Political uproar in Spain and Italy are rattling investors and shaking voter confidence just as stability is needed to push through economic reform measures to save their economies.
The political turmoil translated into sharply higher bond yields in Spain and Italy on Monday, reversing a downward trend that began last August, when the European Central Bank agreed to backstop any euro zone country in danger of getting shut out of the debt markets.
Spain's 10-year bonds rose a hefty 23 basis points, to 5.44 per cent, the biggest one-day rise since September, as allegations of secret slush funds continued to hammer the centre-right government of Prime Minister Mariano Rajoy. Spanish yields are now higher than they were a year ago. Italian yields were up 14 basis points to 4.48 per cent. (A basis point is 1/100th of a percentage point.)
The euro fell more than 0.5 per cent and the main European indexes lost about 1.5 per cent.
"Investors are once again being spooked by political uncertainty from both Spain and Italy as both countries deal with local political difficulties that could derail ongoing and future reform programs," said Michael Hewson, senior market analyst at CMC Markets UK.
Mr. Rajoy, leader of the Popular Party, is under pressure to resign because of the scandal that has dominated the media in recent days.
On Saturday, after two days of silence, Mr. Rajoy denied taking under-the-table payments. "Never, I repeat never, did I receive or hand out black money, not in this party nor anywhere else," he said.
He declared his innocence again Monday, in Berlin, where he met German Chancellor Angela Merkel and vowed that the controversy would not weaken his government. "I have the same desire, hope, strength and courage [as I did] when I arrived," he said.
Ms. Merkel declared that Mr. Rajoy's government had the German government's "full trust" in fixing Spain's economic and financial crisis, which has seen the jobless rate climb relentlessly to 26 per cent, the highest in the Western world.
Media reports allege Mr. Rajoy and some Popular Party colleagues operated a double accounting system to make secret cash payments to party officials.
A Madrid analyst, who did not want to be identified because his firm occasionally does work for the government, said the slush-fund allegations could not come at a worse time for the government. "Voters will lose confidence in the whole political system," he said. "It is dangerous when the government is asking for sacrifices from the people."
The Italian trouble is related to Italy's third-biggest bank, Monte dei Paschi di Siena, which has received two government bailouts and may yet have to be nationalized as its losses mount.
The bank is closely associated with Italy's Democratic Party, whose chief, Pier Luigi Bersani, is leading in the polls, though slipping from his highs as former prime minister Silvio Berlusconi makes a late surge before the Feb. 25 general election. "The Monte [banking] scandals now look like overwhelming the Italian election campaign and put Bersani and the Democratic Party's victory at risk," James Walston, political commentator at the American University of Rome, said in his Monday blog.
The Monte controversy centres on allegedly unreported derivatives deals. The bank, now under new management, has admitted that the derivatives losses might total more than €700-million ($945-million).
The bank is also accused of vastly overpaying for Italy Antonveneta in 2007, when it was owned by Spain's Santander bank. Monte paid €9-billion for the bank, representing an earnings multiple that was roughly twice the going rate at the time.
The sharp rise in the euro in recent weeks has also raised the anxiety levels of investors, who fear the feeble European recovery will collapse as the common currency gains momentum, hurting exports. Since the summer alone, the euro is up 30 per cent against the yen, though less so against the dollar and pound.
In a Monday note, ING Financial Markets economist Carsten Brzeski said the soaring euro effects different countries in different ways. Spain and Portugal, which mainly export to other euro zone countries, would not be hurt much. But other countries that rely heavily on exports outside the region will face new problems. France and Italy, he said "could be pushed into new crisis territory on the back of the stronger euro."