Scotland vote risks 'scary' Asian flight from sterling

Powerful investors across the world have woken up to the possibility that Scotland may vote to break up the UK, with some already preparing defensive action that risks a potentially dangerous flight from sterling and Britain's bond market.

Japan's biggest bank, Nomura, has advised clients to slash financial exposure to the UK and brace for a possible collapse of the pound after polls showed the independence campaign running neck and neck.

"The 'fast money' funds started moving a week ago but now we are seeing 'real money' clients acting," said Jordan Rochester, the bank's foreign exchange strategist. "The risks are suddenly seen as much greater for Japanese pension funds."

Nomura advised investors to take out protection on British banks, insurers and pension funds through the market for credit default swaps.

"Sterling could fall at least 15% in a worst-case scenario. These are scary times," Rochester added.

Stephen Jen, head of SLJ Macro Partners, said Asian investors were flabbergasted by the sight of an ancient and successful union tearing itself apart for no obvious reason.

"They simply don't understand it, and nor do I," he said. "We have always assumed the UK would stay united, but now everything we thought about the UK has suddenly been tested, and will have to be repriced. Sterling could weaken a lot, though just how far it falls depends on complicated dynamics. If Scotland tries to keep all the oil and refuses to take on its share of the public debt, there could be a run on UK assets."

Sir James Mirrlees, adviser to Scotland's first minister Alex Salmond, said two weeks ago that an independent Scottish state would repudiate its 8.5% share of the UK debt unless Westminster agreed to a sterling union. "Britain inherits the debt. It is Scotland's bargaining position," he said.

Britain is already skating on thin ice with stretched debt ratios and a current account deficit above 5% of GDP, the worst in the developed world.

Simon Derrick, from Bank of New York Mellon, said the UK had become a magnet for the "carry trade", sucking in funds from Japan, the Middle East and other regions searching for yield.

"Sterling has been the darling of the foreign exchange markets because people thought the Bank of England would be the first to raise rates. The risk of Scottish independence has caught them off guard."

Derrick said a prediction of a 15% plunge in sterling was "quite conservative" given the dangers of a messy divorce. "We think the high $1.40s against the dollar is entirely feasible."

European banks are also watching nervously. France's biggest lender, BNP Paribas, warned of a rising risk of a "market-unfriendly outcome" after a Yes vote, due to intractable disagreements between Westminster and Edinburgh.

Gilts would see a one-notch downgrade by credit rating agencies in such circumstances, pushing up spreads on 10-year debt by 25 basis points compared with European peers. Scotland would see a jump of around 150 basis points with a BBB rating, lower than Italy or Spain. This would moderate to just 50 points if there was an amicable settlement allowing Scotland to keep sterling and rely on the Bank of England as a lender of last resort for its banks.

Deutsche Bank said Scotland could see a downgrade of up to five notches from the UK's current AAA level, raising Scotland's borrowing costs by 130 to 160 basis points above British levels. It warned that capital flight might make it impossible to hold together a currency union even if it was agreed.

The risk now is that the world's superpower creditors take fright and start to dictate an outcome that neither London nor Edinburgh will welcome. "Asia has suddenly come alive to this, and people are asking a lot of questions," said David Bloom, head of currencies at HSBC. - ©The Daily Telegraph, London