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Julian D. A. Wiseman
Abstract: divorce is expensive. Any possible new monetary arrangements for Scotland will be expensive. Some arrangements pay those costs up-front, other delay and exacerbate them. But they are all expensive.
Publication history: only at www.jdawiseman.com/papers/finmkts/20140224_scotland_pound.html. Usual disclaimer and copyright terms apply.
Contents: • Introduction; • Scotland cannot be expelled from the £; • Scotland as Greece; • Saving the banks; • A new currency for Scotland; • Democracy; • The debt; • Can’t we just be friends?; • Conclusion; • Footnotes.
If Scotland chooses to be independent, what would be its monetary arrangements? And how would the debt of the UK be shared? These matters have been much discussed, and it seems much misunderstood — by both the Yes and No campaigns.
The UK Treasury has published Scotland analysis: Assessment of a sterling currency union, a document which comes close to contradicting itself. The following are from page 6, and from page 53 ¶A.13.
Independence means leaving the UK’s monetary union and leaving the UK pound.
the authorisation for the Bank of Scotland, Clydesdale Bank and the Royal Bank of Scotland to issue sterling banknotes would also cease.
But on page 55, ¶A.17:
If the continuing UK state were not to agree to a formal currency union, an independent Scottish state could still use the UK pound through so-called “currency substitution”. This occurs where a state chooses to use a foreign currency in parallel to or instead of a domestic currency, good examples being Panama’s use of the US dollar or Montenegro’s use of the euro. However, importantly for Scotland, the state choosing to use this foreign currency relinquishes control over its monetary policy and interest rates and no longer has access to the central bank as lender of last resort to its financial sector. Panama has no influence over US economic, fiscal or monetary policy and Montenegro has no representation or influence at the European Central Bank and its economic circumstances are not taken into account in the ECB’s setting of monetary policy for the euro area.
This ¶A.17, ignored in the rest of the document, is important. If the Scottish authorities want to use the £ as their currency, that cannot be stopped by the continuing UK. Indeed, Ecuador and the United States are not friends, but the currency of Ecuador is still the USD. Further, if the Scottish authorities wish to allow some banks to print banknotes, exchangeable on demand for £ (or for gold, or for anything else), that cannot be stopped by the continuing UK. The continuing UK just cannot stop a sovereign state (any, not just Scotland) legislating that the GBP is to be its currency, that shops in its territory are to quote in GBP, that taxes are to be paid in GBP, that banks may issue notes bearing a “£” symbol, etc. It is very bad for the continuing UK, which should and will take actions to lessen the long-term risks, but is outside its jurisdiction.
Consider a monetary union between a large country of 58m people, and small country of 5m. The small country might have a national debt of a few hundred billion — small enough to be rescued by the bigger country. It will have borrowed that money on financial markets, largely from the financial institutions of the larger country (because the larger country has more money than the smaller). So, if the smaller country were to default, that cost would land, largely, on the financial institutions of the larger country. As the crisis develops, the larger country will realise that “If we don’t help, they destroy our banking system, which will cost us a major recession and a fortune to repair. Rescuing the small country is awful, but cheaper.” The small country will know this in advance — the finance minster, of course, having carefully read all of jdawiseman.com. Governments of the small country, knowing of the free insurance, will respond to the usual voter pressure to spend more and tax too little. Creditors will lend too much too cheaply, knowing that the small country is just too big to fail, and will, in a crisis, be rescued.
With a tiny country this doesn’t have to happen. If, say, the Isle of Man were to be nearing default (it isn’t, but pretend), the authorities in London would not have to intervene. That scale of default might cost the banks a modest loss, small relative to their capital, and perhaps even small relative to a typical quarter’s profit. So the authorities in London cannot be pressured into spending money on a rescue: the threatened damage is too small. A tiny country must stand on its own feet, or rather stand on its own taxpayers, and knows this, and is known to know this.† And similarly, Ecuador is tiny relative to the United States, and so the US would not have to rescue an Ecuador nearing default. And in the past, has not.
But despite this problem, the continuing UK cannot prevent Scotland from having the pound as its currency.
What should the continuing UK do if Scotland unilaterally decides to use the pound? The danger is that a Scottish default destroys the banks of the continuing UK.
The solution is to require banks to hold extra capital against Scottish risks. It is concentration risk: not concentration risk for any bank, concentration risk for the continuing UK. In particular, the UK’s bank regulator could require banks to hold an extra 10% of capital against any Scottish risk, looking through shell entities to the underlying risk. Pension funds would require different rules, perhaps the valuation of Scottish assets at 60% of the market price. The practical effect would be to reduce the amount of Scottish risk taken on by UK entities. That has three effects. One, it would raise Scotland’s cost of borrowing, which might discourage some of that borrowing. Two, it would ensure that a larger proportion of Scotland’s borrowing is from sources other than the continuing UK. And three, the extra capital would help the continuing UK’s financial system withstand such a default.
(However, if somebody in a marriage is trying to save that marriage, threats are unlikely to help. So this is unlikely to be said now. But, post-divorce, faced with a Scotland determined to enjoy its too-big-to-fail guarantee, the national interest—the interest of the continuing UK—will be seen cold and clear. Just as Edinburgh will defend its national interest, without caring whether that is or isn’t pleasing to the neighbours to the south.)
No, it isn’t nice. Divorce isn’t. And pre-divorce advice from divorce lawyers also isn’t nice. Divorce just isn’t nice.
So two sovereign states sharing one currency risks too-big-to-fail problems, and the larger country will wish to prevent those. It seems that the UK Treasury wants Scotland to use a different currency. Oh dear: that also has a slew of little-considered problems, even if the new currency is the euro. Anyway, let’s assume that Scotland introduces a new currency, the SQP‡.
Existing English-law contracts denominated in GBP of course continue in GBP. What about Scottish-law contracts? If they all remain in GBP, including mortgages and salaries, then the new SQP just wouldn’t be used. So standard practice for new currencies is to deem that local-law debts of the old money are payable in the new, at some legally mandated conversion rate. Assume that Holyrood rules that in all Scottish law contracts a debt of GBP is to be paid in SQP, at a rate of 1-to-1.
Then the GBP/SQP price drifts away from 1, perhaps up, perhaps down. So consider two firms: one has a contract to buy widgets for £10 from a Scottish factory (Scottish law, now in SQP), and a contract to sell them for £11 (not Scottish law, perhaps English law, perhaps Chinese law, so still GBP). Previously, there was a pre-costs profit of £1. And there is another firm, buying widgets from elsewhere for GBP 10 (English-law, still GBP), and selling them to a Scottish manufacturer for £11 (Scottish law, so now in SQP). Once GBP/SQP has moved more than ±10%, one of these firms is bust. Bye bye. Sorry workers.
If that intermediary is a dealer, politicians will claim not to care. But that intermediary might just as easily be a manufacturer, buying smaller pieces and from them assembling larger pieces. A real manufacturer, employing people wearing blue collars, whose redundancy politicians claim not to want.
And for financial entities, it could be even messier. Banks have long-term loans to industry throughout the UK, some under English law, some under Scottish law. The risks of these are hedged with contracts that are almost always English law. There will be a substantial mismatch, resulting in randomly assigned profits and losses. And insolvencies.
Holyrood might try to lessen the damage by pegging GBP/SQP to 1. Of course, defending that might need a lot of foreign exchange reserves. But Scotland’s Future: Your Guide to an Independent Scotland says:
It would, of course, be open to people in Scotland to choose a different arrangement in the future.
So if a bank lends money for twenty years under English law, it can hedge that currency and interest-rate risk in a 20-year £-denominated contract. But the SQP, which is pegged to the GBP today, might be something different tomorrow. Perhaps pegged to the £ at a different rate, or to the €, or perhaps something else. Eventually there would be a separate market in SQP risk.
If Scotland keeps the pound, with no countervailing measures from the authorities of the continuing UK, that is a giant too-big-to-fail problem. It will be feared that Edinburgh politicians will spend freely on populist measures until the bill lands on London.
But any countervailing measures will have an economic cost, mostly falling on Scotland, and slightly on the continuing UK. Everything that goes wrong in independent Scotland’s economy will be blamed, fairly or not, on those “wicked” countervailing measures.
Or Scotland could introduce a new currency, perhaps the €, perhaps a new SQP. Which contracts are converted? However that is chosen, Scottish firms will end up with a mixture of Scottish-law new-currency contracts, and other-law GBP contracts. Some places will make windfall profits, doubtless taxed away. Other will make losses, and for some the losses will cause bankruptcy and job losses.
If the new currency is the SQP, companies will find it (more) difficult to arrange long-term borrowing. So they will borrow in foreign currency (£, € or $), entailing all the macro-economic Asian-crisis risks of foreign-currency borrowing.
Doubtless some will see this mess as a price worth paying. Fine, but the Scottish people should give not only their consent, they should give their informed consent. Pretending that divorce will be costless is dishonest: it is not enough to give a vague wave of the hand and say “trust me”. Doing that would be a bad start for the democracy of a new Scotland.
Yes campaign: admit the costs, and justify that they are worthwhile. Then, when the costs arise, you will not be hated for them.
If Scotland votes for independence, what would happen to the national debt? Well, neither side will agree to anything if not agreeing is better. There will only be agreement if both sides prefer it to no deal.
For the continuing UK, default would be terrible. It would self-evidently be worse than shouldering the debt alone. And even transferring £8 per £100 of the debt to Scotland would be a ‘default’ in the technical sense (the investor seeing a AA+ issuer being replaced by a single-A issuer). So Scotland will refuse to pay, and the debt will be that of the continuing UK.
Part of this has been acknowledged in a paper, undated but released 13th January 2014, entitled UK debt and the Scotland independence referendum:
In the event of Scottish independence from the United Kingdom (UK), the continuing UK Government would in all circumstances honour the contractual terms of the debt issued by the UK Government. An independent Scottish state would become responsible for a fair and proportionate share of the UK’s current liabilities, but a share of the outstanding stock of debt instruments that have been issued by the UK would not be transferred to Scotland. For example, there would be no change in counterparty for holders of UK gilts. Instead, an independent Scotland would need to raise funds in order to reimburse the continuing UK for this share.
Debt between sovereigns cannot be enforced (except by war). So if Scotland owes money to the continuing UK, and Scottish voters decide that they would rather spend this on something else, what can the creditor—the continuing UK—actually do? Not much.
However, early action can lessen this problem. If Scotland agrees to pay a fair share—unlikely given how bad are all the monetary choices—the UK should promptly sell it, ideally directly, but if necessary as an asset-backed pass-through security. (There is precedent: in June 2004 Germany securitised and sold Russian Paris-Club debt.) That done, a Scottish a default would be a proper default, with all the reputational and financial costs that entails. “Let’s not be a banana monarchy” is more likely to persuade Scottish voters not to default than “make payments to London because we agreed to do so”.
Germany is a large country, bigger than the whole of the UK. Denmark is a small country, of similar population to Scotland. They are neighbours, and very friendly. Can’t we do the same?
We can, eventually. But not at the start. Germany and Denmark have settled rules of interaction, and settled habits within those rules. Disputes have been settled, and are accepted as settled.
That is not true of new neighbours. London will see a huge and dangerous too-big-to-fail guarantee, which used to be low risk because London had the sovereignty to prevent debt accumulation, and is now high-risk. Edinburgh will see a very useful too-big-to-fail guarantee, which it will want to retain. Settling this entails unpleasant manoeuvring by both sides, before, during, and for a while after negotiations.
Eventually things will settle: probably some risk of too-big-to-fail guarantee remaining, but probably lessened at some cost to Edinburgh. Then, when that has become an accepted part of the furniture, and when the manoeuvring is less immediately remembered, we can be friends.
And even London conceding to the SNP’s desire for a currency union won’t make for a friendly relationship, as correctly said in the letter dated 11th February 2014 from H M Treasury’s Permanent Secretary:
If the dashing of Scottish expectations were perpetually blamed on continuing UK intransigence within the currency union, relations between the nations of these islands would deteriorate, putting intolerable pressure on the currency union.
Divorce isn’t nice. Divorce is expensive.
Pretending otherwise is dishonest.
— Julian D. A. Wiseman
London, 24th February 2014
† Another case when this problem doesn’t occur is if the small country is of much better credit than the large. Small is too small to rescue large; and large won’t rescue small because it is the large that will need rescuing. Presumably this stabilised the pre-euro Belgium-Luxembourg monetary union. So far, it is not obvious that Scotland would be the “much better credit”.
‡ SQP?! ISO-4217 currency codes have three characters, such as GBP, USD and JPY. They start with a two-letter ISO-3166 country code (GB, US, JP), followed by a single letter representing the currency’s name (in these cases P = pound, D = dollar, Y = yen). And in ISO 3166 the two-character Scotland-like ‘S_’ possibilities are already taken: SC = The Seychelles; SO = Somalia; ST = São Tomé and Príncipe; SL = Sierra Leone; SA = Saudi Arabia; SN = Senegal; and SD = Sudan. Only three S_ possibilities are available: SP, SQ, and SW. (Others: SB = Solomon Islands; SE = Sweden; SF is “indeterminately reserved” for Finland; SG = Singapore; SH = Saint Helena; SI = Slovenia; SJ = Svalbard and Jan Mayen; SK = Slovakia; SM = San Marino; SR = Suriname; SS = South Sudan; SU used to be the Soviet Union and is now “indeterminately reserved”; SV = El Salvador; SX = Sint Maarten; SY = Syria; and SZ = Swaziland.) Alternatively an independent Scotland could, from the Gaelic name ‘Alba’, request AB (as AL = Albania, and AA is reserved for testing and private use); or from ‘Caledonia’ it could be CE (as CA = Canada; CL = Chile; CD = Democratic Republic of the Congo; CO = Colombia; CN = China; CI = Côte d’Ivoire). Of the possibilities available, the least unsatisfactory—and so used in the main text—might be SQ, even if pronounced “Scw…” rather than “Sco…”. So, to end a long detailed footnote, it really might be that a new Scottish currency would be the SQP.
The Scottish goverment has removed from its website Scotland’s Future: Your Guide to an Independent Scotland. Happily, it survives at webarchive.org.uk.
And the FT seems to have removed from its website the story of 25 June 2004 entitled Berlin to plug budget gap with Russian debt securitisation. Happily, it survives at archive.org. Some extracts follow.
The German government yesterday unveiled plans to plug as much as €5bn (£3.48bn) of its yawning budget deficit with an innovative securitisation transaction that will repackage a large chunk of Germany's Russian debt commitments. Bankers will next week start a roadshow across Europe and the US to market the securitisation of Germany's Paris Club debt through the issue of three, five and 10-year bonds. One finance ministry insider said: "What interests us is the cash we get now and the risk we get rid of. …" … Paris Club debt has rarely been securitised before and although Berlin has ruled out further such transactions this year, it could use the Russian deal as a blueprint at a later date. Bankers said Russia had raised "no objections".
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