2.13 Under any of the four options, independence would have immediate implications for the macroeconomic framework of an independent Scottish state:
• new monetary arrangements would have to be defined, through a negotiated
international agreement with the continuing UK and/or with the euro area, and through the setting up of new independent monetary institutions. In addition to the issue of suitability of monetary policy discussed in Chapter 1, this process would involve a number of transition costs and raise some key questions around credibility, models of governance and political accountability of the new institutions;
• a fi scal framework that complements the choice of monetary framework would need to be established; and
• a new independent Scottish state would have to introduce its own framework for fi nancial stability, both for crisis prevention and crisis management. In the area of crisis prevention, an independent Scottish state would have to comply with the EU requirements and set up its own regulatory regime.4 The new independent Scottish state would also have to set up its own crisis management procedures, or negotiate with the continuing UK or the euro area the conditions to share common procedures. A formal sterling currency union
2.14 Throughout this paper, a formal currency union refers to the case where two or more independent states formally agree to share a single currency and common institutions and policy settings.
2.15 Examples of such formal agreements between independent states are rare. The euro area is the main example of a modern formal currency union. This example has the following institutional and policy features:
• members of the formal currency union adopt a common monetary authority that represents and is accountable to the currency area as a whole, but is independent from political pressures and national interests; and
• members of the currency union also agree on a number of formal arrangements over fi scal policy and fi nancial stability. These arrangements apply to all members of the currency union and are designed to prevent the risks of spillovers between members affecting the stability of the union as a whole.
Unilateral use of sterling
2.16 Unilateral use of a foreign currency refers to the case of a state adopting unilaterally the currency of another – generally larger – state, while the larger state is not required to change any of its institutions and policies, and may simply continue to operate with a focus on its formal area of responsibility without taking account of conditions in the client state. This process is often referred to as dollarization, reflecting the historic dominance of the unilateral use of dollar although since the creation of the euro there have been examples of euroisation. So the case of an independent Scotland potentially adopting sterling unilaterally has come to be referred to as “sterlingisation”.
2.17 The experience of existing dollarized (or euroised) economies show that money supply is entirely market driven. The foreign currency used for day-to-day transactions must be obtained through borrowing or capital income from investments abroad, or by exporting goods and services. To ensure the provision of smaller coinage to their economy, dollarized countries often print a local currency which is fully convertible into the foreign currency. 2.18 The main examples are for small, developing, very open economies such as Panama or
Montenegro, with relatively less sophisticated financial sectors than that of Scotland. It is unlikely their experience will provide a fully relevant example of how such arrangements may apply to an independent Scottish state deciding to informally adopt sterling (or any other currency) as its domestic currency.
4 Under the EU Treaties, an independent Scottish state would be required to have its own regulatory regime, unless it was able to negotiate any changes to standard conditions. It would need to establish a competent authority that would regulate and supervise financial services provided in Scotland. All EU Member States are responsible for putting in place a regulatory regime that fulfils the State’s obligations and are also liable for infraction proceedings if the regulator behaves in a way which is contrary to European rules. An independent Scottish state would also be required to have its own body of financial services legislation and would be responsible for ensuring that it is compatible with EU law.
Joining the euro area
2.19 This option is to some extent better defined than the previous two, as it is possible to look at the experience of Member States who have adopted the euro since its formation, and experiences of those already in the euro area.
2.20 Under the EU Treaties, all Member States, except those with an explicit opt-out (UK and Denmark) are required to adopt the euro in future. The question of an independent Scotland’s EU membership is considered in detail in the UK Government’s paper
Scotland analysis: Devolution and the implications of Scottish independence, which makes clear that it is far from certain that an independent Scottish state would be able to secure an opt-out. Such a decision would not be in the hands of the UK or an independent Scotland but would require the agreement of all 27 (soon to be 28) EU Member States. Unless a formal euro opt-out were to be negotiated, an independent Scottish state may end up de facto negotiating simultaneously a commitment to adopt two different currencies: the euro (through negotiations over EU membership) and sterling (through negotiations over the membership of a formal sterling currency union).
2.21 Euro area institutions are currently undergoing significant changes and the exact conditions for fiscal policy and financial stability could be very different by the time an independent Scottish state were to adopt the euro.
A new independent Scottish currency
2.22 Finally, an independent Scottish state could introduce a new independent Scottish currency. It would then need to chose one of the following exchange rate regimes (by increasing degree of commitment to exchange rate stability):
• fl oating exchange rate, where exchange rate movements would be driven by market demand for the independent Scottish currency;
• managed exchange rate, where an independent Scotland would decide to manage its exchange rate against another currency (e.g. sterling, euro or US dollar), in the form of a band or a spot peg;
• currency board, where an independent Scotland would commit to full convertibility of its currency at a fixed parity with another currency such as sterling, euro or US dollar. 2.23 In all cases, a new currency would have to be introduced that would replace sterling. This
might come with a number of transition costs for the issuing authority and for households and businesses (including the financial sector).
2.24 In a floating and in a managed exchange rate regime, an independent Scottish state would have its own central bank. It would have more or less latitude to conduct independent monetary policy and operate as a lender of last resort to commercial banks, depending on the type of exchange rate regime chosen and on the external constraints to the exchange rate.
2.25 Alternatively, an independent Scottish state could replace its central bank with a currency board. A currency board is a monetary authority that is required by law to manage a country’s foreign exchange reserves in order to maintain a chosen exchange rate and full convertibility between the domestic currency and the anchor currency. This would be similar to the current arrangements in the Channel Islands, the Isle of Man and Gibraltar (see Box 2C).