What would the currency options be for an independent Scotland?

If Scotland were to become independent from the rest of the UK, it would need to decide what currency to use. Options include sticking with sterling, creating a new national currency or joining a monetary union, such as the eurozone.

Currency issues were central to the independence debate in 2014 when the first referendum on Scotland’s future in the Union was held. They continue to cause controversy as discussions about a second referendum gather steam.

The reason is that the choice of currency regime is about much more than simply the denomination of notes and coins that circulate in an economy. In reality, the decision gets to the very heart of the economic foundations of a country.

So what are the key issues surrounding currency options for an independent Scotland? What are the trade-offs and where are the main controversies?

The principal currency options for Scotland

A country’s currency regime defines how its currency relates to other countries’ currencies. Is the relationship fixed or flexible and how does this affect the operation of monetary and fiscal policy? Currency choice can define the currency regime, but it need not.

A number of currency options were discussed in the 2014 referendum, and these remain the principal choices for an independent Scotland:

First, an independent Scotland could continue to use sterling – either formally, by being part of a sterling monetary union with the rest of the UK, or informally, which is usually referred to as ‘sterlingisation’. The latter is the equivalent of dollarisation, whereby a country aligns its currency to the US dollar. It has close parallels in the form of a currency board.

Second, an independent Scotland could seek to enter a monetary union with another country, or group of countries, and adopt their currency. The most likely candidate would be to join the eurozone. All of these represent a fixed exchange rate regime.

Third, by issuing its own currency, an independent Scotland would open up other exchange rate regime options such as a fixed but adjustable peg or a freely floating exchange rate.

Each of these options comes with costs and benefits. Deciding which would be the optimal currency arrangement requires assessing the costs and benefits of the different regimes relative to the underlying macroeconomic structure – the trade balance and fiscal position – of Scotland.

Why is the currency regime issue fundamental to constitutional change?

There are two key reasons why the currency regime is so important in the context of constitutional change.

First, an independent Scotland would have its own distinct balance of payments accounts, which would define its trade and capital transactions with the rest of the world – and these accounts would need to balance (see Hallwood and MacDonald, 2000).

Crucially, the way in which they balance differs depending on the currency regime. For example, with a flexible exchange rate regime, the exchange rate moves to ensure that, say, a deficit on the current account of the balance of payments is financed by a surplus on the capital account.

A key feature of a fixed exchange rate regime is that it commits the central bank of a country to defend the ‘peg’ and since the exchange rate cannot, by definition, move to ensure the balance of payments balances, this is achieved by changes in a country’s foreign exchange reserves.

For example, a deficit on the current account would require a corresponding outflow of foreign exchange reserves to ensure that balance is achieved on the balance of payments. This would require the central bank to run down its reserves to maintain the value of the peg.

The second reason why currency regime choice is important relates to how it affects the banking sector and the ability of a country to run an independent monetary and fiscal policy. We turn to these issues below.

The currency debate in 2014 and now

In the 2014 referendum, the Scottish government’s official policy was to remain part of the UK’s formal monetary union despite the then Chancellor of the Exchequer, George Osborne, ruling this option out (White Paper, 2013). Uncertainty over the currency regime in 2014 is seen as a significant contributing factor to the outcome of the vote.

Since then, there has been a more expansive debate about currency options. The pro-independence Green Party, for example, favour a separate Scottish currency, as do many in the ruling Scottish National Party (SNP).

The SNP’s official policy on currency was restated in the 2018 Sustainable Growth Commission report (SGC). That report argued that the Scottish government no longer needed to press for a monetary union, but that an independent Scotland should simply continue to use sterling post-independence in an informal relationship with the rest of the UK, much as some countries use the US dollar informally.

The form of sterlingisation envisaged in the SGC report is one in which an independent Scotland would have its own (albeit limited) central bank and there would be some, but perhaps not all, commercial banks domiciled in Scotland.

Without its own currency (or the lack of a formal agreement with the UK), the Scottish central bank would only be able to provide limited ‘lender of last resort’ functions (Armstrong and McCarthy, 2014). This refers to the situation where a bank or other financial institution is unable to obtain the liquidity it needs for its day-to-day operations, or in an emergency, from the interbank market and has to call on the central bank. This turns out to be especially important in the case of the informal use of sterling since, as we shall see below, it will create a key liquidity drain from the financial system.

In a further contrast to 2014, the SGC argues that the informal use of sterling post-independence should be part of a transition to a new separate currency in the future. The creation of this new currency would occur once six specific tests had been satisfied, including the creation of a sustainable fiscal policy and a credible monetary policy. There has been demand within the SNP to move quickly on this transition. In April 2019, delegates at the party’s spring conference voted in favour of a new currency ‘as soon as practicable’.

But as we shall see, the reality of changing currency regimes is inherently complex and subject to pressures outside the control of policy-makers. Evidence throughout macroeconomic history shows that planning a transition with the expectation that it is entirely in the gift of politicians is unrealistic. The experience of Czechoslovakia in the 1990s provides a timely reminder of this.

What are the economic arguments in favour of using sterling post-independence?

There are a number of reasons why seeking to continue to use sterling post-independence might be favoured. First, there is a transaction cost argument: that continued participation in a sterling zone would minimise the costs of trade with Scotland’s main trading partner, the rest of the UK.

Costs arise with a separate currency as people and businesses face conversion costs, as well as uncertainties that come from the value of goods and services changing as exchange rates fluctuate. Such costs are likely to be at their greatest with a floating rate regime, and impart an extra wedge into the costs of trade through the need to hedge the risk of currency movements.

It is possible that a newly minted currency might be more volatile, at least during the early stages. In 2014, such costs were argued to be between 0.5% and 1% of GDP for Scotland – between £500 million and up to £2.5 billion for the higher bound (see MacDonald, 2014).

A further advantage of sticking with sterling would be the avoidance of the costs of setting up a new currency both for the government but also households and businesses (Tetlow and Soter, 2021). Retaining sterling would also avoid a redenomination issue in the sense that the establishment of a new currency at anything other than the implicit one-to-one peg would have implications for the value of sterling-denominated assets and liabilities, such as pensions and mortgages.

One of the key disadvantages of a fixed exchange rate currency regime – such as sterlingisation – is that, in such a set up, the central bank, as we noted above, has to subjugate monetary policy to defend the pegged rate by drawing down (in the case of a deficit), or building up (in the case of a surplus), foreign exchange reserves.

In such a regime, the central bank cannot adjust the exchange rate or interest rate. Clearly, this would limit the ability of an independent Scotland to deal with local economic shocks since flexibility in the exchange rate can provide an external adjustment mechanism and act as a ‘shock absorber’.

But if an independent Scotland were able to continue to be part of a formal monetary union with the rest of the UK, it would still have the support of the Bank of England in terms of both its economy and banking system. That would clearly not be the case with the informal use of sterling where the Scottish central bank’s monetary policy would simply be tied to defending the fixed exchange rate arrangement and the implicit one-to-one peg.

How robust might a sterling zone be post-independence?

Central to how robust a fixed exchange regime is over time are the economic fundamentals that underpin it.

In 2014, the Scottish government argued that a sterling arrangement would be robust, drawing on research on the idea of ‘optimum currency areas’ (MacDonald, 2014). These studies posit that countries might be well-suited to a fixed exchange rate regime (including monetary union) if there is a sufficiently high degree of labour and capital mobility between the participating countries, the countries have a high degree of trade with each other and their business cycles align.

But this is only part of the story. Key to understanding how stable a fixed exchange rate regime with sterling is – either formally or informally – also depends on whether such a regime is consistent with the underlying macroeconomic fundamentals in the individual countries themselves, and specifically the fiscal and balance of payments deficits. This is where things arguably get more challenging for arguments in favour of retaining sterling.

Official statistics show that Scotland currently has a structural fiscal deficit – in other words, its public spending is higher than the revenue it generates, for example through taxes. The pre-pandemic (2018/19) fiscal deficit in Scotland was 7.7% (compared with a UK deficit of 1.8%).

In addition, the available data on Scotland’s current account position show a net trade deficit in 2020 of around 8.4% of GDP. The net factor income component of the Scottish current account is not available on a continuous basis and the latest data on this series are for 2017 and give an overall current account balance of around 10% of GDP in that year (Scottish National Accounts Programme). Given the net trade deficit was 6.7% in 2017 and that it is unlikely that the net factor income component of the current account will have improved since 2017, it is not unreasonable to assume that the overall current account balance of payments deficit remains in the region of 10% of GDP. The latter deficit has two very important consequences for the financing of government debt and the stability of the banking sector.

Government debt, the banking sector and monetary and fiscal policy

First, and in terms of government debt, a fixed exchange rate and large current account deficit would – over time – be incompatible. This would be starkest with the informal use of sterling where, as highlighted above, an independent Scotland would have to raise foreign exchange reserves to finance the current account deficit. Although in principle such reserves could be borrowed, in practice, financial markets might take a dim view of such an arrangement since it would not be sustainable or credible given the magnitude of the current account deficit.

As other countries’ experiences demonstrate, the only sustainable way to preserve the fixed exchange rate relationship would be to run a fiscal surplus (see Tetlow and Soter, 2021). But this would require a significant programme of fiscal consolidation from Scotland’s likely initial starting position (with knock-on implications for policy choices post-independence).

In the case of a formal monetary union, the reserve needs of an independent Scotland would be covered by the Bank of England, although that would presumably come at the price of limits on the independence of fiscal policy. Although a formal monetary union arrangement might be expected to be more resilient to such pressures than sterlingisation, there would nonetheless still be a tension in such a system with the incompatability of a fixed exchange rate, an implict one-to-one peg and a large current account defecit.

Of course, financial markets would recognise this. Being forward-looking, international investors might be sceptical that a fixed regime could be maintained without major adjustment, this being especially so given the clear statement in the SGC report that the use of sterling post-independence is a purely transitory relationship.

This would present important challenges for policy-makers:

they could follow through with potentially politically challenging fiscal consolidation policies to shore-up Scotland’s core macroeconomic fundamentals to be consistent with a sterling currency regime or;
abandon the fixed exchange rate regime and introduce a devalued Scottish currency, which given the size of the current account deficit, noted above, could be very significant indeed.

Even the potential of the second option would see financial markets build a risk premium into the interest rates they would be prepared to lend at. Such effects are likely to be most significant in the borrowing markets for sovereign debt (government borrowing). Any concerns over an independent Scotland accelerating the timetable for any planned introduction of a new currency (intentional or otherwise), would only add to the associated risk premium. The situation would be exacerbated by households and businesses moving assets out of the country.

Liquidity and lender of last resort

The above effects would be important to address in any form of fixed exchange rate system. But a second challenge with sterlingisation is that any balance of payments deficit would see sterling reserves draining out of the system, along with the deflationary consequences of this. But with limited – and finite – inherited reserves, an independent Scottish central bank under sterlingisation would be constrained in how much leeway it would have to combat this.

These issues would be compounded if the Scottish central bank was prepared to offer deposit insurance for Scottish-domiciled banks that would add to the sum needed to support the balance of payments (see Armstrong and McCarthy, 2014). Of course with a formal monetary arrangement these issues would continue to be dealt with by the Bank of England, at the price of compatible rules for the operation of fiscal policy in Scotland.

What this discussion highlights is that crucial to any choice of currency regime for an independent Scotland is not just a recognition of what might ‘make sense’ from a microeconomic or trade perspective, but also the fundamentals of the macroeconomy.

The continued use of sterling post-independence – either under a monetary union or sterlingisation – would require a strict macroeconomic regime be put in place. This would demand short-term adjustments to Scotland’s fiscal and balance of payments position. If not, retaining sterling would be a poor anchor for an independent Scotland.

What about other options?

In thinking about the appropriate currency regime for an independent Scotland, a key lesson is the importance of compatibility with underlying macroeconomic fundamentals – and most importantly, a country’s balance of payments position.

In this regard, many economists would argue that a regime more compatible is that of a ‘free float’. This is a flexible exchange rate determined by demand and supply of domestic and foreign currencies.

In principle, a flexible exchange rate does not require any foreign exchange rate holdings, although, in practice, countries with a floating regime do hold such reserves. A flexible exchange rate regime would be compatible with the foreign exchange reserves an independent Scotland would likely inherit post-independence.

Such a regime would provide a period of stability for the central bank and treasury of an independent Scotland to build credibility in the operation of fiscal and monetary policies. It would also allow time for foreign exchange reserves to be built up if there was a desire to move to a more fixed form of exchange rate regime in the future.

It is noteworthy that aside from the short-lived European Exchange Rate Mechanism (ERM) experience, since 1973, the UK has operated a flexible exchange rate regime. This regime has absorbed many of the shocks hitting the UK economy since the 1970s, from stagflation through to Brexit and the Covid-19 pandemic.

For a newly independent Scotland with a balance of payments deficit and fiscal deficit, the initial currency depreciation could be steep, with knock-on implications for the value of assets and liabilities denominated in sterling. Issues of redenomination and transactions costs would loom large.

But this currency thistle of redenomination has to be grasped at some point on the journey to Scottish independence. The message of this article is that if Scotland is to become independent, the sooner this is addressed, the better given the way that capital markets operate in a globalised economy.

Where can I find out more?

Scotland’s lender of last resort options: Discussion paper from the National Institute of Economic and Social Research (NIESR).
Scotland: Currency options and public debt: Armstrong and Ebell consider three currency options for an independent Scotland.
Currency options for an independent Scotland: Report from the Institute for Government on Scotland’s currency choice and effects of borrowing from international markets on monetary and fiscal policy, economic and financial stability, and trade opportunities.
Currency issues and options for an independent Scotland: Ronald MacDonald discusses the implications of currency decisions.
An independent Scotland’s currency options redux: Assessing the costs and benefits of currency choice: Working paper by Ronald MacDonald on the associated costs of currency choices for Scotland.