Wednesday, 25 September 2013

A fair division of reputational assets

In the Scottish independence debate, HM Treasury has asserted, in the first of its Scotland Analysis series of papers, that Scotland would become an entirely new state, with rUK inheriting the legal personality of the current UK. Needless to say, the Scottish Government did not agree with this statement and Nicola Sturgeon pointed out its status: it is legal opinion, this is perhaps very well informed opinion, but opinion nonetheless. This was much discussed at the time in terms of its implications on EU membership etc, but a new implication of this assumption is emerging.

At the International Conference on Economics of Constitutional Change held last week in Edinburgh, Dr Angus Armstrong of the National Institute of Economic and Social Research (NIESR) presented a paper on the currency options for an independent Scotland (Armstrong & Ebell), making the link that debt levels were an important consideration in making this currency choice. The analysis underlying this paper appears sound: it concludes that a small state with volatile tax revenues will pay a higher interest rate on its borrowings than a larger state with stable tax revenues (for a given average tax revenue per unit GDP, and debt stock level per unit GDP). The methodology looks solid and the conclusions are intuitive.

I do however question the assumption made in this paper about the splitting of debt. It suggests that rUK is "the continuing UK" and that newly independent "Scotland would also have to compensate the continuing UK for being relieved of its fair share of the existing UK public debt at the time of independence". Whilst both the UK and Scottish Governments have agreed that the assets and liabilities of the current UK should be split fairly, they may disagree on the method of this splitting, and what constitutes 'fair'. However there seems to be an emerging consensus that assets fixed in geography should accrue to the country in which they reside, and moveable or financial assets and liabilities should be split on a population basis. So let's consider splitting the UK debt by population and look at the consequences of assuming that "Scotland would also have to compensate the continuing UK for being relieved of its fair share of the existing UK public debt at the time of independence".

To simplify things massively let's assume that:
# the market value of UK debt, at the point at which it is to be split, is £1359B
# this is all 5 year zero coupon bonds
# which yield 2%p.a.
# Scotland is 10% of the UK by population
# The analysis in Armstrong & Ebell suggests that Scotland would pay 3.5% on its debt [this is not the real number from the paper, but just to keep things relatively simple].

The face value of the outstanding debt stock is £1500B. I think a reasonable way to split this is that Scotland becomes responsible for repaying 10% of this face value, £150B, as it becomes due. rUK would pay the other £1350B on the due date. The current market value of the debt will fall as existing creditors are not as happy with their new counter-parties as they were under the previous union. But this happens after every election: a prudent government issues debt for sensible reasons at low interest rates; then loses an election to an imprudent government and the interest rate rises; existing debt-holders get burnt. The Scottish independence referendum is another election, and not one that creditors can reasonably claim to have been ignorant about: most of the existing debt stock has been issued since 2007 when the SNP first came to power.

However, if the rUK was to be considered as "the continuing UK" then the scenario I've outlined in the previous paragraph may constitute a default by the UK - something that "the continuing UK" will never do. And if instead Scotland has to buy out the debt from rUK by raising new Scottish debt, it would need to pay rUK £136B to extinguish its liability, by issuing 5 year zero coupon bonds with face value of £161B - rather than £150B. This boils down to saying that in order for rUK to maintain the reputation of the current UK in international credit markets, Scotland should pay a premium. Is this 'fair'? In my view, any reputational assets currently "owned" by the UK should also be divided fairly.

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