UBS discusses potential political scenarios in Germany amid elevated risks

Political risks in Germany persist after recent regional elections weakened Chancellor Friedrich Merz and the governing coalition, according to UBS economists. The elections in Berlin and several eastern German states dealt significant blows to governing parties, especially the CDU/CSU. The Alternative for Germany (AfD) gained the most, now leading national polls at 29%, compared to 20% for the CDU/CSU.

Three possible scenarios were outlined for the government's future: The first involves the existing coalition staying under Merz's leadership, who has CDU/CSU support. The second scenario would replace Merz with another CDU/CSU politician through a constructive vote of no confidence, which wouldn't necessitate a national election but requires agreement between the CDU/CSU and Social Democrats on a new chancellor.

The third possibility is Merz initiating a confidence vote, potentially leading to early elections if he loses. Merz has ruled out this option, and the AfD's current popularity may dissuade governing parties from opting for an election. The political instability occurs as Germany aims to overcome five years of stagnation, with GDP growth projected at 1% in 2026 and 1.5% in 2027.

Supported by a substantial fiscal package, the growth could add 0.6 percentage points each year. Under the first two political scenarios, major economic policy changes would likely be limited. However, a government facing more political pressure might prioritize fiscal stimulus. The fiscal expansion could face greater risk under the early-election scenario, as the government could lose the ability to approve annual budgets.

Political uncertainty could also delay Germany's role in EU decisions about the bloc's budget and China trade policy.