Investors cast doubt on Spain’s rosy economic picture by Fortune Editors @FortuneMagazine May 30, 2013, 9:41 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons A disastrous share offering in Madrid earlier this week portends continued economic trouble for Spain and, quite possibly, for the European Union. Shares of Bankia, the nationalized Spanish lender, fell by as much as 21% Tuesday as the bank issued 11.5 billion new shares in a bid to boost the bank’s depleted capital base. The drop added to losses sustained last week when institutional investors sent Bankia’s share price down by a whopping 50%. Overall, the bank’s shares have lost 80% of their value since it was formed in 2011. The Bankia share sale wasn’t supposed to go so terribly wrong — indeed, the government, which ordered the move, thought it would evoke confidence in the badly-damaged Spanish banking system. Instead, the Bankia bungle has raised new questions on Wall Street as to the true state of the Spanish banking system, as well as Spain’s overall economic trajectory. Thought to be bottoming out from a terrible recession, Spain may actually be in far worse shape than the market believed. So much so, in fact, that investors and analysts have started to openly question the validity of economic data issued by the Spanish government. If it’s discovered that the banks or the government have been fudging the numbers in any way, then whatever confidence the market once had in Spanish sovereign debt and that of other troubled European nations would be totally wiped away, potentially setting off another destructive round of attacks against European sovereign debt — one that might ultimately prove fatal to the euro. Spain has enjoyed a bit of a holiday of sorts from the tumultuous and seemingly never-ending European debt crisis. This year the markets have been mostly concerned with Cyprus and its failed banking system and Italy with its dysfunctional political system. During that time Spain was able to issue enough long-term debt at relatively low interest rates, with the Spanish 10-year bond dipping below 4% in May for the first time since 2010, thus allowing the government to continue borrowing sufficient cash at low rates to support its mounting debt load. The nation’s conservative government, led by Mariano Rajoy, has tried to curb spending in an attempt to balance the nation’s budget. The government has told the public that it has been able to cut the nation’s budget deficit to just 7% of GDP — down from 11.2% in 2009. It has eliminated nearly 400,000 government jobs and brought labor costs down to where they were in 2005. Spain also posted a current and capital account surplus for the first time in 15 years and an overall trade surplus for the first time in 40 years. And while the government reported last quarter the nation’s GDP was still contracting, falling 0.5% from the prior quarter, it wasn’t seen by the markets as being terribly bad. MORE: Lloyd Blankfein is wrong about Europe Given the relatively positive economic outlook relayed by the Spanish government it is odd that the Bankia share sale would go so horribly wrong. It is possible that Bankia is a unique exception and is therefore not a great reflection of Spain’s overall economic recovery. But that’s hard to believe given its size, encompassing 10% of the nation’s deposits and 10% of its mortgages. A more plausible explanation for the busted offering is that Spain’s economy isn’t performing as well as Spain’s government is saying. Banks are notorious for underreporting loan losses tied with bad bets in an attempt to look healthier to investors. For example, Spanish banks maintained that their net loan losses averaged just 3% from 2008 to 2012, even as unemployment in the nation during that time rose from 10% to 25%. That simply made no sense given the positive correlation of bank loan losses with unemployment. Eventually, the Spanish banks were forced to come clean and admit they were sitting on a bunch of non-performing assets, leading to last year’s bailout. Has the Spanish government taken a page out of the banks’ playbook and started fudging their numbers to try and fool the markets into believing that Spain is on the road to recovery? Some on Wall Street have started to openly question the validity of Madrid’s rosy economic indicators. Michael Cembalest, the chief investment officer of J.P. Morgan JPM , posited in a recent note as to whether or not it was wise for the markets to accept Spanish GDP data at face value. Cembalest, who was one of the only bank investment officers who refused to put his clients’ money in funds run by Ponzi master Bernard Madoff, noted a number of strange economic indicators based on Spanish GDP numbers — indicators that seem to show that the GDP numbers coming out of Madrid aren’t to be trusted. MORE: Young U.S. workers are worse off than in parts of Europe Cembalest isn’t the only one on Wall Street with doubts. Traders who deal in sovereign debt have told Fortune that they are beginning to take a closer look at Spanish economic data from other sources, such as the OECD, which came out with a pretty grim report on the state of the Spanish economy on Wednesday. It projects the unemployment rate in Spain will continue rising in 2013, peaking next year at 28%, and that Spanish GDP will contract 1.7% this year, four times as much as it did last year. Sovereign debt investors count on governments to report the truth. Those countries with transparent and solid economic statistics attract more capital and pay lower interest rates than those that play games with investors. Bankia’s terrible share sale has investors wondering if the Spanish government is playing fast and loose with their economic data. If true, this doesn’t bode well for the EU and its hopes of putting the sovereign debt crisis to bed. If investors no longer trust what one EU government says, they may decide to stop listening to all of them. That could spell disaster for the euro as governments again find it difficult to borrow from the markets. The Spanish government can either step up and make the tough changes needed to tame the recessionary beast, or they can play games with the markets and buy some time.