Currency conundrum for an independent Scotland

If the vote in the referendum asking “Should Scotland be an independent country?” concludes with a majority vote “Yes”, then negotiations over Scotland’s secession from the United Kingdom would begin. The current Scottish government is aiming for that secession to take place in March 2016.

The consequences of a ‘Yes’ vote are very uncertain, particularly with regard to the currency arrangements for Scotland and that uncertainty has been rendered acute by comments from the Scottish and UK governments, HM Treasury and the Bank of England.

Whilst Scotland would initially have no means of settling any currency other than sterling, there is the problem, highlighted by the euro, of managing a currency union without fiscal and banking union. If we assume that the UK excluding Scotland (UKXS), rejects continuing Scottish/UKXS currency union, the two most plausible possibilities, would be that Scotland ether performs “sterlingisation”, where Scotland unilaterally circulates sterling, much as countries such as Monaco and Montenegro use the euro; or introduces a currency board where the new Scottish currency is effectively pegged one-for-one against sterling, and the most obvious parallel is Hong Kong’s currency board and link with the US dollar. Both would have the political and economic advantage of continuity with existing currency arrangements at the retail level. In both cases it would be likely that GBP would be accepted as a medium of exchange in Scotland.

A third alternative, either immediately or following a peg break, would be a float. Since it would be probably driven by politics rather than economics, a float cannot be ruled out in the way that, for example, Greece leaving the euro could. Slovakia is the obvious precedent of a peg breaking without unmanageable consequences.

Looking at the choices in more detail , with ‘sterlingisation’, where the Bank of England is not available to act as lender of last resort, the control of risk associated with a lack of ability to create liquidity (or, generally, to offset its withdrawal) is to have a very well capitalized banking system, such that no back up is practically required. This would be tricky if the traditional Scottish banks stay Scottish.

With a currency board, the ability of the “Central Bank of Scotland” to expand its balance sheet in supporting Scotland’s financial sector would be subordinate to maintaining a stable exchange rate against the British pound sterling. The central bank could face the dilemma of either credibly acting as a backstop for its banks or credibly defending parity with sterling, but not both, and ultimately the stability of the peg is a function of the willingness of non-Scots to hold Scottish pounds. This imposes a different set of constraints, via the monetary “trifecta” which suggests that two of the three elements ‒ exchange rate; money supply; and free capital flows ‒ can be targeted, but not three. Given the current full union, the external position isn’t clear and would be subject to arbitrary change as currency flows take place. The analogy is Target 2 flows under EMU; during union, they are offset by the central bank. Should a negative feedback loop arise, a possible result would be a large claim held on Scottish banks by the Bank of England, a potential “foreign liability”, and a drag on the peg.

Turning to the idea of a free float, near failure of the euro was largely posited on the presumption that there would capital flight from the presumed de-valuer to the presumed re-valuer but it is not clear that on real economic fundamentals, a Scottish pound would depreciate substantially against GBP, but prospective volatility of a Scottish currency, and uncertainty over the resolution of financial fundamentals, would make depreciation against GBP at the point of float the most plausible and likely outcome. This is important because conditional on an expected move in either direction, the costs of a breakup become indeterminately large and Scotland’s scale is likely sufficient that that whilst it cannot leave its currency union, it can destroy it. Managing this risk would require co-operation from the UKXS authorities and there is a particular vulnerability since any flows would risk becoming self-fuelling.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla