German politics a new risk for investors?

BERLIN Wed Jun 4, 2008 11:57am EDT

BERLIN (Reuters) - The rise of the new Left party has upset the German political landscape, raising investor fears of government instability and a reversal of economic reforms after next year's federal election.

Infighting in Germany's "grand coalition" has already dimmed prospects for meaningful reform before the September 2009 vote but fears about what kind of government might emerge after that date are the main source of concern.

Support for the Left party, a grouping of ex-communists and disaffected blue collar workers, has risen to 15 percent in recent polls, narrowing the options of the country's large parties, particularly the struggling Social Democrats (SPD).

Chancellor Angela Merkel's Christian Democrats (CDU) still harbor hopes of returning to power in 2009 with their partners of choice, the liberal Free Democrats (FDP) -- a dream team for financial markets.

But that seems unlikely, with most polls showing them just shy of a parliamentary majority on around 48 percent combined.

The SPD, junior partners to the CDU in Berlin's uneasy left-right government, appear to have only one realistic option if they want to snatch the chancellery away from Merkel -- forming a coalition with the Left and environmentalist Greens.

Despite repeated vows to the contrary, some Germany watchers believe it may be only a matter of time before the SPD goes down this route, with major implications for policy in Europe's largest economy.

"As it stands now the chances of a left wing government are increasing," said Juergen Michels, an economist at Citigroup.

"That means the risks are rising that reform initiatives that were watered down under the current coalition will be reversed even more. Over time this would have a negative impact on the German economy."

The Left wants to unwind labor market reforms put in place by former SPD Chancellor Gerhard Schroeder, introduce a generous nationwide minimum wage and impose bans on stock options and layoffs at profitable companies.

For now, the chances of a so-called "Red-Red-Green" coalition taking power in 2009 seem remote at best.

Although the SPD and Left have a long-standing partnership in the city-state of Berlin, cooperation at the federal level is unlikely as long as Left leader Oskar Lafontaine, a hated figure within the SPD, remains in charge.

The SPD's current leadership may prefer four years in opposition or another term as junior partners in a "grand coalition" under Merkel to an unstable Left link-up.

MORE COMFORTABLE WITH LEFT

But signs the SPD is growing more comfortable with the idea of working with the Left are everywhere.

By nominating their own candidate last week to challenge Horst Koehler for the ceremonial post of president, the SPD has tacitly acknowledged that it is ready to rely on Left party votes to get its candidate, Gesine Schwan, elected.

In the state of Hesse this week, the SPD, Left and Greens banded together for the first time to overturn student fees introduced by Merkel's conservatives.

The SPD's youth wing came out with a strategy paper recently which urged a more open discussion about cooperation with the Left party at the federal level, Der Spiegel magazine reported at the weekend.

Andrew Bosomworth, co-head of portfolio management at Pimco Europe in Munich, said that for now the prospect of a sharp shift leftwards in Germany was not enough to scare away investors, who are more focused on broad economic trends, monetary policy and inflation.

But he acknowledged that recent political developments in Germany, including a partial reversal of labor market reforms under Merkel's coalition, could weigh on sentiment longer-term.

"It is a slow bleeding, not acute enough to make financial markets worry, but over time it is a big negative," said Bosomworth. "We've already seen a populist reversal of reforms that had put German finances on long-term sustainable path."

Against this backdrop, markets may find themselves in the unlikely position of rooting for another "grand coalition" in Germany next year.

Merkel's government has been beset by bickering in recent months, battling publicly over tax cuts and climate policy. It has come under criticism from industry for boosting jobless benefits for older workers and ignoring caps on state pensions.

But it has also presided over Germany's strongest economic expansion since the country's post-reunification boom.

Since 2005 it has consolidated the budget, raised the retirement age and boosted subsidies to new parents -- all measures which have put Germany in a better position to weather the looming economic storm from its ageing population.

"A grand coalition would probably end in a mess again, but at least it would offer the chance for more reforms," said Citigroup's Michels.

(Writing by Noah Barkin; Editing by Jon Boyle)

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