Mizuho Market Comment 20 April, 2021

Colin Asher Senior Economist [email protected] | +44 20 7012 5262

Too early for GBP to be concerned about Scottish independence

 Scottish independence is the main issue in the 6 May Scottish parliamentary elections  GBP is unlikely to be badly hit by a win for the pro-independence parties…  …as there are many additional hurdles to be overcome before a referendum can be held.  Even if Scotland eventually gains independence, it is not necessarily bad for sterling

The 18 September 2014 referendum on Scottish independence, in which 55% of voters opted to remain as part of the United Kingdom, was supposed to settle the question for a generation. So why does Scottish independence remain a burning issue north of the border and the main focus of the upcoming elections to the Scottish parliament on 6 May?

What has changed since 2014 and does it justify another referendum?

The primary change since 2014 is Brexit. In the 2016 Brexit referendum Scotland voted strongly to remain in the EU (62% vs 38%). Now that the UK has finally left, many Scots feel that they have been removed from the EU against their will. The Brexit decision only underscores Scotland’s lack of self-determination on the major issues of the day. Brexit is seen as yet another unpopular decision imposed on the Scottish people by a Westminster government with different priorities. In addition, many Scots see the Scotland Act of 2016 as a poor substitute for the powers that they were promised by the leaders of the main UK parties just ahead of the 2014 referendum, as an inducement to remain part of the Union. The Smith Commission, set up by then PM David Cameron in September 2014, promised much but ultimately delivered little in terms of additional, concrete devolution.

Polls point to a win for pro-independence parties

The latest polls show little change since the last Scottish election in 2016. The SNP currently has 61 seats in the 129 seat chamber. It governs as a minority government. However, with the Scottish Greens having 5 seats, there is a small pro- independence majority in the parliament. Both the SNP and the Scottish Greens have included a firm commitment to hold another independence referendum in their manifestos ahead of the upcoming election.

We see a roughly 60% chance that there is a pro-independence majority the Scottish parliament in the wake of the elections. Betting markets currently see a ~60% chance that the SNP holds a majority on its own. However, winning the election is just the first step. It is a necessary but not sufficient condition for an independence referendum.

Pro-independence polls weighed on GBP in 2014. Pro-independence parties to remain in control in 2021 GBP during Aug/Sep-2014 Scottish Parliament - seats (total 129) …o1.70ther metrics suggest less optimism 0.765 5 GBP/USD EUR/GBP (rhs, inverted) 5 1.68 0.770 8-Sep: First poll shows pro-independence result 0.775 1.66 23 0.780 1.64 SNP 0.785 Green 1.62 0.790 61 Conservative 1.60 Labour 0.795 18 Sep: Lib Dem 1.58 Referendum 0.800 Other 1.56 0.805

30

5

Source: Bloomberg, Scottish parliament

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If the pro-independence parties win – what next?

Firstly, for the referendum to be recognised abroad it needs to be legitimate. This is key for EU acceptance of any referendum, as some EU countries (Spain) are fighting similar battles and are not keen on encouraging independence. Currently, this means it needs the consent of the UK government in Westminster. Our baseline assumption that PM Johnson will simply refuse to allow a referendum, at least in the short term. It is possible he may hold out beyond the duration of the current parliament. We assume Johnson (or his successor) will eventually be forced to concede a referendum but it is only at this stage that a referendum becomes an issue for markets. Note that there was an 18-month gap between the announcement of the 2014 referendum and the date it was actually held. It may be a little shorter next time but it will still be a substantial period of time to allow a full campaign which explores all the issues.

Secondly, we assume a roughly 50/50 chance of any independence referendum resulting in a win for the pro-independence side. In the wake of the Covid crisis and the resulting surge in public debts, as well as the decline in oil prices since 2014, the economics of independence look less attractive now. In the wake of any referendum announcement, GBP will likely be driven by the polls as it was in the run up to the September 2014 poll. It is possible that the polls show a strong lean one way or the other, thus making GBP less sensitive but our baseline is that the polls for any referendum decision will be reasonably close for much of the duration of the contest.

Thirdly, even if Johnson allowed a referendum and even if the pro-independence side won, the SNP has yet to determine what currency arrangements it would pursue. Official SNP policy is to continue to use GBP, at least in the short term as detailed in former SNP MSP Andrew Wilson’s Growth Commission Report of 2018. GBP was to be retained until six economic tests had been met, which the author thought might take upto a decade. At the Party Conference in 2019 the currency plans passed but with an amendment stating that the new parliament should introduce a new Scottish currency “as soon as practicable” after independence. It seems as if the longer-term plan is to rejoin the EU and eventually join the euro.

However, there is a major snag with the above plan to use GBP in the short term. The UK is unlikely to allow it and will likely push for plans for an independent currency sooner rather than later. Here a look at the Velvet Divorce – the separation of the Czech and Slovak Republics - is of interest, especially with regard to currency arrangements. The two countries planned to share their old currency while they worked out the details of their separation – a plan which included a joint monetary policy board. However, markets were unwilling to wait and capital flowed out of Slovakia and into the Czech Republic. On February 8 1993, just 38 days later, the two countries were forced to introduce separate currencies well ahead of the proposed schedule.

Too early for GBP to become sensitive to independence concerns.

The key to how markets perceive the UK/Scotland split will be in the details of the agreement, with most focus on legacy debts/fiscal issues and oil. Ahead of time, it is hard to know exactly how these issues will be dealt with. That said we see a consensus for a weaker Scottish currency in the wake of any split amid fiscal concerns. For GBP, there is much more debate as to how events would play out. The UK economy would be smaller but also likely fiscally better off, albeit with a slightly weaker trade balance in the wake of any split. It is possible, even likely in our view, that GBP ends the process in a better position. While short-term volatility and some GBP downside seem a given in the event of a referendum being called, a weaker GBP is much less of a sure thing in the long run.

Scottish trade is mainly with the rest of the UK… …and its deficit is well above the UK average Destination of Scottish exports (2018 - Total £85bn) Scotland's fiscal deficit (% of GDP) 60 Scotland (excluding North Sea oil) Scotland Inc North Sea oil (geographic share) 50 UK 0 40 -2

30 -4

-6 20 -8 10 -10

0 -12 Rest of UK EU Non-EU 2015/16 2016/17 2017/18 2018/19 2019/20

Source: www.gov.scot

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