Betting men (or indeed women) will by now be having palpitations. With just two days to go before the general elections in Germany - Europe's biggest economy - it's still an extremely close-run thing.

In one corner stands the incumbent, the embattled Chancellor Gerhard Schröder, who has staked his future on the outcome of what was effectively a snap election call after his embarassing local election defeat.

In the other stands Angela Merkel, the leader of the opposition Christian Democratic Union, who until a matter of days ago was seen by political pundits as a virtual shoo-in to take control of the country.

Now, things are less clear - with Herr Schröder reported to have made significant gains in the past couple of days.

But, after he was originally elected on a tidal wave of popular support, including from both the domestic and international business communities, Herr Schröder has lost a lot of his shine - for both the residential masses and the financial sector.

Frau Merkel on the other hand - dubbed "Frau Thatcher" in reference to the radical reform agenda offered by the former British prime minister - has seen her star rise dramatically.

This is not an election over reform agendas - Herr Schröder has already campaigned, and won, twice offering stiff changes designed to liberalise the economy and help streamline Germany's complex and unweildy corporate structures.

But, perhaps ironically, business and the markets nevertheless want change. And the favoured outcome is what would traditionally be seen as a fudge - a coalition between the ruling FDP and the Christian democrates (CDU/CSU).

Klaus Baader, European economist at Merrill Lynch, summed it up succinctly in a report sent to clients earlier this week. Herr Baader wrote: "The brief outline of the two main parties' plans makes clear why financial markets and the stock market, in particular, favour a coalition of CDU/CSU and FDP (the latter has a particularly aggressive tax-cutting agenda, financed by radical expenditure reduction)."

Herr Baader points out that the Christian Democrats have a more radical agenda on tax - favouring a 2 per cent hike in VAT to 18 per cent and a cut in corporation tax to 22 per cent. The party also wants to push through reforms to Germany's labour laws which have traditionally placed a large amount of power in the hands of the unions.

But, according to Herr Baader, the CDU is the more "regressive" and "fiscally restrictive" of the two. While its plans are more "business-friendly" than the SPD's, its policies would probably dent consumption growth and act as a negative counterweight to its other policies.

The perfect compromise, and the most likely outcome, he says, is a coalition. "Forming a government should not be difficult and the government should have a relatively easy time passing legislation through the upper house."

The one thing the financial markets definitely don't want - and no surprises here - is a left-wing government, or a coalition that depends on the left for successfully voting through its policies. Were this to happen, stock markets and even the traditionally lacklustre bond markets would suffer, most economists argue.

Whatever the outcome, politics do matter to markets. Despite its disappointing economic condition, German equities have risen 15 per cent this year, making them among the world's top performers as dealers remain confident that economic reforms will eventually materialise.

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