Photographer: Jack Ladenburg
Photographer: Jack Ladenburg

Investors worried about Spain’s political stability have been dumping their Spanish holdings and pushing up the country’s borrowing costs after the eruption late last week of a corruption scandal involving Prime Minister Mariano Rajoy.

Until now, the government’s durability had been one of the few advantages that Spain held over fellow euro-area problem-case Italy, a country that has seen almost as many elections as Christmases over the past few decades and is about to stage another.

In reality, the likelihood that the Rajoy scandal will force the collapse of the current right-of-center government is slim. But investors are right to be concerned, because political stability involves more than the survival of a country’s government -- it also requires the trust of the electorate in the institutions that govern them. Allegations of corruption at the highest level are corroding that trust in Spain.

On Jan. 31, the Spanish newspaper El Pais published copies of what it said were ledgers from secret accounts held by Luis Barcenas, the former treasurer of the ruling People’s Party, which revealed the existence of a party slush fund. The newspaper said 7.5 million euros in corporate donations were channeled into the fund and allegedly doled out from 1997 to 2009 to senior party members, including Rajoy.

The party has denied wrongdoing in a statement, and Rajoy reiterated that position over the weekend and again on Feb. 4, during a news conference with German Chancellor Angela Merkel.

Resignation Request

The denials failed to kill off the scandal. Opposition leader Alfredo Perez Rubalcaba, of the Spanish Socialist Workers’ Party, has called for Rajoy’s resignation, which would spark an early election. Yet it isn’t clear how much good this would do Rubalcaba or his party.

According to the latest opinion survey by Spain’s Metroscopia polling agency, the socialists and Popular Party are neck-and-neck, each supported by less than 25 percent of those polled, and Rubalcaba is less popular than Rajoy. What’s more, only 21 percent of the electorate wants a new election, so the socialists might be punished at the polls if they were to force one.

Another potential trigger for the government’s collapse could be external, as was the case for Italy in August 2011, when the European Central Bank effectively pulled the plug on then-Prime Minister Silvio Berlusconi. The same thing could come about in Spain if bond yields rise high enough to require the ECB to step in and buy bonds, and ECB President Mario Draghi decides that Rajoy and his government have to go before he will open the purse strings. But those are big ifs. A more likely outcome would be a series of resignations and new appointments as the Rajoy administration cleans house.

That said, the scandal will probably increase voters’ resistance to the unpopular reforms that Rajoy tried to introduce. With the euro area’s second-highest level of unemployment -- 26 percent in the fourth quarter of 2012 -- Spain has been one of the countries hit hardest by this crisis. Trying to get the electorate on board for painful labor-market reforms and further wage and pension cuts will be an even harder sell for a government perceived to have been dipping into a slush fund to feather the beds of its leaders.

Even if the Rajoy scandal doesn’t prompt the government’s collapse, it’s deeply damaging. It will drive another nail in the coffin of public trust in Spain’s political leaders and institutions. Confidence was already low following scandals that implicated Barcenas, former Chief Justice Carlos Divar and King Juan Carlos’s son-in-law, Inaki Urdangarin, who faces charges of embezzling funds from charitable organizations.

Little Trust

According to the Metroscopia poll, 76 percent of Spaniards don’t believe the People’s Party’s denials of the slush-fund allegations. Even more damning, 58 percent of the party’s supporters think it’s lying. All of the Spanish businessmen with whom I discussed the latest scandal expect it to get worse before it gets better. Their assumption that there are more skeletons in the government’s closet indicates what little trust they have in their leaders.

As public trust in a country’s government erodes, so will the functioning of its wider institutions. If left to worsen, these failures render a country’s business operating environment unstable and unattractive to investors, who are forced to worry about sudden changes in regulation, corruption and even security.

Any such loss of confidence would be especially problematic for a country such as Spain, which relies heavily on foreign capital and investment to finance its current-account deficit. Spain has an extremely high external-debt burden, probably more than 150 percent of gross domestic product in 2012. If foreign investors perceive the country to be an unattractive place to do business and withdraw their capital, this will spark a severe balance-of-payments crisis.

Spain’s troubles have been billed as an economic crisis, a property crisis, a banking crisis and a debt crisis. It’s all these things. But Spain is also well on the road to an institutional crisis. Unless the government can respond to this latest scandal by proving the allegations wrong or showing that it’s finally serious about eradicating corruption, Spain will take another step away from a return to health.

(Megan Greene is a Bloomberg View columnist and chief economist at Maverick Intelligence. Until 2012, she was director of European economic research at Roubini Global Economics LLC. The opinions expressed are her own. Follow her on Twitter.)

To contact the writer of this article: Megan Greene at megan@maverickintelligence.com.

To contact the editor responsible for this article: Marc Champion at mchampion7@bloomberg.net.