Banks, Bluster and Machiavelli’s Guide to Elections

By Fernando Betancor.

With the main pro-independence parties posting impressive increases in voter intention in the last two weeks before the Catalan regional elections cum plebiscite, Madrid is clearly worried. And well they should be: the main pro-independence parties have gone from polling a meager 40% of voter intention to 49.8% in just two months[1]. That is a very big swing: and if the momentum continues, Junts Pel Sí and CUP could break the magic 50% electoral majority they desire on the 27th of September. To pile on the pressure, the heads of the Spanish government and state have been furiously busy having themselves photographed with heads of state like Barack Obama and Angela Merkel, David Cameron and Jean-Claude Juncker all followed by a caption: “An independent Catalonia will be isolated”. Out of the EU, out of the Euro, out of NATO, out of friends and out of luck.

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Joining this unhappy chorus of doom, the main “Catalan” financial institutions, CaixaBank and Banc Sabadell warned that the “economic uncertainty” arising from a victory of Junts Pel Sí and a subsequent exit of Catalonia from the Euro area would oblige them to consider alternatives to their current operating models. In other words, they would close shop in Catalonia and move to Madrid. This would lead to loss of employment, financial exclusion and a credit crisis in the break-away region:

“The expulsion of Catalonia from the euro zone, resulting from a unilateral breakup of the prevailing constitutional framework (of Spain), would mean that banks based in Catalonia could face serious problems of legal insecurity. These difficulties would force entities to reconsider their operational strategy, with a resulting risk of reduced banking services, leading in turn to financial exclusion as well as to more expensive, reduced credit.”[2]

Finally, Spain’s Central Bank joined in by talking up the possibility of a “corralito”, or capital controls, in the event of a Catalan UDI (unilateral declaration of independence)[3]. Citing the example of Greece, Central Bank governor Luís María Linde said that the Catalan state would be automatically out of the Eurozone, out of Europe and unable to access ECB funding for its banks. That would lead to an economic collapse as consumption plummeted and Catalan companies found themselves unable to access credit from banks.

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All very daunting prospects – which is precisely what they are intended to be. Daunting to Catalan voters who are thinking of backing Junts Pel Sí or CUP in this Sunday’s election. Let’s forget for a moment the fact that CaixaBank and Banc Sabadell depend on billions in Spanish sovereign bonds as part of their Tier 1 capital, bonds which might become worthless in the event of a Catalan repudiation of its part of the national debt; or that both institutions are major investors in the SAREB, with hundreds of millions of euros tied up in the Spanish “bad bank” – again at risk. How much of this menace is real and how much is bluster?

The Barcelona-based banks could certainly take some immediate action, which would be to change their official domicile from Barcelona to Madrid. They could also begin to move some headquarters staff positions to the Spanish capital. But that’s about it, short-term.

  • They are not going to shut down their branches in Catalonia. The loss of deposits would destroy the banks;
  • They are not going to shut down their headquarters in Barcelona and Sant Cugat overnight. Anyone who has worked a day in the private sector knows you cannot move a combined 10,000 or so staff in a week or even a few months, even if all of those people agreed to go. Nor can you simply hire that many qualified people in Madrid without major disruptions to your business;
  • Nor will the Bank of Spain impose a corralito on only one part of the country. How would it manage that? It’s only an hour’s drive from most parts of Catalonia to France or another Spanish province – what prevents people from simply withdrawing their cash from Aragón or Valencia? Not to mention the financial impact on the entire Spanish banking system from having large portions of their consumer, commercial and mortgage books suddenly turned into NPL’s.

It is entirely possible that over the long-term – three to five years – the “Catalan banks”[4]might move their staff to Madrid and divest themselves of much of their Catalan books. But it is worthwhile asking why they would do so.

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Putting the cart before the horse

When unionists speak of the inevitability of Catalonia’s expulsion from, well, everything, they recite it as if it were Holy Writ. And to a certain extent they have a point: a new Catalan Republic would require readmission to all of the international organizations that it forms part of today as a constituent region of Spain. But the sequence of events is important and here is where the unionist argument tends toward the deceptive: for Catalonia to find itself outside of Europe, it would first have to be recognized as independent by Spain. That is an incontrovertible fact: Spain cannot argue that one if its regions is outside of the European system unless it first recognizes the sovereignty and independence of that region.

Which begs the question: if Spain goes so far as to recognize Catalan independence, why on Earth would it act against its own interests by attempting to exclude the Catalan Republic? Either Spain refuses to recognize Catalan independence, in which case it must attempt to restore the national authority by any means necessary; or else it does recognize Catalan independence, in which case, the Spanish government must negotiation with the new Catalan government. Recognizing independence, but then refusing to negotiate makes no sense at all because it would lead to absolute economic and legal chaos not just for Catalonia, but for Spain as well.

Of course, there is a non-negligible possibility of Mr. Rajoy declaring martial law, sending in the police – or army – to arrest the Catalan leaders if they declare independence. In fact, I’ve argued in the past that there is a high probability of this. However, assuming for the moment that Spain rejects a violent course of action, what course is left to them in the event Catalonia secedes? Ignoring the Catalan declaration is obviously not a sustainable situation; it is either the police or negotiation. And if it is negotiation, why would there be any “legal insecurity” that the bank federations warn about? Questions of legal structures, regulations and jurisdiction, division of public property and assumption of powers would all be dealt with during the transition period.

Furthermore, in the event that Spain chooses – or is forced – to recognize Catalan independence and negotiate the terms of separation, there is no reason for Catalonia to ever leave the Eurozone or European Union. Why? Because Spain has the power to declare Catalonia a successor state and heir to all the rights and obligations undertaken by the Spanish state. It would undoubtedly require an act of the Spanish parliament to confer this; but the precedent certainly exists. In the case of the “Velvet Divorce” of Czechoslovakia, both the Czech Republic and Slovakia assumed successor state status and neither had to reapply to join the United Nations or other institutions to which the predecessor state pertained prior to division.

Catalonia constitutes 20% of Spain’s economy and receives 25% of the tourist visits to the country. What would be the likely impact on the Spanish economy if Mr. Rajoy suspended Catalan autonomy and sent in the police and/or the tanks? What if the 49% of the Catalan electorate supporting the pro-independence parties responded by sustained, peaceful work stoppages and blockades? The damage to Spain’s economy, fiscal position, sovereign bond rating and international reputation could be devastating and long-lasting. Additional points to consider:

  • CaixaBank and Banc Sabadell are systematically important institutions within Europe. They owe the ECB and other European banks billions of Euros. What would happen if these two institutions failed due to the chaos in Catalonia?
  • What happens to the other Spanish banks who have major commercial and consumer loan portfolios in Catalonia? If a large percentage of Catalan individuals and business are forced to suspend payments, what happens to the balance sheets of BBVA and Banco Santander?
  • What happens to all of the Spanish companies that depend on the port of Barcelona or on Catalan companies as key producers of value-added imports to their businesses?
  • Europe had three years to build a firewall around Greece, representing 1.3% of the European GDP. It has had no time at all and made no effort to build a firewall around Spain, which is 7.6% of the EU economy. How does Europe deal with this situation?

Unfortunately, there are no good answers to these questions. Anyone who tells you differently is pushing an agenda. Not even European leaders can honestly state that they know how things will play out; there are too many variables and too much uncertainty. It is my belief that Madrid will not negotiate and will attempt to restore its authority over Catalonia, by force if necessary. But if I’m wrong, then there is every reason to believe that a negotiation will achieve much of what the pro-independence supporters claim.

Independence without consequences? Not so fast….

There are strong arguments in favor of Spain swallowing its pride and keeping Catalonia inside the European Union, most importantly to avoid self-inflicted economic pain to the rest of the country. But that does not imply that there would be no economic consequences to independence. Even in the rosiest scenario painted by pro-independence advocates, Catalonia would experience a significant disruption in her trade patterns and a sizeable short-term dislocation to her economy.

Mr. Pankaj Ghemawat has been studying interregional and international trade flows for Catalonia with colleagues in the University of Navarre and the IESE Business School. 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. However, there is substantial empirical evidence that trade ALWAYS drops whenever a political separation occurs between regions of a previously unified state. After the “Velvet Divorce” of Czechoslovakia, trade between the two portions of the country dropped by two thirds within 5 years.  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).

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 a scenario of exclusion from the EU and single currency, Catalonia would be forced to issue its own currency. 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;
  • If Catalonia stayed in the EU and Eurozone, then there would be no depreciation to assist Catalan exports, but there would be no new tariffs with the rest of Europe. The net effect would be similar, but with a smaller recession and a smaller growth rate on the back-end.

I have attempted to represent these effects in a four-stage model using Mr. Ghemawat’s  estimates as a starting point. The data is a little out of date, but the orders of magnitude do not change:

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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.

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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.

In the event of a Euro exit due to Spanish refusal to negotiate, Catalonia would repudiate its portion of the Spanish national debt. This would leave the new republic with a very low debt-to-GDP ratio of only 33%, one of the lowest in Europe. Additionally, the Govern would both stop making and stop receiving intraregional transfers with the Spanish Treasury. The net effect of this would be that Catalonia would not only have a very low public debt, it would be running a significant fiscal surplus. That surplus would allow the Generalitat to increase government spending 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. Even a 2% or 3% of GDP increase in government expenditures would largely offset the impact of a gradual loss of regional trade, as long as it was productive spending and investment, until exporters began opening new markets with more competitively priced goods and services.

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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 Catalans would no longer be focused so exclusively on the Spanish economy, large as it is. They would view trade with Southern France or Northern Italy as equally attractive to trade with Navarre or Aragón, and the market is larger too. 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. Convivencia Cívica Catalana, a pro-union group, notes that Catalonia exports more to Aragon than it does to France, and more to Cantabria than to the United States. Rather than an argument in favor of union, it could be considered a major problem: the French and American economies have the ability to absorb far more of Catalonia’s exports than Aragon and Cantabria ever could, once the region begins to view those destinations on an equal footing.

The full divorce between the Spanish and Catalan private sectors would therefore take time. 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; it will not be immediately possible for Spanish companies to source new inputs and products, reroute port traffic, find new suppliers in a matter of weeks or months.

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 Catalans should consider following the Irish model and establishing a low, flat corporate tax rate. Finally, the government should nonetheless show its pro-business credentials very early on and 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.

The Machiavelli Gambit[5]

If the preceding analysis leads one to conclude that opposing Catalan independence – in the event that a majority of Catalans ask for it – would be madness and economic suicide for Spain, it remains true that the interest of the majority of Spaniards might not coincide with those of the Spanish elite running the country. One chart[6] in particular raises concerns for me:

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The increasing strength of the Socialist Party and of new challengers like Podemos and Ciudadanos has the ruling Partido Popular with its backs against the wall. It is mired in corruption scandals and facing disaffection from its hard right wing for a failure to deliver the promised reforms on abortion and education. Mariano Rajoy has shown himself perfectly willing to play the nationalist card to drum up his base – just ask anyone living in Gibraltar – and the opportunity to deal decisively with the troublesome and “treasonous” Catalans might prove a God-sent opportunity to regain the electoral momentum in the run-up to the December general elections.

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“Saved the unity of Spain, dealt with those odious Catalans that no true Spaniard can like, centralized the functions of the state to do away with all those annoying redundancies in the regional governments”… If the trade-off is a few more years of economic chaos and a few more points to the unemployment statistics versus keeping and holding power, who can doubt the choice that the Populares will make?

Please fasten your seat belts, there is turbulence ahead.

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Sources and Notes

[1] Intención de Voto en Cataluña – link deleted

[2] Nota de Prensa, Declaración Institucional, AEB & CECA, 18 September 2015

[3] “Spanish central bank warns Catalonia over EU exit,” The Scotsman, 21 September 2015

[4] There are no “Catalan banks” of course; every bank in Spain is a “Spanish bank” or Spanish subsidiary of a foreign bank, all operating under a license from the Bank of Spain, regardless of where it is domiciled. Nor would Catalan independence change that fact; CaixaBank and Sabadell would remain Spanish banks.

[5] Fernando Betancor, “The Machiavelli Gambit: Is Mariano Rajoy Fomenting Catalan Secession?” Common Sense, 17 May 2014

[6] Sondeo de intención de voto en las elecciones generals – link deleted

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