BERLIN (Reuters) – German Chancellor Angela Merkel faces tough negotiations to bridge policy differences with the business-friendly Free Democrats (FDP) after an election which gave her a new term as head of a center-right government.

After barely squeezing into office four years ago and being forced into a ruling partnership with her main rivals, the Social Democrats (SPD), Merkel secured a parliamentary majority with the FDP, her partner of choice in the Sunday vote.

But the parties, who ruled together between 1982 and 1998 under former Chancellor Helmut Kohl, must now hunker down and forge compromises on issues ranging from taxes to labor market policy and domestic security.

“There are some notable differences between Merkel’s conservatives and the FDP on economic policy, so there could be some struggles for them here,” said Dietmar Herz, a political scientist at Erfurt University.

Projections of the election results from German public television stations showed Merkel’s conservative bloc — the Christian Democratic Union (CDU) and the Bavarian Christian Social Union (CSU) — on 33.8 percent, down from 35.2 percent in 2005, and their second-worst result in the post-war era.

But the FDP compensated for those losses, surging to 14.5 percent, its best score ever, and putting the center-right partners over the top.

The SPD, which has been in government for over a decade, was the big loser in the election and will join the environmentalist Greens and Left party in opposition after plummeting more than 11 points to 23.1 percent, the party’s worst result since the war.

Merkel’s SPD challenger Frank-Walter Steinmeier, who served as her foreign minister for the past four years, called it a “bitter defeat.” Projections showed the Greens on 10.1 percent and the Left on 12.5 percent.

MARKETS COULD GET BOOST

Markets, who had feared a second grand coalition would lead to policy gridlock, could take cheer on Monday from the result, which gives the conservatives and FDP a narrow but solid majority in parliament.

“For financial markets this will be a positive,” said Klaus Wiener of Generali Investments.

“There will be more regulation, we’ve seen this come out of the G20meeting as well, but only as much regulation as will be necessary.”

The next government faces major economic challenges. It will have to get a surging budget deficit under control, cope with rising unemployment and ward off a credit crunch as fragile banks rein in lending.

Together with the FDP, Merkel is expected to look for opportunities to reduce taxes, sell off state holdings in companies like rail operator Deutsche Bahn, and reverse an SPD-orchestrated phase-out of Germany’s nuclear power plants.

Merkel’s conservatives said before the vote they would pursue 15 billion euros in tax cuts if elected but refused to put a timeframe on their plans given the dire state of public finances. The FDP wants to move quickly and favors a much larger 35 billion euros in cuts.

Merkel, Germany’s first woman chancellor, ran a cautious campaign that steered clear of the bold economic reform plans she advocated before the 2005 vote.

While governing with the SPD over the past four years, she has shifted leftwards, adopting traditional leftist themes like climate change and family policy which could put her at odds with the FDP.

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Source: Reuters  (Writing by Noah Barkin)

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