Scotland and the banks

The UK government this week ruled out any question of agreeing to a currency union with an independent Scotland. Joseph Cotterill of FT Alphaville explains why the UK unquestionably has the power to do this and there is little the Scottish government can do about it:
"From the date of the Treasury’s promise on gilts, the Scottish government effectively conceded its maximal demand already. Furthermore it couldn’t use market volatility to revive the issue: any share of the debt it paid would be to the UK government. The market itself would trade on the UK’s gilt guarantee...." 
In other words, because the UK Treasury has guaranteed to honour all existing UK debt issuance, the SNP's threat to repudiate Scotland's share of UK debt if it doesn't get currency union has no market impact. It is therefore hollow. The lesson for the SNP is - never, ever underestimate the deviousness of Treasury mandarins.  Wily though he is, it seems Alex Salmond is no match for Sir Nicholas MacPherson.

So where does this leave Scotland's currency conundrum? The following options remain (assuming, of course, that the Scottish people vote for independence on September 18th):

- using sterling without currency union ("sterlingisation"), or another currency such as the dollar ("dollarization")

- creating a new Scottish currency

- joining the Euro.

Andrew Lilico has ably discussed the third of these and I shall not cover it further here except to say that if Scotland joined the EU (or remained in it, depending on your point of view) it would have no choice but to join the Euro. That leaves Sterlingisation and creating a new Scottish Currency. As I shall discuss, there is really little difference between the two.

Full Sterlingisation

First, let me make it clear that an independent Scotland could use sterling as its currency if it so chose, with or without the agreement of the UK government, just as any foreign country can. The UK government cannot prevent it from doing so. Nor would independence mean Scottish banks having to relinquish existing holdings of sterling reserves, as some have suggested. They would simply become foreign exchange reserves on their balance sheets. Scottish banks would no longer have access to Bank of England liquidity facilities, of course, which might make payments a bit clunky until everyone adopted mobile money platforms. But as long as Scottish banks could continue to obtain sterling on the open markets, they could continue to fill their ATMs with sterling notes and issue loans in sterling. Sterling coins would remain legal tender as at present (sterling notes are not, in Scotland).

So far, this is no different from the many small countries that use the US dollar or the Euro. Sam Bowman of the Adam Smith Institute cites Panama as an example of a small country that is successfully using the US dollar as its own currency. Indeed it is. But I fear he is comparing apples with nuclear warheads.

Joseph Cotterill (op.cit) describes full sterlingisation of the Scottish economy as "rather ill thought out" (i.e. batshit insane) given the size of its banking sector. I have to agree. The small countries such as Panama that use foreign currencies do not have banking sectors that are somewhere between 8 and 12 times GDP depending on who you talk to, as Scotland's currently is. For comparison, Iceland's banking sector at the time of its collapse was about 9 times its GDP and Cyprus's banking sector was 7 times its GDP. Furthermore, Scotland's cross-border liabilities post-independence would dwarf those of Iceland. Scotland could not possibly bail out its banks in the event of a financial crisis like that in 2008. But neither the UK Government nor the Bank of England would have any responsibility for doing so either. Full sterlingisation could therefore result in the disorderly failure of Scotland's banks, with catastrophic consequences not only for Scotland but for its principal trading partner, the UK. This is indeed "batshit insane".

Scottish currency with fixed sterling peg

Sam Bowman and Lawrence White of the Institute of Economic Affairs both argue that despite the risks, Scotland would still do best to use sterling without currency union. They argue the case for use of sterling as an anchor for "free banking", in which commercial banks issue banknotes at par with sterling and there is no central bank. As this is how Scottish banking used to work prior to the 1844 Bank Charter Act (though the anchor at that time was gold, not sterling), emotionally this approach might have considerable appeal to supporters of Scottish independence.

But this is not full sterlingisation of the Scottish economy. What they are actually suggesting is a Scottish currency called the "pound" which is legally fixed to sterling at par. This is a logical extension of the present situation in Scotland. Scottish banks issue their own banknotes which are 100% backed with sterling reserves. In Scotland they are exchangeable at par with sterling notes and coins, and both sterling and Scottish notes circulate freely.

Unfortunately the same is not true south of the Border. Scottish notes are not widely accepted in payment for goods and services, although banks will accept them in exchange for sterling. But English banks only accept them because they know that the Bank of England will honour them at par - and that is because of the existing currency union. If the currency union were to end at independence, there would be no reason for English banks or the Bank of England to accept Scottish notes at all, let alone at par. They would, in effect, be a foreign currency.

North of the border, after independence, Scottish notes and sterling notes and coins would continue to circulate freely as competing currencies just as they currently do. But south of the border, Scottish notes would have much less value than they currently have - indeed they might be worthless everywhere except Scotland, just as the "Bristol pound" is worthless everywhere except Bristol. Only those who were doing business in Scotland or planning to travel there would want Scottish notes, and indeed as long as sterling was equally acceptable in Scotland, they might not bother with Scottish notes at all. So there would be a simply enormous exchange difference between Scottish notes and sterling.

This creates a massive problem with White's ideas for free banking based on Scottish currency backed by sterling reserves. White envisages banks being free to issue whatever currency they wish without reserve restriction (the existing 100% reserve requirement would be lifted). But they would be legally required to guarantee exchange of Scottish notes for sterling at par.

At independence, Scottish banks would retain whatever reserves they already have on their balance sheets. But after independence, banks would no longer have access to Bank of England lending facilities, so they would have to obtain sterling reserves in the open market, either by borrowing or purchasing. This raises a difficult question. FX transactions are an exchange. What would Scottish banks have to offer in exchange, if Scottish bank notes were not a tradeable "currency"? And borrowing these days is collateralised (repo). What would Scottish banks have to offer as collateral for sterling reserve borrowings in the open market? Their own government's debt is unlikely to have the standing in the market that UK gilts have. Admittedly they currently have sizeable holdings of gilts, just as they currently have large quantities of reserves. But once they started fractional reserve issuance of Scottish notes, their reserve holdings would quickly diminish. To start with they would no doubt repo out their safe liquid assets for sterling, but once they have encumbered their safe asset holdings, what then? I'm not sure exactly what line a new Scottish regulator would take on the shrinkage of Scottish bank liquidity buffers due to fractional reserve issuance of Scottish notes, but international liquidity standards are getting ever tighter: would a Scottish regulator really buck this trend in the interests of maintaining the Scottish money supply? Under regulatory pressure, the Scottish banks might be forced to restrict both note issuance and credit creation in order to avoid running down sterling reserves. And of course, they would cease to provide sterling notes to the economy at all.

White seems rather keen on this idea (my emphasis):
Should Scotland retain the sterling standard, private banknotes would continue to provide better currency (more reliably redeemable for Bank of England notes or one-pound sterling coins) than currency issued by a new Scottish central bank or currency board. A Scottish commercial bank that fails to redeem its notes or deposits at par in sterling can be sued. A government central bank or currency board that devalues against sterling cannot. The importance of maintaining its reputation in a competitive environment would deter a commercial bank from acting in ways that might endanger its ability to maintain par redemption. A government monopoly faces no such reputational constraint, since its customers have nowhere else to turn.
So, legal enforcement of exchange parity between Scottish banknotes and sterling would be a fixed currency peg, preventing the Scottish currency from devaluing and forcing everyone in Scotland to use Scottish notes. In effect, White is saying that a democratically-elected Scottish government couldn't be trusted to protect its currency. But in proposing a fiat sterling anchor (as opposed to gold) he is implying that a democratically-elected UK government CAN be trusted to protect its currency. This is hardly a ringing endorsement of Scottish independence.

The history of the "Pound Scots" does not suggest that such an implied peg could reliably be held. Reserve-restricted banking is a profit-killer for banks when reserves are in short supply and expensive. And the resulting tight money supply and restricted credit creation can be a serious brake on economic growth. Banks would inevitably resort to fractional reserve money creation, both to improve their own profits and in response to political pressure: I have no doubt that, faced with a credit crunch due to reserve constraints, a Scottish government would want to "get banks lending" just as the UK government has done in recent years. This would implicitly devalue the Scottish notes relative to their sterling reserves. So they would not only be worthless OUTSIDE Scotland, they would be worth less than sterling WITHIN Scotland too. How long does White think the Scottish banks would remain solvent?

White is pinning his hopes on Scotland becoming an offshore tax haven similar to the Channel Islands (since Scotland would be similar to a Crown Dependency after independence). This would attract continual inflows of sterling in much the same way as a persistent trade surplus. If it worked, this would of course ensure an ample supply of sterling reserves, so the liquidity crunch I described would not be a risk. But he should be careful what he asks for. If there is one thing we have learned from the Eurozone crisis, it is that fixed currency pegs and free movement of capital can be a very bad thing. If Scotland attracted all this money, what would it be used for? And how long before private and, perhaps, public debt burdens became unsustainable, as inflows of hot money fuelled credit bubbles?

Anyway, why on earth does he think the UK government would tolerate Scotland becoming a sterling tax haven? I suppose he is looking at the UK's inaction over Ireland and assuming it would do nothing about Scotland. But Ireland is a Euro tax haven. Scotland would be a sterling one - and that is a very different matter. I can't see the UK government doing nothing about it. At the very least I would expect significant cuts in corporation tax, and possibly withholding taxation of cross-border sterling flows - especially if, like the Channel Islands, Scotland remained outside the EU.

But what about the banks?

But there is a much bigger problem here. It's not unusual for economists to take no account of the commercial interests of banks when suggesting changes to monetary arrangements. And I am always amused at their surprise when the results are not what they expected. But in this case they have failed to see a simply enormous elephant.

Although they are, perhaps without realising it, proposing a new Scottish currency, both White and Bowman assume that Scotland would not have its own central bank. Scotland has two very large banks - RBS and HBOS - and a number of smaller players, including the newly-created English bank TSB and the Australian-owned Clydesdale. The majority of both RBS's and HBOS's business is in England & Wales. If this isn't obvious, remember that by far the largest part of RBS's business portfolio is the English banking giant NatWest, and the former English building society Halifax remains the largest mortgage lender in England & Wales, dwarfing the assets of its Scottish parent Bank of Scotland.

NatWest is a wholly-owned subsidiary of RBS which is incorporated in London. Post independence, therefore, NatWest would continue to have access to Bank of England liquidity facilities. Its parent, RBS, would not. If I were running RBS, faced with loss of Bank of England support for my Scottish operations, no Scottish central bank, and a fixed currency peg that would quickly drain my liquidity reserves, I would reincorporate in England. Wouldn't you? Indeed, if the Scottish government refuses to accept a share of the costs of bailing out RBS in 2008, the UK government - currently the largest shareholder - might insist that RBS reincorporated in England, to eliminate the risk that a Scottish government might force RBS to drain liquidity from its UK subsidiary to support its Scottish operations. In fact it might push for this even if Scotland did buy some of the shares.

The other big Scottish bank, HBOS, is already a wholly-owned subsidiary of the English bank Lloyds. HBOS is currently incorporated in Scotland. But faced with the loss of Bank of England liquidity support not only for its Scottish operations, but also for its important Halifax mortgage lending portfolio, wouldn't Lloyds also decide to move its Scottish subsidiary to England? And even if it decided to leave BOS itself in Scotland, the UK regulator might force separation of the Halifax lending book into a new UK subsidiary. Scottish independence could have the perverse effect of forcing further deconglomeratisation of Lloyds.

So I question whether, in the absence of a Scottish central bank, the large Scottish banks would remain either large or Scottish. This might be a good thing for Scotland, since it would reduce the size of its banking sector to something more compatible with its GDP. But how would the Scottish government feel about Scottish currency note issuance being done entirely by foreign banks?

A genuinely independent Scottish currency 

It's entirely possible that the Scottish government would not like Scottish currency issuance to be entirely in the hands of foreign banks. Politically this would certainly be problematic, since currency is part of national identity. So I guess the answer is obvious. Create a new Scottish central bank responsible for issuing Scottish pounds, fully backed by the Scottish government. And end the anomalous creation of Scottish notes by banks.

In the interests of cross-border liquidity, it would be wise for the new currency to be tradeable. But the Scottish government would have to decide whether or not to allow the new currency to float. It might be wise for a new Scottish currency to be pegged to something, probably sterling but potentially also either the dollar or the Euro. New currencies tend to take a beating on foreign exchange markets, especially when the country's debt doesn't have a good credit rating either - which in Scotland's case it won't, simply because of the lack of any credit history. In the interests of inflation control, therefore, a peg to a stable currency in good standing would be a sensible move, although I think it should not be a fixed peg such as White suggests - a crawling peg or something similar would be more sensible.

But Scotland's government should understand that this dilutes its independence. In effect, it would be giving up control of monetary policy to the country whose currency it is using as its anchor. And this would also to some extent dictate its fiscal policy too, since monetary tightening or loosening due to changes in the value of the "anchor" currency would require a fiscal response that might not be what the Scottish economy needed or its people voted for. Is this what the SNP really want?

If it really wants independence, then the only alternative is a new tradeable Scottish currency floating freely against all others (although it could be pegged to a commodity such as gold or oil). Whether it is issued by a Scottish central bank or by commercial banks in a "free banking" model is really not that important. What matters is that the currency should be genuinely independent. If it is not, then neither is Scotland.

UPDATE

For those who are not clear why a fixed currency peg combined with free capital flows necessarily means that monetary policy cannot be independent, I am adding this link about the so-called "impossible trinity" or "trilemma". It's Wikipedia, but pretty clear and about right, and has a handy diagram.

FURTHER UPDATE

Here are two further links, respectively from pro-independence and anti-independence writers, both arguing that currency union is not a flier. Sillars (pro-independence) is strongly in favour of a Scottish currency. Tomkins (anti-independence) is more noncommittal but gives a very good explanation of the reasons why the UK will not agree to currency union.

Time for wise leadership on currency - In Place of Fear (Sillars)
The SNP's currency nightmare - Notes from North Britain (Tomkins)

And here is the BBC's writeup of Andrew Marr's discussion with Jose Manuel Barroso, President of the European Commission, in which Barroso confirmed that an independent Scotland would have to apply for EU membership and might find it difficult.





Comments

  1. I bags naming it. It's got to be mickles and muckles. Anything else just won't do.

    ReplyDelete
  2. The model Scotland should follow is that of Norway; independence means self-reliance, being beholden to no one. Like being self-employed, but with a lot of natural resources to make the long dark nights cosy. They could have the truly independent Scottish shilling of 100 cents...

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  3. What Scottish banks under sterling-isation, currency peg or anything else? There would be none. RBS, TSB and every bank which does business in the city of London would re-incorporate in London as soon as feasibly possibly.

    Any sane Englishman will be withdrawing deposits, assets and business without explicit guarantees by the Chancellor and\or Bank of England.

    The SNP will be begging the English to take them off their hands to stop a run on them , stop them going bust and to save thousands of Scottish jobs.







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  4. Oh where to start!

    Panama? Why would that count as an example that indy Scotland would wish to follow?

    Dollarization in Panama makes sense. The country gained independence in 1904 about the same time that the Panama canal was in the works ( a US funded construction).

    According to the treaties governing the Canal the US was the de-facto and de-jure custodian of the water passage till 1999.

    The US built the canal but also operated it for 99 years, taking into account that around 80% of Panama's GDP relates to Canal operations, the dollar was THE currency of choice, since there was a dependency with the US operators of the Canal.

    In essence Panama had a guaranteed inflow of dollars for 99 years so pegging the balboa (no relation to Rocky Balboa guys sorry) to the dollar made perfect sense.

    In the case of Scotland there is no guarantee of a continuous inflow of pound sterling. If Scotland pegged its currency to the pound it would probably share the fate of Argentina rather than Panama.

    Secondly banks (although banks count as the no.1 concern) I don't agree with Frances insofar as banks would reincorporate in England. It makes absolutely no sense for the BoE to allow (post independence) RBS to transfer to England. Why should it? RBS is an ongoing concern and there will be further implications post independence. The BoE will be taking additional risks on board by allowing RBS to reincorporate in the UK.

    Chances are the BoE will force RBS (post independence) to convert its UK branches into a subsidiary ringfencing UK operations from the rest of the group. The BoE has applied similar measures in other cases. In 2012 they force converted Bank of Cyprus branches into subsidiaries sheltering UK based customers from the raid on deposits that followed in 2013.

    Under this scenario RBS can't drain RBS UK subsidiary since regulators will intervene once they see capital fleeing north.

    Take Italy's Unicredit it owns a German subsidiary HypoVereins Bank, with the on going euro crisis and credit crunch in the periphery, Germany's Fin.Services Regulator BaFin has stepped in on a number of occasions hindering fund movements between parent and subsidiary. Bear in mind that both Italy and Germany are Euro members. The EU commission is examining whether BaFin has violated any rules.

    Clearly the PRA/FCA will be more effective than BaFin since they will be dealing with a foreign non-sterling country.

    As for the EU. All new members to the EU are forced by accession treaties to adopt the Euro. The UK Denmark and Sweden secured opt outs but the new treaties do not afford new members such luxuries. Also as per EU's (abysmal) financial crisis management rules, euro members and applicants are forced to sign very tight fiscal policy contracts with the EU the so called Fiscal Compact and Six Pack forcing members to tighten their belts. It's Maastricht on steroids!
    If Scotland proceeds with EU accession talks they will be doing nothing less than letting Brussels tie a noose around their necks wantonly committing suicide....

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  5. George,

    the decision to reincorporate in England would be made by the banks themselves, not by the Bank of England.

    Otherwise a great comment. Thanks!

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    Replies
    1. Frances

      I am not so sure about that. If Scotland secedes from the UK wouldn't RBS (assuming that at the time of independence its domicile is Scotland) be considered a foreign bank and require regulatory approval to set up shop in England? Of course should RBS decide to reincorporate in England before Scotland secedes then yes you are correct it's not BoE's decision.

      Even if RBS moves to the UK any capital transfers to its foreign country (Scotland) subsidiary (in the absence of a currency union) will be scrutinised and can be halted by regulators a la BaFin-HVB-Unicredit.

      Delete
    2. George,

      If RBS left its decision until after independence, then yes it would require regulatory approval. But I don't think that approval would be denied. The UK has form on this: HSBC moved its headquarters from Hong Kong to London in 1992, partly because of the forthcoming return of Hong Kong to China and partly because it was taking over Midland Bank. The arrival of HSBC was welcomed by government at the time and there was no regulatory opposition. I suspect that an application from RBS would be treated similarly because of its ownership of Nat West.

      The UK generally does not like interfering with transfers between parents and subsidiaries.

      Delete
    3. Frances,

      HSBC - RBS different banks, different times. If I was BoE's governor I would see independence as a golden opportunity to strengthen the system by dumping the problematic RBS/HBOS onto Scotland ringfencing any UK holdings from the parent. One less problem to worry about.

      In any case, splitting a banking system as immense,as deeply interconnected, as complex and with a large international footprint as that of the UK will be an interesting case study. As far as I am aware it hasn't been done before. The closest example I can think of is the Austro-Hungarian Empire (which didn't play out well) but banks were not as large or complex back in the day!

      Have a nice day, I'm off with my b*tch and my mutt! Walk time is upon us!

      Delete
  6. On the truley independent currency issue, how about a Currency pegged to GBP for 5 years (say) that then floats? If the issue with a floating currency from the start is lack of credit history causing high prices, then let's build up a history first?

    (I think a lot of the debate on independence is being held on a very short term view, considering the economics immedietly after independence, when really we should just admit that might be turbulent times and also do our best to consider the economics decades after independence)

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  7. Who is this senior civil servant anyway? He'll be one of those types who salivated over the McCrone Report in secret dreaming up new roads to improve his commute to work while the Scots were lied to prior to the last referendum is he? Scots have learned about his ilk at a very great cost. Such a shame rUK don't learn such lessons quickly enough to ensure they aren't sitting helplessly by as senior civil servants jump on those gilded revolving doors to the board rooms of formerly public institutions. Like hospitals.

    Who pays his wages? Does he work for some rUK authority? What happened to his political neutrality? Gone the same ditch as the political neutrality of the mandarins at DWP has it? And he showed that off in public too? Amazing who often in one week the Scots have shown Whitehall to be what it really is for all the world to see, to whoever cared to observe. A Mandarin crafting a list is showing Salmond what? A list. When will these Mandarins produce a list of torture victims to show the British public how badly their politicians serve them? Don't Mandarins think the public should know about the war crimes? Why aren't these people, in the interests of the nation, backing up Craig Murray? Too busy dealing with the Scots democratic silliness are they? Ah the cherry picking innocent-faced mandarin. How trustworthy and clever they are!

    Now, the No campaign on the other hand, along with Westminster/Whitehall...they do struggle with even the basics, don't they! They really are silly. They are convinced the Bank of England is the Bank of England. Now, there is a misnomer if ever there was one. Surprisingly enough, the Bank of England is the Central Bank of the UK. Did the the name on the headed notepaper fool anyone? Tell me it didn't! They really do need to get to grips with language. GB isn't another word for England and just because a UK institution is branded as English, doesn't mean it is. Informing the public of that must have fallen off the Mandarin's list of to-dos I suppose. How odd.

    When the Scots go... what makes anyone think they won't be taking the Bank of England with them? Scots could take the bank, and rUK could take the Trident bombs and keep the Olympic stadia. Fair swap!

    How are those debt guarantees looking to the markets now? No. They aren't reacting to anything the Scots are demanding? They aren't reacting to anything denied to the Scots? Not yet anyway.

    I'm sure the markets won't mind at all. What? The Scots won't get their fair share... I wonder what the markets would make of a country robbing their "best friends", those "equal partners" so blatantly? Rob the Scots. Do it. And next time rUK wants help... who will answer the ringing phone? And when rUK does get an answer what interest rate will be offered? A country that can't, won't feed it's poor, selling off anything that isn't nailed down, robbing it's best friend, the friend it relies on for energy, that can't sort out flooding... what interest rate will be on offer?

    No. Of course the markets won't react, of course they won't see rUK as an untrustworthy basket case no one should deal with. Not at all. The civil servants have it all in hand. Of course they do. They know what they are doing. Yes.

    Restoring Scotland to an autonomous nation is not such a big deal. Many a country have done just that in the last 100 years. The Scots have been busy studying. London, on the other hand, they appear to be busy selling of whatever they can lay their hands on. The world has experience. Sorting out a Central Bank should they decide to have one won't be too much of a problem. And they'll inform the rest of the UK of that decision when they decide the time is right, not when some ignoramousaurus of the BBC pouts: Tell me now or I'll pretend you are stupid.

    ReplyDelete
  8. I like the entrepreneurial attitude of Anonymous: "Restoring Scotland to an autonomous nation is not such a big deal."

    As an immigrant from Indonesia now living in England, I grew up watching the troubles of Timor-Leste. So I'm quite interested to see how Scottish independence will play out.

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  9. " Only those who were doing business in Scotland or planning to travel there would want Scottish notes, and indeed as long as sterling was equally acceptable in Scotland, they might not bother with Scottish notes at all. So there would be a simply enormous exchange difference between Scottish notes and sterling."

    I've seen this case made a few times, and if it were 1982 it would have value. Debit cards, anyone...?

    ReplyDelete
    Replies
    1. Debit card use would require sterling reserves, which in the absence of central bank support the Scottish banks would have to obtain on the open market, as I explained in the post.

      Delete
    2. Yes, but isn't it the case that Scottish banks currently hold sterling reserves in order to underwrite the currency they already print?

      This does seem a little like a 'twonk' issue, used by people with one particular viewpoint in any choice of two to present complexity as a reason to subvert a fair choice. Please note, I'm not suggesting that you're guilty of this at all, but rather the complexities you present - all valid, I'm sure, but then again, all solvable with a little will - could easily be spun as insurmountable by those with an agenda.

      Delete
    3. Scottish banks have sterling reserves to support the currency that is CURRENTLY IN CIRCULATION. Not to support currency they will print in the future. Do you want Scotland's economy to grow? Growing economies require more money to be in circulation.

      Delete
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