The leader of the Christian Democratic Union (CDU) has a healthy position in the polls and has been boosted by an impeccably timed improvement in the Euro-zone economy. Yet, while Merkel’s lead looks solid, the polls increasingly suggest that a coalition of several parties will be required. Whether Merkel is a strong or a weak Chancellor matters enormously for the rest of Europe.
Two main scenarios are likely, either the existing coalition prevails, between the CDU and its junior partner, the pro-business Free Democratic Party (FDP), or it is replaced by a ‘grand coalition’ of parties. Last weekend’s Bavarian state elections appeared to put a dent in the prospects of the first scenario, or at least suggest that if the incumbent coalition survives it would carry a much smaller working majority. While Merkel’s sister party, the conservative Christian Social Union did exceptionally well in these polls, the FDP’s share of the vote slumped to 3.3%, significantly below the 8.0% it secured in 2008.
The alternative option would be a grand coalition between Germany’s two main parties, Merkel’s conservatives and the centre-left Social Democrats (SPD). While financial markets may interpret this outcome as a positive one for European assets, as the SPD are widely seen as supportive of growth and more accommodative on assistance for debt-laden peripheral euro members, we should be careful to avoid exaggerating the impact. It is true that the SPD have been campaigning based on a more aggressive public works programme, with infrastructure improvements in areas of transport, education and broadband a priority. However, the party has also been quite explicit that any spending on infrastructure renewal be funded by a higher tax platform – reckless pump priming can be ruled out then. They are also more in favour of a financial transactions tax, which could have serious implications for trading in European financial markets.
The party may also be less minded to adopt a softer, debt-forgiving approach toward Europe than the markets currently assume. Indeed, interviews with party leader Peer Steinbruck suggest there is actually very little difference between the SPD and the CDU when it comes to the ‘solidarity in exchange for solidity’ approach adopted by Merkel on sovereign debt.
All that means the formation of a government need not be particularly swift. Such a coalition is likely to be secured only after a round of protracted political horse trading – which could take weeks or even months. Things may be further complicated if the Euro-sceptic Alternative fuer Deutschland (AfD) party manages to break the important 5% barrier. They are consistently polling around 3-4%, but opinion polls have large margins for error, particularly when it comes to new parties. What is certain is that a 5% turnout for AfD would likely come at the expense of the CDU’s current partner, the FDP, and hasten the prospect of a grand coalition. A high AfD turnout may also influence thinking from all the major parties and nudge Merkel’s position to a more hard-line stance.
What implications will the election have for the wider Euro-zone? The first thing to say is that Merkel appears to be feeling rather vindicated that the recent uptick in European growth is just reward for the efforts of member countries on fiscal discipline, structural reforms and rebuilding faith in the sovereign debt markets. The question going forward is whether she will seek to build on this success in her third term in an attempt to cement a positive legacy for the Euro-zone? With unemployment still at generational high levels across the region, there is a growing, perhaps overly-optimistic sense, that Merkel will indeed become more proactive. This may include more forceful attempts to encourage the French to embrace structural reform in exchange for greater German debt solidarity for the periphery and shoring up a backstop for banking union. Other difficult questions lie ahead though, such as the willingness to provide even more debt relief for countries such as Greece.
Of course, envisioning a positive legacy for the Euro-zone is far more difficult than achieving it. Progress on the building of pan–European institutions and the ceding of sovereignty remains unlikely without the region being in crisis mode. We believe that the path of least resistance will continue to be found. A solution to more onerous issues such as banking union may remain elusive, while credit growth in the periphery will take time to recover, it is therefore likely that the Euro-zone economy will continue to lag the rest of the developed world – a relatively helpful backdrop for European bond investors.