A sobering read for anyone concerned about the economy in an independent Scotland. This is an internal report from a London based investment company. This is not a political report but is provided to inform on the businesss internal view on the impact of Scottish independence. The Scottish referendum – September 2014 The financial implications of independence for Scotland The markets scepticism that Scotland will vote for independence on 18th September has been meaningfully tested by recent opinion polls, which have shown that the sizeable majority in the “No” camp has evaporated into statistical insignificance. As such, the outcome looks too close to call. And the financial market implications of a vote for an independent Scotland appear meaningful. Currency union break-ups have been rare and tumultuous events, and hence we expect international interest to be significant. In Scotlands case, scrutiny over the course of a break-up in the event of independence would be intense: the country is highly developed and has an outsized financial sector relative to the rest of its economy. Even if the “Yes” vote fails to win the day, a close vote could mean that companies start organising their affairs on the basis that separation remains possible, leading to lower investment in Scotland. What could a new currency look like? Starting with the basics, the choice of currency regime post-potential independence is far from clear. But the advice commissioned by HM Treasury, and the extraordinary intervention of Sir Nicholas McPherson – the permanent secretary to HM Treasury – is unequivocally against monetary union. This makes the unanimous rejection by the UK political parties of a monetary union with an independent Scotland appear more than grandstanding, and leaves two currency options: 1) Sterlingisation, e.g. the unilateral adoption of the pound but with no say in monetary affairs or access to the central bank as lender of last resort, or 2) A new independent currency The investment implications of the two different choices vary, but neither looks likely to be conducive to short-term financial stability. It seems reasonable to question whether Scottish depositors might doubt the degree to which an independent Scotland would be able to maintain a currency peg, or whether a new Scottish currency would suit their needs, and shift their deposits to the UK. This would put immense pressure on both the peg and the remaining financial system, potentially leading to a Scottish government bankruptcy. It happened in Argentina in 2001, when it was forced off the US dollar by failing depositor and investor confidence. Implications for Scottish banks The balance sheet of Scottish banks is around twelve times the size of Scottish GDP (versus around five times for the rest of the UK), bringing financial-system stability into focus. Scottish banks would retain the ability to access the Bank of England as a Lender of Last Resort before independence was completed in 2016. Assuming banks will need to continue to have this access, we would expect the bulk of the banking system to shift domicile south of the border before 2016 (they would be required to do so under EU law and the Bank of England’s regulatory requirements, given that this is where the majority of their business lies). This would leave banks in Scotland run either as foreign branches or separately- capitalised Scottish subsidiaries. Uncertainties could impact risk assets Markets dislike uncertainty, and the timetable for the complex negotiations surrounding constitutional divorce is necessarily long. Given the constitutional and economic uncertainties attached to a potential break-up of the UK, a vote for independence is likely to deliver a negative shock to UK financial assets and lead to meaningful currency weakness. However, despite the change in the opinion polls, financial markets still attach a very low probability to independence. We are unable to discern any meaningful risk premium in UK equities, and the sterling weakness experienced over the past month has been principally against the US dollar: sterling is almost unchanged against the euro and the yen. A brand new currency would be unlikely to deter international investors from financing good projects with solid fundamentals. But, absent a crash in asset prices exposing immediate cheap valuations, investors are likely to wait until the fog of political, monetary, financial and economic uncertainties that would envelop an independent Scotland is lifted before committing funds. In addition, Scottish and other UK companies that historically operated defined benefit pension schemes with a large workforce split between Scotland and the rest of the UK may, in the event that an independent Scotland joined the EU, find that they had new “Section 75 Debt” liabilities owing to the cross-border nature of their pension fund membership. While this sounds pretty arcane, it would likely be extremely costly for many firms. Understanding where these costs lie, and how large they would be, could impact these companies’ stocks and bonds meaningfully: although there is a chance that legislative changes could be negotiated at the European level to avoid this large, and mostly unknown, cost arising. Other investment implications Scottish banks could see their value fall should they suffer depositor flight. Domestic Scottish-facing companies with significant amounts of sterling debt, referencing English law, may find their assets and liabilities no longer matched (e.g., they would have sterling liabilities but Scottish currency revenues). This situation has caused all sorts of problems in emerging markets where this sort of mismatch is most common. Scottish energy companies could be advantaged by a change in taxation arrangements that moved their incentives more in line with those seen in Norway. But there would be large question marks over North Sea oil decommissioning costs, which the UK government has historically been seen to be backstopping. Given the likely hit to business confidence that would come from the political and constitutional uncertainty following a “Yes” vote, we would expect the Bank of England to delay or slow its hiking path. As such, short-dated gilts would perform strongly. Long-dated gilts may benefit from a “flight to quality” although the perspective of international reserve managers on the political developments introduces uncertainties into this call. Even if the “Yes” vote fails to win the day and the “No” vote triumphs by a slim majority, the prospect of a “Neverendum” remains. While less disruptive to financial markets, this looks to be of great danger to the people of Scotland. It is likely that companies will organise their affairs from now on, on the basis that separation is possible if not likely. This is likely to lead to lower levels of investment in Scotland than would otherwise have been the case - as has been documented in the case of Quebec following their referenda to leave Canada.
Posted on: Sat, 13 Sep 2014 11:26:15 +0000