Economic Implications for the United Kingdom of Scottish Independence - Economic Affairs Committee Contents

Chapter 3: Currency Options and Consequences

54.  The choice of currency is perhaps the most important economic decision an independent Scottish Government would face. As well as establishing the notes and coins in everyday use, it would have far-reaching consequences for economic policy. If, as the Scottish Government currently proposes, an independent Scotland were to retain sterling, monetary policy would continue to be set by the Bank of England. This has implications for the regulation of Scotland's financial sector which in turn is likely to have implications for tax and spending policies (see Chapter 4). What may seem like a dry and technical issue is, as Professor Gavin McCrone reminded us, "of the greatest importance for those of us living in Scotland".[63] It is essential that clarity is achieved on this decision and its consequences before the independence referendum. Alternatives to sterling, such as Scotland adopting the euro, or having its own currency, are discussed in Appendix 6.

Current Government positions

55.  An independent Scotland could continue using sterling without the rest of the UK's consent in the same way some Latin American countries have adopted the US dollar and Montenegro uses the Euro. Under this option—known as dollarisation—Scotland would have no formal central bank and no access to the services of, or influence over, the Bank of England. But Scotland has a large financial services sector which relies on access to central bank services. Professor Jim Gallagher of Nuffield College, Oxford said that, because of this, dollarisation "is not a viable option" for somewhere like Scotland.[64]

56.  The Scottish Government is not therefore interested in dollarisation and favours a monetary union between an independent Scotland and the rest of the UK. Mr John Swinney MSP, Cabinet Secretary for Finance, Employment and Sustainable Growth in the Scottish Government, told us:

    "The core proposition is for us to establish a formal monetary union with the rest of the United Kingdom with the Bank of England operating as the central bank for sterling and so on, discharging its functions on behalf of both fiscal authorities in Scotland and the rest of the United Kingdom. Those functions would be on essentially price stability and financial stability."[65]

He added: "The Bank of England is … the Bank of the whole United Kingdom … we would wish the Bank of England to continue [to be] lender of last resort to [Scottish] financial institutions."[66] We therefore concentrate in this chapter on the implications of this approach.

57.  Rt. Hon Michael Moore MP, Secretary of State for Scotland, told us: "Our starting point is that the rest of the United Kingdom would keep the Bank of England and that would be for the rest of the United Kingdom's economy."[67] The UK Government's report Scotland analysis: Devolution and the implications of Scottish Independence says it would be

    "open to representatives of an independent Scottish state to seek to make use of arrangements now operative within the UK should they so wish, although any proposals would need to be considered carefully and may not be straightforward or necessarily in the interests of the continuing UK … Proposals for a formal currency union or for an independent Scottish state to have recourse to the Bank of England's functions could form part of independence negotiations should representatives of an independent Scottish state want to table them."[68]

58.  The position of both the UK and Scottish Governments on how an independent Scotland could retain sterling as its currency and what it would entail needs to be made clear. Both Governments have a duty to inform Scottish voters ahead of the referendum.

Currency choice and monetary policy

59.  The benefits of using sterling in a currency or monetary union are clear.[69] The avoidance of exchange costs, the elimination of currency risk, the continuation of existing contracts written in sterling and easier price comparison between products all minimise transaction costs and foster competition. The high degree of economic integration and mobility of capital and labour between Scotland and the rest of the UK is best maintained if they use the same currency.

60.  If an independent Scotland used sterling, its monetary policy would continue to be determined by the Bank of England. While the Scottish and the rest of the UK economies remained similar there is no reason why they could not be both served by the same monetary policy. But if the two economies started to diverge, a single monetary policy would be less suitable. The ICAEW wrote:

    "From Scotland's point of view, there are major risks inherent in retaining sterling if Scotland is unable to influence the Bank of England's monetary policy. This is clearly a matter for negotiation, but Scotland's position would appear to be extremely unsatisfactory if it retains sterling but has no say in the Bank's monetary policy."[70]

61.  Ms Johann Lamont MSP pointed out:

    "The MPC's composition can only be altered by amending existing legislation. This would be subject to the will of Westminster … Moreover, all of this neglects one important point, namely that the MPC was deliberately set up as an 'expert' committee, not one that represents geographical interests."[71]

62.  Effective governance of monetary policy requires the Monetary Policy Committee (MPC) of the Bank of England to continue to consist of experts. It would be unacceptable for the MPC to have members representing the interests of a separate country.

Currency choice and financial regulation

63.  The Bank of England is responsible for the smooth running of the banking system, ensuring that payments between banks are made and received in a prompt and secure manner and for overall financial stability. The Bank manages liquidity and risk in the banking system under the Sterling Monetary Framework.[72] It has this role because, as Bagehot famously said, "Money will not manage itself."[73]

64.  Mr Swinney, as noted in paragraph 56 above, clearly expressed the Scottish Government's desire to see the Bank of England continue to operate in an independent Scotland and be lender of last resort to Scottish financial institutions.[74] The Bank of England would also be responsible for "macroprudential regulation for the purposes of financial stability".[75]

65.  Sir John Gieve, former Deputy Governor at the Bank of England, explained to us the functions of the Bank of England which might be involved.[76] There is a gradation of central bank functions depending on how much risk they involve to capital and therefore the taxpayers. Lender of last resort is intended to be a liquidity operation where funds are lent on the basis of good collateral and the institution is thought to be solvent. If an independent Scotland were a member of the EU and Scottish banks had branches which operated in the rest of the UK, the branches would have as much right to lender of last resort facilities as, say, the rest of the UK branches of a German bank, if they were seen as solvent. Moreover, that a Scottish parent bank had sterling assets for collateral would tend to make lender of last resort facilities for its branches in the rest of the UK less risky for the Bank of England. But such facilities would not apply to branches either in Scotland or overseas.

66.  Mr Swinney has also stated that an independent Scotland would also need to set up a national financial regulator to meet EU requirements. He told us:

    "There would also be a requirement for micro-regulation in relation to the operations of financial services companies [based in Scotland]. Clearly, we would have to fulfil our obligations in that respect. We are anxious to ensure that that function is taken forward in a fashion that is as conducive as it possibly can be to the operational activities of the relevant financial institutions."[77]

Financial regulation in an independent Scotland would therefore be the responsibility of two regulatory bodies reporting to two Governments.

67.  A separate Scottish institution set up to carry out prudential regulation of Scottish financial services companies would reduce the knowledge of the Bank of England in dealing with a counter party. The effects might be felt increasingly over time as regulations in Scotland and the rest of the UK gradually diverged. Even though lender of last resort lends against high quality collateral, there is always some residual, perhaps operational, risk involved. The Secretary of State for Scotland said that the Government "would have serious doubts over wanting to provide the lender of last resort facility".[78] For the Bank of England to provide central bank services to substantial financial institutions operating in an independent Scotland and regulated by a body reporting to an independent Scottish Government implies that the Bank would accept risks over which it had little control, which seems implausible.


68.  The Scottish Government's Fiscal Commission Working Group proposes a new governance structure for the Bank of England: an independent Scotland would become a shareholder of the Bank of England on the basis of population or output or a combination of the two (as with the European Central Bank).[79] Either would mean a Scottish shareholding of less than 10%. The Scottish Government would also have input into the appointment process of key positions and to the remit and objectives of the Bank.[80] The Working Group also recommends that a 'Macroeconomic Governance Committee' oversees matters which require coordinated input and/or agreement from both Governments. A representative from the independent Scottish Treasury could attend MPC meetings on a non-voting basis. Mr Moore told us: "Territorial representation on the MPC … is quite out of keeping with its primary purpose and the way it is convened at present … I am clearly not persuaded that would work or is desirable."[81]

69.  The Fiscal Commission's unprecedented proposal for the Bank of England to be overseen by both the rest of the UK and Scottish Governments would lead to significant governance and accountability problems. We do not see why the UK Government would agree to this proposal.


70.  Many Scottish financial institutions sell the bulk of their products to customers in the rest of the UK. For example, Scottish insurance companies sell over 90% of their policies in the rest of the UK.[82] Witnesses expressed concern at the prospect of a separate Scottish regulator in addition to the existing regulator for the rest of the UK. Mr David Nish, CEO of Standard Life, said: "I do not think that there is a working model [of cross-border regulation] that I can find."[83] He added: "The more you introduce complexity, the more likely it is that costs will increase."[84] Standard Life estimates its current regulatory costs for its UK business "are in the region of £40m per year".[85] Mr Owen Kelly of Scottish Financial Enterprise agreed that additional regulation would incur additional costs.[86]

71.  Mr John Cridland, Director-General of the CBI, expressed concern that different regulators might over time lead to diverging regulations and a segregated market. He said:

    "It is extremely difficult to separate out what are integrated businesses, where the biggest share of their business lies outside Scotland, whatever their historic routes or location decision … In one small island with those integrated businesses, the logic would be that there is a single financial regulator—not two financial regulators."[87]

A separate Scottish financial regulator may be a requirement for an independent Scotland to join the EU but it would be likely to add to compliance costs and complexity for Scottish financial institutions with large cross-border businesses.

Currency choice and the fiscal consequences

72.  In rare circumstances the Bank of England may provide liquidity assistance to an institution outside the published Sterling Monetary Framework. This is known as Emergency Liquidity Assistance (ELA) and is typically extended to UK headquartered institutions thought to be solvent but known to be at risk. For example, in 2008 the Bank of England provided £61.6bn of secret emergency funding to RBS and HBOS.[88] Because ELA involves risk to the capital of the Bank of England if the institution fails, it requires authorisation from the Chancellor of the Exchequer to indemnify the Bank against losses which might arise, as was done in the case of RBS and HBOS. Since the Chancellor represents taxpayers' interests, ELA may be extended to UK headquartered institutions but not to foreign institutions.

73.  Mr Swinney's proposals imply that an independent Scottish Government would wish the Bank of England to extend ELA support to Scottish institutions if needed. This would require the Chancellor of the Exchequer to put at risk taxpayers' money from the rest of the UK for the benefit of institutions based, and possibly regulated in, an independent country. Sir John Gieve summarised: "Is it conceivable that the UK Government could decide to, so to speak, leave things as they are—i.e., with an implicit guarantee or whatever? I would have thought that they would think very hard before doing that."[89]

74.  For the rest of the UK Government to allow the Bank of England even to consider extending ELA to an institution based in an independent Scotland would require a prior undertaking by the Scottish Government to make good any losses. A simple promise would not be enough because the size of possible losses would be unknown. To safeguard the interests of its taxpayers the rest of the UK Government would want assurance that the funds could be repaid in a timely fashion. ELA to RBS and HBOS was equivalent to slightly more than half Scotland's GDP. Total state support to the two Scottish banks was equivalent to 211% of Scotland's GDP.

75.  It is difficult to see how the UK Government could extend central banking services to an independent Scotland since the UK Government would lack control over the tax and spending policies of an independent Scotland.


76.  There are transitional risks in changing long-established currency and financial regulation arrangements. Dr Karen Henderson noted that the Czech-Slovak monetary union ended prematurely because of speculative capital movement and concerns about the Slovak budget deficit.[90] The union lasted only five weeks instead of the anticipated three years.[91] If a currency union is thought to be unsustainable capital may begin to flow from one member country to another. The British Academy wrote:

    "One important lesson from the way separation of [the Czech-Slovak] currency was handled relates to the prevention of bank runs: the anticipation of the devaluation of a currency can lead to rapid depletion of banks, as started to occur in Slovakia immediately on separation."[92]

They acknowledged, however, that a similar outcome might not necessarily occur in an independent Scotland.

77.  Continued use of sterling by an independent Scotland in monetary union with the rest of the UK is the stated preference of the Scottish Government. But it would raise complex problems of cross-border monetary policy, multiple financial regulators and taxpayer exposure and could only come about, if at all, on terms agreed by the UK Government. Arrangements should be clear before the referendum. But the proposal for the Scottish Government to exert some influence over the Bank of England, let alone the rest of the UK exchequer, is devoid of precedent and entirely fanciful.

63   The Scotsman, Matter of no small change by Gavin McCrone, 28 February 2012  Back

64   Q 626 Back

65   Q 883 Back

66   Q 884 Back

67   Q 911 Back

68   HM Government, Scotland Analysis, paragraph 3.37 Back

69   To be clear on terms, currency union and monetary union both describe where two or more countries use the same currency. In a currency union there is usually one national central bank whereas in a monetary union there are several or a shared central bank (such as the ECB in the European monetary union). The UK Government refers to a currency union whereas the Scottish Government proposes sharing the Bank of England hence they refer to a monetary union. Back

70   ICEAW paragraph 17 Back

71   Johann Lamont paragraph 59 and 62 Back

72   The Sterling Monetary Framework describes the Bank of England's liquidity operations. Back

73   Walter Bagehot (1873), Lombard Street Back

74   Q 884 Back

75   Q 888 Back

76   QQ 918-920 Back

77   Q 888 Back

78   Q 911 Back

79   Fiscal Commission Working Group (2013), First Report-Macroeconomic Framework, p 184 Back

80   ibid. p 185 Back

81   Q 911 Back

82   Q 571 Back

83   Q 612 Back

84   Q 617 Back

85   Standard Life Back

86   Q 617 Back

87   Q 316 Back

88   Bank of England, Additional information provided to the Treasury Committee by the Bank of England, 24 November 2009 Back

89   Q 919 Back

90   Dr Karen Henderson paragraph 15 Back

91   British Academy paragraph 31 Back

92   ibidBack

previous page contents next page

© Parliamentary copyright 2013