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Voters will head to the polls to decide Germany’s next government leader at the weekend. According to the latest opinion poll from Politico, the centre-right Christian Democrats (CDU/CSU) remain the frontrunner, gaining 29% support, followed by the far-right party Alternative for Germany (AfD) at 21%.

Chancellor Olaf Scholz’s Social Democratic Party (SPD) stands in third place at 16%, while the Greens are at 13%. The far-left party and the Alliance Sahra Wagenknecht (BSW) are on 6% and 5% respectively.

If the poll’s survey is accurate, a potential outcome could be a coalition of the CDU with the SPD or the Greens, as neither party is likely to gain enough votes to form a government alone. The key issues the new ruling party coalition will face centre on Germany’s debt limit, immigration, and climate change.

A reform to Germany’s “Debt Break”

Germany’s economy contracted for the second consecutive year in 2024 due to structural economic issues. Soaring energy prices have weighed on its manufacturing activities since Russia’s invasion of Ukraine in 2022. The rising cost of living, increasing migration, and green energy regulations have caused public and business dissatisfaction, necessitating reforms in these key policies.

The first agenda item the new government is expected to address is the reform of Germany’s “debt break”, a fiscal rule enacted in 2009 that limits government borrowing by controlling the budget deficit to 0.35% of the country’s gross domestic product (GDP).

Chancellor Olaf Scholz and the Greens have both called for increasing the debt level, as there is a shortfall of €25bn in the 2025 budget. However, his coalition partner, the FDP, rejected the proposal, leading to a government collapse. Scholz argued that Germany’s debt-to-GDP ratio is far lower than other developed economies, such as the US, the UK, Italy, and France, all of which have surpassed a 100% debt-to-GDP ratio.

Additionally, Germany faces pressure from NATO and US President Donald Trump to increase its defence spending. The Bundestag approved a special fund of €100bn for military spending. The current government budget will need to increase to 3.6% of GDP to meet NATO’s target.

The CDU’s leader, Friedrich Merz, prefers to retain the debt break and advocates reducing social benefits and downsizing government employment. Controversially, he also supports tax cuts, which would reduce government revenue. Merz has expressed a willingness to negotiate terms for cutting government subsidies. A potential outcome could be an increase in government debt while simultaneously reducing taxes and social spending.

Illegal Immigration and Green Energy Transition

The ruling party coalition will address illegal immigration while encouraging legal migration for skilled workers. Merz has called for stricter migration rules in his campaign. Scholz and the Green Party have also pushed for the deportation of illegal migrants.

Regarding the EU’s climate goals, the new ruling party coalition may challenge the economic impact of high green energy costs on Germany. The country’s auto industry has been facing multiple growth bottlenecks, including high inflation, rising costs of meeting green transition targets, and intensifying overseas competition. The CDU leader, Merz, has criticised Germany’s climate policies, calling wind turbines “ugly” and indicating a potential shift in green energy regulations. This could lead to adjustments in the timeline for achieving climate targets and a more flexible approach to traditional energy sources.

The Potential Market Reaction

The DAX has been repeatedly hitting new highs throughout February, with defence stocks leading broad gains amid peace talks to end the Ukraine war. Germany’s equity markets are likely to continue this trend, as a CDU-led coalition could boost market sentiment in the short term. Firstly, the election result will provide certainty. Secondly, the proposed policy shifts are pro-economic growth, fuelling optimism about the country’s economic outlook.

The euro may also strengthen, as a stabilising economy could attract investors to German government bonds, pushing up bond yields. However, prolonged post-election negotiations may dampen investment sentiment and place pressure on stock markets and the euro. “For the EUR, the most significant risk is that coalition negotiations become prolonged, with the typical correlation between heightened political uncertainty and a weaker currency”, Michael Brown, a senior research strategist at Pepperstone in London, wrote in a note.

Ultimately, movements in European stock markets and the currency are primarily driven by external factors, particularly developments in the US. Therefore, any market reaction is likely to be short-lived.