Scotland’s Independence Could Hurt British Pound

A referendum on Scotland’s independence, due to be held next week, could see Scotland leaving the union after 300 years of membership.

Fiercely contested between the pro-independence campaign of Scotland’s nationalist party and the conservative and social democratic opposition (“Better Together”) of the British Conservative and Labour parties, Scotland’s bid for independence is entering a stage described as “squeaky-bum time,” the unnerving but exciting final stages of a closely fought championship. The term was coined by a Scottish football manager, Sir Alex Ferguson, in 2003.

Yet, the implications of Scottish independence — a potential exit from the British pound, loss of membership in the European Union, trade effects and the copycat effect on other states — are farther reaching than the colloquialism would suggest.

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If polls suggesting a shrinking margin for ‘no’ voters are any indication (Scotland’s left has traditionally been an opponent of independence), the Scottish people’s decision is on a razor’s edge.

Political Risk of a ‘Yes’ Vote and Effect on the Pound Sterling

Unlike the political risk associated with conflict in the Middle East or even the manageable risk of predicting a British exit from the European Union, a Scottish exit from the United Kingdom has the potential to adversely affect the stability of the British pound.

In light of the wider regional effects of Eurozone deflation, as well as the strength of the U.S. dollar, Britain’s currency has remained relatively stable. However, a YouGov poll in early September showed a shrinking margin of support for maintaining the union (6%), causing the pound sterling to dip briefly in value. Since early summer, when the exchange rate against the U.S. dollar reached an all-time high at 1.72, the pound sterling has dipped in value (see graph).

Fluctuations in GBP-USD exchange rate 2014,
with a drop earlier this month to 1.63 (Source: X-Rates)

Will Scotland Adopt an Alternative Currency?

The independence campaign led by Scottish National Party leader Alex Salmond has promised that Scotland will retain the pound. Westminster, however, rejects this promise.

In theory, there are several options for Scotland moving forward. The first would be for England to establish a currency union with an independent Scotland. The second would be for Scotland to keep the pound without entering a currency union with England, as in the case of Montenegro and the European Union.

In the worst-case scenario, Scotland would be forced to adopt an alternate currency, a move that would place its largest banks, the Royal Bank of Scotland and the Bank of Scotland, in jeopardy. This would also potentially harm the world’s third largest reserve currency (after the U.S. dollar and the Euro): the British pound.

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An historical precedent for this is the breakdown of the Soviet socialist republics into sovereign entities, in which the Russian Federation, and the ruble, suffered significantly after inheriting both the foreign assets and the foreign debt of the former Soviet Union.

Scotland is of course a much smaller and wealthier country than any of the former Soviet republics were in 1991, but the effects of the U.K.’s adopting Scotland’s national debt without entering into a currency union could be similar in nature if not in size.

Capital Flight Could Affect Britain as a Whole

Although it is impossible to predict the outcome of the Scottish referendum in a week’s time (the last successful Western European vote of independence, when Norway left the union with Sweden, happened in 1905), it is possible to make predictions about the immediate economic and financial effects of a pro-independence outcome.

The risk of bank volatility is moderate, given the potential liquidity effects of mass withdrawals from Scottish banks, which would also influence two of the largest banks in the United Kingdom. Second, a potential debt transfer between Westminster and Edinburgh, which already spends £1,000 more on each citizen than the U.K. average, will have the effect of significantly limiting the new Scottish government’s ability to make policy, a moderately likely outcome.

Third, government borrowing costs will rise as a result of the transfer of financial and economic sovereignty to Scotland. And with the need to set up an independent central bank and financial regulator in the case of an exit from the shared currency, this could also affect investor confidence in Scotland.

With these factors in mind, a political solution could be expected sooner rather than later, in the interests of both an independent Scotland and England. Both Salmond’s projected one-and-a-half year window to renegotiate a currency union, as well as a Westminster proposal to transfer tax-raising powers to Scotland by 2016 are, and were, inadequate. The potentially deleterious effects on the stability of the British pound if no deal is found would be significant.

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