The City of London has long viewed the European project with a mixture of cynicism and detachment, and this week’s political theatre in Madrid does little to alter that perception. Pedro Sánchez, Spain’s Prime Minister, is once again performing a high-wire act to remain in office, relying on a patchwork of regional parties and a reluctant legislature. The spectacle would be merely entertaining were it not for the signal it sends about the fragility of the eurozone’s fourth-largest economy.
British institutions, from the Bank of England to the Treasury, are watching closely. Not out of solidarity, but because instability in Spain has a habit of rippling through European bond markets. Spanish 10-year yields have already crept up 15 basis points this week, a haircut that investors are pricing in for the privilege of holding Spanish debt. The spread over German bunds meanwhile has widened to 85 basis points. That is not a crisis, but it is a warning shot.
Sánchez’s margin for error is shrinking. His coalition government survives on a knife edge, dependent on votes from Catalan separatists and Basque nationalists. These are not reliable partners; they demand concessions that undermine fiscal discipline. The Prime Minister’s recent budget negotiations saw him promise increased spending on regional autonomy, a move that will do little to reassure markets already nervous about Spain’s public debt to GDP ratio hovering near 110%. The Bank of Spain’s own forecasts project that the deficit will exceed 3% this year, breaking EU fiscal rules with impunity.
This is where British scepticism meets reality. The European Commission has warned Spain about its excessive deficit, but Brussels has shown little appetite for enforcing rules when it comes to large member states. Sánchez knows this. He gambles that the EU will look the other way, just as it did with France and Italy. But markets are less forgiving. Capital flight from Spanish bonds into safer assets like UK gilts or German bunds is quiet but persistent. The pound has strengthened against the euro this week, not because of stellar UK growth, but because investors seek refuge from peripheral eurozone risks.
The Bank of England’s Financial Policy Committee, meeting next week, will take note. While the direct exposure of British banks to Spanish sovereign debt is limited, the contagion channel through European banking stocks is real. A Spanish political crisis could trigger a broader sell-off in European equities, dragging down London-listed stocks that derive significant revenue from the continent. The FTSE 100 closed flat on Tuesday, but the midcap index lost 0.4%, driven by financials with European exposure.
Sánchez’s survival instincts are strong. He has reshuffled his cabinet, appointed a new economy minister, and promised to accelerate structural reforms. But the structural reforms he touts are vague: labour market flexibility, pension sustainability, and digitalisation. These are the same promises made by his predecessors. The International Monetary Fund’s latest Article IV consultation on Spain notes that ‘implemented reforms have been partial and their impact on productivity is yet to be seen.’ Translation: all talk, no action.
Meanwhile, the European Central Bank finds itself in a bind. It has signalled that rate cuts are coming, possibly as early as June, to support a sluggish eurozone economy. Lower rates would provide relief to Spain’s heavily indebted government, reducing its debt servicing costs. But they also risk fuelling inflationary pressures in the services sector, which remains stubbornly high at around 4%. The ECB’s dilemma is Spain’s opportunity. For now.
What does this mean for British savers and investors? The lesson is simple: diversify. UK inflation is showing signs of easing, with the CPI expected to dip below 2% by the summer. Real yields on index-linked gilts are positive again, offering a genuine hedge against both rising prices and European political risk. The prudent portfolio manager will increase allocation to domestic bonds, reduce exposure to peripheral European equities, and keep a watchful eye on the pound. Sterling’s resilience is not a vote of confidence in UK economic management; it is a vote of no confidence in the eurozone’s ability to handle its own house of cards.
Spain will not collapse tomorrow. Sanchez will likely survive the next confidence vote. But the underlying rot of political fragmentation and fiscal profligacy remains. The City remembers that every European crisis in the past decade has started with a political tremor in a peripheral state. This tremor may yet become a quake.
Alastair Thorne, Chief Financial Editor
