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".
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 optionknown as dollarisationScotland
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.
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
He added: "The Bank of England is
Bank of the whole United Kingdom
we would wish the Bank
of England to continue [to be] lender of last resort to [Scottish]
We therefore concentrate in this chapter on the implications of
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."
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
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."
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
Currency choice and monetary
59. The benefits of using sterling in a currency
or monetary union are clear.
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
"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."
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
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
Currency choice and financial
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.
It has this role because, as Bagehot famously said, "Money
will not manage itself."
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.
The Bank of England would also be responsible for "macroprudential
regulation for the purposes of financial stability".
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.
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
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
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".
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.
BANK OF ENGLAND GOVERNANCE
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).
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
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."
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.
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."
He added: "The more you introduce complexity, the more
likely it is that costs will increase."
Standard Life estimates its current regulatory costs for
its UK business "are in the region of £40m per year".
Mr Owen Kelly of Scottish Financial Enterprise agreed that
additional regulation would incur additional costs.
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
"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
regulatornot two financial regulators."
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
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.
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 arei.e.,
with an implicit guarantee or whatever? I would have thought that
they would think very hard before doing that."
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
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.
The union lasted only five weeks instead of the anticipated three
years. 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."
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
63 The Scotsman, Matter of no small change by Gavin
McCrone, 28 February 2012 Back
Q 626 Back
Q 883 Back
Q 884 Back
Q 911 Back
HM Government, Scotland Analysis, paragraph 3.37 Back
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
ICEAW paragraph 17 Back
Johann Lamont paragraph 59 and 62 Back
The Sterling Monetary Framework describes the Bank of England's
liquidity operations. Back
Walter Bagehot (1873), Lombard Street Back
Q 884 Back
Q 888 Back
QQ 918-920 Back
Q 888 Back
Q 911 Back
Fiscal Commission Working Group (2013), First Report-Macroeconomic
Framework, p 184 Back
ibid. p 185 Back
Q 911 Back
Q 571 Back
Q 612 Back
Q 617 Back
Standard Life Back
Q 617 Back
Q 316 Back
Bank of England, Additional information provided to the Treasury
Committee by the Bank of England, 24 November 2009 Back
Q 919 Back
Dr Karen Henderson paragraph 15 Back
British Academy paragraph 31 Back