This blog originally appeared on The Economics of Constitutional Change, 3 December 2013
The level of debt and how an independent Scottish Government would deal with it is a hugely important issue. Given that it is currently running a deficit – its spending exceeds its tax revenue – Scotland will be dependent on the commercial money markets to supply funds to pay for that part of the costs of public services which cannot be paid from current revenues.
Market sentiment will play a key role in determining the price that the Scottish Government pays for this borrowing facility. If the markets think Scottish bonds will be low-risk and highly tradable, they will charge a low price. If they take the opposite view, then the Scottish taxpayer will have to pay high interest charges on its debt. The White Paper estimates that these charges will lie in the range £2.7bn to £5.5bn. Even the lower end of this range is greater than the Scottish government’s current capital budget.
Some of the debt will be held by Scottish financial institutions, and may play an important role in, say, paying for Scottish pensions. Some of the costs of debt will be recycled from Scottish taxpayers to Scottish pensioners. But if Scotland is in a currency union with the rest of the UK, Scottish pension funds will have the option to buy rUK debt without taking any exchange rate risk. Symmetrically, rUK pension funds will have the option of investing in Scotland without the risk of currency depreciation. However, any hint that Scotland might change its currency would likely lead to a reduction in cross-border investments since ultimately pensioners want to be paid in their home currency.
The White Paper suggests that:
“To manage future debt and borrowing, Scotland will establish a debt management function. This will be an early priority following a vote for independence and Scotland will be operationally ready to borrow from the markets from independence day.”
The clear expectation is that Scotland will need access to markets immediately after independence. This function will be performed by a debt management office (DMO). It will issue new debt at a range of maturities, to cover Scotland’s immediate borrowing needs. The amount required will depend on many factors – economic activity, tax rates, oil prices on the revenue side and demands on public services on the spending side. As indicated recently by the IFS, population ageing is one of the longer term, but inescapable, causes of upward pressure on spending.
So much for new debt. What about existing UK debt and assets? The White Paper argues that two methods could be used for calculating this debt: the first simple one is based on a population share, the second is based on aggregating past fiscal deficits. The estimated aggregate debt based on this method depends on where you start the clock running. The White Paper chooses 1980-81, just before oil revenues start to have a major impact on UK public finances and not surprisingly comes to a favourable conclusion about the size of the debt. Then again, the UK government might argue that Scotland should bear a larger than its population share of the debt because of the extent to which financial institutions based in Scotland have been bailed out by UK taxpayers. In these circumstances, a compromise around the population method may be the most likely outcome.
The Office for Budget Responsibility forecasts that by 2016-17, UK debt will be £1.6 trillion. Debt interest charges will be £64.4bn. Using the population method, Scotland’s share of the debt would be £132bn. This will exceed 80 per cent of Scotland’s GDP.
The White Paper argues that the Scottish Government will not take legal ownership of this debt. Instead it will make payments to the UK government to meet the servicing costs of Scotland’s agreed share of the debt. Thus, because these historic debts were accumulated when Scotland was part of the UK, there will be no change in their management. One advantage for Scotland in this arrangement is that the “price” it will have to pay on this debt is relatively low because the UK can borrow very cheaply even though its debt is high (see Figure 1). Japan and the US are also very heavily indebted, but have no problem in finding willing lenders. This is partly a function of their credit worthiness, built up over a long period. It is also due to the liquidity of their markets – the ability to trade different types of bond at low cost.
Whether the rUK will agree to this arrangement is more doubtful. One positive from the arrangement is that rUK would not have to enter into negotiations with existing debt holders to ask them to give up some of their existing and familiar UK bonds in exchange for new and unfamiliar Scottish bonds. On the negative side, the rUK debt to GDP ratio would increase to 94 per cent because rUK GDP would equal the previous UK total less Scotland’s contribution, while the size of its debt would not change. This might increase its cost of borrowing at the margin if the markets take a negative view of this higher ratio. The rUK government would also have to consider the risk that Scotland might at some time renege on the arrangement. Agreement might not be forthcoming until Scotland agreed to pay compensation for these extra risks.
Another twist to this argument comes due to the Bank of England’s quantitative easing policy, which led to it purchasing £375bn of UK government debt in order to boost the level of liquidity in the economy. The Bank of England’s holdings of UK government bonds thus substantially exceeds all reasonable estimates of the size of Scotland’s debt. The Bank is in a somewhat different position from commercial holders of government debt and there might be a way for it to exchange some of its UK bond holdings for new Scottish bonds which the Scottish government would service in the usual way. But this would mean that the Bank of England would become one of the major holders of Scottish debt and it would probably wish to be paid a significant price for being willing to convert UK debt into Scottish debt.
On the other hand, if no agreement with the owners of UK debt for conversion into Scottish debt can be arranged, some of Scotland’s share of UK debt will come up for redemption each year. New debt will have to be issued and at that point there is an opportunity to sell new Scottish bonds. This process of redemption and reissuance will be the way in which Scotland acquires its own national debt. Because the average maturity of UK debt is amongst the longest of any nation – around 9 years – this process will be gradual. This is to the advantage of the Scottish exchequer since it will not have to pay the higher costs associated with selling relatively large tranches of debt in any single year.
Around £50bn of debt is redeemed each year at present. Scotland will have to create new debt to cover its share of redemptions. Based on population share, this would amount to around £4bn a year – this partly explains why it would be necessary to have a DMO immediately available to a new Scottish Government. How the market views lending to Scotland relative to lending to UK will determine if Scotland has to pay higher interest charges. The White Paper is optimistic on this point.
Figure 1: Central Government Debt and Long-Term Interest Rates 2012
Figure 1 shows the association between central government debt (expressed as a share of GDP) and long-term interest rates for OECD countries in 2012. UK long-term rates are relatively low, given its level of debt. UK rates are very similar to Scandinavian rates even though its level of debt is much higher. This may reflect the much larger market in UK bonds, which makes it less costly to arrange trades.
What about assets? The White Paper claims that Scotland would be entitled to its share of UK assets and that this could be used to offset the debt. It puts the value of UK public sector assets at £1,267 billion, though the source of this aggregate is not clear.
We do have estimates for UK fixed assets in 2007 of £425bn of which £29bn (6.8%) is owned by the Scottish Government. Scotland’s shortfall relative to its population is £6.6bn. However, for example, this does not include the assets of the Ministry of Defence. Nevertheless, the location of defence assets is identified and if these were added, the value of assets physically located in Scotland would come close to its population share. Hence the case for compensatory payments to Scotland, at least on the basis of fixed assets, may be quite limited.
The White Paper estimates that Scotland will be in fiscal balance in the first year of independence (this is conditional on continuing adherence to the austerity measures put in place by UK government). The IFS estimate is for a 2 per cent deficit. The difference is almost entirely accounted for by a difference of opinion on the value of future oil revenues.
If the White Paper is correct, in the first year of its operation, the Scottish Debt Management Office would be engaged in floating debt equivalent to its share of redemptions. If the IFS estimate of the deficit is correct, there would be a need for a further 2 per cent of GDP, worth approximately £3bn, to be sold. This would constitute net new borrowing for the Scottish government.
There would also be payments to UK government of around £4.6bn – double the Scottish Government’s capital budget for 2014-15 to meet its obligations to service historic UK debt. As this debt falls due for redemption, however, these servicing costs will decline, while the charges on Scottish debt will increase as more of it is sold. Eventually, Scotland will have a debt stock of its own and the markets will decide the price at which it can borrow.