Explained: Scotland’s currency options

With only days to go until Scotland votes on whether it wants independence from the UK, a huge question mark hangs over what currency an independent Scotland would use.

The Bank of England and the big guns at Westminster have said that an independent Scotland will not be able to continue to use the pound; however, the pro-independence campaign led by Alex Salmond is calling Westminster’s bluff. So who is right?

In principle, there is nothing stopping an independent Scotland using the pound as its chief currency. This would see Scotland go against Westminster’s wishes and use the pound anyway. However, this would come with a hefty price, and the cost could be greater than the benefit of independence.

Why Westminster is against Scotland using the pound
While Westminster politicians are unlikely to want to see the Union break apart under their watch, they are not denying Scotland use of the pound just out of spite. The eurozone sovereign debt crisis is a good example of why shared currencies without shared governments don’t work – they lead to bailouts and devastating austerity drives.

The UK will want to avoid this at all costs, so even if it did agree to a currency union with Scotland, Westminster would probably demand control over Scottish fiscal policy and banking regulation, rendering independence toothless.

Since control of the Scottish tax base has been the central pillar of Alex Salmond’s Yes campaign, he might find it hard to swallow handing back fiscal powers back to George Osborne at the Treasury, which is why currency union is not a real option for Scotland.

Sterlingisation
The Yes campaign has argued that, at least in the beginning, an independent Scotland would unilaterally adopt the pound, a process known as sterlingisation.

Although this would solve the problem about what unit of exchange Scotland would use, even the Yes camp has argued that this is only a stop-gap measure.

There are three major problems with sterlingisation for Scotland:

Firstly, Scotland would have no central bank, and no say at the Bank of England, so it would essentially have to mimic the Bank of England and force its banks to raise interest rates when the BoE raises rates and vice versa. The big problem with this is that Scotland could be at a different stage of the economic cycle compared to the UK. If its economy was suffering and the BoE started hiking rates, Scotland would have no choice but to follow suit, which could have devastating economic consequences. 

Secondly, the outgoing EU Commissioner for economic and monetary affairs, Ollie Rehn, said earlier this month that if Scotland adopts sterlingisation it will not be able to join the EU. To become a member of the EU, a country needs to have a central bank, for example when Iceland applied to join the EU in 2009, a functioning central bank was one of the criteria for entry. Scotland would need to have a serious think about what is more important: Becoming a member of the EU and gaining entrance to the lucrative single market or keeping the pound.

Thirdly, sterlingisation would require foreign exchange reserves, and lots of them. Since Scotland runs a hefty deficit (even when accounting for all of those oil revenues) and its bills need to be paid in pounds, it would need a ready supply of sterling to avoid default. If reserves started to run out, then public spending would have fall to save money and gather pounds. The Scottish nationalists may find this a hard sell, as the Yes campaign has tried to position itself as the anti-austerity party during this campaign.

Even Alex Salmond has said that sterlingisation is only a stop-gap; however, the road beyond sterlingisation seems to lead to nowhere.

Other currency options
In fairness to the Yes campaign, the currency options are fairly thin on the ground at this stage.
The first is for Scotland to create its own currency. This is an enormous project that is mind-bogglingly complex.

Firstly, deciding how to value a new currency – it would probably be pegged to the pound, at least at the beginning, although that requires large amounts of foreign currency reserves which can be hard to come by in lean economic times.

Once you have decided on the value of the currency you then need to form a central bank. This brings up its own host of questions such as would the bank be independent from government, a bit like the Bank of England, who would be on the policy decision committee, what targets to set them and much more.

Bank of England Governor Mark Carney said that for a central bank to be a credible lender of last resort it would need currency reserves equivalent to between 25% and 100% of GDP, since Scotland’s GDP is estimated at between £130billion and £140billion, this is no small chunk of change.

There are a myriad of other questions to consider from a practical point of view including when the currency would go into circulation, where would it be minted, and would the British monarch still be on the currency of an independent Scotland?

While a separate currency may be the most appropriate option for Scotland, as you can see, it is an extremely complex and costly solution. The other option is for Scotland to look North. If the UK is so vehemently opposed to currency union, could Scotland form a union with one of its Scandinavian neighbours?

There is a historical precedent for this, in 1873 Scandinavia had a currency union, it didn’t last, but they may be more easily persuaded than Westminster due to cultural and historical links with Scotland.

Dollars and sense
If Scotland gets really stuck, it could try to adopt the US dollar. If it didn’t mind becoming the 51st American state or having Washington control its fiscal policy and the Federal Reserve set its monetary policy, this could be the best outcome for Scotland.

The pro-independence campaign have focused on Scotland’s oil resources as pivotal to its bid for independence, since oil is priced in dollars, if Scotland started to use the greenback it would avoid unnecessary currency risk for its oil revenues. Saudi Arabia and other major Middle East oil producers have currencies that are pegged to the dollar, so maybe Scotland should too.

As you can see, the reason why the Yes campaign has avoided the currency question is more than likely because it is too complex to condense down into political slogans. However, one thing certain, if Scotland does vote for independence the Scottish pound may not be long for this world.

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Kathleen Brooks is author of Kathleen Brooks on Forex, published by Harriman House.