In September 2014 the Scottish people will vote on independence from the UK, which has raised the issue of what kind of currency regime an independent Scotland would face.
The current Scottish government has made it clear that it wishes to keep the British pound sterling as opposed to introducing an independent free-floating currency.
The idea being proposed is that an independent Scottish economy operates within a 'Sterling Zone' - the closest and most obvious comparison being that of the Eurozone.
The benefits of keeping the British pound sterling
There are two reasons why the Scottish Government have proposed keeping the British pound.
Firstly, they believe voters will be more likely to vote for independence should sterling be retained.
Secondly, it makes economic sense.
Deutsche Bank's Macro Strategist Oliver Harvey point out the following economic benefits of sticking with Sterling:
- Scotland’s business cycle is highly correlated to that of the rest of the UK which is by far Scotland's most important trading partner. It is even more correlated to the rest of the UK than certain English regions (Yorkshire and Humber, the East Midlands). Therefore, the idea that currency devaluation will boost Scottish exports fails to stand.
- The argument that Scotland would not be able to finance the stock of debt it assumes from the rest of the UK by gaining fiscal independence and ceding monetary independence is seriously flawed. Instead, the risks associated with adopting a different currency could be far greater.
- Were existing liabilities transferred into Scottish currency, foreign investors would not only be instantly exposed to currency risk, but it would also provide a huge incentive for the Scottish government to monetize the debt.
- This could spark a crisis in investor confidence and capital flight. The massive spikes in peripheral bond yields during the height of the Eurozone crisis were associated with precisely this phenomenon as mark et priced in monetary union breakup.
- Scotland would cede a substantial part of policy independence by being forced to defend the purchasing power of its independent currency.
- Keeping the pound could be a crucial factor in retaining investor confidence in an independent Scotland.
- Scotland would accrue the advantages of ‘importing’ the UK’s inflation regime, further strengthening credibility.
- Scotland would incur significant costs by adopting its own currency.
But the UK won't want a Sterling Zone
So, the arguments presented by Deutsche Bank for Scotland using the British pound sterling within a Sterling Zone ultimately hinge on the realistation that there is little benefit to Scotland of adopting its own currency.
The problem for Scotland is that the rest of the UK appears opposed to the creating of a Sterling Zone that is shared between the UK and the Scottish.
Both George Osborne, the Chancellor, and Ed Balls, the Shadow Chancellor, have made clear they are not in favour of the proposal.
So, what would an independent Scotland do?
The answer according to Deutsche Bank would be for the Scottish to peg their currency to that of the UK.
"If the UK was unwilling to allow Scotland to remain a formal part of sterling area following independence, the Scottish government would have other options to retain the advantages provided by monetary union.
"The Scottish government could peg an independent currency to the pound, either via a conventional peg or currency board similar to the one used by Hong Kong.
"A peg may also provide additional policy flexibility in the event that imbalances were to emerge."
It should be kept in mind however that maintaining a currency pegging regime would also require Scotland to hold sufficient reserves to defend it.
"This may present a problem for a future Scottish government, given that UK reserves are relatively small relative to GDP," says Harvey.
To sum up, Scotland's business cycle is highly correlated to the rest of the UK, it is highly competitive and an exit from the sterling area could spark a market crisis if UK liabilities were transferred.
"We suggest that if the country were unable to remain formally part of the sterling area, it could peg its currency to the pound," says Harvey.