Schroeder said his party would never join a coalition under Merkel’s leadership. (Reuters).

The most likely outcome would appear to be a "grand coalition" among Merkel's Christian Democrats (CDU), their sister party, the Christian Social Union (CSU), and the SPD.

But hostilities between Germany's top two parties, after an unusually nasty campaign, could prevent that before October 18, the deadline by which the new parliament must sit and traditionally chooses a chancellor.

Neither Merkel, 51, nor a defiant Schroeder, 61, seemed prepared for the compromise and cooperation necessary to link up with each other in an alliance that would normally put the strongest party's candidate in the chancellery, Reuters said.

On German television, Schroeder mocked Merkel and vowed his party would never form a coalition under her leadership.

"Mrs Merkel will not obtain a coalition with the SPD if she wants to become chancellor," Schroeder said in a round-table debate with the main candidates.

Schroeder could try to seal a so-called "traffic-light" coalition with the Greens and the liberal FDP, which did far better than anticipated.

But FDP chief Guido Westerwelle categorically ruled out such an alliance on Sunday.

Merkel's conservatives and the FDP could also try to woo the Greens into what commentators have dubbed a "Jamaica" coalition because the colors of the parties match the black-green-yellow of the Jamaican flag.

"This is a total disaster," Michael Burda, an economics professor at Humboldt University in Berlin, told Reuters.

"Merkel has a razor-thin lead so she has an implicit right to start negotiations to form a government. But if you look closely there aren't many options."

"Germany faces difficult times because the formation of a new government will be tough," added Thomas Straubhaar, head of the Hamburg-based HWWA economic research institute.

"Whatever emerges will be comparatively unstable."

If all attempts at coalition-building fail, the only way out would be new elections -- a first for postwar Germany.

The election's impact on German foreign policy is less clear. Merkel had vowed to improve ties with Washington, strained by Schroeder's vocal opposition to the Iraq war, and prevent Turkey from joining the European Union.

The results outcome also left economists disappointed. Financial markets' immediate reaction was to sell euros.

The vote had been viewed as a watershed for the whole euro zone, setting the tone for elections in 2006 and 2007 in Italy and France.

Both countries had been watching the election closely, eager to see which path Germans chose – the liberal, unregulated route favored in the US and Britain or the state-heavy role preferred in much of Europe.