Berenberg Macro Views Narrowing Scottish polls raise UK ...Berenberg Macro Views Economics 1 Narrowing Scottish polls raise UK political risks • The UK recovery is increasingly solid,

Berenberg Macro Views

Economics

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Narrowing Scottish polls raise UK political risks

• The UK recovery is increasingly solid, but political uncertainty looms: Uncertainty could knock our above-consensus growth forecasts of 3.1% and 3.3% for 2014 and 2015 off course. Scottish independence (18 September referendum) is one key risk. Support for independence has risen by 5-10 points since December (Chart 1).

• We do not expect politics to derail the recovery: Those opposing Scottish independence still have a large lead. But we need to watch the risk carefully. The polls will probably tighten further as the vote nears.

• Only a small economic impact before the vote: Further narrowing in the polls would fan uncertainty. But ahead of the comparable 1995 Quebec independence vote, Canadian bond yields changed little.

• Mind the incentives: There are upside as well as downside risks from the Scottish vote. An independent Scotland, or one with more policy levers from devolution, would have strong incentives to implement pro-growth reforms. Alternatively, it could lurch to the left.

• Transition would be painful: Uncertainty and perhaps austerity would seriously dent the economy north of the border during the transition to independence. UK growth would also be hit. But all parties would have strong incentives to prevent a calamity.

• Watch the risks: The deal after a yes vote could take a long time to agree, dragging out uncertainty. The question of what currency Scotland would use has the potential to cause significant disruption.

• Brexit: With a pro-EU part of the UK gone, markets might worry that the “rump UK” could vote itself out of the EU. That serious uncertainty would cast a shadow over the investment outlook.

• The May 2015 UK general election is a source of uncertainty too: The two main parties are neck and neck in the polls. Either could win. But there is a significant probability of a hung parliament, raising the chances of a left-leaning coalition government and some mildly anti-business policies. Scottish independence could force another general election a year or so after May 2015.

Chart 1: Scottish independence campaign gains ground

No lead, excluding don’t know responses. Each diamond shows an individual poll result. The line shows the average of the last available observation from each of the six polls. Source: UK Polling Report.

Key Macro Views reports

Understanding Germany – a last golden decade ahead 13 October 2010

Tough love: the true nature of the euro crisis 20 August 2012

Long and winding road: UK unemployment 4 September 2013

Home truths: UK housing 18 September 2013

US date with destiny 10 October 2013

How low can it go? British saving 1 November 2013

Guidance irrelevant 14 November 2013

Europe 2020: Reaping the rewards of reform 26 November 2013

Euro Plus Monitor 2013: From pain to gain 3 December 2013

Global outlook 2014 13 December 2013

UK: Snowballing recovery means earlier rate hike 13 December 2013

Do the mistakes matter? BoE Inflation Report 13 February 2014

21 May 2014

Rob Wood Chief UK Economist +44 20 3207 7822 [email protected]

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Big political risks this year

Just as the economic outlook is clearing, the political one is clouding. That could prevent the surge in business investment needed to make the recovery sustainable, posing risks to our above-consensus UK growth forecasts. We do not expect the risks to materialise, but they are worth watching carefully.

Uncertainty, the enemy of growth, is likely to rise as Scottish independence polls narrow. The no to independence campaign leads ahead of the 18 September referendum, but that lead has fallen (Chart 1) and Quebec’s 1995 experience with an independence vote suggests further narrowing (Chart 3). The May 2015 general election could also raise uncertainty.

Focusing on the economics of independence, there are upside as well as downside risks. We expect a no vote. But in the event of a yes, politicians would have strong incentives to agree a quick divorce, given the economic fallout of dragging their feet. There could be some long-term upsides for Scotland. An independent Scotland, or one with more policy levers from further devolution, would have greater incentives to implement big reforms that deliver a more dynamic economy. Politicians hold the key.

In the event of a yes, the transitional period after the vote is likely to see a serious setback for the Scottish economy and a material hit to the “rump UK” (RUK). It is impossible to estimate the precise impact. But the recent experience of elevated uncertainty suggests a material effect. Scotland may need significant austerity, and a new currency could cause significant disruption. A left-leaning government that has not issued debt before could scare markets. Emigration could rise. But the RUK would probably help to contain the risks. It has no interest in seeing the Scottish economy collapse.

The key risks are: RUK and Scotland might not agree a quick deal, due to the emotive issues at stake; the resilience of the Scottish financial sector to a split; and a Scotland from the UK would make a British exit from the EU much more likely in 2017.

There is a significant probability of a hung parliament in the May 2015 general election, raising the possibility of a left-leaning coalition. If Scotland voted out, another general election may need to be held when Scotland becomes formally independent, meaning more uncertainty.

The political outlook is a risk to our above-consensus growth forecasts Uncertainty is likely to rise as Scottish independence polls narrow

Long term, there are upside as well as downside risks from Scottish independence

The transitional period after a divorce would be tough economically There are big risks

A hung parliament looks likely in 2015

Chart 2: General election polls close Chart 3: Quebec polls narrowed

Average of last five polls. Source: UK Polling Report, last accessed 20/5/14, Berenberg calculations

Polls ahead of 31 October 1995 Quebec sovereignty referendum. Excluding don’t knows. Source: Johnson and McIlwraith (1998)

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Scottish referendum polls

The catalyst for poll narrowing this year seems to have been the Westminster parties ruling out a currency union with an independent Scotland. Lecturing from Westminster did not seem to aid the yes vote. Chancellor George Osborne led the argument from 13 February, which was followed by a rise in support for the yes vote.

A new catalyst for further erosion of those opposing independence’s lead could be the 22 May European elections. The latest polls put the opposition Labour party and the anti-EU United Kingdom Independence Party (UKIP) neck and neck with around 30% of the vote.

Scottish voters are Europhile compared to the rest of the UK. In the latest YouGov survey, they would support membership of the EU by 54% to 24%, compared to 42% to 37% for the UK as a whole. UKIP leader Nigel Farage has little support north of the border. A recent visit was cut short amid abuse directed at him. Scottish Leader Alex Salmond could use a UKIP win in May to rally more support to his independence cause.

Careful, polls differ widely The polls differ wildly in the support they attribute to the yes and no campaigns. The polling is more sporadic than for general elections, and the question differs between polls (Table 1). So figuring out support for independence requires some judgement. Simply taking the average of the last few polls could be very misleading. If polls that tend to find the most support for independence happen to be taken more frequently – as they were last month – support for a split will appear to rise more than it really has.

Polls that record the most support for those opposing independence ask the more appropriate question in our view, so we place more weight on them. Those polls ask how people would vote if the referendum were held right now. The surveys finding the most yes support ask how people would vote in a referendum held in September. That may make the decision seem less urgent, and raise the possibility of the person being polled changing their mind at a later date. On that basis, the no lead is still probably 10-15 points.

But the lead has narrowed across all polls. And it is impossible to know for sure which poll is giving the most accurate reading. An additional uncertainty is that 16 and 17 year olds can vote in the September poll. It is not straightforward to appropriately weight survey responses given the lack of voting history for that age group. Importantly, they show relatively high support for a split. Bottom line, the race could already be tight, and will probably tighten further.

The no’s lead should be sufficient, but polls will probably narrow Quebec is not a perfect example, but it is one reasonable comparison we can use. The 1995 poll question there was less clear than in Scotland. Quebeckers were asked whether they wanted “sovereignty”, which was widely misunderstood.1 The polls narrowed by up to 10 points in the two months

Yes support rose after George Osborne entered the fray European elections could be a catalyst for further poll tightening UKIP win could rally support for independence among relatively europhile Scots The polls differ wildly We place most weight on the polls giving the most no support The no lead has narrowed across all polls

The Quebec example shows the polls will probably narrow further

1 Smith, B (2013), ‘The Quebec Referendums’, House of Commons Research Paper 13/47.


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prior to the vote (Chart 2). That vote ended 50.6% voting no to sovereignty.

As continued campaigning makes the idea of Scottish independence seem more reasonable, support for it could rise. Moreover, the nationalists have a positive vision of Scotland to sell, whereas the unionists are more restricted to highlighting the economic problems with a split.

Still, a 10-15 point lead for opponents to independence should be sufficient to withstand further yes gains. Yes and no positions are held strongly, so it will be tough for either side to gain ground by taking votes from the other. The unionists currently have around 55% support from those voters who have decided which way to cast their ballot. The rise in yes support has come mainly from falling don’t knows. The no’s could retain that share and maybe add some of the waverers.

Table 1: Scottish independence polls ask different questions

Ordered by support for independence (highest to lowest)

Question

Panelbase There will be a referendum on an independent Scotland on 18 September 2014. How do you intend to vote in response to the question: should Scotland be an independent country?

ICM As you may know, a referendum on independence will be held in Scotland on 18 September 2014. Voters will be asked, “Should Scotland be an independent country”. Do you think you will vote Yes or No?

Survation In the referendum, voters will be asked, “Should Scotland be an independent country”. If this referendum were held today, do you think you would vote “Yes” or “No”?

YouGov If there was a referendum tomorrow on Scotland’s future and this was the question, how would you vote? Do you agree that Scotland should be an independent country?

TNS There will be a referendum on Scottish independence on 18 September 2014. How do you intend to vote in response to the question: Should Scotland be an independent country? Yes, No, Don’t know

IPSOS-Mori Do you agree that Scotland should be an independent country? (Based on those certain to vote in a referendum)

Source: UKPollingReport.co.uk

Support for yes could rise as idea of independence becomes more mainstream Still, 15-point no lead should be sufficient to endure


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Economic impacts if Scotland votes no

Uncertainty ahead of the vote could deter investment and big ticket spending in the RUK and particularly in Scotland, where the uncertainty will be greatest. However, there is little sign of any effect so far. Scottish manufacturing firms’ optimism and investment intentions have fallen a little further behind the UK over the past few quarters, but the change is not significant relative to the volatility in business surveys (Chart 4). The economic fallout will be greater the tighter the vote is expected to be.

UK government borrowing costs could rise a little too, reflecting the possibility of a bad economic event following a yes vote and uncertainty about post-independence arrangements. But any rise is unlikely to be economically significant. In the run-up to Quebec’s 1995 referendum, government borrowing costs rose a little as the yes vote gained ground in the polls. Canadian yields rose by 20bp relative to UK yields in the final month of the campaign, while those for Quebec rose by about 40bp (Johnson and McIlwraith, 1998).2

Chart 4: Little sign of uncertainty effect on Scottish manufacturers

Net % balance of responses, Scottish Chambers of Commerce results minus British Chambers of Commerce results. Source: BCC, SCC.

If Scottish residents believed Scotland would adopt its own currency after independence – which could depreciate given the fiscal position and likely recession – then they might also worry that their sterling savings would be better kept in an English account. The Euro-crisis is a good example of how financial tensions in one country can transmit to another. It also shows how fear of a currency union break-up can lead to capital flight.

That is a risk, but capital movements are unlikely on a large scale in our view, certainly before the referendum, in part because the Scottish independence movement is not aiming to adopt its own currency and because the polls are not sufficiently close at this point. Setting up new bank accounts and shifting deposits is a significant undertaking. But banks may become more reluctant

Uncertainty ahead of the vote could deter spending UK government borrowing costs could rise a little

There could be fear of a new currency… …although we do not judge capital flight to be a significant risk ahead of the vote

2 Johnson, D and McIlwraith, D (1998), ‘Opinion polls and Canadian bond yields during the 1995 Quebec

referendum campaign’, The Canadian Journal of Economics.

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to extend credit in Scotland as the vote approaches.

Consequences of a no vote This would solve much of the immediate uncertainty. Any small rises in borrowing costs for the UK would dissipate quickly, as they did following the 1995 Quebec vote. Scotland would almost certainty gain further powers through devolution eventually.

Further devolution of powers could drive reform and a more dynamic Scottish economy. Additional devolution would not be without its own uncertainties though. If the Scottish parliament gained further powers, it would make it harder to justify Scottish members of the Westminster parliament voting on matters that do not affect Scotland.

There could be long-term costs from a no vote. If the vote was close, and perhaps even if it was not, then there could be continued speculation about independence, much as there was in Quebec between its 1980 and 1995 referendums on independence. That could harm Scottish economic prospects. Uncertainty regularly features as a possible reason for past economic problems in Quebec. As regions of a country can decline for a long period without independence worries eg Detroit in the US, it is difficult to be sure of the effect uncertainty has had in Canada.

A no vote would eliminate much of the uncertainty More devolution could drive reform But there could be continued speculation about independence after the vote, undermining the economy


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Consequences of a yes vote

The key point is that it would not be sensible for UK politicians to undermine the Scottish economy. That should limit the downsides during what would still be a tough transition period. Beyond the transition are upside as well as downside risks from a yes vote. An independent Scotland would reap all the rewards as well as the costs of its policies. So the government would have the incentives to introduce serious reforms that boost the Scotland’s long-term future. Whether the new government would use its new powers well or not is the long-term issue for Scotland.

The RUK and Scotland could prosper apart. Both are large enough and rich enough. But would the countries choose poor policies and decline, or growth-enhancing reforms and thriving economies? An independent, Scotland could lurch to the left with growth-sapping policies. It is also possible to imagine the RUK, shorn of Scottish support, voting itself out of the EU. It may not be Scotland that suffers long-term from a yes vote.

All the parties would have a strong incentive to agree a velvet divorce quickly. The UK government would negotiate hard, especially as the future electorate would not include the current 59 Scottish Members of the Westminster Parliament. But it would not make sense to undermine the Scottish economy. UK politicians would not want an economic calamity just before a general election, and they want Scotland to be able to credibly commit to repaying its share of current UK government debt. Alex Salmond, having got his prize of independence, would probably want to agree a compromise very quickly.

Still, the transition years would be tough. Uncertainty would rise sharply after a yes vote. The Euro-crisis shows the impact that could have in Scotland and the UK if it is not addressed fast. Scotland will probably need considerable additional austerity, and currency issues could cause substantial disruption.

There are six big issues that would shape the economic fallout over the first few years of independence. What would the fiscal outlook be? How resilient would Scottish financial firms be to the change, and where would they locate their headquarters? What transition help would the RUK give Scotland? How would the May 2015 general election work, given that Scotland would still be part of the UK then, but negotiating independence? Could Scotland join the EU, on what terms, and when? How would UK asset prices react and how would the Bank of England and government react to that?

The theme running through the rest of this report is that none of the problems are insurmountable. The RUK, or international bodies, could provide significant help to smooth the transition. But that help would come with strings attached that would probably hit Scottish growth initially. Independence could seriously dent Scottish growth, resulting in stagnation or possibly recession. The RUK would also be hit materially.

There are big risks. Politicians could find it hard to reach a quick compromise on the emotive issues that need resolving. Or sufficient backstops may not be put in place to ensure the transitional problems dissipate rapidly.

It would not be sensible for UK politicians to undermine the Scottish economy The RUK and Scotland are large and rich enough to prosper apart All the parties would have a strong incentive to agree a quick velvet divorce But the transition years would still be very tough economically

There are many areas of uncertainty None of the problems are insurmountable, but the solutions are mostly bad for the Scottish economy Big risks to our central case


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Boiling all this down, there are really three key issues. First, could Scottish and RUK politicians come to a deal quickly (and would markets and the public trust politicians to reach a deal quickly)? Second, how good or bad, economically, would a political compromise be for Scotland and the RUK? Third, how wisely would the new Scottish and RUK governments set their economic policies? The next few sections discuss these issues.


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Both parties have an incentive to agree a quick deal

In the event of a yes vote for independence we expect a velvet divorce. A quick deal that splits assets and liabilities along geographical and GDP based criteria, where relevant (eg oil geographically, debt by relative GDPs). The technical challenge of splitting two advanced countries would take a long time to work out, but an outline political deal that markedly eased uncertainty could be reached relatively quickly.

Politicians on both side of the border would have an incentive to rapidly agree an amicable divorce. Ahead of the May 2015 general election, the Westminster parties should certainly have little interest in precipitating a new economic crisis. That would obviously be bad for the RUK economy in the short term, but could also severely damage relations between the two countries which would, after all, still be sharing a border and plenty of infrastructure. In the event of a yes vote, we expect that, having got his big prize, Alex Salmond would be pragmatic.

The incentives to agree a deal would probably be stronger for the government north of the border. The epicentre of any downturn would be in Scotland. It is hard to be precise, given the paucity of data, but the Scottish fiscal position would, in all likelihood, be worse than for the UK as a whole. As a result, accessing markets could be difficult for an independent Scotland, unless the RUK provides backstops. The Scottish government would have a strong incentive to agree a divorce that allowed the RUK to provide that help.

The RUK parties do not have incentives to agree an advantageous deal for Scotland though. RUK would be roughly ten times the size of Scotland and the former’s politicians would hold a number of aces: the door to easy EU membership, for instance. RUK political parties would be answerable to a non-Scottish electorate post-independence, which would weigh against a favourable deal. That is particularly true for the opposition Labour party, which currently has 41 of the 59 Scottish Members of Parliament in Westminster. Losing that support would mean it would need to compete harder for Conservative votes.

That being said, RUK politicians’ standing would not be improved by precipitating a crisis north of the border. Moreover, it would not make economic sense to undermine the Scottish economy. RUK politicians would want a Scotland able to credibly pay its share of the current UK government debt.

If the deal for Scotland was so bad that it pushed the economy into a severe recession, RUK taxpayers would end up on the hook for all debt repayments. Markets may bet that the RUK government would ultimately provide additional assistance to the new state. They may well eventually have to provide help for Scotland anyway (during the Euro-crisis, the RUK provided special help for Ireland, for instance, which has not been part of the UK for nearly 100 years).

We would expect a velvet divorce following a yes vote

Politicians on both sides of the border have incentives to agree a quick split The incentives would be stronger for Scotland, which would be the epicentre of any economic problems A deal is likely to be fair rather than advantageous for Scotland But RUK politicians’ standing would not be improved by a crisis north of the border RUK taxpayers would end up on the hook for a bailout


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How good or bad would the deal be for Scotland?

There are a number of aspects to this, ranging from the fiscal position to the currency and the EU.

1. What would the fiscal outlook be?

2. How resilient would Scottish financial firms be to the change?

3. What transition help would the RUK give Scotland?

4. Could Scotland join the EU, on what terms, and when?

5. How would the May 2015 UK general election work, given that Scotland would still be part of the UK then, but negotiating independence?

Tricky fiscal position post-independence An independent Scotland would probably have to impose significantly more austerity. Accessing markets could be difficult unless the RUK provides backstops. Any economic downturn around independence would add to those difficulties.

Long-run government borrowing projections are always uncertain. But it is likely that the Scottish government’s position would be worse than for the UK as a whole. That is because Scottish revenues are dependent on declining North Sea oil and Scotland has worse demographic trends.

The independent Institute for Fiscal Studies (IFS) forecasts that on current policies, and assuming current UK debt were split on a per capita basis, the Scottish budget deficit would remain high in the near term and would rise massively over the next 50 years (Chart 5).3 Those prospects have improved a little since the IFS forecasts were made, but the key point remains the same.

Independence would mean more Scottish austerity

The Scottish government position is likely to be worse than for the UK The IFS forecasts the Scottish budget deficit would balloon

Chart 5: Scotland needs more austerity Chart 6: Population could cause fiscal problems

Borrowing and debt as % of GDP. Debt on the left-hand side, borrowing on the right. Source: IFS

“E&W” refers to England and Wales. Population on the right hand side, 2012=100. Dependency ratio is children and pension age people per 1,000 of working age. Source: ONS

3 Amior, M, Crawford, R, Tetlow, G (2013), ‘Fiscal sustainability of an independent Scotland’, Institute for

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On that central forecast, an independent Scotland would need to impose additional tax increases or spending cuts of 4.1% of GDP in 2021-22 to put Scottish government debt on a path to 40% of income by 2062-63. That austerity is in addition to the austerity planned by the current government up to 2017/18, and compares to a UK requirement of 0.8% additional austerity.

That tightening would probably need to be more severe, if the IFS had used the EU fiscal rules. Those rules require countries to cut debt to 60% of GDP over 20 years, rather than to 40% of GDP over 50 years in the IFS case.

Chart 6 shows two of the drivers of that fiscal outlook. The Office for National Statistics (ONS) forecasts that the Scottish population will not rise as fast as in England and Wales. The ONS also forecasts that the Scottish dependency ratio will rise more than the UK’s.

An independent Scotland could alleviate those two problems by being more open to immigration (it would have an incentive to be, given the fiscal outlook). But that would be a slow-burn solution and there would be risks in the meantime. Quebec, for instance, found that net immigration slumped in the years around its 1995 independence vote.

Scotland highly geared to North Sea oil Declining North Sea oil and gas revenues are the other reason for the weaker Scottish fiscal outlook. They accounted for about 14% of government revenues in 2012, if total UK revenues were split on a geographic basis. That fell to about 8% in the first three quarters of 2013.4

Chart 7: North Sea oil tax revenues set to decline

% GDP. Source: IFS

The IFS fiscal projections assume, optimistically in our view, that North Sea revenues would not decline at all after 2018/19 (Chart 7). The Scottish fiscal deficit would be much worse if the IFS used the revenue forecasts from the UK fiscal watchdog, the Office for Budget Responsibility (OBR).

The Scottish government assumes that North Sea oil revenues will be around

An independent Scotland would need to impose more spending cuts or tax rises EU rules would probably mean more severe tightening Scotland has a worse demographic problem That could be fixed by immigration Scotland would be dependent on declining North Sea oil

The IFS oil forecasts look optimistic So do the Scottish government’s

4 Moody’s (2014), ‘Rating scenarios for an Independent Scottish Sovereign’

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3-4 times higher than the OBR does. Those forecasts seem to use optimistic assumptions. For instance, a March 2013 Scottish government paper projecting oil revenues used upper bound estimates from the industry group “Oil and Gas UK” as a central case.

Neither the OBR nor the Scottish government can accurately project the value of North Sea oil output. So it would be sensible, as the Scottish government’s fiscal working group and the IFS have recommended, for an independent Scottish government to target a specific fiscal deficit excluding the contribution from oil. A stabilisation fund could then help smooth the overall deficit. Excluding North Sea revenue, the Scottish budget deficit is estimated at 14% of GDP in FY 2012/13.5

Risks to borrowing costs The fiscal and long-term projections are extremely sensitive to the assumptions. In the most optimistic IFS outlook, in which Scotland experiences “high” migration, achieves 2.2% productivity growth (higher than most of the developed world has achieved over the past 20-30 years), takes a low share of debt, equal to 40% of Scottish income and pays a 5% interest rate on that debt, then Scotland would need an additional 1.9% of austerity.

The point is that Scottish independence would come with significant fiscal sustainability risks. They would be greater the higher the share of UK legacy debt that Scotland takes on initially, the slower growth is, and the higher government borrowing costs are.

A country with no history of issuing its own debt and with a tough fiscal outlook, or risks of a tough outlook, could find it expensive to issue government debt. As far as rating agencies go, Moody’s has indicated that Scotland could get a sovereign rating between A1 and Baa1, depending on its post-independence arrangements. That would put Scotland on a par with Estonia and the Czech Republic at the upper end, and Russia and Trinidad and Tobago at the lower end.

The National Institute of Economic and Social Research (NIESR) estimates that an independent Scotland’s borrowing costs would be 72-165 basis points higher than now, assuming that it retained sterling. In the short term though, market panics over sustainability could mean much higher spreads than that.

To ensure maximum credibility, it would be important for Scotland to set up an independent fiscal watchdog as soon as possible after independence (as the independence campaign and the IFS have recommended). Scotland would almost certainly need help to issue debt, from the UK or elsewhere, initially after independence.

The UK would be hit too Splitting debt by population or GDP, Scotland would take on 8-10% of UK government debt, worth 74-101% of Scottish GDP, depending on whether debt is measured in net or gross terms, and on whether debt were split on a

Oil revenues are difficult to forecast, so Scotland would have to target budget ex-oil

It is hard to think of a scenario that does not involve more Scottish austerity Scottish independence would come with significant fiscal risks Scotland could find it expensive and difficult to issue debt NIESR estimates borrowing costs would rise 72-165bp in the long term Scotland would need to set up an independent fiscal watchdog

Scotland would likely to have a large debt stock

5 Government Excpenditure & Revenue Scotland 2012-13, http://www.scotland.gov.uk/Resource/0044/00446179.pdf


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per capita or GDP (including geographical oil split) basis (Table 2)6

The Scottish government has proposed an alternative, which adds up all estimated Scottish government budget deficits since 1980 (those data can only be estimated, since much of government revenue and expenditure is consolidated at the UK level). On that basis and using data up to FY 2011/12, Scotland would take on debt worth around 40% of its GDP. That is unrealistic. The result is heavily driven by North Sea oil, which has to date been a UK resource.

Table 2: Debt to GDP ratios after independence

RUK Scotland Debt divided on a per capita basis PSND 89% 74% Maastricht 102% 86% Debt divided on a GDP basis (geographical oil split) PSND 87% 87% Maastricht 101% 101%

PSND refers to Public Sector Net Debt, the UK government’s definition of debt. Maastricht is the EU definition of gross debt. Figures show debt/GDP ratio, %, assuming oil were split geographically. Source: Armstrong and Ebell (2013)6

Scotland would most likely agree to make its share of debt payments out of tax receipts, income and new debt issuance. Issuing 70-100% of GDP in debt immediately upon independence would be impractical.

That has two implications. First, it interacts with the currency arrangements as Scotland would have large sterling-denominated debts, raising risks to its borrowing costs if it did not retain sterling. Second, it would leave the RUK legally responsible for all the government debt, but with a smaller economy to support it. UK debt payments would not be unsustainable. Post independence, the UK would also have a debt to GDP ratio of 90-100% of GDP depending on how it was measured. But UK borrowing costs could rise a little.

As an aside, there is an interesting question about whether it would pay off for the Scottish government to do an asset for debt swap. For instance, it could sell rights to future oil tax revenues in order to pay down its government debt stock, thereby making the fiscal optics immediately better. That would undermine the independence movement’s reasoning for a split: that oil revenues could be saved to build up a huge wealth fund for future generations. But it might be a pragmatic option.

Formal currency union is unlikely The currency arrangements could initially be a cause of serious volatility. Past examples of currency-union splits are of only partial use as comparisons. Many happened in the midst of a sharp economic downturn after the Soviet Union breakup, so currency volatility would have been a small drop in the ocean of general economic collapse. Moreover, most examples involved countries with dramatically less sophisticated financial systems than the UK, with much lower government debt and certainly with financial sectors worth

Scottish government rosy option for splitting the debt is unrealistic

Scotland would gradually take on share of UK debt So Scotland would have large sterling-denominated debts An asset-for-debt swap could resolve some problems, but is also unrealistic Currency arrangements could be a source of serious volatility

6 Armstrong, A and Ebell, M (2013), ‘Scotland’s currency options’, NIESR Discussion Paper 415.


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less than the 12.5 times GDP in Scotland.7

There are three basic options. Scotland could retain sterling either with a formal currency union or through “sterlingisation”. It could issue a new currency, say the Scots pound, which could float or be pegged to sterling or another currency eg the euro or a basket of currencies. Or Scotland could seek to join the euro.

Retaining sterling would eliminate any currency volatility and mismatches (particularly on the government side). But the Westminster parties have ruled out a formal currency union with Scotland. While a lot of the independence terms are probably negotiable, on this issue their words have been sufficiently strong that they should be believed.

The Chancellor said: “It is clear to me I could not as Chancellor recommend that we could share the pound with an independent Scotland… It would cost jobs and cost money and wouldn’t provide economic security for Scotland or for the rest of the UK.” The Chief Secretary to the Treasury, Danny Alexander, said “there will not be a currency union in the event of independence.” That statement was accompanied by a paper from the Treasury recommending no currency union, and the shadow Chancellor Ed Balls appeared on television alongside George Osborne to say there would be no currency union in the event of a Scottish government.

The Scottish government argues that a union would be in the RUK interests because the current UK is an optimal currency area. They believe the UK government is bluffing, and would relent upon independence. Yet, there is more to a successful currency union than optimal currency area theory. Refusing to share a currency with Scotland would raise UK transaction costs. But the costs of a currency union could be larger.

The reasoning boils down to the issue that a currency union could require Scotland and the RUK to enforce fiscal rules on each other. A tough rule-book is the solution the Eurozone has pursued since the crisis. Markets failed spectacularly in enforcing discipline on Eurozone governments before the crisis, so politicians have now written probably the toughest fiscal rule book in the world (see New euro rules: the world’s toughest rulebook, 31 May 2013).

Unfortunately, a sterling fiscal rulebook would simply not be credible. It would require detailed oversight by the RUK parliament of all Scottish government budgets, as is now seen in the Eurozone. There would have to be a fine for breaking the rules. But how would the RUK enforce a fine if Scotland broke the fiscal rules? The Scottish voters would not accept that and would severely punish any party that actually paid the fine. Outside politics, those rules would create enormous resentment in an already tricky situation.

The point is that the RUK could not enforce budgetary discipline on Scotland but would inevitably be expected to bail out the government north of the border in the event of a big economic downturn. That is not to say the Scottish government would run irresponsible fiscal policy. But the experience of the Eurozone shows that market discipline is not enough to ensure that

Scotland has several options Keeping sterling would limit volatility… …but the UK government has ruled that out There is more to currency unions than optimal currency area theory Currency union would need a fiscal rulebook

Such a rulebook would not be credible The RUK could not impose budget discipline on Scotland

7 Figure taken from Carney, M (2014), ‘The economics of currency unions’, Bank of England speech.

http://www.berenberg.de/cgi-bin/content/content.cgi?rm=show_doc&ial=1&sb_userid=0&sb_eventid=0&doc_id=44618


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fiscal positions are always sustainable.

Some form of banking union is also a key pre-requisite for a stable currency union, as demonstrated by the Eurozone now introducing such an agreement. The Scottish financial sector is huge and could place serious pressure on the fiscal position during a downturn, meaning RUK help could be needed (a common fiscal backstop – the ESM – was needed in the Eurozone). A stable currency union would require the RUK to agree to be a fiscal backstop for an independent Scotland or a common set of rules, which seems unlikely without the RUK also having some control over Scottish policies. The latter is not credible.

Scotland would, in a currency union, have to seek representation on national policy bodies, like the Bank of England’s Monetary Policy Committees. But allowing Scotland a population-share of votes would set a difficult precedent (would Wales, the north east and Cornwall, for instance, then be able to demand their own population-share on policy committees?). And it would not even solve the problem. Scotland would get one of nine votes on the Monetary Policy Committee for instance, giving no effective power at all.

Even if the RUK and Scotland tried a union, it would probably not be credible. The Czech Republic and Slovakia tried one initially when they split, but it lasted less than two months amid capital flight. The bottom line is that a formal union is unlikely.

Floating Scots pound is the most likely option Absent a formal currency union, the Scottish government currently wants to unilaterally adopt sterling post-independence. Whether that would work is questionable. It did not in Slovakia’s case, for instance. The two sides had to quickly adopt separate, but pegged, currencies. Subsequently the Slovak currency depreciated.

The sterling options open to the Scots would be sterlingisation or a currency board. Currency boards can operate in the long run. They have in Hong Kong and some European countries. But there are likely to be significant credibility problems with applying the model to Scotland.

Both options would rule out Scottish use of much macroeconomic stabilisation policy and impose tight restrictions on fiscal policy (see Armstrong and Ebell, 2013).

European states that have switched to a currency board in recent years have had much less sophisticated and smaller financial sectors than Scotland. For instance, the main Slovakian bank on independence was government owned. As the UK’s ill-fated experience in the Exchange Rate Mechanism shows, if a currency peg is not credible then markets can force a change, which would be possible in this case.

A currency board would require tight fiscal policy to make it credible: countries need to self-insure against economic downturns by building up large foreign currency reserves and keeping government debt low. That could make the arrangement more difficult to set up amidst high debt levels. Previous examples of currency boards often started amidst low debt levels. A currency board also needs to be a long-term arrangement, otherwise markets

RUK would also need to agree to a banking union Scottish representation on policy bodies would not work A currency union is unlikely to be credible Scotland may find it difficult to unilaterally adopt sterling Currency boards can work effectively…

…but may not do so for Scotland Currency boards often begin life during huge economic turmoil They require tight fiscal policy


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would test the peg. There would be a tail risk of some capital outflows.

In essence, for the peg not to be tested, markets would need to believe the Scottish government would be willing to endure a big economic downturn if necessary. Estonia, for instance, saw its GDP contract 18% in 2008-09 as it held the line on its currency board. Latvia experienced a greater than 20% fall in GDP between 2008 and 2010 as it maintained much higher interest rates than the rest of the Eurozone and submitted to an IMF-EU programme in order to stick to the peg.8 Those are extreme examples. But the point about being prepared to stick to the peg is important.

Markets may believe the Scots have a high tolerance for pain, or they may not. The uncertainty is important for the chances of a currency board working without causing a downturn. Even if a currency board were credible, the Scottish government would need to run tight fiscal policy in the new regime. That would mean a very tough few years after independence.

Importantly, Scotland has other alternatives available, for example a freely floating currency, or one tied to the Euro. The former would give the Scottish government full control over its macroeconomic policy, but could cause significant disruption. The latter might be sustainable if it was also backed by Eurozone countries

The most likely solution in our view is that Scotland attempts a form of sterling peg. It may be credible, but the risk is that the peg quickly fails and the Scots pound depreciates amidst an economic downturn. There would certainly be a lot of uncertainty about how well any currency arrangements would work until they were actually tested. In other words, the currency arrangements mean uncertainty could drag on until formal independence, which might not be until 18 months or more after the referendum.

None of this discussion means that Scotland could not prosper as an independent country with its own currency. Plenty of countries of Scotland’s size do, and not many have the good fortune of being endowed with large oil reserves. The point is that the transition could be economically painful, and there would be big risks from large sterling-denominated debt. Pain has been one constant among previous currency breakups – although many have followed events that were already causing huge economic downturns.

EU membership: what about the euro? As a small nation on the edge of Europe, joining the EU should be a priority for Scotland. It is part of Salmond’s plan. Part of the divorce terms with the RUK would likely be that the latter would not veto Scottish EU entry, and could effectively sponsor Scottish membership.

Some European leaders have spoken of the difficulties of Scottish EU membership. Jose Manuel Barroso, the EC president, has said that “it would be extremely difficult, if not impossible” to secure universal approval for Scotland’s EU membership. Herman van Rompuy, European Council president, has also spoken against it.

Markets would need to believe the Scottish government would tolerate a big downturn The uncertainty means a currency board may not work Scotland has other alternatives The most likely solution is a Scots pound pegged to sterling Scotland could prosper with its own currency after a painful transition Scotland is likely to remain part of the EU EU leaders have said it would be difficult

8 HM Government (2013), ‘Scotland analysis: currency and monetary policy’.


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But the EU can be very flexible when it wants to be, and this is likely to be one of those instances. With the UK on side, Spain – facing its own breakaway region that would want EU membership – could be cajoled by the other members to accept Scottish membership.

While the EU can be flexible, it is not typically fleet footed. It is easy to commit quickly to allowing Scotland entry. But the negotiations could drag on. It took 10 years between Croatia’s application and actual accession. Of course, Scotland is currently an EU member so negotiations should be easier. The point is that negotiations may not proceed with urgency.

One uncertainty is whether an independent Scotland could inherit the UK’s current position with the EU. That would mean inheriting the opt-out from the euro and the rebate on the EU budget, among other things.

Those issues are unlikely to have much practical effect, however. EU membership comes with a requirement to commit to join the euro eventually. That requires countries to have their own currencies, an independent central bank and to meet the convergence criteria. But the timing can be flexible, as it is for Sweden and Poland. Scotland would not have to prepare immediately, or even over the next few years, for euro entry.

The one possible practical impact of the euro commitment would be on the currency arrangements after independence. If Scotland had to join the euro eventually a sterling peg would, by definition, not be a long-term relationship. The key question is whether the Scottish government could convince markets that it would not join the euro for a long time while also sticking within the spirit of the Treaty agreements.

It is possible to take a rosy view on what the EU would allow. But realistically, it is simply not possible to know how an EU of 500m people would negotiate with a relatively small new state. The bottom line is that an independent Scotland would very likely be able to be part of the EU. But there could be serious transitional issues and uncertainty.

Best possible result What would the best possible deal look like? Akin to the velvet divorce in Czechoslovakia. That would mean splitting assets and liabilities on population or GDP grounds, and the RUK providing backstops to allow Scottish access to markets initially. Sharing a currency did not work in that instance, so the Scots pound option is most likely, possibly using a currency board.

In the Czechoslovakia case, it took five months from agreeing independence to signing the declaration. That is a very short period when talking about splitting up a country.

In the Czechoslovakia example, assets were split 2:1 between the Czech Republic and Slovakia, respectively, reflecting the balance of population. That included splitting military equipment and gold at the central bank (although there was a dispute about that).

Both countries grew strongly after independence despite the enormous downturn after the Soviet Union split. The Czech Republic contracted 11.6% in 1991 according to the OECD. It also reflects the potential for serious

The EU can be flexible when it wants to be… …although it is not typically fleet footed. Negotiations could drag on Would Scotland inherit the UK’s position in the EU, with opt-outs?

Scotland may have to join the euro eventually Could a commitment to euro entry affect the credibility of a currency peg? Scotland will be part of the EU, but there could be transitional issues

The best possible deal would be a velvet divorce Czechoslovakia split quickly

Simple allocation of assets and debt Both countries grew strongly, reflecting huge potential for catch-up


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catch-up with more developed neighbouring countries.

The Czechoslovakia case was easier in some respects. There was much less government debt to argue about. Slovakia had a debt to GDP ratio of 23.7% of GDP in 1993, a year after independence (when OECD statistics start). The Czech Republic had a ratio of 14.7%. Although both had large government deficits through much of the late 1990s, the negotiations would probably have been much more difficult if both countries had started with a debt ratio closer to 100%.

Scottish divorce likely to be messy for a few years We believe a quick deal is likely. Some well-judged statements from politicians could allow markets to trust that a deal will be forthcoming, even before negotiations are completed. But even that means a period of uncertainty for firms and households.

We conclude from this discussion of the likely shape of a deal that it would not be good for Scotland in the short term. The government’s financial position means there would probably need to be significant further austerity. Government borrowing costs would be higher and there would probably be economic disruption from a new Scottish currency. There would be the tail risk of some capital outflows. Scotland would be able to maintain EU membership, but not necessarily on the same terms as the UK has now. Scotland might need to agree to join the euro, although that would have few immediate practical implications.

The RUK and possibly international organisations, like the IMF and the EU, could provide sufficient backstops to an independent Scotland to add credibility to the new arrangements and prevent any really serious immediate downturn. That is, Scotland should get help to ease market access initially and combat uncertainty. But that help is likely to come with strings attached.

The RUK in particular is likely to insist on some conditions in return for remaining legally responsible for all the legacy debt and probably sponsoring new issues after independence. That means a GDP-based split of the legacy debt and sufficient assurances that the new Scottish state would quickly deal with its government borrowing outlook (and thereby make the backstops less risky for the RUK).

Some of Scotland’s financial sector could shift its headquarters to London given the likely economic disruption; that might significantly hit the economy. Overall, we judge that the few years following the vote, and perhaps following the introduction of a new currency, would be tough though not calamitous. A number of parties would provide help, subject to conditions. The BoE would be likely to immediately loosen monetary policy, probably through a huge new dose of quantitative easing.

Czechoslovakia split was easier given little debt

A quick deal is likely, but there will still be significant uncertainty A deal would not be good for Scotland in the short term

RUK and others could prevent a really serious immediate downturn RUK would insist on conditions for help The Scottish financial sector could move south, causing disruption


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Long-term economic impact – mind the incentives

The question about the post-vote deal, splitting assets and liabilities, currencies and so on, is not the most interesting. Whatever the split, there would likely be a few difficult years for Scotland. But the Scots should get enough backstops to prevent a really serious recession.

The key to the longer-term outlook for Scotland is how policies would change following a yes or no vote. Would the Scottish government pursue better or worse economic policies? There are risks either side.

A no vote would eventually lead to more devolution. That could allow the Scottish government to better tailor policies to Scottish circumstances. But with the rest of the UK still on hand to support the economy if anything goes wrong, the incentives to go for a supply-side revolution might not be sufficiently strong. More devolution could well mean little.

A key unknown would be whether the independence campaign would continue despite a no vote. Quebec offers a good example, where a second referendum was held 15 years after the first and speculation continued during the interval. Now a Scottish referendum vote is possible, the uncertainty about future votes could weigh persistently on investment north of the border.

A yes vote could lead to a leftward tilt in Scotland and policies that harm long-term growth prospects. On the other hand, a Scotland that would reap all the benefits as well as all the costs of its actions might have the incentives to pursue growth-enhancing policies. Leaders do not always take the route of worthwhile reforms immediately, partially because they can be painful. Think of Francois Hollande or Gerhard Schroder. Ireland did not perform well economically until a long time after independence from the UK in 1922. But many governments get there eventually. Indeed, policies both north and south of the border could tilt right. The long term could be positive for an independent Scotland.

The UK could come off the worst It is possible to imagine Scotland tilting to the left amid an economic downturn. But it is also possible to imagine the rest of the UK, shorn of Scottish support for the EU, voting itself out of the EU single market. Indeed, that could be one of the long-term risks for the UK.

Scotland is relatively europhile, supporting continued UK membership of the EU by a sizeable margin. A recent YouGov poll showed Scottish voters supporting EU membership by a 54-27 margin. For the UK as a whole the support was 42-37. Scottish independence could also raise the chances of a future Conservative government, which has committed to an in-out EU referendum. So Scottish independence would materially affect the chances of the UK staying in the EU, which could raise uncertainty and hit RUK prospects.

However debt and assets are split, Scotland will have a difficult transition The long-term outlook depends on government policies

More devolution after a no vote could mean more reform Uncertainty about Scotland’s position could drag on after a no vote There are both upside and downside long-term risks to a yes vote The UK would not be immune. A British exit would be more likely following a Scottish exit Scotland is relatively europhile


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Risks to our Scottish independence calls

Around our central case are big risks that are worth watching. There are three big risks on the downside.

First, the Scottish government or Westminster parliamentarians could stick rigidly to the positions they have set out ahead of independence, making the divorce slow rather than quick, and very unfavourable to Scotland. The currency arrangements and the location of military bases could be very difficult negotiating points if neither side backs down. If uncertainty dragged on for longer, then the economic downturn following a yes vote would be worse.

Second, a newly independent Scotland may not have UK backstops. A left-leaning government could scare investors, forcing much more dramatic austerity than might otherwise be needed. A post-vote economic downturn could worsen the fiscal position materially, also raising required austerity. The new currency could depreciate. Independence along with a sharp downturn could drive emigration to the RUK. That might put Scotland in a bad economic position.

Third, EU membership may be more difficult to negotiate than we have assumed. There are a number of scenarios here, with the worst being that Scotland, for a time, faces higher costs of exporting to a big market.

On the other hand, politicians also have the capacity to surprise in a good way. They may agree a deal even faster than we expect. Announcements shortly after the vote could assuage market fears. Backstops provided by the RUK and other groups could be completely credible and eliminate most uncertainty. A newly independent Scotland may pursue radically reformist policies that set the stage for a strong long-term economic outlook. Independence may encourage support from Scots who had previously emigrated. An open and welcoming Scottish state could benefit from large inward migration, perhaps from highly skilled workers.

On balance, we see the risks tilted in the positive direction.

Three big downside risks Politicians might not agree a quick deal Scotland might not get sufficient backstops to prevent a significant contraction EU membership might be more difficult to negotiate There are plenty of upside risks too

We see the risks tilted to a relatively positive outcome


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May 2015 UK general election

There is a significant probability of another hung parliament. But with the two main parties neck and neck in the polls, either could win outright with a possibly wafer-thin majority. Much will depend on how far the economic recovery feeds through into higher support for the government. The Scottish referendum could have a huge effect, if it results in a yes vote.

The Labour opposition’s lead has fallen from a steady six points to around three over the past three months. Much of that seems, based on the aggregate data, to be due to UKIP gaining share at Labour’s expense.

That is important. The Conservatives’ poll readings have been steady at 32% over the past year. To get a majority in 2015, the Conservatives need to beat their 2010 election result of 36% of the vote compared to 29% for Labour. That will be difficult.

Sitting governments have not generally been able to increase their share of the vote. Opposition parties often lose support running up to an election, but Labour would need to lose a large amount over the next year for the Conservatives to gain a full majority. Polling at the minute gives Labour, on some calculations, enough support to be one seat short of a majority in parliament (see UK Polling Report).

According to polls, Conservative leader and incumbent Prime Minister David Cameron is preferred as future prime minister to Labour leader Ed Miliband. The Conservatives are trusted more on the economy. That has not yet shown up in stronger poll readings, but it could over the next 12 months. That would erode Labour’s chances of being the largest single party.

A big unknown is how UKIP voters will side come May 2015, and how any increase in their share of the vote will translate into other parties’ results in the UK’s first-past-the-post system. UKIP gained 3.1% of the vote in 2010. It is currently running closer to 15% in the polls. If its support wanes as the real vote approaches, the Conservatives could benefit.

Bottom line, the Conservatives seem likely to win the largest share of the popular vote in the general election, but that may not be enough to gain a working majority in parliament. There is a significant probability of a hung parliament. What a hung parliament would mean depends on how much support UKIP and the Lib Dems get, and if either teamed up with another party.

A Lib-Lab coalition is possible. A UKIP conservative coalition would be hard to sustain, given the problems that have hit UKIP since its media presence has risen and the mix of Europhiles and Europhobes in the conservative party. In any case, UKIP are unlikely to win enough to seats to hold the balance of power.

There is a risk then of some populist measures that could modestly damage the economic outlook. Taxation and government spending would probably be higher under a future Labour government than under the Conservatives. The issue is how well that is spent of course, but the pre-2010 experience

A hung parliament in May 2015 is possible Labour’s poll lead has fallen…

…though not because the Conservatives have gained share Sitting governments struggle to increase their vote share But the Conservative leader polls better than his Labour rival UKIP increases the noise in the polls Implications of a hung parliament depend on Lib Dem position

Prospects for a Lib-Lab coalition That could mean some populist, growth-damaging policies


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does not augur well.

That being said, the budget deficit will still be very large, and any government will have to focus on lowering it. So economic policies will probably not differ enormously.

In the event of Scottish independence, Scottish voters would probably still be able to vote in the May 2015 general election. The referendum would be a reason to start negotiations on Scottish exit. But the actual UK separation would not happen until 2016 probably (that is the timetable the Scottish government is working on). In that case, Scottish voters would still be part of the UK in May 2015.

After Scottish independence, the 59 Scottish MPs in the Westminster parliament would probably need to leave. A new election could be required. That would particularly hurt the Labour party, which accounts for 41 of the 59 Scottish MPs, and raise the chances of a subsequent Conservative government. The same might be true in the case of a no vote, if further devolution of powers to Scotland also meant a change to the position of Scottish MPs in the Westminster parliament.

Any government’s room for manoeuvre will be limited by the large budget deficit Scottish voters could participate in general election even if they voted for independence Another election could be triggered when Scotland left the union (if voters say yes to independence)


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Disclaimer This document was compiled by the above mentioned authors of the economics department of Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as “the Bank”),. The Bank has made any effort to carefully research and process all information. The information has been obtained from sources which we believe to be reliable such as, for example, Thomson Reuters, Bloomberg and the relevant specialised press. However, we do not assume liability for the correctness and completeness of all information given. The provided information has not been checked by a third party, especially an independent auditing firm. We explicitly point to the stated date of preparation. The information given can become incorrect due to passage of time and/or as a result of legal, political, economic or other changes. We do not assume responsibility to indicate such changes and/or to publish an updated document. The forecasts contained in this document or other statements on rates of return, capital gains or other accession are the personal opinion of the author and we do not assume liability for the realisation of these.

This document is only for information purposes. It does not constitute a financial analysis within the meaning of § 34b or § 31 Subs. 2 of the German Securities Trading Act (Wertpapierhandelsgesetz), no investment advice or recommendation to buy financial instruments. It does not replace consulting regarding legal, tax or financial matters.

Remarks regarding foreign investors The preparation of this document is subject to regulation by German law. The distribution of this document in other jurisdictions may be restricted by law, and persons, into whose possession this document comes, should inform themselves about, and observe, any such restrictions. United Kingdom This document is meant exclusively for institutional investors and market professionals, but not for private customers. It is not for distribution to or the use of private investors or private customers.

United States of America This document has been prepared exclusively by Joh. Berenberg, Gossler & Co. KG. Although Berenberg Capital Markets LLC, an affiliate of the Bank and registered US broker-dealer, distributes this document to certain customers, Berenberg Capital Markets LLC does not provide input into its contents, nor does this document constitute research of Berenberg Capital Markets LLC. In addition, this document is meant exclusively for institutional investors and market professionals, but not for private customers. It is not for distribution to or the use of private investors or private customers.

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Berenberg Macro Views Narrowing Scottish polls raise UK ...Berenberg Macro Views Economics 1 Narrowing Scottish polls raise UK political risks • The UK recovery is increasingly solid,