By Adrian Croft
MADRID (Reuters) - Mariano Rajoy was sworn in for a second term as Spain's prime minister on Monday but may struggle to form a cabinet that can overcome scars left by 10 months of political deadlock and allow him to govern effectively.
The conservative Rajoy was sworn in before King Felipe at Zarzuela Palace near Madrid after winning a parliamentary confidence vote on Saturday, giving Spain a fully-functioning government once more after two inconclusive elections and fruitless coalition talks.
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Rajoy's appointment was not enough to dispel investor concerns over Spain's ability to implement reforms and rein in a burgeoning deficit.
The country's benchmark 10-year bond saw its yield drop slightly in line with most other euro zone government bonds on Monday, while the country's benchmark IBEX stock index .IBEX tracked a weak open across major European stocks.
Rajoy, who will head a minority government with the weakest mandate in Spain's modern history, is working on a new cabinet that must build cross-party support to pass reforms in a hostile parliament.
His team, to be announced on Thursday, will be scrutinized for signs he wants a fresh start by bringing in new faces, even if most are expected to come from his People's Party (PP). There were no immediate leaks on the new cabinet to the Spanish press.
Rajoy, 61, governed with an absolute majority in his first term and was often disdainful of the opposition. Now he must convince opposition parties he is genuine about working with them.
Spain suffered a severe recession during Rajoy's first term when its banks needed a 41 billion euro ($45 billion) European bailout but the economy is now recovering.
The fragmentation of Spain's parliament arose from widespread disillusion with the political establishment and the emergence of new parties at a time of economic hardship, with unemployment peaking at 27 percent, and anger over corruption.
Rajoy has said he is open to dialogue and negotiation, but in an uncompromising speech before Saturday's vote, he urged opponents not to tie his hands, saying: "Spain ... needs a government that is capable of governing."
He will have backing from the liberal Ciudadanos (Citizens) party, the fourth-largest group in parliament, on a list of 150 previously agreed measures.
"Whatever government there is, there will be a change of direction and there will be reform measures," Ciudadanos lawmaker Jose Manuel Villegas told reporters on Monday.
But even with Ciudadanos' votes, Rajoy lacks a majority. He faces hardline opposition from anti-austerity Podemos, the third largest party in parliament.
The Socialists, the second biggest, are licking their wounds over their leaders' decision to permit a Rajoy government after earlier blocking him.
Edoardo Campanella, an economist with Italian bank UniCredit, said the new Spanish government would be weak with every measure entailing "endless and draining" negotiations.
"It is hard to expect the adoption of major reforms like, for instance, a further consolidation of the banking system or a further overhaul of the labor law," he said in a note.
After 10 months of paralysis, urgent issues await Rajoy's attention. First will be a new budget for 2017 to appease Brussels and meet next year's deficit targets, which will require either spending cuts or raising extra revenue.
Rajoy will also have to respond to an independence push by the wealthy northeastern Catalonia region, which plans a referendum next year on breaking away from Spain.
(Additional reporting by Sarah White, Angus Berwick, Abhinav Ramnarayan, Atul Prakash and Dhara Ranasinghe; Editing by Mark Heinrich)