Answering your questions
Many thanks to those who have tried out the tool, and engaged with our analysis.
We would like to keep updating this site and using it as a place to explore some of the issues around currency and Scottish independence. New data will emerge, further details of plans will be announced and colleagues will contribute to and challenge our analysis.
One of the goals of Our Money is to keep the conversation around currency at the heart of the debate about Scottish independence. In that spirit, we wanted to answer some of the questions that we’ve seen come up over the past couple of weeks, and provide some more details about our analysis.
The SNP says that after a transitional period where Scotland keeps using British pounds, it will introduce its own currency. The timeline for this is not provided by the Scottish government – they say it will happen ‘as soon as possible’ and will be determined when a set of (currently undefined) criteria are met around fiscal sustainability, institutional preparedness and market credibility.
However, the Scottish government does not have the luxury of setting its macroeconomic policy in a vacuum. Lending markets will have a keen eye on Scotland as it treads a path towards independence. It is our view, based on the extensive international finance literature, that these markets will force the shift to a new devalued Scottish currency far more quickly than the Scottish Government suggests. The problem is this: the First Minister is proposing that lenders hand over billions pounds worth of sterling to an independent Scotland. However, because she is also proposing Scotland moves to a new currency, she cannot guarantee to those lenders that they will be repaid in Sterling, or at all.
The markets have a habit of decrying this kind of uncertainty. They would likely create pressure (for example by increasing debt costs for Scotland) that would act to force Scotland’s hand and push it towards a more sustainable settlement – its own currency. This would most likely be immediately following independence if not before.
As the widespread evidence on historical devaluations demonstrates, once this new currency is introduced, it is our view that a depreciation would persist until the underlying fundamentals point in a different direction. In the immediate days following a devaluation exchange rate changes would likely be volatile, as foreign exchange markets often are in response to big events, and overshoot ‘fair value’. Ultimately, the ‘fair value’ of Scotland’s currency would be 20-30% lower than the British pound, and the valuation would trend towards this level.
I would expect the devaluation to persist until the underlying macro fundamentals changed and, particularly, the balance of payments deficit. If the standard traditional trade elasticity conditions hold, the currency depreciation in itself should help to address the balance of payments deficit although will take time and will need to be supported by conservative fiscal policies if the Scottish Government wished to turn the devaluation round over time. There is also the possibility, due to the so called ‘J curve’ effect that Scotland’s Balance of payments deficit would worsen in the short term.
The Scottish government may well indeed seek to peg the value of the Scottish pound to the British pound (or Euro) when the currency is launched, but it would need to ensure that the value set for the currency was at a fair value. This would require them to set the currency in the 20-30% devaluation range that we have referred to. Otherwise they would face a very costly speculative attack on the currency which would result in the classic combination of high interest rates, currency depreciation and massive foreign exchange rate losses. Crucially, also it would need to have its own central Bank with the institutional structure to run such a regime including the ability to print money.
By pegging a country’s currency to other currencies, the Scottish Government would be giving an unlimited commitment to defending the currency at the pegged rate. This means that the rate at which you peg has to be at fair value and that you need to have very large foreign exchange reserves to defend the peg to counter any potential speculative attack and have macroeconomic policies which are in line with a pegged rate. Other countries that peg their currency have foreign exchange reserves in the range of 20% (Denmark) to 60%+ (Singapore) of GDP and run conservative fiscal policies in order to generate the necessary foreign exchange reserves, which are a form of national saving. Indeed, most countries that peg their exchange rate run fiscal surpluses which would certainly curtail the flexibility of macroeconomic policy-making.
Few countries build their foreign exchange reserves by borrowing, as suggested by The Scottish Government in its recent economic statement for an independent Scotland. It is not a credible policy to financial markets and is often a signal that a currency is about to be subject to a speculative attack.
As one of Scotland’s – and the world’s – leading economists and currency experts, Ronnie has set out the currency options for a newly independent Scotland. Now take the test to find out what they would mean for you.
The interest rates offered on government debt have to respond to the market’s willing to lend at those rates. There are several factors that mean that Scotland’s interest rates are likely to be higher than those offered by the UK. These can be thought of as ‘premiums’ which are applied to the current rate of interest.
Liquidity premium: Scotland is a smaller economy, with a smaller total debt pile than the UK. This means the market for its debt will be smaller. There will be fewer people looking to buy and sell its debt at any given moment. This means that the government will have to offer a more attractive interest rate in order to ensure that its debt can be shifted, and to keep the market moving. This is estimated to be 0.7-1.7% in a normal interest rate environment. During the past decade of very low interest rates, experts estimated it at 0.4-0.9%
Initial premium: A new currency has to rely on new and untested fiscal and monetary institutions. In the early days of such a scenario, lenders will demand a premium on debt offered by a government to cover the risk that its institutions are not well set up to maintain economic stability. This is estimated to be of the order of 1% when a new currency is launched. Over time, this initial premium should fall.
Exchange risk premium: A new Scottish pound would be expected to fall in value by 20-30% against the British pound. Even after such an event, there would be expected to be volatility in its value, whilst the currency was establishing itself, and whilst a market equilibria is found. This risk of variability in the exchange rate would be factored into an additional premium on the debt, as changes in that rate affects the value of the debt and interest paid.
If the Scottish pound depreciated by 25% against the British pound, it would be worth £0.75. If we wanted to buy a pint of milk for £1 (British) using Scottish pounds, it would now take (1/0.75 =) 1.33 Scottish pounds. So for Scottish people, a devaluation of 25% causes the cost of buying foreign goods and services to increase by 33%. A 20% devaluation increases costs by 25%, and a 30% fall would increase import prices by 43%.
When a new Scottish currency is launched, its value will be determined on the financial markets. The value of a currency is influenced by a range of factors that help central banks and investors to judge its ‘fair value’. The current account balance is the most important input, but others such as productivity and total debt also play a role.
Scotland’s economic data suggests that a Scottish pound would be worth 20-30% less than a British pound. The current account deficit is estimated to be far worse than the UK’s, as is the fiscal deficit.
Balance of Payments (Current Account) Deficit: Data from the Scottish National Accounts Programme indicates that Scotland has run a persistent onshore trade deficit over the whole period it covers (1998-2020) and the deficit has risen sharply since 2017 with an increase from 6.0 to 8.3% of GDP. The most recent calculations for the offshore account and net primary income are for 2017. Using this data yields a current account deficit of 10% of GDP in 2017, and given past historical estimates of the current balance are similar, there can be little doubt that as things stand an independent Scotland would inherit a current account deficit of at least this magnitude. The UK’s deficit has ranged between 2% and 5% in the last couple of decades.
Fiscal Deficit: Prior to the pandemic, the GERS (Government Expenditure Review Scotland) showed a deficit of 9.2-10.8% of GDP from 2016/17 to 2019/20 excluding the north sea, or 7.7-10.1% including the North Sea. There was a spike in 2020/21 (23.8% of GDP without the North Sea, 22.4% with). This year, the war in Ukraine has driven up oil and gas prices, which means that the deficit figure is likely to be lower than usual. Fundamentally, Scotland’s fiscal deficit is around 10% of GDP. In 2016-19, this was 2-3% for the UK government, although the pandemic and energy crisis have caused short terms increases. If Scotland were to take its share of UK debt with it into independence, it would have a debt to GDP ratio of around 100% which is also relatively high.
Our goal is to help people to understand how Scottish independence, and the choice Scotland makes for its currency, would impact them and why.
Our work is based on analysis by one of Scotland’s leading economists, Professor Ronald MacDonald.
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