A Balanced View of the Economics of Independence in Catalonia

by Angel Ubide, PIIE, September 15, 2015

Editor’s Note: In the light of the recent independence referendum in Catalonia, in which some 43% of the population took part despite police attempts to prevent the vote from taking place by means of violence, we are posting this 2015 article on the economics of the proposed secession.

Two years after voters in Scotland rejected independence from the United Kingdom, Spain faces the threat of breakup as Catalonia holds regional elections on September 27. The Catalan president, Artur Mas, leads a pro-independence coalition for these elections, Junts pel Si (Together for Yes), with a single aim: to start a process of independence culminating in secession in 18 months. Polls show the independence coalition achieving a narrow majority in Parliament, though with just 40 percent of the popular vote.
With its capital in Barcelona, Catalonia, a region of about 8 million people on the Mediterranean coast just below the Pyrenees, is one of Spain’s more prosperous regions. The pro-independence coalition argues that an independent Catalonia would be economically better off. In fact, a Catalan secession could wreak economic and political havoc in Spain and especially in Catalonia, throw the European Union into an existential crisis, and boost the incipient nationalistic and populist movements that have sprung up in Europe after the long recession. The pro-independence arguments, while held passionately, are biased, based on dubious assumptions and unlikely scenarios, or just wrong.
The process of unilateral independence, or just its persistent use as a political negotiating tool, would create uncertainty and impede Catalonia’s growth. Its recessionary impact means it could take years for Catalonia to regain its current level of GDP.
Background
The Spanish Constitution, adopted in 1978, three years after the death of dictator Francisco Franco, set in motion a process of fiscal federalism, allowing regions to gradually acquire the ability to govern themselves following decades of authoritarian rule. Regional politics in Spain ushered in debates about the speed of transferring powers. Today Spain is one of the most decentralized countries among advanced democracies. Almost two thirds of government spending is managed at the regional level, more than the maximum offered to Scotland after its failed independence referendum in 2014.
A highly controversial and botched attempt to negotiate a new Statute of Autonomy for Catalonia, which was approved in a referendum only to be later ruled unconstitutional in 2006, gave initial impetus to the independence movement.
The financial crisis of 2010 forced budget cuts throughout Spain. Most regions, including Catalonia, had a past of fiscal profligacy and lost market access, and the central government imposed stringent austerity on them as a condition for liquidity support. The Catalan government resorted to the tried and tested strategy of blaming a foreign enemy for its troubles, charging further that Spain “stole from Catalonia.” Independence was seen as an ideal political escape to mask its fiscal crisis.
Three fundamental arguments are invoked to support independence, each based on incorrect numbers or assumptions.
Argument 1: Spain steals from Catalonia
The pro-independence narrative maintains that Catalonia contributes too much to Spain and would save €16 billion (over 7 percent GDP) if it became independent. But that number ignores expenditures, such as army or border control, that an independent Catalan government would be responsible for. In fact, Catalonia does pay more to Spain than it receives mostly because its per capita income is higher, and its payments result from the country’s progressive taxation formulas.
Detailed analysis (link is external) that allocates revenues and expenditures based on its personal or regional nature shows that the excessive contribution of Catalonia is at most about €3 billion, or about 1.5 percent of GDP. Thus the size of the potential unfair treatment of Catalonia is small.
Argument 2: Growth would have been stronger in an independent Catalonia
The contention that an independent Catalonia would achieve faster growth outside Spain runs into three counterarguments.
First, no historical evidence supports this claim. Andres Rodriguez-Pose from the London School of Economics has studied the economic record of independence, mostly in Eastern Europe and the former Yugoslavia, and finds (link is external) that countries at best maintain their previous growth paths.
Second, no evidence suggests that institutions in Catalonia perform better than the Spanish average. Anecdotal evidence (link is external) suggests that corruption is as pervasive in Catalonia as in the rest of Spain. On a more scientific basis, the 2012 European Commission report (link is external) [pdf] measuring the quality of government in European countries and regions shows Spain ranked 13 out of 27 EU countries, while Catalonia ranked 130 out of 199 EU regions, thus in the bottom third of EU regions. Catalonia also ranked last among Spanish regions.
Third, Catalonia’s potential growth benefited massively from the 1992 Olympic Games, which were financed mostly by the Spanish State and the City of Barcelona, with a minor contribution by the Catalan government, and which opened up new parts of the city with civil infrastructure investments. Research (link is external) conducted by the University of Barcelona and the City of Barcelona shows that this spending not only boosted the economy before the games but also provided long-lasting benefits. For example, Barcelona moved higher in the “best city to conduct business” ranking.
Argument 3: “Catalexit” would be positive
The pro-independence camp maintains that an independent Catalonia would be viable, but this contention overlooks how the change in the status quo will bring a long, uncertain, and economically costly transition process, transforming the Catalan economy, reducing its GDP, increasing the volatility of per capita income, weakening its financial system, and increasing the cost of capital.
For example, the European Union rules hold that if a region becomes independent, it must start the process of EU accession from scratch. Catalonia’s GDP is about the same as Greece’s, but its population is smaller and it has no geopolitical value that would compel the European Union to make an exception to the rules. The Greek crisis has shown that the European Union is firmly against political moral hazard. Therefore, Catalonia would have to build new institutions and meet the EU and euro entry criteria during a long transition period, increasing uncertainty that would weaken growth.
Catalonia runs a large trade surplus, but it is mostly with Spain (about 10 percent of GDP), while it runs a large trade deficit with the rest of the world (about 4 percent of GDP). Independence would trigger the so called “frontier effect” (regions trade more with regions in the same country than with regions across a national border). Analysis (link is external) of differences in trade between the Canadian provinces and US states, or between Spanish regions and Portugal, suggest a potentially large drop in trade between Catalonia and the rest of Spain, about 50 to 70 percent, that would erase Catalonia’s trade surplus, resulting in a decline in Catalan GDP as much as 10 percent.
In addition, most large Spanish and multinational corporations headquartered in Catalonia would probably leave in order to remain inside the European Union. Anecdotal evidence suggests ongoing planning along these lines. Something similar happened in Scotland, where large firms and banks made clear they would relocate if the independence referendum had won. Quebec has suffered the loss of many headquarters because of its decades-long push for independence, and Quebec firms have suffered (link is external) [pdf] an “independence risk premium” in their stock valuations and higher capital cost for firms. Were something similar to happen in Catalonia, the fiscal base would contract and tax revenues would fall, offsetting any savings from independence. A smaller and less diversified economy would also become more volatile to external shocks.
Before being recognized as an independent state, Catalonia would remain inside the euro (as part of Spain), but the uncertainty would likely trigger deposit outflows in the banking sector, as happened in Greece. Once independent, Catalonia would have to create its own central bank and currency. With no institutional history, its new currency would likely be weak and interest rates and inflation high. It could still use the euro, as a euroized country similar to Kosovo or Montenegro, but at the cost of losing control of its monetary policy. The branches of Spanish banks in Catalonia could continue to receive liquidity from the European Central Bank (ECB) via their Spanish owners, but the ECB and the single supervisory mechanism (SSM) would likely adopt a very bearish assessment about the availability of eligible collateral and the solvency of these branches. Catalonia doesn’t have market access and it is rated BBB–. If the liquidity support from Spain becomes doubtful, this rating will certainly be downgraded, even if Catalonia repudiates its share of Spanish debt. Overall, monetary and financial conditions will be tighter in an independent Catalonia.
Markets are starting to move in response to talk of independence. The spread of Catalan bonds has increased to around 200 basis points over Spain and around 325 basis points over Germany, and these spreads will surely skyrocket in the event of a victory of the pro-independence coalition.
Conclusion
These are not extreme or unrealistic scenarios. These are just observations based on economic theory, recent events, and historical evidence, under the assumption that current legislation will be respected.
The bottom line is that legal, institutional, and economic factors combine to make clear that the independence process would generate uncertainty and kill growth—for Spain and even more so for Catalonia.
Catalonia has thrived in Spain. The rational alternative to independence would be to update the Spanish fiscal federalism regime. A negotiated constitutional reform after the Spanish general elections is the best solution for all parties.

This is an edited version of remarks by the author at the event “Political Economy of Catalonian Independence,” held September 9, 2015, at the Peterson Institute for International Economics.
 

SUPPORT OFFGUARDIAN

If you enjoy OffG's content, please help us make our monthly fund-raising goal and keep the site alive.

For other ways to donate, including direct-transfer bank details click HERE.