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.

7/9/2014: Scotland's Financial Services and the UK

Here is an interesting tweet on the size and inter-links between Scottish Financial Services and the UK:

But here are some other facts:

• Financial Services contributed £8.8bn to the Scottish economy in 2010 or over 8% of Scottish onshore economic activity.
• Financial Services direct supported 85,000 employees and indirectly provided jobs for 100,000 more, accounting for around 7% of total employment.
• Banking, as a sub-sector of the Financial Services is the largest contributor to the Scottish economy adding over £4bn, or nearly half of the total financial services contributions.
• Adding to the financial services the associated professional services combined broader financial services sector employs a total of 148,600 people, or 6.1% of total Scottish employment, contributing over £14bn to the economy, 13.1% of Scottish GDP.
• More than 40% of Scottish postal services & almost 30% of Scottish accountancy services are sold to the Scottish financial sector. Almost 19.4% of all 'other business services' in Scotland are supplied to the financial services contractors, 18.7% of all advertising, 18.2% of computing services, 18.1% of real estate services, 17.6% of printing and publishing, 20% of research services, 16.3% of legal activities, 16% of telecommunications, and 13.4% of air transport services.
• The Scottish banking sector (a subset of Financial Services sector) is huge. The assets of the whole UK banking sector (including Scotland) are ca 490-500% of UK GDP. Scottish banks assets total around 1,254% of Scotland’s GDP, not counting any effects on the GDP from a vote for independence. In comparison, at the end of 2007, Icelandic banks had assets were around 800% of GDP, while Cypriot banks assets amounted to around 700% (450% for domestic banks). Irish banking system reached around 894% of GDP at the peak of pre-crisis boom.
• Scottish banking system is heavily concentrated (a factor that played significant role in the Cypriot banking crisis): the two largest banks – the Bank of Scotland and the Royal Bank of Scotland (RBS). As the UK Government report (see link below) of May 2013 notes, "There could be questions about an independent Scotland’s ability to stabilise its banking system in the event of a future financial crisis. In 2008, the UK Government spent £45 billion recapitalising the RBS in order to protect the deposits and savings of households and small business. In addition, the bank received £275 billion of guarantees through the UK Government’s Asset Protection Scheme. This combined support from the UK Government to RBS is equivalent to some 211 per cent of Scottish GDP in 2008." The later accounts for Scotland's geographical share of North Sea oil revenues.
• Quoting from the same report: "The Scottish financial services industry estimates that 90 per cent of its customers are located in the rest of the UK, and the market is highly integrated for most financial products. For example, 89 per cent of stocks and shares Individual Savings Accounts (ISAs) provided by Scottish firms are sold to customers based in the rest of the UK, and 33 per cent of the Individual Savings Accounts (ISAs) opened by Scottish consumers were with non-Scottish firms."
• Two main banks in Scotland control 70% share of the market for SMEs lending in 2011, Lloyds: 36% and RBS 34%.

On the opposite side of trade: 

• 70 per cent of all pension products bought by Scottish consumers are from firms based in the rest of the UK.
• 48 per cent of adults in Scotland currently have an ISA, which attract UK tax relief. Per UK Government report: "ISAs would cease to be available in the current form if Scotland separated from the rest of the UK."
• 24 per cent of employment in the UK life and pensions sector is based in Scotland, but 91% of pensions products originating in Scotland are for non-Scottish residents.
• Funds management is a big business in Scotland, with an estimated £750bn of assets under management and an estimated 3,600 people employed (directly and in related services). The Scottish share of the UK asset management sector was 6.4% in 2010. Two of the UK’s top 10 asset management firms: BlackRock International Ltd (the largest in the UK) and Standard Life Investments (the ninth largest) were based in Scotland.
• 90% of Scottish Financial Services customers reside in the rest of the UK. 84% of mortgages issued in Scottish institutions are to customers outside Scotland. 
• 58% of total exports and 71% of total imports in Scotland are with the rest of the UK.

More analysis and facts on the interlinks between the UK and the Financial Services in Scotland available here:
https://www.gov.uk/government/publications/scotland-analysis-financial-services-and-banking

Шотландский Выход: Финансовый Риск для Великобритании

Here is a handful of edited notes relating to my interview this week on BBC Russian Service. In Russian.

These cover the topic of financial costs and risks to the UK from potential Scottish Independence vote.

Возможность выхода Шотландии из валютной системы Великобритании и создания собственной валюты несомненно представляет серьезные проблемы не только для Шотландской экономики, но и для Великобритании. 

В первую очередь, проблема для Великобритании будет заключаться в том каким образом долгосрочные финансовые контракты - страховые, пенсионные и инвестиционные контракты - будут расчитываться в новой валюте. Просто перевести их по начальному обменному курсу в Шотландский фунт будет слишком рисковано. Если в будущем Шотландия проведет девальвацию валюты, эти контракты понесут реальные потери. Каким образом риск таких потерь может быть покрыт на балансовых счетах банков и инвестиционных и пенсионных фондов в Сити - это не понятно. При этом, Английским банкам и банкам других стран придеться покрыть такие риски с момента изменения валюты. Это потребует серьезных средств и поглотит большой обьем капитала банков. Что может привести к новому финансовому кризису.

Один вариант - это создать еффективно две валюты: одну валюту непосредственно привязанную к фунту стерлингу, другую - независимую от фунта стерлинга. Первая валюта покроет существующие контракты, вторая будет работать в экономике. В этом случае, Шотландия примет весь риск перехода на новую валюту на себя. Однако, банкам за пределами Шотландии да и международным банкам работающим в Шотландии все равно придется искать новый капитал что бы покрыть уменьшенный риск девальвации и более высокий риск дефолта. 

Ну и, конечно, Шотландия окажется на финансовом тонком льду - Ллойдс и РБС имеют настолько гигантские активы, что Шотландия, как независимое государство, мгновенно превратиться в Новую Исландию. С рыбой и какой-то нефтью, но без вулканов и дешевой энергетики. Иначе говоря - потенциальным банкротом. А это означает еще более высокий риск дефолта и серьезные вопросы сможет ли Шотландская валюта перенести финансовый кризис и поддержать Шотландскую банковскую систему.

Опять же, вопрос не теоретический с точки зрения Сити и всей остальной Великобритании: риск дефолта в Шотландии - это риск дефолта на облигации и активы и депозитивы Шотландских банков. Цепочка финансовых контрактов и их подписчиков тянется далеко за пределы Эдинбурга.

Один пример: во время последнего финансового кризиса, Ллойдс поглотил 20.5 миллиардов капитала, предоставленного Банком Англии. Банковская группа РБС поглотила 46 миллиардов фунтов. Где Шотландия сможет найти такие деньги если будет новый кризис? Сможет ли страна с 130 миллиардами валового дохода буквально напечатать 67 миллиардов фунтов новой валюты только для того что бы покрыть риск двух банков?

Конечно нет! А значит все контракты переводимые в новую валюту будут оцениваться значительно ниже чем их оригинальная, начальная оценка в фунтах стерлинга.

Практически, переход на новую валюту это проблема новых рисков и старых долгов. Вспомните хорошо известное выражение: если вы должны банку 10,000 это твоя проблема. Если вы должны банку 10 миллионов, это уже проблема банка. Шотландская банковская система имеет активы в 12.5 раз превышающие валовой продукт страны. А Лондон практически банкир Шотландской банковской системы... Разве приходиться удивляться тому что Сити сегодня очень обеспокоен возможностью того что Шотландия выйдет из системы стерлинга?