The prospect of Scotland potentially leaving the UK paradoxically brightens the outlook for UK manufacturing and foreign trade as further devaluation of the sterling would render British exports more competitive and boost inflation and growth.
The UK FX rate has been greatly influenced by politics ever since the first – and failed – attempt at Scottish independence occurred in Autumn 2014. While last year's Brexit vote sent the pound lower by 15pc, expectations of an economic downturn fell through as the UK foreign trade deficit narrowed and gains in inflation spurred domestic consumption. The second referendum in Scotland, or indyref2, is poised to further support the trend, making supply-side shifts in the UK economy irreversible.
"The eventuality hasn't been largely factored in the pound's value so far," Ipek Ozkardeskaya of London Capital Group Limited said. "If Scotland decides to proceed with the second referendum to quit the UK, there would certainly be another fundamental downshift in the pound’s value, both against the US dollar and the euro."
In June 2016, Scotland, along with Northern Ireland and the London metropolitan area, voted in favor of Remain, but the overwhelming leave vote in Wales and the rest of England proved decisive in the Brexit process. A nascent manufacturing renaissance in the English North has been one of the consequences, with the pound's weakness supporting British exports.
"If there was another Scottish referendum, the Pound would weaken for the same reasons plus there would also be those created by Brexit," Viraj Patel of the London branch of ING Bank NV said.
Scotland, on its part, is heavily dependent on England economically, according to last year's assessment by the UK Parliament. Access to the UK market of goods and services, as well as labor market, are currently more important to Scotland than access to the EU market due to Scotland's closer ties with England and a shared border. For instance, roughly 94pc of Scottish insurance products were sold to the rest of the UK, with only remaining 6pc in Scotland itself, and almost none to the EU.
"The single market is a key UK asset and the certainty and level playing field of rules on tax, law and regulation adds to economic growth… we feel inevitably that if there were two independent countries in this one island there would be a fragmentation of the single market," John Cridland, Director-General of the Confederation of British Industries observed.
On Monday, the House of Lords started an inquiry of PM Theresa May-proposed legislation that authorizes the UK’s separation from the EU. The Scottish National Party’s (SNP, the ruling party in Scotland) ambition is to leave the UK whilst remaining in the EU. That means that the English-Scottish border would essentially become the UK-EU border as well should the indyref2 go as planned, and the isolationist drive in the UK, spearheaded by the UKIP and most Tory hardliners, would mean an effective disruption of all economically beneficial ties between England and Scotland.
"The GBP slides this morning against all major currencies after the Times reported that UK Prime Minister Theresa May is preparing for Scotland to potentially call an independence referendum in March to coincide with triggering of Article 50. The referendum may be allowed but only after the UK leaves the EU," Johnny Bo Jakobsen of Nordea Markets said.
That being said, the UK will be in the middle of a supply-side revolution in the economy, supported by the pound’s weakness and gains in domestic consumption driven by quicker gains in prices, when Scotland has a chance to vote on leaving the UK in order to subsequently negotiate its accession in the EU. This puts Scotland in a “grey zone” economically for an indefinite period of time when it is neither a part of the UK or the EU, if the Scots vote “Leave” on indyref2.
The rest of UK, in such case scenario, will face a sharp and immediate devaluation of the pound, which will likely become weaker than the US dollar and the euro. Spiking inflation will result in higher interest rates from the Bank of England (BoE), which, in turn, will attract safe haven investment in a scenario, similar to the events that typically entail the hikes in borrowing costs by the US Federal Reserve.