Britain faces storm as giant global investors awaken to break-up dangers

Nomura tells clients to slash financial exposure to the UK and brace for a possible collapse of the pound

Powerful investors across the world have woken up to the possibility that Scotland may vote to break up the United Kingdom, 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, warning that the separation of England and Scotland after more than 300 years would be a “cataclysmic shock”.

“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 (CDS). It recommended “short” positions on UK banks as well as Gilts with a maturity of three to five years, a market segment owned heavily by foreign investors.

 

 

“We could see a lot of money being pulled out of UK investments. Sterling could fall at least 15pc in a worst case scenario. These are scary times,” Mr Rochester added.

Equity prices linked closely to Scotland fell heavily in the first day of trading after a YouGov poll showed the Yes camp pulling ahead for the first time, but it is far from a rout. Lloyds Banking Group and Standard Life both fell 2.4pc, while the Royal Bank of Scotland was off 1.3pc.

Stephen Jen, head of SLJ Macro Partners and a Chinese-speaker from Taiwan, said Asian investors are flabbergasted by the sight of an ancient and successful union tearing itself apart for no obvious reason. “It is totally bizarre. They simply don’t understand it, and nor do I. Until a week and half ago everybody thought there was a zero probability of Scotland voting Yes,” he said.

“We have always assumed the United Kingdom 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, a Nobel economist and adviser to Scotland’s Alex Salmond, told The Telegraph as recently as two weeks ago that an independent Scottish state would repudiate its 8.5pc share of the UK debt unless Westminster capitulates and agrees to a sterling union. “Britain inherits the debt. It is Scotland’s bargaining position,” he said.

Britain is particularly vulnerable to political risk of this magnitude because strategic stability has long been in its trump card, giving it a cushion of credibility during bouts of economic crisis. The country is already skating on thin ice with stretched debt ratios and a current account deficit above 5pc of GDP, the currently worst in the developed world.

Simon Derrick, from Bank of New York Mellon, said the UK is leveraged to global financial cycle and has 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,” he said.

Mr Derrick said a 15pc plunge in sterling is “quite conservative” given the dangers of a messy divorce. “We think the high $1.40s against the dollar is entirely feasible. People always underestimate how far sterling can fall when the tide turns,” he said.

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 the 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 the 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 130-160 basis points above British levels. It warned that capital flight might make it impossible to hold together a currency union even if it is agreed, as occurred with the Czech/Slovak monetary union after the country broke up in the early 1990s.

Sir James has proposed a Hong Kong-style currency board pegged to sterling as a fall-back option but most experts say this would be almost impossible with huge foreign reserves, ultimately as much as 50pc of GDP or more. Scotland would begin with tiny reserves, leaving it vulnerable to a speculative attack unless it imposed capital controls.

The risk now is that the world’s superpower creditors take fright and start to dictate an outcome that neither Westminster and 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.

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