Breaking up union is hard to do
The Bank of England should prepare for the possibility of Scottish independence
by John Nugée
Tue 13 May 2014
For much of 2012 and 2013, markets were concerned with the possibility that one or more countries might leave the euro area. That this is no longer considered likely, is partly due to the recovery in peripheral countries’ economies, and partly due to the European Central Bank’s (ECB) repeated resolve not to let it happen.
But there is another monetary area, which might well see a change of membership, and rather sooner than markets expect. That is the sterling monetary area, presided over by the Bank of England (BoE).
At the moment few people consider sterling to be anything other than the single currency of a single state, the United Kingdom. And markets have yet to show that they have begun seriously to factor in how the referendum in Scotland in four months might change this. But with the polls narrowing north of the border, it is no longer sensible to rule out the possibility that the pro-independence campaign might be successful. And if it is, this will pose a problem for the BoE.
While much is unclear about the terms of any separation, the Westminster parties have stated categorically that on the currency, an independent Scotland will not be offered the status quo, i.e. a full monetary union with the rest of the UK. And whatever alternative currency arrangements Scotland does adopt – whether sterlingisation, a separate currency pegged to sterling or a separate and floating currency – will take time to decide and construct. In the meantime, there will be significant uncertainty, and the potential for a very British form of capital flight, as people resident in Scotland seek to move money to bank accounts south of the border, to make sure that it stays in sterling whatever Scotland decides.
Nor is it possible to take much comfort from the fact that although the referendum is this September, any actual independence will not be until 2016 at the earliest. Markets and finance tend to move in anticipation of events, and the process is likely to start as soon as the result of the referendum is known.
This has the potential to put strains on Scottish banks’ liquidity, in exactly the way that banks in the periphery of the euro area found that their customer deposits were being run down during the height of the euro crisis. The natural response from the BoE will be to extend credit – against collateral of course – to any Scottish bank requiring funding. And as long as Scotland has not yet left the UK, there is no reason for them not to.
Except that following a Yes vote, Scotland and its banks will be ‘in the departure lounge’ – not yet left the UK, but about to. And when they do, the funding for the Scottish banks will turn into an international exposure. The analogy is with the Target-2 balances in the euro area, which are not an issue if no country leaves the euro, but very much an issue as soon as one does.
The ECB claimed that, since exit from the euro was impossible, concern over Target-2 balances was unwarranted. The BoE will not have that luxury if Scotland votes to leave.
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