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Currency Battle Looms for Scotland

Kiran Stacey, Political Correspondent
Alan Copson | Photographer's Choice | Getty Images

An independent Scotland will be able to keep the pound, the UK government will argue next month – but only if Scottish ministers accept budget constraints set by London.

In a paper published in early March, the coalition will back down from its previous resistance to the idea of sharing the pound as advocated by Alex Salmond, the SNP leader. But in a position likely to trigger a big row with the Scottish government, George Osborne, the chancellor, will say such a currency union would require ministers in Holyrood to accept a deficit cap, to be policed from London.

The argument will form the crux of the next and most controversial in a line of government analysis papers on how an independent Scotland could function. British ministers know they are likely to prompt a big battle between London and Edinburgh, but are keen to force the SNP to join a debate about the consequences of a vote for independence.

One senior coalition official told the Financial Times: "This is different from a straight transition from sterling to sterling, there would be a negotiated settlement.

"It very much suits the Scottish government to have a simplistic set of messages saying we will have sterling and the queen and anything else not to frighten the horses. But as soon as you look at it in any detail, it doesn't work."

The British government's new argument marks something of a u-turn for Mr Osborne. He has previously argued that sharing a currency would require some form of fiscal integration between the two countries, but that he could not think of a mechanism that would make that work.

The chancellor told the CBI last September: "It's difficult to argue for establishing a monetary union while pursuing fiscal and political separation . . . I have seen no such credible mechanisms proposed by those advocating independence. I am not clear they exist."

British officials have long argued that allowing an independent Scotland complete control over its own budget could undermine a joint currency if a Scottish government decided to run unsustainable deficits and allowed debt to rise. They now believe that a deficit cap policed strictly by the Bank of England could eliminate that problem.

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The coalition's new argument will put Mr Salmond in a difficult position. The Scottish first minister abandoned his party's longstanding support for joining the euro as the euro zone crisis unfolded, and has since then insisted an independent Scotland could retain sterling. Coalition officials say he will now be forced to choose between reversing his commitment to the pound and accepting an independent Scotland could not have full control of its budget.

They point to comments made by John Kay, a former adviser to Mr Salmond and Financial Times columnist, who said last year that a separate Scottish currency was necessary for full control over tax and spending.

Tensions between London and Edinburgh are not likely to end there. In its next analysis paper, the British government will argue that an independent Scotland could not undergo a repeat of the 2008 financial crisis without risking complete collapse.

The coalition will argue that the country's financial services sector is so big that a separate Scottish government would not be able to afford to bail it out. Ministers will point out that when the UK government nationalized RBS in 2008, its balance sheet exceeded 2.2 trillion, 50 per bigger than the entire British economy.

The SNP will release its own analysis later this year into how it envisages Scotland would operate if voters choose independence in next year's referendum. The party currently faces an uphill battle to secure a "yes" vote. The latest polls suggest 32 per cent of Scots back independence, while 47 per cent would prefer to remain in the union.

However, that leaves 20 per cent of the electorate undecided, giving Mr Salmond scope to believe he may yet repeat his shock victory in the 2011 Holyrood elections, where he defied all expectations to win an SNP majority government.