Peter Jones: Debt risk is a potential deal breaker

Bank of England governor Mark Carney has major concerns about a currency union. Picture: AFP/Getty
Bank of England governor Mark Carney has major concerns about a currency union. Picture: AFP/Getty
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Peter Jones writes that recent global currency turmoil underlines the uncertainties that might afflict an independent Scotland.

CURRENT rather dramatic events in world currency markets illustrate why the matter of the money that an independent Scotland might use is a big issue that is capable of making or breaking the Yes campaign.

And it will be much in the news this week, with Bank of England governor Mark Carney and sundry experts in town to give their views. Right now, the outlook looks bleak for Alex Salmond, so I thought I would try and give him some helpful advice.

Present currency markets turmoil illustrates how far removed their operations and movements are from what seems like common sense fundamentals. Mr Salmond and his supporters argue that possession of oil wealth, big renewable energy potential and an export surplus makes Scotland a sound economic unit which would be a big asset and strengthen sterling in a common currency union with the rest of the UK.

It sounds like, and indeed is, common sense, but only up to a point. The problem for Mr Salmond is that it is only a very small part of the argument, and the bigger part, which he does not talk about, points to a different conclusion.

Last week, rising Argentine inflation (reckoned to be more than 25 per cent) and its central bank ceasing to support the peso caused confidence in the currency to evaporate and it lost nearly a fifth of its value against the US dollar.

Meanwhile, the South African rand and Brazilian real also lost value, mainly because the Chinese economy, to which both are big exporters of raw materials, looks to be slowing.

The Turkish lira also dropped because of political fears that the Ankara government is being dragged down as a result of corruption scandals, as did Russia’s rouble amidst concerns that its economy is in trouble.

And then, forecast changes in US monetary policy had a profound effect on the ocean of investment money sloshing around looking for a home where it can earn more money. The tide of opinion, which has been pushing waves of money –the IMF is reported to have assessed it at about $470 billion (£284bn) – towards emerging markets and currencies (the likes of Brazil, Russia, and South Africa), has suddenly reversed and is pushing it back to the US, the euro, and to a limited extent, the UK.

What can we learn from this? Firstly, that being a much-lauded new and rising economic star, such as the BRIC economies have been, doesn’t guarantee that there will be no reverses. Secondly, that having big oil resources – Russia is reckoned to have earned about $400bn (£241bn) from oil exports last year while Brazil has both big oil deposits and renewables potential – doesn’t mean that market opinion will always shine on you.

Then there is the more general lesson that a currency is not necessarily valued in the markets by the foundations of the economy in which it stands, but is more commonly assessed according to the risks it presents and the comparative value it can offer in relation to other currencies.

And that’s really the basis on which a UK sterling zone in which there are two sovereign governments will be viewed by investors. They will look at the potential risks and rewards – and the economic fundamentals of Scotland having oil resources, exports, etc, will be a secondary consideration.

So, assuming that an independent Scotland takes on an “equitable” share of the UK debt as the Scottish Government’s white paper puts it, or a “fair and proportionate” share as the Treasury calls it, what would be the risks?

Well, investors’ main concern would be that Scotland might default on the interest and principal repayments due on its “equitable” share. The point of the recent Treasury note was to recognise this risk and to extinguish it by saying that all existing UK debt at the date of independence would continue to be honoured by the government of the rest of the UK.

That, however, isn’t the end of the matter. Scotland would be paying money to the UK Treasury, estimated to be up to £5.5bn annually in the independence white paper. That’s if Scotland takes a population share – 8.4 per cent – of the debt. I reckon it would have to be a higher share – based on GDP – and since that includes most North Sea oil GDP, it could be as much as 9.75 per cent.

That better reflects both countries’ earnings abilities, hence their ability to pay, and so also fits the description of “equitable/fair and proportionate.” Indeed, as holders of UK bonds are likely to be mainly concerned about ability to pay, they may well force that division regardless of what the two governments negotiate with each other.

But let’s stick with the £5.5bn for the sake of argument. Investors will know that will be a pretty big chunk of the £64bn the Scottish Government is likely to be spending annually. They will also know that oil revenues are also a big part of the taxes Scotland needs to raise, and that they are volatile. So they will worry that there is a risk Scotland might default.

You and I might think that risk is absolutely negligible, but current market turmoil tells us that’s not what the markets may think. That won’t affect the cost to taxpayers of the stock of debt on independence day, but it is likely to increase the cost of post-independence new debt issued by both governments.

The risk could be reduced by Scotland issuing new bonds equivalent to the value and maturity profile of the Scottish debt share, handing the lot to the rest of the UK Treasury, then paying it all the interest. That could then be guaranteed by establishing a sovereign wealth fund (assuming there are enough surplus oil revenues) and giving the rest of the UK the right to draw it down if the Scottish Government doesn’t make its debt payments.

This wouldn’t extinguish all risk, but it gets rid of a lot of it, benefitting both governments and their taxpayers. The only snag, of course, is that it relies on oil prices being sufficiently high to get an oil fund established straight away. That’s a bit of a gamble, especially as one of the problems causing market turbulence is slowing growth in China and Russia, which may cause oil prices to fall.

That, however, is just another of the real market uncertainties that an independent Scotland would have to deal with.