Pound Got Pounded

The major event in the UK this month is undoubtedly Scotland’s independence referendum on September 18. The latest polling result from YouGov shows that, excluding undecided voters, ‘Yes’ vote (51%) surpassed ‘No’ vote (49%) for the first time on September 6 on the question ‘Should Scotland be an independent country?’. GBPUSD slumped more than -1.5% to 1.607 (as of September 9), the lowest level since November 2013, following the -1.6% selloff last week. The uncertain outlook, economic, fiscal, monetary, political, etc, in the continuing UK (rest of UK, rUK) after Scotland goes independent has been unnerving investors. Worse still, it appears that the British government has not prepared any contingency plan for the case of a breakup, although the BOE indicated that it has plans to provide emergency lending to Scottish banks in the case of deposit flight. The Scottish Government proposes that the Independence Day will be on March 24, 2016. That will ensure that the Scottish parliament elections would take place on May 5 2016 and there would be sufficient time for negotiation of various issues after the September 18 referendum. We believe the issues concerning investors the most are the currency and debt allocation/fiscal issues in rUK. These are the areas that this article would focus on.

Currency

Of main concern is what currency an independent Scotland would use. Scotland’s First Minister Alex Salmond indicated that the most preferred option is to continue using the sterling by setup a formal currency union with rUK. 75% of firms surveyed also favored this option as there would be no transactions costs and no currency risks with respect to trades between Scotland and rUK. Meanwhile, using the sterling would allow the Scottish Government and businesses to access to sterling markets (e.g. issue bonds). By doing this, Scotland would be giving up its independence on monetary policy as the BOE would be responsible for monetary policy for Scotland as well as rUK. Scotland could at most one in nine votes in the MPC as its contributed around 8-9% of the UK’s GDP. However, this idea was rejected by all three major political parties at Westminster despite the threat that an independent Scotland might refuse to share national debt.

Another option is ‘sterlingisation’ -Scotland continues to use sterling informally. The disadvantage of this option is that, with sterling being a ‘foreign’ currency in Scotland, it would completely surrender the control over monetary policy. Without formal commitment to a currency union is detrimental to investors’ confidence, triggering capital flight from Scotland and tightening financial and monetary conditions there. Separately, Scotland may consider establishing its own currency and join the Eurozone. However, the Scottish government does not seem to be interested in it.

Debt allocation/fiscal position

Another key issue is how the debt in the UK would be shared among an independent Scotland and rUK. The Treasury has promised to guarantee the entire UK debt in the immediate event of a split while the Scottish government has indicated that it would take its ‘fair share’ of the debt. Note that the ‘fair share’ of the debt indicated by the Scottish government is conditioned on that it would have ‘a fair share of the assets of the current UK and the pound’. With the three main Westminster parties rejecting Scotland from using the pound after independence, it is very likely that the Scottish government might refuse to share the debt as it does not have a ‘fair share of the assets of the current UK and the pound’. The default would cost over 100B pound no matter it’s calculated using the number of population or economic output.

The split of UK’s North Sea oil and gas wealth will be subject to intense negotiation.

The Scottish government estimated that oil and gas production in Scottish waters could generate as much as 57B pound in tax revenue by 2018 while more than half the value of total reserves in the UK Continental Shelf are still to be extracted. On the contrary, the UK’s Office for Budget Responsibility (OBR) projected that oil tax revenue would fall from 6.7B pound this year to 4.1B pound by 2017/18. In any case, the UK has over the past four decades received as much as 300B pound of offshore oil and gas production taxes of which 90% production was done in Scottish waters. The demarcation of the oil resources would be the key and is directly affect the oil revenue in rUK.

While the rUK government revenue is prone to fall, spending would also drop given the loss of 8.3% of the population and almost 1/3 of the land. However, the actual reduction in spending should be less than simply per capita spending for Scotland, as spending defence and international services, etc is not deducted directly proportional to population. We expect the reduction in spending would be smaller than the reduction in revenue. Together with a worse scenario that Scotland refuses to share the debt, fiscal position in rUK would see significant deterioration. Worse fiscal situation and greater exposure to external shocks might deter investment spending.

The pound was dumped in recent days, mainly due to the significant uncertainties associated with the case of Scottish independence. A number of key issues need to be negotiated and the process would be lengthy and tense. The BOE would likely remain cautious on the developments in rUK, leading to the delay of the first rate hike (market expectation is 2H15). The uncertain prospects would continue to pressure GBP after the referendum (in case of independence).

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