Macro Bytes: Scottish elections under the microscope

Stephanie Kelly

Hi and welcome to Macro Bytes My name is Stephanie Kelly and together with my co-host, Paul Diggle, will be guiding you through the complex world of politics, economics and markets. This week, we're going to be delving into UK politics, with a particular eye on the outcome of the recent Scottish parliamentary elections, and also the local English elections. And in particular, what's come onto the agenda as a result, Scottish independence.

Clip by Nicola Sturgeon

[...] with the SNP and the Scottish Greens stood on a clear commitment to an independence referendum within the next parliamentary term. And both of us made clear that the timing of a referendum should be decided by a simple majority of MSPs in the Scottish Parliament. So in no way can a referendum be described as just a demand of me, or of the SNP. It is a commitment made to the people by a clear majority of the MSPs, who have been elected to our national parliament. It is the will of the country.

Stephanie Kelly

And there we heard Nicola Sturgeon making the case for Scottish independence in the wake of the Scottish elections. And this is a question investors are increasingly asking, will Scotland leave the UK? What does that look like? What does it mean from an investor perspective? Today, we'll delve into the key waymarks, political and macro outlook on this topic. It is worth saying upfront that we are going to be coming at this from the perspective of economists, answering investor questions, and not representing a kind of a formal company view from abrdn. So to help me get to grips with these big questions, I'm delighted to be joined again by our Macro Bytes regular Luke Bartholomew. Welcome, Luke.

Luke Bartholomew

Hey, Steph. Thanks for having me again.

Stephanie Kelly

So let's kick off. Maybe if we zoom out a little first, and talk about the pre election context. So we're past Brexit, what do you, I guess, how would you define the UK political environment that we find ourselves in this year? Maybe in comparison to pre COVID, pre-Brexit? How do you define it?

Luke Bartholomew

I guess we're still not quite post COVID, yet, still going through COVID. I think my preferred reading of the election, and I'm interested in whether you agree with this, but it was largely a vote of support for incumbent party. So we saw the conservatives doing well, England, Labour in Wales and the SNP in Scotland. And to an extent, I think that is a vote of confidence in the vaccine rollout. I think there are questions to be asked about the quality of the whole COVID response, including timings of lockdown of course, over the entirety of the last 18 months or so. And I think those questions actually stand for all regions of the UK. But on the virus rollout itself, that has been, I think, a relative success. And that's what's been reflected. So I think that is largely the dynamic that's driving politics at the moment. And then from there, I think we are set up for some relatively punching growth numbers this year. And that's partly because last year was so bad to put it bluntly. And so there's a fair bit of bounce back to come from that. But, the kind of growth numbers that we're looking at, some of the strongest, perhaps even the strongest in the post war period, I think, will potentially also be quite an important aspect of the political landscape and could change some of the narratives.

Stephanie Kelly

So that's super interesting, Luke, in particular, because I obviously revealed my own preference to believe that we are post-COVID, we're obviously very much not post-COVID. But we are kind of post-Brexit, insofar as, yes, there's ongoing uncertainty by the Northern Irish protocol, which is very consistent what we've talked about in this podcast before, that Brexit kind of never ends in terms of the uncertainties that are created through it, and the ongoing kind of relationship evolution that will happen between the UK and Europe. But I guess politically, it's interesting to see, there's a lot made of kind of the Hartleypool local election, which, for listeners who aren't super close to UK politics, or aren't based in the UK, is a traditional, really strong Labour Party stronghold, that in this case, went to the conservatives, and people saw this as this really symbolic change, right. And I think in some ways, I'm really apprehensive about using local elections to extrapolate off to national support, because it can be in some countries, local issues that dominate, personalities, potholes, that kind of stuff. However, I do think this is a good example of where, through Brexit and through the COVID responses, you said Luke, they've been able to kind of take up a lot more of the ground of UK politics, you've got a conservative party that is theoretically conservative, but it's also has pretty progressive have green policies compared to lots of other countries with more left wing governments, for example. They may not shout about it as much, but they in reality do. And I think what that's done to the Labour Party is, it's really limited its wiggle room within UK politics, right? It's losing ground. It's lost ground in Scotland. And it's clearly struggling to define itself. In a world where increasingly, former Labour strongholds the sort of, quote unquote, red wall, have been eroded through Brexit and through what is seen as at the moment, quite a positive COVID response.

Luke Bartholomew

Yeah, I guess an interesting question is like whether the Labour Party sees itself, squeezed on the left by the Green Party. And if you look closely, you could arguably see some of those dynamics at work in this election. And I know you've talked on this podcast before about German politics. And that seems to be in what's happened in Germany, right that the German left have been squeezed by the Greens. So perhaps that's another dynamic to be looking at closely that Labour sort of loses, you might call to the cultural right in the red rule to the Tories due to sort of identities having been shaken up by Brexit, and then loses on the progressive wing because it's losing green voters that way.

Stephanie Kelly

Yeah, I think that's a super interesting element. So becomes like, where does Labour stay in a world where increasingly kind of, relatively centrist voters are more comfortable voting conservative? I guess the other question, which we can't know yet is the fallout up post-COVID. Because obviously, you're starting to see it a little bit in the media, the kind of assessment of how the government really performed, etc, etc. And it depends on which side of the media you read as to whether that's really glowingly positive or more negative. But I do think, you often see in other countries in history that during a crisis, the government can hold up really well. And then post-crisis, they're just... nothing is handled perfectly in a crisis. And that leads to fallout kind of later down the line. But that might be a number of years away before we see any of that.

Luke Bartholomew

Yeah, exactly. Well, I guess there is now going to be a public inquiry, right. So potentially that phrase up some interesting things. Now. I mean, I think we could spend a very long time discussing the ins and outs of the handling of the UK's COVID response. And I think there are some quite hard questions for the government to answer, I mean, pretty recent, pressing ones on travel bans and the Indian variant, but my sense might be that a lot of people might just want to move on after this. For all that, the fact of the matter is that handling hasn't been spectacular throughout the whole course of the thing. Maybe people just want to focus on the vaccine thing, the whether that gets us out of it. And that's enough to buy a grace period, to be honest.

Stephanie Kelly

Yeah. Well, I guess we'll find out. And I think, in the meantime, the more pressing question is probably above the English border in Scotland, where increasingly there has been, I would say, since Brexit, having been based in Scotland, there have been increasing discussions about Scottish independence since Brexit took place. Because Scotland was a country that voted by majority to remain within the EU during the Brexit referendum. And so since then, there has been kind of, if you look at the polling data, there's been a growing trend towards support for Scottish independence. Now, that's actually fallen off recently, in the last number of months, we had seen quite a significant rise, whereby a majority were in favour. Now, that's much, much more mixed. But nonetheless, after the Scottish elections, as we heard at the start of this show, we saw this rise in at least political rhetoric, and particularly the SNP polishing its roadmap for independence, and saying that it's going to push forward now with pursuing Scottish independence. So I wonder, Luke, I mean, to what extent do you think the Scottish elections mattered in terms of changing this course or not?

Luke Bartholomew

So I guess the first question is, how much does it matter that the SNP didn't get an outright majority themselves? That they, obviously there is still a pro-independence majority in Holyrood, through coalitional voting support from the Greens who are themselves also pro-independence. I mean, maybe it weakens the argument a little bit. At the margin, I suppose another interesting thing is, that Sturgeon was asked it's quite interesting question. Imagine this hypothetical voter that likes your handling of the pandemic, but doesn't want another referendum or independence anytime soon, who should they vote for? And she responded, well, they should vote for me and the SNP with confidence that our priority will be coming back from the pandemic. So, perhaps the combination of there not being an outright majority and the sense in which, perhaps, unionists can make an argument that the SNP will lend some votes that weren't true independence votes. That maybe that somewhat weakens the argument to push an independence referendum anytime soon. But my sense is, at the very least, that they will go through the motions or some sort of motion will pass by rule in favour referendum, and then it will be in, in the UK government's court to decide. So perhaps one of a better phrase, but the ball will be in the court for them to decide what to do next. And I understand what I mean, how you think they will react to be honest, the UK government?

Stephanie Kelly

So that's a really good question. And maybe it's worth us, kind of, laying out again, particularly for listeners who aren't based in the UK or don't follow this very closely. The SNP released this kind of roadmap to independence before the election, which was, I think, an 11 point plan. But I think it can really be boiled down to three steps. The first was- get a majority in the Scottish elections. Now, as you said, they didn't get a majority, but there is a pro-independence majority because of the Greens are also in favour. So then the next step is - request permission from Westminster, from the UK Government to hold a referendum, because under the current legislation, that's what's required. I think a broad expectation has been that the Conservatives are unlikely to approve that. That's what they've said, at least in terms of their when they've been asked about it. I think, as you mentioned, COVID creates a sort of an interesting time element of this for investors who are thinking about this or worried about kind of timelines for these kinds of political risks. Nicola Surgeon has said that they wouldn't pursue it, I think until the COVID crisis has ended, which we kind of take to mean probably, the beginning of 2022. Essentially, we expect the COVID crisis continues to be something that is the front of mind for Government. And then she had previously said that she won't wait longer than two and a half years in so we actually do have sort of a two year window, I guess, at this point in which we would expect them to kind of move forward with this. Now, that gets to your question Luke, which is, would the Conservative government go for a Scottish independence referendum? Obviously, at the headline level, they've said that they won't, which seems like a reasonable kind of expectation for investors to have. However, for the Conservatives, if they see the writing on the wall, when it comes to Scottish independence, might they actually decide to approve it at a time where they see independence support rates as relatively low. At the moment, for example, it's very, very tight. And the expectation, I think, or the hope from the Conservative Party, would be the during an actual referendum, risk aversion would mean that ultimately they wouldn't pass. So I guess that's the question Luke do they try and, essentially, do they think it's inevitable, first of all, and then if they do think it's inevitable, do they try and actually approve it and surprise everyone, when they've been saying they wouldn't approve it thus far?

Luke Bartholomew

I think that probably is a sense, the referendum in the next five years or so is probably inevitable, and their sense that they're playing for time. I mean, and but there's an argument, Is there much to be gained by playing for time? I mean, are you sort of actually falling into an SNP trap by denying the referendum and allowing them to make an argument that, this is a union without consent without an exit? What do we have to do to get, permission to be able to hold a referendum if a majority of SNP seats in Scotland, if a majority in Holyrood isn't enough, what do we have to do? And that sort of argument might mean that actually delaying it buying time ends up hurting the union's cause. So perhaps there is, if you're the government or reason to go a bit earlier, particularly if there is some sense that the vaccine thing went very well, and there's some warm glow about, it was by being part of the UK's procurement process that Scotland was able to enjoy a successful rollout. And by virtue of the NHS, which is a UK wide institution, and was able to have a successful vaccine rollout if you're able to mobilise those arguments at a time where they're sort of top of mind and so therefore, not too far in the path, that might be quite powerful.

Stephanie Kelly

Yeah, absolutely. And I think that's one of the big the big uncertainties with all of this as investors really are understanding what the machinations are of leadership in any political party, which is, which is always really tough. So we imagine that the conservatives continued with the line that they've had, which is that they want to prove it, the next step in the SNP roadmap to independence had been if they were refused, we will legislate for it at Holyrood specifically. And that throws up huge uncertainties around the legality of doing so. And there's a big question mark about whether this would end up in the courts, right?

Luke Bartholomew

Exactly. Yeah. I mean, that was where my slightly unfortunate turn of phrase that it would be back in the UK's court earlier comes to light. And yeah, I mean, it does seem that we are to some extent going down the US line where a lot of very political questions do end up in court, of course, Article 50. And then proroguing of Parliament during the Brexit affair all ended up in the Supreme Court. And I think it's relatively likely that, this would end up there as well. I didn't think the UK government would cede to Holyrood that it has the devolved ability to be able to legislate for its own referendum. I don't see them giving up that without a legal fight. I mean, do we have a sense of how that case would go, Stephanie?

Stephanie Kelly

So this is kind of interesting. I mean, I thought it was interesting that after the Scottish elections, Conservative leadership and key ministers like Michael Gove had come out and basically said, we don't want to go to court over this, which maybe speaks to your view, Luke, around the possibilities of Conservatives see the writing on the wall and have to kind of ascend before it gets to the legal kind of challenge. If it did go to the Supreme Court. I mean, here, it's a little bit fuzzy. The precedence suggests and this is kind of based on, the online legal debates that happen, that this is something that would get turned down basically in the Supreme Court and that Westminster would ultimately be successful. But we know from recent judgments around proroging the parliament, for example, you can get surprise judgments. So I think that's always a potential. Maybe if we spend the last sort of five minutes then saying, because from our conversation, it feels like investors should be, allowing for the strong possibility, that an independence referendum potentially takes place in the coming years, if not in the next five, or if not in the next two years, but potentially the next five or 10, as the push kind of continues. So in that case, what are the big questions you have as an economist, when you look at the Scottish independence question, what are the big challenges from an economic perspective? Do you think?

Luke Bartholomew

So it's probably unsurprising to hear me say this, but I think the first and most pressing is the currency question. And it's sort of unsurprising, though, that sort of continues to be one of the most important debates in politics, because it is like the most important economic thing to get right. And so far, as I can see, there are three or maybe three and a half options that an independent Scotland would have for its currency, one would be continue to use Sterling but outside of sterling union, which might essentially look the same, because you're still using pound coins and notes or whatever. But it is a profoundly different economic arrangement for reasons that we can get to. The second is to have their own currency. Scotland, independent Scotland can have its own central bank, can issue its own currency. And the third would be to join the Euro. And I suppose the half option that I alluded to there is to have an independent currency, but then to peg that, either to Sterling, or the Euro. And each of those options comes with a number of both short and long term challenges, I think that needs to be thought through quite carefully.

So in the case of using Sterling but outside of Sterling union, it is important to say that no one could stop an independent Scotland from using pound as the unit of currency, absolutely not. But it is in the gift of the UK government as to whether that occurs within a Sterling union. And there is absolutely no reason to think that there would be a Sterling union, post-independence. What Sterling union means effectively, that you're in the monetary framework of the Bank of England and have recourse to the bank of England's facilities. So what does it mean to use Sterling but be outside of Sterling union? Well, one monetary policy is going to be set in London for the economic conditions of the rest of UK without any regard to what's happening in Scotland. Now, that might not actually be as bad as it sounds economically in the short term if you think that the two countries are relatively aligned and synchronised, although perhaps in time, they would divert and that will become more of an issue. But I suppose there are sort of sovereignty questions about the fact that your monetary policy is being set in a different country. But outside of that, it's the sort of the lender of last resort facilities that come from being part of the Sterling union, which strike me as being the most important thing to leave. So one, there isn't a lender of last resort to the banking system. And that creates a very strong incentive for the financial sector to move to somewhere where such a lender of last resort would be. Second, an independent Scotland would affectively be borrowing in a new foreign currency, it wouldn't have a central bank being able to print currency notes in the union of currency that it borrows in and as we saw during the Eurozone crisis, that can have quite significant impact on financial stability and spreads, so they wouldn't be the lender of last resort to the government debt market. And so this is easily missed, I think becoming better understood that there is also like a final lender to the lender of last resort that exists within our current monetary architecture. And that's through the dollar swap line that all major developed central banks have with the Fed. So they're able to access dollars on demand in a crisis, as indeed they needed to during March last year, during the worst of the COVID shock. And, again, an independent Scotland, using Sterling outside of Sterling union, you wouldn't have access to that facility, as well. So you are losing a lot of the backups that you have to your financial sector, and government debt market if you go down the route of using Sterling, but outside of a Sterling union.

In terms of an independent currency, so the risk there would be that it's very likely in the short term, at least, that the market would value your new independent currency, weaker than it values, say, the Pound or Euro at the moment. And the problem with that is if you have deposits sitting in your bank account in Scotland, currently denominated as pounds, and there is some concern that they're going to be re-denominated as the new currency, which is going to be weaker. And of course, you take those pounds as they are at the moment and go and put them into a bank account in London, or wherever else it might be, where they won't be re-nominated in that weaker currency. And another word for that is bank run, it is effectively withdrawing deposits in Scotland and moving them to somewhere where you don't feel like it's going to be re-denominated. And the other aspect of that is that all private debt arrangements would stay denominated in that current currency. So if you have at the moment in Scotland, a mortgage in pounds, it will continue to be a mortgage in pounds after an independent currency is launched, it's just that you will be earning in the new currency but having to pay your mortgage debt in Sterling. And if the new currency is weaker than that effectively increases the value of the mortgage, that you have to pay off as well, which is why that sort of raises the prospect of maybe you want to peg your new freely floating currency, to the Pound or the Euro. So to avoid that risk of people pulling deposits out because they're worried of a weakened currency, and the impact of the real value of debt. But the problem with that is, is that it requires significant credibility to keep a peg of an exchange rate in place, significant FX reserves and the commitment to be able to run a much, much tighter monetary policy, then you might need to keep interest rates systematically higher to keep the peg in place. And as soon as the market sniff that that peg might not be credible, it breaks pretty quickly. And I think there would be reasons to think that would be the case here.

Could also peg to the Euro. But that would have the same questions about the credibility of the peg, which brings us to the final option, which is joining the Euro itself, which arguably, independent Scotland would be connected to do anyway, if it were to rejoin the EU. It could try to negotiate an opt out from the Euro, which EU may or may not be willing to grant depending how generous it's feeling. But my sense is that they are becoming a lot less generous in granting those opt outs. So in joining the Euro, that probably is the most stable long term arrangement, I would think. But the problem in the short to medium term is that there are quite strict criteria that had to be met, the Maastricht convergence criteria, one of which is that your deficit needs to be less than 3% of GDP. And for an independent Scotland to be running that sort of relatively smooth deficit would require in the short and medium term, a significant tightening in the public finances. So the transition again, could be pretty painful. And Rocky.

Stephanie Kelly

I think that's probably the clearest articulation of the options around Scottish independence that I've heard, and I think goes to show that the questions that it throws up for investors, and the reason why this is increasingly on the, kind of, horizon when it comes to investment discussions and political risk in the UK. Unfortunately that's all the time we have left. Thank you so much for joining us again.

Luke Bartholomew

Pleasure. Thank you for having me.

Stephanie Kelly

As always, to our listeners. If you have any comments on discussion today, questions or ideas for future episodes, you can email us at macrobytes@abrdn.com. In the meantime, we'll be back next week, so please join us then.

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