Gilts or Kilts? Implications of a YES vote to Scottish Independence

In recent weeks the gap in opinion polls between those in favour and those against Scottish independence has narrowed from about 10% to about 5%. With some months of campaigning still to go, the vote on 18 September looks increasingly likely to be close. What are the likely political, economic and market implications of a Yes vote?

Political implications

• Negotiating the split. The SNP envisage 18 months of negotiations prior to becoming independent on 24 March 2016. However, they would be negotiating with the UK government and there is a general election due in May 2015 which could easily lead to a change in the governing party or coalition. The outgoing government is unlikely to deem the negotiations as an important priority, and the new government may well have more pressing policy priorities than reaching an agreement with Scotland – the power is biased towards the UK Government in the timing and pace of any negotiation.
• Impact on Westminster parliament. Should a new government be led by Labour, then they face the risk that after March 2016, with an independent Scotland in place, the Scottish Labour MPs would have no right to vote at Westminster. This could easily deprive such a government of their majority and could lead to a general election or a change in the governing party. Such a scenario gives a very strong incentive for a Labour-led government not to reach an agreement with the SNP. A UK parliament with no Scottish members would mean a near permanent majority for the Conservative party and a clear rightward shift in the political debate in the rest of the UK.
• EU membership. Under current EU law, Scotland would have no automatic right to become a member of the EU – in theory, it would have to negotiate terms and win a unanimous vote from all the other countries. This is by no means certain as Spain in particular is likely to vote against such a move, given its concern about setting any precedents when its own Catalan people are calling loudly for independence.
• United Nations. If Scotland were to leave the UK, it would be likely to reduce the global political influence of the rest of the UK. Its permanent seat on the UN Security Council might well be called into question, as it would be the smallest country with that privilege. Even today, with Scotland, the UK is less than 1% of the world population.

Economic implications

• Currency. All three major UK parties at Westminster have been clear that they would not agree to a currency union with Scotland. In practice, however, they could not stop Scotland from using the pound, though in that situation Scotland would have no influence over the UK’s monetary policy set by the Bank of England. In theory (again), if Scotland were to become a member of the EU then any new member of the EU has to adopt the Euro as its currency. Creating a brand new Scottish currency is also possible, but would create the need for foreign exchange transactions and heavy costs for Scottish businesses. A negotiated agreement, which created a formal currency union, would allow Scotland to keep the pound and possibly have a Scottish member on the MPC. However, events in the Eurozone in recent years highlight the dangers and effective loss of sovereignty in being a small country in a currency union when there is no fiscal or political union.
• Banking system. RBS is the largest Scottish bank with a balance sheet of over £ 1 trillion at the end of 2013 (and this has halved over the last 5 years) with capital of almost £60 billion; given the size of the Scottish economy, a Scottish government could not credibly act as backstop should RBS get into financial difficulties again, whereas currently RBS does benefit from being an institution of systemic importance in the UK that the government is committed to supporting in extremis. Scotland’s ratio of banking assets to GDP is 12:1, which is higher than the peak levels seen in Iceland in 2007. It is likely that RBS would choose to relocate its headquarters to London, which would lead to the loss of a significant number of jobs in Edinburgh.
• Dividing assets and liabilities. Scotland is about 8.5% of the UK’s economy and population. The SNP is claiming just about all of the UK’s North Sea Oil, its major resource asset, since it would lie in Scottish territorial waters, but only expects to take on 8.5% of the National Debt. The UK government might argue that North Sea Oil belongs to the UK today and so be prepared only to cede 8.5% of the resource asset. The stream of revenue from taxation on North Sea Oil is a key source of money to pay for future welfare spending in Scotland, and the SNP’s economic forecasts assume much greater tax revenues in future years than the forecasts of the current UK government.
• Credit rating. As a relatively small and new country, with a reasonably high initial level of debt, Scotland would be likely to have a lower credit rating than the rest of the UK, even if there were a strong currency union in place; this will increase borrowing costs for Scotland. There is an additional danger that by reducing the size of the UK economy, and with investors implicitly believing that in a crisis the UK would come to Scotland’s rescue, that the UK’s credit rating would in fact be lower as well. Both countries could lose out.
• Tax revenues. A number of Scottish-headquartered companies have indicated that it may be commercially necessary or desirable to have a UK headquarters for their business outside Scotland, due to all the uncertainties regarding currency, trade, tax, EU membership and regulation. This might substantially reduce the corporate tax revenue to a new Scottish government from Scottish companies.
• Prices. Many companies in the UK have national pricing policies, which effectively subsidise providing goods and services to less central regions such as Scotland. Tesco have already indicated that they might adopt a national Scottish pricing policy, which would mean higher prices for Scottish shoppers.

Market implications

• Currency markets. Sterling is likely to be viewed as a less attractive currency, since it may be backed by a smaller country and tax base than it is currently, and would generally carry less weight or influence in wider world affairs. The most likely market response to a Yes vote in the referendum would be for Sterling to fall against the other major currencies, and gilt yields to rise.
• Effect on business investment. For business, a vote for independence would undoubtedly create a whole range of issues, about which there would be uncertainty and risk. On pensions, for example, there are completely separate EU regulations for pension funds which cover more than one country. This may require large extra contributions by companies to deal with current deficits. In financial services, many providers may judge that it would be preferable to be regulated by the FCA alone rather than by both the FCA and a new Scottish regulator, paying extra regulatory fees. Firms carrying out regulated activities might seek to move employees outside Scotland. All such uncertainties would be likely to lead to delays in investment spending by businesses.
• Scottish bonds. A new market in Scottish government debt would need to be created, and such debt would be likely to trade at higher yields than the debt of the UK. UK government debts are called gilts and any Scottish government debt has already being colloquially labelled as “kilts”.

The possibility that Scotland might vote NO, but with a very small majority should also be considered. This could be the worst possible outcome since the SNP would undoubtedly believe that a second referendum, in say two years, might enable them to get over the line. International investment into Scotland would be likely to be damaged as investors would have no clarity on Scotland’s legal status and the UK government might well believe that it would derive little benefit from supporting the Scottish economy by, for example, relocating civil servants there.

In the long term, both Scotland and the rest of the UK could be viable, solvent, independent but closely allied, political entities – if both existed today, there would be no obvious reason or need to suggest they form one larger country. However, the transition from the current version of the UK to a smaller version would create major political and economic uncertainties that would be likely negatively to affect business and the economy in the short term. The period of negotiations spanning a UK general election is particularly unhelpful in this regard, and the ramifications on Scotland’s relationship to the EU are significant, but extremely unclear.

It is striking that with less than five months until the referendum, how many major unanswered questions there are about what would happen in the event of a YES vote. In no particular order, these are (i) what currency would Scotland use and how much influence would Scotland have over its monetary policy? (ii) would a newly independent Scotland be a member of the EU and on what terms? and (iii) what happens if no satisfactory agreement can be reached in any negotiations between Scotland, the UK government and the EU? Clear answers to these questions would provide a much more satisfactory basis for Scottish voters to make an informed choice.

For now, assuming a NO vote with a reasonable majority, there are no investment implications. A narrow NO vote or a YES vote would be likely to be negative (but not hugely so) for the bond markets and for the currency, but the weaker currency would be likely to be a positive for the stock market. The impact on financial markets would depend on how constructive the UK government and the European Commission choose to be in dealing with the Scottish representatives seeking to create a new country.