Scotland: A Significant Event Risk

September 18 is the day the citizens of Scotland who are resident there will be able to vote on whether or not they wish Scotland to remain united with England as part of the United Kingdom or to separate and become an independent country. Until about a week ago, the chances for a majority “yes” vote were widely thought to be limited – a “tail risk” for investors. Then several opinion polls indicated that the share of respondents in favor of Scotland’s leaving the UK was roughly equal to the share wishing it to remain in the union. It is not clear that those indicating “yes” to a poll taker will vote the same way in the privacy of a polling booth when they consider the possible economic implications and the great uncertainty as to the outcome of the lengthy negotiations that would follow a “yes” vote. Nevertheless, the possibility of separation has become a significant “event risk" for investors and is already having effects beyond the UK. For example, in Spain, where there also is significant pressure for the separation of the Catalonia region from Spain, bond yields have bounced up.

A poll released yesterday gave the “no” vote a slight lead, relaxing investors’ anxiety a bit. But the outcome remains too close to call with any certainty.

The list of uncertainties about the outcome of negotiations that Scotland would have to undertake on the path to becoming an independent nation (not only with England but also with the European Union, NATO, and other international organizations) is long; and many have serious implications, the majority rather negative in our view. Here are some of the more important questions.

Will Scotland be able to continue to have the pound as its currency? The leader of the independence movement, Alex Salmond, includes keeping the pound as part of his vision of an independent Scotland. However, the governor of the Bank of England, Mark Carney, threw cold water on this option, saying that a currency union between the United Kingdom and an independent Scotland would be “incompatible with sovereignty.” There will then remain two main options for an independent Scotland – either to follow the pound without being able to have a say in BOE monetary policy and therefore having to rely heavily on fiscal policy, or to have a separate free-floating currency and independent central bank that would have control over monetary policy, though the country would likely face higher sovereign borrowing costs.

A separate currency would also impose transaction costs on trade between Scotland and England. Non-oil exports to the rest of the UK amount to about a third of GDP. Some firms may decide to relocate activities in the rest of the UK. This seems most likely for financial firms. Indeed, Scotland would have a banking system that is very outsized. According to Credit Suisse, Scottish banking assets are some 1200 percent of GDP. The Lex column in the Financial Times suggests “the RBS [Royal Bank of Scotland] and Lloyds, seeking certainty on currencies and deposit guarantees, would probably decamp for the UK.” Standard Life has indicated they also would consider moving their headquarters to London if Scotland votes for independence. Who would supervise the banks and other financial firms and guarantee bank deposits and who would be the lender of last resort are other important uncertainties.

North Sea oil and gas production raises other important issues. Will production lie largely within Scotland’s territorial waters? The Northern Isles, including Shetland and Orkney, could decide not to be part of an independent Scotland. Their territorial waters cover a large portion of the oil and gas fields.

Another uncertainty is membership in the European Union. An independent Scotland might well be welcomed into the EU, but the process may not be smooth or quick. A number of EU members who have separatist movements of their own would be reluctant to appear to endorse a successful breakup of a sovereign country.

NATO membership is a question as well. The UK’s nuclear submarine fleet is based in Scotland.

We will not go into the complex budgetary and taxation issues a move to Scottish independence raises. We would just note that Scotland relies on transfers from England to balance its capital account. England will remain the guarantor of the existing debt. Scotland will owe its share of the debt to England and is likely to be faced with higher financing costs than England is. Scotland hopes to move to a lower corporate income tax in order to attract business, following the example of Ireland. Their timing may be off on this, as the UK has indicated it will be reducing the corporate income tax, and the same may also happen in the US.

While we do not yet know the results of the September 18 vote, nor the eventual answers to the above and other uncertainties that would follow in the event that “Yes for an Independent Scotland” carries the day, we do know that markets do not like uncertainties. Both the pound and the UK equities market have been hit by concerns about Scotland’s future, despite the relatively strong performance of the UK economy.

We are underweight UK-specific ETFs, relative to our benchmark, in our International and Global ETF Portfolios, and we are following developments with great interest.

BY Bill Witherell