UK warned against pact with Scotland

With Scotland looking for permission to secede from the UK in the referendum later this month, the possibility of a currency union closer to home has been dismissed by the UK government.

In a report from HM Treasury, published in February, it warned: “Within a sterling currency union, an independent Scottish state would find it more difficult to adjust to the effects of economic challenges, such as a fall in the global oil price, than Scotland currently does as part of the UK. The continuing UK would become unilaterally exposed to much greater fiscal and financial risk from a separate state.”

It concludes: “On the basis of the scale of the challenges, and the Scottish government’s proposals for addressing them, HM Treasury would advise the UK government against entering into a currency union”.

Monetary unions and exchange rate mechanisms are generally proposed as a method for exchange rate stability and certainty, which can help manage inflationary or deflationary pressures. But like most things, exchange rates come down to supply and demand, so if you have an imbalance in your current accounts and you need people to buy your currency, you can either attract them through higher interest rates, or depreciate the currency so much it becomes attractive to speculators.

However, Paul Lambert, head of currency at Insight Investment, says: “If you have a fixed exchange rate situation but you have an imbalance in your current account position, how does the capital account come back into equilibrium? That is the problem.”

In terms of the previous gold standard and Bretton Woods systems, capital accounts in countries were brought back into equilibrium through either a shift in reserves or in policy. But with a monetary union, it’s not just a nominal exchange rate mechanism, it is a real one.

The euro crisis, for example, was triggered by the imbalance between the current account surplus of the core countries and the deficits of peripheral countries.

“That is okay if you have offsetting capital flows, which is what you had before the financial crisis, but then the capital flows stopped and you had these big current account imbalances. This is what every currency crisis in a monetary union or fixed exchange rate environment is about – you don’t have the capital flow to offset the current account,” Mr Lambert explains.

Frances Hudson, investment director and global thematic strategist at Standard Life Investments, notes some of the economic factors that can determine whether a currency union might succeed are whether there is a free trade area and also a mechanism for transfer payments.

“The more closely that countries are aligned economically, the more sense it makes. What you see in most of the US and Canada, which are examples of successful currency unions, is that you get variations in taxes between states, on things like sales tax. But you also get a situation where states that are net contributors to the budget seem to be okay with some of that federal money being deployed elsewhere.”

This supports the UK’s reasons for dismissing the idea of a currency union with Scotland, on the basis that should Scotland’s economy suffer from its reliance on energy, the rest of the UK could have to foot the bill.

That said, not all currency unions are enshrined in law, some are by custom and association, with many countries pegging their currency to something like the US dollar, such as some of the Asian exporting countries, while Switzerland manages its currency with reference to the euro.

Ms Hudson adds: “There are lots of informal ways of achieving something that has characteristics of a currency union, without going the full way. It depends on the motivation for it and whether or not it’s a positive action. For example, this is going to be good for growth and trade, or if it is more of a defensive banding together.

“A currency union takes away sovereignty over your monetary policy and that’s quite a big thing to give up. Perhaps the conclusion is that a currency union is a step on the way to more integration, but it can’t be an end in and of itself as it wouldn’t be a stable equilibrium.”

Nyree Stewart is features editor at Investment Adviser