A "Yes" vote for Scottish independence represents a "high risk" event according to Citi's Michael Saunders. With the so-called 'neverendum' now less than a month away, Citi continues to highlight three particular concerns if Scotland does vote for independence: Scotland’s relatively weak fiscal position, Scotland’s large banking system and uncertainties over the currency arrangements of an independent Scotland. The Scottish Government seems to be seeking a policy of "sterlingisation" - which even their economic advisors judge "is not likely to be a long-term solution." For now a "no" vote is most likely, however, even if the Scottish referendum does not pass, the UK political landscape is likely to remain in a state of flux.
The referendum on Scottish independence will be held on September 18 this year, with a simple Yes/No vote on the question “Should Scotland be an independent country?” A simple majority of eligible votes will suffice to win. All parties involved have agreed to accept the result as binding. In the event of a “yes” vote, there will be negotiations between the UK and Scottish governments over the details for Scotland’s independence, with any actual move to independence probably taking place during 2016-19.
The potential problems that might face Scotland if it becomes independent have come into sharper focus.
First, the relative weakness of Scotland’s fiscal position is clearer. We judged back in March that the fiscal deficit of an independent Scotland (as a share of GDP) would be 2-3 percent of GDP above the UK average in coming years. This reflects Scotland’s relatively high level of public spending per head and the diminishing offset from oil and gas tax revenues, which are trending down amidst falling output and rising production costs. Data since then highlight this issue. Profits (ie revenues less operating costs and capital costs) from oil and gas production in Scotland (including a geographic split of oil and gas) have fallen from £14.0bn in 2011 to £7.2bn in 2013.
In turn, Scotland’s aggregate tax revenues (including a geographic share of oil and gas tax revenues) fell by 2.1% in 2013 after a 2.0% drop in 2012, with oil and gas tax revenues down 37% YoY in 2013 after a 24% drop in 2012. Scotland’s oil and gas tax revenues in 2013 totaled just £4.4bn (3.0% of Scotland’s nominal GDP), down from £9.2bn in 2011 and the lowest as a share of Scotland’s nominal GDP since 1999. Aggregate UK receipts of Petroleum Revenue Tax fell a further 42% YoY in January-July this year, although data for receipts of oil-related Corporation Tax (which recently have been larger than PRT) are not yet available.
Second, the referendum campaign has not dispelled uncertainties over Scotland’s possible currency policy. The SNP’s stated aim is to seek a formal currency union with the rest of the UK, while taking over a proportion of the UK national debt (either the population or GDP share, it would make little difference).
However, the Conservatives, Labour and Lib Dems have all ruled out a currency union. This point has been strengthened by the recent report from the UK Parliament’s Scottish Affairs Committee, which concluded that “a currency union between the continuing UK and a separate Scotland would not work well for either country. Scotland would be tied to an exchange rate which became less and less suitable for its economy, and heavily constrained in its economic policy. Without a banking and fiscal union, and the political union which is essential to sustain it, such a currency union would be unstable.”
The SNP does seem to have a Plan B, which is an informal policy of “sterlingisation” — whereby an independent Scotland would unilaterally adopt sterling as its currency without a formal currency union with the UK — while not accepting any obligation for Scotland’s share of the UK national debt. As SNP leader Alex Salmond recently argued: “There is literally nothing anyone can do to stop an independent Scotland using sterling, which is an internationally tradeable currency... Assets and liabilities go hand in hand, and no one would expect Scotland to pick up a share of the debt if we were being denied a share of the assets.”
However, sterlingisation would have considerable disadvantages for Scotland in our view, in that an independent Scotland would have no say in the monetary policy of the rest of the UK (rUK). In addition, while the BoE does regular sterling operations with a wide range of banks in respect of their UK business, Scotland’s banking system would have no guaranteed access to a lender of last resort facility or provider of emergency liquidity. The BoE’s adoption of a formal mission statement (“Promoting the good of the people of the United Kingdom by maintaining monetary and financial stability”) makes it clear that the BoE’s responsibilities are limited to the economic and financial stability of the UK. The BoE is not responsible for the monetary and financial stability of any country (including an independent Scotland) that is pursuing a sterlingisation policy (although it might have to offset the effects on the rUK of any Scottish-related instability).
The experience of EMU crisis countries in recent years - until Draghi’s “whatever it takes” commitment made it clear that the ECB would seek to ensure financial stability in the periphery - highlights the possible dangers that could face an independent Scotland pursuing sterlingisation. Indeed, the Scottish government’s own Fiscal Commission has suggested that sterlingisation is unlikely to be a durable framework: “International evidence suggests that informal monetary unions tend to be adopted by transition economies or small territories with a special relationsip with a larger trading partner (e.g. between the UK and Jersey, Guernsey and the Isle of Man). Advanced economies of a significant scale tend not to operate in such a monetary framework. Though an option in the short-term, it is not likely to be a long-term solution.”4 The National Institute recently reached the same conclusion, arguing that sterlingisation probably would not be viable for long, especially given Scotland’s large banking sector5. In our view, it is astonishing that the Scottish government, in seeking independence, has reached this stage without a clear plan for an issue as basic as its currency and monetary policy setup.
Third, there continue to be uncertainties over the large Scottish banking system, with assets in excess of 1000% (one thousand per cent) of Scotland’s annual GDP and including large businesses in the rest of the UK. If these businesses remain Scottish-based, then the potential costs if the Scottish government has to provide a bail-out or deposit guarantee insurance could threaten Scotland’s fiscal position. However, as the National Institute warns, regulatory pressures might force these banks to re-domicile to the UK: “the Prudential Regulatory Authority is likely to require a systemically important bank carrying out its business in sterling to be based in the UK… The regulatory and commercial interests both suggest that at least the two government part-owned banks would redomicile into the rest of the UK.” Of course, if those banks were to relocate to the UK to gain a more secure fiscal backstop, Scotland’s economy and labour market would probably suffer.
Perhaps in light of these issues, the latest Scottish Social Attitudes survey shows that while a large majority of Scots still believe independence would lead to increased pride in their country, there are growing worries that independence would reduce Scotland’s voice in the world, harm the economy, increase income inequality, reduce the safety of bank deposits and harm peoples own financial position. The SSA survey suggests that the preferred option among Scottish voters is for increased devolution within the UK rather than independence outside the UK.
Opinion Polls Still Point to a “No” Vote
Although there is considerable variation among individual polls, we have not changed our base case scenario that a "yes" vote for Scottish independence remains a low probability, high risk event.
But What if... Some Possible Implications Of a “Yes” Vote
Nevertheless, even if a ”yes” vote looks unlikely at present, it is not impossible. In our view, a “yes” vote would have several key implications:
Bad for UK growth. Uncertainties over the economic prospects, policies and currency arrangements of an independent Scotland probably would hit growth in both Scotland and the rest of the UK (rUK), raising the incentive for firms to “wait and see” or to expand elsewhere. Exports to Scotland account for roughly 4% of GDP for the rUK and Scotland would immediately be the rUK’s second biggest trading partner, slightly behind the US and slightly above Germany. Moreover, many banks and businesses have sizeable cross-border exposures between Scotland and rUK, and some firms may seek to limit such exposure as a hedge against the possible breakup of sterlingisation (if that is the policy adopted).
Bad for mainstream UK political parties, good for the anti-EU vote. Once independence happens, Scottish MPs would no longer attend or vote at the Westminster parliament. This would disproportionately hurt both Labour and the Lib Dems: Scotland accounts for 9% of seats at the Westminster parliament (59 out of 650 seats in 2010), but accounts for 16% of Labour seats, and 19% of Lib Dem seats. Conversely, only one out of the 306 Conservative MPs elected in 2010 is from a Scottish seat. However, although the maths of a postindependence Parliament would favour the Conservatives, we believe a “yes” vote would also badly hurt the personal position of PM Cameron, by making him the PM “who lost the UK”. The key winner in UK political terms would probably be UKIP: this reflects the damage to the three main Westminster parties, the evidence that voters are prepared to reject the establishment and vote for radical change, and also the extent to which the themes in the Scottish referendum debate — a choice between membership of a larger bloc or independence — are likely to have echoes in any future EU referendum. A secondary winner might be London Mayor Boris Johnson, who seems to be positioning himself as the radical outsider as candidate to succeed Cameron as Conservative party leader.
Uncertainties are likely to drag on for a while. The Scottish government has said that in the event of a “yes” vote, it would aim to complete negotiations quickly and for Scotland to become independent in March 201611, ahead of the Scottish parliament elections scheduled for May 2016. In practice, the process might well take longer, especially given the interruption of the UK general election in May 2015 and possibility that the election might change the UK government. Indeed, given that Labour has now moved slightly ahead of the SNP in voting intentions for the Scottish parliament in recent YouGov polls, one can imagine scenarios under which negotiations on Scottish independence have to be completed after May 2016 under a Labour-led Scottish government (which opposed independence), a Labour-led rUK government and with a Johnson-led Conservative party in opposition that is moving towards advocating EU exit.
BoE on the alert: BoE Governor Carney noted in his Inflation Report press conference that the BoE would be ready to act if Scotland-related uncertainties escalate: “we also have responsibilities, as you know, for financial stability in the United Kingdom and we will continue to discharge those responsibilities until they change... Uncertainty about the currency arrangements could raise financial stability issues. We will, as you would expect us to have contingency plans for various possibilities”.
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With a “no” vote, the UK would still face rising political uncertainties. The UK political landscape is in a state of extreme flux, with the enduring Scottish independence movement, the rise of UKIP as a political force and resultant change in UK party political dynamics, the moderate-to-high probability of a change of government in the 2015 elections and uncertainties over post-election fiscal policy, plus the non-negligible risk of a referendum on UK exit from the EU in 2017-18 or so. Even if the “no” camp prevails in September, we do not foresee a return to the pre-referendum political status quo in the UK. In our view, the outlook for UK political risks will remain elevated well beyond the referendum, and we suspect these UK political risks are underpriced in markets.
More broadly, "Referendum Risk" is one of the more powerful manifestations of what we have termed Vox Populi risk, the Crimea being a particularly powerful, if extreme, example. In particular, what happens in Scotland will be particularly closely watched in Spain, which is facing a referendum on Catalan independence. Latent independence movements elsewhere, such as Belgium, could also be influenced by the outcome in Scotland. We regard the revival of local/national concerns, from Scotland to Spain and beyond, as part of continuing anti-establishment sentiment and a backlash against globalisation. And the UK experience (with growing support for UKIP alongside faster economic growth) raises the issue that economic recovery alone may not be enough to reverse the rise in anti-elite, anti-establishment sentiment.