| LONDON, March 26
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
"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)