Scexit: Can Sterling Weather the Great British Divide?

On Wednesday 29 March, the British Prime Minister officially began the process of leaving the EU. Brexit might be taking up the column inches, but there's more to play for than trade deals and shared custom agreements. On Tuesday 28 March, the Scottish Parliament voted in favour of holding a second Independence Referendum.

The news that Sturgeon intends to call another vote for Scottish Independence was not entirely unexpected -- grumblings from the SNP have abounded since July. The majority of Scottish voters have no appetite for a Brexit, and the probability of being dragged kicking and screaming from the familial bosom of Europe might just be enough to ignite a desire for an Independent Scotland with EU membership.

The practicalities of a Scexit remain sketchy at best. The first attempt at Independence relied on the profitability of North Sea oil – which has plummeted since the Scots last went to the polls. The first bid was soundly defeated by a 10% margin, and recent data suggests there's even less interest in a split the second time around. Only 40% of Scots are thought to welcome a pre- Brexit dash for freedom. Nicola Sturgeon will need to convince her electorate she can compensate the significant financial support her country currently receives from Westminster. Most critically of all, she will need to set out how to create a Europhilic Scotland with a deficit that would preclude membership.

What Happens If Scotland Goes It Alone?

When news of a second Referendum broke on 13 March, sterling initially dipped, but quickly recovered any lost ground to finish the week at one month highs. Tuesday's announcement that Holyrood would call a second referendum barely impacted the currency. The invoking of Article 50, however, saw a fluctuation between losses and small gains, with the Pound trading at $1.239 by late Wednesday night.

Doubts over the legitimacy of the SNP's Independence strategy might be negating any impact on the Pound now, but the currency is unlikely to remain so resilient should the possibility of a sterling-wielding Scotland, independent of both the UK and EU, become a real possibility.

The most recent figures put Scotland's annual public spending deficit at 9.5% of GDP. Currently, that's propped up by a transfer between Scotland and the UK of around £9 billion, but an Independent Scotland would have to dramatically cut public spending or significantly increase taxes to compensate. Either could lead to a serious contraction of the domestic economy. A significant increase in taxes (recent estimates suggest an annual hike of GBP £1,000 per person would be needed to offset current spending) or cuts in public spending are likely to have a negative impact on pivotal industries such as retail, construction, tourism, and agriculture. This is before we account for any future decisions on the division of national debt between Scotland and the rest of the UK, and the impact a divide would have on the job market.

To add to these economic woes, an Independent Scotland without the Euro to fall back on would have few choices but to dollarize sterling (i.e., use the Pound outside of an official currency union). This would rob Holyrood of any control over the management of the monetary framework and severely limit its ability to provide liquidity to the financial sector at a time of massive upheaval.

An alternative could be to copy the 1926 example of the Irish Free State, and create a Scottish currency anchored to sterling. Scotland would gain some economic controls while maintaining the stability of the Pound and neatly side-step any additional costs associated with trading with the rest of the United Kingdom.

Of course, this assumes that the Pound will weather Brexit intact. The growing threat of an independence vote in Scotland destabilizing the United Kingdom could create further uncertainty and weigh heavily on investor sentiment; faith in sterling is likely to plummet should both Scotland and the rest of the UK extradite themselves from the tangle of longestablished unions at the same time. The Pound did navigate the first independence referendum in 2014 well, only dropping to five month lows as voting day hit the horizon and public sentiment swung towards an out vote. By post-Brexit standards though, that low ($1.611) now seems positively buoyant. A second Scexit – with or without European support – could very well lampoon the floundering currency. Uncertainty revolving around Brexit has already made the outlook for Sterling bearish, with the Scottish referendum development encouraging bears to install renewed rounds of selling. Since the Brexit shocker back in the June 2016, the GBPUSD has traded in a very wide range, but Scexit might well act as a catalyst for another market shaking selloff.