Catalan Referendum: Risks are severely underpriced in the Euro

After months of bullishness, the Euro has experienced a healthy retracement for the past month. EUR/USD topped just short of the 1.21 mark and is now back in the mid-1.17 levels now. The main reasons for that pullback have been found in regular central bank talk (ECB hesitation to initiate tapering, Fed hawkish shift hinting another rate hike this year) and political uncertainty from the German election outcome, with the far right party becoming the third political force in the German parliament.

But most of the market talk still overlooks a serious issue. We believe that the conflict between the Catalan and Spanish governments is a serious threat to the Euro.

It wasn’t until last week that Catalan referendum started appearing in the headlines and main market reports. EUR/USD actively reacted to the news for the first time on last Monday’s opening, quickly falling below 1.18 and losing about 80 pips on the day. Still, this is a mild reaction to the gravity of the events that happened all across Catalonia on Sunday. Calling the referendum illegal, the Spanish government decided to close polling stations and sent their police against peaceful citizenship trying to vote.

The wave of violence enacted by the Spanish government has just aggravated a political conflict that has been there for years, even if ignored by markets. Moreover, it adds another nightmare for European officials to deal with. Even if Grexit and the sovereign debt crisis were dodged, the structural infrastructure of the Eurozone was not reformed. The European Union still stands on shaky grounds:

• Italian banking sector is reportedly hanging over a huge pile of debt, only managing to stay afloat thanks to ECB’s quantitative easing program. Same could be said about Italian and Spanish sovereign debt
• Brexit ongoing negotiations are just starting and talks will be long and difficult. Even if the UK has a higher risk here, the stakes for the European Union are vast. A Hard Brexit would be a political and economic disaster
• Angela Merkel’s leadership has been weakened by her unconvincing win in the German election, especially after the surge of the far right. Most of her colleagues in the European Council face the same issue within their countries, with European core values being questioned

Enter the Catalan quest for independence, which might be the spark that turns everything loose. The tug of war between the Catalan and the Spanish governments is about to reach its breaking point, and it is not a minor issue: Catalonia is the wealthiest region in Spain, accounting for about 20% of Spanish GDP, about the size of Portugal’s economy.

Catalans have been asking for the right to decide its status for years with no political answer from Spain’s central office. Prime Minister Mariano Rajoy and his allies deny any political negotiation to the issue, calling Catalonia’s quest to decide its own future unconstitutional. They have very little leverage as their hardcore voters don’t seem eager to a negotiated solution. Same happens in the Catalan side, moreover after Sunday’s events.

Despite the violence and repression from police, over two million of Catalans cast a vote for Catalonia to become a new republic, independent from Spain, on Sunday. Even if the figures are not solid (about 5% of the polls were lost, democratic conditions were severely damaged), more than two million people voted for independence, which accounts approximately for half of the voting population. The other half seems to be divided among those who seek for a reformed, federal Spain and those who are okay with the current status quo.

The Catalan government, with a majority of seats in the regional parliament, has vowed its intentions to make that vote effective in the coming days. The Spanish government is considering to suspend the autonomy of the Catalan institutions if that happens. Top Catalan officials have made appeals to the European Union to intervene and help negotiate a solution, but the European Commission has gone silent on the issue, deemed “a Spanish internal affair”. An affair that risks becoming a rotten apple if not addressed immediately.

Otherwise, the conflict is set to escalate this week, with today’s general strike in Catalonia being a serious message. Catalans have repeatedly made peaceful claims, with no violent protests since the independence movement gained traction and became mainstream in 2012, but people discontent is growing. Unions are starting to get involved. All kind of economical working sectors, from railway drivers to banking officers, are protesting. That strike could be extended and severely damage Catalan, Spanish and European economies. Angela Merkel, Mario Draghi and other top European officials should intervene this time. 

If not, the Euro risks another huge crisis at the heart of one of its biggest economies. The one that might not be dodged.