Dr Angus Armstrong, NIESR and ESRC Fellow
SCOTLAND’S CURRENCY OPTIONS: A ‘HARD’ CURRENCY?
“In a world of sovereign states, nothing can be regarded as truly irreversible”
Professor Benjamin Cohen
Good morning ladies and gentlemen. It is a great pleasure to address this Scotsman Conference on the Economics of Independence.
My remarks this morning follow-on from a speech I gave at an ESRC conference here in Edinburgh last month. This discussed whether a currency union between an independent Scotland and the rest of the UK is a viable option. While there are certainly very good reasons to use the same currency, economic instability on one side of the border would be more likely to spill-over to the other side. An agreement to minimise the spill-over would be extremely difficult to enforce. Europe is a case in point. Despite Article 125 in the Maastricht Treaty (the famous “no bail-out” clause), Germany has become exposed to the central banks of Southern Europe to the tune of one quarter of its national output. It is only because of a commitment to greater political union between nations that the system holds together. The whole point of independence is that Scotland and the rest of the UK would, at least politically, move apart.
This morning I will discuss the other leading option – the prospect of an independent Scotland re-introducing its own currency. This is far from hypothetical. I understand that in recent weeks the leader of the Yes campaign has also suggested that this would be the best option for an independent Scotland. This appears to becoming the ‘Plan B’. Indeed, if Scotland is to join the European Union then a pre-requisite of joining the euro is to already have had an independent currency and central bank.
However, the key point I wish to make today is that if Scotland is to prosper over the long term, it is not enough just to have a new currency. It is not enough to advocate a new currency as a process of elimination. And it is not enough to advocate a new currency on a text book case of how this could allow an independent monetary policy.
Above all else, an independent Scotland requires a ‘hard’ currency if it is to prosper. What do economists mean by a ‘hard’ currency? At a minimum it enables the development of a domestic long term debt market. Sterling and the euro are ‘hard’ currencies. The argument is that upon gaining independence, Scotland would have to issue over £130bn of bonds in the new currency. If they are to be bought at a reasonable interest rate, investors need to be confident that their savings are safe. The necessity of debt issuance requires that any new currency must be a ‘hard’ currency.
- 1. Re-denomination and debt
Let me start by reviewing some of the mechanics of re-denominating a currency. There are many examples of re-introducing currencies, such as after the collapse of the Soviet empire twenty years ago. But the extent of integration between Scotland and the rest of the UK, size of global capital flows and febrile financial conditions for any indebted country may make this challenging.
An independent Scotland would have to move swiftly to create the necessary institutions and capital markets. This would include a central bank, a payments system, deposit insurance, prudential and conduct financial regulators, a debt management office, an exchequer, a tax collection agency, a fiscal commission, equity and capital markets and, of course, a currency mint.
The assets and liabilities of the existing UK would be divided between the successor UK and Scotland. The major assets are the oil fields and state offices and the major liability is the UK public sector debt. If the public sector debt is divided on a population basis, an independent Scotland is likely to start with over £130bn of debt. This does not include future public sector liabilities (such as state pensions) or contingent liabilities (such as bank deposit insurance).
There would also be many technical issues to solve. The Scottish Government would presumably pass a redenomination law to introduce the new currency. This would require wages, pensions and procurement in Scotland to be redenominated. Debt contracts such as mortgages and company loans under Scots Law would be converted and, to avoid financial imbalances, even some deposits may need to be converted. Eichengreen’s (2007) review of the Argentine experience is that it is better to go the whole hog rather than only redenominated some contracts. All of this must happen before independence in 2016. Without these institutions being in place on independence there would be a very real risk of capital flight. This may require capital controls, which in a financially sophisticated country like Scotland, could become very problematic. It is always worth remembering that in the political separation of Czechoslovakia the currency union broke-up in six weeks.
Having resolved these preliminaries, the next task would be to negotiate how to transfer the ‘fair’ share of public debt to an independent Scotland. The technicalities involved are under estimated. Scotland does not have a spare £130bn (roughly double the best guess of remaining tax revenue from oil) and the UK is unlikely to be keen for an IOU from a foreign country which would surely impact its credit rating. I am surprised that the UK government has neither announced how it considers the debt should be divided or how this would be achieved. It is not surprising that others will take the initiative on what is deemed to be ‘fair’. Whatever interim arrangement is agreed, a fast track of Scottish debt issuance is certain to follow.
The new Scottish Debt Management Office will seek to issue bonds in the new domestic currency (to prevent a currency mismatch) and of long term maturity (to avoid roll-over risk). In other words, Scotland requires a ‘hard’ currency if it is to successfully issue this much debt. This is no mean feat, and will take time to achieve. If investors do not believe this is ‘hard’ currency, higher interest rates and shorter debt maturity will leave the economy vulnerable.
- 2. So what makes a currency ‘hard’?
So far the definition of a ‘hard’ currency has been unhelpfully circular: a hard currency requires a long term debt market which in turn requires a hard currency. Ultimately, it depends on the confidence of domestic and foreign investors. Confidence is always very difficult to define, at least in a robust way. It is likely to be some function of macroeconomic conditions, political predictability and a history of honouring payments built up over the long term. This latter point seriously questions the economic coherence of not accepting a fair share of debt.
Necessary economic conditions include at least the following three factors. First, a history of low and stable inflation; this will prevent currency losses for foreign investors and an erosion of real returns for domestic investors. Second, strong productivity growth in the non-oil sector of the economy to increase competitiveness in the long term and a good real rate of return for investors. And third, low levels of debt and high reserves just to be ready for those periods of economic turmoil which inevitably follow for all countries. If all three conditions are met, then the balance of payments would be sound and every chance that the currency would come to be seen as a ‘hard’ currency in time.
What exchange rate arrangement would have the best chance of achieving these economic conditions? The Scottish government would have the choice of whether to have a fixed exchange rate (presumably to sterling) or floating exchange rate or somewhere on the spectrum between the two. A fixed exchange rate (if it is credible) would minimise the cost of hedging currency risk and bring the advantages of greater price transparency (easier to compare price). In theory, the closer to a floating exchange rate the more flexibility Scotland would have in setting monetary policy. However, this ignores the fact that Scotland must develop a large long term bond market in short order. In practice, the choice will be dominated by what is needed to create a ‘hard’ currency.
In the past, Ireland chose to fix its exchange rates at parity when leaving sterling. The Irish central bank then spent the next fifty or so years defending the exchange rate until joining the ERM. Crown dependencies (Guernsey and Jersey) have currency board like arrangements with the Bank of England, usually considered the ultimate ‘hard’ currency arrangement. The widely feted Scandinavian countries have a variety of exchange rate arrangements, but with the exception of Norway they are either fixed or managed. The small but high income states in Asia also have strict exchange rate regimes. Hong Kong operates a currency board while Singapore has a carefully managed peg. Hong Kong is a good example of an economy with a large financial system which faced huge political uncertainty – hence the parallel with Scottish independence. The currency board was introduced in 1983, a year before the Sino-British Declaration.
If the new Scottish currency could be successfully fixed to sterling, this would remove most of the exchange rate uncertainty. For a small open economy, this would also be the best way of signal to investors an intention of keeping inflation low and stable. Essentially this would be using the anti-inflation credentials of the Bank of England. This would inevitably come at the cost of removing or severely limiting any tools of monetary policy from the Scottish central bank. Contrary to some suggestions, because of the need to develop a ‘hard’ currency this means there would be little or no independent monetary policy.
- 3. Is a fixed / managed exchange rate possible?
An independent Scotland would face two hurdles in maintaining a steady exchange rate. The first is a flow issue. Scotland’s population share of foreign exchange reserves at the Bank of England would be about $10bn – too small to support or defend a moderate currency attack. To accumulate reserves Scotland would need to run steady balance of payments surpluses. At this point, it has to be said that we know very little about the position of Scotland’s external accounts. The Scottish Government’s experimental national accounts data currently uses a residual balancing item rather than any direct measure. This suggests a small deficit, although there is great uncertainty around the figure. Judging from the fiscal deficit and the absence of any clear sign of excess saving in the private sector, the likelihood is that the external account is currently a deficit.
Scotland would clearly benefit from exporting oil. However this would be partly offset by the repatriation of profits from foreign companies operating in the North Sea and the end of the block grant income transfer from Westminster. Most economists estimate that the taxes from North Sea oil and the additional block grant transfer roughly balance themselves out. How this all balances out in terms of the external accounts is really very difficult to know with any precision.
One way to accumulate foreign exchange reserves is to run a severe austerity policy. This will depress domestic demand and imports and so lead to current account and balance of payments surpluses. Even Europe’s weakest economies are now running current account surpluses. This was broadly speaking Ireland’s strategy after gaining independence. The sole aim of economic policy was to maintain external surpluses and confidence in the currency. Yet this comes at a considerable cost to the domestic economy. In Ireland the cost in terms of economic development was also high.
However, this brings the second hurdle into play. Scotland would have a high debt to output ratio and a policy of depressing demand might raise the debt burden (measured by debt to GDP). At some stage investors may doubt the ability of the Scottish government to stay the course and lose confidence in the capital markets. External shocks will inevitably happen. In Europe those countries with impaired banking systems and now high public sector debts, austerity may have increased rather than reduced the debt burden. This is where being confident of about strong productivity growth in the non-oil sector in an independent Scotland relative to the rest of the UK and European competitors, is essential.
- 4. How can ‘hard’ currency status be achieved?
If what I have said so far all sounds quite difficult, then I have made my point. If a fixed or heavily managed exchange rate is a pre-requisite for a new small open economy to develop a domestic bond market and borrow substantial funds, then there are some difficult choices ahead. Hard currencies are prized possessions.
The aim is to run large balance of payments surpluses (to accumulate reserves) and at the same time reduce the debt burden. One approach would be to credibly commit to using the tax receipts from North Sea revenues to repay national debt in an independent Scotland. If the interest rate of Scottish debt is higher than could be guaranteed through investments then this, rather than a sovereign wealth fund, would be the prudent course of action. If this could half the debt burden in twenty years then Scotland would on the basis of this metric at least have the possibility of creating a ‘hard’ currency. The government would also have to run a tight fiscal policy to accumulate over a significant period of time. Whether this is a price worth paying is for the referendum next year.
 Director of Macroeconomic Research, National Institute of Economic and Social Research, and Senior Scottish Fellow, Economic and Social Research Council.
 Benjamin Cohen, ‘Beyond EMU: The problem of sustainability’, in Barry Eichengreen and Jeffrey Frieden (eds), The political economy of European unification, Westview, 2000.
 The history of multi-national currency unions is not encouraging. Michael Bordo and Lars Jonung, The future of EMU: what does the history of monetary unions tell us? NBER WP7365, 1999.
 The two other options are joining the euro or ‘sterlingisation’(using sterling without the agreement of the UK). While the euro is certainly a ‘hard’ currency, it is not being considered as an option. Sterlingisation is not a reasonable option given the dependence of Scottish banks on the UK payment system.
 The Office of Budget Responsibility estimates the public sector net debt will be £1,580bn in 2016-17 (when independence would occur) and Scotland’s population is approximately 8.4% of the UK total.
 Not all contracts will be between parties in Scotland, under Scots Law or specify a Scottish court as arbiter. Presumably many corporate transactions are in English Law. In such cases, redenomination could become contested.
 B Eichengreen, (2007), The Breakup of the Euro Area, mimeo.
 The UK Government would have considerable leverage on redenomination and the transfer of debt. It is unlikely that an independent Scotland could simply walk away from a fair share of debt.
 An independent Scotland could conceivably issue sterling or euro denominated bonds and swap the proceeds into the new currency. But this would require an institution (presumably a Scottish bank) taking the currency risk instead.
 Finland is in the euro zone, Denmark is pegged to the euro, Sweden has a managed rate against the euro and Norway is not a member of the EU.
 The Singapore dollar is also fully backed by foreign currency by law.
 There would always be the possibility that the peg would be changed.