Explainer-Germany's new debt settlement, and where it could still go wrong

By Thomas Escritt

BERLIN (Reuters) -Germany's conservative leader and would-be next chancellor Friedrich Merz has agreed what amounts to a fiscal policy sea-change with support from the Social Democrats (SPD), his likely coalition partner and the Greens.

What have they agreed, and what could still go wrong?

WHAT HAVE THE THREE PARTIES AGREED?

After marathon talks, Merz's conservative bloc, the SPD and the Greens agreed to exempt security spending, very broadly construed, above 1% of economic output from the constitutional "debt brake" spending cap.

Spending on civil defence, IT security and "aid to states attacked in violation of international law" - a clear reference to Ukraine - will count as defence spending, meaning that in theory Germany can borrow unlimited sums to finance them.

They also agreed to create an off-balance-sheet special fund worth 500 billion euros ($543 billion) to finance infrastructure, of which 100 billion euros will be spent by the governments of Germany's 16 states. In addition, states will themselves be allowed to borrow up to 0.35% of GDP above the debt brake - giving them some 16 billion euros in spending room.

A further 100 billion euros from the fund will be used to stock up a climate and transformation fund that was created by the Greens when they were in charge of climate policy in Chancellor Olaf Scholz's outgoing government.

HOW WERE THE GREENS WON OVER?

Just a day before Merz announced the agreement, the Greens were signalling they might not back the conservatives' and SPD's plans for boosting defence spending, saying they were concerned about the haste with which it was being passed and were worried the money would be frittered away on tax cuts.

The creation of some 116 billion euros in spending money for the states is a significant win for the Greens, since they are in government in seven of the 16 states.

The climate money is also important for a party that has made climate change mitigation a central pillar of its policy platform.

DOES MERZ HAVE THE VOTES?

Both measures need the support of two thirds of the Bundestag, the German parliament. In the old Bundestag, which is still in session, the combined votes of the conservatives, the SPD and the Greens clear that threshold with 30 votes to spare.

That buffer is important, given the possibility of ill or dissenting members in the 733-member parliament.

Merz spent the election campaign promising not to open the spending taps only to announce a tectonic shift in German fiscal policy days after winning. Some legislators in his Christian Democrat (CDU) party and its Bavarian CSU allies may feel that is too sharp a U-turn, or that the SPD, the junior party in the planned coalition, has been given too much leeway.

Merz said on Friday he was confident the deal would pass.

COULD LEGAL CHALLENGES SINK THE PACKAGE?

The measures, which include constitutional amendments, will be passed by the old Bundestag. Once the new lower house elected on February 23 is seated, the conservative-SPD-Green caucus would no longer suffice for two thirds, giving the military-sceptic Left party the power to block it.

Both the far-right Alternative for Germany (AfD) and the Left party, which gained most in February's national election, have launched urgent legal challenges against what they say is a manoeuvre to thwart the will of a parliament elected less than two weeks ago.

Germany's powerful Constitutional Court has a history of overriding government decisions, including in core matters of budgetary policy.

The Court's scepticism about special funds of the kind now planned paved the way for the fall of Chancellor Olaf Scholz's government and the February early election that he lost.

Judges may also feel that squeezing the legislation into the period before the new Bundestag is seated is democratically questionable - as some lawmakers and legal experts also argue - or gives legislators too little time to debate the measures.

Marco Buschmann, FDP justice minister in Scholz's collapsed government, has said he regards the proposed measures, even if passed by the outgoing parliament, as legally sound. Most experts agree with him.

THE UPPER HOUSE IS THE FINAL HURDLE

The Bundesrat, Germany's upper house, represents the governments of the 16 states that make up the federation.

The states, which for years have complained that they bear the brunt of Germany's fiscal squeeze, have every incentive to pass the loosening package, since they will be among its major beneficiaries.

But the conservatives, SPD and Greens still need the backing of one more party for it to pass the Bundesrat: that could be the Left, its populist splinter the Sahra Wagenknecht Alliance (BSW), the FDP or the Bavarian Free Voters party.

The AfD is not an issue here, since it does not serve in a state government, and the Bundesrat represents governments, not voters.

The BSW, Kremlin-friendly in its rhetoric, would be unlikely to back measures to increase defence spending, and the Left is also opposed to defence spending. The FDP, pro-Ukraine and pro-military spending, dislikes excessive borrowing.

That means Bavaria's Free Voters, sticklers for fiscal discipline from Germany's wealthiest region, are likely to play a crucial role. They have declined to commit so far, but many analysts think they could be persuaded with the right offer. 

($1 = 0.9207 euros)

(Reporting by Thomas Escritt; editing by Matthias Williams, Toby Chopra, Aidan Lewis)