.

There are additional funds outstanding under the Asset Protection Scheme. Lloyds has left that scheme and RBS announced its intention to depart this year. There are also guaranteed loans under the Credit Guarantee Scheme, again likely to be terminated this year.

So who should be liable for whatever debts remain if and when independence transpires? The banks were based in Scotland but had activities across the UK and much more widely – and the regulation was by the UK government.

The Scottish Government’s latest Government Expenditure and Revenue Scotland 2010-11 report examines Scotland’s share of the permanent effects of the UK government’s financial sector interventions. These are based on population shares but that does not mean the same basis would be used for any later calculation.

This is a complex story, but this issue will matter in the event of independence and possibly also as Scotland moves further towards full fiscal devolution. Of course the story will change between now and a 2014 referendum, and between that date and any subsequent settlement. PSND may or may not behave as forecast. Changes in interest rates could change pension liabilities. The banks’ equity shares may be sold off.

Decisions taken in any settlement could well influence what level of debt an independent Scotland might inherit and the new nation’s credit standing as it sets out on a new and largely uncharted economic course.

• Jeremy Peat is director of the David Hume Institute and Lesley Sutton is research manager. Her paper can be found at davidhumeinstitute.com