British financial assets will face a rough ride if Scotland secedes. But market pandemonium is extremely unlikely to lead to a real crisis.
Currency traders have been the most sensitive to news about the referendum. They have already driven sterling down to its lowest in nearly a year against the dollar since a weekend opinion poll showed the pro-independence “Yes” camp in the lead. It’s very likely that the pound would suffer further losses if Scots vote to break away in the Sept. 18 referendum.
Once upon a time, currency values were at the centre of monetary policy, and sharp market moves were considered national emergencies. Now, though, central banks look at exchange rates as just one variable among many. British authorities have adopted a hands-off approach to exchange rates since the 1992 exit from the European exchange-rate mechanism. The Bank of England stood by when the pound fell by a third against the dollar between late 2007 and early 2009.
Mark Carney, the current governor, will not be sending the monetary policy cavalry to rescue sterling if there is pronounced post-referendum weakness. On the contrary, a falling pound will be welcomed in a country with a persistent trade deficit. The welcome will be especially warm considering that the euro, the currency of the United Kingdom’s largest trading partner, has been weakening. Higher import prices might push the inflation rate up, but these days inflation tends to be too low, not too high.
Policymakers would worry more if foreign investors shied away from UK government debt, leading to a sharp sustained rise in UK bond yields. That could hurt economic activity. It’s a possibility, even though the government pre-emptively promised to honour all existing debt in the event of Scottish independence. After all, investors often shun uncertainty. With nearly 30 percent of British government bonds in foreign hands, gilts will no doubt suffer if the “Yes” camp wins.
Still, investors do not seem to think that capital flight will snowball into a full-blown euro zone-style debt crisis. In the market for buying protection against defaults, a British default is still viewed as nearly as unlikely as a German one.
That confidence makes sense. A lesser Britain might end up burdened with more debt, but the Bank of England can head off a steep rise in gilt yields. For starters, it could delay its first interest rate rise. Money markets are already starting to price in that possibility. And if push really came to shove, the central bank could always resume its gilt purchases.
In theory, excessive money creation could destroy investors’ confidence in the government’s creditworthiness. In practice, the UK has stored up enough credibility that investors will not lose faith just because a tenth of the country’s population will be spun off. After many years of quantitative easing, the markets are comfortable with this sort of monetary policy.
As for stocks, investors’ knee-jerk reaction to a Scottish “Yes” might well be to sell UK equities. But weaker sterling and the likelihood that UK monetary policy would stay accommodative for longer could soon spur a rethink.
Financial stocks will be more vulnerable, but the UK authorities won’t allow a worst-case scenario – banks frozen out of funding markets. After all, if the 2008 financial crisis taught policymakers one thing, it is to act swiftly to prevent a liquidity problem turning into a solvency one.
Big market swings are very likely if Scotland votes for independence. But policymakers would have to forget all the lessons of recent financial history for fluctuations to turn into disaster.