Author: Charles Proctor
Now that 2014 is well and truly with us, it is perhaps unsurprising that the Scottish independence debate is beginning to heat up. The referendum is due to be held on 18 September, and will determine whether Scotland remains a part of the United Kingdom or begins to set its course as the world’s newest independent nation.
The last two weeks have seen various developments on the financial front, which have consequences in both the economic and the legal spheres.
The purpose of this briefing is to examine those developments and to consider their possible implications – both for Scotland and the remainder of the United Kingdom.
On 13 January, HM Treasury made a significant announcement – albeit described as a “technical note” – about responsibility for UK debt in the event of Scottish independence.
Whilst the document does indeed incorporate a certain amount of technical detail, its opening statement is of great significance to holders of UK public debt. It reads:
“…In the event of Scottish independence from the United Kingdom, the continuing UK would in all circumstances honour the contractual terms of the debt issued by the UK Government. An independent Scottish state would become responsible for a fair and proportionate share of the UK’s current liabilities, but a share of the outstanding stock of debt instruments that have been issued by the UK would not be transferred to Scotland. For example, there would be no change in counterparty for holders of UK gilts. Instead, an independent Scotland would need to raise funds in order to reimburse the continuing UK for this share…”.
The statement was designed to reassure investors, in the sense that they will have purchased gilts on the credit of the UK Government and would not wish to find that the identity of their counterparty had changed as a result of Scottish independence. The primary motivation behind the "technical note" was, no doubt, to avoid disruption to the Treasury’s borrowing arrangements as a result of political and economic uncertainty surrounding Scotland’s future as part of the Union (or otherwise).
The opening statement to the note is clear and unequivocal. Any investor who acquires UK gilts prior to the referendum date will retain legal recourse to the UK Government, even if Scotland ceases to be a part of the Union. But what are the rules that will determine the extent of Scotland’s obligation to reimburse the United Kingdom on account of the public debt?
The magnificently titled Vienna Convention on Succession of States in respect of State Property, Archives and Debts (1983) is perhaps the only international agreement that might be thought to offer some assistance in dealing with the division of debts and assets. The Convention is, however, subject to a number of limitations. First of all, although the terms of the Convention may be reflective of general international law, it has not yet attracted enough signatories to enter into force. Secondly, the United Kingdom is not a signatory in any event. Thirdly, the Convention only applies to debts owing by a State to other States or international organisations (i.e. not to private investors). Fourthly, the main operative provision in the field of State debt (Article 40) rather unhelpfully contents itself with the statement that "…unless the predecessor State and the successor State otherwise agree, the State debt of the predecessor State shall pass to the successor State in an equitable proportion, taking into account, in particular, the property, rights and interests which pass to the successor State in relation to that State debt …". It is fair to say that this rather open-ended provision does not greatly advance matters, and this leads inevitably to the conclusion that any negotiated independence agreement for Scotland will depend entirely upon the usual process of horse-trading. Allocation of the debt burden will therefore form part of a larger slate of issues on the bargaining agenda.
It may well be that the Treasury’s technical note will hold the line and preserve stability in the gilt markets for the time being, pending the outcome of the referendum. Of course, a "no" vote will render the note an irrelevance. But what are the longer term implications of that note in the event of a "yes" vote?
First of all, it is clear that investors in the gilt markets are entitled to rely on the note and – absent formal legislation to reverse its effect – the terms of the note will, in substance, be legally binding on the Government of the remainder of the UK.
Secondly, assuming a referendum vote for independence, this would mean that the remaining United Kingdom would be responsible to creditors for the entirety of the pre-independence debt stock. This may place the UK’s credit rating in jeopardy at several levels, namely:
It follows that the technical note on government debt means that the UK Government’s credit rating – and, hence, borrowing costs – will to some extent hinge on developments north of the border. In other words, the remainder of the United Kingdom will have a very direct interest in the success of the Scottish economy, at least until its share of the existing debt has been redeemed.
It is true that the Scottish First Minister said that the UK Government was "…being hoist by its own petard …" in issuing the statement. Yet, in truth, the UK Government was merely acknowledging the true legal position. The United Kingdom will be a continuing State following Scottish independence, and would be contractually bound by pre-existing debt obligations in any event. Indeed, in a later interview with the Financial Times, the First Minister himself made the same point, referring to the national debt as "…the legal liability of Her Majesty’s Treasury…".
Currency issues – the options
Since the Scottish National Party began to canvass the case for independence, the currency issue has been much to the fore. Enthusiastic consideration was at first given to joining the euro but, in reality, this was never a viable option at the point of independence. There were two core reasons for this:
The creation of a new Scottish currency might also have been seen as an attractive move, in the sense that it would "symbolise" Scotland’s nationhood and provide a daily reminder of its new status. It would also allow Scotland to implement its own monetary policy. But the Scottish Government dismissed this possibility, apparently on the pragmatic ground that the new currency and its central bank would need a period of time to establish their credibility, and this would lead to exchange rate risk both within the financial system and in terms of Scotland’s international trade. The possibility of a new Scottish currency is therefore disregarded for present purposes. It should however be noted that the Business Secretary, Vince Cable, has recently remarked that Scotland needed a "… Plan B… a fully separate currency…". These remarks were immediately dismissed by the Scottish Government, but the episode suggests that the possibility may have to be revisited at some point.
By this process of elimination, the continued use of the pound sterling remains the only game in town. As might be expected, that situation creates political and financial problems for both parties. These are compounded by the fact that there are, in fact, two sterling options for Scotland.
Sterling in a monetary union
The continued use of sterling – within a framework to be negotiated with the remainder of the United Kingdom – was the preferred option of the Scottish Fiscal Commission and has been adopted by the Scottish Government in its Independence Guide. A monetary union of this kind would have to be the subject of an agreement between the two sides, since a union of this kind presupposes a bilateral arrangement.
No doubt with an eye to the financial crisis, the Independence Guide notes that "…A shared successful monetary union needs to have an adequately designed framework for financial stability and fiscal sustainability…" In terms of the regulation of banks, insurers and large investment firms, the Independence Guide proposes "… a shared Sterling Area prudential regulatory authority….or, alternatively, a cooperative arrangement between the existing UK authorities and a new Scottish Monetary Institute…". It also proposes that the Bank of England should continue to undertake certain roles on the basis that it will be "…accountable to both countries…". That may be a difficult mandate for the Bank of England to fulfil, when the two nations may have differing interests.
In a careful and thoughtful speech in Edinburgh on 29 January, the Governor of the Bank of England, Mark Carney, analysed the pros and cons of a sterling monetary union with the remainder of the United Kingdom. Clearly, he was astute to avoid political issues but focused instead on a "technocratic assessment" of effective currency unions.
Given that Scotland and the remainder of the UK are major trading partners, there are a number of advantages to the use of a common currency in the post-independence era. The absence of exchange rate risk will promote trade in goods and services, and mobility in both the labour and the capital markets. The costs implied by uncertainty and instability in the foreign exchange markets are also eliminated. These are, of course, very much the arguments put forward by the pro-single currency campaigners during the period leading up to the establishment of the euro in 1999. Regrettably, subsequent experience in that area has not been wholly positive. A number of unhappily termed "peripheral" Eurozone countries have discovered that their inability to control interest costs or to influence exchange rates has left them – in a financial crisis – with but one resort: "internal devaluation" or, in more direct terms, rising unemployment. It follows that the absence of any control over monetary and exchange rate policy will leave an independent Scotland with few mechanisms to assist it in dealing with any future economic downturn.
The UK Government has said that it would not necessarily agree to enter into a form of monetary union with Scotland. Yet it would be in the interests of the United Kingdom for Scotland to continue to use sterling (whether or not as part of a formal monetary union) because that is the currency in which Scotland will have to make reimbursement payments to the UK Government in respect its share of pre-existing public debt. The political stakes appear to be high, in that the Scottish Government has stated that it will not assume responsibility for a proportion of the United Kingdom’s overall indebtedness unless a monetary union is also agreed.
Although the point has not, thus far, been discussed in great depth, it may be noted that sterling will become a different currency if the UK and Scotland enter into a monetary union in the fullest sense, since it will no longer simply be the lawful currency of a single country, but the single currency of two countries. This may appear to be a technical quibble, but it may have practical consequences. For example, if sterling were the joint currency of the two countries, then it may be inferred that its value should not differ greatly from its present value, because the currency would continue to represent the same economic area. On the other hand, in the absence of an agreement as to a sterling monetary union, then sterling will be backed only by the economy of the remaining United Kingdom. It may be assumed that the latter situation would have an impact on the external value of the currency.
If the Government of the remaining United Kingdom does indeed decline to enter into a monetary union agreement, or the two countries fail to negotiate mutually acceptable terms, then it would remain open to Scotland unilaterally to adopt "English" sterling as its currency. This process may be unattractively termed "sterlingisation". The expression "dollarisation" is equally unattractive but, for obvious reasons, rather better known. This refers to the process by which a country simply adopts a foreign currency as legal tender within the national economy. Examples of "dollarised" economies include El Salvador and Ecuador. Strange though it may seem, a country that wishes to adopt a foreign currency in this way does not require the consent of the issuing or "parent" State for that purpose. Scotland could therefore use sterling as its national currency of account, regardless of the wishes of the UK Government.
It is noteworthy that Latin American countries have adopted the US dollar in order to counteract inflation and instability in the local economies, and because the use of that currency brings a degree of credibility to national economic policies. It must be doubtful that the unilateral adoption of sterling by Scotland would bring the same benefits. Moreover, Scotland would clearly suffer the disadvantages of this kind of monetary arrangement – namely, that it would have no control over monetary policy or the money supply. This factor would mean, in turn, that Scotland would not have a central bank in the usual sense of that term. The authorities in the United Kingdom would owe no duties or obligations to Scotland in the management of sterling. The result would be that any economic shocks that are local to Scotland could only be addressed through fiscal policy (i.e. through reduced public spending and/or increased taxation).
In view of this analysis, it is perhaps unsurprising that "sterlingisation" is not seen as a viable option. From Scotland’s perspective, an agreement on monetary union would clearly be preferable, partly because the economic benefits are more obvious and partly because an agreement of this kind would be more obviously consistent with that country’s newly-acquired independence and sovereignty.
The recent history of the financial crisis has concentrated minds on the occasional need for official support to troubled banks. This may essentially take two forms:
Once again, experience in the Eurozone has demonstrated that the absence of a proper institutional structure to deal with a banking crisis can prejudice the very existence of a currency union. It is for this reason that the Eurozone is moving towards a "banking union" which must, as a minimum, comprise:
Given that Scotland would not have its own central bank, it would need to negotiate arrangements under which the Bank of England could continue to provide emergency liquidity assistance to Scottish institutions. Equally, whilst Scotland could establish its own deposit protection scheme – and would have to do so to comply with EU Directives – it would not be easy to establish the credibility of such arrangements, bearing in mind the size of the Scottish banking industry as compared to the size of the economy as a whole. The Scottish Government’s Independence Guide contents itself with the observation that Scotland would establish a deposit guarantee scheme similar to the UK scheme, but does not deal with the strength of the government backstop to that scheme.
It should be noted that the political temperature in the banking union debate was increased by Vince Cable on 5 February, when he observed that the Royal Bank of Scotland would almost certainly wish to move its head office to London in the event of a "yes" vote. The symbolic importance of such a move would be obvious, and the necessary implication is that the UK Government would be hostile to a union arrangement that potentially involved UK taxpayer support for Scottish banks.
What conclusions can be drawn from this discussion?
As Mr Carney’s Edinburgh speech implied, monetary union and banking union must effectively go hand in hand. This is the harsh but realistic lesson of the Eurozone’s financial crisis. Mr Cable’s subsequent comments demonstrate that agreements of this kind may be difficult to achieve at a political level – perhaps for the very reason that the UK Government has no desire to replicate the European monetary experiment. From Scotland’s point of view, it will be important to secure a robust agreement on these twin issues, but the challenges could clearly be significant.
Nevertheless, given the close trading links between the two regions, the future relationship and prosperity of the two separate nations will in any event be closely intertwined. Although the UK Government currently adopts a negative attitude to an agreement on monetary union, it may well be that a "yes" vote will produce a more pragmatic negotiating environment.
Charles Proctor, Partner, Fladgate LLP (email@example.com)