Merkel backs Spain's embattled PM

Merkel also praised the "impressive" reforms implemented in the southern euro-country, which received a credit line of up to €100 billion for its troubled banks.

"We have a very trusting relationship. The entire Spanish government is working on structural reforms needed to bring the country back to the strength that is commensurate with its size," she said.

The German Chancellor refused to accept any comparisons between the Spanish party funding row and the so-called Spendenaffaere affair, which brought down her mentor and ex-chancellor Helmut Kohl.

"I am convinced the government and Prime Minister Rajoy will succeed in their task and Germany will support them as much as it can," Merkel said.

Rajoy, for his part, strongly rejected the allegations made by his former party treasurer, who claims to have run secret books relating to a tax-dodging account used for under-the-counter payments.

"These accusations are absolutely false. I have the same determination, courage and strength to continue as a Prime Minister. The Popular Party has an absolute majority, we have introduced reforms and we will stay on course to help Spain recover from its worst crisis in 30 years," Rajoy said.

Earlier that day, both the European Commission and the International Monetary Fund said the Spanish bailout programme is on track and further payments can be made.

But the positive news from Spain's donors were overshadowed by the continued political scandal, which has already taken a toll on Spain's borrowing costs.

The interest rate on the 10-year bond jumped by 23 basis points to 5.4 percent.

Meanwhile, Italy's costs also rose as the country is preparing for general elections, with the fate of technocrat PM Mario Monti unclear.

Plagued by record-high unemployment rates and a continued recession, Spanish people have taken to the streets and demanded Rajoy's resignation in protest over the news about the alleged corruption case.

Two rival newspapers - the left-leaning El Pais and the centrist El Mundo - have published documents showing payments to members of the ruling Popular Party. According to the documents, Rajoy collected over €25,000 per year between 1997-2008.

The Spanish opposition is now demanding for Rajoy to resign. An online petition calling for him to step down has gathered more than 740,000 signatures.