Kevan McDonald: Currency questions need answers

LET me start by saying that, as politicians go, I do like Alex Salmond. He is bright, witty and articulate, and would I imagine be engaging company over a pint of beer, or perhaps a good single malt. However his reluctance or inability to deal credibly with a number of very significant questions relating to the true costs and impact of independence on Scotland (and her people) does concern me greatly.

The currency after independence has been a key campaign issue. Picture: TSPL

I would like to set out a number of these issues and the particular grounds for my concern, and to invite Mr Salmond to provide a comprehensive, credible and robust response on each of these issues.

The principal concerns for this article relate to currency, the new State’s cost of borrowing, banks and the impact of independence upon the Scottish financial services and asset management sector.

Currency

In theory there are a number of currency options available to Alex Salmond. These are the Euro, Pound Sterling, US dollar or the Scottish Groat. Alex Salmond has at least until now firmly committed himself to the Pound Sterling.

There are very good political and other reasons for this stance and the failure to enunciate any Plan B on currency. There are currently more than one million outstanding Scottish mortgage loans provided by banks, building societies and other mortgage providers to home buyers in Scotland in Sterling currency which loans require to be repaid in Sterling, sometimes over an extended period of 25 years. The total outstanding mortgage debt is currently estimated to be well in excess of £100 billion. Many of these mortgage providers are based outside Scotland, generally in England. Similarly, Scottish-based companies and businesses have borrowed many billions in Sterling from various UK banks (and others) to finance their businesses and operations.

If all of these borrowers were paid their salaries and wages (or in the case of Scottish-based businesses, made their local sales) in a currency other than Sterling, a number of new risks and significant costs would have been created for them overnight.

First there would be a mismatch between the currency they receive and the currency in which they may have to make their interest payments and loan repayments. They may also have to meet significant (new) currency hedging costs and the cost of purchasing another currency (Sterling) to meet their mortgage and other Sterling interest and loan repayments.

For these and many other reasons Sterling is, in reality, the only currency option currently available, at least in the near to medium term.

Politically, Alex Salmond knows with absolute certainty that if he cannot offer the Pound Sterling to Scottish voters in September this year, then his chances of success on 18 September 2014 are very dramatically weakened indeed. The Euro is still fundamentally discredited with the Scottish electorate and not likely to be trusted by the Scottish electorate for some time. I do like the sound of the Scottish Groat, but it has been consigned to history where indeed it should remain.

Sterling zone

If we take it then that Sterling is the only viable currency option at this particular juncture, then a currency union with the rest of the UK Sterling zone is a requirement. If the rest of the UK were to agree to such a Sterling zone that would mean very considerable input and influence on Scotland’s borrowing and taxation policies being required and exerted by the Bank of England and the UK Treasury. This means that true independence will simply not have been achieved and is illusory.

We have all learnt from the failed Euro experiment (which has consigned a number of the Mediterranean countries to long-term zombie status) that currency unions cannot properly function without fiscal and political union to which logically, they must be a stepping-stone. Scotland would however be seeking a currency union whilst trying to step away from fiscal and political union. This would be a neat trick worthy of that great escapologist Harry Houdini himself.

A better analogy may however be to a master of illusion such as David Copperfield, because as Alex Salmond well knows, a ‘Yes’ vote in September this year will not in fact result in Scotland keeping the Pound, but in reality will be a vote for switching to the Euro within a few short years.

I agree with the SNP that Scotland would ultimately be admitted to the EU. I am sure that the negotiations would be difficult involving detailed agreement on Scotland’s budget contributions as a new member, detailed agreement on the Common Agricultural Policy, Fisheries Policy and many other such matters. Scotland would however only be admitted as a “new” member state and talk of automatic admission as an “existing” member is errant nonsense. Scotland is not a party to any of the existing EU Treaties (or any of the precursor treaties going back to the 1972 Treaty of Rome). It therefore cannot enforce any of such treaties and neither can it amend them.

As a result, a condition of Scotland’s admission as a new member state of the EU will in truth be Scotland’s binding commitment to joining the Eurozone. There may well be a period of a few years to allow orderly transition to this, but this will be the inevitable eventual outcome. We should all be in no doubt of that whatsoever. A Yes vote this September will therefore actually be a vote for the Euro which will create major issues for Scotland in trading with its single largest global customer, the rest of the UK. Remember we export more by value annually to Worcestershire than we do to China. More than two thirds of all our exports each year are to the rest of the UK.

This is the real confidence trick at the heart of the SNP’s currently stated policy on currency! Sterling is and can only be, a stepping stone to the Euro. Scotland will have about the same influence in the EU as Greece (which has a population of over 11 million) and we have all seen how well membership of the EU has served the Greeks.

Borrowing Costs

Following independence, Scotland would require to borrow money from the wholesale international money markets. These markets will be happy to lend to Scotland but they will certainly charge Scotland more to borrow money than they currently charge the UK. This is simply because Scotland’s international credit rating will be weaker than that of the UK as a whole with no track record. Scotland, with a population roughly the same as Yorkshire, represents a higher credit risk as it is smaller, with a much smaller economy, is less diverse in its manufacturing and industrial base and has a proportionately larger public sector.

Its economy would have an unhealthy dependence on oil and gas revenues which are volatile and likely to remain so. Any debt instruments issued by Scotland would also be less liquid as there will, by definition, be a much smaller market with less demand and greater difficulty to buy and sell.

There is then additionally the lack of any track record of servicing and repaying national debt, and a risk premium which will accrue as a result of that. The UK by comparison has been repaying its national debt dutifully since the Napoleonic wars, but Scotland will have no track record at all.

This increased cost of government finance would need to be met and would also inevitably push up our own personal borrowing costs and mortgage rates. We should all be clear that these costs would inevitably increase and would also be likely to be significantly more volatile in future in their movements.

Banks

Like it or not (and I don’t), none of the main “Scottish” Banks is now managed or controlled from within Scotland. This is a major adverse change from 10 years ago. The Royal Bank of Scotland and the Bank of Scotland (now fully subsumed into Lloyds Banking Group) are now firmly managed out of London following their respective collapses and bail-outs with all significant credit decisions being taken by executive teams and committees which are based in London. Clydesdale Bank is managed from Australia where its parent National Australia Bank (NAB) is based.

Without substantial banks with liquidity and solid balance sheets able to lend based in Scotland, managed and making their decisions here, we are at a very significant disadvantage to our international competitors and achieving any real and sustained growth in our corporate sector (which is where the jobs and taxes come from) will be the more difficult. This challenge should not be underestimated.

Our corporates will effectively be competing for capital allocation from banks which are no longer domestic banks and where those in charge of lending will need to justify their decision to allocate capital to a small country on the fringes of Western Europe with an ageing population, disproportionately large public sector and an economy which is the 85th largest in the world and no longer part of the 6th largest economy (measured by nominal GDP).

We might also reflect upon what would have happened had Scotland achieved the goal of independence in, say, 2005 or 2006. The banking collapse would still have taken place in 2007/08, only Scotland would not have been able to afford the bail out of RBS and HBoS, our international credit rating would have been destroyed and our costs of borrowing would have soared. A smaller country and economy will by definition be less stable and more volatile than a very much larger one and we should not assume that such bank collapses are necessarily a thing of the past.

Scottish Banks have failed or collapsed in the 1770s, 1820s, 1850s, 1870s, 1920s, 1930s, 1960s and late 2000s. We should ask ourselves how Scottish taxpayers would afford to support even this year’s losses announced by RBS (£8.2 billion plus). Its total losses now since the banking collapse (in addition to the bail out costs) are in excess of £46 billion.

Financial Services/Insurance and Asset Servicing Industry

This sector is in, Scottish terms, high profile, continues to flourish and directly employs more than 125,000 people. It has recovered well from the 2008 crisis. Edinburgh remains Europe’s 14th largest financial centre and this sector employs more than 5 per cent of the Scottish workforce and generates over £5 billion per annum or 6 per cent of Scotland’s GDP.

Funds under management here in Scotland are currently estimated at over £350 billion and there are many marked and encouraging success stories. Earnings in this sector are well above the Scottish average which is due to the skill sets and qualifications which are required for this particular service industry. Many of these employees will be higher rate income tax payers and their expenditures will support local retail and other activities. They are significant net contributors to the Scottish economy.

More that 90 per cent of the funds managed and looked after by this sector relate to pension funds/investors and clients who are based outside Scotland. They have chosen to place their funds here given the political stability of the UK, the fact that Scotland as part of the UK and along with the rest of the UK, has Sterling as its currency and given the stability which is generally garnered from being part of the 6th largest economy in the world (measured by nominal GDP).

If one looks a bit deeper, say at our large life companies, like Standard Life and Scottish Widows, the bulk of their funds come from clients based elsewhere in the UK, principally in the South East. What is the likelihood in the real world of these savers and investors choosing to leave these funds, post-Independence, with these companies based in an Independent Scotland?

All of a sudden their funds are held in a country which is not part of the sixth largest economy in the World (but one which is no longer in the top 80), with perceived significant political risk and potential (future) currency exposures, subject to the risk of future wealth taxes and the absolute certainty of increased compliance and regulatory costs. If it were me (based in London) making a dispassionate decision about where my retirement funds should be managed these are all risks that I simply would not need to take. I would most likely decide to select a fund manger based in the South East and relocate my funds there instead.

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This is however not simply an issue for investors outwith Scotland but a major issue for savers and investors who are resident here. Post-independence Scotland would require its own bank and financial services compliance and regulatory regimes. Recruiting experts with the relevant knowledge and expertise to discharge these vital functions effectively is critical. We have no experience or track record of doing this. Any system is only as good as the people whom comprise it. The costs are likely to be significant and the available “pool” to share and recoup these costs will be very small compared to the UK financial services industry as a whole. These costs will therefore have to be absorbed entirely by the Scottish financial services industry, which in turn will have to pass them on to their Scottish savers and investors.

This is likely to put this Scottish industry at a marked competitive disadvantage in what is truly a global market and one where scale and efficiencies of scale are increasingly critical. There may be a helpful comparator here which those in Scotland concerned about these issues facing the Scottish financial services sector would do well to examine and to interrogate. In the 1970’s Quebec was a very significant financial centre which employed well over 150,000 people and was home and headquarters to many substantial banks and financial institutions.

The demand for independence for Quebec from the rest of Canada (the Quebec libre movement) and the risks that such separation imposed, directly resulted in over 300,000 Canadians leaving Quebec and at the time in a very marked decline of that industry much of which migrated to Toronto, where such demands and risks were not an issue for businesses or investors. We have just this week seen Standard Life’s announcement on its own potential relocation. There must be a compelling logic for Standard Life and indeed its comparators who are currently based in Scotland to be regulated in the country where the vast majority of their customers live. That is simple common sense.

All of Scotland’s publicly listed and/or larger companies with substantial sales and/or businesses outwith Scotland, will now be considering the impact of a potential yes vote upon their businesses and formulating their own detailed contingency plans. The directors of these companies are all under a legal duty to act in the best interests of their shareholders and are also legally obliged to identify, assess and manage all significant risks to their businesses. The recent statement from Standard Life should not therefore have come as any surprise. It may be the first large company in its particular sector to go public on this matter, but it certainly will not be the last.

Conclusion

It concerns me just how few Scottish businessmen have publicly raised the concerns they may have for their business and/or their workforce arising from the prospect of Independence. It seems to me that a full, open and robust exchange of views with complete transparency on each side of the debate is the only way to ensure that, one way or the other, an informed decision is made on this truly vital matter and that any major issues are not overlooked. It is also the democratic way. To that particular audience I would say now is the time to let your views be heard and to raise your heads above the parapet; particularly if you are not a tax exile and are truly committed to Scotland’s future prosperity.

• Kevan McDonald is a Partner at Dickson Minto W.S. The views expressed in this article are Mr McDonald’s alone, and do not represent those of Dickson Minto W.S.