Why Scotland should step back from the brink

Scottish voters go to the polls on September 18 to decide whether they want to end their 307-year-old union with the rest of the United Kingdom. The race is tight: A YouGov poll released last weekend showed that support for independence had risen last weekend to 51 percent compared to 49 percent against. However, polls in recent days merely showed a narrowing lead for the "no" camp, not a defeat. Ultimately, we believe Scottish voters are likely to think twice and say "no" to independence — not least due to the potential financial consequences.

Scotland independence vote
Andy Buchanan | AFP | Getty Images

While it is not our base case, the risk of Scotland choosing independence is now real. If Scotland votes "yes," assets and deposits may flee the fledgling country, which would pose an immediate challenge for the Bank of England. Negotiations on a formal currency union would be opened as part of wider talks, to the discomfort of many. Scotland potentially could retain the British pound, but with heavy qualifications to its sovereignty.

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There is also the thorny issue of EU membership. Here, Brussels may well dig in its heels — there is no precedent for a new applicant coming from an existing member state, post secession. Treaty negotiations might take many years and complicate the use of sterling by Scotland over the longer term.

The decline of sterling since the polls has highlighted the very real and rising threat of a "yes" victory and gives us some insight into the potential market reaction should voters deliver it.

A key support for sterling in recent months has been the expectation that the Bank of England would raise interest rates sooner than other central banks. A "yes" vote would change this perception, as members of the bank's monetary policy committee would be likely to delay their calls for higher rates until the economic impact of separation were known, most likely not until after the general election.

A further concern for sterling would be the outcome of negotiations on a currency union. Although the three major political parties have rejected this idea, the Scottish National Party is likely to campaign hard to make it a reality. However, Scotland has no legal right to a "part" of the pound as the currency is inextricably linked with the Bank of England and Scotland does not have a central bank of its own.

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Even if a currency union with the remaining UK were to happen, there is a slight risk of fragmentation occurring, especially if disagreements arose around fiscal targets, banking policy, or within the Bank of England's monetary policy committee. After the referendum, the British pound could start pricing in a higher level of risk.

On the equity side, stock markets do not like uncertainty, and victory for the "yes" campaign creates just that. This suggests that further volatility could beset those companies exposed to Scotland as investors grapple with the potential economic, political and currency impact. While the direct revenue exposure of UK equities to Scotland is small at around 2 percent to 3 percent, such sectors as energy, financials, and utilities will likely be more negatively affected by the subsequent uncertainty.

A "yes" vote should affect the UK government bond market less as any concerns about the stability of UK finances will likely be countered by demand for safe-haven assets. Furthermore, the uncertainty provoked by a "yes" vote more than likely would force the Bank of England to keep rates lower for longer, at least until the economic impact became clear. Thus the overall impact on yields in the short term should be limited.

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The political and constitutional consequences of a victory for the independence side are difficult to quantify but highly significant. The likelihood of extended negotiations would undermine the current political time table around austerity. The outcome of the 2015 general election could also be influenced: It's possible a "lame duck" parliament might result whose main mandate would be negotiating the terms of independence. Furthermore, questions would likely be raised about the status of the 59 Scottish members of parliament.

Another consideration would be the date and outcome of the UK's proposed referendum on EU membership, slated to take place by the end of 2017 should the Conservative Party be reelected. The absence of the largely pro-Europe Scottish public increases the likelihood of the remaining part of the UK exiting the EU. And outside British borders, a "yes" vote may also encourage dissatisfied citizens in other parts of Europe, such as the Catalans and Basques in Spain, to also press for independence votes.

It is our base case that the enormity of a "yes" vote and the risks it creates will receive a great deal of attention over the next few days and will ultimately help deter voters from favoring independence. But financial markets, especially in the UK, would be foolish to dismiss it as a threat.

Commentary by Bill O'Neill, head of the UK investment office at UBS Wealth Management. Follow UBS on Twitter @UBSamericas.