George Kerevan: The Treasury Blinks First

Tuesday, 14 January 2014 16:48

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George Kerevan explains Monday’s Treasury announcement on interest rates, Scotland and the UK’s growing National Debt.

ON Monday, the UK Treasury issued the following statement. It’s worth reading in detail:

“The Treasury has today set out detail on government debt in the event of Scottish independence. The technical note makes clear that the continuing UK Government would in all circumstances honour the contractual terms of the debt issued by the UK Government. An independent Scottish state would become responsible for a fair and proportionate share of the UK’s current liabilities.”

1. WHY HAS THE TREASURY ISSUED THIS STATEMENT?

Quite simply, the Treasury’s refusal to plan for Scottish independence has spooked the financial markets and this is a belated attempt by the Treasury to calm things down.

The UK’s finances are a mess. Britain has an alarming high National Debt of around £1.4 trillion, to which Chancellor Osborn is adding in excess of £100 billion every year. Total debt as a proportion of UK national income is rising (see tables on page 30 of the Chancellor’s Autumn mini-budget).

Worse – as far as lenders are concerned – is the fact that the UK still has a so-called structural deficit. A structural deficit occurs when a country is still adding to the total national debt at the top of the economic cycle, when tax receipts are at their highest. At the top of the cycle, a prudent nation should be saving (i.e. running a budget surplus). Adding to your debts even in good times makes the markets jumpy. Mr Osborne says he will get rid of the structural deficit in 2018, but he’s been wrong before and the markets know it.

Despite this background, the Westminster Government has been saying very publicly for the last three years that it is making no contingency plans for what might happen if Scotland votes Yes next September. It is refusing to enter any pre-referendum talks regarding any aspect of the financial arrangements that Scottish independence might entail, especially matters of debt and currency. Witness then Scottish Secretary Michael Moore speaking in early 2013:

“We will not be negotiating in advance…it would be irresponsible, it would be a betrayal of our responsibilities, for UK ministers to act on behalf of only part of the UK against Scotland’s interests in some kind pre-negotiation…”

On the contrary, it is grossly irresponsible of Westminster ministers to ignore the fact that by refusing pre-negotiations, or any form of contingency planning, they have upset the markets. Lenders, understandably, want to know who is responsible for paying them after Scottish independence – especially given the disastrous state of the UK’s finances.

The issue is not – despite the spin of Danny Alexander, Chief Secretary of the Treasury – that the markets are worried about Scotland’s ability to pay. Rather, they are worried that Messrs Osborne and Alexander have been sleepwalking towards the break-up of Britain without a contingency plan. So the markets started hinting that (faced with this uncertainty) they might charge the UK Treasury (not Scotland, which won’t actually be formally independent for several years) a higher interest rate on new UK debt, to cover the higher risks this Treasury-inspired uncertainty is causing.

So on Monday the UK Treasury had to admit up front that it alone is legally responsible for the debts it has contracted and that it will honour interest payments on that debt. Note: this has always been the legal position but by refusing to comment before now the Treasury has deliberately and irresponsibly sown seeds of confusion. It is ordinary Scottish, English, Welsh and Irish taxpayers who suffer the consequences.

(By the way, it is not as if the UK treasury is actually ignoring the referendum. Thousands of man-hours are being wasted at the Treasury producing copious public reports designed to attack the SNP and the Yes Campaign. A quick look at the Treasury website lists 8 such reports since last February, totalling over 800 pages.)

2. WILL AN INDEPENDENT SCOTLAND HAVE TO PAY HIGHER INTEREST RATES?

Danny Alexander’s latest ploy is to claim that independence will lead automatically to the Scottish Government having to pay higher interest rates on public borrowing than the present UK. Here he is writing in The Scotsman on 13 January:

“…an independent Scotland would likely face significantly higher borrowing costs. That means big spending costs or tax increases elsewhere to balance the books”.

(Note: As regards “balancing the books” at the UK Treasury, Chancellor Osborne has just announced another £25 billion in cuts. Vote No and you’ll get to enjoy these cuts after the 2015 Westminster general election.)

Rather than speculate, let’s look at what countries are actually paying in interest rates on public borrowing. The safest form of lending is to the German Government. The risk premium on state borrowing is calculated on the extra paid over the going rate for German 10-year government bonds.

At the start of January 2014, the yield (i.e. interest) on UK Treasury debt was 1.03 percentage points over the going rate for German bonds. But just look at what other small industrial nations of Western Europe are paying. In practically every case it is less than the UK Treasury pays: Austria (+0.36 points over Germany), Denmark (+0.06), Finland (+0.21), Netherlands (+0.32), and Sweden (+0.58). Why would Scotland, with a GDP per head in the global top 20, pay more than these countries never mind more than the UK with its mega debts?

Some will mention the contingent liabilities left over from the 2008 banking crisis as a potential problem. But little Switzerland had just as big a problem with its banks during the Credit Crunch. Today, the Swiss Government pays less for its public borrowing that even Germany! The Swiss pay 0.61 percentage points below what the safe German Government forks out to the markets.

What about Ireland, which does have a serious budget crisis (and no oil as yet)? Ireland pays a spread of +1.45 percentage points over the German rate. But that compares well with the UK’s +1.03, largely because the Irish have an export boom while the UK trade deficit is one of the worst in the industrial world.

What about Belgium, which has been on the verge of spitting into two new states for some time? Belgium government bond yields are +0.68 points above the German – way lower than UK Treasury debt.

Note also that the UK has artificially kept its borrow costs down by having the Bank of England print pounds (electronically) and use the cash to buy Treasury bonds (i.e. lend to the Westminster Government). Take away this ‘quantitative easing’ and the cost of UK Treasury borrowing would shoot up.

There’s an important caveat we have to make. Of course if Scotland ran an unsustainable and irresponsible structural deficit like the UK Treasury then the markets would punish us – and they would be right to do so. However, such profligacy is highly unlikely. In fact, during the entire period from 1980 till 2012, Scotland (with its proportionate share of oil revenues) ran an average annual budget surplus equivalent to 0.2 per cent of GDP. In the UK, on the other hand, this period saw an average annual budget deficit equivalent to 3.2 per cent of GDP. So Scotland has a track record of responsible budgeting – something the markets will take into account.

Note also that Scotland’s entire national debt on independence is likely to be around £100 billion. George Osborne and Danny Alexander borrow more than that every year! Scotland’s entire debt as a proportion of its GDP is likely to be around 10 percentage points lower than for rUK. Again, these numbers should give confidence to lenders to Scotland. On the other hand, the same cannot be said of rUK, which might explain why the Treasury has been reluctant to contemplate a future without Scotland.

3. HOW WILL SCOTLAND PAY ITS SHARE OF THE UK NATIONAL DEBT?

The SNP has always said that Scotland would accept a ‘fair share’ of the UK national debt (calculated as a proportion of the population) and shoulder the interest rate burden accordingly. In effect, this would operate as if the UK Treasury had made an equivalent loan to the Scottish Government. As the Scottish Government is likely to inherit an annual budget deficit, it would need further borrowing and have to go to the markets for this. To be realistic, a new nation with no credit track record might incur a short-term risk premium but there is no reason to suppose that average borrowing costs would not settle down quickly – and be lower than for rUK.

However, the SNP argues that as well as taking on a fair proportion of the UK national debt it also wants a fair proportion of UK assets. Alex Salmond has also made it clear that part of these negotiations would include the question of retaining a common sterling currency area.

Enter Alistair Darling – who is under constant sniping by Tory critics in London for his leadership of the No campaign. Darling responded to Monday’s Treasury announcement with uncharacteristic and bizarre language, which suggests Tory criticisms are needling him. Darling accused Alex Salmond of threatening to default on interest payments to the rUK Treasury post independence.

He added: “It appears the First Minister needs a basic lesson in economics. The UK pound is a monetary system underwritten entirely by the UK Government. It’s not an asset to be shared like the CD collection after a divorce.”

Of course, the First Minister never threatened default or came anywhere near saying anything of the same. What he did ask for was for the UK Treasury to open immediate contingency negotiations with the Scottish Government that would limit any delay in coming to an agreement over interest rate payments and the asset division. Ten Downing Street immediately issued a statement saying there would be no negotiations.

This intransigence on the part of London is likely to lead to more market jitters. For Alistair Darling (a lawyer by trade and not, like Alex Salmond, a professional economist) could not be more wrong about the link between the currency question and government debt.

As we noted above, the real reason the cost of UK public borrowing is not higher is because the Bank of England has printed money and – effectively – used the cash to buy Treasury bonds. (It ‘launders’ the money by buying bonds at an above the odds price on the open market.) To date the Bank of England has spent £375 billion on this exercise. However, as a result of funding the treasury by (essentially) resorting to the printing press, the Bank of England now owns around a third of the UK national debt. And that, Mr Darling, is an asset that comes into the negotiations over Scottish independence.

Eight per cent of the Bank of England’s Treasury bond holding – acquired through quantitative easing – should by rights go to Scotland. But that transfers ownership of a chunk of rUK debt to a foreign country. It means that instead of the UK state owing itself money (because it ‘owns’ the Bank of England) it would suddenly have a new foreign creditor.

To avoid this financial problem, surely it would be preferable to have a common sterling zone and have formal Scottish representation on the Bank of England’s Monetary Policy Committee (which sets interest rates). In return, an independent Scotland would magnanimously forgo removing its share of the Bank of England’s assets from London.