Written by: Simon Derrick | Chief Currency Strategist, BNY Mellon
On September 18, 2014, the Scottish electorate voted in a referendum on the question, "Should Scotland be an independent country?" In the end, 2,001,026 people voted for Scotland to remain in the Union with England and Wales, while 1,617,989 were in favor of independence. In the aftermath of the vote, Prime Minister David Cameron said "…the debate has been settled for a generation...there can be no disputes, no re-runs, we have heard the settled will of the Scottish people.1" As the events of this weekend have shown, he may have spoken prematurely.
Speaking last Friday in the aftermath of the UK referendum on membership of the European Union (“EU”), Scottish First Minister Nicola Sturgeon said that a second referendum on Scottish independence was "highly likely2" and that the Scottish government would begin preparing legislation. This point was reinforced on the following morning when she stated: "The cabinet expressed its pride at the overwhelming vote to stay in the EU. We are determined to act decisively and to build unity. A second independence referendum is an option that is very much on the table...3"
As such, we need to consider some of the issues that could face the financial markets if Scotland decided to hold a second referendum and decided to leave the United Kingdom. In particular, it is worth considering the options that would face Scotland with regard to which currency it might use.
1: Continuing to use the British Pound (GBP)
Opposition from London to a currency union with Scotland was robust back in 2014. The Governor of the Bank of England, Mark Carney, told the TUC Congress in September of that year that there had to be three components to a successful currency union. These were (i) the free movement of goods and services across the different parts of the currency, (ii) a banking union underpinned by common institutions such as a central bank, and (iii) elements of shared fiscal arrangements. He added: "You only have to look across the continent to look at what happens if you don't have those components in place. A currency union is incompatible with sovereignty.4"
This issue would be complicated even further should Scotland succeed in persuading all of the remaining members of the EU that special arrangements should be put in place to protect Scotland's position in the EU (although this seems highly unlikely given the domestic issues that this could raise for other EU members). There was little surprise that both Spanish Premier Mariano Rajoy and French President Francois Hollande made clear their opposition to a special deal for Scotland last Wednesday. However, even if a deal were to be struck now, it might not matter all that much in the end. Speaking to the BBC on February 16, 2014, the then-president of the European Commission Jose Manuel Barroso asserted "In case there is a new country, a new state, coming out of a current member state, it will have to apply and… the application and the accession to the European Union will have to be approved by all the other member states of the European Union. I don't want to interfere on your referendum here, your democratic discussion here, but of course it will be extremely difficult to get the approval of all the other member states to have a new member coming from one member state. We have seen Spain has been opposing even the recognition of Kosovo, for instance. So it is to some extent a similar case because it's a new country and so I believe it's going to be extremely difficult, if not impossible, a new member state coming out of one of our countries getting the agreement of the others.5" In other words, even if Scotland managed to retain membership of the European Union now, it could lose this membership anyway, should it decide to become an independent sovereign nation.
While the government in London might refuse to enter into a currency union with Scotland, this does not mean that Scotland couldn't continue to use the British Pound (“GBP”). (It is worth noting, by the way, that the UK is in a currency union with Jersey, Guernsey and the Isle of Man). Panama and El Salvador, for example, use the US dollar (“USD”) without being in a currency union with the United States. However, it means that Scotland would have no say over monetary policy or have a lender of last resort for its banking system. As such, this could only provide a temporary solution.
Standard & Poor's highlighted the risks for Scotland in April 2014 when it said there were "important considerations and uncertainties6” that factored into the creditworthiness of banks should Scotland vote for independence. It said it counted the existence of a Scottish central bank, the Scottish government's attitude towards helping struggling banks, changes to financial regulation and independent Scotland's currency among crucial factors that could impact its ratings on the country's banks. It added "…the willingness and ability of a future Scottish government to support its banking system is challenging at this point."
It also highlighted that the Scottish banking system's assets were at the time 1,254% of Scotland's gross national product as compared with the banking assets of Iceland in 2007, which were 880% of Iceland’s gross national product just before its banking system collapsed. Standard & Poor's stated: "We note a possible parallel here with Iceland, where in 2008 the national deposit insurance scheme could not honor claims when the country's outsized banking system failed.7"
2: Adopting the Euro (“EUR”)
Membership of the EU is a pre-requisite to be considered for membership of the EUR. It is therefore unlikely (given Mr. Barroso's comments) that Scotland could become part of the single currency straight away. Nevertheless, it is possible that, much like Montenegro and Kosovo, it could use the EUR without being part of the Euro-area. Still, this raises exactly the same issues as using GBP when it comes to the matter of setting monetary policy or having a lender of last resort.
It is also worth noting that Olli Rehn, who stepped down in July 2014 as European Commissioner for Economic and Monetary Affairs, stated just ahead of the last referendum that it would “simply not be possible" for Scotland to join the EU if it adopted so-called "sterlingisation."8 In other words Scotland needs its own currency first, and the appropriate monetary authorities, if it is to join the EUR.
3: Re-launching the Pound Scots
Prior to the 1707 unification of the Kingdoms of Scotland and England, the unit of currency in Scotland was the Pound Scots. It is entirely possible that a newly independent Scotland could re-launch the currency and establish its own central bank (this seems the most likely final outcome). However, while this appears to be the most sensible long-term option, establishing the appropriate infrastructure (including the creation of a new central bank) would still take time. In the absence of a temporary currency union (with assurances being made on both sides) to provide support to the financial system in the interim should it be needed, this could leave Scotland in an uncomfortable position for several years.
Tellingly, when asked on BBC Scotland's Sunday Politics show about his currency plans in September 2014, the then First Minister of Scotland Alex Salmond “…insisted he had plans for a "monetary authority," if there was no currency union and a separate Scotland could no longer rely on the Bank of England.”9
5 http://www.bbc.co.uk/news/uk-scotland-scotland-politics-26215963 (please click on video)
Chief Currency Strategist, Head of the BNY Mellon Markets Strategy Team
Simon Derrick is a managing director of BNY Mellon and is head of the BNY Mellon Markets Strategy team. Simon established the team more than 10 years ago, and has guided its development into a preeminent center of excellence within BNY Mellon. His insights and commentaries have made him an indispensable source for financial journalists around the world, and his frequent on-air appearances have made him a fixture on electronic news outlets.
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