23 October 2017

The price of Catalan turmoil


In a deliberately confusing speech during a plenary session of the regional parliament on October 11, Catalan President Carles Puigdemont unilaterally announced the independence of Catalonia and then proposed that parliament suspend that independence so as to start negotiations with Spain’s national government.

Spanish President Mariano Rajoy responded with a touch of cheek, asking the Catalan government to clarify without delay whether it had declared independence or not. Rajoy’s government threatened to remove the executive in Catalonia and take over the reins of the regional government if the response was either affirmative or ambiguous.

In response to this ultimatum, the Catalan government reacted sent a letter to the Spanish government in which it neither confirmed nor denied having seceded. On Saturday, Rajoy delivered on his threat, announcing  that he would ask the Senate (where the governing party has a qualified majority) to remove Puigdemont and his Cabinet from office by invoking article 155 of the Constitution, which allows the central government to dismiss a regional executive that is not complying with its constitutional obligations.

This implies that the central government will assume the powers and duties of the regional government, including public security, finances and control of the Catalan public media. Rajoy committed to holding regional elections to restore Catalonia’s self-governing powers within six months.

In the meantime, the political turmoil has already claimed its first victim: business. Around 40 large companies headquartered in Barcelona (probably more by the time you read this) are moving their headquarters to other Spanish cities as a result of the uncertainty created by political instability. These include six companies on the IBEX 35, the main stock market index in Spain.

The economic consequences of companies moving their headquarters out of Catalonia could be disastrous, although not for the reasons you might think. In fiscal terms, the impact will be hardly perceptible, at least in the short term. Sales and corporate taxes (the main taxes paid by firms) are collected by the central government, which means that Catalonia’s public finances will barely be affected.

But the turmoil in Catalonia is sending a negative signal to both current and potential investors. One of the considerations large companies take into account when undertaking investments in a country is political risk –  the chance that actions or measures carried out by the government bring about legal and political uncertainty which might hurt profitability.

Political risk can increase their cost of capital (the interest rate at which firms raise funds), which in turn would reduce their profit margins; it can halt planned investments; and in the worst-case scenario, it can persuade companies to up sticks and move elsewhere. All this would of course result in steep declines in economic activity, employment and, ultimately, living standards.

In the remote case Catalonia became an independent state without the agreement and consent of the international community, political risk could also result in difficulties for a hypothetical autonomous Catalan government to raise financing in the international markets. The risk premium of Catalan debt would probably skyrocket and access to external funds would be merely a chimera.

If the political situation does not change in the next few months, companies moving their headquarters will be the beginning of a downward spiral that could trigger an economic crisis of unprecedented magnitude. Even though intervention by central government might bring political stability and legal certainty in short term, the underlying political conflict won’t vanish overnight.

Ideally, the long-term solution would involve a new financing system not only for Catalonia but for all Spanish regions that widely decentralized tax revenue collection (under the current system, only spending is decentralized) and grant them more fiscal powers. Thereby, fiscal competition among regions would create an incentive to lower taxes, which in turn would attract new investments from abroad.

In any case, the economic situation is still susceptible to deterioration not only for Catalonia but for Spain as a whole. This could jeopardise the country’s spluttering recovery. Does either side of the Catalan stand off realise that they aren’t just playing with fire politically, but causing major problems for a country with an already fragile economy?

Luis Pablo de la Horra is a Spanish finance graduate