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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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