Clock ticks for German fiscal bonanza deal but optimism drives euro up

By Andreas Rinke and Matthias Williams

BERLIN (Reuters) - Germany's likely next chancellor Friedrich Merz is in a race against time to secure support for a massive increase in state borrowing but optimistic comments by party negotiators after emergency talks pushed the euro on Tuesday to a five-month-high.

The clock is ticking for Merz to persuade lawmakers in the outgoing parliament to back plans to unshackle Germany's tight borrowing limits as a way to revive its moribund economy and pump hundreds of billions of euros into defence.

The Greens party, whose votes are needed to pass the measures in the outgoing parliament, withheld their support and put forward their own proposals on Monday night.

But co-leader Felix Banaszak hinted at further negotiations, saying the Greens had given themselves a week to see if they could reach an agreement with Merz.

Thorsten Frei, a senior lawmaker in Merz's conservative CDU/CSU bloc, said the two sides were not far apart. "Now we have a foundation on which we can move towards each other," he said.

Sources in both Merz's conservatives and their likely coalition partner in the next government, the Social Democrats,said a deal might not be possible this week but could still be clinched at the last moment.

The euro rose 0.8% on Tuesday to $1.0926, its highest since October. It has gained more than 4% so far this month, in part on the prospect of a German spending spree.

Merz announced last week he and SPD leaders had agreed on reforming debt rules to enable higher spending on defence and state borrowing and on introducing a special 500 billion euro ($540 billion) infrastructure fund.

Merz has said boosting defence spending is an urgent priority. After winning the February 23 election, he said it was "five minutes to midnight" for Europe, faced with a hostile Russia and an unreliable United States under Donald Trump.

The Greens have accused Merz of using European security as a pretext to fund measures to please his political base, such as tax cuts and restoring diesel subsidies for farmers. They have demanded more money for climate protection, affordable housing and creating opportunities for Germany's poorest.

Merz wants to push through his plans in the outgoing parliament because in the new Bundestag that begins on March 25, they would become harder to pass with the necessary two-thirds majority. An enlarged contingent of far-right and radical left lawmakers is threatening to block them.

"Expect very intensive negotiations behind the scenes over the next days," said Carsten Brzeski, global head of macro at ING. "There are many possible options for how this could play out."

The outgoing parliament is due to discuss the various proposals for increasing defence spending this Thursday, with a vote expected next Tuesday.

NO GREEN WRECKING BALL?

Investors and some economists have long urged Germany to reform its constitutionally enshrined state borrowing limits - known as the "debt brake" - to free up investment.

The reform would mark a rollback of borrowing rules imposed after the 2008 global financial crisis that many see as an outdated fiscal straitjacket.

Merz wants to amend the constitution so defence expenditure above 1% of economic output is exempted from debt brake rules, and for a commission separately to develop proposals for broader debt brake reforms to boost investments permanently.

The Greens' parliamentary group instead drafted a law that would foresee spending on "defence and security policy tasks" above 1.5% of gross domestic product exempt from the debt brake - with security defined more broadly to include intelligence capabilities, foreign aid and safeguarding tech systems.

The party would also prefer a complete overhaul of the debt brake rather than a special fund for infrastructure.

Conservative lawmaker Frei said the Greens' 1.5% proposal was "very plausible" and other details needed to be looked at individually.

"There is a possibility that the Greens might fold. There is a lot of pressure from the media," said a note by the Eurointelligence think-tank.

"It is also not in their character to throw the wrecking ball. Their biggest fear is to be criticised for being extreme and unreasonable."

(Reporting by Andreas Rinke, Sarah Marsh, Markus Wacket; writing by Matthias Williams; editing by Aidan Lewis and Gareth Jones)