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Spain's Rajoy Scandal Threatens Europe's Fragile Peace

Spain's Prime Minister Mariano Rajoy attends a Parliament session in Madrid

Photograph by Javier Soriano/AFP via Getty Images

Spain's Prime Minister Mariano Rajoy attends a Parliament session in Madrid

(Corrects to reflect that Berlusconi comments were made in a news report rather than an advertisement.)

Just as investors were starting to breathe easier about Europe, the threat of political upheaval in Spain and Italy could send them scurrying away again.

Spanish bond yields spiked Monday to their highest level in seven weeks, as Prime Minister Mariano Rajoy faced calls to resign over reports that he received illegal payments from a political party slush fund. Rajoy vehemently denies the allegation, but new polls show a majority of voters want to call a general election. “The dynamics in Spain are devastating,” strategist Michael Leister of Commerzbank in London told Bloomberg News. An election “would be a real shocker for the market.”

Bond yields also are widening in Italy, where former Prime Minister Silvio Berlusconi has pulled nearly even in polls with center-left opponents who’ve been ensnared in a derivatives-trading scandal. With national elections set for Feb. 24-25, “Political risk is likely to become a more prominent source of market turbulence in the next few weeks,” Francis Yared, head of European rates strategy at Deutsche Bank (DB) in London, wrote in a note to clients.

The fear is that political turmoil could undo a fragile détente that has held since last summer in the euro zone’s third- and fourth-largest economies. Backed by European Central Bank President Mario Draghi’s promise of unlimited sovereign bond-buying, the governments of Rajoy in Spain and Mario Monti in Italy pushed ahead with unpopular austerity and structural reform measures. In the end, the ECB didn’t have to buy either country’s debt, as investors began tiptoeing back in, and borrowing costs fell back to affordable levels.

Now, though, Spain is in an uproar over reports by the newspaper El Pais that Rajoy received more than €277,000 ($375,000) from a secret fund run by the former treasurer of his People’s Party. The newspaper last month published copies of handwritten ledgers kept by the former treasurer that appeared to show regular payments to Rajoy over an 11-year period. A spokesman for the prime minister has said the records were “doctored,” and Rajoy said on Feb. 2 that he was the victim of a smear campaign.

Support for the prime minister appears to be dwindling fast. A poll published by El Pais on Feb. 3 showed his party with only 23.9 percent backing, the lowest on record, while 77 percent said they disapproved of Rajoy as head of government and 54 percent said a general election should be called.

The scandal in Italy revolves around disclosures that former managers of lender Monte dei Paschi di Siena executed secret derivatives contracts to conceal hundreds of millions of euros in losses on prior swaps. There’s no evidence that government officials took part in the coverup, but the former Monti government approved a taxpayer bailout of the bank, which has close connections to the Democratic Party of the Left headed by Pier Luigi Bersani.

Former Premier Berlusconi has taken advantage of the scandal in televised comments linking the bailout to an unpopular property tax. Recent opinion polls show Berlusconi has pulled within five or six percentage points of Bersani, as he promises to roll back tax increases and other austerity measures imposed under Monti. Italian voters are increasingly weary of austerity, as the economy remains mired in recession and is expected to shrink 1 percent this year.

Spain, where unemployment is at 26 percent and the economy is forecast to contract 1.5 percent this year, also is at risk of an austerity pushback. “In a recession of this magnitude, the worst thing that can happen to the Spanish economy is a political scandal,” José Carlos Diez, chief economist at Intermoney in Madrid, told Bloomberg News. “This is a theme that is going to be in the spotlight for a while and could undermine investor confidence if not addressed quickly.”

With reporting by David Goodman, Lukanyo Mnyanda, and Sharon Smyth of Bloomberg News

Matlack is a Paris correspondent for Bloomberg Businessweek.

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