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Scottish independence: turning up the heat; turning on the risk ?

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Patrick Kelliher

Many divorces start off amicably until there is a disagreement over the dog, the CD collection or some other possession, at which point proceedings become increasingly acrimonious and detached from reason. Scotland is still mulling its divorce from the rest of the UK, but its partner has already claimed the dog, or in George Osborne's case, the pound sterling. It has brought the independence debate to a new level. The SNP appear to be struggling to respond, but some in the "yes" camp have suggested that if Scotland cant share the currency, then Scotland should refuse to pay its share of the UK's debt. To my mind, this is a marked escalation in rhetoric yet the markets are unmoved: there has been little change to either the FTSE100 or to UK gilt yields [1]. Perhaps the market believes Osborne's move has decisively removed the prospect of Scottish independence. Perhaps they judge political rhetoric - from both camps - to be just bluster. However, risk managers should not be so sanguine. Three potential risks spring to mind:

Scottish "default"

George Osborne has poured scorn on the notion of Scotland reneging on its share of the UK national debt, claiming it would become a pariah. I believe he has overstated his case: the market would not experience a default unless the UK defaulted on the share of debt attributable to Scotland which is unlikely (though not unprecedented: in the 1930s, the UK defaulted on debts to the US after Germany ceased war reparations to the UK that were funding this debt). Put another way, the default would be a problem for Osborne and his successors in the UK Treasury, not the markets problem. Furthermore, while there may be doubts about the character of the Scottish government and its prospects, it would have a clean balance sheet which the markets always find attractive.

So Scotland could conceivably default on its share of the UK national debt and still retain access to markets. It is a feasible option. It may also be attractive politically - at £1,240bn, UK public sector net debt amounts is nearly £20,000 per man, woman and child in the UK [2]. The "yes" campaign have started to make a populist case for a default based on Scotland only sharing liabilities if it shares "assets" such as the Bank of England and the pound. The prospect of walking away from such an onerous debt could be seductive, offsetting any drop in support from loss of the pound. Even if it does not go so far, it could still default on the share of debt owed to the Bank of England, which holds £375bn in Gilts. This would still amount to just under £6,000 for every man, woman and child in Scotland [3] which politically might be a more plausible yet still enticing proposition

Even a full default should be manageable for the rest of UK ("RUK") - it would increase debt : GDP in the RUK by less than 9%. On an internationally comparable basis, the debt : GDP ratio for the RUK would increase from 88% to 96% - higher than France, but less than say Belgium [4]. However, while manageable, it may still trigger downgrades of RUK government debt which may in turn lead to an increase in Gilt yields.

Worse, it may lead to a loss of confidence in Gilts. Woody Allen once joked that the Russian revolution started when people realised the Tsar and the Czar were the same person. Scottish default could be a trigger for markets to re-appraise risks attaching to UK Gilts, and may recognise that "austerity" Britain with a chancellor committed to slashing public spending is the same country that spends £8 for every £7 it raises in taxes [5]. Whatever the reason, once confidence is lost, it can be very difficult to regain. This confidence could be lost in the run up to the independence vote, regardless of the eventual outcome. Until the matter is settled, I believe there is material political risk attaching to UK Gilts which does not seem to be priced into current yields.

Bank downgrades and funding problems

If Scotland is to have its own currency, it will create a problem in terms of what currency existing loans and deposits held by Scots should be denominated in. There is nothing to stop these continuing to be denominated in sterling, but there would be a mismatch between borrowers incomes in the new currency and their debts. A collapse in the new currency relative to the pound could lead to a sharp increase in borrowers experiencing difficulties - a (possibly extreme) example would be the problems experienced by Hungarian borrowers and banks who took out loans in Euros and Swiss Francs. Note I do not believe a collapse in any new Scottish currency is inevitable or even likely - from below I think there is a risk the Scottish currency could appreciate against sterling - but the risk of depeciation is there and it may lead to downgrades of banks with significant loans outstanding in Scotland.

Such banks may also be more vulnerable to bank "runs" if depositors fear their sterling deposits may be forcibly converted to a new Scottish currency. This may be unlikely, but the Eurozone crisis has shown that depositors are prone to panic, and irrational fears of forced conversion can assume a momentum of their own [6]. The run on Northern Rock has highlighted that UK savers are not any more level headed. Again, the risk of a run is one that could easily crystallise before the referendum - the mere threat of a "yes" vote and a rumour of forced conversion could be enough. It would be ironic if the threat to exclude Scotland from sterling triggered a run on a Scottish bank before the referendum, forcing the UK government to rescue it.

Currency woes

A third concern relates to the long-term impact of Scotland leaving the sterling zone. For financial services companies, like other companies operating north of the border, a new currency will lead to a mismatch between costs denominated in the new currency and sterling revenues. Here the risk is of an appreciating Scottish currency, perhaps driven by rising oil prices (which might also increase energy costs). Scotland could suffer from "Dutch disease" with rising oil prices boosting Scotlands currency and making Scotland uncompetitive relative to companies south of the border. Unlike the prospect of rising Gilt yields and bank runs, this risk is broadly symmetric - a depreciating Scottish currency could bring gains for financial services firms which usually do most of their business south of the border.

The SNP have made an interesting point about the impact of Scotland's exclusion from sterling and its impact on the RUK's balance of payments. In terms of trade in goods and services, in 2013 the UK's imports exceeded exports by £30bn. However the value of oil exports was £39bn in this year [7] - in other words, excluding oil exports would have more than doubled the UK's trade deficit in goods and services. As the bulk of these oil exports would arise from Scotland, the rest of the UK is likely to have a significantly higher trade deficit which may have negative implications for sterling going foward.

Conclusion

I am not convinced the case against Scotland joining a currency union is as clear cut as George Osborne and others make out. Certainly the Bank of England seems to have a plan to manage such a union, and I don't think the contingent liability of UK taxpayers in terms of bailing out Scottish banks would be any different under a currency union than it is at present in the political union. There would be long-term costs to businesses across the UK from a separate Scottish currency, while the loss of oil exports could undermine sterling, to say nothing of the risks of retaliatory Scottish default and/or the adverse impact on banks.

However George Osborne's pronouncement would appear to be driven more by political considerations, with the referendum debate becoming more an existential political struggle than a debate over economics. This is to be expected given the importance of the referendum, but Osborne's refusal to consider a currency union has increased the temperature of the debate and has increased political risk for all companies operating in the UK.

 

Notes

[1] The 10-year UK nominal Gilt yield has fallen from 2.95% p.a. on the 12th February - the day before Osborne ruled out the currency union - to 2.81% p.a. on the 27th February (source: Bank of England, http://www.bankofengland.co.uk/statistics/Pages/yieldcurve/default.aspx) while the FTSE100 has risen from 6675 to 6810 in the same period.

[2] Public sector net debt figure at end-January 2014 from ONS (http://www.ons.gov.uk/ons/rel/psa/public-sector-finances/january-2014/stb---january-2014.html); divided by an estimated UK population figue of 63.7m at mid-2012 (http://www.ons.gov.uk/ons/rel/pop-estimate/population-estimates-for-uk--england-and-wales--scotland-and-northern-ireland/mid-2011-and-mid-2012/index.html) including 5.3m in Scotland.

[3] Figure of £375bn based on Bank of Engand Asset Purchase Facility purchases (http://www.bankofengland.co.uk/markets/Pages/apf/results.aspx) divided by 63.7m UK population to get a per capita figure.

[4] 88% is taken from "Government Deficit and Debt Under the Maastricht Treaty, September 2013" (ONS, 2/10/2013 at http://www.ons.gov.uk/ons/rel/psa/eu-government-debt-and-deficit-returns/september-2013/stb---september-2013.html) and is based on a gross government debt figure of £1,386.7bn. The factor of 9% (actually 8.7%) is based on an estimate of Scotland's share of UK GDP of 8% based on 2011 Gross Value Added figures (see http://www.ons.gov.uk/ons/rel/regional-trends/region-and-country-profiles/key-statistics--december-2013/directory-of-tables.html#tab-Economy). Debt:GDP ratios for other countries can be found from Eurostat (http://epp.eurostat.ec.europa.eu/portal/page/portal/government_finance_statistics/data/main_tables).

[5] In 2012/13, UK central government expenditure was £630bn against receipts of £550bn (source "Public Sector Finances, December 2013", ONS - http://www.ons.gov.uk/ons/dcp171778_349775.pdf).

[6] In the case of Cyprus, such fears turned out to be quite justified.

[7] See table 1, p33 of "UK Trade, December 2013" (ONS, http://www.ons.gov.uk/ons/dcp171778_349216.pdf).

 

 

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