Scotland's First Minster, Alex Salmond, has made two elements of his plans on currency for an independent Scotland clear. First, he would see a ‘Yes’ vote as a mandate to press the UK for a formal monetary union, even though that option has already been clearly rejected by the Treasury and the three main political parties. Second, the First Minister has threatened to walk away from Scotland’s share of the UK public debt if his bid for a formal monetary union is not successful. He has also insisted that Scotland would be able to continue using the pound informally in any event.
This leads us to believe that adopting Sterling informally while reneging on the debt might, in fact, be the Scottish Government’s Plan B. To be clear, we do not know for sure that this is Plan B. But given Mr Salmond’s statements and the total silence on any other option, we suspect that this is at least being seriously considered.
If Scotland refused to accept what is widely seen as a ‘fair share’ of the existing UK debt, would this constitute a default? The debt cannot be considered to be either ‘odious’ or ‘illegitimate’. Neither can it be argued that Scotland would be doing this because it is impossible to repay the debt. It would simply be because the UK Government chose not to enter into a formal monetary union. This would add on average £5,300 to the debt of all taxpayers in the rest of the UK. While this may technically not be a default, it strikes us as ‘opportunistic’ and therefore likely to be interpreted as a default.
If Scotland were not to pay its fair share of debt, we expect that it would have a junk rating status. The important lesson from the sovereign debt default literature is not the higher borrowing costs, but that governments are excluded from raising new funds in international capital markets for an average of 10 years. Scotland is unlikely to be excluded from markets for so long, but there is no free lunch from an opportunistic default.
If the EU were to admit a country – any country – which had just seceded and walked away from its debts, it would be creating an extraordinary precedent with potentially far reaching consequences. In Realpolitik terms, the highest hurdle for any Scottish bid for EU entry would be obtaining Germany’s ‘yes’. Germany is the main creditor nation, the most economically powerful country in the EU. If Scotland were allowed to set a precedent for EU membership after secession, despite debt repudiation, Germany would be highly exposed to any other ensuing post-secession insolvencies.
Scotland is likely to face twin deficits in the year that it might become an independent nation. These deficits are substantial: a fiscal deficit of over 6% of GDP and an external deficit, although difficult to judge, may be similar in magnitude. This includes a geographic share of North Sea oil and gas reserves. An independent Scotland would inherit perhaps £7bn of foreign exchange reserves. Given the amount of debt an independent Scotland is also likely to inherit from the rest of the UK, 'Sterlingisation' is likely to be vulnerable to even a modest shock. If financial service exports suffer as firms migrate the currency arrangement would prove even more vulnerable.
If the Scottish Government chose to combine 'Sterlingisation' with reneging on a fair share of existing UK debt, this would increase rather than reduce the fragility of the exchange rate arrangement. Entry into the EU would be out of the UK's hands. International investors are likely to see walking away from debt as 'opportunistic' and charge very high borrowing premiums or exclude Scotland from international capital markets. This would imply an immediate return to a fiscal surplus and unprecedented austerity. Whether citizens of Scotland would accept this policy simply to hold onto sterling would become a source of speculation. We would expect the currency arrangement to fail and Scotland would be forced to introduce its own new currency within one year.
Introducing a new Scottish currency has always been the most sensible option. We would recommend this is carried out before losing £7bn of foreign exchange reserves rather than after.
Dr Angus Armstrong is Director of Macroeconomics at NIESR. Dr Monique Ebell is a Research Fellow at NIESR. The authors have published numerous papers on the macroeconomic and financial implications of Scottish independence, and they are available here: http://niesr.ac.uk/research-theme/economics-scotland
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