Separatism in the EU (2017)

Recently, referendums in Scotland (2015) and Catalonia (2017) have renewed concerns about separatism and fragmentation in the EU. There is a large number of groups seeking greater regional autonomy and in some cases outright independence in various EU member-states. The potentially most politically significant autonomy-seeking and/ or separatist movements are to found in Northern Italy, Scotland, Belgium and Northern Spain. Though unlikely, in the Spanish and UK case, one successful separation might trigger further departures (Wales and Northern Ireland in the UK; Galicia and the Basque Countries in Spain).

Following the recent referendum, Catalonia has come closest to declaring nominal independence, but is facing fierce opposition from the central government in Madrid. The government in Madrid is concerned about losing an economically important region and its possible knock-on effect on other Spanish regions. States generally defend their territorial integrity. The most likely outcome is one where after changes to the Spanish constitutions is granted far greater autonomy, but remains formally part of Spain and the EU. 

In Italy, Lombardy and Veneto, two of Italy’s wealthiest regions, have just held referenda to try to obtain greater fiscal autonomy from the central government. Unlike in Catalonia, the referenda were approved by the central government in Rome and the outcome was non-binding. Over the medium term, the two regions may be able to retain a greater share of taxes, but breaking away from Italy is not currently on the political agenda. 

Belgium has seen long-simmering differences between French-speaking Wallonia and Flemish-speaking Flanders. A break-up is unlikely in the very short term. If it happened, it would be relatively amicable. Both regions would want to remain part of the EU following the partition.  The status of Brussels would prove difficult to find a solution for. Wallonia would lose out economically, being the poorer region. An alternative scenario is one where Wallonia joins France and/ or Flanders joins the Netherlands. But this assumes sufficient public support for such a solution in all four countries. A divorce would be relatively amicable and comparable to the separation of the Czech Republic and Slovakia in the early 1990s. An amicable separation would increase the likelihood of both regions retaining EU membership.

Scotland held a referendum on independence in 2015 and was narrowly defeated. Right after the UK Brexit referendum, Scotland looked as if it might go for another referendum given that the majority of Scottish voters had voted to remain in the EU. However, SNP losses during the 2016 parliamentary elections it and its political mandate in favour of independence. That said, in case of a hard Brexit and/ or increased economic problems in the UK, Scotland may hold another referendum in a few years. Such a referendum is unlikely to take place before 2020 and its success or failure would probably hinge on what the EU would offer in terms of its future relationship with an independence Scotland.

Source: Informo

The EU has been firm on not re-opening border disputes in Eastern Europe. While the separatism issue is somewhat different, it is also similar in the sense that the EU is keen to avoid instability and fragmentation. The EU is very unhappy about Brexit. If two member-states decided to merge, that would likely be acceptable to the EU and the EU member-states. The EU had no problems with East Germany becoming part of the EU following German re-unification. Separatism is another matter, as it risks leading to increased political instability and fragmentation – and the EU is already dealing with a number of semi-existential issues (e.g. euro area reform, security, less multilateral US, Brexit, refugees). While it would be politically difficult to deny recognition to a peaceful separatist movement, the EU and especially its member-states will not want offer separatists any incentives, either, by granting them, for example, immediate/ automatic EU membership or access to the EU Common Market. 

The EU prefers any demands for sovereignty to be settled amicably and preferably through greater regional autonomy, including fiscal and administrative decentralisation. The EU will also make it clear that the separatist region would not qualify for immediate EU membership, thus imposing significant economic and financial intolerable costs on the separatists. The EU may adopt a different stance in case of an amicable separation. The EU and its member-states, especially those facing possible separatist groups themselves (Spain, France, Italy etc.), will not do anything to encourage separatism in the EU. This would open the proverbial can of worms. Politically, this creates significant incentives for member-states to oppose separatism in order to prevent an amicable separation and indirectly prevent the separatists from remaining in the EU post-independence.

EU membership comes with a great number of economic (and financial) benefits, especially for smaller economies. Economically, leaving the EU Common Market would force the new economy to default to WTO rules. The WTO lays down rules for trade in goods, but services, investment and cross-border labour mobility would be severely impacted. Moreover, whether the newly independent state defaults to WTO rules will depend on whether it manages to gain sufficient international recognition to be admitted to the WTO and it does not address whether or not the government has enough technocrats to implement the measures necessary to join the WTO. The financial sector would be affected very negatively. The local banking system would lose access to cut off from central government central bank liquidity and its lender0of-last resort. This would likely force the government to redenominate the currency and introduce capital controls or unilaterally adopt the euro (or pound in the case of Scotland). This would lead, as see in the case of Scotland and Catalonia, force banks and other financial firms to relocate. Local companies that rely on exports are similarly exposed to economic and financial distress in case they lose access to the Common Market. If the new state does not achieve international recognition, the country as a non-member will not even have access to the IMF. The short-term economic effect of dropping out of the EU would be disastrous. EU will be keen not to lower the exit costs high for fear of otherwise encouraging other separatist movement and fragmentation. Leaving aside the economic shock, the longer-term consequences would be negative, too. If the UK finds it difficult to strike favourable trade deals, much smaller economies like Catalonia or Scotland would find it even more difficult to do so. 

What would successful separatism mean for the country the separatists are separating from? Italy would lose its economically most successful and wealthiest regions and Southern Italy would receive fewer national financial transfers. Depending on how public debt is shared, this could put the rest of Italy into a difficult financial position. If Scotland became independent, Northern Ireland and Wales might follow, even if at present this does not seem very likely. Similarly in Spain, Catalan independence might trigger centrifugal forces in Galicia and the Basque Countries, even though these regions are far less economically successful and are less likely to seek independence given the immediate fiscal/ financial losses they would incur. Catalonia would be able to retain control of all of its taxes, but these would be much diminished given the economic consequences of independence. The break-up of Belgium would create two successor states comparable in economic size to city-states like Hong Kong or Singapore. Even if they gained EU membership, their weight would be diminished. If other regions followed Catalonia and separated from Spain, Spain would be comparable in terms of GDP to the Netherlands. The remaining entities will be somewhat poorer economically, but the departing regions are more at risk of suffering an economic and financial crisis.

Separatism is unlikely to succeed in the EU over at least the next decade or so. Economically, the costs of independence are very significant. Fiscally, independence is self-defeating via its negative impact on the separating economy. Financially, the economies would see currency redenomination, possibly a banking crisis and an exodus of banks, financial firms and outward-oriented companies. Politically, the EU and EU states remain very much opposed to further fragmentation. The costs of separation should make it relatively easy to mobilise business in favour of finding a solution short of independence and to weaken public support for it. (It would probably require a surge in political violence to change public attitudes sufficiently to be willing to bear the costs of separation.) Last but not least, formal independence would have to be recognised by the international community. If this does not happen, the region/ new state will be left in further political, economic and financial limbo. The most likely scenario is one where separatism can be defeated by granting regions significant autonomy allowing the region to remain in the EU Common Market. There are many example of how this can be achieved (e.g. German-speaking Southern Tyrolia, Scotland). 

US trade policy towards China - a few random observations (2017)

China accounts for half of the US trade deficit, but much less in value-added terms. In value-added terms, the bilateral trade deficit (16% of total) is only slightly smaller than the deficit with Japan (13%) and Germany (11%). (This is not likely to cut much ice.)

On March 31, 2017, President Trump issued an executive order for the USTR and Commerce Department to submit an Omnibus Report on Significant Trade Deficits that focuses on major bilateral merchandise trade imbalances.  At the April 6-7, 2017, summit meeting, Presidents Trump and Xi agreed to establish a “100-day plan on trade”.  On April 20, 2017, the Trump Administration initiated a Section 232 investigation on the effects of steel imports on U.S. national security. On April 27, the administration initiated a similar investigation on aluminum. (China is the world’s largest producer of these commodities.) On August 14, 2017, President Trump issued a memorandum directing the USTR to determine if China's policies regarding IPR theft and forced technology requirements "may be harming American intellectual property rights, innovation, or technology development," and thus warrant USTR action under Section 301 of the 1974 Trade Act. On August 18, 2017, the USTR announced it had launched a Section 301 case against China. 

The US imposed tariffs of 20-50% on US imports of solar panels and washing machines (including imports from China) in January. US solar and washing machine tariffs were the result of a little-used provision of US trade law Section 201, Trade Act of 1974 (global safeguards action). Under Bush and Obama, safeguards were used but proved temporary (2002 Bush steel; 2003, the WTO ruled against the US and the Bush administration withdrew the tariffs; Obama 2009 tariff on Chinese tyres; China filed a WTO dispute, but WTO largely upheld US safeguards and Beijing was not legally authorized to retaliate. China hit back by launching its own investigation that resulted in a new antidumping tariff on US exports of chicken feet. Washington challenged Beijing's chicken feet tariffs at the WTO and largely won its case.) As for the 100 day plan on trade, China promised to import more beef (but this is a promise it had made before the Trump administration took office) and open its financial sector further. In an attempt to assuage Washington, it also signed large business deals during the US president’s visit to Beijing (but these deals were generally already in the pipeline.) This has not satisfied the US administration and has not prevented it from taking trade measures, directly or indirectly aimed at China. 

Under more controversial US trade laws than those invoked in the solar case, the US administration has also decided to impose tariffs on steel and aluminum for national security reasons (under Section 232 of the 1962 Trade Expansion Act). It is also seeking to take measures in response to China's alleged theft of intellectual property (under Section 301 of the 1974 Trade Act). The US administration decided to impose tariffs on Chinese aluminum foil producers, which it says were unfairly subsidized and were selling the products below fair-market value.  Antidumping duties are said to range from 49% to 106%. Countervailing duties are said to range from 17% to 81%. (In 2016, value of foil imports from China estimated at USD 389m.) The US will reportedly also impose tariffs of 25% in steel and 10% on aluminum imports under Section 232 as early as next week.

Beijing has been trying to manage trade tensions in a number of ways (signing of large business contracts, promise of market opening). In response to the imposition of tariffs on Chinese solar exports, Beijing has launched an anti-dumping/ subsidy investigation into USD 1 bn of US sorghum exports to China. It also seems to consider taking action on US imports of aircraft and soybean. The investigation could result in new Chinese tariffs that would hurt US farmers. China seeks retaliation by targeting the US president’s political base. China will seek to retaliate without violating WTO rules ensuring that retaliation is proportionate.

A full-blown trade war remains unlikely given the economic damage it would do to both sides. There are signs of increasing congressional and business opposition to US protectionist policies. The fall in the equity market following the steel and aluminum tariff announcement might also make the US administration more cautious. China will retaliate, but only in a measured way. The EU, Canada, Mexico and others are likely to do the same while bringing their cases to the WTO. 

The US is also moving towards tightening the rules governing its inward FDI regime. Congress is keen to tighten the rules, not just on national security grounds but also to prevent China from acquiring “strategically important technologies”. It is very likely that such a move is also being seen as a possible bargaining chip vis-à-vis Beijing in an attempt to open the Chinese economy to US/ foreign direct investment. Investment and IPR are other points of contention between the US and China and is likely to remain a cause of friction (and bargaining).

Source: WTO

US, NAFTA, Mexico - a quick observation (2017)

The US has been running persistent trade deficits with both Mexico and Canada. Observers believe that the negotiations are unlikely to be concluded this year. It is also not very likely that negotiation will break down this year. That said, Mexico’s threat to retaliate against US steel tariffs might raise US-Mexican tensions. Same for US-Canada.

An analysis of US jobs that rely on exports to Canada and Mexico finds that a NAFTA dissolution would cost less than 200,000 jobs in the US export sector over a 1-3Y period. By comparison, a total of 7.4m US workers were displaced or lost their jobs involuntarily during 2013-15. The most affected states would be Arkansas, Kentucky, Mississippi, and Indiana. The most affected sectors would be autos, agriculture and manufacturing.

NAFTA supply chains help reduce production costs by providing low-cost intermediate inputs to US firms. Lower production costs mean domestic consumer prices and the cost of US exports are lower than they would otherwise be. In order to be eligible for duty-free imports under NAFTA, member countries must abide by rules of origin. Tightening rules of origin, which effectively raises the cost of trade, is unlikely to increase trade or lower the trade deficit but is very likely to disrupt supply chains. Often higher tariffs are circumvented or third-country producers step in to provide additional supply. The economic impact on the US will be limited.

As for Mexico, if NAFTA is dissolved, Mexico would default to WTO rules. This will affect trade, but the macro impact would be manageable, not least because the Mexican peso would adjust, keeping Mexican exports to the US competitive. Higher inflation following currency depreciation would require higher interest rates, but the economic shock would prove temporary. Mexican manufacturing exports would face an average tariff of 2.4%, while Mexico under WTO rules would be allowed to impose import duties of 5.2% on US manufacturing exports. This is an average. Individual products may face stiff duties (e.g. Mexican pick-up truck would 25% tariff). Not all Mexican and Canadian exports to the US use NAFTA rules. This will further mitigate the impact of NAFTA dissolution on Mexican exports to the US,

A NAFTA break-up would hit domestic Mexican investment and cause a short-lived recession. Moody’s estimate of Mexico’s medium-term GDP path may be somewhat optimistic. Mexico’s growth potential is 3% at best. But the NAFTA shock would prove temporary and Mexico would return to its pro-dissolution growth path after 12-18 months. The impact would be manageable for the following reasons. Mexico would revert to (low) WTO tariffs on the slightly more than 50% of its exports to the US that currently take place under NAFTA rules. US companies would continue to have significant incentives to do business with Mexico due to significant supply chain integration and low transportation costs. Mexico’s flexible exchange rate regime would act as an automatic stabiliser and help the economy adjust to less favourable terms-of-trade. Mexico would also be aggressively pursuing trade agreements with other countries following NAFTA dissolution to offset some of its negative impact. 

Mexico is rated investment grade and has access to the IMF Flexible Credit Line. Its macro policy track record is strong. A flexible exchange rate will help Mexico absorb any trade shock.