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This Is a Problem for Scotland, Not the UK

10/09/2014 15:04 BST | Updated 10/11/2014 10:59 GMT

If Scotland votes next week to dissolve a Union which has lasted just over three hundred years, then this will be very sad, in all sorts of senses but, for the main, the sadness for the UK will be mostly emotional, whilst for Scotland the implications will be massively detrimental from an economic standpoint. Once the post-referendum rump of the UK, (let's just call it the UK), dries its eyes at the loss of Scotland, the realisation will quickly dawn that, in bald economic terms, we lost just 9% of GDP and 9% of our population. That equates roughly to the US losing the state of Texas. Culturally shocking, yes, but in reality just taking the size of the UK economy back to where it was in 2011.

The pound was already suffering following the second TV debate, in which Alex Salmond seemed to score a significant victory, and last weekend's Sunday Times YouGov poll, showing the 'Yes' campaign with a narrow majority for the first time, caused an immediate further depreciation of Sterling against both the US Dollar and the Euro. The poll showed a 47% 'Yes' vote for independence, 45% 'No' and 8% Don't Know. Without the Don't Know's, that's 51% 'Yes', and 49% 'No'.

It is undoubtedly the case that a 'Yes' vote on 18th will lead to short-term mayhem, with Sterling and Gilts coming under severe pressure and the prospect of UK rate rises receding somewhat, although a very large fall in the Pound could be self-correcting in this respect, as it may raise inflation concerns at the Bank of England.

In reality, an Independent Scotland would have four choices with regard to its future currency:

1) a currency union with the UK

2) Sterlingisation

3) a new currency

4) join the Euro.

1) Would be most desirable from the point of view of Scotland's banks, as they would retain the support of the Bank of England, the only problem is that all major UK political parties have said they would not agree to such a union, and anyway the irony is that for a currency union to have any chance whatsoever of gaining Westminster's agreement, Scotland would have to cede monetary and fiscal power to the UK-otherwise we would be creating another Frankenstein, bearing an uncanny resemblance to the Euro; a half-completed chimera that would ultimately come to a disastrous end.

2) Given that even the SNP envisages full independence will only be implemented in March 2016, then this alternative will be the default state of affairs during the long and painful process of transition negotiations. The very worrying implication for Scotland would be that there would be no more 'lender of last resort' in Threadneedle Street for Scottish banks, so they would need to be much more heavily capitalized than UK or international competitors, effectively rendering them uncompetitive and uneconomic. Actually the banks would have to re-domicile to the UK and there would be no legal right for the Scottish Banks, (Bank of Scotland, Clydesdale and RBS), to issue notes. Solution 2) has been employed in Panama and Montenegro.

3) Fine, but in that case the Scottish people had better get used to much more expensive borrowing, (on both a national and personal level), as the new Central Bank of Scotland would have to maintain much higher rates to defend this new baby of a currency and markets would demand much higher returns to buy Scottish 'Gilts'. There would be huge capital flight as businesses rushed to sell Scottish-based assets; Alex Salmond's promise of a corporate tax rate that is 3% below the UK's will hardly be enough to prevent this, and depositors will be queuing up to remove their money from Scottish-based banks no longer backed by The Old Lady. This would be a massively volatile currency, with concomitant costs for Scottish exporters. Presumably there would be an attempt to peg to the Pound, as Denmark does to the euro. Scotland could attempt to build up reserves over a long time by running budget surpluses, but current estimates put a Scottish budget deficit at 14% without oil, and with oil maybe 5-8%, but oil revenues will decline to a miniscule £1-2bn per year on average in the 2020's. This compares with a UK deficit of 5% this year, with budget balance projected by 2017. A massive austerity drive, or much higher taxes, would be required. Very sad and very unnecessary.

4) A very long game, as Scotland would first have to successfully apply for EU membership, and do the Scottish people really want to join the Euro club, with monetary policy to be set by the ECB, usually to suit Germany? This is alternative 1), but worse.

These are the 'uncertainties' to which the 'no' campaign has been referring and which have undermined Sterling in the short-term. Several weeks ago I suggested that buying volatility was the best trade, but that ship has now sailed.

The political consequences of a 'Yes' vote are actually likely to be come to be seen as Sterling and Gilt-positive, once the dust settles and investors realise that, with Labour losing 40 Scottish seats in Westminster, vs. just one Conservative seat, it is highly likely that the UK will enjoy Conservative governments as far as the eye can see. Even if Labour gain a small majority next May, it will be short-lived, as everyone will know they will lose those seats, and hence legitimacy, as soon as Scotland is fully independent.

Trading GBP before the vote will be very difficult, as one's fortunes will be beholden to the vagaries of poll results, but ultimately I think that the GBP will strengthen again, as 1) or 2) are the most likely options in the case of a 'yes' vote, which represent pretty much status quo for the UK, and to over-simplify somewhat, 3) and 4) mean the problem has 'gone away', as does a 'no' vote.

When combined with the political calculations, I feel Sterling's current funk represents a great medium to long-term buying opportunity, especially against the Euro.

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