Sunday, September 14, 2014

14/9/2014: Pound, Scotland and Ireland's Risks

There are many arguments pro and against Scottish independence. And there are many arguments pro and against Scottish independence from various perspectives, including non-Scottish/UK ones. Not to try replicate these or to pretend to provide a comprehensive list of these, let me touch upon a couple points as viewed from Ireland's position vis-a-vis independent Scotland or Scotland remaining a part of the UK.

Take the fate of the British pound were Scotland vote for independence. Most likely this will be higher in value vis-a-vis the euro in the short run due to simple short-term risk valuations, usually known as a knee-jerk reaction. However, once the markets fully factor in the disappearance of Scottish GDP and demand from the UK markets, the value of the pound will have to come down vis-a-vis the euro. There is a problem with this from the point of view of Ireland as it entails:

  1.  falling competitiveness of Irish goods and services exports to the UK; and
  2.  falling attractiveness of retaining UK banks' presence in Ireland.

Let's look at the first point. As sterling falls in value against the euro, Irish exports to the UK will become more expensive. At the same time, Scotland itself is likely to undergo currency devaluation (direct, assuming it opts for its own currency or indirect - aka internal - if it pegs to sterling or stays in a currency union with the UK). Which means that both areas will cut purchases from Ireland, with Scotland cutting these more dramatically than the rest of the UK. Symmetrically, our imports from the UK and Scotland will become cheaper, which means we will tend to buy more of these. The end result: our trade balance with the UK and Scotland is going to fall. And it is the trade balance (not exports alone) that determines external trade's contribution to GDP.

Meanwhile, lower value of sterling (and/or Scottish currency) will lead to revaluation of returns on investment for UK and Scottish banks and firms made in Ireland. In simple terms, interest rates will rise faster and higher in the UK with weaker currency. Which means higher returns for UK banks in the UK than in Ireland. Meanwhile, with devaluation of the pound, funding Irish divisions losses will be more expensive for the UK and Scottish banks. Which means lower returns and higher costs of losses for UK banks in Ireland. Sign a 'bye-bye' note to RBS' Ulster Bank.

At the same time, the thriving financial services 'outsourcing' industry of the IFSC, currently serving numerous UK-based firms from Dublin will be looking at rising sterling cost of providing these services. Just at the time when independent Scotland is devaluing (lower cost in sterling terms) and attempting to lure these services into its own thriving back office services centres. If Scottish authorities play it right, there can be a double-incentive for some back office activities to re-domicile out of Ireland into Scotland.

Stronger euro relative to sterling is also going to carry over to tax arbitrage by the ICT services companies, which are currently booking billions of revenues from the UK into Ireland. As the values shrink expressed in euro terms, profits declared here for tax purposes, small as they already are, are going to get even smaller. For MNCs using Ireland as a cost (transfer pricing) centre, the same effect will be to reduce the transfer pricing margin in euros. Again, this will not play well with their GDP-linked activity.

All of which implies quite a risk from Irish economy's point of view.

None of the above should be treated as a comprehensive list of positive and/or negative effects of the possible Scottish 'yes' vote, nor should it be treated as supporting either 'yes' or 'no' camp. I am simply providing one small exercise of thinking about the possible effects of a 'yes' vote.

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