This Isn't Brave Scotland, It's Foolish

It is undoubtedly the case that a ‘Yes’ vote on September 18 will lead to short-term mayhem. While I want to emphasise here that this is not our central expectation – and today's YouGov poll shows a swing back towards the No vote at 52% – it is a tail-risk scenario of which investors should be aware. Sterling and gilts will come under severe pressure, with the distinct possibility that sterling suffers a fall in the range of 10-20% against a dollar which is at last beginning to flourish due to the perception that rate rises from the US Federal Reserve may come earlier than expected. That rise may come as early as the first quarter of 2015. GBP/USD faces 1.40 nightmare Buying volatility may still be the best trade, and although that ship has just left port, there may still be time before the vote to profitably buy options. During the 1992 ERM crisis and the global financial crisis in 2008, one-month GBP/USD volatility hit 30%. The most damaging dynamic for sterling, and the UK economy, would be the enormous uncertainty created by the inevitably extended and fractious period of negotiation that would be necessary to determine what currency an independent Scotland would, (or could), use, how much current UK government debt Scotland would take on board, and how relevant assets would be split, including North Sea oil. Even the ‘yes’ campaign envisages full legal independence will only be implemented in March 2016, but this is hopelessly optimistic – at least three years is a more realistic guess. Fantastic four In reality, an Independent Scotland would have four choices with regard to its future currency. 1) Currency union with the UK It would be most desirable from the point of view of Scotland’s banks, as they would retain the support of the Bank of England. The only problem is that all major UK parties have said they would not agree to a union, and so the irony anyway is that under a currency union, to have any chance whatsoever of gaining Westminster’s agreement to the same, Scotland would have to cede monetary and fiscal power to the UK. Otherwise we would be creating another Frankenstein, bearing an uncanny resemblance to the euro; a half-completed chimera that would ultimately come to a disastrous end. 2) Sterlingisation The scary implication for Scotland would be that there would be no more ‘lender of last resort’ in Threadneedle Street for Scottish banks, so they would need to be much more heavily capitalized than UK or international competitors, effectively rendering them uncompetitive and uneconomic. This solution has been employed in Panama and Montenegro. Actually, whatever currency regime Scotland adopts, the banks would have to re-domicile to the UK and there would be no legal right for the Scottish Banks, (Bank of Scotland, Clydesdale and RBS), to issue notes. 3) A new currency Fine, but in that case the Scottish people had better get used to much more expensive borrowing, (on both a national and personal level), as the new Central Bank of Scotland would have to maintain much higher rates to defend this new baby of a currency and markets would demand much higher returns to buy Scottish ‘Gilts’. There would be huge capital flight as businesses rush to sell Scottish-based assets, Alex Salmond’s promise of a corporate tax rate that is 3% below the UK’s will hardly be enough to prevent this, and depositors will be queuing up to remove their money from Scottish-based banks no longer backed by The Old Lady. This would be a massively volatile currency, with concomitant costs for Scottish exporters. Presumably there would be an attempt to peg to the pound, as Denmark does to the euro. Scotland could attempt to build up reserves over a long time by running budget surpluses, but deficit current estimates put a Scottish budget deficit at 14% without oil, and with oil maybe 5- 8%, but oil revenues will decline to a miniscule £1-2 billion per year on average in the 2020s. This compares with a UK deficit of 5% this year, with budget balance projected by 2017. A massive austerity drive, or much higher taxes, would be required. Very sad and very unnecessary. 4) Join the euro A very long game, as Scotland would first have to successfully apply for EU membership, and do the Scottish people really want to join the euro club, with monetary policy to be set by the European Central Bank, usually to suit Germany? This is option 1), but worse.