Tuesday, November 26, 2013

Scotland as a Sovereign Credit: A Preliminary Glance

A year from now, Scotland will vote on independence. The Scottish National Party has published its 667-page blueprint for “Scotland’s Future”. I have looked at the document and have read some critiques of it. It is a bit daunting to try to read the whole thing at one sitting. It’s not a light read.

The SNP’s white paper raises many interesting questions, such as:
1. The legal status of UK nationals residing in Scotland, and vice-versa.
2. The formula for dividing up the national debt.
3. Relationship with the EU.
4. Currency arrangements.
5. Security arrangements: neutrality, or alliance with the UK and NATO?
6. Immigration policy.
7. Form of government: kingdom or republic?
8. If a kingdom, which royal house?
9. A written constitution?

The white paper purports to answer these questions, but the UK government has agreed to nothing whatsoever. The document represents a Scottish wishlist, nothing more. Scotland cannot propose a Confederate-style secession on unilateral terms. Rather, she will have to secede as the result of a mutually negotiated settlement with the UK. In such a negotiation, she holds very few cards. The UK government can say nyet to to everything, if it wants.

What I would like to do is to look at an independent Scotland as a sovereign credit. Unfortunately, the white paper does not resemble a rating package or even an offering circular. It is a political manifesto with the occasional nugget of useful information.

There is already quite a bit of literature about the fiscal outlook for an independent Scotland. This is a contentious subject in which my expertise is limited. I would prefer to look, today, at Scotland’s external position.

The SNP’s plan provides for the Bank of England to act as Scotland’s central bank. Instead of adopting the euro or a new currency, Scotland would keep the British pound.

I will dispense with the problematic question of British consent to such an arrangement. After all, any country can adopt any foreign currency as its domestic currency, just as a number of countries use the dollar without permission. I will also ignore the question as to how Brussels would feel about a candidate member opting out of the common currency.

My question, as a credit analyst, is: How would Scotland’s external position look?  Independence does not mean escaping the UK debt-free, given that the parting would be by mutually negotiated agreement. Scotland would have to accept a pro-rata share of the UK national debt. Thus, Scotland would sail forth burdened with a substantial debt load (perhaps ~75% of GDP) denominated in foreign currency, and would perforce continue to borrow in foreign currency. I say foreign, because I cannot see a Tory-led government agreeing to cede any degree of political control over the BofE to a socialist foreign country. (I say Tory-led since Labour would be the loser without Scotland.) Countries such as the Bahamas, El Salvador, Panama and Ecuador can adopt the dollar if they choose, but that only allows their central bankers to gaze at the Eccles Building from Constitution Avenue. It doesn’t give them a seat on the FOMC.

Should Scotland adopt sterling as its currency, it would be committing mortal sin at birth: owing a lot of debt in a currency it can’t print, just like the PIIGS on the continent. The Scottish financial system will be 100% “sterlingized”. Needless to say, this would be a very interesting country and banking system to analyze and rate. I can predict this much without having seen any official numbers: Scotland is not AAA. The Scots will point to Norway, but Norway has no debt, a great track record, and a large sovereign wealth fund. I would point to Ireland.

Because Scotland must command continuing access to the international debt market, she would have to be quite self-disciplined in her fiscal policies. No Troika rescue for her (unless she joined the eurozone). The UK has been allowed by the market to run big fiscal and current account deficits because she prints her own currency. Had the UK joined the eurozone, her rating would be lower today, and she might very well have become a PIIG herself: the UK has had some very bad numbers since the Crash. An SNP-ruled Scotland, with its leftist social-welfare agenda, would not be permitted to run a large fiscal deficit, because she will have to continually roll her debt, just like Ireland and the other PIIGS.

What kind of an economy is Scotland? I would say volatile, due to dependence on oil exports and related economic activity. What kind of a credit would Scotland be with Brent crude at $50? One would like to know the oil price below which the government runs a deficit, and then run  oil-price simulations to suss out the probabilities. Given that we’re talking about expensive North Sea oil, my guess is that the breakeven is a pretty high price: far above the Gulf states’ breakeven. In other words, a somewhat fragile credit given its debt load. Not Norway.

Another potential roadblock: How do you separate one sovereign obligor into two, without the original obligor guaranteeing the other? There is no provision in the UK’s bonds for credit substitution, and there is implicit protection against such an event.  Is the UK is going to call its debt and replace it with a securities package, as in a distressed exchange, or would the swap be voluntary? Is any of this legal under English law? What recourse would gilt-holders have? You can bet that the hedge funds would bring suit, since Scottish bonds are likely to trade below par. Will the UK have to guarantee the bonds that are assumed by Scotland? That would work, but would be politically unpopular down south, because the UK can’t force Scotland to honor its debts.

And what are we to make of the bonds that the UK is selling today? Do they have the risk of an involuntary conversion into the debt of an inferior credit? If there is no such risk, then how will the national debt be divided? You may recall that Russia solved this problem by keeping all of the Soviet Union’s debt (and then defaulting on some of it). The UK will never agree to this, and if it did, it wouldn’t be AAA given its recalculated debt ratios.

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