Germany's Merz races to win support for major financial package

By Sarah Marsh and Matthias Williams

BERLIN (Reuters) -The parties hoping to form Germany's next government have agreed to create a 500 billion euro infrastructure fund and overhaul borrowing rules, a tectonic spending shift that jolted markets on Wednesday on hopes of reviving Europe's largest economy.

After three years of attacking what he called the outgoing government's profligacy from opposition, Germany's likely next leader Friedrich Merz is now trying to use the narrow window before new legislators officially take up their seats to pass the massive borrowing package.

The move, which relies on the make-up of the old parliament from before the February 23 election, looks certain to prompt legal challenges.

The about-turn is a consequence of the turmoil caused by the return of Donald Trump to the White House, bringing with it a realisation that Europe can no longer rely on the United States to guarantee its security in the face of a hostile Russia.

Trump froze military aid to Ukraine after a bitter clash last week with its president, Volodymyr Zelenskiy, reinforcing fears that the U.S. could strike a deal with Russia to end the war in Ukraine while disengaging from Europe.

Merz's conservatives and the Social Democrats (SPD), who are in negotiations to form a coalition following the election, will put their proposals to the German parliament next week, with a vote possible on March 17.

But the Greens party, whose support is key to getting the reform through the outgoing parliament, refused to pledge support, questioning why climate-friendly policies had not been included.

The far-right Alternative for Germany (AfD) joined the radical Left party in threatening legal action. Together, the two parties would have enough votes to block the reform once the new legislators are seated.

SEA CHANGE

The U-turn in Berlin late on Tuesday marks a potential sea change in economic policy after decades during which Germany’s neighbours have criticised it for holding regional growth back with excessive budgetary thrift.

The plans also envisage removing a self-imposed upper limit on defence spending, which has long seen Germany either missing or barely meeting NATO targets.

Economists say it remains to be seen whether a defence spending "surge" and an accompanying modernisation of Germany’s creaking infrastructure can improve the competitiveness which figures such as Mario Draghi, ex-chief of the European Central Bank, say is crucial to revive the euro zone's economic growth.

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 and support an economy that has contracted for the past two years.

But others, like government economic advisory panel member Veronika Grimm, said the new spending could endanger Germany's role as an anchor of European stability and drive up interest rates.

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

The euro hit its highest level in nearly four months on Wednesday after news of the plans.

Germany's blue-chip index jumped to near a record high. Construction firms were among the top gainers, with Heidelberg Materials, the world's second-largest cement maker, up 16% at the top of Frankfurt's blue-chip index.

European defence company shares have also soared as momentum to ramp up spending gathers pace. German defence companies Rheinmetall, Hensoldt, Thyssenkrupp and Renk had notched up gains so far this week of between 17% and 30% as of Wednesday.

Germany's move also throws down the gauntlet to France, where President Emmanuel Macron wants to bolster defence spending but is struggling to tame an unruly budget deficit.

AMENDING CONSTITUTION

Merz said his CDU/CSU conservative bloc and the SPD would submit a motion to parliament next week to amend the constitution so defence expenditure above 1% of economic output is exempted from debt brake rules.

A commission of experts will separately develop a proposal for modernizing the debt brake to boost investments on a permanent basis.

According to a poll by INSA, 49% of Germans support loosening the debt brake while only 28% are against. But changing the debt rules and creating a special fund require a two-thirds majority in parliament.

The conservatives and SPD are rushing to get the moves passed in the outgoing parliament, given far-right and far-left parties will have a blocking minority in the new parliament after scoring strongly in last month's election.

The AfD threatened legal action against what it called an "orgy of debt". The radical Left party has threatened a legal challenge if Germany issues new debt to fund defence expenditure.

Business lobbies welcomed the plans but said they need to be accompanied by regulatory reforms.

($1 = 0.9351 euros)

(Reporting by Andreas Rinke, Riham Alkousaa, Sarah Marsh, Holger Hansen, Markus Wacket, Thomas Escritt, Christoph Steitz, Kirsti Knolle, Rene Wagner; Writing by Matthias WilliamsEditing by Gareth Jones)