Catalan Crisis: Is a Further Escalation Possible?

Last week saw a dramatic escalation of the Spanish political crisis. The banned Catalan independence vote took place on 1 October and the results indicated 90% "Yes", with a participation of 43% residents as estimated by the Catalan electoral office. These numbers should, however, be read with a pinch of salt given the irregularities in the process and the likelihood of double voting.

Two Distinct Possible Outcomes in Coming Days
A further escalation is certainly a risk. The positions of the parties involved remain far apart. As things stand, we see two distinct possible outcomes in coming days:

• The regional authorities led by Carles Puigdemont decides to call for a unilateral declaration of independence. Such declaration would remain legally unbinding and unrecognized by Spanish and EU laws. The central government could respond by triggering Article 155 of the Spanish Constitution, effectively suspending the autonomous status of the region, an unprecedented decision.
• The Catalan government refrains from calling unilateral independence and some kind of mediation or dialogue between the central and regional government is possible as a first step of de-escalation of the crisis.

The first outcome would be perceived as a clear escalation of the crisis for financial markets, while the second would be a basis for stabilization of the crisis. Economic pressure from large corporates based in the region has also started to emerge and will likely play a role in the decision to call for independence or refrain from it. Indeed, businesses have begun to consider relocating their headquarters, with the boards of Caixabank and Sabadell, the two largest lenders in the region, agreeing to move their legal bases out of Catalonia.

Market Stress Likely to Persist in the Short Term...

The heightened tensions have been visible in the domestic financial market over the past week. Spain’s 10-year borrowing costs hit their highest level since March as tensions between Madrid and Catalonia were increasing. Sovereign spreads over Germany widened to 132 basis points, before correcting somewhat although they remain above their pre-referendum level. Domestic equities have been affected too, with the MSCI Spain index down by nearly 2% over the week following the referendum, and after having already underperformed the rest of the Eurozone in the past three months.

Looking ahead, a further escalation of the crisis would likely be mirrored by renewed market stress. An additional underperformance of domestic stocks is likely in such a scenario, despite valuations being already attractive versus the rest of the Eurozone. Within fixed income, Spanish government bond yield spreads could widen above 150 – 160 basis points, but the presence of the European Central Bank (ECB) as a buyer in the bond market should act as a ceiling above these spread levels.

...With Limited Contagion to the Eurozone

Overall, the increased tensions have resulted in domestic market stress, but contagion to the rest of the Eurozone has been relatively muted for the time being. In case of a further escalation, we would not rule out short-term contagion of a small magnitude to other peripheral banks and sovereign yields, but other European markets should remain more or less shielded. While the Euro could potentially weaken on any unilateral declaration of independence, legal ramifications are likely to stay limited, which should prevent a protracted impact on the common currency.

Under an extremely negative scenario, where the Spanish economic recovery could be at risk for a protracted period, and financials in Spain and the rest of the periphery come under high pressure, financial stress could cause the ECB the delay its decision regarding tapering its Quantitative Easing (QE) program. Any announcement could then potentially be delayed to the December meeting, or even a later stage, if market stress remains elevated in coming months. But such an extreme outcome remains very unlikely for the time being.