Germany Elects a New Government – Is a Turning Point for the Euro Ahead?

While political attention is currently focused on Donald Trump, a new government will be elected in Germany on February 23. Will this serve as a turning point for the eurozone, or will downward pressure only be reinforced?

Key points:

• Early elections in Germany will take place on February 23.
• The Union and AfD are leading in the polls.
• A Grand Coalition appears to be the most likely outcome.
• The most probable results are unlikely to disturb the markets.
• Markets will be cautious of support for radical parties and coalition discussions.

Social dissatisfaction is growing due to the economic stagnation in Europe’s largest economy. Although the economy has slightly recovered from the pandemic-induced slowdown, its GDP has contracted annually by 0.3% and 0.2% over the past two years. This means that the size of the nation’s economy, once held up as a model, is roughly the same as it was five years ago.

The German economy is expected to remain a brake on the common bloc for the foreseeable future. Industrial weakness, particularly in the automotive sector, is one of the main factors, as are the energy crisis and competition from China. Projections for GDP growth by the Bundesbank were revised downward in December; it now expects an increase of just 0.2% in 2025 and below 1% in the following two years.

Whether the factors holding back the economy are structural or cyclical is a matter of debate, but its poor performance has contributed to a significant shift in the country’s political landscape. In recent years, there has been an increase in support for right-wing politicians, with the populist, Eurosceptic, and anti-immigrant Alternative for Germany (AfD) polling around 20%—double its result from the 2021 elections. The center-right Union (CDU/CSU), which has historically dominated German politics, has also seen a similar rise, now standing at about 30% compared to 24% in 2021.

The losers are the Social Democrats (SPD) and the Free Democratic Party (FDP)—members of the Traffic Light Coalition, which collapsed in November due to a conflict between Chancellor Scholz (SPD) and Finance Minister Lindner (FDP). The SPD has 10 percentage points less support in the polls than in 2021 (25.7%). The FDP, which secured 10% of the votes four years ago, is now polling at around 4%, and may risk not entering the next Bundestag (the party must secure at least 5% in the elections and win in at least three constituencies to gain representation). The Greens, the last member of the Traffic Light Coalition, are at a similar level to their 2021 result, where they received around 15% of the votes.

Support for the Left (Die Linke) has also not changed significantly (in 2021, it received 4.9% of the votes, but still entered the Bundestag). Interestingly, a new party has emerged on the left. At the beginning of 2024, the anti-immigrant, populist, and Eurosceptic Alliance of Sahra Wagenknecht (BSW) was formed, garnering about 5% support in polls.

What Issues Are Most Important?

According to the ARD-Deutschlandtrend poll from January 9, the most important issues for voters are immigration and the economy—37% of respondents identified the former as key (+14 percentage points in a month), while 34% selected the latter (-11 percentage points). Both AfD and BSW present extreme views on this matter, but a shift towards more stringent control is apparent across the political spectrum. The Union, in particular, has adopted a more restrictive stance, while the Greens and the Left remain committed to an open policy.

In recent polls, the economy is only slightly behind immigration in importance. Exiting stagnation will be very significant for voters; as expected, strategies on this issue differ drastically. The Left, SPD, and Greens advocate for a reform of the debt brake (Schuldenbremse), which limits the annual structural budget deficit to 0.35% of GDP. The Union appears to take a more cautious approach to significant changes in this regard. Its leader and likely next chancellor, Friedrich Merz, did signal some openness to reform during a recent television debate. It’s also notable that the Union wants to stimulate the economy through tax cuts that would go unfunded. Liberals and the AfD oppose relaxing fiscal rules.

One of the main reasons for the problems facing the German economy is high energy prices. Major parties (Union, SPD, Greens) generally support the continued development of renewable energy. Meanwhile, the AfD is in favor of relaxing energy restrictions and returning to nuclear power. This idea has also gained attention from the Union, but is opposed by the other two main parties.

In the mentioned poll, foreign policy issues related to armed conflicts and peace rank third, with parties differing in their approaches to the Russian-Ukrainian war. AfD and BSW want to cease arming Ukraine and tighten relations with Russia. The Union, Greens, and FDP take the opposite stance, while the SPD approaches the issue with considerable reserve.

What Are the Possible Election Results?

The German electoral system is mixed. Voters cast two votes on one ballot: one for a candidate in their constituency and one for a party candidate list in their federal state. The second vote is more significant as it determines the distribution of seats in the parliament, and in 2025, this will be even more critical. The parliament will consist of exactly 630 seats—about 100 fewer than currently.

It is almost certain that no party will receive a majority of votes needed for solo governance, so attention will focus on potential coalitions. The Union (CDU/CSU), which is leading in the polls, will likely be central to all discussions. Due to its radical views, which the main parties reject, the AfD is unlikely to be part of any coalition, despite enjoying considerable support. The far-left Die Linke and BSW are also unlikely to be included in such coalitions, even if they manage to enter the Bundestag, which is not guaranteed.

The most probable outcome seems to be a Grand Coalition between the Union and the SPD. A black-green coalition (Union and Greens) is also possible, but it is unlikely to be the Union’s first choice, as numerous high-ranking politicians—including CSU leader Markus Söder—would criticize this idea. Based on the polls, both two-block coalitions seem possible, along with a three-block coalition that includes the FDP. Ideologically, this party is closest to the Union, but given the current support for FDP, such a coalition is not particularly likely. Moreover, a coalition between FDP and SPD might be politically challenging, considering the conflict between the party leaders—Scholz and Lindner.

How Might the Euro React?

The impact of elections in Germany on financial markets has so far been limited. Investors are focused on other issues, particularly the start of Trump’s second term, and the volatility of the EUR/USD exchange rate is mainly driven by news regarding tariffs.

The most probable outcomes of the elections in Germany do not seem to pose a significant threat to the euro. Possible coalitions would provide a compromise between the conservative-liberal approach emphasizing deregulation and lower taxes, and the environmentally-socialist stance favoring higher spending. While such a balance may work in some aspects, it may not be favorable for enacting the critical changes in old policies that have led to increasing discord in German society.

Since no majority government will be formed, the greatest risk for financial markets may be the prolongation of coalition talks, which could take weeks or even months. In 2017, the Grand Coalition was formed after nearly six months following the failure of coalition talks between CDU/CSU, the Greens, and the Free Democrats. After the last elections in 2021, the coalition government of the Traffic Light Coalition was established after 73 days. Markets do not react well to uncertainty, and an extended period of political uncertainty could weigh down the euro, as it would delay essential reforms needed to help the German economy emerge from crisis.

A different threat may come from a strong showing by the far-right and Eurosceptic AfD. If the party significantly surpasses polls, it could lead to turmoil in the markets, as investors may brace for a rise in populist movements across Europe. A good performance by the Left, especially the radical BSW, might also be interpreted as negative. Increasing political fragmentation could hinder the formation of a governing coalition, and a strong BSW could heighten perceptions of growing populism in the heart of Europe.

Authors: Roman Ziruk – Senior Analyst, Ebury