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Why the Fitch Warning on Catalonia is Totally Wrong

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A full copy of Fitch’s release is included at the end of this post, in the Sources and Notes section.

On the 29th of September Fitch Ratings issued a negative warning[1] on bonds pertaining to the Autonomous Community of Catalonia and the Institut Catalá de Finance. This was the same day that the Spanish government appealed the Catalan referendum law and the Constitutional Court agreed to suspend it while hearing arguments about its constitutionality. To be clear, the “Rating Watch Negative” (RWN) is not a downgrade: it is a warning to institutional investors that there are reasons to expect a downgrade in the near future. The current ratings of the Catalan bonds under review are one step above junk bonds[2], at the same level as all of Spain’s regions. A downgrade to junk would not only imply a significant increase in the bond premium and the cost of debt, but it would block out most foreign institutional investors, who are often prohibited by law from investing in speculative grade bonds.

The reason Fitch gave for the warning is worth quoting in full here:

“Fitch believes that Catalonia will require additional funding from the FLA in 2015 and because of difficulties in accessing the international capital markets the region is likely to remain highly dependent on FLA for funding. International investors are also unlikely to purchase bonds issued by the regional government given present political uncertainty.

Although Fitch expects that the central government would continue to financially support Catalonia, as a default would have negative implications for all regions trying to access the capital markets, as well as for the central government, Fitch believes that developments over the next six weeks are likely to complicate the relationship between Catalonia and the central government.”

The FLA is the Fondo de Liquidez Autonómica (Autonomous Region Liquidity Fund), a credit line established by the central Treasury just after the height of Spain’s credit crunch in July 2012. Because the Spanish sovereign has better and cheaper access to international credit markets as well as the back-stop of the European Central Bank, the FLA was a form of passing on some of these savings to the regions rather than having them cripple themselves by contracting new debt with much higher premiums. It was also a means of exerting greater political control over the highly autonomous finances of the autonomous regions, as access to the FLA was conditional to meeting deficit reduction conditions imposed by both the Treasury and the Spanish Parliament.

Fitch argues that Catalonia will require additional funding beyond its tax receipts in 2015. They further argue that, because of the current political tensions between Madrid and Barcelona over the referendum issue, access to the FLA is not guaranteed and that access to international markets is even less likely. Therefore a downgrade warning is justified.

Why Fitch Has it Totally Wrong

The justification sound reasonable enough on the surface, but the ratings agency’s logic suffers from a very serious flaw: the statement contains language that contradicts the premise of the warning.

 “Although Fitch expects that the central government would continue to financially support Catalonia, as a default would have negative implications for all regions trying to access the capital markets, as well as for the central government”.

So a Catalan default would have “negative implications” for all Spanish regions as well as the sovereign? In other words, if the central Treasury decides to cut-off Catalan access to the FLA, then Catalonia must default on its bonds, which would then provoke a run on all the bonds of the other Spanish regions. The Spanish state would then have to step in to back-stop all of that defaulting regional debt, which would increase the debt-to-GDP ratio of Spain by an additional 20% of GDP, to about 115% of GDP[3]. On top of that, the risk premium on Spanish bonds would increase significantly as well.

regionaldebt

Is that in the least bit a plausible scenario? Yet Fitch follows that sentence with the following:

Fitch believes that developments over the next six weeks are likely to complicate the relationship between Catalonia and the central government.”

It would be akin to cutting off your nose to spite your face. It makes no sense whatsoever.

I don’t mean to imply that the Treasury is going to simply throw money at Catalonia. There will undoubtedly be a very hard negotiation if the Generalitat goes back to the FLA in 2015. But the negotiation will be based on technical matters: meeting deficit reduction targets, budget allocations and admissible spending categories; NOT political issues.

For the sake of argument, let’s look at the worst case scenario that Fitch believes may arise due to the “tensions” between Madrid and Barcelona (personally, I think there is 0% chance of this happening):

  1. The Spanish government cuts of Catalonia’s access to the FLA in 2015 in order to put financial pressure on the Generalitat. How much pressure is applied and what are the actual financing needs of the Catalan government?

This year, the Catalan government has borrowed €5.774 billion through the end of August[4]. Extending that out through the end of the 2014 at a constant rate yields a total of €8.661 billion in borrowing from the FLA. That would be somewhat less than the €10.05 billion borrowed in 2013, and could be due to improved economic performance and slightly lower unemployment. Let’s assume the 2015 funding gap is similar to 2014 and place it at €9 billion.

  1. As soon as the Spanish government denies access to the FLA, Catalonia will begin legal action against the Treasury. I assume that this is purely a political decision, and not one based on any non-compliance on the part of the Generalitat with the FLA’s conditions;
  2. Catalonia will also stop transfers of all taxes and imposts received to the central Treasury. According to the published budget of the Generalitat[5], those transfers in 2014 will amount to an estimated €16.5 billion.
  3. The Treasury would, of course, escalate by stopping transfers to the Catalan government. Those amount to €4.5 billion[6].

After this tit-for-tat exchange, the Catalans would find themselves without a funding gap at all… they would have a surplus at the end of the year of €3.0 billion (16.5 – 4.5 – 9.0 = 3.5).

catalanbudget

I don’t think this is a particularly fruitful line of analysis: these sorts of unilateral actions would lead to the breakdown of the state mechanism and almost certainly provoke the Catalan government into declaring independence: precisely the opposite of what the central government is trying to accomplish.

It is possible that Fitch is baking into its warning and “independence risk premium”: but if so, they are wrong to do so. First, because they make no mention of the risk of independence in their statement: which would be highly misleading if it were a “material condition” of their analysis. Second, if they did take into account an “independence premium”, they couldn’t keep treating the Catalan debt as sub-national debt, which is clearly what they are doing. They would have to provide a full analysis of the financial viability of a Catalan state, with full fiscal and monetary powers associated with any sovereign. They clearly don’t do that either.

Catalonia either is a region of Spain or it isn’t. There is no “a little bit pregnant” here:

  • If it is a region of Spain, it is going to get the needed funding, because if the Spanish Treasury tries to play hardball, it could precipitate the very declaration of independence that they’re trying to avoid. I’m sure there will be a negotiation between the Generalitat and the Treasury, but it will be a technical conversation on deficits, budget allocations, and spending categories: it will not and cannot be political;
  • If it isn’t a region of Spain, then it can no longer be treated as a sub-national bond; it would have to be rerated as a sovereign bond, supported by the full fiscal and monetary authority of any sovereign. That would require a separate rating and a separate methodology, which Fitch is obviously not in a position to provide at this point.

Final Point

I also found it odd that Fitch should issue a warning on Catalan bonds only. Spanish regional bonds had already been reviewed on 25 July 2014 and were not due for another review until the next year, with no date scheduled. To issue an off-schedule warning means a material change in conditions, and that is almost certainly justified by events (I am arguing that their conclusions are wrong, not the events that lead to their analysis).

What is strange to me is that Fitch shouldn’t consider these same events – the escalating conflict between Spain and her richest region – to be worthy of a warning for the Spanish sovereign. After all, we’re only talking about 20% of Spain’s GDP at play… Let me be absolutely clear: I am not accusing Fitch of taking sides or being partisan in their rating. I think they are being exceedingly cautious after being browbeaten for missing everything in the run-up to the 2008 financial crisis. My only complaint is that I consider their analysis and conclusions to be poor.

It will be very interesting to see what happens on October 24th when Fitch is scheduled to review Spain’s creditworthiness. If this warning is any indication, the sovereign must be impacted as well.


 

Sources and Notes:

[1] “Fitch Places Autonomous Community of Catalonia and Institut Catala de Finances on RWN,” Fitch Ratings, 29 September 2014

[2] For long-term bonds, Fitch’s rating of BBB- is the lowest investment grade rating available; for short-term issues, it is F3.

3 It would actually be closer to 120% of GDP, since Spanish debt has increased by about that much since the 31st of December 2013.

4 “Las CCAA del FLA reciben hasta agosto 14.806 millones, con Cataluña en cabeza,” Agencia EFE, 22 September 2014

[5] Budget. 2009 – 2014, Statistical Yearbook of Catalonia, Departament d’Economia i Coneixement, Generalitat de Catalunya

[6] Idem

Fitch Places Autonomous Community of Catalonia and Institut Catala de Finances on RWN   Ratings  Endorsement Policy
29 Sep 2014 2:06 PM (EDT)

Link to Fitch Ratings’ Report: Autonomous Community of Catalonia – Rating Action Report

Fitch Ratings-Barcelona-29 September 2014: Fitch Ratings has placed the Autonomous Community of Catalonia’s (Catalonia) and Institut Catala de Finances’ (ICF) Long-term foreign and local currency Issuer Default Ratings (IDR) of ‘BBB-‘ on Rating Watch Negative (RWN). Their Short-term foreign currency IDRs of ‘F3’ have also been placed on RWN. Catalonia’s EMTN programme and bond issues, rated ‘BBB-‘, were also placed on RWN.

Under EU credit rating agency (CRA) regulation, the publication of International Public Finance reviews is subject to restrictions and must take place according to a published schedule, except where it is necessary for CRAs to deviate from this in order to comply with their legal obligations.

Fitch interprets this provision as allowing us to publish a rating review in situations where there is a material change in the creditworthiness of the issuer that we believe it inappropriate for us to wait until the next scheduled review date to update the rating or Outlook/Watch status.

The last scheduled review date for Fitch’s ratings of the Autonomous Community of Catalonia was on 25 July 2014 and the next review date for 2015 has not yet been set.

KEY RATING DRIVERS

The Rating Watch action reflects increased tensions between the central and regional government of Catalonia following the latter’s unilateral call for a non-binding consultation on the future of the region within Spain or as an independent country, on 9 November.

The Rating Watch action on ICF reflects the credit links of the institute to Catalonia.

The President of Catalonia, Artur Mas, signed the law calling for the non-binding “consultation” to be held on 9 November. However, the central government has labelled this consultation as a referendum in disguise, adding that only the central government can call a referendum. The central government will be submitting a recourse to the constitutional courts to provisionally freeze the process. Nevertheless, tensions between both governments are likely to increase, particularly in the run-up to the consultation date.

Presently Catalonia is at the rating floor that Fitch introduced for all Spanish regions on 8 March 2013 of ‘BBB-‘. The rating floor was established to reflect the central government’s support for autonomous communities through various instruments, including access to the regional liquidity fund (FLA).

However, this floor is also subject to the co-operative relationship between the regions and the central government and Fitch considers this as difficult in the case of Catalonia under present circumstances. Fitch believes that Catalonia will require additional funding from the FLA in 2015 and because of difficulties in accessing the international capital markets the region is likely to remain highly dependent on FLA for funding. International investors are also unlikely to purchase bonds issued by the regional government given present political uncertainty.

Although Fitch expects that the central government would continue to financially support Catalonia, as a default would have negative implications for all regions trying to access the capital markets, as well as for the central government, Fitch believes that developments over the next six weeks are likely to complicate the relationship between Catalonia and the central government.

Fitch will closely monitor the steps that both the central and regional governments would take in the run-up to the consultation date to ensure readily available financial support from the central government, which is key to maintaining the rating floor for Catalonia. Fitch will maintain the rating floor for all other Spanish regions.

RATING SENSITIVITIES

Fitch expects to resolve the rating watch within the next three to six months pending developments over the consultation. If the floor is removed for Catalonia, the region’s rating is likely to be downgraded by at least two notches.

Contacts:

Primary Analysts
Guilhem Costes (Catalonia)
Senior Director
+34 93 323 8410
Fitch Ratings Espana, S.A.U.
Paseo de Gracia, 85,
Barcelona 08008

Ines Callahan (ICF)
Associate Director
+34 93 323 8747
Fitch Ratings Espana, S.A.U.
Paseo de Gracia, 85,
Barcelona 08008

Secondary Analysts
Patricio Novales (Catalonia)
Analyst
+34 93 467 8417

Guilhem Costes (ICF)
Senior Director
+34 93 323 8410

Committee Chairperson
Raffaele Carnevale
Senior Director
+39 02 87 90 87 203

Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com; Athos Larkou, London, Tel: +44 203 530 1549, Email: athos.larkou@fitchratings.com.

Additional information is available on www.fitchratings.com

Applicable criteria, “Tax-Supported Rating Criteria”, dated 14 August 2012, “International Local and Regional Governments Rating Criteria outside the United States”, dated 23 April 2014 and “Ratings of Public Sector Entities” dated 4 March 2014 are available at www.fitchratings.com.

Applicable Criteria and Related Research:
Tax-Supported Rating Criteria 
International Local and Regional Governments Rating Criteria – Outside the United States
Rating of Public-Sector Entities – Outside the United States

Additional Disclosure
Solicitation Status

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY’S PUBLIC WEBSITE ‘WWW.FITCHRATINGS.COM’. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH’S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE ‘CODE OF CONDUCT’ SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE

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Discussion

4 Responses to “Why the Fitch Warning on Catalonia is Totally Wrong”

  1. About apocalypse if Catalonia becomes independent, perhaps you would smile reading my post in my bloc, “Commonmisery”:
    http://blocs.mesvilaweb.cat/solbalaguer

    Posted by Soledat Balaguer | October 2, 2014, 11:06
    • Dear Soledat,

      For the record, I don’t believe in the “apocalyptic” scenario upon independence. I don’t think it will be a gravy train either; but no nation as industrialized, as educated, and as well situated in Europe will be in trouble for very long. In fact, I would argue that the best thing that could happen to the Catalan economy would be to get kicked out of the Euro, were it not for Catalonia’s external energy dependence (unlike the Basques, who are sitting on top of one of the largest shale gas fields in Europe).

      Posted by fdbetancor | October 2, 2014, 13:02

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