Economic Reality Could Hamper Business-Friendly Merkel

LONDON -- Investors pinning their hopes that the reelection of Angela Merkel as German Chancellor would bring radical, market-friendly reforms are in for a big disappointment. After her victory Sunday, Merkel quickly said she will launch a new conservative coalition that brings to an end the awkward "grand coalition" over the past four years between Merkel's conservatives and the Social Democrats.

Pundits were quick to say that this will signal the beginning of a more liberal agenda which would favor business more than in the past and could lead to some cuts in corporate taxes. Investors appear to be buying into that view, sending German stocks up 1.4% to 5656.49 points.

But Martin Lueck, an economist with UBS in Frankfurt warns the reality of an ailing economy will shape the new government's policies. "The shift to a center right government doesn't mean that will be more market oriented policies," says Lueck. There is very little room to do that. The new government will be shaped by the economic conditions and the state of the public finances rather than the other way around."

Lueck says it's a "misconception" to think that Merkel's new conservative coalition will usher in tax cuts and market-friendly reforms. "Everybody knows it is hard to cut taxes and even more now when there is no money'' in the public coffers after the government has put in place an 85 billion euro stimulus package," he says.

Lueck also said investors shouldn't expect a new stimulus package once the current one expires next year. "There is no money to do that either," he says, adding that the government is projecting a 4% deficit this year compared to almost zero in 2008. The deficit is likely to grow to 6% next year when the maximum level should be 3%. "The government will need to either cut expenses aggressively - which is really hard to do - or hike taxes in some areas to claw back the losses," Lueck says.

Lueck says many people took the promises of tax cuts by Merkel at face value but she is less of a reformist as she would like others to believe. "She fits more in the role of a moderator rather than pushing for painful reforms," he says.

Of course not everyone subscribes to his view. Holger Schmieding, head of developed Europe economics with Bank of America Merrill Lynch, said that with Merkel's victory German economic policies will shift towards a "pro-growth agenda". "We expect some tax cuts, spending restraint and modest structural reforms to strengthen the incentives to work, invest and create jobs," Schmieding said in a note entitled "Angela Libre".

While Schmieding says the pro-growth policies make little difference to the near-term prospects for a strong cyclical recovery, which is largely dependent on a rebound in global manufacturing, the shift will likely show up over time in a stronger trend performance of the German economy. "We see the result as a significant positive for German equities, a modest positive for the euro and broadly neutral for German bonds," he says.