Germany may not get the aggressive economic reforms conservative leader Angela Merkel promised ahead of this month's election but markets are slowly waking up to the fact that the alternative may not be so bad.

In recent days the likelihood has increased that Mr Merkel, who failed to win a parliamentary majority with her reform-minded Free Democrat (FDP) allies in the September 18 poll, will forge a coalition government with Chancellor Gerhard Schroeder's Social Democrats (SPD).

Before the vote, the idea of such a "grand coalition" had markets spooked. When the election results came in, German stocks and the euro currency fell.

But two weeks later, the main German stock index is back at a three-and-a-half-year peak and economists are warming to the prospect of a new government that they say could push through much-needed changes to the federal system, implement tax reforms and get German finances in order.

"The hope that Germany would be a shining European example for accelerated reforms has been dashed," said Holger Schmieding, an economist at Bank of America. But Germany has already made significant progress and some of that would continue under a grand coalition. Countries like France and Italy will still have reason to look to Germany."

The renewed confidence, which is emerging only a week after experts across Europe were ringing alarm bells over Germany's economic future, is based on several factors.

First, the likelihood of an unstable three-way coalition government composed of the environmentalist Greens, the FDP and either Ms Merkel's Christian Democrats (CDU) or Mr Schroeder's SPD has virtually vanished.

Ms Merkel and Mr Schroeder have sat down and talked in recent days and appear on track to form a relatively stable coalition, even if Mr Schroeder has yet to drop his insistence that he remain Chancellor.

Second, markets are taking a second look at what a "grand coalition" could accomplish and liking what they see - a view reinforced by comments from both Ms Merkel and Mr Schroeder in recent days that a new government would push major reform projects. Klaus Zimmermann, president of the Berlin-based DIW economic institute, says that in many reform areas a coalition of Ms Merkel and Mr Schroeder's parties would be preferable to the CDU-FDP alliance markets had been hoping for before the vote.

"I honestly believe that a grand coalition could do more in the current political climate," Mr Zimmermann told Reuters.

"Federalism reform can only happen in a grand coalition. Cleaning up the budget and simplifying the tax system are other areas that could be tackled."

The one area that, from a markets perspective, would probably suffer in a CDU-SPD government would be labour market reform.

Ms Merkel had vowed to cut payroll costs, ease rules on firing and shake up Germany's sectoral pay awards system to allow more individual deals between workers and employers on a company by company basis.

Those plans - which some economists view as crucial to kickstarting Germany's jobs market and economy - are likely to fall by the wayside during tough coalition talks with the SPD.

But that will not prevent German companies from continuing to take matters into their own hands, restructuring and striking pay deals that investors say have made them much more competitive in recent years.

German carmaker DaimlerChrysler's announcement last Wednesday that it had offered staff at its Mercedes Car division voluntary redundancy packages with the aim of cutting 8,500 jobs was a reminder that streamlining has progressed further in Germany than in many other European countries.

Mr Schroeder, whose "Agenda 2010" reform package contained the most far-reaching reform of Germany's welfare state since World War II, deliberately shied away from promising more pain during the election campaign.

But with or without him, the SPD is no longer the reform-shy party it once was. Together, economists say, a CDU-SPD government could represent a step forward for German economic reforms and not the big step backward that many had assumed.