Part 1 of Iain Hardie’s two-part analysis on the Scottish Bond Issue

What Can Be Learned for Devolved Scotland?

First Minister Humza Yousaf’s announcement that Scotland could issue bonds has prompted some interesting reaction, especially in the London press. Matthew Lynn claims in the Telegraph that such bonds would deal Scottish independence ‘a fatal blow…forever’. There are apparently not enough letters in the alphabet to cover how low Scotland’s credit rating would be. A Financial Times editorial makes comparisons with Venezuela and, as Lynn does, Argentina. Yousaf is presented as a modern-day successor to John Law, an eighteenth-century Scot whose monetary innovations in France ended in economic disaster.

This is all highly misleading (To be fair, both newspapers also carried far more balanced assessments.) Scotland can issue bonds successfully. The City of Aberdeen borrowed £370 million in this way in 2016, and there is no reason to believe that Scotland cannot follow suit. The Scottish government already borrows from the National Loans Fund (NLF), a UK government entity which also lends to councils across the UK. The cost of that borrowing is a margin over the UK’s own borrowing costs through issuing government bonds (‘Gilts’, hence the Scottish government bonds already being called ‘Kilts’). A Scottish bond will very likely be priced in a similar way. Scotland’s borrowing is currently capped at a total of £3 billion, a small amount relative to the size Scotland’s economy and the Scottish government’s income. Repayment of the NLF borrowing is not a significant challenge for the Scottish government, nor would a bond issue be. There is a question as to whether a bond issue would be cost-effective compared to the NLF, but it can be easily launched.

Some of the negative reaction has therefore been much ado about little. There are nevertheless questions regarding the implications of such a bond issue, in particular if this would be a major vote of confidence from international investors in Scotland and its government now, and after independence. This first blog considers the implications of a bond issue for Scotland if it remains in its current devolved situation. Part 2 will consider the implications for an independent Scotland.

A devolved Scottish government would be a sub-national (sometimes called municipal or sub-sovereign) issuer. Bonds are commonly issued by similar entities around the world. In almost all cases, a key consideration for investors is the nature of the support from the central government. In pre-independence Scotland, this would be the Westminster government. We can be confident that the UK government would not give a Scotland bond an explicit guarantee, which would be a legally binding guarantee to pay interest and repay the bond if the Scottish government was unable to do so. Such explicit guarantee would be the best form of support for investors, but an implicit guarantee is far more common in such cases. An implicit guarantee is not a legal obligation by the central government to repay the bond issue, but the nature of the relationship between central government and sub-national issuer is such that investors can assume that support will be forthcoming.

The City of Aberdeen bond issue involves an implicit guarantee. The credit rating agency rates the bond A1, one level below the rating of the UK government, and far above the rating Matthew Lynn illogically suggests is appropriate for Scotland. A crucial influence on the rating is ‘a high likelihood that the government of the United Kingdom (not, note, of Scotland) would intervene in the event of acute liquidity stress’. In other words, an implicit guarantee. The Westminster government is not legally obliged to ensure Aberdeen’s bonds are repaid, but investors can be confident that they would. Aberdeen’s credit rating has been downgraded twice since the bond was issued, each time the result of a downgrade for the UK itself. As a result, investors in Aberdeen’s bonds are ultimately not expressing confidence in the creditworthiness of the City of Aberdeen, but in support from the UK government if that was needed.

Central government support for sub-national issuers is fairly common though not universal. Famously, in 1975 the US government refused to bail out New York. In the UK, support can be expected if necessary to meet contracted expenditure including debt repayment, following intervention of the sort that happened recently for Birmingham City Council. There has been some speculation since Yousaf’s announcement that support would not be forthcoming, particularly from an aggressively right-wing Westminster government. This seems very unlikely. Economically the cost to the UK as a whole of a Scottish default would be high, not least in the damage to other UK sub-national borrowers from what would be perceived as a politically motivated unwillingness to ensure debt repayment. The UK will also remain a significant creditor of Scotland through the NLF, giving an interest in avoiding collapse. Politically, refusal would be inept. The UK government may well be tempted when a bond is initially marketed to remind investors that there is no explicit guarantee, because a large difference in interest rate between Gilts and Kilts might be considered a useful political message. A Westminster refusal of support, however, would forego an opportunity to highlight the strength of the union and risk a narrative similar to ‘Westminster supports Birmingham but not Scotland’. There may not even be opposing parties in Holyrood and Westminster at the time support is needed.

We can assume that investors and rating agencies would see a Scottish bond as benefiting from an implicit UK government guarantee. There could be a theoretical threat to such a guarantee from changes in the nature of the relationship between Westminster and Holyrood short of independence, especially further fiscal autonomy, but this seems unlikely to be significant to investor demand for a bond issue. As a result of this implicit guarantee, as with Aberdeen, the bond issue is not a test of investor perceptions regarding the creditworthiness of Scotland in its current constitutional position.

The spread Scotland pays – the difference between the Scottish bond and the government bond benchmark in the relevant market – will be highly visible, and something unionists will doubtless seek to exploit. However, little can be learned from this spread. As noted, the perceived creditworthiness of the bond will be heavily influenced by the implicit guarantee. As importantly, the spread on any issue is influenced by factors outside the control of the issuer, most obviously overall market conditions reflected in the spread of other comparable issuers. The Scottish bond will unavoidably be far less liquid – harder to buy and sell – than Gilts. A new issuer in the market is also likely to pay a premium. For the proposed pre-independence issue, nevertheless, a spread of less than 1 percent – the Scottish Growth Commission’s (SGC) assumption for an independent Scotland – should be achievable, especially if the Scottish government can be patient in waiting for favourable market conditions. It might be possible for unionists to argue that the spread below the SGC assumption shows the value of the implicit guarantee and therefore of the Union, but this is probably an overly technical point to exploit fully.

A bond issue offering better terms than alternatives is obviously worthwhile, but one that does not might still be worth doing. However, the positives are small, so any premium paid should also be small. Marketing Scotland to bond investors does have value over the medium term, for investment in Scotland generally as well as the Scottish government itself. Humza Yousaf is right to claim that an issue could ‘raise ]Scotland’s] profile as a place where investment returns can be made’. The value of this is not easily quantified. It is also ironically greater if Scotland does not become independent. If the Scottish government remains a devolved administration, its bond market issuance, and that of any Scottish public sector borrowers, will most likely continue to be similar in currency and creditworthiness to the proposed bond issue, maximising the future benefit of marketing Scotland as an issuer.

In terms of bond investors, the reality of a Sterling bond issue is that ‘international investors’ really means UK investors, most obviously London-based. Issuance in US dollars or euros could reach a broader range of investors. The cost of such issues outside the Sterling market is difficult to predict, especially if it involves the Scottish government swapping the proceeds into Sterling, but is probably higher than Sterling issuance directly.

For all the talk of attracting international investors, the bedrock of all developed bond markets is demand from domestic investors. The main reason the UK government, for example, enjoys relatively long maturity debt relative to comparable countries is demand from UK institutional investors, particularly pension funds. Individual investors also lend the UK government well over £200 billion through National Savings & Investments. Countries with very high debt levels, such as Japan and Italy, have benefited from high demand for government debt from their own investors.

Whether devolved or independent, Scottish government borrowing would benefit from domestic support. The Scottish government has already explored an issue sold to Scottish individual, or retail, investors. This bond issue would be an opportunity to start developing support from Scottish institutional and retail investors.

Iain Hardie is an honorary fellow at the University of Edinburgh. He is an expert on political economy, with a particular focus on financial globalization, financial markets and government bond markets. He entered academia following a long career in investment banking in London and Hong Kong, specialising in emerging bond markets.