By Nigel Davies
MADRID (Reuters) - Spain's deepest economic crisis in decades has disrupted the delicate power balance between the central government and highly autonomous regions like wealthy Catalonia, complicating the country's austerity drive to renew investor confidence.
Spain's 17 autonomous regions were granted autonomy in the 1978 Constitution recognizing their nationalistic ambitions, but the bulk of power remained in Madrid.
The regions account for around 50 percent of public spending, almost all of it on health and education, but most have few powers to collect taxes, so depend on transfers from the central government.
Over the years, the culturally and linguistically distinct Basque Country and Catalonia have used their nationalist parties' clout in the national parliament to win concessions from the central government and deepen their autonomy.
But now, with the euro zone debt crisis mounting, the economy in its second recession since 2009, and the regions blamed for overspending, the central government has passed new rules allowing it to take control of budgets of regions that cannot meet tough deficit targets as soon as May.
Spain's regions missed deficit targets by a wide margin last year and international investors are keen to see signs that the central government will not let them overspend again as the country battles to avoid a bailout like neighboring Portugal.
This week the central government rejected draft budgets from northeastern Catalonia and southern Andalucia, which together make up almost a third of the country's economy.
The central government is changing rules so that regions can hike university fees and charge more for medication, moves that could well spark street protests. But so far marches and a recent general strike have been largely peaceful.
The regions are seen bowing to the tough controls because the crisis has eroded their credit ratings and they are depending on the central government for financing.
But even if they pull together to cut costs, Spain will struggle to meet its deficit goal of 5.3 percent of gross domestic product this year because the economy is in recession and falling income will hit revenue.
CHANGE THE MODEL?
The conservative People's Party is seen as less respectful of regional autonomy than the Socialists, who voters kicked out in November after seven years in power.
Some PP leaders have used the crisis to suggest openly the need for an overhaul of the regional model, returning powers to the centre after 30 years of autonomy.
Esperanza Aguirre, the powerful PP head of the region of Madrid, last week met Prime Minister Mariano Rajoy and proposed the regions hand back control of health and education to the central government.
The idea was quickly dismissed by Rajoy's administration, but the flames had already been ignited.
"There is growing tension between Madrid and Catalonia; things cannot go on like this. There's a lot of people who are infuriated here," said Ramon Tremosa, European member of parliament from Catalan ruling party CiU, which is centre-right like the PP.
Some of the most intense protests to date against austerity have been in the Catalan capital Barcelona, where hundreds of thousands marching against labor market reforms last month also carried banners calling for more independence.
Tremosa said the central government's drive to increase control was unfair since Catalonia was making deeper cuts.
Catalonia pledges fiscal discipline, but argues that it should have more control over its taxes, following the example of more federal states like Germany.
"Will this government that has always seen Spain as a unified nation governed from Madrid, will they consider that freedom to manage is the best solution in order to improve public finance?" Albert Carreras, economy secretary for the Catalan government, told Reuters.
While the populous and relatively poor southern region of Andalucia does not have an independence movement like Catalonia, it poses problems for the austerity drive. It is the biggest region still in the hands of the Socialists, who are expected to forge an alliance with a smaller leftist party to govern it.
Yet Andalucia's financial plight will most probably force change.
"In Andalucia once the government is established it won't have any choice but to make a pact with the central government because it needs financing and to pay its providers. Andalucia also has the highest unemployment rate in the country so it urgently needs policies to generate jobs," said Jose Ramon Pin, professor at the IESE business school.
Leftist parties and labor unions have accused the central government of violating the constitution by increasing control over regional spending.
But Pin, a former member of parliament who signed the 1978 Constitution, said that changes so far made by the PP were purely technical.
The 11 regions that are ruled by the PP have all signed up to the government's austerity plan, and other regions are expected to fall into line because the central government has agreed to loan them 35 billion euros ($46.00 billion) to meet outstanding payments to suppliers in return for fiscal discipline.
"One of the biggest doubts over Spain is the state of the regions. But we are going to intervene in regional finances if they cannot reduce their costs. They have no alternative but to cut their deficit," said a high-ranking government source.
The main factor that could knock the deficit off target is a steeper than expected recession that would reduce tax income at all levels of government and erode the 42 billion euros in savings that Rajoy pledges for this year.
"There are substantial risks to the downside that could jeopardize credible reform efforts. There is an ongoing process to pay down debt going on across a number of sectors which creates a toxic mix for growth," said Silvio Peruzzo at RBS.
He said it was hard to estimate the fall in revenues this year, though expected that the government may need to embark on more measures, such as raising value-added tax, which is low compared with other European Union countries. ($1 = 0.7609 euros)
(Reporting by Nigel Davies; editing by Elizabeth Piper)