Peter Jones: Triple A no defence against yield risks

ONE of the joys of the independence debate is that it forces people like me to learn about things I never thought I would have to know much about – like the workings of the government bond or sovereign debt markets.

And one of the lessons is surprising – that an independent Scotland, despite apparent oil wealth, would almost certainly face higher borrowing costs than the UK does.

Why this should be is complex, but the basic fact is that the real cost of government borrowing can bear very little relation to the credit rating bestowed on the borrower by the ratings agencies – Standard & Poors, Moodys and Fitch.

Like most people, I assumed that the yield (interest rate to you and me) a government pays in the international markets depends almost entirely on the perception that potential lenders have of the likelihood of getting their money back. If a country’s economy goes into a tailspin and starts shrinking, tax revenues which are the source of paying back the borrowing also contract.

Potential lenders see this and deduce that the chances of the government welshing on its borrowings are increasing. So they demand a higher yield to compensate, which is what happened to Greece, Cyprus, Ireland, and other unfortunate countries.

Surely this could not possibly be the case with Scotland? After all, Scotland has an onshore economy which, post-recession, is managing to produce some modest growth. And with independence, Scotland would gain the great bounty of North Sea oil with an asset value, based on current prices, which is ten times onshore GDP. From that, you could reasonably expect to extract a fifth of that value in taxes over the next 30 years, or twice annual GDP.

So an independent Scotland, once you also factor in the wealth that might be in store from the development of the potentially huge renewable energy resource, is surely an entirely creditworthy prospect. Any investor ought to have 100 per cent certainty of being repaid and therefore a triple-A credit rating must be all but guaranteed.

Well, it might be. But the horrid fact is that triple-A status does not guarantee that a country pays rock-bottom interest rates.

The evidence is readily available from current bond market data. Among the countries which have a Triple-A rating are Norway, Finland, Sweden and Denmark – all small countries comparable to Scotland as the SNP has pointed out repeatedly.

On a ten-year government bond at the end of last week, the yield Norway was paying was 2.19 per cent and Sweden’s yield was 1.81 per cent, both more than the UK rate of 1.78 per cent. On the other hand, Denmark’s yield was lower at 1.49 per cent as was Finland’s at 1.55 per cent.

Given that Norway has pots of oil, much more than Scotland in terms of the resource-to-GDP size, and an economy with little banking risk, whereas Denmark, Finland and Sweden have no oil, this doesn’t seem to make any sense. These countries have equal credit ratings, but unequal borrowing costs. Why?

The answer is that the risk of default, which is what credit ratings are mainly based on, is but one of a number of risks that market players take into account in their buying and selling decisions.

One is liquidity risk. If the general size of a bond issue is small, then there will be relatively fewer buyers and holders of it. So if you are a UK pension fund that suddenly decides that you have to sell, say, your Norwegian bonds, there is a risk that you might not be able to find a buyer.

Another is exchange rate risk. A government bond is denominated in the currency of the issuing government and, if that currency falls in value relative to the currency in which your pension fund is denominated, then the value of your foreign bond will fall and your pension fund will be worse off.

The exchange rate risk intensifies the liquidity risk. In the high-speed trading world of modern markets, time matters down to thousandths of a second. If a currency is falling in value and you want to offload bonds in that currency, delays of even a few seconds in finding a buyer can cost a pension fund millions of pounds.

These risks mostly explain why these four Triple-A countries have widely varying borrowing costs. The Norwegian and Swedish krone both float in the currency markets and so their relatively small bond issues are subject to exchange rate risk which multiplies the liquidity risk.

Finland, on the other hand, uses the euro as its currency and the Danish krone is pegged in value to the euro. So for investors whose funds are denominated in euros, Finnish and Danish government bonds carry no exchange rate risk. The liquidity risk is also unimportant because there are many eurozone investors desperate to put their money into long-term safe havens.

Indeed, such is the demand for Danish debt that, last year, the Danish central bank cut nominal interest rates on short-term deposits to less than zero. The current nominal yield on bonds of less than two-year duration is negative, about -0.1 per cent. In other words, investors have to pay the Danish government for the privilege of holding its bonds.

Could Scotland aspire to this happy Nirvana? No. As Jens Peter Sorensen, chief analyst at Danske Markets, explained last year to Reuters, part of Denmark’s allure stems from its close links to the strong neighbouring German economy. “You get something outside the euro, but you get something that is attached to the decent part of the euro,” he said. Denmark also has a fundamentally sound economy, with total government debt only about 45 per cent of GDP. Scotland, however, while its economy may be reasonably sound, would be attached to sterling and a UK economy which, according to the SNP, is in terminal decline. It would also inherit a share of UK debt which looks likely to be somewhere between 60-80 per cent of GDP.

None of this is saying that Scotland is too poor or too stupid to run its own affairs – the usual insensate online response that columns like this get from cybernats. But it is saying that independence is not the all-round free lunch some nationalists portray it to be.

There may be benefits, but there are also costs and a relatively high cost of government borrowing would be one of them.