Appendix 1: Correspondence
from Rt Hon Danny Alexander MP
Letter from Rt Hon Danny Alexander MP, Chief Secretary
to the Treasury, 19 May 2014
The Referendum on Separation for Scotland
At my appearance before your Committee
last week, I committed to writing to you setting out my views
on mortgage costs, financial regulation and EU fiscal rules if
Scotland voted to become independent.
As set out in Scotland analysis: Financial
services and banking, the price of mortgages is usually based
on an average of retail and wholesale funding costs known
as the "fund transfer price". There are a number of
reasons why the fund transfer price and therefore mortgage interest
costs would be higher if sovereign debt interest costs rose. This
includes the sovereign's role as the fiscal backstop and the role
that sovereign debt plays in providing collateral for wholesale
funding.
Assessing this relationship for a sample
of countries that experienced downgrades over the August 2007
- May 2011 period, the Bank for International Settlements (2011)
concluded that 64 per cent of domestic banks in their sample experienced
their credit ratings lowered within six months following the sovereign
downgrade and this relationship is particularly strong for those
countries that experienced a significant deterioration of their
sovereign credit risk, such as after a default.
The National Institute of Economic and
Social Research have estimated that sovereign borrowing costs
in an independent Scotland would be higher than UK borrowing costs
by up to 1 .65 per cent. Professor Charles Goodhart found that
an independent Scottish state could easily pay an interest premium
over the UK rate of above 1 per cent "even if economic events
went quite well, potentially spiking far higher, as seen in the
euro area, if economic developments should deteriorate".
Professor Ronald MacDonald commented that "it is now widely
accepted that an independent Scotland would incur a premium on
its debt... This premium would be determined by financial markets
but is likely to be in the region of 1 - 2 per cent above what
HMT would have to pay on similar UK debt". Citigroup and
Deutsche Bank have similar estimates.
If sovereign interest rates increased
by 1.65 per cent and 75 per cent of this increase were passed
through to banks and mortgage holders, the first year's repayments
on the average Scottish house, assuming a 75 per cent loan to
value mortgage, would increase by £1700.
On financial regulation and the question
of whether relocation can be achieved simply by moving a "nameplate"
without moving jobs, clearly that is not possible. For financial
regulatory purposes the location of a firm's head office will
be determined by the location of the firm's central management
and control functions. For practical purposes that usually means
not only the location of the firm's senior management but also
central administrative functions such as internal audit and central
compliance. So, as a minimum, you would expect to see these high
quality jobs transfer with the transfer of a firm's head office.
More broadly both Standard Life and
Alliance Trust have already announced that they are putting in
place arrangement to establish companies and functions registered
outside of Scotland. It is inevitable that Scottish financial
sector jobs would follow. After all up to 90 per cent of financial
products sold by Scottish based firms are sold not to Scotland
but to the rest of the UK. The Governor of the Bank of England
Mark Carney said to the Treasury Select Committee that, in the
event of Scottish independence, it is a distinct possibility that
RBS and Lloyds would consider moving head offices to the continuing
UK. This is due to EU rules under CRD IV, the BCCI directive.
The Committee also asked about the fiscal
rules that an independent Scotland would be subject to as a non-euro
area member of the EU, and whether it would be bound to joining
the euro. As I noted during the Committee meeting, the Government
recently published a 'Scotland analysis' paper on the EU and International
Issues which explores these issues. The following extracts from
this paper answer the questions that arose:
3.34 As part of the negotiations
of its EU membership, an independent Scottish state would need
to resolve the question of euro membership. The EU Treaties oblige
EU Member States to adopt the euro upon meeting certain monetary
and budgetary convergence criteria; only the UK and Denmark have
negotiated exemptions. Under EU enlargement criteria, membership
of the single currency is obligatory for all accession states,
and all countries that have joined the EU since 1993 have been
formally required to commit to adopt the euro in due course.
3.36 The current Scottish Government's
stated policy of a formal sterling currency union with the rest
of the UK is at odds with the formal EU requirement for a commitment
to join the euro, as well as acceptance of the Maastricht conditions
on deficit and debt, as part of the acquis. Since an independent
Scottish state would be a new state and would have to go through
some form of accession process to become a member of the EU, it
would in principle be required to make a formal commitment to
adopt the euro at some time in the future, unless it were able
to negotiate a formal opt-out. Such a decision would not be in
the hands of the continuing UK or an independent Scottish state
but would require the agreement of all 28 EU Member States.
3.39 Adopting the euro would result
in an independent Scottish state being subject to sanctions and
stronger fiscal and economic rules than non-euro area countries
under the EU's Stability and Growth Pact and the European Semester.
For example, it would be required under Article 126.1 of the Treaty
on the Functioning of the European Union (TFEU) to "avoid
excessive deficit", defined as a deficit of 3 per cent of
Gross Domestic Product (GOP) and a debt of 60 per cent of GOP.
The UK, as a result of its opt-out from the euro under Protocol
7 5 of the TFEU, is only required to "endeavour to avoid
excessive deficit". The UK cannot face any form of sanctions
under the Stability and Growth Pact as a result of Protocol 15,
which exempts the UK from coercive measures.
3.40 In the event that an independent
Scottish state failed to avoid excessive deficit and was placed
in the EU's excessive deficit procedure, the European Council
would agree recommendations oh correcting the deficit. These would
set out the measures that an independent Scottish state should
take to get its deficit below the 3 per cent target. In the event
that these recommendations were not implemented, the Council of
the EU could decide, on the basis of a Commission recommendation,
that an independent Scottish state had failed to take effective
action to correct the deficit and it could subsequently face annual
fines from the EU up to 0.5 per cent of its GOP.
3.41 In the event that an independent
Scottish state did not have an excessive deficit, it would still
be required to make progress towards a Medium-Term Budgetary Objective,
which is a deficit well below 3 per cent. Again, in the event
of inadequate action to meet this objective, an independent Scottish
state could face sanctions under EU rules. Under the recently
agreed reform to euro area governance (the Budgetary Monitoring
Regulation, commonly known as 'the two pack'), an independent
Scottish state would have to submit a draft budgetary plan to
the Commission every October for the opinion of the Commission
and for discussion by other euro area Member States.
3.42 As well as stronger fiscal rules,
an independent Scottish state would also face stronger economic
surveillance measures if it were to join the euro. Under the EU's
new macroeconomic imbalances procedure, an independent Scottish
state could face sanctions if an excessive macroeconomic imbalance
in its economy was identified by the Council and it failed to
correct it in sufficient time. In addition, it could face sanctions
in the form of what is known as macrö conditionality, where
budget payments would be suspended in the event that it did not
comply with economic and fiscal recommendations. The latter would
apply even if an independent Scottish state was not a member of
the euro. The UK has secured an opt-out from this.
3.44 Of course, an independent Scottish
state may not be ready to join the euro immediately on joining
the EU. Those countries that are committed to join but have not
yet met the criteria for doing so have what is called a 'derogation'.
Those countries cannot face sanctions before they join the euro
(apart from in the form of macro-conditionality as outlined above)
but must take steps to meet the convergence criteria to ensure
their economies are ready to join the euro. Progress is assessed
annually. The UK is not required to prepare to join the euro given
its opt-out.
Additionally, the Committee specifically
asked about Croatia's position with regards to its deficit and
joining the euro. As mentioned above, all EU Member States are
committed to join the euro unless a specific opt-out has been
negotiated. This applies for Croatia, which did not negotiate
an opt-out as part of its accession process. Moreover, with a
deficit of around 5% GDP, Croatia has been placed in the Excessive
Deficit Procedure, with a deadline of correcting its deficit to
below the EU's 3% deficit to GDP target of 2016. In the event
that Croatia fails to meet this target, it would not face euro
area only sanctions (as a Member States with a temporary 'derogation').
However, it could face sanctions in the form of 'macro-conditionality'
as outlined above.
I am copying this letter to the Chancellor
of the Exchequer and the Secretary of State for Scotland.
Danny Alexander
May 2014
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