Catalan separatists could hold key to Spain's electoral gridlock

* LATEST DEVELOPMENTS

* Stocks, bonds fall as no party or bloc clinches majority

* Spain faces lengthy negotiations or fresh election

* PM Sanchez has more options with regional parties

* Exiled Catalan independence leader signals tough stance

BARCELONA/MADRID, July 24 (Reuters) - A Catalan pro-independence party could hold the key to unlocking Spain's political gridlock after a national election ended in a hung parliament.

The centre-right People's Party (PP) and the far-right Vox won the most parliamentary seats in Sunday's ballot with a combined 169 - short of the 176 seats needed for a majority despite poll predictions the bloc was on course for an outright victory.

The ruling Socialists (PSOE) and far-left Sumar won 153 seats - a better than expected performance.

The PP will be given the first stab at trying to cobble together enough votes in parliament to form a government. But its alliance with Vox and tough stance on separatism will make it difficult to gain support from any other faction.

Prime Minister Pedro Sanchez looks to have better chance of negotiating support from small Basque and Catalan separatist parties, as he did following 2019's election.

Sanchez could win over left-wing separatist party Esquerra Republicana de Catalunya (ERC), which has seven seats. But he will likely also need the backing of the more hardline Junts, which has not supported him in the past four years and also holds seven seats.

Thus the former Catalan regional government president Carles Puigdemont, who lives in self-imposed exile in Belgium since leading a failed push to split Catalonia from Spain in 2017, unexpectedly finds himself a potential kingmaker.

If Sanchez can secure the five seats from the PNV, six seats from Bildu - both pro-indepedence Basque parties - and seven seats from ERC, as he did in 2020, an abstention from Junts would still be enough for his PSOE-Sumar coalition to win an investiture vote.

Junts Secretary General Jordi Turull said on Monday he would use the "window of opportunity" created by the election impasse to achieve Catalan independence.

"The state knows that if it wants to negotiate with us, there are two issues that are fundamental and generate consensus in Catalonia which are an amnesty and self-determination," he told local radio station RAC 1.

Turull was among the nine Catalan jailed separatist leaders pardoned by Sanchez in 2021 for their role in the 2017 independence bid. However, many more are still facing trial, chief amongst them Puigdemont.

Puigdemont, who still wields considerable influence within Junts, said in mid-July the party would not support Sanchez because he was unreliable. Early on Monday he tweeted that Junts is a party that keeps its word.

Puigdemont was stripped of the immunity he had as a member of the European Parliament earlier this month, paving the way for his extradition. Spain's prosecutor on Monday reissued a capture order against Puigdemont. He could face between 6-12 years in prison for embezzlement, the prosecutor's office said.

The Catalans are likely to play hardball in any negotiations as rapprochement with Madrid has not worked in their favour, said Joan Esculies, a writer and analyst on Catalan politics.

"The independence movement continues to lose votes," Esculies said. "The only thing that keeps them in the headlines right now is the fact that the combination of seats means that Junts' and Puigdemont's decision...holds the key to the formation of the government."

DIFFICULT SITUATION

Going into the election, the PP had looked set to forge a winning alliance with Vox - an outcome that would have brought hardline nationalists into government for the first time since the end of the Franco dictatorship and Spain's return to democracy in the 1970s.

PP leader Alberto Nunez Feijoo has claimed victory and urged other parties not to block his bid to form a government for the sake of stability in Spain.

"It is a very difficult situation to resolve," a Vox official told Reuters.

If neither bloc is able to garner enough parliamentary support to form a government, a second election around Christmas-time is probable, Eurointelligence said in a note.

A PSOE source said the party was confident of reaching an agreement but that negotiations would take time.

"We are sure about that, and that there will be no repetition (of the election)," the source said.

Spanish stocks fell and government bond prices dipped in early trading amid the prospect of a protracted deadlock.

"Absent a majority from either the right or left side of the political fence, the outcome of the election will bring up weeks, if not months, of political uncertainty to an already weak Spanish economy," said Luis Enrique Silvia Yanez, an economist at Moody’s Analytics.

The law does not set a deadline for the process but if no candidate secures a majority within two months of the first vote on the prime minister, new elections must be held.

Another PSOE source said the party would let the PP make the first attempt at forming a government.

"There's no rush, let Feijoo do what he wants to do," the source said. "The next step is to go on holiday."

(Reporting by Joan Faus in Barcelona, and Belen Carreno and Emma Pinedo in Madrid; additional reporting by Inti Landauro; writing by Charlie Devereux, Editing by Angus MacSwan and Aislinn Laing)