Wednesday, 27 August 2014

Scottish Independence Myths - How to buy imports?

I've been amazed at how poor the understanding is on how cross border trade actually work in a modern financialised world. It's almost like they've never spent any time at the sharp end of a firm's invoicing and payment operation, and exposed to the constant stream of marketing from banks.

The introduction of an independent free-floating Scottish currency is no barrier at all to cross border trade - because the banks are already setup to support it and make money doing so. It's very straightforward.

Let's run through a scenario. As we have already learned Scotland runs balanced trade with the rest of the world and the trade deficit is therefore with the United Kingdom. So we'll take the case of a Shropshire based company exporting goods/services into Dumfries and Galloway.

The exporter could throw up their hands, refuse to accept Scottish money under any circumstances and demand payment in good old British pounds.  The result of that would be the loss of the customer (probably to a Scottish based competitor or one that read and understood bank marketing leaflets), reduced turnover and profit and perhaps even layoffs amongst the staff. Only economists would think that is a rational response to the situation or at all likely.

In a real business, sales is everything and you do whatever you can to keep the customer. Exporters need to export. The first call would be to the firm's bank to see what they can do.

Here is the overview of the situation:

For simplicity I'm assuming that the customers and supplier both bank with RBS. That isn't at all necessary. This setup just cuts out the noise of clearing and makes the point very clear. 

The Kirkcudbright branch operates primarily in Scottish Pounds and does its reserve operations with the Scottish Reserve Bank. The Telford branch operates primarily in British Pounds and does its reserve operations with the Bank of England. The customer's bank account is in Scottish pounds and the Exporters in British Pounds. 

RBS plc owns both the bank branches and produces its own balance sheet in British pounds - because that's its functional currency. That means Scottish assets are translated into the functional currency equivalent at the reporting date according to the usual IFRS rules. In other words Scottish assets are reported in British pounds even though they are actually denominated in Scottish pounds. 

So we take a sale of goods and services from the Exporter to the Importer. The exporter prices the invoice in Scottish Pounds because that's all the importer has. In this case 'no deal' unless the exporter does that. (Again that isn't necessary, the process works just as well in reverse). 

Of course Scottish Pounds are no good in Telford. So they have a word with their bank in Telford, who is quite happy to purchase the invoice at the current exchange rate. So the exporter is credited with British pounds (which as we know the Telford branch just created ex nihilo) and the Bank takes the invoice.

This expands the balance sheet of the Telford bank branch - it has an invoice asset and a cash liability to the exporter, plus a bit of profit for itself. 

Now because RBS has Scottish businesses it is quite happy to receive Scottish pounds. So it instructs the Importer to settle the invoice to the bank's own account at the Kirkcudbright branch - in the usual manner of any factored invoice. An intra group loan (which in banking circles is known as a 'deposit account') links that back to Telford and clears the invoice. 

What has happened here is that the bank has executed a swap because it has a foot in both camps anyway. Therefore it can provide the swap service quite happily to those entities that don't have that structure available to them - for a fee of course. 

The actual structure will be more complicated than this simple overview (the factoring operation is likely to be a separate subsidiary with multi-currency accounts for example), but the essence is the same.

From the point of view of RBS plc, it had liabilities in Kirkcudbright to the Importer and now it has slightly smaller liabilities in Telford to the exporter - plus an amount of profit for itself. The exporter produced and sold their goods and stays in business, the importer got their goods and can use them.

Win-Win all round. Another good day for dynamic currency systems.


Anonymous said...

Surely the problem is that in real life many transactions are more complex than the simple example given and paid in installments, paid at regular intervals, ordered some time before the invoice is issued or payment demanded etc. In any of those cases the possibility of changes in the exchange rate means a buyer doesn't know what they will be paying at the time of deciding to buy (or seller wouldn't know what they would receive depending on whose currency the value is set in).

For example my previous (Scottish) employer used to sign contracts to supply his English customers for periods of 3 years or so. He potentially wouldn't know how much he would be paid in Scottish pounds 2 years after the contract commenced and whether it would cover his costs. Alternatively his customers wouldn't know how much they would be paying if the terms were fixed in Scottish pounds. The result would be whoever had to agree a fee/payment set in a foreign currency would be unlikely to agree to it.

Neil Wilson said...

That's what future contracts were invented for.

He would know because he'd hedge the fx risk - which is exactly what you do now if you have the same contract into the Eurozone.

Nothing here is new and only applies to Scotland. It's just standard world trade.

JD said...

The amount of flagrantly false information spread on Scottish Independence is beyond infuriating. Your example is perfect - how on earth do people think the billions in trade with the Eurozone occurs? It's just bizarre.

It's going to be up to Spain or Portugal or Italy to go back to their own currency and (quickly) show the world the critical advantages that it can bring.

Anonymous said...

Neil, say the operation got really big, tens of millions of Scotish Pounds. If the English exporter still had enough English Pounds to pay his English wages, and decided to open a Scotish bank account to keep his Scotish pounds there, would that be more profitable than factoring every individual invoice?

Neil Wilson said...

Yep. Weir Group for example would just keep the cash in each country and do the liquidity swaps intra-group.

Hence why I find it amusing that the 'No' campaigners are using Weir Group as an example, when it already has operations all over the world in multiple currencies and therefore already have internal treasury operations.

Obviously large companies want to avoid having to do the work of currency translation, and are happy to socialise that cost onto the nation as a whole.

But it is a short term profit driven view, and a state has to take a longer and wider term view.

Anonymous said...

Dear Neil, could You please extend this example with information how international clearing works between two different banks in two different countries with two different currencies?
Thank You.

Neil Wilson said...

All that happens is the bank that does the swap then does a normal transfer to the other bank (via a suspense account if needed).

This can either happen on the pay leg or the receive leg.

So you could have a customer of Lloyds paying to RBS, which then does the swap as above.

Or you could have a customer of RBS which after the swap then transfers to a customer of Lloyds in the usual fashion.