Election Primer: Merkel Chancellor, Grand Coalition Likely

BMI View: Angela Merkel will retain the chancellorship, but the composition of the current government looks likely to change from a centre-right coalition to a grand coalition between the centre-right and centre-left. This implies a slight shift in fiscal, immigration and eurozone policy, and more disagreement on energy policy, but any changes in overall trajectory will be modest.

With a few days to go before the September 22 German federal elections, the outcome is too close to call. We still believe Angela Merkel will remain chancellor, and that a grand coalition between the centre-right Christian Democrats (CDU-CSU) and centre-left Social Democrats (SPD) is the most likely scenario, although we are much more confident on Merkel staying in office than the nature of the coalition. We also do not rule out a surprise strong showing by the newly founded Alternative for Germany (AfD) party, which is running on a euro-sceptic platform and has surged in the polls over recent months.

Neither the CDU-CSU nor SPD would likely to join a coalition with the AfD if the latter did manage to cross the electoral threshold, but the party could steal potential votes from the centre-right Free Democrats (FDP), the junior member of the current governing coalition. This in turn would make a grand coalition more likely, as the FDP's popularity is currently teetering around the 5% threshold required for Bundestag representation. Another potential surprise could come from a high turnout, since around half of all voters are still undecided, meaning there could see a substantial divergence between official polling and the final result.

Race Not Yet Decided
Germany - How Germans Would Vote Today, %

Election Primer: Merkel Chancellor, Grand Coalition Likely

BMI View: Angela Merkel will retain the chancellorship, but the composition of the current government looks likely to change from a centre-right coalition to a grand coalition between the centre-right and centre-left. This implies a slight shift in fiscal, immigration and eurozone policy, and more disagreement on energy policy, but any changes in overall trajectory will be modest.

With a few days to go before the September 22 German federal elections, the outcome is too close to call. We still believe Angela Merkel will remain chancellor, and that a grand coalition between the centre-right Christian Democrats (CDU-CSU) and centre-left Social Democrats (SPD) is the most likely scenario, although we are much more confident on Merkel staying in office than the nature of the coalition. We also do not rule out a surprise strong showing by the newly founded Alternative for Germany (AfD) party, which is running on a euro-sceptic platform and has surged in the polls over recent months.

Race Not Yet Decided
Germany - How Germans Would Vote Today, %

Neither the CDU-CSU nor SPD would likely to join a coalition with the AfD if the latter did manage to cross the electoral threshold, but the party could steal potential votes from the centre-right Free Democrats (FDP), the junior member of the current governing coalition. This in turn would make a grand coalition more likely, as the FDP's popularity is currently teetering around the 5% threshold required for Bundestag representation. Another potential surprise could come from a high turnout, since around half of all voters are still undecided, meaning there could see a substantial divergence between official polling and the final result.

Given the level of uncertainty, we outline potential coalition governments (it is highly unlikely for any party to win an outright majority) in order of probability, and our expectations for policy mix under the two most likely scenarios. However, we also note that regardless of which of the two most likely scenarios plays out, the difference in policy will be modest, since the CDU-CSU is likely to remain the dominant party, and the upper house (or Bundesrat, which is not up for election on September 22) will continue to be controlled by the SPD and Green Party. In short, under Merkel the government will remain committed to fiscal consolidation, debt reduction, and the policy of Energiewende (energy transition from nuclear to renewables).

Likely Coalition Scenarios

1. Black-Red (CDU-CSU/SPD): Probability 50% - This scenario will also largely depend on whether the FDP gets into parliament. If not, Black-Red is the most likely outcome, although it is also a possible scenario even if the FDP does pass the 5% threshold. There has been some speculation that Merkel would prefer a grand coalition, as it would allow for broad-based consensus on key policies, particularly those related to periphery eurozone bailouts. Therefore, while both Merkel and SPD leader Peer Steinbrueck have ruled out a grand coalition, we view this scenario as slightly more likely than a CDU-CSU/FDP coalition.

Policy Mix Under Black-Red

Fiscal: Calls from the SPD for higher tax and spending (financial transactions tax, tax increase for top earners, statutory minimum wage), but majority of proposals torpedoed by CDU-CSU . The SPD has run on a platform of higher taxes and current expenditure, but Merkel has pledged not to raise taxes. A tax hike would be very unpopular with the electorate, and also unnecessary given the improving economic outlook. If the CDU-CSU does give ground it will likely be on the expenditure front, although with limited risk of diverging from the fiscal consolidation path.

Energy: More disagreement on energy policy, specifically in the areas of shale gas fracking, renewable feed-in-tariffs and the level of government intervention in prices . The main divergence on energy policy between the SPD and CDU-CSU is the level of regulation for the sector. Broadly speaking, the SPD is strongly in favour of greener policies, while at the same time shifting more of the cost from consumers onto big businesses. While Merkel will remain committed to boosting the use of renewable energy, her party will continue to seek ways to ease the cost of this policy in order to maintain competitiveness of German industry.

EU/eurozone: Strong public criticism for eurozone governments that falter on reform agenda, but boosting financial support to governments which have implemented reforms . The SPD has struggled to make any headway in criticising Merkel's eurozone policy, which has received broad-based support from the German electorate. Both parties remain nominally committed to Germany's role at the heart of the eurozone and EU, but both are unwilling to provide carte blanche to governments unwilling to reform. The SPD will succeed in pushing Merkel towards greater dialogue with other eurozone member states, but with limited impact on closer banking and fiscal union.

Immigration: Implementation of policies aimed at making it easier for higher-skilled migrants to enter Germany, although vocal criticism to such policies from within the government . The SPD has been quick to criticise the anti-immigration rhetoric from the Christian Social Union (CSU), the Bavarian sister party of the CDU. With Merkel herself pushing for more high-skilled migrants, a black-red coalition would likely be more open to immigration than the current administration. However, CSU leader Horst Seehofer has said he would not support a CDU-CSU coalition unless Merkel agreed to a car tax on non-Germans, which many critics argued was just another symptom of the party's anti-foreigner stance. We do not expect Seehofer to follow through on this threat, but the CSU is likely to maintain a strong anti-immigration bias to pacify its conservative support base in Bavaria.

2. Black-Yellow (CDU-CSU/Free Democrats): Probability 40% - Continuation of the current government. This scenario will depend on a) whether the FDP can breach the 5% electoral threshold, and b) whether the two parties together can gain at least 47% of the total vote (probably the minimum required to ensure a workable majority). At present, polls suggest the FDP may just scrape through with more than 5%, but that together the two parties have only 45% support, which would be insufficient to form a government. Nevertheless, the FDP often does better in elections than polls suggest, so a continuation of the current administration is still a very realistic scenario.

Policy Mix Under Black-Blue

Fiscal: Continued focus on fiscal consolidation and a reduction of the public sector debt burden towards the 60% of GDP mark (from above 80% at present). However, with the current economic recovery looking sustainable into 2014, consolidation would not necessarily entail any reduction in fiscal expenditure. On the contrary, Merkel's electoral campaign pledged around EUR30bn in additional funding for both capital and current expenditure, although the government has also ruled out any tax hikes to fund this additional expenditure.

Energy: Push for ways to reduce the cost of Renewable Energy Sources Act (EEG) on businesses, such as reduction in future energy subsidies. Although the Free Democrats are more pro-business than the CDU-CSU, both are in favour of reducing the cost of EEG on businesses. Nevertheless, the coalition would be limited in how far it could amend legislation, since the upper house is still controlled by the SPD and Green Party, which both favour placing the burden of adjustment on energy-intensive industry.

EU/eurozone: Little change from the current stance of doing just enough to keep the eurozone together . However, this policy has faced opposition from right-wing members of Merkel's own party, and has also opened up the political space for the emergence of a eurosceptic party, the Alternative for Germany (AfD). Sustained anti-euro pressure from the right would ensure the government continues to criticise fiscal slippage and lack of structural reform elsewhere in the eurozone. Since we believe France and Italy will struggle to implement significant reforms over the next few years, we would expect further deterioration in Franco-German and Italian-German relations under a CDU-CSU/FDP coalition, in turn limiting progress on eurozone banking and fiscal union.

Immigration: Merkel would toe a fine line between encouraging more highly-skilled immigration while appeasing the anti-immigration elements of her own government . In May this year Merkel stated that Germany should do more to boost immigration to overcome the country's demographic decline. However, Christian Social Union (CSU) leader Horst Seehofer is one of the most outspoken critics of lax immigration policy, and following his party's success in the September 15 Bavaria state elections, he may feel confident enough to prevent a more accommodative immigration policy.

Other Potential (Albeit Unlikely) Coalitions

3. Black-Green (CDU-CSU/Greens): Probability 5% - Based on current polling this is a potential coalition government, and the two parties are not that far away on eurozone policies. However, we believe they remain too far apart in terms of ideological leaning and energy policy that they are unlikely to be able to form a workable coalition.

4. Red-Green-Die Linke (SPD/Green/Die Linke): Probability 3% - Barring an unprecedented turnaround in support for the SPD and Green Party, this is the only realistic coalition that could see Merkel replaced as chancellor. However, relations between the two centre-left parties and the far left Die Linke, formed from the remnants of former-East Germany's Communist Party, are so poor that we do not believe they could realistically work together.

5. CDU-CSU/AfD (perhaps with FDP): Probability 2% - Even if the AfD does achieve Bundestag representation, we believe it almost impossible to see Merkel working with the eurosceptic party. While this could provide her with a workable right-wing coalition, and therefore avoid the need for a grand coalition, it would force her to adopt a much more anti-European stance than we believe she (or many within her party are) is willing to take.

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