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Rabbie Burned

25 February 2014 By George Hay

Scottish dreams of secession are likely to get boxed in by the hard realities of the debt markets. An independent Scotland would find it hard to adopt either the pound sterling or the euro, after dual snubs from London and Brussels. But whether it ends up with the pound, euro, or something else, the more fundamental question is how the UK’s pre-existing debt load weighs on the new country’s freedom.

Even if the euro zone crisis hadn’t happened, joining the euro looks a non-starter. Scotland would have to comply with strict convergence criteria stipulating a budget deficit below 3 percent of gross domestic product – requiring tax hikes or spending cuts to shrink from nearer 5 percent. Yes-voters seem to recognise that fact, and seem to want to join just the European Union – not the euro zone. But as European Commission President Jose Manuel Barroso intimated on Feb. 16, the bid is bound to fail – unanimity would be near impossible to find in favour of Scotland joining. Furthermore, all new EU members are expected to join the euro – opt-out clauses like those exercised by the UK or Denmark won’t be possible in the future.

The pro-independence lobby says it is keen on keeping the pound and forming a currency union with the rest of the UK. The Bank of England would set interest rates and regulate Scottish banks – in exchange, the Yes-voters hope for some form of power-sharing in its governing bodies. But that looks sub-optimal as well. Even if UK Chancellor George Osborne hadn’t poured scorn over the idea on Feb. 13, Scotland’s relatively small economic weight would have little influence over the BoE’s policies. It would still be left dependent on interest rates set for London financiers rather than for Scottish businesses.

That leaves the option of a brand new Scottish currency – call it the rabbie, after the country’s most famous poet Robert Burns. It would be the logical solution. Scotland would gain full fiscal and monetary flexibility. And it wouldn’t be forced by currency union partners to cut spending or raise taxes in the short term.

But whichever route is chosen, Scotland has a problem. Even by 2019 its spending will outstrip revenue before interest costs, according to the National Institute of Economic and Social Research. Imagine Scots took on debt at around their current level of 70 percent of GDP, and that their primary deficit is 2.5 percent on average over the next five years. Assume also that it costs Edinburgh 3.8 percent to finance this deficit – on the basis that the UK’s debt as a whole has an average maturity of well over a decade, and debt investors might require a 100 basis-point spread over the UK’s current 2.8 percent 10-year gilt yield to finance an independent Scotland. By 2019 Scottish debt would then reach 90 percent of GDP, assuming modest average GDP growth of 1.5 percent, according to Breakingviews’ calculations.

In a currency union – either with Frankfurt or London – the central bank would balk at such a small country being burdened with such a large debt. Scottish independence leader Alex Salmond would be forced into a series of tax hikes and spending cuts. Scots might soon feel as powerless and resentful as Greeks – but with no one to blame for their misfortunes.

Armed with the rabbie, Scotland could keep cutting interest rates, or even printing money, to avoid the pain. But sooner or later Salmond would have to opt for fiscal discipline – not to assuage currency union partners, but to lure bond investors to Scottish debt. Or he would need large sterling reserves to see off currency speculators, who would know his resources were not inexhaustible and who would keep testing the rabbie. Yields on new Scottish debt could rise, worsening the debt situation.

A radical option, appealing to the more hardcore nationalists, would be to just walk away from the debt. On paper, this sounds beguiling: even if Scots had to pay Greek-style yields on their debt, it wouldn’t matter for decades.

In reality that will not happen, even though advocates of independence assert Scots have no legal obligation to shoulder their debt, and even though the UK government has prepared for such a worse-case scenario by saying it will guarantee all current UK debt. If the Scotland/UK divorce settlement turned nasty, London might fight for a bigger share of the oil receipts that made up 19 percent of overall Scottish revenue in 2011/12, and that would push up the deficit again. There would also be transactional costs from doing business in different currencies, estimated by Salmond on Feb. 17 to be 500 million pounds a year. That is bad news given that 70 percent of Scottish trade is with the rest of the UK. But most of all, rabbie-denominated debt yields would spiral even faster.

That leaves Salmond well and truly boxed in. Yes-voters reckon most of the negative talk is wrong-headed. They insist that independence will boost Scottish GDP growth. But, like the assumptions that the UK will play ball on a currency union, or the hope that a new currency would increase rather than diminish flexibility, Scottish voters should take this with a pinch of salt.


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