A week ago I posted here on the Scottish currency issue, in the context of a stooshie (English: kerfuffle) I had created when commenting on SNBP policy. For technical reasons, although that was written as a Twitter thread I could not post it as such then. Now I have edited it and put it out on Twitter. This is that thread posted here, for the record. There have been quite a lot of edits since the original post - including eliminating the first 700 or so words and adding in a lot more technical background explanation.
A week ago I caused a bit of a Twitter fuss when writing about SNP policy. I wrote a blog in response. This is the Twitter thread version….and is all about whether the SNP's leadership is serious about independence, or not, and what will make that possible.
Wanting to be independent requires a credible plan to deliver an independent country. And this is what the SNP lacks. It has no apparent route to achieving this aim at present, politically, as internal disputes show.
Worse though, it has no coherent plan as to what to do if independence was achieved. The closest we get to that plan is still the Sustainable Growth Commission report by Andrew Wilson, formerly an MSP. As far as we can tell this is still leadership policy.
I say ‘as far as we can tell' because a key component in this plan, that Scotland should use sterling after independence, was overthrown by the membership of the SNP in conference resolution in 2019, but the party leadership has ignored that and is still fighting back against it.
And this is where the issue really is. It's my suggestion that the SNP leadership is pursuing a policy that would destroy the aspirations of the SNP's membership and leave Scotland a poor and even ruined country if independence were to happen, and all because it fears markets.
That SNP leadership plan is to use sterling – without England's consent – after independence. This plan is called ‘sterlingisation.'
It seems that the leadership are pursuing this idea because they believe that the money markets might not lend to Scotland if it asked to borrow in Scottish pounds after independence.
They do however believe that those markets would lend to an independent Scotland if it borrowed in sterling, albeit at a higher interest rate than they would charge to the rest of the UK.
To put it simply then, what the SNP leadership seem to think is that the money markets will not trust Scotland's promise to pay in its own currency but that those same markets will trust Scotland's ability to repay if Scotland borrows in another country's currency.
This makes no sense at all. At the most basic level, either the money markets will think Scotland can repay, or can't repay. If the SNP leadership think the markets will lend to Scotland in sterling then they are at least saying they think Scotland is credit worthy.
But then what the SNP leadership are implying is that they share the belief that they think that the money markets will have that Scotland is not capable of having, or running, its own currency, and that it must remain dependent on England after all.
This is the real issue that I am discussing. The key question to be answered when discussing the Scottish currency issue is a simple one: it is about whether Scotland can successfully run its own currency, or not. On that one issue does the whole future of the country hang.
By committing itself to sterlingisation the SNP's leadership is sending out the clearest possible message on this issue. It does not believe it can run a Scottish currency. There is no point beating about the bush, that is what it is saying.
Politically that is disastrous. It indicates a lack of faith in Scotland. Why else is the SNP suggesting this when the evidence is that lots of new small(ish) countries have launched new currencies without problem and that almost all countries actually do create their own money?
I am baffled as to why the SNP leadership believe that Scotland cannot do what so many others have done without the help and assistance of England. It seems to be that the excuse is that this is what Ireland did in 1922. And I can summarise how that went: it was a disaster.
Ireland suffered decades of poverty as a result of using the pound. None of the benefits of independence were delivered until this policy was finally abandoned. Scotland has to avoid that fate.
But to understand this, let me explain why sterlingisation will deliver that disaster. There are quite a lot of reasons. I won't apologise for addressing them.
First, Scotland would have to borrow in sterling, which then means Scottish debt would have to be repaid in English pounds.
And all those English pounds would have to be earned by selling Scottish made goods and services to England to get sterling, which no Scottish bank could create, but which every bank in England can. Scotland would be immediately in hock to English banks.
But worse, Scotland would then be desperate to make exports so that it could service its loan repayments. The efforts of Scottish people would not be used to improve life in Scotland. They would be used to repay the owners of Scottish debt in England.
And you can be sure that the interest rate paid would be higher than is paid on UK government debt now. So the amount of work the people of Scotland would have to do to service this debt owing in English pounds would increase.
Put simply, Scottish effort would be directed towards making the owners of its debt denominated in English pounds richer. And Scotland would be poorer as a result. Using sterling would be like having a new English tax on Scotland from which Scotland got no benefit, at all.
But it's worse than that. If the interest rate due on Scottish government debt was higher than in England so would other interest rates in Scotland be higher. And so the cost of living of those who have to borrow in Scotland would go up.
And, of course, anyone repaying their personal loans would also be repaying in English pounds – meaning that they too would be helping the flood of wealth out of Scotland and into England.
I will ask a straightforward question. Is that what independence is for? The SNP leadership say it is. I say it is not.
It gets worse still though. As the Scottish intertest rate would not be set in Scotland – it would simply be the English interest rate plus a bit – the Scottish government would be unable to use interest rate changes to manage the Scottish economy. It would be rudderless.
And worse, again, if Scotland does not have its own currency it could not do what the UK government has done during the Covid crisis and create new money to tackle the crisis using quantitative easing – which is literally central bank money creation.
The UK government has done more than £400 billion of quantitative easing over the last 18 months or so – and as a result none (I mean none) of the cost of that crisis need fall on taxpayers. But if Scotland had been independent and using sterling it could not have done QE.
If Scotland could not have used QE then the whole cost of the Covid crisis would have fallen on Scottish taxpayers. They would have had to repay debt due in sterling when no repayment of the new money created in the UK is ever going to be required.
Not being able to use QE would have been calamitous for Scotland if it had been independent and using sterling as its currency during the Covid crisis. It would have been brought to its knees by the collapse in its economy as a result of having to borrow in sterling.
And I stress, very strongly, if Scotland had its own currency after independence it could use quantitative easing, which is now the most powerful economic management tool available to any country, but only if it has its own currency.
(And before you ask, eurozone countries do use QE, they just do it collectively, so that is not a counter-argument).
There is another problem in sterlingisation. This results from the suggestion the Scottish Growth Commission makes that it would be necessary to build foreign exchange reserves whilst using sterling as the currency before Scotland could ever consider having its own currency.
Andrew Wilson said that whilst using sterling Scotland would not have to just repay foreign debt to England – which he said would be owing on independence, about which I do not agree, at all - but it would also have to build up foreign currency reserves as well.
In other words, not only would Wilson have Scotland earn currency to repay old debt to England it does not owe, and to repay new debt it need not borrow from England – but he also says Scotland must also run a surplus on its foreign trade to earn yet more foreign currency.
So, he and the SNP leadership would have the Scottish people working hard to earn foreign currency even though they would see no gain from it just so that a very large pile of foreign cash could be built up in the Scottish central bank.
Let's be clear what the consequence is. Standards of living in Scotland would fall. And Scottish government services would have to be cut to reduce borrowing to the greatest degree possible, because that is what would be necessary to build those foreign exchange reserves.
And that double whammy on the wellbeing of people in Scotland would be all about creating reserves so that one day Scotland could move away from sterling to have its own currency. But the key point is that even then Wilson and the SNP leadership will not believe in that currency.
We know that because what they'd want to do is ‘peg' it value against another currency. In effect they'd say it had a fixed exchange rate with sterling or the euro. To maintain that peg would require lots of foreign reserves – because that is the price of a fixed exchange rate.
To keep an exchange rate fixed foreign reserves have to be owned so that Scottish currency can be bought in foreign exchange money markets to keep its value up if it fell, or was subject to attack from foreign exchange traders.
In other words, all that the long post-independence austerity that the SNP leadership seem to want would be about is building up the foreign exchange reserves required to create a fund that could be attacked by bankers for their profit.
This is how foreign exchange traders in banks work. If they see a country trying to keep a fixed exchange rate and they know that it has the foreign exchange reserves to buy their own currency back in the money markets what they do is attack that currency.
They attack by selling that currency – knowing that they are forcing the country in question to spend its reserves to keep the value of the currency up despite the attack it is suffering, which is seeking to force its price down.
And the bankers keep attacking, using all the resources available to them, until eventually the country runs out of reserves to defend its currency. Then the country stops, and the value of the currency falls. The traders have gambled on this happening. They win as a result.
The country has lost face: in the battle with the bankers it has lost. And what is more it has lost its reserves – which would be created through austerity imposed on the people of Scotland in its case – in the process.
But, if the country had its own currency from day one and said it was not going to intervene in money markets to defend its value the bankers would have no one to trade against from whom they could profit.
Simply letting the value of the Scottish pound float would stop the traders from attacking. And there would be no need for reserves to defend the currency. And so there would be no need for the austerity to create them.
The only reason for accumulating the reserves the Growth Commission is fixated on was to defend the Scottish currency from attack. It was a policy written by those in financial markets about the games bankers play from which Scotland could never win.
There is an alternative. If the Commission had sufficient confidence in the Scottish pound to say it could float and would get its value not from the amount of reserves Scotland had available but simply from the strength of the Scottish economy none of this would be needed.
So, let me begin to draw a conclusion. It is this. Because the SNP leadership believe that they cannot run a currency, and that the money markets are the actual people they will have to keep happy rather than the people of Scotland, they will not let Scotland have that currency.
And because they will not let Scotland have its own currency because they are so frightened of money markets they would rather impose austerity on Scotland and cut its standard of living and increase its interest rates and effectively impose a tax to repay foreign currency loans.
Incidentally, not having its own currency would also prevent Scotland from joining the EU, as it is pre-condition of membership that it has, but let's leave that aside.
So, I see nothing in the SNP leadership's plans that is compatible with a plan for independence that can deliver for the people of Scotland. Instead I see a plan that is going to harm Scotland, and frankly take it on the same path as Ireland had after it became independent.
The reality is that none of this is necessary. If the SNP leadership believed in itself, in Scotland and the role of government then as many (me included) have argued, Scotland could have its own currency within weeks of independence.
That currency should float on foreign exchanges, which is exactly what the pound does now, of course. There is no problem with it, and in that case no significant foreign exchange reserves are needed. That is one problem solved.
What is more, if only the Scottish government believed it could stand up to money markets – which is the key issue – it could set its own interest rates, use QE, run deficits and fund them with borrowing in Scottish currency – and so deliver wellbeing for Scotland as a result.
And what is more, Scotland could then deliver all those policies that the SNP members want. But – and I cannot stress this enough – the policies of the SNP leadership will never permit those policies to happen as it stands, in my opinion.
This is why I said that the SNP leadership was neoliberal – which is what started the reaction on Twitter that I referred to at the start of this thread.
Neoliberalism is most identified by the belief that no one – including governments – can buck the rule of markets – and especially the money markets – who neoliberals say can hold governments to account and break them for not doing as they wish.
QE has proved that this is utterly untrue – and is based on economic theory I had known of for a long time. And so what QE also proves is that it is essential that Scotland has its own free-floating currency on independence. This is vital.
But right now the SNP leadership is in denial of this. It is still promoting a policy for Scotland that will subject its people to austerity for the sake of its fear of those markets.
If only the SNP leadership would instead learn modern monetary theory, take note of the lessons of QE, and free itself from the fear of markets it could deliver for Scotland and the SNP membership what the latter know Scotland needs.
But they won't do that. And so, as I am told very often when talking to people in Scotland, people still do not know what to believe about independence and so still have reservations.
I have more than reservations: I think what the SNP leadership is proposing is deeply dangerous for Scotland and its people. And because I think this really matters I have had the courage to say so.
Please feel free to disagree with me. Argue the facts, theory or implications. I have set out my reasoning. The SNP leadership should set out theirs. If they think they can deliver for Scotland using the currency of another country they need to say why. I see no way that they can.
Worse, I think that it is neoliberalism – a failed political dogma – and its associated austerity that drives their thinking. And that is very far from the left-wing view of most SNP members.
This means that this is an issue for the SNP to resolve now, because unless it does I cannot see how independence will happen. The currency question killed independence in 2014. Surely the SNP leadership aren't going to let it kill it again?
The current SNP leadership policies suggest that they will. If the SNP membership really want independence they have to get those policies changed, or they're not just wasting their time, but are going to make life in Scotland very much worse.
As I said previously, everything hangs on the currency question and I can only see one answer to that question. Scotland has to have a free-floating currency on independence or it will never be independent. I really do think it is that simple.
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“I am baffled as to why the SNP leadership believe that Scotland cannot do what so many others have done without the help and assistance of England.”
Forgive me, but I do not think that characterisation of the issue describes the real nature of the underlying problem. The SNP have consistently been wrong about currency (since 2014); let us take that as a given about which we can agree and move on; but the SNP do sense, probably intuitively, that there is an issue of political signifcance here, a puzzle they are not sure how to solve. After all, they may be poor or old-fashioned neoliberal economists, but there are savvy politicians among them, and we may assume their political antennae are acute. The issue in Scotland is fundamental, and is not being solved: the currency the electorate is prepared to support, or prepared to abandon is the biggest issue of all. It is a mistake to confuse support for the Union and support for the currency in Scotland: the currency is far, far more important than the political Union.
I suggested in your previous thread on this issue that from the perspective of the Scottish electorate the issue is not about the Union or its politics (Austerity-for-nothing, Brexit, Covid and the relentless cycle that produces the over-ripe stench of Sleaze from Westminster, clinging now to its fabric like the enduring smell of a skunk; has virtually killed the ‘bond’ of Union, and significantly reduced support for it in Scotland): but the currency, like nothing else can, focuses the full attention of Scots more than anything in the Constitution (it isn’t the country of Adam Smith for nothing).
The issue is not a matter of abstract analysis, but of deep-rooted confidence in the money on which people rely; if you wish to change the currency, it is therefore a matter of decisively persuading the electorate, ex-ante any change to currency: and how, precisely you propose to persuade, and to implement it. To paraphrase M&S; this is not any old currency that Scots are attached to; this remains a world currency, that for most of the three hundred years of the Union was in most respects, the world’s reserve currency (and its rise to predominance notably was as a function of Union), until the US dollar rose to prominence, largely following the prescriptions it learned from the UK. For Scots the currency (sterling), is really all that is now left of genuine, substantive, enduring value, from a shared but decayed history of Union and Empire. There is your context. There is the problem.
I noticed in the last thread on this issue, nobody at all answered the question on currency that I posed: QED.
John, I suspect that the SNP leadership political antennae are more tuned to the signals emanating from Scotland’s over sized finance industry than to any supposed emotional attachment of Scots to the pound sterling.
It’s an interesting point actually that John and Clive are raising. Even in the point I raised about currency being probably the best expression of sovereignty, that factor means nothing if you cannot persuade the Scot’ voter that (1) its a good idea and (2) the value of what they had in GBP will be maintained in the transfer over from GBP to Scottish poonds or whatever.
In comparison, friends in the EU during the adoption of the Euro felt that they had lost out – they perceived prices to be higher (this was in France and Italy BTW) after the adoption of the Euro and that feeling still lingers. People don’t really want to vote for change to make themselves worse off (unless of course, like BREXIT, they are lied to on an industrial scale).
So, even if we agreed that a SCP was a great idea, the art of making it real is how do you sell it to the Scottish public, and what polices are there to counteract the obvious lawlessness of the financial sector?
The truth of the matter seems to be that other than here and Dr Rideout, I don’t see Scottish politicians willing to have a genuinely honest conversation with the public about this. Maybe they just couldn’t be bothered – it’s complicated and goes against the laissez faire/lazy attitude that many modern (post-modern?) politicians have to these issues – leave it to the market, they know best etc.
But it is rather a shame that it will be ignorance and fear that leads to Scots not having their own currency in the end and also leaves those countries with their own currency in an in imperious position over other countries.
Mr Osborne,
It isn’t ’emotional’ it is based on three hundred years of experience; and that enduring solution currently stands against a demonstrably incomplete hypothesis that has not been worked through; for example as Mr Parry has illustrated. You have missed the point.
Your reference to the SNP listening too closely to the finance sector can also be true; and you would still miss the point. In real terms the currency is the anchor of the Union, and all there is left that prevents the hulk of Union drifting inevitably into the breaker’s yard.
Is there a solution? Only if the hard work is done first; the alternative is a quasi-federal solution, which the majority would probably have approved in 2014, if it had been offered. Note that the UK in 2014 effectively turned the Incorporating Union Scotland and England formed in 1707, into a Federal Union; solely because of the currency. That should demonstrate just how much the currency matters.
Using GBP as the currency for an independent Scotland is, as you say, nuts. I would add that Scots would have greater control over their fate if they remained in the UK and kept sending 50 SNP MPs to Westminster – at least there would be a sporting chance of a coalition government where SNP MPs could deliver for Scotland. Using GBP would make independence illusory for all the reasons you state.
I would not completely rule out a switch to EUR. One could conceive of a situation where sacrificing monetary sovereignty might make sense if the package of political and financial support from the EU were sufficiently attractive…. but I susp[ect this is unlikely.
So, a new currency is most likely to be the best solution.
Now, at the risk of annoying you and Tim Rideout, I STILL think the conversion plan fails to address some serious issues.
First, the potential Asset/Liability mismatch that banks will be forced to take on as individuals/companies exercise (or not) their option to convert future liabilities from GBP to SCP. If a company redenominates its loan from GBP to SCP the lending bank will be forced to sell SCP (forward) as a hedge. I accept that the mirror image is true that (say) pension funds will want to convert GBP assets into SCP assets if their pensioners choose to take their pension payments in SCP. But we don’t know how this would pan out and it is entirely possible that borrowers (with revenues/wages) in SCP leap to convert to SCP whilst pensioners choose to wait and see. How do you deal with this potential selling pressure on SCP?
Second, speculators will jump on this. They might borrow $1bn from RBS in Edinburgh and deposit £1bn in Barclays London which would give them a cheap option to be short SCP at 1 to 1 vs GBP. These flows could be very destabilising for both FX and Interest rates.
I stress, these are NOT reasons to stay with GBP as the national currency of Scotland….. but they are things that need to be thought out in advance.
There are possible solutions but at this stage I seem to be the only one articulating this risk. Am missing something…. or are you?
Clive
The question you are not addressing is where those SCPs come from
Isn’t that the missing element in your equation?
Richard
They come from the Scottish Central Bank as lender of last resort.
Now, if they choose to restrict lending of SCP then that will have implications for interest rates.
Imagine I am a Scottish bank and a Scottish customer owes me 1 GBP due in 10 years time… and I owe a London bank 1 GBP in 10 years time. At present I am hedged. Under the proposed conversion I (the Scottish Bank) am short an option… the customer has the right to sell SCP (v GBP at 1 to 1). My hedge is to sell SCP (spot) which will put downward pressure on the SCP FX rate and upward pressure on SCP interest rates (because I have to borrow the SCP that I need to sell short as my hedge)…. and the Scottish CB will, ultimately, have to underwrite the other side of my trade.
The problem for a new Scottish CB is that they can sell SCP without limit at 1 to 1 to meet demand to convert GBP assets to SCP assets but the mirror image (with liabilities) is NOT true as they do not have unlimited supplies of GBP. This asymmetry means that the SCP will most likely trade at a small discount in the grey market just prior to floatation….. and this likelihood could be self fulfilling as speculators look for ways to set up shorts at 1 to 1.
Not saying that this WILL happen – but could well happen and Scotland must be prepared.
If ep[ople convert to SCP from £ where is the shortage of £s?
Following on the comment I made above, I am inclined to agree with Mr Parry. I do not claim every pensioner uses the finegrained technical judgements Mr Parry deploys, but they do not need to do so in order to reserve their judgement or weigh a balance of probability (indeed Mr Parry uses their potential resistance to form his case). Intuitive heuristics is what people use in daily life. Cognitive psychology has built an established literature exploring the phenomenon; unlike neoliberal economics, not as an abstract theory, but as a description of real human decision making. Nor do pensioners need to have read Kahneman and Tevrsky to use the cognitive notion of ‘anchoring’ in their personal life. I am proposing that for many Scots sterling is the monetary ‘anchor’ which establishes the basis for any comparison they are offered. There has to be a very powerful and persuasive reason to jettison the anchor. It has not yet been produced.
Clive, there are no FX risks for the commercial banks. The Scottish bank (subsidiary of a bank holding co, e.g. RBS Plc as the S£ only subsidiary bank owned by Natwest Group Plc) will deal only in S£. It will therefore neither be owed or owe Sterling to anyone (unless for some reason it has loans or advances to the parent company that are not in S£). The rUK bank (subsidiary such as Natwest Bank Plc owned by Natwest Group Plc) will operate only in sterling. All existing sterling accounts (loans and deposits) currently in RBS Plc are shunted into Natwest Bank Plc by means of a High Court Scheme of Arrangement as part of the new currency preparations. RBS Plc will open new S£ accounts for clients that ask for them. At that point for a brief period RBS Plc would have zero loans and zero deposits because they would all have been moved to Natwest Bank. In the case of Santander UK Plc you don’t need to do that as they would establish Santander Scotland Plc with an empty book and thus zero balance sheet. The RBS type arrangement would apply to those banks that are currently domiciled in Scotland, so RBS, BoS, Clydesdale, Tesco Bank, Sainsbury Bank and perhaps a couple of others. All other banks domiciled in rUK or elsewhere that wish to operate in Scotland just need to establish XXX Bank (Scotland).
I believe it is not possible to move a company registered in Scotland to being registered in England and that can only be done by ‘selling’ the assets or by a court sanctioned scheme as above.
Any risk is taken by the Scottish Reserve Bank. The transition has to be managed such that the value of sterling cash and deposits exchanged into the S£ always stays at least slightly ahead of the reverse flow of S£ to rUK in order to repay sterling debts such as mortgages. If it does not then either the SRB would have to provide sterling or there would be downward pressure on the FX rate (if the banks are selling S£ proceeds or e.g. a new mortgage to obtain the equivalent sterling to settle the old sterling mortgage in their rUK subsidiary. I am sure this can be managed – for example people will have to have S£ (it is all voluntary, but paying tax is not and can only be done in S£), while you could e.g. slow down the clearing of old sterling debts by various means or accelerate exchange of sterling deposits. The below is Point 20 from the FAQ at https://reservebank.scot/the-quick-guide-to-the-new-scottish-currency#gsc.tab=0
Our best estimate currently is there are about £200 billion of sterling deposits and £130 billion of sterling loans. The end point of the exchange process is essentially that what the commercial banks currently have on deposit in their BoE Reserve Accounts would have all moved to the SRB Central Bank Reserve Account at the BoE. That is £27 billion in the case of RBS Plc. Note that while the SRB will end up with something like £60 billion of sterling, that will be physically located in the SRB account at the BoE. As with any other base sterling it can’t actually leave the BoE accounting ledger.
20. It has been claimed that the commercial banks will face huge foreign exchange risks?
This is not true. We have already seen that the banks will have to divide into a Scottish Bank and an rUK Bank. The S£ customer deposits and new loans and mortgages in the S£ will be entirely in the Scottish Bank. The old Sterling deposits and old Sterling mortgages and loans will be entirely in the rUK Bank. As we already saw the balance sheets in the rUK banks will fall with no mismatch between assets and liabilities. The balance sheets in the Scottish banks will rise, again with no mismatch between assets and liabilities. There is nothing owed from the Scottish Bank to the rUK Bank, or vice versa. If there is nothing owed, then there is no foreign exchange risk.
What risks there are, are taken by the Scottish Reserve Bank. Those are any risks during the short fixed rate of the official Exchange Period when banks and the public are indemnified against FX movements / costs, and later as the SRB will have a large holding of foreign currency that might rise or fall in value. Equally we (individuals and companies) will have a currency risk to the extent that we retain Sterling deposits in our old bank accounts (now located in the rUK part of our bank), leave our mortgages and loans in Sterling, or remain in receipt of a pension paid in Sterling. The public information campaign will educate us about those risks and ensure we can take suitable action in good time if we wish to do so. Many people may choose to leave their arrangements as they are, perhaps keeping a Sterling loan because they also have a Sterling income (e.g. a pension or share dividends). The more adventurous might choose to speculate that the S£ could rise against Sterling, but that is not recommended for anyone without a clear understanding of the risks and a willingness to accept that could cause a loss just as easily as a gain.
The fact Tim Rideout has risen to the challenge of looking at the minutiae concerning these issues is commendable and compelling.
The ‘elephant in the room’ however is do the politicians (the so-called ‘leadership’) think and know the same? Are they prepared to put as much work into it?
How it comes across to me is that they are just not bothered.
What do the SNP actually want? Just to be the biggest political clan in Scotland? Because I don’t think that that is enough to be honest.
Splitting the current bank into GBP business and SCP business (NatWest and RBS) is a red herring – you cannot change the overall risk position.
After independence, fixed rate loan interest/capital payments that the bank were expecting to receive in GBP will now be paid in SCP (with no change in nominal interest rate).
Now, the bank that previously had no FX or Interest rate risk suddenly has both and will have to take action. They will need to sell the stream of SCP cash flows and buy a stream of GBP cash flows.
In practice, (assuming it starts from a fully hedged position) the bank will
1. Receive fixed in the GBP interest rate swap market
2. Pay fixed in the SCP interest rate swap market
3. Pay SCP v GBP in the Cross currency basis swap market
4. Sell SCP v GBP (spot FX market).
Will they be able to? Now, if asset holders and liability holders transact in equal and opposite directions in similar sizes then there is a decent chance that this works…. but what if they don’t?
Can the SRB take the other side of the trade? Well, if there is bigger desire to switch assets into SCP there is no problem as the SRB can deliver SCP at will…. it is only bounded by the SRB’s willingness to hold GBP balances. But what if it is the other way round? The strain will have to be taken somewhere either spot FX, SCP IRS or the CRX and the SRB will not be wholly in control of its fate.
I fear that younger Scots earning in Scotland and companies with borrowings will be keen to convert their liabilities (mortgages and loans) to SCP but asset holders (older Scots) may wait and see.
This might be containable – it depends on the size of the mismatch but this asymmetry is a red rag to a speculator. Take a look at Target 2 balances for an idea of the size of flows that could be involved if speculators get a whiff of weakness.
As I have said already, Scotland needs the SCP… but you underestimate the risks at your peril.
What is the liability that the bank has in GBP?
Why does it have it when it can create the loan without borrowing?
Or are you saying it has sold the loan and now has to collect to service the loan it has sold?
And is that Scotland’s problem?
Have you considered capital adequacy rules for the Scottish commercial banks? You envisage that they start with zero balance sheets denominated in Scottish currency. They then take over, in total, £200bn current accounts due to customers and £130bn loans due from customers, converting these to Scottish currency at 1:1. They are owed £70bn equivalent from the Scottish Reserve Bank. But you’ve not provided them with any equity, so if they make any loss they’re insolvent.
In the meanwhile, the Scottish Reserve Bank has £70bn–worth of Scottish denominated liabilities due to the Scottish commercial banks and £70bn of sterling assets due from the Bank of England. Again, you’ve not identified whether it has any equity or where it comes from. That’s a massive foreign exchange position. By comparison, the Bank of England had net foreign currency assets of just £18m on its February 2021 balance sheet.
First, the BoE has almost no equity
Like the SRB it dies nit need it. By definition it is solvent
And do you really think the SRB would allow banks with no equity?
Clive, you are simply wrong about this. Where are all these swaps and hedges and whatever you are worried about?
I have a loan at Santander say £100,000 for my mortgage and pay £1000 per month, plus my current account has a balance of £2000. So Santander establish Santander (Scotland) alongside the current Santander (UK). I instruct Santander to exchange £1000 from my current account into S£. So that £1000 moves from Santander UK to the SRB who issue S£1000 to Santander (Scotland). So debit my current account £1000, credit Santander UK Reserve account (Santander UK view), and at the BoE debit Santander UK reserve account £1000 and credit SRB reserve account by £1000. The Santander UK balance sheet has simply shrunk by £1000. There are no unmatched assets or liabilities and no need for anything external to Santander UK. Meanwhile the SRB credits the Santander Scotland reserve account S£1000 for onward transmission to my new current account. The Santander Scotland balance sheet has gone from zero to S£1000 and it has an asset of S£1000 in its SRB reserve account and a liability of S£1000 being my deposit in my new current account. Nothing is unmatched and there is no need of anything else external to Santander Scotland.
For the mortgage: I remortgage with Santander Scotland who grant me a new loan of S£100,000. They exchange that into £100,000 which is paid to Santander UK in full settlement of my old mortgage. I cease my £1000 per month repayment and replace it with S£1000 to Santander Scotland. So Santander UK receives the £100,000 which is credited to my old loan account which is now Nil. If this went via the FX market then in terms of the accounting the new mortgage of S£100,000 is paid to the FX broker by Santander Scotland. Debit my loan account S£100,000 and credit my current account, debit my current account and credit the FX broker. If the FX broker does not use Santander Scotland then credit the Santander Scotland reserve account at the SRB for onward transmission. Meanwhile at the SRB, debit the Santander reserve account with S£100,000 and credit the reserve account of whichever bank the FX broker uses. Santander Scotland has created an asset of my S£100,000 loan which is matched by the liability of either the deposit in the FX broker Santander Scotland account or the credit to their reserve account (which they might need to finance with a loan from the SRB on the security of the new asset if there are not enough reserves). FX broker debits their sterling account at a bank in UK and credits Santander UK (if the FX broker does not bank with Santander UK), which means at the BoE debit the reserve account of whichever bank the FX broker uses and credit the reserve account of Santander UK for onward credit to my old mortgage account. So for Santander UK the asset (my mortgage) has gone as have the repayments and they replaced it with the debit to their reserve account, i.e. cash.
There are other ways of doing this as it could be done internally to the banking group or via the SRB providing the sterling. What may happen is that Santander Scotland has insufficient reserves (i.e. not enough in the reserve account) while Santander UK has excess reserves. That is because one is creating new loans where the cash leaves the bank while the other is having loans repaid where the cash is accumulating in the bank. That means the Group has to transfer reserves from the UK bank that does not need them to the Scottish bank that does. For example, Santander UK opens an S£ account at Santander Scotland and vice versa. So this time the transaction could be internal to the Group, so my S£100,000 is credited to the S£ account of Santander UK. Meanwhile Santander UK debit the £ account of Santander Scotland with £100,000, and credit my mortgage account. If the rate is not one to one (as it will be during the first couple of months) then the FX risk falls on me and not Santander. I might need more than S£100,000, for example, to clear the old mortgage. Santander Scotland would have the S£100,000 asset of the loan to me and the liability of the Santander UK S£100,000 deposit, while Santander UK has simply replaced a loan asset to me with a loan asset to Santander Scotland. If they don’t like the fact that there is now a loan from Santander UK to Santander Scotland then they can settle it between them, e.g. with transfer of capital or reserves at Group level. They could also use this arrangement for people exchanging sterling to S£ instead of doing it via the SRB, which would then be crediting the Santander Scotland sterling account at Santander UK while debiting the Santander UK S£ account at Santander Scotland (which is the opposite of the mortgage repayment).
There is no involvement of any external loans, payments to financiers, etc. If Santander UK did, e.g. have a money market loan which had provided reserves for the past issue of loans then they simply use the loan repayments (i.e. the excess reserves) to settle it. That loan could in effect transfer to Santander Scotland if they wished as it could take out a market loan to bolster its reserves that matched the old market loan being cleared off at Santander UK.
If you take the case of RBS Plc it has a £90 billion balance sheet with £75 billion of deposits and cash at the BoE of £26.5 billion with assets of £55 billion of loans. It is essentially all Scottish so all of that moves out of Sterling and the new RBS would look the same except in S£, but with the S£26.5 billion reserves in the SRB and what was the £26.5 billion at the BoE would still be at the BoE except in the SRB central bank account instead, as part of our foreign reserves.
“Where are all these swaps and hedges and whatever you are worried about?”
There are GBP 44 trillion (yes, trillion) in sterling interest rate swaps currently outstanding (according to the BIS).
And how long are they in duration?
Your plan seems to boil down to “I just repay the GBP loan and take out a new SCP loan” and your explanation involves just tracking the GBP and SCP balances at the two Central Banks which, by construction, will always balance. But you completely fail to address the risk related to (and the Present Value of) future payments associated with the loan or swap. This where the trouble is and it IS important. Important because…..
(a) existing annuities, loans, bonds and swap contracts can run for a long time all will be hedged in some way or other and if the annuity or loan can be converted to SCP but the hedge cannot there is a problem….. and one that the regulators will be all over with regard to capital requirements etc.
(b) Concerns about (a) will mean that, in the run up to an Independence Referendum no bank will do business in Scotland as it currently does. Shorter term loans at higher rates would be the most likely outcome.
(c) Existing contracts might be manageable…. but once independence becomes a near term possibility there will be huge speculative positions put on that will have the potential to destabilize the financial system
I am worried that the chief architect for the SCP does not see the problem.
Again, I ask, how would you mitigate this Clive?
And how long are they in duration?
Most quite short… but some will be out to 50 years. The short ones will have rolled off by the time independence comes along but it will make banks reluctant to trade with Scottish counterparties in the run up to a Referendum (if this plan is what becomes policy)
Clive, I appreciate you sharing your view.
Yo share the view that having its own currency would be best for Scotland
If you think prior notice of its introduction would be wrong what would you suggest?
I believe Mr Parry is quite right about this. It appears a large part of the activity of modern banking in swaps, futures and hedges is simply being ignored here; at your peril.
John
So what do you recommend?
Are we really now to be held hostage to bankers?
And in what country is that risk?
It seems that ultimately it is not in Scotland
Richard
Richard,
I did not suggest that there is no solution (nor does Mr Parry, if I understand his position); but rather that nobody has adequately addressed the problem. I have been waiting for that position to be presented by the leading advocates of a Scottish currency, and have yet to see it (unless I have missed something).
I am neither a banker nor a trader, so i am not going to take the foolish step of offering a glib solution to a complex question that requires extensive and detailed programmed solutions by people who live within that activity; because that is the global financial system we have and Scotland will live within.
Two points I would make, from history, however: First and most recent, in the US a great deal of the problem during the financial crash centred around Credit Default Swaps, not for some esoteric derivative; but because the CDS’s were used to securitise massive quantities of low-grade house mortgages that offered no real collateral. The effect this had on ordinary people in the US was catastrophic; compounded by the US Treasury’s (Bush and Obama) failure to operate a foreclosure rescue programme that protected the homeowners, rather than the banks. I suspect the rise of the Tea Party and of right-wing Main Street populism started from there. Read Neil Barofsky, ‘Bailout’ (2012) for the best, authoritative account, in my opinion.
Second, money and banking has developed its own, increasingly complex processes over time (now disappearing from view in the shadow banking world). Academic Economics has done a very poor job keeping pace with these developments; the best insight and understanding on a theoretical level is (as far as I can see) provided by Perry Mehrling, because he looks at how it is actually done, and although a technical economist, his baseline approach at Columbia is double-entry book-keeping (I wish he would address the issue of a Scottish currency!). Taking a step back, both Keynes and Hayek’s view of macroeconomics (and of money) was wrong, and more important, misleading. Morris Copeland’s Money Flow model demonstrated powerfully (as a minimum) that there was unidentified activity (differences on reconciliation) that was simply never going to be picked up by Keynes and Hayek’s abstract, over-simplified non-moneyflow models.
I think that Mr Parry, who is a great deal nearer the coal-face of money operations than I have been, is right to be concerned.
John
Thanks
I saw a comment on Twitter, can’t remember who said it or the exact wording but it went something along the lines of:
Q. What currency will you use?
A. The same currency you’ll use to buy our oil, gas, power and everything else you want.
In reply to your last reply……
IF people convert GBP assets to SCP assets in sufficient quantities then there will be enough GBP held by the Scottish Central bank to meet flows in the other direction…. but that is a big IF. Because, if not then there is chaos…. and we know that older Scots (a) own the assets, (b) are cautious and (c) are more likely to be in favour of the Union.
Beyond that, the risk taking capacity of the hedge fund community is enormous and if they latch onto this trade then they could easily swamp the Scottish CB irrelevant of what Scots choose or choose not to do.
What countermeasures? Well, exchange controls, swap lines with the BoE, statement from the BoE that SCP has a significant role to play in rUK FX reserves etc.
My point is that a serious plan must address these issues.
I agree
Looking at this another way, it seems to me that it suits the neoliberals in charge of Westminster to benefit from Scotland currently being in the Union, but that the form of independence currently proposed by the SNP would have glorious opportunities for immense profits at the expense of the people of Scotland. Ergo, there would be rich personal rewards for people who succeeded in persuading Scots voters to vote for this form of independence.
I appreciate that you don’t think Scotland would need to accept ownership any share of the UK national debt upon independence, but would the money markets agree? Might they see this as a sovereign default and offer only very high interest rates for borrowing as a result?
In essence, will they accept the argument that an independent Scotland might make for not absorbing any share of that debt? What if they didn’t?
How can you default on a sum not owing because someone else is going to settle it if settlement is ever required?
Isn’t this merely a matter of perception though, and presumably Westminster would publicly talk long and loud about how Scotland has defaulted on its share of the national debt? And we can probably be certain that Westminster will at least threaten to use every ounce of its considerable influence on money markets to ensure Scotland suffers the maximum inconvenience?
A responsible planner would at least examine this scenario, even if just to discount it as too unlikely to warrant mitigation efforts.
My suggestion has always been that if the rUK reduces its national debt having taken QE into account then Scotland should bear its share of the reduction. That is fair. But there is no way Scotland should repay debt to rUK when rUK is not actually repaying debt.
There is no default in that.
And rUK has no track record in repaying debt
The Treaty of Union has created major problems of interpretation, even whether it ‘sounds’ in international law, because, under its terms neither party to it now exists**. It is a strange proposition to argue that an independent Scotland (which is not obliged to accept the debt, which is a matter for negotiation between the parties in international law, yet at the same time Scotland is not entitled to any control over the currency in which the debt interest and repayment is fixed); can “default” on the debt, when it follows that in international law ‘Scotland’ does not (yet) exist.
More importantly, the British Government, representing rUK (as the ‘continuator state’ in international law) made clear to the whole world in 2014, that the currency would continue to be entirely under the control of, and the debt the responsibility of rUK alone. rUK excluded Scotland from its own currency on indpendence (ironically invoking the principle of Federal Secession to an Incorporating Union that England had required Scotland to accept; turned upside down in an instant); in order to protect the stability of the continuator state principle. Scotland has not challenged that principle, but it is not within the patronage of rUK simply to pass on unchallenged and unilaterally, part of its debt to the seceeding state, solely because it is convenient to rUK.
I could say here, what is obvious in justice and equity; if Scotland is obliged to give up all control or any say over its longstanding currency, and the debt is determined by negotiation under international law; there are no justifiable grounds for Scotland accepting a part of rUK’s declared debt – in what becomes a foreign currency: that isn’t a negotiation, but insanity. It does not wash.
But even that point is, in any case irrelevant; because the question you posed was about ‘money markets’; why do the money markets care when the negotiated settlement between Scotland and rUK has already established the ground rules? the currency and debt will be the asset and the responsibility of rUK; according to the British Government and rUK. The answer is, therefore: the money markets don’t care provided somebody of substance is on the hook: rUK by self-declaration and through rUK’s own appeal to the rule of international law.
The British Government does not wish or intend to negotiate on the matter. It has already accepted the full consquences. So be it.
** Read Crawford and Boyle’s British government sponsored legal opinion: “Annex A
Opinion: Referendum on the Independence of Scotland – International Law Aspects”
There are only two names on the Gilt – the UK Treasury as issuer and the (current) owner. No mention of Scotland (or Australia or any other former territory). Only person that can default is the UK Treasury. It is also not possible to remove the UK Treasury as the issuer / repayer and replace with somebody else. That is fixed for all time when you issue it.
Agreed, entirely
Thanks Timothy that’s helpful – you feel that Westminster and their allies in the financial media will be unable to convince the money markets that Scotland is a “bad debtor” as a result of that?
Or do you feel that they won’t even try?
I do agree with you 100% but you still managed to give me quite an abrupt answer the last time I commented on this issue!
I’m sure there is general agreement that Scotland can run its own currency. There are examples of smaller countries who do just that. In any case, if Scotland wants to rejoin the EU it will have to show a track record of doing that too.
However, many Scottish people will be concerned that a new Scottish Pound, or whatever it ends up being called, will end up being worth less than the current UK pound. They’ll be concerned their wages will be lower, their houses will be worth less and so will their savings if they opt to stick with Scottish pounds. Of course we don’t know that will happen. It’s possible the Scottish Pound will rise against the UK pound.
But voters don’t like uncertainty where their money is concerned. That’s what will be worrying the SNP leadership at the moment.
Tell me how the pound falling in value has impacted you Jim?
Choose the time period you like. Say post-2015 if you want.
Or since 1990.
But tell me what it has meant to you.
@ Richard,
If you are saying that a lower exchange rate can be beneficial overall then I agree with you. However, ours is very much a minority view. A higher rate is seen as a sign of economic success by most. It is others we need to convince, both in Scotland and the rest of the UK too.
Agreed
As far as I can see it..
If the S£ were to collapse such that Scottish products were significantly cheaper surely the situation would to some extent self correct itself?
Yes….
You ask……. “What is the liability that the bank has in GBP?
Why does it have it when it can create the loan without borrowing?
Or are you saying it has sold the loan and now has to collect to service the loan it has sold?
And is that Scotland’s problem?”
If the bank creates an asset (the loan to the Scottish client) it must also be creating a liability. At the moment the loan is made that liability is a sight deposit made by that same client… but you can’t run a bank like that, regulators do not allow it. In reality the bank will borrow money for a longer maturity. For illustrative purposes, I merely set up the simple case of a bank balance sheet that comprise one asset (a fixed rate loan to the client) and one liability (a fixed rate bond issue in GBP) to show where the problems arise (ie. a balance sheet with no FX or Interest Rate risk to one which has massive interest rate and FX risk). In reality, a bank’s balance sheet is far more complex but my simple model does, I hope, show the problem.
Is its Scotland’s problem? Yes, under the proposals suggested right now any UK bank will cut back its business in Scotland or at least charge a higher rate of interest on loans due to the potentially optionality that they are offering the borrower.
Tim has now responded
That might be the response
I am nit convinced by your case as yet Clive: I cannot see the gross mismatch that you are, even with this explanation
So, are you saying that you understand there mismatch but that the numbers are small and that banks will just live with it?
If so, that is progress…. there IS a mismatch but to suggest that banks can just live with it shows a complete lack of understanding of the risk and regulatory framework that banks operate in.
As to the size of the problem do remember that the size of the issue might well balloon as speculators get involved. For example, during the EUR crisis the German Target 2 balance jumped from close to zero to EUR 800bn. This number (in some sense) represented people wanting to ensure that in any EUR break up that they got “Neu-mark” rather than “Franc-nouveau”. This is a large number – about 30% of German GDP at the time. How would Scotland handle these type of flows?
What the BoE will do on this does not worry me – that is the rUK problem, not Scotland’s
What will Scotland do is my question?
And what happened when other states launched their currencies?
Do we know?
Let’s hone this down to what matters – if we can. I think we need to do that
This thread is, I think, important but is now rather fragmented. To summarise my position…..
1. With regards to independence, I don’t have a dog in the fight. The last thing Scotland needs is another English/Welshman telling Scots what is best for them.
2. If independent then Scotland needs the SCP.
3. A plan to achieve this needs to be part of any Independence Referendum manifesto. Arguments to park the issue of currency until after the vote are wrong – voters deserve and want honesty.
4. It can be done – there are lots of examples…. but there are a lot of complications and no recent, obvious template to use.
5. I understand Tim’s desire to claim that the conversion to a newly created SCP is straightforward and I am not suggesting that the issues I raise should be part of the manifesto. But “behind the scenes” (and I would include this blog) there needs to be a more detailed plan that identifies what risks there are and what can be done to mitigate them.
6. I do not have the broad appreciation of politics and economics that you and Tim have but the FX and Interest Rate world is one where I do know what I am talking about.
7. I don’t have answers to the issues that concern me. I DO have some thoughts but they need fleshing out… and this is best done in by debate…. and that is why I am happy to engage with this blog. My persistence on this issue should be taken as a sign of interest and respect – not bloody-mindedness!
But, for now, the sun is out and the garden beckons!!
I hope we can continue this
There have been quite a number of currencies launched – surely this has been planned and mitigated before?
Yes, there have… the EUR does not count because it was an amalgamation of existing currencies….. although I was involved giving evidence to Brussels from a market traders perspective on a lot of the sort of detail that we are looking at here. (On a side note, these people were always so much smarter, nicer and spoke better English than their UK Treasury counterparts!)
CZK-SKK (1993) is perhaps the most recent relevant one although with substantial differences. First, there was no option – you either got CZK or SKK according to set criteria (mainly geographic); second; it was two new currencies rather a splinter away from an existing (and remaining) one; third, the Czechoslovak koruna was not a major international currency like GBP; fourth, the EU was desperate to make the split a success so offered substantial “backstop” support to the process. Even so, the SKK fell sharply upon floatation – I forget how much and I can’t seem to find data from 1993 but if my memory serves it was about 20%.
Further back there are many examples of new currencies created from the retreat of the British Empire.
So, yes, we can look back and see what went well and what went badly and hopefully avoid any major pitfalls.
Thanks Clive
It does seem that the SNP or others should be raising funds for more research into this
Thank you Mr Parry, your Czech/Slovak comparison, not ideal but the best we have (1993) makes the point. Of your four key points: “second; it was two new currencies rather a splinter away from an existing (and remaining) one; third, the Czechoslovak koruna was not a major international currency like GBP;” are well made. The fourth, on the support of the EU, and fall in the Slovak Koruna on flotation; it is also worth remembering that Slovakia later joined the Euro in 2009.
Clive, I think at least one issue is we need to sort out what a bank is (or monetary institution since there are also building societies and credit unions). I think you are seeing ‘bank’ as something like Natwest Group Plc. That is not a bank. Only the component legal entities with banking licences that are within the Group are banks. So Coutts & Co, Isle of Man Bank, RBS, Natwest, etc. Each of these is a legally self-contained accounting entity (limited company) with their own banking licence and regulatory regime. Banks do not straddle international borders and banking regulatory systems – bank holding companies (the owners) may. Legally and regulation wise there is no connection between Santander UK Plc and Groupo Santander SA, other than the latter owns 100% of the shares in the former.
The requirement that all current banks operating in Scotland must have (or already be) or establish an rUK operating, registered and regulated bank is not a red herring. It is a obligatory part of the process. That also applies the other way – any bank which wishes to conduct business in Scotland must establish a Scottish registered, licenced and regulated bank. After the introduction of the S£ then only banks domiciled, registered and licensed by the SRB will be permitted to operate and conduct business in Scotland in the S£. No rUK bank will be permitted to offer deposit taking, loans etc in S£ to anyone in Scotland. That applies the other way – no Scottish bank will be permitted to conduct business in sterling by accepting deposits or offering loans in sterling. Your most recent example of the one item balance sheet fails because it is not permissible (or possible) for the Scottish bank to create an S£1000 asset by granting a loan to a Scottish customer and a liability of Sterling £1000 as a deposit. If it grants a S£1000 loan the liability is a S£1000 deposit in the client’s current account. Sterling has no place or role in this.
It should be clear by now that the Scottish bank will conduct business ONLY in S£. It will have NO sterling deposits or assets. The same applies the other way in that the rUK bank will conduct business ONLY in sterling. It will not offer any S£ loans or accept S£ deposits. The only exception to this would be if the two sister banks internalise exchanges between them (rather than going via the FX market or the SRB) in which they may have correspondent bank accounts with each other. However any S£ due to the rUK bank would be physically in the Scottish bank and any sterling is physically in the rUK bank.
A bank accounting ledger works in one currency only. Where they offer clients accounts in other currencies then I understand from talking to senior bankers that is almost always via the ‘correspondent bank’ process. RBS in the past offered dollar accounts, but the dollars were actually in its US correspondent (which the group owned) of Citizens Bank in Boston.
I do not see what relevance there is in the £44 trillion of derivatives etc in the London Casino. I suspect few of those involve UK high street banks and are mostly the likes of Barclays merchant bank, Deutsche, JP Morgan and then all the traders, etc. The present day RBS Plc basically only does business in Scotland so has no foreign assets or liabilities to hedge. It’s balance sheet is very simple – there is no external funding. No bonds, no city finance, there is a small loan from Natwest Group, otherwise nada.
There are a lot of investment managers and sundry funds in Scotland (Scottish Widows, Standard Aberdeen, Baillie Gifford, etc) but as the markets they use are in London, NY, etc then those funds and their cash will stay as they are in sterling (and in an rUK part of the relevant banking group). So none of what they do with hedges, derivatives, swaps and the like are of any relevance to the S£. I do not think Scotland currently has anything that could be classified as a significant merchant bank. So you are looking at a pretty simple currency where there just isn’t going to be all this trading and speculating because it will stay exactly where it is just now – in London.
So far as speculation against the S£ is concerned then at the outset there may be something of the order of S£40 billion created in the first week, and none of that will be owned by anyone outside Scotland that had not just requested their bank to purchase it for them. Certainly no international speculator will own a single S£ (though they are free to buy them after that). Within Scotland those that are hesitant will keep their cash in the existing sterling account (now located within the rUK part of the banking group). In time they will have to move most of it as it just won’t be convenient to operate like that (as it would not be for me to keep my current account in Euro in Germany while living in Scotland).
The only risk here (which the SRB, BoE and commercial banks will manage) is to ensure that the exchange of deposits proceeds slightly in advance of the settlement of sterling liabilities. At the extreme for example you could envisage something by which everyone sought new S£ loans to pay off their sterling equivalents, while everybody decided to keep 100% of their deposits in Sterling. That would not work, but 1) tax and sterling ceasing to be legal tender in Scotland ensure a demand for S£, and 2) the Scottish banks can’t practically or from a regulatory view point grant unlimited loans on the back of no deposits and a zero reserve account balance. The bank would have to provide the reserves to do so by means of share capital or a loan from the parent group, which means selling sterling to buy S£ to deposit at the SRB in the reserve account. So e.g. RBS Plc sells the £27 billion in the BoE reserve account to the SRB in order to get the S£27 billion reserve it needs in its SRB reserve account to support its new S£ loan book and deposits.
Happy to continue the discussion (though I think the blog isn’t effective). Maybe we should have a Zoom call between you, me and Richard?
I recognise I’m well out of my depth with the intricacies of cross-border banking arrangements and FX dealings, but this blog is an amazingly effective learning tool, so might I ask, if you do take the topic to Zoom to thrash out a practical solution, that a summary be posted here to enable interested observers to better understand the outcome and the reasoning?
Whatever the outcome, it impinges on numerous issues, not least the voting decision in any future referendum; I’ve already written here that I want to see an independent Scotland in my lifetime, but not if it condemns my children and grandchildren to a life in a state with a lame-duck economy. There’s broad concensus here that an independent Scotland is likely to prosper and that having its own sovereign fiat currency is a sine que non for that. The debate is now about protecting that currency from speculative intereference. Is there any scope for legislation to prevent speculative meddling or does Scotland simply have to put up with it?
I think Tim, Clive and I will be talking. We will report back.
yes – a zoom or face to face might be a good idea.
I am at a complete loss as to why you can’t see there is a problem.
If I owed you money (in a trade agreed a year ago) and was due to repay you EUR1.00 in 10 years time and then today said – “actually, I will repay you in GBP 0.85 instead” (0.85 being today’s spot rate) how would you feel?… and what might you do about it?
Let’s have call
I will mail you
“I am at a complete loss as to why you can’t see there is a problem.”
Neither can I. It is concerning that the proposition of a Scottish currency can be pushed so far without the most challenging issues not only being addressed; but noticed.
We notice
But actually, no one can tell us what the issue really is
Some bankers won’t like this is not the reason for Scotland to not have its own currency
Nor can the implications be explained as yet: I am having to read them in to what is being said
I am not blaming anyone, but seeking a path through this is the aim and I do not think it helos to lay blame when no one can paint a complete story right now
That’s why more work is required
That’s the only fair conclusion. But better do that now
I do not argue with any of that. The problem is a difficult one, which is why simple prescriptions without close knowledge of the detailed money flows (spots, hedges, futures, swaps) is of little value. I have already said that beyond very few economists like Mehrling, mainstream economics offers precisely nothing here; so it takes an insider like Clive Parry (we are lucky to have him) properly to describe the nature of the problem. Scotland cannot change the world, but it does have to live in the world.
At the same time, nothing is certain. As we know from bitter experience, the regulators do not know how to do this; the operation of banking, insurance (which is what hedging is), risk management, the Repo market, which is used not to finance goods and services but to finance the holding of a financial asset; and the actual trading behind monetary economics, which has moved its techniques as rapidly as the technology (if not judiciously), and it is difficult for Governments or regulators to keep pace with the speed of change (the law is still operating with a mindset stuck in the age of the quill pen); or understand fully the implications of what is unravelling in front of them .
My concern has been that the proposals that have been put forward for a Scottish currency have not recognised fundamentally how banks actually operate in the modern world.
I think we recognise how they operate
The question is, is that operation allowed to constrain political choice?
And how are these two issues reconciled?
In fact, there are intertwined series of Repo, Eurodollar and FX markets. Mr Parry has neatly summarised the issue in a single statement: “If I owed you money (in a trade agreed a year ago) and was due to repay you EUR1.00 in 10 years time and then today said – ‘actually, I will repay you in GBP 0.85 instead’ (0.85 being today’s spot rate) how would you feel?… and what might you do about it?”
But that risk exists in all financial transactions
Clive says:
If I owed you money (in a trade agreed a year ago) and was due to repay you EUR1.00 in 10 years time and then today said – “actually, I will repay you in GBP 0.85 instead” (0.85 being today’s spot rate) how would you feel?… and what might you do about it?
And John Warren joins in with:
In fact, there are intertwined series of Repo, Eurodollar and FX markets. Mr Parry has neatly summarised the issue in a single statement: “If I owed you money (in a trade agreed a year ago) and was due to repay you EUR1.00 in 10 years time and then today said – ‘actually, I will repay you in GBP 0.85 instead’ (0.85 being today’s spot rate) how would you feel?… and what might you do about it?”
I am sticking to my guns on this – Clive and John are chasing after dragons.
Maybe they think something is being re-denominated here? If so they are wrong as that is not the case. The only items to which the Lex Monetae will be applied will be official (i.e. state) debts and payments that are not state to state. So any ScotGov bond (of which there are currently none) would be re-denominated into S£ whether the bond holder likes it or not. Equally supplier invoices to ScotGov will be payable in S£ as of the day that the currency comes into use where the supplier is domiciled in Scotland. Foreign suppliers – I guess ScotGov has at least two years to sort out its general purchase terms & conditions such that foreign suppliers are aware that bills will be paid in S£ in the future unless agreed otherwise between the state and the supplier. Invoices are settled in 30 days so it is a very transitory issue to sort out so it is clear – Scottish suppliers don’t get a choice, foreign suppliers then it depends on the circumstances.
ScotGov does owe money to the National Loans Board, as do most councils. As these are state to state debts freely agreed in sterling then you can’t use the Lex Monetae so they will have to be a subject of negotiation but International Law would leave them as sterling I think.
Beyond that what exactly is the relevance of the Repo, Eurodollar, FX or any other market contracts / deals to the S£? The relevant ones to sterling are in sterling and will stay in sterling. Why is anybody going to get back 85 pence in the pound on anything?
Let us consider some examples:
XYZ Maps is due $135,000 from a US customer (in my dreams!), so should be £100,000, but payable when we deliver the maps which will only be in 6 months. So we enter a Futures contract now for the conversion of the $135,000 in 6 month’s time. Not something I have ever done so I don’t know what fees would be like etc. At the start of month 3 Scotland switches to the S£ and that becomes legal tender in Scotland. There is no effect at all on our Futures contract. It is still a sterling – dollar conversion and we will still be paid out in sterling at the end of the 6 months with whatever is the agreed net amount.
Santander (UK) Plc has securitised a block of £100m of mortgages for customers domiciled in Scotland. Two years later Scotland switches to the S£. There is no initial effect at all as the exchange into the S£ of sterling deposits and liabilities is voluntary. Santander (UK) has exactly the same liability as it had to repay the merchant bank or whoever on the agreed terms, it is also an entirely English domiciled and regulated bank so ScotGov actions have no effect. However, over the next couple of months Santander (UK) Scottish customers start requesting to re-mortgage into the S£. They do that, as already explained at length, by Santander (Scotland) granting a new mortgage where the proceeds of converting that into sterling are sufficient to repay Santander (UK) in full. The FX risk is borne by the mortgage holder if they failed to do this during the short Exchange one-to-one period. So far as Santander (UK) is concerned this is just an early redemption and they deal with the repayment to the security holder as they normally would. There is no extra risk to either Santander (Scotland), Santander (UK) or the security holder. Until such time as the Scottish customer pays off their sterling mortgage in full they have just the same liability to Santander (UK) as they have had and need to continue the agreed monthly repayments in Sterling. Under the current regulatory system if the BoE decides the re-classify loans made to Scottish customers by English banks as now being ‘foreign’ then the reserve requirements are slightly higher. That will just incentivise banks to assist Scottish customers to re-mortgage. However what the BoE does or does not do is a matter for negotiation between it and the SRB so the sensible thing would be to phase in a re-classification of Scottish customers from ‘domestic’ to ‘foreign’ rather than go for maximum disruption.
The D. JOHNSTON & COMPANY (LAPHROAIG) LIMITED (a subsidiary of Suntory domiciled in Scotland) has taken out a £100m loan from Barclays Bank for a distillery expansion on Islay, repayable over 10 years at a rate of BoE Base Rate plus 6%. In Year 2 the S£ is introduced and becomes the sole legal tender in Scotland. This has no effect on the agreement between Laphroaig and Barclays which remains sterling and tied to the BoE base rate. If Laphroaig want to change that they will need to repay Barclays in full in sterling and seek a new loan in S£ from a Scottish registered bank.
Shell & BP (Scotland) Ltd (registered in Scotland) produces 1 m barrels of oil per year from their North Sea operations. This is sold in US$ on the international markets at $70 / per barrel. That yields $70 m. They use hedging and futures contracts via the London markets and bank the proceeds to the $ account with HSBC (and the dollars are actually located in the HSBC (US) Bank in New York which is the correspondent bank for HSBC in London). The replacement of sterling by the S£ has no impact at all on any of that. However, they will have to pay wages, rates, PAYE, corporation tax, rent, etc on their Aberdeen offices in S£. A small proportion of that S70 m will thus have to be exchanged via the FX market into the S£. They declare a dividend of $20 m to transfer their profits back to the parents. The S£ is of no relevance to that. They are entitled as now to produce and file their annual accounts with Companies House Scotland and Revenue Scotland in dollars if they wish, but any tax due has to be paid in S£ only. The hedging and futures operations continue as now in sterling or dollars in London and the S£ is of no relevance.
Baillie Gifford Plc, domiciled in Edinburgh, manages funds and trusts worth £500 billion. They currently bank with RBS Plc, domiciled in Scotland. In the run-up to the introduction of the S£ their bank accounts are transferred by a High Court of Session scheme of arrangement to Natwest Bank Plc in London. There is no stock exchange in Scotland and 90% of Baillie Gifford clients live outside Scotland. They keep all the funds and trusts and related client funds bank accounts at Natwest in Sterling. The S£ has no effect, except that Scottish clients of Baillie Gifford now hold units in a foreign as opposed to domestic fund. The clients will have to declare income and gains from those funds as usual except valued in S£ on their returns to Revenue Scotland. Baillie Gifford may start new funds, e.g. a Scottish Government Bond Fund, which would be managed in S£. There are plans to start a Scottish Stock Exchange which would operate in S£ and would allow companies with interests in Scotland (e.g. Diageo) to get a S£ listing. Baillie Gifford will need some S£ as they will pay wages, rent, rates, tax, utilities etc in S£. They will be regulated by the SRB and whatever other bodies ScotGov puts in place. However their funds will as now have to comply with LSE, NYSE etc rules.
I still have not found a dragon!
If I might summarise, what you are saying is that there isn’t a redenomination.
Do you agree?
In that case you are asking where is the risk?
If there is no redenomination then the banks are fine…… but what about the Scottish businesses that find their liabilities in GBP but all their revenues in SCP?
They will be left having to repay GBP loans (with penalties possibly) and take out SCP loans on terms not known right now.
What (if I lived in Scotland) happens when I wander into my bank and ask to switch to a SCP mortgage and the bank say certainly sir. That will be a £1,000 fee and the new rate will not be 2% but 4%. The banks will have a field day under this regime!
The risk MUST lie somewhere – either with the banks or their clients. Either there are mandated rules for conversion and the banks will bear the risk or everything is done a open market prices in which case the clients will bear the risk.
So. now we are getting to the question to debate!
The risk can be identified – now, how do we agree who bears it?
Yes, there is no redenomination. This is a voluntary exchange of one currency for another, just like going to the Post Office to get Euro for a holiday. A redenomination, which is compulsion, would just crash the currency on the first day of trading as all those that did not want the new S£ sought to get back to sterling.
I wrote a whole lot more, but the web page just lost it while I was trying to correct a spelling mistake 🙁
“But that risk exists in all financial transactions”.
Scottish people and Scottish businesses are suddenly going to find that they have this significant potential new risk (in a specialist area of which they probably know little), imported into their lives in all kinds of everyday transactions that they have never had to contemplate before (because there was one currency), and never suspected existed; and now having to manage a risk against a new currency that is not, in Mr Parry’s words “a major international currency”.
In financial terms and in risk profile terms to the bank customer (who will carry the risk); this may look as appealing as a Brexit II.
I do not see this risk as real
Tim has explained why
Sorry, but I think it immaterial
“The risk can be identified – now, how do we agree who bears it?”
The Scottish electorate.
I do not think it is immaterial; it is an unknown risk, and people do not like unknown risks; and it does not stay in some rarefied banking world of derivatives; it will have real effects. Scots are remarkably cautious (if the weren’t Scotland would now be independent). Equally important, politically? Certainly not to Scottish business which sell or buy primarily in England, or to older Scots with cross-border interests of any kind. I do not think you are allowing for the diversity of issues, the complexity of outcomes.
So, I think we need to think much more about how to mitigate these risks
That is the challenge now
To make this clear: I do not think ‘no-redenomination’ fixes this problem; or that it is all immaterial, nothing to see here. I am surprised Dr Rideout appears to be making light of it: “Well at least we solved that one!”.
I have watched the Scottish hospitality Industry unite as never before and galvanise its opposition to incremental effects of small additional Government regulations over vaccine passports; in the middle of a pandemic: producing an effective media campaign against Government action that is, after all undeniably intended to protect public health. The industry challenges the evidence for the changes vociferously.
Now translate that same sense of industry self-interest over increased costs into the many SME’s with Scottish suppiers, or customers – newly faced with a new currency and for the first time cross-currency transactions that the banks are hedging; or private pensioners with cross-border interests. I suspect, ‘you ain’t seen nuthin yet’.
I started by saying that the I believed the Scots were more committed to the currency (sterling), than to the Union. I believe that to be true. This does not mean nothing can be done – but it does require those behind a new Scottish currency to be adepts, who have rigorously thought through everything. I do not believe we are there yet; either her, or by Common Weal; and of course the Scottish Government appear to have completely stalled.
I agree – we are not there yet
But let’s celebrate we are now getting closer to at least defining the problem – which is always a critical step
It does not mean I know all the answers, of course
Well at least we solved that one! It should have been obvious from all my lengthy descriptions that there was no re-denomination so I will have to make that point clearer in future.
The banks will not have a field day. They will do what the central banks and regulators tell them. A lot of folk have a fixed term on the mortgage, but usually not more than 3 years. Just introduce a condition that as soon as Scotland votes for Indy that anyone in Scotland taking out a fixed term mortgage must have a break clause available as and when the S£ is introduced. Same on new commercial loans. So that reduces us to only loans before IndyRef 2 and which still exist 2.5 years later when the S£ comes in. I suspect the central banks can apply sufficient sticks and carrots to solve that.
In terms of new Scottish loans from e.g. Santander (Scotland) – why should the mortgage rates be any different at the outset to those offered by Santander (UK)? I can’t see any reason at the outset why the SRB base rate would differ from the BoE one. That might change but not for a while. The SRB can provide unlimited cheap reserves to the banks in Scotland just as the BoE can in rUK. For the new Scottish banks to start life by annoying the SRB would probably not be clever!
I do not forsee any insurmountable problems and, unless the SRB appoints Andrew Bailey as the first Governor, then all they need is to be well prepared and actually understand what they are doing and can do if required.
Anything else is just the ‘Scots don’t understand’, they are ‘too poor’, ‘they will have to pay more because they are not British’ or that sort of trope.
Yes – we are getting somewhere.
So, we have established that we need sufficient lead time so that the bulk of contracts entered into that cover the transition will be traded with full knowledge of the impending changes coming…. but that does raise the spectre of Scots having to pay more for financing during that period (to reflect the required break clauses etc.). How do we deal with that?
We also need to make sure that this lead time is not used by speculators to build up positions that might destabilize things. How do we prevent that?
We also need to think carefully about what terms and conditions might apply to new contracts in SCP versus the equivalent GBP contracts they replace. Santander will offer different rates on SCP mortgages (to GBP rates) in the same way that they offer different rates on USD mortgages. If the Authorities choose to mandate those terms then we are back to an effective redenomination. If left to the market I fear the transition might seen as be unfavourable by people…. or end up tying the SRB to an interest rate policy that mimics London. This still needs more thought.
Not redenominating does solve some problems… but raises others.
I am not saying that this means a new SCP is a bad idea – just that the transition needs to be robust in all reasonable scenarios.
Clive
I cannot agree more with this:
This still needs more thought.
Are you still up for a call sometime?
Richard
Notice that the different rates and arbitrage opportunites lead Mr Parry to see ways in which re-denomination may reappear as a problem, under a different guise; just when you thought you had fixed it. Modern international banking is a many-headed Hydra, and will find its way into areas where you least expect to encounter it. It is doubtful if there is even a usable definition of a bank; in the last financial crash it almost sank a large chunk of the insurance market, whole.
Thank you Mr Parry for your steadfast interest.
What we did see that there were no banks, only state guarantees
And that is the issue we also have to address
“What we did see [was] that there were no banks, only state guarantees”.
Fine, that is George Friedrich Knappe, ‘The State Theory of Money’ (1905); but that isn’t what we actually have; which is a state theory as lender of last resort; of a private system of first (and preferred) resort.
I think the private system is a veneer over the state reality
This is what I implied by my comment
But I like your challenges!
Richard, your site always makes me think. You provide an invaluable service to the polity.
🙂