Scottish referendum: entropy trumps integration

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Eric Lascelles, chief economist, RBC Global Asset Management comments on the implications of the Scottish referendum for independence.

For several decades, globalization raced forward, with the formation of the EU, Eurozone, NAFTA and the creation of many other free trade deals.However, globalization may now be slowing. Global trade growth has slowed. There has been an increase in protectionist barriers and unrest. And independence movements have reared their heads in many parts of the world, including Scotland, Ukraine, Catalonia, Basque, Venice, Quebec and Belgium. The U.K. also contemplates leaving the EU.Among these, Scotland has its referendum on independence scheduled for September 18.The vote is a simple yes/no on a full and unambiguous separation. A 50%+1 outcome suffices.

Odds of separation

The initial expectation was that Scotland would be unlikely to separate, and polling initially supported this view. The first debate went to the unionists, bolstering this view.However, ever since, the momentum has turned. Subsequent debates have tilted pro-independence, and polls have accordingly shifted to a much tighter race.

  • Polling

The latest poll shows a remarkable 51% support for separation – the highest yet – while several others are in the high 40s.  There is clear upward momentum.It is useful to appreciate the difference between polls and probabilities. When one camp polls at 60%, the odds of victory are not 60% but rather something more like 90%+. Of course, this distinction shrinks as the numbers veer  ever closer to 50%. Right now, the main British betting websites put the odds of separation at 47%. Of course, the race isn’t over yet. The Unionists are now offering greater political devolution to Scotland in an effort to turn the tides, and this may yet prove sufficient to halt the separatists’ momentum.

  • Historical precedent

There are a number of historical precedents for independence votes.However, few offer a useful guide to the likely dynamic in the Scottish vote, since few have had reliable polls beforehand, and most have been landslides (unlike for Scotland).

Case in point, South Sudan’s referendum on independence in 2011 showed 97% support in polls, translating into a 99% vote in favour of separation. Other examples include many ex-Soviet bloc countries from the early 1990s such as Slovenia, the Baltics and Ukraine (As an interested aside on Ukraine, the independence vote from Russia at that time revealed 83-86% support in eastern Ukraine, and 54% support in Crimea).

Quebec’s 1995 vote is perhaps the most useful point of comparison, since it occurred in a developed nation, enjoyed broadly accurate polling and was a close vote. As with Scotland, the Quebec sentiment shifted steadily toward sovereignty in the weeks leading up to the vote, peaking at 53% of decided voters in favor in the last poll. Crucially, however, the actual vote was “only” 49.6% for separation. In other words, the sober second thought of a voting booth chopped more than 3 percentage points from the “yes” camp. There is a good chance that a similar slippage occurs in Scotland, arguing that the odds are still materially in favor of a “no” vote.

Consequences of secession

The referendum provides a Boolean yes/no outcome. After the vote, the probability instantly crystallizes at 100% for one camp or the other. Given that markets have currently priced in a slightly less than 50% possibility of separation, markets will have to move in one direction or the other after the vote.What would happen if Scotland voted to secede?

  • Markets

The pound is down sharply so far — -6% versus the dollar since mid-July, and could be expected to fall another 6-10% if Scotland actually separated. Equities are down slightly and British yields are up slightly, but not substantially.Separation could conceivably slow Bank of England tightening as they wait to see the dust settle.

  • Initial economic hit

The initial economic hit would come primarily in the form of a sharp loss of confidence in Scotland, and to a lesser extent, the U.K.In turn, hiring and business investment in Scotland would likely slow substantially given a desire for greater clarity over the likely course of taxation, regulation, what currency Scotland would use and how much access Scotland would have to U.K. and EU markets.A significant amount of money would likely flow out of Scotland (this has already begun), in part due to economic concerns, but mainly due to the possibility of remaining funds being converted involuntarily into a new currency and devalued.In short, the Scottish economy should suffer initially, even though actual separation would not occur for a few years.

  • Big questions

There are three big questions for Scotland.

I.        How much public debt would Scotland take on from the U.K.? We imagine its fair share of the total, based on GDP weight or population weight. Inevitably, negotiations will be contentious, and this is a point on which Scotland has the upper hand (it is presently U.K. debt, not Scottish debt).However, the union has the upper hand on another question – the question of whether Scotland could continue using the pound. The U.K. has argued it couldn’t do so without permission. In reality, this is partly being used as an (effective) bogeyman in the lead up to the vote, and partly as a bargaining tactic to ensure that Scotland absorbs its fair share of the debt. In the end, Scotland would likely continue using the pound.But this would come at a significant cost. Scotland would have no control over its monetary policy (which admittedly isn’t that much worse than today, when it is only an 8% population-weighted influence on the Bank of England’s thinking). But there is reason to think that labor and capital mobility would decline between Scotland and the U.K., meaning that Scotland’s economy might look even more different than usual, creating the potential for seriously inappropriate monetary policy on occasion.

II.        Even more worrying would be the Scottish financial system. The big British banks based in Scotland (RBS and Lloyds Bank) would likely move their headquarters to the UK. This would be partially to retain the certainty of British regulations, partly to retain sure access to EU markets, and mainly to retain access to the BoE lending window. In contrast, Scottish-based institutions would be without a lender of last resort – a dangerous vulnerability. Also, RBS is 81% owned by the British government, with Lloyds 25% publicly owned. The exit of these firms would be a big hit to the Scottish economy, even though moving headquarters would not mean the wholesale removal of all operations.

III.        Would Scotland remain part of the EU? This is not clear. The short answer is that Scotland wouldn’t leave the U.K. immediately, so initially Scotland would remain part of the EU. Our strong suspicion is that by the time Scotland separated, it would have managed to retain (or, more complicated) regain full access to EU markets. The only situation in which this becomes seriously doubtful is if a full vote across all EU members were necessary, in which case the complexity (and perhaps antipathy from other countries grappling with their own home-grown independence movements) would render the outcome less certain.

  • Medium term economic implications

Some of the initial knee-jerk concerns would eventually abate.On the plus side, Scotland’s economy is broadly fine going into the referendum – in fact, Scotland is has a slightly higher GDP per capita than the rest of the U.K.. Moreover, there are examples of small states being highly successful by focusing on particular niches or advantages, such as Ireland and Luxembourg.

However, North Sea oil is tailing off fairly quickly, Scotland has a disproportionately old population, and Scotland has enjoyed an outsized share of government transfers from London. Calculations suggest a non-trivial fiscal gap of almost 2% of GDP that would have to be closed, necessitating Scottish austerity.Of course, opting for independence is far more about culture and pride than it is money, and so this economic assessment does not by itself mean that Scotland should or shouldn’t separate..As for the British economy, it would benefit from redirected capital flows, and would ultimately retain 92% of its heft. In essence, the economic effect would be fairly small, with positive capital flows managing to roughly offset the initial uncertainty. The U.K.’s global clout would be mostly unchanged.

  • Political implications

In the event of secession, there is a good probability that British Prime Minister Dave Cameron would resign, at which point a far less EU-friendly leader might take his place.On the other hand, the odds of a Labour victory in next year’s May 7th (2015) would rise significantly, making them the likely favorites.

  • Ominous precedent for other regions seeking independence

Catalonia will vote on an independence referendum on November 9. However, courts have ruled the vote illegal. The fear is that a yes vote in Scotland would create a greater argument of legitimacy for Catalonia, and also create  a roadmap for how it might occur.For context, national governments have occasionally rejected separatist votes. For instance, in 1933, Western Australia voted to secede from Australia, but the result was ignored. Venice had a vote on separation from Italy in March 2014 with 89% voting yes – it was unrecognized.

Implications of a “no” vote

The U.K. is increasingly committed to granting Scotland additional powers, such that even a “no” vote represents “sovereignty lite.”Financial markets would recover recent losses – most notably, the pound.The issue of separation would probably be settled for decades.

Bottom line

Our bottom line is that the referendum is growing much tighter, but the odds still firmly support Scotland remaining a part of the U.K. If the polls tilt another 3 or 4 percentage points higher in favor of the “yes” camp, we will have to revisit that assessment.The referendum is certainly momentous to markets, and sure to send markets moving whichever way the vote goes. However, a “yes” vote need not mean disaster. After an initial rough patch, Scotland is certainly capable of being a successful independent nation, if slightly less wealthy than under the U.K. umbrella.

We continue to believe the economic outlook for the British economy is good over the next few years, regardless of the referendum.

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