Scotland referendum 2014: the impact of independence on the UK's currency
Analysis of the potential changes to the UK's currency as a result of a Yes vote in the Scottish independence referendum.
Part of a collection of articles produced by the House of Commons Library which explore the potential impact of a Yes vote on the UK, aiming to inform the debate from an impartial viewpoint.
We do not know what currency Scotland would use if it became independent
Retaining the pound would make trade between Scotland and the UK easier. However, this would require agreement between Scotland and the UK
If Scotland had its own currency, this would raise the costs of trading between the two countries but give each greater freedom to pursue their own economic policies, through for example, setting different interest rates
The choice of currency will be one of the most important decisions which a new Scottish Government would have to take, should Scotland vote for independence.
It would obviously have huge implications for the Scottish economy but would also affect the UK. The choice of currency would affect trade between Scotland and the UK. But it would also have implications for interest rates, tax and government spending and the financial system.
The Scottish Government position
The Scottish Government argues that an independent Scotland should retain the pound and that this would be in the economic interests not just of Scotland but of the UK as well.
In the White Paper, "Scotland's Future", the Scottish Government stated that “using Sterling will provide continuity and certainty for business and individuals, and an independent Scotland will make a substantial contribution to a Sterling Area.”
The UK Government position
Sharing the pound would need agreement to be reached with the UK Government.
This has, however, been ruled out by the Conservatives, Labour and the Liberal Democrats. These parties have all argued that such a “currency union” would be bad both for the UK and for an independent Scotland.
The economic issues raised for the UK would depend on the choice of currency made by Scotland. The implications for the UK would be different, depending on whether agreement were reached on Scotland keeping the pound or whether Scotland used its own currency or joined the euro.
Examples of countries sharing a currency
The Eurozone is the best-known example of a currency union. There are currently 18 countries sharing the Euro. There are other examples of countries linking their currencies.
For example, there is a common monetary area covering South Africa, Lesotho, Swaziland and Namibia. The currencies of Luxembourg and Belgium were linked between 1921 and 1999 when both countries joined the Euro.
The Irish currency was linked to sterling until 1979. There was a short-lived monetary union between the Czech Republic and Slovakia following their split in 1993.
Trade and the balance of payments
If Scotland were to leave the UK, there could be a significant effect on the UK's balance of payments. Scotland's exports and imports would no longer count towards the UK's trade balance.
UK trade with Scotland would count towards the balance of payments, whereas currently it is excluded as it is commerce within a single country.
The effect could be significant. The oil and gas industry contributed £32 billion to the UK balance of payments, according to Oil and Gas UK's Economic Report 2013.
There would be costs for business if Scotland and the UK had different currencies. These include transactions costs involved in converting currencies during trade between the two countries.
Scotland is the rest of the UK's second largest trading partner (third if the euro area is treated as a single country) so these costs could be considerable.
Besides transaction costs, separate currencies would mean greater exchange rate risk for businesses operating either side of the border.
A UK business considering trading with or investing in Scotland would face the risk of the pound fluctuating against the currency used in Scotland.
While it may be possible to hedge against these risks to some extent, this is another way in which separate currencies would raise costs to business.
A formal currency union would avoid both these transaction costs and exchange rate risks.
Formal currency union
A currency union would pose some risks for the UK, however. For example, it has been argued that higher oil prices would mean an appreciation of sterling which could be detrimental to the UK economy by making exports less competitive.
If the majority of oil revenues were allocated to Scotland, the UK would not benefit from higher tax revenues resulting from a higher oil price but could lose out from a less competitive exchange rate.
Interest rates and the wider economy
Formal currency union
If Scotland and the UK were to reach a formal agreement to share the pound, this would have implications for the way interest rates are set. At the moment, the Bank of England sets the official interest rate for the whole of the UK.
If the pound were shared, a single interest rate would be set for the sterling currency area; in other words there would be a single interest rate for both Scotland and the UK.
The implication for the UK would be that its official interest rate would now be set, at least in part, by reference to economic conditions in another country.
While the UK would make up the large majority of economic activity in the sterling zone, and interest rates would therefore tend to reflect UK economic conditions, there would be an element of risk that interest rates would be set at the ‘wrong' level for the UK as they would need to take economic conditions in Scotland into account.
The risk to Scotland from a single interest rate for the sterling area would be greater as it would make up a much smaller proportion of the zone's economic activity.
The Scottish Government has played down these risks, arguing that economic conditions in Scotland are similar to those in the rest of the UK, meaning that a common interest rate could well be appropriate.
A shared currency would expose each country to financial and economic risks originating in the other. In a currency union, economic and financial risks arising in one country are more likely to spill over to other members than if they had separate currencies.
So, if Scotland and the UK agreed to form a currency union, this would almost certainly include measures to mitigate these risks.
One issue with a formal currency union is that any such agreement would be between two countries of very differing size.
The population of the UK would be around 11 times larger than that of Scotland. Depending on how North Sea oil is divided, the GDP of the UK would be around 10 times larger than Scotland's.
This has led to some debate about whether an agreement could be reached between two countries of such differing sizes.
For example, the Permanent Secretary to the Treasury has raised doubts about whether Scotland would be able to bail out the much larger UK economy.
In his advice to the Chancellor, he said “this asymmetry could only cause continuing UK problems unless Scotland is prepared to cede substantially more sovereignty on monetary and fiscal matters than any advocates of independence are currently contemplating.”
If Scotland were to have its own currency, there would be no need for an agreement with the UK. A new Scottish central bank would set interest rates for Scotland. If Scotland were to join the euro, its interest rate would be set by the European Central Bank.
In either of these two cases, the Bank of England would set interest rates for the UK.
Library research papers
There is further information in a House of Commons Library note, which sets out more detail on the currency options available to an independent Scotland:
House of Commons Library Standard Note Economic aspects of Scottish independence: currency, SN06685 (latest update: 26 February 2014).