With Germany facing weeks of political uncertainty after the weekend general election produced an inconclusive outcome, Gerhard Schroeder's challenger Angela Merkel this afternoon reversed her decision to rule out talks with the outgoing chancellor.
Mrs Merkel's leadership of the conservative Christian Democrats (CDU) is in doubt after a massive poll lead was squandered during the campaign leading to her party managing just three more seats than Mr Schroeder's centrist Social Democrats (SPD).
Earlier, Mrs Merkel said she would hold talks with smaller parties with a view to forming a coalition but that she would not talk with Mr Schroeder. However, she later agreed to talks with Mr Schroeder though both leaders are insisting they will not concede the chancellorship in the event they agree a coalition.
Michael Burda, Humboldt University in Berlin
Mrs Merkel, still looking subdued and shocked after an unexpectedly poor showing, struck a conciliatory tone in promising to talk with all parties except the far-left Left Party.
"We don't have a preference," she told reporters, insisting however that her CDU party and their sister Christian Social Union CSU had come out on top in the vote, giving her the right to replace Mr Schroeder as chancellor.
The Social Democrats, energised by a result that put them just a percentage point behind CDU despite forecasts of a blow-out, continued to sound defiant. "It is clear that Germans do not want Mrs Merkel as their chancellor," SPD chief Franz Muentefering told a news briefing.
"We have a responsibilty to make clear that we want to rule with Mr Schroeder as chancellor and implement much of that which we have undertaken to do."
The likeliest outcome to Germany's most inconclusive election in the post-war era remains a "grand coalition" of the CDU/CSU and SPD. But divergences between the parties - not only about who should lead but also over the CDU's proposed labour market reforms - could prevent any accord before an October 18th deadline for the new parliament to sit.
"This is a total disaster," said Michael Burda, an economics professor at Humboldt University in Berlin. "Merkel has a razor-thin lead so she has an implicit right to start negotiations to form a government. But if you look closely there aren't many options."
The euro sank to a seven-week low this morning as the result became clear while German stocks lost 0.8 per cent of their value.
German utility and auto stocks were particularly hard hit. "On balance, the only certainty is a period of uncertainty ahead," said economists at Credit Suisse First Boston.
Bank of America predicted further losses on equity and foreign exchange markets. "Whatever the colour of Germany's new government will ultimately be, the pace of structural reforms is likely to be slow," economist Holger Schmieding said.
The political manoeuvring by the largest parties will be matched by the smaller parties hoping to secure an influential place in government. The liberal Free Democrats (FDP) and the Greens both scored nearly 10 per cent - far better than anticipated.
They will be the largest parties to be wooed by rival camps, and although Mr Schroeder and Mrs Merkel have ruled out a three-way coalition, analysts maintain the option will not be ignored.
With the SPD winning just three fewer parliamentary seats than the CSU, the possibility of an unprecedented coalition is real. Among the more plausible alternatives to a "grand coalition" is a so-called "Jamaica coalition" - the parties whose black, yellow and green colours match the Caribbean island's flag - or a "traffic light coalition" incorporating the leftist Greens and the free-market FDP.
Leading SPD members suggested the Free Democrats (FDP), whose 9.8 per cent of the vote made them the third-strongest party, could be lured into government with Mr Schroeder.
"We have points in common with the FDP, particularly when it comes to tax," SPD Interior Minister Otto Schily told reporters.
But FDP leader Guido Westerwelle ruled out the "traffic-light" option of going into government with Mr Schroeder's SPD and the Greens. He said the SPD had no mandate to form a government but would consider the Jamaica option led by Mrs Merkel's Christian Democrats along with the CSU and the Greens.
Agencies