Scotland Independence Delves in Sterlingisation amp Currency Boards

If Scotland’s first Minister Alex Salmond presses on with the idea of adopting the pound and insisting with his threats to not meet Scotland’s end of liabilities, then it would raise the risk of having a newly-independent state instantly becoming a pariah in global credit markets, possibly at the expense of periodic volatility in gilts and sterling.

The notion of an independent state that is dependent on energy oil exports without securing independence over currency or monetary policy could be chaotic to its overall economy as economic cycles are likely to diverge. And independent outside the EU would weigh on Scottish companies securing access to the continent via unifying business/commerce standards.

Since Whitehall has clearly eliminated the prospects of approving currency union in the case of an independent Scotland, the possible (realistic) alternatives include the following:

Currency Board

A Scottish monetary body (not central bank) issuing Scottish currency, fully backed by an achor currency (sterling) at a fixed rate, or with limited fluctuation.  In order for each unit of local currency to be convertible to sterling, the currency board must hold foreign reserves (sterling-denominated bonds and sterling notes/coins) to equal at least 100% of Scottish currency in circulation. The currency board’s main function will be to exchange local for anchor currency without any discretion over monetary policy (no lending to banks or the government).  Thus, taxes and foreign borrowing become the government’s main source of revenue, in addition to seigniorage (the total value of currency over the cost of producing it). The currency rate set by the board would fully determine the balance of payments vis-à-vis all its trading partners irrespective of how Scotland fares economically relative to each of its partners.  The lack of autonomous monetary policy would require staunch fiscal discipline and robust supervisory functions of a heavily bank-oriented economy such as Scotland.

Having the Scottish currency fixed to sterling would not prevent currency speculators from destabilizing it if the currency board’s assets are seen inadequate or Scotland’s economy diverges significantly from that of the UK.

Sterlingisation

Unlike a currency board which may involve a Scottish currency, “sterlingisation” would most likely involve sterling as Scotland’s sole and official legal tender (such as the USD in the case of dollarisation in Panama), whereby monetary and currency policies are imported from the Bank of England. The lack of a central bank means there will be no lender of last resort to banks or to the government, and since there is no local currency to issue, there will be no seigniorage revenue. In the event that Scotland’s economy diverges away from that of the UK, it could sustain inflationary or deflationary implications from the lack of controlling its own money supply.

Advantages of “sterlingisation” over currency board include: lower transaction costs; elimination of currency devaluation risk or speculative attacks; lower cost of foreign borrowing (assuming UK’s fiscal profile remains stable).

These two arrangements enable an independent Scotland to adopt sterling without the necessary approval or backing of the Bank of England, while enabling it to export to the rest of the UK –free of currency risk—which accounts for nearly 60% of Scotland’s total exports. But a currency board—or any resulting monetary authority—must be sufficiently equipped to absorb any shocks to Scotland’s vast banking sector, whose assets account for 1200% of GDP. The sooner PM Cameron & Westminster have imposed their stance on currency union and sharing of liabilities, the less likely the pound and gilts will be held hostage to the fluctuating polls of a largely undecided Scotland.