LONDON, March 26 Britain's pound could face a lengthy period of weakness if Scotland decided to leave the United Kingdom after more than three centuries of union, with global investors likely to steer clear of the sort of shock such an event could create.
To date at least, Scottish secession has been regarded as an unlikely "tail risk" for most global money managers eyeing opinion polls that have consistently shown a plurality of Scots want to remain in the United Kingdom.
As a result, currency markets don't yet appear priced for even the remotest chance of a Scottish exit, with few signs of even hedging activity against future ructions. In fact, the pound has gained 3 percent against the dollar in the past six months to $1.6550 as traders and investors appear to focus solely on the prospect of higher UK interest rates.
But as September's referendum nears amid signs of some narrowing at least in the gap in opinion, strategists warn that wariness of sterling could build up. The latest ICM poll on Sunday showed just a seven percentage point gap in favour of the union - down from a 12 point lead last month. As many as 15 percent of those polled were still undecided.
Some investors could be factoring in a chance of the United Kingdom splitting up while still assuming little damage to the pound. Talk of a possible breakup of the euro three years ago, for example, did not cause a sharp fall in the European single currency because many investors assumed a core euro centred on Germany would rise.
But unresolved issues over what currency an independent Scotland would use, concern about the redistribution of debt and revenues from North Sea oil, a probable cut to "rump" Britain's credit rating and possibly even trade hindrances between the two countries would be more likely to push the pound lower.
While many analysts have yet to calculate a fair value at which a post-secession sterling will trade, some estimate it would shave up to 10 percent off current levels to bring the pound down to between $1.50-$1.55 against the dollar.
"It will be very negative both in the short term and the longer term for the pound if Scotland gets independence," said Steve Barrow, head of G10 currency strategy at Standard Bank.
"Size does matter, so Scotland leaving the UK will have a negative impact. Besides, investors do not like uncertainty and if Scotland leaves the UK, it will create just that."
The near $2.5 trillion UK economy is only Europe's third largest but the continent's biggest destination for foreign direct investment (FDI), a key driver of currency flows. According to UNCTAD, a United Nations body, FDI inflows to Britain totalled $62 billion in 2012.
An Ernst & Young survey reckoned Scotland secured more than 10 percent of those UK inflows in 2012.
VULNERABLE TO DEBT
Only after a vote would both sides sit down to divide revenues and debts. The details would matter, and any prolonged uncertainty would be destabilising.
Giving Scotland its geographic share of North Sea oil would leave it with a higher GDP per capita than the rest of Britain. If debt were then to be divided by population, that would mean the rest of Britain would end up with a higher debt ratio as a share of its remaining GDP.
Think-tank National Institute of Economic and Social Research (NIESR) in a paper published in February said the gross debt-to-GDP ratio of "rump UK" would rise to 104 percent from 94 percent projected for 2016/17 when independence takes effect. Scotland's debt ratio would fall to 84 percent of GDP.
The higher debt ratio for the rest of Britain could leave the pound vulnerable, particularly if it led foreign investors, who now own 30 percent of UK government bonds, to trim their holdings and exit the currency.
"An independent Scotland would bring major uncertainties, costs and risks - mostly for Scotland, but also for the remaining UK," Blackrock analysts said in a note.
Blackrock, the world's largest investment manager, does not see much risk for holders of the remaining UK's debt unless an independent Scotland were to default, which is unlikely. The UK Treasury, for its part, has already committed to honouring all outstanding debts.
"Yet there could be some limited downward pressure on gilt prices due to the small probability of Scotland's finding it difficult to meet its obligations to the remaining UK at some point in the future," it added.
Analysts say the pound's status as a reserve currency - a currency sought by other central banks as part of their reserves - was unlikely to be undermined if Scotland broke away.
"Most reserve currencies have problems, like the euro with the euro zone crisis and it still is one," said Simon Derrick, head of currency strategist at BNY Mellon. "What will hurt sterling more is the uncertainty of Scotland breaking away."
Scotland would face the bigger currency question: it is not yet clear what currency would be used there at all. But the uncertainty north of the border could hit the pound too.
"International investors will stay away from the pound if there is uncertainty right at Britain's doorstep," said Chris Turner, head of currency strategy at ING.
All three major British political parties have ruled out allowing Scotland to keep the pound in a currency union, while joining the euro seems a distant prospect. That leaves the most likely options for Scotland to be either an independent floating exchange rate or a currency peg.
Both options have risks, said Desmond Supple, an analyst at Nomura, London, who estimated Scotland would have reserves of just $4.5 billion to safeguard a new currency.
"A floating exchange rate could see a highly volatile exchange rate, while a peg could be undermined by the available pool of foreign exchange reserves," Supple said, adding another possible approach could be forming a Scottish currency board.
Financier George Soros, famous for speculating successfully against sterling 22 years ago, said an independent Scottish currency could face attack and urged euro membership instead.
The long list of risks makes it all the more puzzling why sterling has been unaffected by the approach of the vote so far.
That may be understandable for a spot market trained on short time frames, but there's been barely a flicker in the implied future volatility surrounding September.
Whether that's confidence or complacency is unclear, but it may just be that markets have not homed in on the risks yet.
"It is hard to price in political risk so much in advance," said Ned Rumpeltin, G10 currency strategist at Standard Chartered, a UK bank. "But if you start to see the 'yes' vote get more traction, that could add a dimension of risk." (Reporting by Anirban Nag; Editing by Peter Graff)