The Scottish Government’s White Paper provides an outline of its proposals for dividing the existing UK public debt and how the rest of the UK might be compensated. This note considers the implications of these proposals for the rest of the United Kingdom. We explain that in all cases, the UK’s debt to GDP ratio will rise, with possible consequences for its credit rating. At the same time, Scotland’s debt burden will be lower than the UK’s in all cases. Which method is chosen could have reverberations for states around the world seeking to unilaterally rid themselves of debt obligations.

i. Which measure of debt?

The Office for Budget Responsibility (OBR) uses several measures of public debt: the two most common are Public Sector Net Debt (PSND) and Gross Debt. PSND is defined as the total issued financial liabilities (government bills and gilts and National Savings debt) minus liquid assets (foreign exchange reserves and cash deposits). The PSND was £1,189bn or 76% of UK GDP at the end of the last fiscal year 2012/13 which the OBR project will rise to £1,580bn or 86% of UK GDP in 2016/17 (the year of possible Scottish independence).

The more commonly used measure of debt internationally is gross debt, also known as the Maastricht definition. As its name suggests, gross debt does not allow for the netting off of liquid assets or the exclusion of debt issued by other public bodies and so can be considered a more accurate indication of state debt.[1] The Maastricht definition of Gross Debt was £1402bn or 91% of UK GDP at the end of the fiscal year 2012/13 which the OBR project will rise to £1,820bn or 101% of GDP in 2016/17.

ii. How to divide the debt?

The division of the UK’s debt and assets is likely to be keenly negotiated. One of the few precedents of peaceful, and neither post-colonial nor immediately post-Soviet splits, is the ‘velvet divorce’ between the Czech and Slovak republics. The general principle was that physical assets belonged to the state in which they were situated, while the debt was divided in line with the relative population size.

In the case of the UK, we follow the precedent set by the Czech and Slovak divorce and attribute a geographic share of oil and gas to Scotland in our baseline case[2], and divide public debt on a population basis, so that Scotland would become responsible for 8.4% of the outstanding debt at independence. The resulting gross and net debt burdens for Scotland are summarized in Table 2.1, under the hypothetical assumption that the outstanding gilts could be divided up. Scotland’s initial gross debt to GDP ratio would be 86%, while the PSND measure would be 74%.[3]

Table 1: Hypothetical debt burden for an Independent Scotland in 2016/17

Total Debt Independent Scotland £bn Debt/GDP% Baseline Gross/Maastricht 1820 153 86% Net/PSND 1580 133 74% Historic Gross/Maastricht 1820 115 64% Net/PSND 1580 100 56%

Sources: OBR (2013a), OBR (2013b) and Government Expenditure and Revenue Scotland (2013)

The Scottish Government has suggested another calculation of debt shares which they call an ‘historic’ basis, which calculates the sum of fiscal deficits on the basis that Scotland the tax revenues from North Sea oil and gas should have been attributed to Scotland rather than the UK as a whole.[4] Starting this calculation in 1980, Scotland’s gross debt would be reduced to 64% of GDP and a net debt burden reduced to 56%.[5]

iii. How to transfer the debt?

Although it seems a technical detail, the precise means of transferring the debt is of great importance. Both sides have ruled-out somehow sharing out the outstanding gilts directly which would change the terms of the debt and constitute a technical default.

This leaves two alternatives. The first option is where an independent Scotland pays the full amount of its share of UK debt at independence, which we call a ‘clean break’ option. Of course, one would need to take the maturity of the debt into account; after all, owing £100 in 10 years time is less burdensome than owing it today. A simple back of the envelope calculation, taking the duration of UK public debt at 8.5 and the 4.1% as the discount factor (the average yield on 10 year UK gilts since 2000) reduces the population share of gross debt from £153bn to £109bn.[6] This means that the Scottish government makes a cash payment to the UK government of £109bn in 2016/17.

The second option, alluded to throughout the White Paper, is that the rest of the UK government remains liable for the entirety of the current UK debt and that an independent Scotland commits to paying its share of interest and principal payments as and when they fall due. We call this the ‘IOU’ option. This proposal was first suggested by the Fiscal Commission Working Group (2013) which suggested that the payments are made in line with the current UK yield curve. For example, if the UK’s debt stock included £1bn in 5 year gilts, and Scotland were responsible for 10% of the UK’s debt, then Scotland would pay the interest and principal on £100mn of 5 year gilts to the UK.

The impact of both options on the UK’s gross and net debt measures is summarized in Table 2. Under both options the rest of the UK’s gross debt to GDP ratio rises by eleven percentage points to 112% of GDP. However, the options differ in their impact on the PSND. Under the ‘clean break’ option the UK would receive a cash payment of £109bn which would leave the net debt or PSND four percentage points higher at 90% of GDP.[7] Under the ‘IOU’ option there is no up-front cash payment. Again the amount of gross debt rises to 112% of GDP, but this time the net debt or PSND rises by nine percentage points to 97% of GDP.

Table 2: Hypothetical debt burdens for the UK in 2016/17

Net Debt Gross Debt £bn Debt/GDP% £bn Debt/GDP% Union None 1580 86% 1820 101% Baseline Clean Break 1471 90% 1820 112% IOU 1580 97% 1820 112% Historic Clean Break 1509 93% 1820 112% IOU 1580 97% 1820 112%

The ‘clean break’ option is preferable from the perspective of the UK, as it would free the UK taxpayer from any continuing liability for Scottish debt, and the cash payment would be subtracted off to obtain a lower net debt figure. Indeed, even though the net debt figure rises, the cash payment could in theory be put on deposit leaving the rest of the rest of the UK economically unaffected. However, under the ‘IOU’ option the UK bears the risk that Scotland might defer or, in extreme conditions, even not repay its obligation. This is obviously not in the interest of UK taxpayers, and would surely attract the attention of the credit rating agencies.

iv. Bottom Line

The amount of current UK debt which Scotland would take responsibility for upon independence clearly matters for the UK’s debt burden. It may be less obvious that the mechanism by which Scotland compensates the rest of the UK also matters, but it is no less important. The UK’s net debt figures are very different depending on whether an ‘IOU’ or ‘clean break’ is agreed. This would certainly attract the attention of credit rating agencies. The UK Government has so far been silent on all of these issues. If the ‘IOU’ option is accepted, it would also be an important precedent for other states or regions around the world considering independence.