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National debt and borrowing costs

Chapter summary

  • The UK national debt stood at just over £1.4 trillion, or 90% of GDP, in May 2014, overshooting by half the 60%-of-GDP upper limit permitted by the Maastricht Treaty. Most commentators accept that Scotland would assume its population share of the national debt, which amounts to £116bn (and rising) even before banking interventions.
  • The accumulation of new debt would also bring major strains. Using data from the Scottish Government, in 2012, if Scotland had secured a population share of North Sea oil, its annual deficit would have been more than four times the 3%-of-GDP Maastricht limit, at 13% of GDP. Only Greece and Slovenia were more indebted.
  • If Scotland secured a geographic share of oil revenues, the position would be a little better, at 8% of GDP. Yet this too would be one of the weakest fiscal positions in Europe. This is not a good starting- point, especially as Scottish revenues are far more cyclical than UK revenues (given dependence on cyclical oil). Scotland’s revenues are more subject to cyclical influences beyond her control than almost any other country in Europe.
  • At a conservative estimate, Scotland would pay an initial risk premium for its borrowing amounting to 50-100 basis points (0.5-1%) over UK gilts. If Scotland did not adopt a disciplined approach, this risk premium might widen materially.
  • If a separated Scotland adhered to the Maastricht debt limit of 60% of GDP, as it would be obliged to do as part of the price of EU readmission, the average household would be £3400-5500 a year worse off by leaving the UK, with a further £500-1000 a year in interest per £100,000 borrowed on mortgage.
  • Scotland would also need to prove itself to capital markets by a period of fiscal discipline, even austerity. Failure to exercise fiscal restraint risks an increasing monetary penalty with higher sovereign yields and borrowing costs. Over many decades the UK Government has built credibility with global lenders. It has never defaulted. This credibility has resulted in low gilt yields that allow the Government to finance its debt with relative ease. Scotland has no track record. 

 

UK debt is among the world’s largest. Scotland’s would be larger.

The UK national debt, at May 2014, stood at just over £1.4tn (90.3% GDP) before banking interventions, or £2.25tn (145% GDP) after banking interventions. The growth in this debt since 2007 is outlined in the table below.

It will be observed from the table that UK Government debt is rising very rapidly. It has increased from its pre-banking-crisis level of just above £550 billion to a current £1417 billion just six years later. It has doubled within the lifetime of the present “austerity” Parliament. Scotland’s share of this rate of debt increase, which is a substantial share given the heavy indebtedness of the Scottish banks to the Exchequer, could not possibly have been supported or funded internally if Scotland had not been part of the United Kingdom. The Scottish economy altogether lacks the track record, the depth of capital pool or the scale of economic activity to fund debt expansion on this scale.

UK net debt before and after banking obligations (£bn) 

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While the exact terms would be open to negotiation, most commentators accept that Scotland would assume its population share of the national debt. This is the most likely scenario. The UK Government would act as guarantor for existing liabilities, with the Scottish Government taking on responsibility, including servicing costs and repayments, for its share of the national debt.

A separated Scotland would take on a national-debt obligation of around £116bn or £186 bn after bank interventions. With Scottish GDP now standing at £129bn a year, Scotland would inherit a debt-to-GDP ratio of 90%, rising to 144% including banking obligations. In a European context, this is a fairly uncomfortable place to start, as can be seen from the chart below. Furthermore, even a 90%-of-GDP Scots national debt breaches the 60%-of-GDP national debt ceiling imposed on new member states by the Maastricht Treaty. 

EU nations’ government debt (% GDP), May 2014 

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However, given current obligations, principally health, pensions, welfare and education (welfare alone costs £2 billion a month), it is improbable that a new Scottish Government would seek to cut public spending. Indeed, there is every probability that public spending would rise given the start-up costs for new departments and the promises made to various interest groups during the referendum debate). A separated Scotland’s fiscal position would be alarmingly weak.

However the current fiscal gap is only part of the equation. The other element is the annual accumulation of Government debt. Using data from the Scottish Government, in 2012, if Scotland had secured a population share of North Sea oil, its annual deficit would have been 13.3% of GDP. Only Greece and Slovenia were in a weaker position.

If Scotland had secured a geographic share of oil revenues, the position would be a little better, at 8.3% of GDP. However this too would be one of the weakest fiscal positions in Europe. This is not a good starting-point, especially as Scottish revenues are far more cyclical than UK revenues (given dependence on cyclical oil). Indeed, Scotland’s revenues are more subject to exogenous cyclical influences than almost any other country in Europe. 

EU nationsannual fiscal deficit (% GDP) 

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It has been argued that Scotland could repudiate its share of the national debt, or threaten repudiation as some sort of negotiating ploy over the Trident nuclear deterrent. Our analysis above, of national debt, is based on a population share. This is clearly open to negotiation. However, if Scotland refused to take its share of the debt it would need to consider the impact on oil negotiations; the impact on capital markets and the Scottish government’s ability to borrow, which would be severely limited; the continuing relationship with the rest of the UK, where 70% of Scotland’s trade goes; and the signal it would give to the rest of the world in terms of upholding obligations and treaties. Repudiation would be a very serious matter, with severe consequences, which would simply not be in Scotland’s long term interests. It is not the choice of a country that aspires to be a respected member of the global community. 

Scotland would also need to prove itself to capital markets. This process would require a period of fiscal discipline, even austerity. Failure to exercise fiscal restraint risks an increasing monetary penalty with higher sovereign yields and borrowing costs.

Over many decades the UK Government has built credibility with global lenders. It has never defaulted. This credibility has resulted in low gilt yields that allow the Government to finance its debt with relative ease. Sovereign yields also feed through directly to the corporate and household sectors, helping to keep their borrowing costs down. This is demonstrated by the chart below, which outlines current UK sovereign yields over a number of periods. Effectively, HMG’s cost of borrowing is 0.9% for 2-year money, 2.1% for 5-year capital and 2.8% for 10-year gilts. These rates are very low by historic comparison. They are lower than what Scotland would be likely to achieve as a separate entity. 

UK benchmark gilt yields (%) 

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The recent financial crisis has again demonstrated the importance of low and affordable borrowing costs, as Spain, Greece, Ireland and others have found to their cost. Fiscal discipline is critical. Scotland’s starting place is not strong. Scotland is far too dependent on oil’s cyclicality, which is not within the control of Governments. At a conservative estimate, Scotland would pay an initial risk premium of somewhere between 50 and 100 basis points (0.5-1%) over UK gilts. If Scotland did not adopt a disciplined approach, this risk premium might widen materially.

That might not sound much. However, for a mortgage holder currently paying interest at 3%, a move to 3.5 or 4% is a significant percentage increase. In this example, a household with a £100,000 mortgage, with current servicing costs of £3000 per annum, could see this rise to £3500 or £4000 per annum. Bond market credibility matters. 

on August 13 | by

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