Sterling risks becoming a doomed currency

Financial markets have a deep aversion to uncertainty. In the coming months, the UK economy and sterling will both be sucked into a vortex of the unknown. It is not just a possible shock from Scotland’s independence vote on September 18^th that is weighing on the pound. Further out there is a much bigger risk in store for UK markets.

UK politics are shaping up for a huge seismic shift in attitudes towards Europe. Next year’s UK general election could mark a High Noon for Britain’s future in the European Union. The stakes are extremely high and the threat to the UK’s future economic prosperity is considerable. Sterling stands at a crossroads. And it is no surprise global currency markets are starting to give the pound a wider berth.

Thanks to growing market worries, the pound has already sunk to a seven month low, losing 7% of its face value two months after hitting the peak of a six year cyclical rally in early July. The currency is likely to feel more pain in the short term – and over the long term too.

Next week’s Scottish independence vote will be cathartic for UK currency perceptions. There is so much at stake – not just for the pound, but for the UK economy and for Britain’s long term political future.

At this stage Scotland’s referendum vote is too close to call. Last minute polls suggest only a 2% swing to the Yes-camp would be enough to win independence for Scotland.

An outright win for independence opens up a Pandora’s Box of deep economic, social and political risks ahead. The only positive outcome for the pound would be for Scotland to reject independence. A short term relief rally would probably follow, but the damage has already been done.

Whatever next week’s outcome, Scottish independence is already a done deal at some stage. The momentum for change and self-determination in Scotland has been so great in recent weeks that the bandwagon effect is bound to carry over.

The economic consequences of Scottish secession are huge. UK GDP would shrink by 8% at a stroke. The UK economy will be deprived of key oil revenues - worth up to £6.5bn in taxes paid to the UK government last year. The crisis in UK public sector finances, already in serious trouble as a result of the post-2008 financial crisis, would deepen even further.

There are no contingency plans for separation. Deep uncertainties remain over Scotland’s currency intentions. Central bank supervisory authority is in serious doubt. There are major question marks over Scotland assuming any share of UK national debt. There are serious risks of a max exodus of Scotland’s financial services sector – major banks and fund managers – seeking cross-border refuge in the UK in the event of a split.

Political and economic divorce would be a very messy, long drawn out affair. Increased uncertainty will have serious consequences for investment, employment and growth prospects for years to come.

The structural shock to UK public sector finances would have grave implications for UK credit-worthiness. UK sovereign debt ratings would be badly affected. The risk of a run on sterling and a sharp sell-off in UK government bonds could lead to a very damaging rise in interest rates and higher long term yields.

Question marks over the pound would play into the Bank of England’s hands short term. The UK economy is well down the road to recovery and looks set to expand by 3.5% this year. The BOE are keen to ‘normalise’ interest rates as soon as possible. Raising UK interest rates from zero back towards a 3%-4% target in the next two years would help stabilise sterling in the event of a market run on the currency. More importantly, the BOE needs to keep a steady hand on the tiller in uncertain times.

There is a much more deep-rooted danger for the UK further ahead – the risk of the UK voting to leave the European Union at some stage over the future. This will come to a head at next year’s general election – due to be held by 7^th May 2015.

Recent polls show the majority of UK public opinion supporting an EU exit. It could be a self-fulfilling prospect. British Prime Minister David Cameron, under pressure from rebels in his own Conservative Party, has already pledged to hold a referendum on the EU by 2017 – if re-elected next year.

If the UK leaves the EU, the consequences for the economy would be cataclysmic. The UK economy could be ruined beyond repair. UK trade would be jeopardised, since the EU is Britain’s biggest trading partner. Major foreign companies would desert the UK’s shores for Europe. Output and employment would collapse – UK depression could be on the cards.

Britain without Scotland and marginalised outside Europe would become an economic backwater. There would be a very serious run on the pound. The odds of sterling testing parity against the US dollar would be very high. Sterling would be a doomed currency.