Before I begin a big vote of thanks
In this post I’m very grateful to Sam Taylor, Sam is an professional fund manager with 17 years experience in financial markets. Sam helped me by providing some substantive crib notes, which you can view here (in some cases I’ve just lifted them straight from Sam’s analysis - why tamper with perfection). Over the past week we’ve debated (and not always agreed) to delve deep into the Common Weal paper and I think it has improved both our thinking about this subject.
What follows is my analysis of the main claims within the Common Weal paper.
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The Common Weal papers have in the past come in for much criticism from this blog, whether on GERS, Pensions or Currency they have not tended to stand up to detailed analysis. Sadly this pattern continues with their latest paper. This purports to identify $40bn of readily realisable reserves available for the Scottish Central Bank (SCB) to defend a new Scottish Currency, as we’ll show here I believe that this is out by a factor of up to ten.
As argued in this blog in the past, the Common Weal is an organisation that unlike the SNP is freed from trying to secure the support of 50% of the population. With this they could confront the reality of independence from a radical socialist and left wing perspective. It’s sad therefore to see so many hard questions ducked in this paper. I would therefore, respectfully, suggest that the Common Weal goes back to the drawing board on both its currency and currency defence proposals.
The Common Weal author
Before starting this analysis it is worth commenting on the author Peter Ryan. The Common Weal present Peter as a financial expert and to be fair he absolutely is an expert in financial services IT implementation. To be clear that doesn't for a minute suggest that Peter cannot be qualified or knowledgeable enough to write a paper of this nature, and there is no doubting his dedication and sincerity given the considerable amount of work that has clearly gone into this publication. However it also means there is no certainty that Peter does have the appropriate expertise to do so and sadly from my perspective having reviewed his work he does not.
The Common Weal Paper
The Common Weal paper basically argues that a newly independent Scottish Central Bank (SCB) could easily and inexpensively generate $40bn of foreign exchange (FX) reserves which would be available to defend the value of a new Scottish currency by intervening in FX markets.
The paper assumes that the new Scottish currency would initially be pegged one to one against sterling (GBP) with the peg at some point being loosened, presumably with a view to eventually allowing the Scottish currency to float freely (ie the exchange rate would then be set by financial markets).
This is important because a pegged currency means the SCB would subordinate monetary policy (setting interest rates and controlling the money supply) to the Bank of England (BoE). That might be an acceptable transitional arrangement, but if independence is to be meaningful the SCB would ultimately need the freedom to diverge from the BoE on monetary policy.
Furthermore given the type of arrangements that the paper is arguing for below (such as a swap with the BoE) it's highly likely that arrangement would contain severe conditionality on Scotland such as the requirement to run a surplus. This shouldn’t come as a shock to anyone on the nationalist side as George Kerevan and Nicholas Macpherson have already set out this out in some detail.
$40bn or $4bn?
The Common Weal paper lays out four distinct sources that would contribute to the $40bn. Here are the four sources, along with a very brief explanation of what makes them suspect (more detailed explanations follow):
1. Scotland's $16bn share of the UK's FX reserves. This is more like $4bn once you net out the corresponding liabilities which have been ignored or simply left out of the Common Weal analysis.
2. $2.9bn worth of GBP notes and coins that would be exchanged for notes and coins in the new Scottish currency. This number is plausible in itself, for as long as the peg is in place the $2.9bn is real and critical to maintenance of the peg. The issue arises if and when the peg is relaxed or abandoned, at that point the $2.9bn has probably mostly been exhausted with nervous Scots deciding it's better to have "hard" GBP currency. Therefore in my view whilst the peg is in place, it is not money available to the SCB to intervene in the FX market and therefore would not count under the terms that the Common Weal have set out for themselves.
3. $13bn from swap lines between the SCB and the BoE. This assumes the BoE would implement up front the type of measures used only in times of financial distress. These emergency mechanism are not designed to raise money but to stabilise economies in an crisis. Indeed taking the example of the US Federal Reserve (which as far as I can make out is the model the Common Weal paper is basing its model on) the arrangements with Canada have never been used and the Mexican swap line was only used during The Tequila Crisis of 1995.
In practice the paper is noting a Scottish Government would go cap in hand to the cUK government to ask for an emergency bailout at the point of independence.
4. $9bn of borrowing is just a plug number to get across the $40bn line. And it's borrowing! Why not borrow the whole $40bn if it's that easy.
So how much did the Common Weal paper actually find?
If we exclude borrowing, which is basically cheating, only $4bn of the Common Weal's $40bn is genuinely likely to be available to defend the value of a new Scottish currency. Whist the $2.9bn would technically be backing a new currency it is not actually available for defence purposes and when you need it most it wouldn’t be there.
The trouble is that the Common Weal need that $40bn money to defend their currency peg policy, without it their hard currency peg is clearly in doubt.
Borrowing on the open market to defend your currency from speculators is like applying going to a loan shark that knows you are all out of options. The markets know full well that the sums you are looking to raise are but a rounding error in comparison to the size of most hedge funds. Speculators from these funds would would be looking to make a profit betting against a Scots£ peg to Sterling, and frankly it would be easy pickings with this proposed set up.
Few people in the market would believe that a Scottish Government would have the credit line available to it to beat off a speculative attack, therefore they will either not lend Scotland the money or they would demand punitive interest rates. For Scotland to have sufficient credibility in the market it would need to have a far more aggressively austere public sector than the cUK and in all probability would need to run a surplus to give itself the credibility that it can indeed pay back its debts.
That's all possible, and a highly credible economic policy, it just doesn't sound like one that the Common Weal would want to sign up to. I’d therefore strongly recommend that the Common Weal attempt to create a more credible currency and currency defence policy.
In my view that means confronting a free floating Scottish Pound and accepting the devaluation may well be likely. That’s hard, and it has significant consequences from a policy perspective but it’s the sort of thinking that a truly radical organisation like the Common Weal should be doing if anyone is going to rebuild the independence movement from its current state of denial.
Robin McAlpine said that the Common Weal was “ready to begin”. You’re not Robin, you’re really not. You need to go right back to first principles and drop the fairy dust approach that has hitherto been the consistent feature of your White Paper project.
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Further details
1. $16bn share of liquid financial assets
$16bn figure comes from a straight misunderstanding of the value of the UK’s foreign exchange reserves and the difference between net and gross. The current gross UK foreign exchange reserves are £175bn (the Common Weal uses out of date March data which is lower) and uses a rough 10% figure to calculate a Scottish share. Well firstly 10% is wrong but you can at least see where the $16bn figure comes from.
The trouble is that the figure is gross, and we’re not sure that the author attempted to work out the difference between gross and net as his Common Weal comrade made the same mistake.
Many of the UK's reserves are tied up in derivative contracts which an independent Scotland would not be a party to. Scotland would not therefore be entitled to a share of those gross assets (as Scotland is not standing behind any international UK debt, just debt between cUK and Scotland). Scotland would however get a share of the £40bn in net UK assets.
So taking a population share (8.3%) of that £40bn we get $4.2bn, so in this case we're about $12bn out.
2. $2.9bn of GBP notes and coins
Provided the population of a newly independent Scotland was convinced that its new currency and central bank were credible, there is every reason to suppose they would willingly exchange GBP notes and coins for notes and coins in the new Scottish currency, and $2.9bn is not an unreasonable number.
As the Common Weal paper acknowledges, the SCB would probably need to establish its credibility by initially pegging the currency one to one against GBP. Every newly issued unit of Scottish currency would be backed by one GBP held in reserve by the SCB, and people would be free to exchange back and forth between the two currencies on a one to one basis.
If the peg were ultimately abandoned and the currency allowed to float freely, the ring-fence would no longer be necessary. However, it would be foolish to assume that the $2.9bn would then be available to intervene in FX markets should the new Scottish currency look vulnerable to a devaluation.
People would see such an event coming, and there would be a rush to exchange notes and coins in the vulnerable Scottish currency for GBP notes and coins. The moment the SCB needed it most, the $2.9bn would be likely to have evaporated before its eyes. In other words this is “shutting the stable door” money that couldn’t support and defend a Scottish Currency.
3. $13bn of swap lines with the BoE
Central bank swap lines are an esoteric subject. For readers interested in some details, the Federal Reserve (the US central bank) has a useful page explaining the principles.
Broadly speaking there are two kinds of swap line: The first is designed to ease global liquidity at times of financial stress, and the second is “for the purpose of promoting orderly currency exchange markets”, typically with key trading partners (Canada and Mexico in the case of the US).
The Common Weal paper appears to conflate the two approaches, and thinks that what are effectively emergency standby mechanisms would be immediately triggered by the BoE in the event of Scottish independence.
The Federal Reserve's liquidity swap lines were a response to the financial crisis of 2007-2009, and are now hardly used at all.
The swap lines envisioned in the Common Weal paper have exchange rate stabilisation in mind, and therefore appear to be of the second type above, and to be modelled on the North American Framework Arrangement (NAFA) swap lines established in 1994 between the Federal Reserve and Canada ($2bn) and the Federal Reserve and Mexico ($3bn).
The Canadian facility has never been used, and the Mexican one was last used in 1995 when Mexico was suffering the effects of a full blown currency crisis ("The Tequila Crisis").
The BoE and SCB might well come up with a similar arrangement to the NAFA swap lines, but it would be a standby measure for use in an emergency, and could not credibly be used as an up front way to generate FX reserves.
4. The €8BN
Ryan at this stage just abandons all pretence about what he's doing. He simply argues that the SCB issue bonds denominated in Euros. Fair enough, but that's just borrowing on the open market.
Just denominating them in another currency doesn't change the nature of the fact that it's borrowing. Euro denominated bonds would probably attract a lower rate of interest for a Scottish Government simply because they could not be paid by printing money and the market would reward that heavy constraint on the Scottish Government. That's all fine but it's exactly the problem that countries like Greece have (debt in a currency they don't control and can't print) so it would need to be considered carefully.
However make no mistake about it this is just debt plain and simple.
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