Scotland’s intention to issue its own government bonds has left more questions than answers. The crucial question from a borrowing perspective is whether it will be cost-efficient. The answer to that lies in how Scotland will approach the capital markets. If the strategy is to become a frequent borrower, it could well be a good move.
In October, Humza Yousaf, the Scottish first minister, said in a statement that he has ‘commissioned initial work including due diligence assessments with the aim of making the bonds available to the market by the end of the current parliamentary session’ in 2026.
There is no doubting that Scotland will pay a premium for its so-called ‘kilts’, versus the UK’s gilts, but exactly what that premium will be depends on the nature of Scotland’s status as a borrower and the credit ratings it receives.
If Scotland becomes a sub-national borrower that is still part of the UK, and assuming the issuance is explicitly guaranteed by the UK, its credit rating will not be much different to the UK’s double-A ratings as there will no extra credit risk for owning these bonds. In this case, Scotland is likely to only be rated one notch below the UK with a single-A rating, with the slight difference reflecting the smaller sized issuance and lower levels of liquidity.
In this scenario, debt capital markets professionals expect Scotland to pay a premium in the range of 20-50 basis points over gilts. But an explicit guarantee also comes with its own issues.
Several responses to the UK Treasury’s 2013 consultation on Scottish government bond issuance noted an explicit guarantee would impose an additional contingent liability on the UK’s fiscal budget. One respondent suggested this liability could be mitigated, however, by charging a fee in exchange for the explicit guarantee. Issuance with an explicit guarantee would also be counter-intuitive to the Scottish National Party’s aspirations for independence and greater autonomy over its finances.
As a standalone borrower, without an explicit guarantee, the spread of kilts would be around 30bp higher at around 50bp-75bp over gilts, according to senior market participants. It would be a difficult price discovery process, given the lack of other explicitly guaranteed UK issuers. But European and Canadian sub-sovereigns, as well as other crown dependencies such as Jersey and Guernsey, all trade at around 70bp over gilts. There are also historical examples with the UK local authority issuances and bonds by the likes of National Rail and Transport for London, as well transactions by Glasgow City Council through a special purpose vehicle. In both cases, explicitly guaranteed or not, investors will also be taking on the risk of Scotland’s constitutional future.
An independent Scotland would be a completely different ball game in terms of both its credit rating and premium. Investors would be looking at an entirely different entity, exposed to a range of economic and monetary risks. A report by S&P ahead of Scotland’s independence referendum in 2014 noted that ‘a decision by a sovereign Scotland to issue its own new and untested currency or to unilaterally adopt the currency of another sovereign without gaining access to that currency’s lender of last resort could pose some initial risks to external financing’. It added that an independent Scotland would also find it hard to have access to the same deep capital markets it would have as part of the UK.
Does it make sense for Scotland to issue kilts?
Any issuance at present would be purely symbolic as, under the current legislation, Scotland can only borrow £450m per year and £3bn in total, with the former representing less than 1% of its total annual budget. If Scotland was to take its government bond issuance seriously, it would need to have the authority to borrow a lot more. This would also help bring the cost of its issuance down and lower its premium to gilts.
What are the alternatives to government bond issuance? Scotland borrows at the same rate as the Treasury via the National Loans Fund, where the spread is currently 11bp over the gilt yield curve priced daily. Anything above that is going to be seen as expensive. But if there is a plan to become a frequent borrower, the cost would come down and there would be range of other benefits, not least having the ability to access capital markets on its own should Scotland gain independence.
Additional benefits include having a diverse range of funding sources and therefore greater flexibility on how it borrows. The structures available through the NLF are limited in comparison to traditional government borrowing via bond markets.
Entering the capital markets would also raise the profile of Scotland to international investors and help develop its own investor base. There is pent-up demand for sterling assets, although lot of this is being sucked up by the UK’s huge amount of net borrowing. There is a price for everything, but that price for Scotland is only worth paying if it is serious about kilts.
Burhan Khadbai is Head of Content, Sovereign Debt Institute, OMFIF.