Merkel’s decision follows setbacks in regional elections in Bavaria and Hesse in which the CDU and its sister party the CSU fared poorly though not as badly as the Social Democrats (SPD). The election results have unleashed ongoing intraparty disputes among the coalition parties, which are likely to dominate the political agenda for the rest of this year and set the stage for changes in government. Upcoming European Parliament elections in May 2019 further increase pressures on the coalition.

Scope’s analyst Bernhard Bartels discusses what is now at stake for Germany (AAA/Stable) and Europe at large.

What is the immediate political impact of Merkel’s decision to retire step by step from politics?

It was largely expected that Mrs Merkel would not run for re-election but the timing of the announcement to step down as a leader of the CDU came as a surprise. The immediate impact is increased political uncertainty, given the possible eventual split of the Grand Coalition government. The leaders of the three coalition parties face more pressure from the parties’ grassroots to change the political agenda, which further destabilises the ties between the current coalition parties. Within the CDU, we can already see conservative and more liberal candidates competing to succeed Merkel with the intention to become the next chancellor.

What are the dangers of a political deadlock for the rest of Europe?

Germany’s political turbulence comes at a testing time for the EU when many, notably French President Emmanuel Macron, hoped a strong administration in Berlin might help lead new reforms to avert future economic and financial crises and restore confidence in Europe’s institutions.

While we acknowledge that progress has been made particularly on the euro area reform agenda, we also caution that it has been slower than previously hoped for. Looking ahead, the political gridlock in Germany adds to the political vacuum in Europe precisely at the time when decisive leadership is needed on several fronts, including the final negotiation of Brexit, Italy’s stand-off with the European Commission, talks around the next EU budget, the upcoming European Parliament elections in May 2019, and in an environment of rising risks associated with the decline of the rules-based multilateral trading system. From a credit perspective, these issues as well as the reforms to bolster the euro area’s preparedness for the next recession and capacity to ex-ante prevent future crises are all relevant for the rating levels of euro area member countries.

What outcome does Scope see as most likely in Germany?

We see an increasing probability that the so-called ‘Jamaica’ coalition of the CDU/CSU, the smaller Liberals (FDP), and the Greens may eventually enter a formation process, if the CDU/CSU and SPD coalition dissolves.

SPD party members are talking about the need for a new roadmap, which could make the current alliance with the CDU/CSU unworkable. The FDP is open to coalition talks, more likely now that Merkel is stepping down as leader of the CDU. The Greens appear eager to return to government.

Calling new federal elections does not seem the preferred option for the CDU/CSU and SPD given their historically weak polls and worries about the rise of the far-right AfD party.

If a ‘Jamaica’ coalition does come together, what might that mean for Europe?

Any government still led by Chancellor Merkel would have the benefit of her unparalleled knowledge of European policy and policy makers. Having the pro-European FDP and Greens at her side could help to maintain her leadership in an unstable European environment.

That said, Merkel’s possible new junior partners have different visions of Europe. The FDP has been critical of burden sharing within the euro area, including scepticism over further integration of the region’s financial system via the completion of the Banking Union and expansion of the role of the ESM and it is also a critic of the ECB’s bond-buying programme. The Greens, by contrast, favour centralised European policymaking particularly on environment, energy and social issues.

Still, despite different visions for Europe, a German ‘Jamaica’ coalition might be an outcome that maintains some momentum behind EU reforms and reassures investors in Germany and Europe.