Spanish Economy Shows Glimmers of Hope, but Prime Minister Gets No Love

Mariano Rajoy, Prime Minister of Spain.
Radolpho Saenz | AFP | Getty Images
Mariano Rajoy, Prime Minister of Spain.

It looks like 2013 is going to be another hard year for Mariano Rajoy.

Despite modest signs that his government's draconian austerity program is helping ease Spain's harsh recession, the Spanish prime minister faces a host of challenges in his second year. The economic crisis still has not bottomed out, the threat of secession in Catalonia is growing, Mr. Rajoy's popularity is plummeting, and now a court-led investigation has uncovered a 22 million euro corruption scheme with his Popular Party (PP) that promises to further erode its already fading public support.

"The diagnosis is clear," says Jaime Pastor, political science professor at the Universidad Nacional de Educacion a Distancia and an expert in mass movements. "Rajoy has portrayed himself as the leader who averted a bailout, but instead he is not only facing the territorial challenge of Catalonia, but also infighting from the more radical right wing."

"We are looking at more political and social instability ahead. If investors' trust erodes, if the cost of borrowing increases again, we are looking at a severe political crisis," Dr. Pastor says.

A Hard Road

Rajoy's political woes stem from a grueling economic crisis that began in 2007 when a housing bubble burst, catalyzing a broader recession in every sector that greatly outstripped the state's ability to confront soaring poverty. The central government, as well as regional and municipal governments, turned to credit, and the deficit ballooned to dangerous levels, threatening the broader EU economy.

Rajoy came to office a little over a year ago, after his party swept regional and national elections. The PP won on the national level with a 16 percentage point difference (45 percent to 29 percent) over the runner-up Socialist Party, and with more than enough parliamentary seats to pass any legislation.

But his government has had only limited success in dealing with the debt crisis. Spain's economy contracted for the fifth consecutive year in 2012, by 1.4 percent, and 2013 is forecast to be worse. The ranks of unemployed, which are expected to continue to swell, have already reached 26 percent – the highest in Spain's history – and account for one-third of all jobless Europeans. Meanwhile, evictions continue to skyrocket, and the dramatic social plight is only compounded by unprecedented public spending cuts and tax hikes that have eroded the country's safety net.

Still, there have been modest positive signs. Rajoy has, so far, successfully managed to delay for months what appeared to be an imminent bailout of the Spanish economy, which could yet threaten the European and global economy. His government's draconian austerity measures are showing early positive signs at a macroeconomic level, even if they are far from trickling down, and the market's rates to lend money to Spain have dropped significantly in the past few months.

But even taking into account Spain's economic plight and the backlash that was sure to accompany the government's harsh remedies, Rajoy is still rapidly losing political support, even within his own party, as scandals and a secessionist drive in Catalonia undermine his ability to govern.

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Support for the PP has plummeted 14 percentage points since the November 2011 elections, from 44 percent to 30 percent, while center and more radical left parties have more than doubled their followers, according to a recent poll by newspaper El Pais. Rajoy's approval rating is now only 21 percent, down from 35 percent in March 2012, and 84 percent of Spaniards say they don't trust his leadership.

Tense relations with Spain's European partners over crisis management have diplomatically hurt Rajoy, and rich but indebted Catalonia, the country's economic motor, is also trying to pummel through a secessionist path that is threatening Spanish cohesion.

The Catalonian parliament last week approved a bill legally embarking the region on a path to independence and on a constitutional collision course with the central government. The outcome is uncertain. A new regional leadership in the Basque Country also wants to redefine its ties to Spain, but it insists it will negotiate, rather than impose a path to independence.

Corruption Scandal

But now a years-old court investigation into the PP finances, which has so far incriminated the party's former treasurer and other top leaders, has uncovered a corruption scheme that allegedly involved millions in kickbacks to PP parliament members and former government officials.

(Read More: Spain's Ruling Party Hit by Major Corruption Scandal)

Private donations, many apparently from some of the country's main construction firms, were reportedly funneled as monthly cash envelopes sourced from a 22 million euro ($30 million) secret Swiss bank account held by the PP's former treasurer, according to a rare public acknowledgement by a former PP member of parliament in El Pais last week.

In an effort to control the fallout, Rajoy promised an internal investigation into the PP's finances and external audit, and he has distanced his government from implicated party officials and promised full collaboration with courts, regardless of the consequences.

The court investigation is ongoing and no top government official has been implicated, but it has severely damaged the government's credibility and its ability to govern. And with the rival Socialist Party still mired in its own infighting and unpopularity, there is no obvious alternative to the PP, should the scandal bring it down.

"We will witness the government's loss of legitimacy, but with no alternative from the left, popular disaffection will increase along with the fear of a social explosion," Pastor says.

Government Shakeup?

Dropping lending rates, which allow the government to finance public spending, indicate markets are confident the reforms and EU support are enough to avert a bailout. Exports are growing, the deficit appears manageable, and a recovery could begin in 2014.

But it's all riding on the assumption that the government can deliver on still-pending reforms, which in turn depends heavily on the internal political stability.

In this scenario, analysts are betting a government shakeup to incorporate apolitical technocrats, as opposed to the ideologically-driven PP politicians, will be required to restore credibility.

"I think it's more probable that technocrats are involved to regain public trust, rather than a change of government," Pastor says. "The government will have to curb its spending cuts, though, in this political situation, and the challenge is convincing those outside Spain that the crisis is under control."

EU and European Central Bank officials will visit Madrid in coming weeks to review Spain's economy, and Rajoy has decided to delay intervening in the Catalonian defiance until the region legally makes an unconstitutional move.

Reining in PP infighting will be trickier, though, depending on the court's findings, a debilitating process that could still take months to resolve.

Regardless, Rajoy is running out of political capital, and Spain's ability to return to economic growth will depend on his ability to manage popular frustration, regional defiance, and now his own party's unity.