"I'm convinced that the coalition creates a genuine opportunity for Germany," Merkel said on Friday. She will become the country's first woman chancellor and first from the former communist East if, as expected, the new parliament formally elects her on 22 November.

She will head a potentially unwieldy bipartisan government that includes her Christian Democrats (CDU), their Bavarian sister party the Christian Social Union (CSU) and the Social Democrats of outgoing Chancellor Gerhard Schroeder.

But the new government - only the second "grand coalition" in post-war history - will be able to operate without crippling opposition from the Bundesrat upper house of parliament, which has blocked reform efforts by previous governments.

In almost a month of relatively harmonious talks, the conservatives and the SPD have bridged differences that bitterly divided them during the campaign.

Ballooning deficit

At the heart of the deal is an agreement to bring Germany's ballooning budget deficit back within European Union borrowing limits by 2007 - a colossal challenge requiring upwards of 35 billion euros ($40.96 billion) in savings or extra revenues.

Gerhard Schroeder fought long
and hard to remain chancellor

A good chunk of that sum will come from higher taxes. The parties agreed on Friday to a controversial three percentage point hike in value added tax (VAT) in 2007, an idea championed by the conservatives during the election campaign.

In return for agreeing to the VAT hike, the SPD secured conservative agreement for a so-called rich tax, which will take the rate for Germans earning 250,000 euros or more up to 45% from 42% previously.

Economists and leaders of German industry worry the tax rises could hit already weak consumption and prevent the parties from achieving their number one stated priority - cutting unemployment.

The CDU was unable to convince the SPD to reverse Schroeder's policy of phasing out nuclear power stations. But they did win concessions from the SPD in labour-market policy.

Weakest growth

Part of the VAT hike will go towards cutting non-wage labour costs - a measure the conservatives say is crucial for encouraging German firms to hire.

Both parties must hope the measures do not hit the German economy, which is already showing one of the weakest growth rates in the 25-nation European Union.

In foreign policy, the parties have vowed to improve relations with the United States which were strained by Schroeder's staunch opposition to the Washington-led war in Iraq.

The CDU and CSU, which oppose Turkey joining the EU, have agreed not to try to prevent membership negotiations that started in October from continuing. But they have vowed to ensure EU criteria imposed on Ankara are strictly adhered to.