Merited punishment

Sterling fall shows rational alarm over Scotland

The market is not too negative about the pound. The fall of sterling - down six per cent against the dollar since July 15 and by two per cent from Friday morning to Monday morning - is less a panic than a rational response to the possibility that the United Kingdom will be divided in two. Of course, Scotland may still vote against independence in the September 18 referendum. The latest poll, which showed a narrow majority in favour of seccession, could produce a contrary surge in favour of stability, especially as London is sweetening its devolutionary offer. That is the lesson from Quebec, still part of Canada after the narrow 1995 defeat of an independence referendum. Still, investors have to think about probabilities, and the odds of breakup are higher now than ever before. If the country is divided, it would not be the end of the world for the pound. But it would be bad. Independence would create a political crisis in London, which would have to be resolved in the midst of a southward migration of much of

Scotland's financial sector and tortuous negotiations over how to apportion government debts and North Sea oil revenues. The shrunken UK is quite likely to end up in worse shape, both north and south of the border.

Also, any new currency arrangement looks bad for sterling. Scotland might use the pound as a de facto currency. The new country would still have a financial system large enough to cause trouble for the Bank of England but which the UK central bank did not control. However, if Scotland were allowed to use pound officially, the BoE would be in the same difficult position as the European Central Bank, relying on the goodwill of a foreign fiscal authority.

Perhaps the greatest risk to the pound comes from the UK's largest trading partner, the euro zone. The loss of relatively pro-European Scotland makes a vote for British exit from European Union more likely. Even before that, the UK would lose out for having abandoned of one of the key principles of European politics - the stability of agreed borders. Since respect is crucial in the endless EU policy negotiations, the loss of British status would be definitive and costly. How much further could the pound fall? The currency traded in an approximate $1.50-$1.65 range from late-2010 to early 2014. The bottom of that probably offers a floor, if not yet a target.