Though the three main Westminster parties have each publicly rejected a formal currency union with an independent Scotland, Alex Salmond and the ‘Yes’ campaign have yet to articulate what a ‘plan B’ would entail. In this article, David McCarthy and Angus Armstrong lay out the options in detail, writing that the limited ability of an independent Scotland to provide ‘lender of last resort’ support to its banking system means that both regulatory and market action will lead the two remaining significant Scottish banks to redomicile

Armstrong, Angus

McCarthy, David

LSE Research Online

8/25/2014‘Plan B’: What are an independent Scotland’s currencyoptions?blogs.lse.ac.uk /politicsandpolicy/plan-b-currency-options/Though the three main Westminster parties have each publicly rejected a formal currency union with anindependent Scotland, Alex Salmond and the ‘Yes’ campaign have yet to articulate what a ‘plan B’would entail. In this article, David McCarthy and Angus Armstrong  lay out the options in detail,writing that the limited ability of an independent Scotland to provide ‘lender of last resort’ support toits banking system means that both regulatory and market action will lead the two remainingsignificant Scottish banks to redomicile.It seems likely that if the Scottish referendum succeeds, Scotland will continue to use the poundsterling in an informal currency union with the UK.  Scottish leaders have not indicated exactly whatthis so-called ‘Plan B’ means.  (‘Plan A’, a formal currency union, has been rejected by the UK).An independent Scotland has three main ways to continue to use the pound sterling: to remove theScottish notes from circulation entirely and use notes issued by the Bank of England (called puredollarization); to continue with the current currency arrangements, where Scottish banks issue theirown notes, which are fully backed by UK pound notes and/or sterling-denominated securities heldeither in vaults in the Bank of England (or, more likely, at a Scottish monetary authority); and tocreate a new currency, called the Scots pound, pegged one-for-one to the pound sterling, whose convertibility will beguaranteed by a currency board which will hold sterling backing assets for every Scots pound note issued. Under alloptions, it is likely that pounds sterling will continue to be widely used in Scotland, so at best, Scotland will operate aparallel currency regime.The implications of an informal currency union for monetary policy and government financeUnder all currency options, Scotland will lose the ability to run an independent monetary policy, so interest rates inScotland will follow interest rates set in London. As the UK and Scottish economies are aligned, this is not likely tobe a serious problem. But, as in the Eurozone, it could create difficulties if they are not.The stock of domestic currency in Scotland will depend on capital flows into and out of Scotland – called the balanceof payments. Scottish exports will depend heavily on oil revenue, which can be unstable (although most oil companyprofits are exported too; a natural hedge). When domestic liquidity is in large supply, the Scottish monetary authoritycould soak up the surplus liquidity by borrowing money domestically and lending it abroad. But when liquidity isshort, it will have to borrow abroad and lend domestically. The first is easy; the second depends on the willingness offoreign creditors to extend loans to Scotland.An independent Scotland will be a heavily indebted country (estimates of explicit debt hover around 90 per cent ofGDP; implicit debt in the form of unfunded civil service pension funds is at least as large again). This existing debt –and any new borrowing – will be denominated in a foreign currency. Just to pay its existing debt, the Scottishgovernment will need to raise large amounts of foreign currency on a regular basis, more if it chooses to run fiscaldeficits.The implications of an informal currency union for the Scottish banking systemModern fractional reserve banking systems are inherently unstable. Banks are subject to liquidity risks as they takedeposits and borrow money over the short term, and lend it out for longer periods. Banks – and whole bankingsystems – may be subject to self-fulfilling crises of confidence if depositors and creditors lose confidence the abilityof a bank to honour its liabilities and rush to cash in their deposits or loans. The risk may spread from bank to bank,1/3or from the banking system to the sovereign, and vice versa, or from one country to another, through a processcalled contagion. Modern central banks aim to prevent and curtail contagion by providing emergency liquidity totroubled banks, or indeed, to the entire banking system. In general, it cannot be said that a bank with a liquidityproblem is solvent until after the fact. Thus, ‘liquidity assistance’ often ends up being a form of solvency assistance. We therefore lump liquidity and solvency support together and call them ‘lender of last resort’ (LOLR) assistance.The amount of liquidity that an independent Scotland could provide to its banking system is limited to the amountthat Scotland holds in foreign reserves, or the amount that Scotland could borrow abroad. In a banking crisis,Scotland would therefore be dependent on foreign creditors to ensure that it could provide liquidity to its bankingsystem. This is not a new problem: during the era of fixed exchange rates, the IMF was created precisely to provideLOLR assistance to countries during crises. Over time, and with the demise of the Bretton-Woods system, the role ofthe IMF has broadened, and other international agencies have emerged.Options for ScotlandSo what options does Scotland have to provide LOLR support to its banking system? Three, really. It could build upreserves, either on the state’s balance sheet by running large fiscal surpluses, or on the balance sheet of theScottish Monetary Authority, or in a separate insurance or financial stability fund, by accumulating balance-of-payments surpluses. Given what we know about the fiscal and balance-of-payments position of Scotland, thisappears implausible.Secondly, Scotland could borrow money from international creditors. Various creditors are possible – the IMF, theEuropean Union, and the Bank of England might all be willing to play a role. (International banks might lend moneybut could exacerbate a crisis by trying to hedge their positions). But international creditors require sovereignguarantees, and will impose terms of conditionality in exchange for support which may be unpalatable. Commercialbanks who provide lines of credit in advance will hedge their exposure during a crisis, worsening outcomes (ashappened to Argentina in 2002).Finally, Scotland could try and transfer the risk onto a third party. We were unable to find examples of such aninternational risk transfer. One option might be the Bank of England, which could write ‘liquidity options’ to Scottishbanks in exchange for a premium received in advance. (This is an extension of an idea suggested for UK banks byBill Winters in a recent review of the Bank of England’s liquidity operations). There are practical issues which makesuch an option unlikely. ‘Fair’ premiums will not be sufficient to control moral hazard, and will be uncollectible inpractice. So to prevent moral hazard, the Bank of England would have to become the de facto regulator of Scottishbanks, and the insurance would have to be made mandatory (creating vulnerabilities for Scotland). Most importantly,it is unclear how this arrangement could be made consistent with the Bank of England’s mandate to uphold theinterests of UK (as distinct from Scottish) consumers and taxpayers. A second option – joining the European BankingUnion – will only provide true risk sharing after a bank has defaulted, through the Single Resolution Fund. Eveninside the Eurozone, the ECB provides liquidity support but risks remain firmly with member states until banksactually default.The outcomeThe limited ability of an independent Scotland to provide LOLR support to its banking system means that bothregulatory and market action will lead the two remaining significant Scottish banks to redomicile. Since one ofScotland’s largest exports is financial services, this will significantly affect Scotland’s balance of paymentssurpluses.  A small and largely domestic banking system will remain. Scots will rely on branches of internationalbanks for banking services.Note: This article gives the views of the author, and not the position of the British Politics and Policy blog, nor of theLondon School of Economics. Please read our comments policy before posting. Featured image credit: HowardLake CC BY-SA 2.02/3About the AuthorDavid McCarthy graduated with a PhD from the Wharton School of the University of Pennsylvaniain 2002.  He has worked at Oxford University and Imperial College, London. While at ImperialCollege he started a highly innovative MSc in Actuarial Finance. In 2011 he took an academicsabbatical to assist the South African National Treasury with the design of reforms to the SouthAfrican retirement system. Since 2013 he has been a Visiting Fellow at the National Institute forEconomic and Social Research in London.Angus Armstrong  is Director of Macroeconomic Research and the National Institute of Economicand Social Research. 3/3

‘Plan B’: What are an independent Scotland’s currency options?

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