Up until a couple of weeks ago, you could sum up the market’s reaction to the idea of Scottish independence in a couple of words: “So what?”
Even the recent slide in the pound was initially triggered by confusion over exactly when the Bank of England is thinking of raising interest rates.
Then suddenly, last week, we got an opinion poll that suggested Scotland might actually vote for independence.
And now, this weekend, The Sunday Times put out a poll that has the ‘Yes’ camp ahead of the ‘No’ camp for the first time, by 51% to 49% (excluding the ‘don’t knows’).
So what if the unthinkable happens when Scotland’s residents vote on 18 September?
The biggest risk of an independent Scotland
Let me be upfront about my biases. I was born in Scotland. I live in England. I consider myself British. I don’t have a vote. But I’d be disappointed – make that gutted – to see the UK cease to exist. So I’m against independence.
Beyond that, the economic case for Scotland staying part of the UK is strong. To be truly independent, Scotland needs a whole load of separate institutions of its own (something that the ‘Yes’ campaign seems reluctant to acknowledge fully). That means a lot of needless duplication and a whole other layer of government on top of all the others we already have.
But what about the impact on the rest of the UK? It’s been easy for investors to brush off the threat of independence until very recently – it seemed so unlikely to happen. And many of them don’t seem to think that it would affect them in any case.
But they’re wrong. A ‘yes’ vote in less than two weeks’ time could have massive ramifications for investors all over Britain. And unfortunately, most of them – in the short term at least – are negative.
Don’t take my word for it. Goldman Sachs just put out a widely-publicised note suggesting that a ‘yes’ vote “could have severe consequences”.
The biggest issue, without doubt, is the currency. The problem is tangled up in politics, but it’s actually pretty straightforward.
Scotland either stays in a currency union with the UK, or it doesn’t. If it wants a currency union, the rest of the UK has to agree with it. And so far, every party who does or might hold power in Westminster, has said that they won’t.
There’s a good reason for this – it’s not just sour grapes. If Scotland and the rest of Britain remain in a currency union, then England, Northern Ireland and Wales are effectively promising to underwrite an independent Scotland. As Martin Wolf put it in the FT the other day, Scotland would need to sign some pretty strict rules making it accountable to the UK government for keeping its public spending under control – not unlike the rules that are meant to govern all the eurozone countries.
The problem, says Wolf, is that “within a currency union, the cost of fiscal profligacy [ie, too much government spending] by a smaller member may be shifted on to the larger one. But the much larger member cannot shift the cost of its profligacy on to the smaller one. Thus Scotland would have an incentive towards profligacy that the UK would not.”
In other words, it creates a massive moral hazard. So if Scotland wants to share a currency in a way that’s acceptable to the rest of the UK, it would have to abide by some pretty strict rules. Which then make the case for independence look kind of pointless.
The danger of not knowing
The alternative for Scotland is essentially to keep using the pound (in the same way that Hong Kong uses the dollar – it uses the currency but has no influence over monetary policy) until it decides to issue a new currency or it adopts the euro or whatever the plan is.
But there’s a problem here too.
You see, it’s impossible to know which route a separate Scotland would go down. So if you have money or assets in Scotland, you might well be worried about what might happen to them if a new currency was introduced. And you’re not going to have any sort of clear picture for a very long time after the vote.
So anyone with any sense of financial risk aversion would have a “strong incentive to sell Scottish-based assets and withdraw deposits from Scottish-based banks”, as Goldman Sachs analyst Kevin Daly put it.
But if there is something as drastic as a run on Scottish banks, then the Bank of England would have to step in to bail them out. You’re then looking at a big drop in the pound at the very least.
This is before we get to the impact on the coming UK elections, in May 2015. The last election was bad enough, producing Britain’s first coalition government since the Second World War. An independent Scotland would make this one even more uncertain. The validity of any general election would have to be called into question if residents of Scotland were allowed to vote for the government of a country they had just decided to leave.
You wouldn’t want to see this sort of upheaval at the best of times. You certainly don’t want to see it at a time when your country remains one of the most indebted in the developed world. Markets may be happy enough to snap up gilts at laughably low yields right now, but chuck in a whole lot of political uncertainty and a nasty spat over custody of a chunk of the national debt, and we could see investors become a lot more picky.
Is there anything you can do about all this? At a broad level, we’ve not been big fans of gilts for some time, as you’ll probably know. And we’ve also been suggesting having exposure to the US dollar for a while, which has strengthened rapidly against sterling in recent weeks – partly because of this and partly because of rising hopes for a US recovery.
For some more specific ideas, Merryn Somerset Webb takes a much more in-depth look at the impact of a potential ‘Yes’ vote in the current issue of MoneyWeek magazine, out now . If you’re not already a subscriber, get your first four issues free here.
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