The City is watching Madrid with a mixture of schadenfreude and concern this morning. Pedro Sánchez, Spain’s prime minister, is clinging to power by his fingernails as a fresh wave of corruption allegations rocks his administration. For UK investors, this is not merely a continental sideshow. It is a reminder that political risk in the eurozone is never truly dormant, and that the ‘Spanish premium’ on sovereign debt can reawaken with alarming speed.
The immediate trigger is a judicial investigation into alleged influence peddling involving members of Sánchez’s Socialist party. While the PM himself is not directly accused, the timing could not be worse. His coalition government has been fragile for months, reliant on support from Catalan separatists and hard-left Podemos. Any defection could trigger a snap election, and markets hate uncertainty more than they hate bad news.
The reaction in bond markets has been muted but telling. Spain’s 10-year gilt yield has crept up 8 basis points this morning, widening the spread over German bunds. This is hardly a crisis, but it is a reminder that peripheral eurozone debt carries a political risk premium that can spike without warning. For UK institutional investors who have loaded up on Spanish government paper in search of yield, this is a yellow card.
More worrying is the potential for contagion. If Sánchez falls, the most likely successor would be Alberto Núñez Feijóo of the centre-right Popular Party. But Feijóo would need to form a coalition, possibly with the far-right Vox, which would be a first since Franco’s death. That prospect unsettles Brussels and could trigger capital flight from Spanish assets. UK-based hedge funds are already gaming out scenarios for a sharp sell-off in Spanish equities.
For the UK economy, the direct impact is marginal. Spain is a significant trading partner, but not in the same league as Germany or France. The indirect channels are more important. A Spanish crisis would reignite fears of eurozone fragmentation, pushing up borrowing costs for Italy and Portugal as well. That, in turn, would strengthen the euro against the pound, hurting UK exporters. The Bank of England would then face a dilemma: raise rates to support the pound, or cut to stimulate growth? Neither option is palatable.
There is also the question of fiscal discipline. Sánchez’s government has run up a large deficit, and his budget plans are predicated on optimistic growth assumptions. If political turmoil causes investment to stall, those numbers will look even more unrealistic. The European Commission’s new fiscal rules, which require debt reduction, could force a harsh austerity programme on any new government. That would be a drag on the entire eurozone, and by extension, on UK demand.
Let’s be clear: this is not 2012. The eurozone has a banking union and a pandemic recovery fund. The European Central Bank has new tools to prevent a bond market meltdown. But those tools have never been tested in a crisis of political legitimacy. If investors start to doubt that Spanish debt will be repaid, no amount of ECB firepower can stop a run. The UK’s exposure is significant: UK banks hold roughly £30bn of Spanish sovereign and corporate debt, according to Bank for International Settlements data.
The bottom line is that Sánchez’s survival is now a test for market confidence. If he falls, gilt yields will spike across the periphery, and the pound will take a hit. If he scrapes through, expect a relief rally. But the underlying rot remains: Spain’s economy is growing too slowly, its public debt is too high, and its politics are too fractured. That is a toxic combination that no prime minister can fix overnight.
For UK investors, the message is simple: diversify your eurozone exposure, hedge against political risk, and keep a close eye on the spread. The Spanish soap opera is far from over, and the final act could be expensive.
This is not a crisis. Yet. But markets are priced for calm, and politics has a nasty habit of shattering that calm without warning. Watch the Spanish 10-year yield. If it breaks 4%, start worrying.
