UK credit rating will almost inevitably be hit if Scotland becomes independent
In reality, the Treasury had little choice but to take responsibility for the UK’s entire debt stock in the event of Scottish independence.
That had always been seen as the preferred option, but as investors returned for the new year and the referendum was suddenly on the horizon they were hungry for reassurance. Their questions over who is on the hook for paying back UK bonds are answered: The UK continues to cover the debt and – this is the tricky question – it must separately agree with a new Scottish government how to share that burden.
The announcement from the government on Monday that it would cover all issued UK government bonds, known as gilts, also makes for reassuring headlines for those voting in the referendum. With a whole list of economic uncertainties around independence and the potential unwinding of 300 years of constitutional union, it is one less thing to worry about.
But it is those holding UK debt that this announcement was really aimed at. There were two possibilities: this cover-all plan and a clean break option, where the bonds currently out there are divvied up and some are designated as falling under the new Scottish government’s responsibility.
Both options are likely to do some damage to Britain’s perceived creditworthiness as its bondholders grapple with the concept of a brand new country. But the second option would have had the most serious implications for the UK’s credit rating and could even have amounted to Britain defaulting on its debt, something that hasn’t happened since Charles II.
Ross Walker, UK economist at Royal Bank of Scotland, said the clean break option might equate to a technical default by the UK government because the counterparty on the transferred bonds would change and the new counterparty – Scotland – would not share the same credit characteristics as the original UK issuer of the debt.
“The British state can just print money to service debt in extremis … if Scotland is independent it would not have that formal printing press option. I wouldn’t want to overstate this but there is a technical credit risk and a higher default risk,” he said.
In his mind, such a move would invite legal challenges.
The mere possibility of it has been one of the factors pushing yields on gilts higher since the autumn, though the improving UK economic outlook and the move to withdraw some stimulus by the US Federal Reserve, so-called tapering, have played a bigger role in that. It is probably too soon to know if this has done the trick but benchmark 10-year gilt yields at least went in the right direction for the Treasury on Monday morning, falling to a one-month low, and held more or less steady since.
Two questions come next: What is a fair division of the costs on the debt stock between the UK and an independent Scotland? What prospects would an independent Scotland have of using debt markets to raise future funds? The two are intertwined.
Walker notes that Scotland has not got away debt free and would still have to pay servicing costs on some of the UK’s debt and redemption when the debt matures.
The Treasury insists “an independent Scottish state would become responsible for a fair and proportionate share of the UK’s current liabilities.”
As for calculating, or agreeing how much, Walker thinks it is simplified by the fact the Scottish population as a share of the total UK population at around 8.5% is broadly similar to the share it makes up of UK GDP (the Office for National Statistics puts that at 8.2% in this December release.)
But there is still room for disagreement, most likely over the contribution from Scotland’s North Sea oil and gas revenues in recent decades. In its white paper last year the Scottish government set out its proposals for dividing the existing UK public debt and suggested a calculation on a “historic” basis, attributing North Sea tax revenues to Scotland rather than the UK as a whole.
Richard Holt, regional economist at the thinktank Capital Economics foresees tense talks over that “fair and proportionate share” of the debt cited by the Treasury.
It is a negotiation in which neither party would have the option of walking away, he notes. The UK would need the costs covered and the new Scottish government would have its future finances to think about.
“If the Scottish government does do anything that appears to involve walking away then it would have serious implications for its credit rating,” he said.
That credit rating is crucial because although the new Scottish state could raise taxes it would most likely have to issue its own government bonds to cover what it owes the UK.
As a government bond issuer, the country would be in most investors’ eyes a new one. Credit ratings agencies and potential bond buyers would want assurances that the new country can pay its debts.
The UK Treasury would be watching the closest. It would hold the biggest IOU from Scotland at the outset and it seems that however the debt was divided up, the remaining part of the UK would end up in a worse position than it already is.
Angus Armstrong at the thinktank the National Institute of Economic and Social Research said that with Scottish independence the UK’s debt to GDP ratio would rise. This week’s bond announcement only confirmed the connection that would continue across the border.
“It means the rest of the UK’s indebtedness would be partially dependent on the creditworthiness of what would become a foreign country. It’s hard to imagine this sort of rise in the UK’s debt to GDP ratio would not attract the attention of the credit ratings agencies,” said Armstrong.
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