Centrist hand on tiller of new coalition

ANALYSIS:Angela Merkel's new government faces a difficult balancing act in the coming four years

CORKS POPPED in boardrooms around Germany this week with the news of Angela Merkel's re-election for a second term in office, this time with the pro-business Free Democrats (FDP).

After a four-year compromise grand coalition, the way is clear for Germany's new centre-right government to get down to the work of reforming Europe's largest economy. Or is it?

Things look good on paper: after an estimated 4.5 per cent contraction this year, analysts expect the German economy to grow by about 1.5 per cent next year. Business confidence has bounced back to a year high after reaching a 26-month low in March.

Just how anxious voters are for a centre-right hand on the economic tiller was clear from post-election analysis: the record 15 per cent vote for the liberal FDP was largely down to economic liberal CDU voters who supported the smaller party to prevent another grand coalition.

"With their election decision, German voters have spoken out against more spending and for more economic rationality and efficiency," said Klaus Zimmer, head of Berlin's DIW economic institute. "The election result clearly obliges the elected parties to take a reform path that matches long-term business rationality."

Merkel's new government may, on the face of it, be more pro-business, but it faces a difficult balancing act in the coming four years.

On the one hand, the new administration has vowed to lighten the tax burden on individuals and businesses in the hope of stimulating the economy back to steady growth. On the other, in face of an extra €100 billion borrowing in 2010 alone, the new government has to try and consolidate the budget if it hopes to meet the stability pact deficit criteria ever again.

Business leaders are hoping to see a reform momentum in its first months in office before the tidal wave of red ink hits the public balance sheet next year.

The German Chamber of Industry and Commerce has called for a 100-day action plan. Topping its to-do list are corrections to corporate and inheritance tax, new measures to secure credit lines for businesses and greater labour market flexibility.

Ahead of coalition talks, Merkel has spooked business leaders by saying to expect more of the same centrist style from her. "You will see me in the future as you've had the pleasure to get to know me in the past," she said on Monday at CDU headquarters, standing under a sign reading "The Political Middle-Ground".

"I do hope to develop somewhat but I won't change entirely in the new coalition."

That is precisely what many German business leaders are afraid of.

In 2005, the CDU and FDP ran their election campaigns with nearly identical manifestos, vowing to push even more radical reforms than those begun under Gerhard Schröder. That nearly cost Merkel the election and, after battling a near economic meltdown in the grand coalition, the CDU leader and her election manifesto are much more cautious on economic and business affairs than the FDP.

Tax will be the single most divisive issue when coalition negotiations began. The only economic issue of note in the election campaign, Merkel's CDU has made a vague promise of "moderate" tax cuts worth €15 billion in the coming years, reducing the entry-level rate from 14 to 12 per cent.

FDP leader Guido Westerwelle has a far more ambitious plan to reform the German tax code, reportedly one of the most complicated in the world. He also wants to cut taxes in all bands to 10, 25 and 35 per cent, with extra tax-free allowances for families. Their tax package, worth an estimated €35 billion, is to be financed by debt and by slashing government subsidies.

The FDP wants to increase corporate tax by 10 percentage points to 25 per cent but abolish commercial taxes entirely; the CDU opposes the plan because cutting commercial taxes would starve local authorities of their main source of income.

The two parties disagree, too, on non-wage costs. The FDP wants to see cuts while the CDU programme, mindful of a looming deficit in the state labour agency, talks only of "stabilisation".

More pessimistic analysts say that hard economic times have put paid to the new coalition's reform hopes before it even starts work.

"Reality will soon catch up with this government," said Dr Gustav Horn, the director of the Institute for Macroeconomic Research in Düsseldorf. "The bubble for tax cuts will soon burst with room just for a symbolic tax cut in one area or another."

Most now are predicting a compromise "mini" tax reform - and then a claw-back through an increase in VAT.

Another issue to watch in coalition talks is the issue of hire-fire laws. Reforms in the Schröder era ended rigid labour market provisions and allowed companies with up to 10 employees more leeway to take on and part with workers. The FDP is anxious to extend this to companies with up to 20 employees, a move the CDU opposes.

After 11 years of Social Democrats (SPD) in government, German union leaders have warned of bad times ahead for workers. Services union Verdi has vowed to keep up its minimum wage campaign, saying: "The CDU-FDP government won't simply be able to wipe away social issues."

One of the few areas though on which the parties agree is to put a statutory minimum wage on the back burner.

Germany's energy companies are the first big winners of the new CDU-FDP coalition. Shares in RWE and Eon shot up when trading began in Frankfurt on Monday morning in the expectation that the new government will end a nine-year-old plan to phase out nuclear power by 2020.

Both the CDU and the FDP promised in their election manifestos to allow nuclear power plants to continue operating until the renewables sector is in a position to fill the energy gap.

"We see nuclear energy as a bridging technology," Westerwelle said. "We see no gain in Germany closing down safe nuclear reactors only to be dependent on energy suppliers from the east." One German bank has estimated that abolishing the 2020 deadline will generate for RWE and Eon a double-digit billion euro windfall.

Finally, away from the headlines, the CDU- FDP government is likely to preside over drastic changes to Germany's banking landscape.

In May, the last government agreed a scheme to allow banks to store in off-balance sheet holding companies toxic assets worth an estimated €190 billion.

Aside from the troubled property lender Hypo Real Estate, the institutions which are expected to take advantage of the scheme are Germany's regional state-owned public banks or Landesbanks. Lacking a proper business model, these banks were far deeper in risky, lucrative toxic papers than their commercial rivals and many are queuing up to relieve their balance sheets.

However the federal finance ministry has made it clear that participation in the bad bank scheme will depend on the banks finally conceding to mergers and adoption of business plans that are credible and modest.

By the CDU-FDP government's term is up in 2013, expect Germany's banking landscape to look a lot less crowded.