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Economy

The Most Important Election

Between the U.S. general elections and the 18th Party Congress in China, most people can be forgiven for thinking that all the exciting elections in November were done and dusted. Of course the transitions in the two most powerful countries in the world are important, but beyond the personalities and the extraordinary spectacle, neither vote promised much in the way of radical change.

Under the radar, elections were held this past Sunday whose implications could reverberate around Europe and the world. On November 25th, voters in a region the size of Maryland went to the urns to deliver a decision that could bring down the fourth largest economy in the Eurozone and send the entire continent into convulsions.

The people of Catalonia, Spain’s wealthiest and prickliest region, were called to vote for a new government, but behind this is the increasing agitation for a referendum on independence. The Catalans, along with the Basques, have long nurtured their separate identities based on linguistic, cultural and historic differences from the rest of Spain; however, it is only with the ever deepening crisis in the Iberian country that has seen unemployment soar to above 25% with no end in sight, that anger, fear and despair have transformed cultural dissonance into a desire for independence.

On August 28th, with Catalan bonds priced out of the market, and a refusal by Catalan banks to extend any further credit to the regional government, the Generalitat was forced to ask for a humiliating bail-out package from Madrid to the tune of 5 billion euros[1]. The Catalan President, Artur Mas, tried to put a brave face on it by insisting that he would not accept any political conditions to the money – which is no different than what Spain has been telling its European partners regarding its own pending rescue – but in fact, they have no choice in the matter. The government of Spanish President Mariano Rajoy had already passed a law that allowed and required the Treasury to supervise and intervene in any region that failed to meet deficit reduction targets or requested a bail-out[2].

Mr. Mas then went to Madrid to demand greater fiscal independence from Madrid in order to address Catalonia’s desperate financing needs. Catalonia, as Spain’s wealthiest region, pays into the central treasury more than it receives back in transfers. Mr. Mas wants more control over this revenue. On September 20th, he made his proposal to modify the financing model to Mr. Rajoy[3].

Mr. Rajoy’s answer was a resounding “no”. With Spain’s finances in the cross-hairs of international investors and the Troika, the last thing he needed was to open a can of worms regarding regional finances. On the contrary, cracking down on the regional governments, which control approximately half of total state expenditures, was absolutely fundamental to his plans to stabilize the budgetary situation in Spain.

Mr. Mas, faced with a fiscal crisis at home and the intransigence of Madrid, decided to increase the pressure on Mr. Rajoy by playing the independence card[4]. While vilifying the Spanish President for “missing a historic opportunity” to set Spanish-Catalan relations on a firm footing, Mr. Mas promised to take all means necessary to “protect the historic rights and future of Catalonia.[5]” This included a referendum on Catalan self-determination. First, however, he called for elections on the 25th of November as a first step in solidifying support for his government and gaining a popular mandate in his quarrel with Madrid.

Mr. Rajoy, faced with a fiscal crisis at home and the intransigence of Berlin and Brussels, decided to increase the pressure on Mr. Mas by declaring any such referendum to be unconstitutional and illegal (both of which are true). Some less than cautious members of Mr. Rajoy’s party[6], as well as certain retired officers[7], loudly and unhelpfully declared Catalan separatists to be traitors and called for the arrest of anyone proposing a referendum on secession.

At least two villages in Catalonia have decided that they are not going to wait on Mr. Mas or his elections at all. Sant Pere de Torelló declared itself “free and independent Catalan territory” on September 4th[8], while the village of Gallifa voted to stop paying taxes to the Spanish Treasury on the 23rd of November[9] (the village will pay its taxes to the Catalan government, which may then forward them on to the Spanish Treasury if it so wishes). If all of this seems a little farcical, it isn’t. It could not be more serious.

Both sides have been plagued by misunderstanding, miscommunications and miscalculations. By unleashing the Catalan ‘independentistas’, Mr. Mas is playing with forces he cannot control. Once the genie of nationalism is out of the bottle, it is notoriously difficult to put back in. Mr. Rajoy, by rejecting negotiation outright and branding the referendum as illegal and illegitimate merely plays into the hands of those wishing for separation. Mr. Rajoy forgets that secession is always “illegal” until it has been sanctified by time and circumstances, yet that has never stopped people from seeking their independence in the past. In this drama, Mr. Rajoy seems fated to the role of Lord North, whose every blundering move in Parliament only served to deepen the crisis between Britain and her colonies.

Mr. Mas Gets More Than He Bargained For

The election was duly held on Sunday and it went off, thankfully, without incidents. This is not a minor observation: there had already been some ugly confrontations and minor violence between “secessionists” and “unionists” in prior demonstrations. As pleasing as this proof of peaceful execution of the people’s sovereignty must have been to Mr. Mas, the electoral results were profoundly less so.

The biggest loser on Sunday was Mr. Mas’ own party, Convergència i Unió, which lost the absolute majority it held from the 2010 election. If the snap election was a strategy to secure a popular mandate with which to play hardball with Madrid, and “independence” as the tactic of choice, then the plan backfired. The other big loser was the Socialist Party, which continues its discredited slide into anonymity and irrelevance. The Socialists barely held their own in the March elections in Andalucía in March and were hammered in conservative Galicia and the separatist Basque country elections in October. The Catalan Independence Party (SCI) lost all four seats and is no longer represented.

The biggest winners were the “hardline” independence parties of Ezquerra Republicana (ERC) which doubled its representation in the Parliament, the Green Party (ICV) and the Alternative Unified Left Party (CUP) which each picked up three seats. For the CUP, this is their first time in Parliament. Ciutadens, a unionist center left party also won big, tripling their representation.

In a broader sense, the balance of power within the Parliament has not changed significantly:

 

Overall, the pro-independence parties gained a seat and the pro-union parties lost a seat. All of the movements seen between parties can be explained as transfers within these positions, which seem to have hardened:

  • Those Catalans who formerly backed the CiU have fled en masse to the more stridently separatist ERC, with a few pro-independence Socialists perhaps going to the CUP. By inflaming the passions of the pro-independence segment and by radicalizing the issue, Mr. Mas’ party was seen as “too moderate” and voters favored the more uncompromising separatist candidates: hoist from his own petard indeed;
  • The increase in the Ciutadens (the Citizen’s Party) may be from disenchanted Socialist voters who are neither pro-independence, yet not ready to “join the dark side” by voting for the center right Partido Popular. Ciutadens no doubt benefited from the mass defection of socialist voters;
  • The governing party in Spain, the Partido Popular, maintained its level of representation, gaining a single seat in Parliament. This is the “hard core” of pro-union, right-of-center voters who have no real alternatives in Catalan politics. The fact that the PP failed to make major gains indicates that voting public isn’t particularly passionate about the policies of Mr. Rajoy, nor was the pro-union position significantly strengthened by images of economic and social catastrophe that would follow a declaration of independence that were used freely by the PP during the election.

 

 There was a strong turnout in the election, with 68% of the voting public casting a ballot, up 10% from the 2010 election[10]. This underlines the legitimacy of the results and should demonstrate to both Madrid and Barcelona that the Catalans are serious about the issue of the referendum. A low turnout would have indicated apathy towards the question.

Mr. Mas will now have to make a pact with one or more of the minority parties in order to secure a majority and govern. The fewer involved, the more likely the coalition will be effective. A pact with the Partido Popular is out of the question with Mr. Mas and Mr. Rajoy at knives drawn. The Socialists might have made a good partner to de-emphasize the independence issue, but Socialist leader Pere Navarro has rejected the possibility out of hand[11].

That leaves the pro-independence parties, particularly the ERC. The ERC and the CiU don’t see eye-to-eye on economic policy, and the Ezquerra is not going to compromise on the referendum issue. Yet Mr. Mas is unlikely to get his coalition without them, and the other alternative parties are either unlikely to join him (Ciutadens) or else no less divergent from CiU than the ERC (CUP and ICV). With ERC as the junior partner, Mr. Mas doesn’t need anyone else, and in return for promising to hold the independence referendum (perhaps sooner than he would like), he will get ERC’s support on the economic and social issues that face the region.

Which brings me to the referendum on independence.

“Give me Liberty or give me Fiscal Autonomy!”

Mas had promised that he would hold a referendum on independence within four years, perhaps timed to take advantage of Scotland’s referendum in 2014. He may not have the luxury of waiting.

Firstly, his new governing partner is far more committed to the referendum than he is, a leading cause of the defection from the CiU to the ERC. Furthermore, leaders within his own party may push for a referendum sooner rather than later.

Secondly, the economic situation in Spain is not getting any better. If anything, 2013 will be worse than 2012. The austerity pain and the anger over it which is driving anti-Spanish sentiments on the street will only intensify. If Mr. Mas remains committed to using the referendum as a blunt instrument with which to pressure Mr. Rajoy into offering greater fiscal autonomy to Catalonia, then he must use it soon before Catalans become so radicalized that they no longer accept fiscal autonomy as an alternative.

According to a poll held in November[12] prior to the elections by the Center of Opinion Studies[13], public support for Catalan independence stands at 57% in a straight up-down vote. This is 6% more than the previous study in June. Support for independence drops to 44% when the option of greater autonomy within a federal Spain is included. 20% of Catalans surveyed support the status quo, and 15% would abstain or have no opinion.

It is likely that the “hard core” of pro-union voters will not be swayed no matter what happens. But if the economy worsens, if unemployment continues to rise, if austerity measures continue to be imposed, and – worst of all – if Madrid continues to turn a blind eye to sentiment on the streets of Catalonia, then we can confidently predict that the percentage of voters favoring independence as the only viable solution for their region will continue to grow. All of these conditions seem likely to be fulfilled.

Mr. Mas thus has a narrow window of opportunity to negotiate a satisfactory outcome with Madrid. His coalition partners will likely force a referendum in 2013 if it becomes obvious that no meaningful dialogue will take place. Furthermore, the ERC may be able to force CiU to agree to hold a binding up-down referendum, rather than a non-binding “public consultation” with multiple options that will split the Catalan vote. If they succeed, then by the middle of next year, a Catalan referendum is very likely to produce a vote for independence by a margin of 60% or greater. Messrs. Mas and Rajoy have painted themselves into a corner.

 

Goodbye Spain

A Catalan popular vote for independence would force the Parliament to vote on a declaration of independence from Spain. The post-election composition of the legislature gives pro-independence representatives a margin of 87 to 48, or 64% of the votes. That is well above the threshold set by the European Union for the Montenegrin secession from Serbia in 2006 (which was 55%)[14].

The main difference between Montenegro and Catalonia is that the 2003 Constitutional Charter of Serbia and Montenegro admitted the possibility of calling for an independence referendum by either of the constituent parties. The Spanish Constitution neither admits the possibility of secession, nor does it permit regional governments from calling binding public referendums without authorization from the national parliament, which is not forthcoming. This makes any vote on independence illegal in Spain and unlikely to find international support. There are too many nations with restive minorities or separatist movements for anyone to support the establishment of a precedent (i.e. Italy, China, most of Africa…).

Arguments of illegality will not stop Catalans from voting or the Parliament from acting as it sees fit, and the United Nations Charter[15] certainly supports the right of self-determination, however much the architects of that document might have had other circumstances in mind. Assume that Catalans vote for and declare independence; the ball is then passed back to Madrid.

There is a non-negligible possibility of Mr. Rajoy declaring martial law, or sending the police (or army) to prevent the referendum from taking place or arresting the Catalan government if they declare independence. If by chance Madrid does orders the forces of law and order in, then Spain and Catalonia might have succeeded in committing suicide. Turning Barcelona into Fallujah and the Plaça Catalunya into Tianamen Square would neither endear Spain to Brussels, nor attract the foreign investment that the country desperately needs. It would effectively wreck the Spanish economy, make Greece look like the poster child of Europe, and possibly bring down the single currency. It seems likely that Europe would use all means possible and necessary to prevent a use of force: which doesn’t mean that they would succeed.

A Going Concern

Let us assume that Mr. Rajoy doesn’t resort to violence. Madrid must then accept the de facto separation of Catalonia and decide whether they will be accommodating or not. The likely answer is not. The “messy divorce” option has severe consequences for all parties, though less messy than the military option. No doubt the Spanish government would derive some pleasure in ignoring and isolating the Catalan government, but then the Catalan government would repudiate its share of the Spanish sovereign debt.

Spain’s “official” debt is today 76% of GDP. That doesn’t count the regional debts, which are backed by the sovereign, and would raise the total to 90%[16]. A Catalonian divorce reduces Spanish GDP by almost 20%, reduces regional debt by 29%, and increases Spain’s debt-to-GDP ratio to 95% (official) or 107% (including regional debt). Either way, those are numbers that bond markets don’t want to see.

Many critics of secession emphasize that an independent Catalonia would be bankrupt: it is the most indebted region in Spain, running a large budget deficit and is locked out of bond markets. On the surface this is true: Catalonia is the most indebted region in Spain, though Valencia is as indebted as a percentage of GDP. Catalonia is running a large budget deficit at 3.7% of GDP; though this is lower than Spain’s and the average for the Eurozone. Catalonia is locked out of bond markets; but Catalonia is not a state and does not control its own finances or its own currency.

 

Superficial observations are often spurious, and they certainly are in this case. The reality that would face an independent Catalonia would be very different:

  • Catalonia would have a debt-to-GDP ratio of 21% and would be the fourth least indebted country in Europe;
  • Catalonia would run a primary budget surplus of 2% if all current transfers between Catalonia and Spain ceased:

 

  • Given a small debt-to-GDP ratio, a primary fiscal surplus and control of monetary policy, there is no reason to believe that a Catalonian state would have any trouble securing financing from international bond markets.

Social Security. The Catalonian fiscal situation appears solid at first blush, much more so than most European states. Spain could decide to deny Catalonia its share of the Social Security Reserve Fund, which is held centrally, in a tit-for-tat escalation of the dispute. The reserve fund is valued at 66.8 billion euros[17], or 1,448 euros per inhabitant of Spain[18]. The Catalan share based on population would thus be 10.5 billion euros. Refunding a Catalan Social Security Reserve Fund under those circumstances would increase the Debt-to-GDP ratio from 21% to 26%: a significant increase, but not impossible.

EU Membership. Supporters of independence argue that an independent Catalonia would “inherit” EU membership and the single currency automatically and thus would not need to go through the application process to join the club. Unsurprisingly, the European Commission has managed to thoroughly confuse the issue by supporting the positions of both Barcelona and Madrid, then back-tracking and declaring that it had no official position on the matter[19]. There does not appear to be any law that explicitly excludes regions of current Member States from inheriting membership upon a unilateral declaration of independence, but that won’t stop the EU from doing whatever it wants.

If the EU does decide to exclude Catalonia, we can bet money on Spain exercising its veto to prevent the break-away region from re-entering the Union. That might be a good thing in the long-run.

The Best Thing That Could Happen

Assume the rump of Spain keeps Catalonia out of the EU; Catalonia would be forced to issue a new currency, its businesses and exports would face tariffs to access their traditional markets, and a whole host of complications would arise. There would be significant economic dislocation in Catalonia.

A new currency would require Catalonia to issue new banking licenses to Spanish banks operating in Catalonian territory, set up a regulatory framework and a central bank, and impose currency controls and a bank holiday while the new currency entered into circulation. Catalan deposits in euros would have to be converted from euros to the new currency: this could become very tricky given the national nature of the Spanish banking system. How does Banco Santander or BBVA treat a customer deposit opened in Barcelona? Does it comply with the new regulations or not? How does Caixa Bank treat its deposits outside of Catalonia? There would have to be a substantial degree of coordination between the Bank of Spain and the new Bank of Catalonia; this might be achievable on a technical level, but political considerations might impose themselves. Yet Spain too would have an interest in clarifying the situation.

Bonds. Catalonia’s government bonds would have to be converted to the new currency at face value and at a 1:1 exchange rate. This is absolutely necessary to prevent the public debt from ballooning out of control when the Catalan currency inevitably depreciates against the Euro. Bond holders will complain and the bonds are issued under Spanish law; however, Catalonia will argue that the Catalan Parliament inherits the jurisdiction over these bonds from Spanish law and would have the competence to redenominate them legislatively.

Catalonia would of course have to make a commitment to bondholders to repay their bonds in full; that should be relatively easy given the low public debt and fiscal surplus. Since Catalonia is fully determined to eventually re-enter the EU and single currency, it would not be a stretch for the Catalans to promise redenomination to euros as soon as they had achieved their goal of membership. That would put the world of creditors firmly in their corner during ascension negotiations.

Banks. Banks remain a tricky issue, as we looked at before with regards to settlement of deposits and prevention of capital flight. There are no Catalan banks, of course, only Spanish banks with headquarters in Catalonia. The Generalitat would have to set up a Central Bank and regulatory authority and issue licenses to banks operating in Catalonia: I would expect them to take a pragmatic approach and to duplicate the existing Spanish structure. This is what they are familiar with, and it avoids the banks having to make messy adjustments to their compliance and oversight organs, incurring additional costs.

The big “Catalan” banks, Caixa Bank and Sabadell, might nevertheless decide to relocate to Spain. Again, this would not necessarily be a problem, if the new Catalonian financial authority facilitated their operations initially so that they could continue to provide banking services to Catalonia’s population. The new FA would have to work closely with the banks to ensure that the deposits of Catalan citizens were identified, controlled and converted to the new currency.

Should the large Catalan banks decide to stay headquartered in Catalonia, the Spanish authorities might decide to make trouble for them since they would no longer be domestic entities, and their current banking licenses might not be modified or reissued. Since this could involve significant dislocation to Spanish citizens with accounts or mortgages at these institutions, and given the overall weakness of the Spanish financial system, it seems highly unlikely that Madrid would take a hard line with the banks, the dispute being with the Catalan government.

Moribund Catalunya Caixa is a separate issue. It has already been intervened by the Spanish rescue fund, the FROB, and the EU has just authorized additional funds to the tune of 9 billion euros in an effort to recapitalize the savings bank. The fourth largest savings bank in Spain, it is set to be restructured and auctioned off: the Generalitat may want to take it over from the FROB to ensure that at least one bank remains wholly Catalan. This would involve paying back the 3 billion euros in public money that the FROB injected.[20]

Another potential issue is the approximately 60 billion euros borrowed by “Catalan” banks from the ECB in LTRO operations[21]. These loans will have to be repaid in a little over 2 years in euros, which may be a problem if the Catalan economy has introduced a new currency. A more detailed investigation of where this funds have gone will be necessary than is possible in this article, much of the LTRO lending was certainly ploughed directly into Spanish sovereign bonds (LTRO was the ECB’s backhanded version of Quantitative Easing). This carry trade was a means of both indirectly financing sovereign bonds while generating profits and increasing core capital for the banks (since the sovereign bonds are considered zero risk assets!). If this is the case with the Catalan LTRO borrowings, then the capital is preserved with the Spanish state and must be repaid in euros, thus eliminating any exchange rate risk at time of repayment. Unless, of course, the Spanish sovereign defaults, which it would not be able to do selectively, targeting only Catalan bondholders.

Economy. The strongest argument made by the opponents of independence is that Catalonia’s main trading partner is the rest of Spain. But cutting itself off from Spain, trade would necessarily drop. This is a rather well-established and empirically supported argument: during the “Velvet Divorce” of Czechoslovakia, trade between the two portions of the country dropped by two thirds within 5 years.[22] This “two thirds” rule seems to hold rather consistently over a large number of independence events since 1900 (such as the break-up of the Austro-Hungarian Empire).

Taking Catalonia’s case: Mr. Pankaj Ghemawat has been studying interregional and international trade flows for Catalonia[23] with colleagues in the University of Navarre and the IESE Business School. Preliminary calculations for interregional and international trade flows in 2011 show Catalonia with an international trade deficit of 15 billion euros, but an interregional trade surplus of 23 billion euros. This results in a current account surplus of 8 billion euros, equivalent to 3.8% of GDP. Catalonian imports are mainly from Germany, Italy, France and China (34.5% of total), which seems to indicate that Catalan firms are acting as value-added importers for the rest of Spain.

If we apply the “two thirds” rule upon independence, Catalan exports to Spain would fall from 23 billion euros to 7.6 billion euros, and create a current account deficit of 7.3 billion euros, or -3.5% of GDP.  This is a serious economic impact, equivalent to a loss of 7.3% of GDP. However, it is only part of the story, as Mr. Ghemawat himself acknowledges in his analysis.

A number of additional factors must be taken into account in order to evaluate the impacts of the loss of trade:

  • As exports fall, imports would fall as well. Part of the fall in imports would be directly related to the fall in exports – this is the nature of the Catalan value-added pass through industry to the other Spanish regions. Another portion would be a contraction in demand due to the reduction in GDP leading to higher unemployment and reduced wages;
  • Under this scenario of exclusion from the EU and single currency, Catalonia would be forced to issue its own currency, as we’ve previously discussed. This currency would depreciate against the Euro, either from market forces or through a deliberate policy of the Catalan government. This depreciation would increase the cost of imports, but it would also increase the value of exports to the Eurozone. More importantly, a sharp devaluation would significantly increase the competitiveness of Catalan exports against an appreciating Euro without the need for wage reductions. This is important from the point of view of maintaining robust domestic consumption in the economy.

I have attempted to represent these effects in a four-stage model using Mr. Ghemawat’s  estimates as a starting point:

Phase 1 of the model is the pre-independence status quo as of 2011. In phase 2 of the model, “Post-Independence (I)”, I have applied the “two thirds” rule to regional trade flows, resulting in a loss of 13.4 billion euros in trade with Spain. This leads to a current account deficit of -3.5% of GDP and a contraction in GDP of -7.3%.

Phase 3 “Post-Independence (II)”, which is occurring almost simultaneously with Phase 2, imports fall due to a reduction in industrial orders and a contraction in consumer purchases of imported goods. Imports will not fall as much as exports, because some imports are not inputs into industrial products, and cannot be substituted or foregone (e.g. energy imports). Without an empirical basis, I have assumed that imports fall by one-third. This results in a net current account deficit of -1.1% of GDP rather than -3.5%, and a net contraction in GDP of -4.9% – still very substantial.


Phase 4 “Post-Independence (III)” is three years after independence. The recent example of Argentina suggests that Catalan GDP will rebound strongly after a sharp, painful contraction. This is due to the rapid devaluation of the currency and a subsequent increase in export competitiveness, along with a decrease in imports due to their higher price in local currency.

Applying similar growth rates to Catalonian exports, and assuming that the decline in consumer purchases of imports is offset by the increase in industrial purchases for value-added re-export, it is plausible to have Catalonia running a slight current account balance and modest growth in GDP from the trade sector of 1.3% per annum.

Government spending would also increase during the first years of Catalan independence: some of it would be discretionary spending by the Generalitat to stimulate growth; much of it would be necessary to develop the essential national infrastructure that might be lacking due to it being located in another region of Spain. Catalonia’s low debt-to-GDP ratio should allow the government to finance such projects – even a 2% or 3% of GDP increase in government expenditures would largely offset the impact of a gradual loss of regional trade, until exporters began opening new markets with more competitively priced goods and services.

It is worth asking how quickly all of these different impacts would be felt. If Catalonia follows the example of the Czech Republic and Slovakia, and the drop-off in exports to Spain occurs over 5 years, then Catalonia might never experience a massive contraction: the increase in competitiveness from devaluation might completely offset the loss of trade from Spain. This is because Catalonia would find itself competitive in all Eurozone members, not just Spain. Catalan exports would also find it easier to compete in international markets, and the port of Barcelona is already a major hub for global shipping. Consider also that the adjustment for Spain will also be considerable; it will not be immediately possible for Spanish companies to source new inputs and products, reroute port traffic, find new suppliers. The divorce in the private sector is likely to take some time, if it ever does complete.

Catalonia is the export motor of Spain, containing 36% of all Spanish companies that export and 27% of total exports, and it remains one of the principal recipients of foreign direct investment[24]. These are important advantages which Catalonia will retain despite the internationalization of the border. Catalan businesses will be able to adjust to the new situation and find new markets for their products and services.

Relocation. The threat of Catalan businesses relocating to Spain is one that should also be taken seriously. Some losses might be incurred; particularly troubling would be the loss of the major “Catalan” banks. However, many industries cannot simply up and leave, as they might have substantial plant and equipment in Catalonia that cannot be moved or rebuilt in the short-term. The Generalitat would have tools to counter this threat.

The most important step would be to quickly establish a policy of transparency, stability and cooperation with businesses. There is nothing the private sector hates more than uncertainty. The Generalitat should announce its policies well in advance and then stick to them. A policy of moderate inflation, competitive devaluation, and investment in necessary infrastructure to support businesses and exporters will be welcomed in the business community.

In order to boost competitiveness further as well as attract foreign investment, the Generalitat should consider following the Irish model and establishing a low, flat corporate tax rate. Whether it is identical to the Irish 16% rate or somewhat higher, the government should nonetheless show its pro-business credentials very early on. The Catalan government should also take the opportunity to completely reform its regulations around new business creation: whereas Spain is number 136 in the ease of doing business index, Catalonia should target being in the top twenty.

Catalonia’s Bad Example: Success

The preceding analysis rests on any number of untested suppositions: whether Spain would react forcefully, whether Mr. Rajoy would accept an “amicable divorce” or play hardball with the separatist region; how the legal tangles of ownership of public property, business licenses and especially financial services are handled; how quickly and thoroughly the intertwined economies of Catalonia and Spain are untangled, and how severe the slump is for the new state; most importantly, whether or not Europe accepts the Spanish position that Catalonia is out of the Euro and out of the EU. In attempting to analyze the impacts on Catalonia of independence, I have attempted to paint a “likely scenario” that avoids extreme cases.

I assume Madrid will not attempt to impose union by force. The effects on the Spain’s economy and international reputation would be devastating, not to mention the long-term human cost to Catalans and Spaniards, and to their young democracy. That doesn’t mean that Madrid will play nice: I also assume that Spain will do everything in its power to block automatic Catalonian inclusion in the EU. I believe they will likely succeed in this endeavor if they attempt it. I also believe that it might be the best thing that could happen to the Catalans.

The Catalan economy would like face a sharp contraction for the first 4 to 6 quarters as dislocations spread throughout the private sector and businesses adjust to the new regulations and new barriers in their traditional market. The contraction could be between 10% and 20% of GDP, about half from the export sector and half from a fall in consumption and private investment.  Some of this contraction would be mitigated by a decline in imports, and some by an increase in public spending. Still Catalans should expect to suffer significant pain through their first year of independence.

If the Generalitat pursues pro-business reforms, the example of Argentina, Mexico, Thailand and other markets that have experienced severe economic contractions followed by large currency devaluations leads me to believe that the Catalan economy will roar back to life in its second and third year, with growth rates of 6% to 8% per annum. Freed from the suffocating yoke of the euro, Catalan businesses would find their products significantly more competitive than before independence, even taking into account the tariffs they would have to pay: on average 6% for advanced economies, but rising to an average of 20% to 30% in agricultural products. Catalan monetary policy – which it would now regain – should be directed precisely at maintaining competitiveness for the export sector through the appropriate peg to the euro.

Pro-business reforms to the corporate tax rate, generous export credits, and a substantial easing in new business creation from what currently exists under Spanish law would convince existing Catalan businesses to stay in the country, and would begin to attract substantial foreign direct investment once the Generalitat proved that it was a going concern: in two or three years. By the time Europe gets around to re-admitting Catalonia into the Euro, the Catalans might find they don’t want to go back.

Europe has every reason to worry about an independent Catalonia, but not because of the political repercussions in Belgium, Italy or the United Kingdom. Europe should be worried of the economic repercussions of the Catalans being expelled from the Euro and succeeding. When Portugal and Greece see Catalonia growing at 8% per year, why would they want to stay in the euro and submit to the same tired old austerity policies? They would not. Catalonia may very well be the detonator that brings down the euro, but not for the reason people think.

Europe may want to consider this and keep Catalonia in the single currency, if only to assure that the shackles remain on the willing prisoner.

 


Sources and Notes:

[1] “Cataluña pide el rescate: solicita 5.023 millones al Estado para financiarse”, Expansión, 28 August 2012 (Spanish only)
[2] Ley Orgánica de Estabilidad y Sostenibilidad Presupuestaria, 27 January 2012 (Budgetary Stability and Sustainability Law)
[3] “Artur Mas pide una Hacienda propia para Cataluña y 4.000 millones”, Cataluña4, 20 September 2012 (Spanish only)
[4] It should be understood that Mr. Mas’ party, Convergència i Unió (Convergence and Union), is a moderate center-right party which is generally considered to be “nationalist” without being “pro-independence”. In Catalonia, this is a vital distinction.
[5] Gardner, David, “Catalan with Spain’s Future in his hands,” Financial Times, 28 September 2012
[6] Aribau, Edgar and Day, Paul “Spain votes to stop Catalan independence referendum,” Reuters, 09 October 2012
[7] Solé, Richard, “Francisco Alamán, coronel del Ejército español: ‘La independencia de Cataluña? Por encima de mi cadáver,” Alerta Digital, 31 August 2012 (Spanish only)
[8] “Sant Pere de Torelló se declara ‘territorio catalán libre’”, El Mundo, 04 September 2012
[9] “Gallifa, the Catalan village that won’t pay tax to Spain,” Euronews, 23 November 2012
[10] Ortiz, Fiona and Phillips, Branden, “Separatist parties win Catalonia election in Spain,” Reuters, 26 November 2012
[11] “Navarro rechaza la oferta de Mas de entrar en el nuevo gobierno,” La Vanguardia, 27 November 2012
[12] “Support for Catalonia’s independence grows and polls say pro-independence parties would win the next elections,” Catalan News Agency, 08 November 2012
[13] Full disclosure: the Centre d’Estudis d’Opinió is an organ of the Catalan regional government
[14] “Montenegro declares independence,” BBC News, 04 June 2006
[15] It is actually the Atlantic Charter of 1941 which lays out the principle of self-determination, which the United Nations Charter subsequently adopted in 1942, and reaffirmed in the Universal Declaration of Human Rights, the International Covenant on Civil and Political Rights and the International Covenant on Economic, Social and Cultural Rights. However, there is nonetheless a legal contradiction between the right to self-determination and the principle of territorial integrity, also enshrined in the United Nations Charter.
[16] Bank of Spain. In fact, the total liabilities of the Spanish sovereign are considerably higher if we take into account the liabilities in the pension system, unpaid receipts to contractors and the liabilities of public corporations. For a complete and succinct account of total Spanish liabilities, see the following article by Zerohedge.
[17] As of 31 December 2011. Ministerio de Empleo y Seguridad Social.
[18] Estimaciones de la Población Actual de España. Instituto Nacional de Estadística.
[19] Pericay Coll, Gaspar, “The European Commission send contradictory messages regarding hypothetical Catalan independence,” Catalan News Agency, 18 October 2012
[20] “Diez entidades financieras han recibido dinero público desde que empezó la crisis,” 20 Minutos, 10 May 2012
[21] “Catalan banks’ debt may stymie separatism,” Bloomberg, 26 November 2012
[22] Ghemawat, Pankaj, “To Secede or Not to Secede: The Case of Europe,” The Globalist, 02 July 2012
[23] Ghemawat, Pankay, Llano, Carlos and Requena, Francisco, “Rethinking Regional Competitiveness: Catalonia’s International and Interregional Trade, 1995 – 2006”, Working Paper WP-802, IESE Business School – University of Navarre
[24] Facts and Figures, Catalonia Investment Agency, Generalitat de Catalunya

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