Merkel’s lead of just three parliamentary seats on Schroeder’s Social Democrats (SPD) dismayed financial markets, who feared a stalemate blocking economic reform. The euro slid nearly one percent to a 7-week low against the dollar and Frankfurt dealers said German shares fell some 2.3 percent in pre-bourse trade.

Easterner Merkel will have the first shot at forming a government but the ambitious tax and labour reforms she pledged on the campaign trail could be sacrificed in the political deals she would need to cut to become Germany’s first woman leader. An exuberant Schroeder, buoyed by a better-than-expected result, vowed his Social Democrats would never enter a coalition under Merkel and told his party lieutenants to study options on Monday for a power-sharing government under his leadership.

“War of the chancellors,” top-selling German daily Bild said in its headline. “Coalition Chaos in Berlin” declared business daily Handelsblatt, arguing that Merkel’s conservatives had been denied a clear mandate to reform Europe’s largest economy. The Sueeddeutsche Zeitung said the weeks ahead would belong to “the Machiavellians and the grand strategists” and warned any Merkel government would be weakened before it entered office.

Early official results showed Merkel’s conservatives scored just 35.2 percent, less than a point ahead of the SPD and up to 14 points down on her poll ratings before a campaign which critics said lacked charisma and was ridden with gaffes. The likeliest outcome of Germany’s most inconclusive postwar election seemed to be a “grand coalition” of Merkel’s Christian Democrats (CDU), their sister party, the Christian Social Union (CSU), and Schroeder’s Social Democrats (SPD).

<B>“Merkel will have the first shot at forming a government but the ambitious tax and labour reforms she pledged on the campaign trail could be sacrificed in the
political deals”</B>

But hostilities between Germany’s top two parties, after an unusually nasty campaign, could prevent any grand coalition before Oct. 18, the deadline by which the new parliament must sit and traditionally chooses a chancellor. “Do you really think my party would take up an offer for talks from Frau Merkel?” Schroeder declared on Sunday night. “The strongest party in parliament has the job of forming the government,” countered a grim-looking Merkel. “I’ll find a way to talk with the Social Democrats.”

If all attempts at coalition-building fail, the only way out would be new elections – a first for postwar Germany. Merkel had vowed to cut bureaucracy, ease rules on firing and cut payroll costs to reinvigorate a German economy that has gone from Europe’s powerhouse to its weak link.

Schroeder insisted his more gradual reforms were starting to show results. Countries like France and Italy had been watching the election closely, eager to see which path Germans chose – the liberal, unregulated route favoured in the United States and Britain or the state-heavy role preferred in much of Europe.

In Asian trade, the euro fell nearly one percent to $1.2113, from $1.2232 late in New York on Friday. That was the lowest since July 29. Valerie Plagnol, chief economist at French broker CM-CIC Securities, described the outcome as “the worst case scenario”. “There’s no certainty whatsoever on whether these parties can agree to form a coalition, whether this coalition can agree on an economic programme, and if this programme will at least be a continuation of the reforms initiated by Schroeder,” she said.

The election’s impact on German foreign policy is less clear. Merkel vowed to improve ties with Washington, strained by Schroeder’s vocal opposition to the Iraq war, and prevent Turkey from joining the European Union. Whether she will be able to see these policies through is now questionable. The tight result immediately set off speculation about new coalition possibilities, some never seen before.

Schroeder could seek a so-called “traffic-light” coalition with the Greens and pro-business FDP, whose 9.8 percent score was better than expected. FDP chief Guido Westerwelle ruled out such an alliance on Sunday but faces pressure to reconsider.

“With the surprisingly good result they scored, the FDP cannot say they will stay out of the search for a stable government,” SPD board member Sigmar Gabriel told German radio. Merkel’s conservatives and the FDP could also try to woo the Greens into what commentators have dubbed a “Jamaica” coalition because the colours of the parties match the black-green-yellow of the Jamaican flag.

<B>Mark JOHN</B>