The first question asked by global investment strategists landing in London this week has been: what on earth is going on up in Scotland?
The surge in support for independence in polls ahead of next Thursday’s Scottish referendum caught markets unaware; its relevance was unclear. Were the Scots serious? Was this just parochial, relevant only to the UK and particularly parts north of the River Tweed, or were there wider ramifications?
The answer is that a Yes vote would be huge for the UK, with substantial implications for the rest of Europe’s markets. Even if the independence movement is thwarted, a strong showing could alter investors’ long-term attitudes towards the UK and other countries with vibrant regional independence movements.
The effects, however, have not yet found full expression. Sterling has dropped more than 2 per cent against the dollar since an opinion poll last week showed the Yes campaign had a chance of winning, but UK gilts and shares have been relatively unaffected. Eurozone government bond markets have mostly remained firm.
Unswayed by emotion
Partly, that is because of the difficulty of pricing in “tail risks” – events which would have profound consequences but have little chance of happening (although Scottish independence is rapidly moving out of that category).
Another reason is that markets – unswayed by emotion – see benefits in a UK break-up. A weaker pound would boost export earnings of FTSE 100 companies; a Bank of England interest rate increase would be delayed. Yet London house prices should be unaffected, while the loss of Scottish Labour voters would increase the possibility of near-permanent market-friendly Conservative governments.
Offsetting such market positives, however, would be the uncertainty and huge disruption involved in tearing up a 300-year-old kingdom. What is more, the UK’s role as a European power would change, perhaps dramatically. Without the Scots, public opinion would tilt further in favour of exiting the EU – with significant implications for London’s role as Europe’s financial capital.
For continental Europe, a Scottish exit from the UK would be highly symbolic. Even if the Yes campaign loses next week, a strong showing would further threaten the gradual process of financial integration that has underpinned Europe’s development since the second world war – and culminated in 1999 with the launch of the euro.
The UK, of course, remained outside the eurozone but events in Scotland are spurring the independence movement in Catalonia – which on September 11 celebrates its national day – and increase the risk of Spain breaking up. Without Catalonia’s relative riches, Spain’s debt dynamics could quickly spin out of control. Unsurprisingly, Spanish bond yields have risen this week, although the market faced the same problem with “tail risks”.
If greater regional independence became established as a trend, similar destabilising forces might erupt in Belgium, Italy or even Germany (Bavaria proudly describes itself as a “free state”).
Bigger was better
Driving European integration has been the idea that larger, deeper and more liquid bond markets produce better economic outcomes. The argument has merit: while the UK gilt market is large, an independent Scottish government would incur a significant risk premium on its borrowings; Europe’s regional bond markets are patchy.
Yet the eurozone crisis revealed substantial flaws in the EU’s institutional structure, which its politicians have tried to correct – in the process creating democratic deficits. “Financial markets have pushed politicians to make decisions ahead of time and where voters are. The result is a big legitimacy issue,” one top European fund manager sighed this week.
A Scottish Yes vote would force EU politicians to make tough choices. Just how easily should regions be able to gain independence and then rejoin the EU? Too easily, and there could be a further unravelling of Europe’s economic integration. Membership of the eurozone in particular was meant to be a one-way process.
“If you allow these nationalist forces to achieve independence easily, you open the door to the regionalisation of Europe, a huge challenge for the union, definitely,” says Antonio Roldán, analyst of Spanish affairs at the Eurasia Group in London.
Against that background, the EU would probably take a hard line with Scotland – through fear of setting precedents for others. Negotiations would almost certainly be protracted, adding to the list of uncertainties a Yes vote would create.
Even if the vote favours the Noes, the legacy of the campaign may be investors’ questions that will not go away.