Merkel wins as Germans choose centre-right

German voters gave Chancellor Angela Merkel a second term on Sunday and a mandate to partner with the pro-business Free Democrats (FDP) in a government that will rein in the role of the state in Europe's largest economy.

Merkel, 55, has ruled for the past four years in a grand coalition with the center-left Social Democrats (SPD), an awkward partnership of traditional rivals.

The election result frees her from the shackles of that marriage of convenience, allowing her to form the center-right government she has argued is best placed to nurture Germany back to health after its worst recession in the post-war era.

Merkel, who narrowly squeezed into power in 2005, appeared relieved at her clear-cut victory in an election which pollsters had predicted could again be a cliffhanger.

What counts for me is that we got a change in the shape of the government, she told supporters who chanted Angie, Angie as she strode up to the stage at her party headquarters, wearing a bright red suit.

We can really celebrate tonight, but afterwards we have a hard job ahead of us, she added, vowing to be a chancellor for all Germans.

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.

But the partners, which last ruled Germany between 1982 and 1998 when Helmut Kohl was chancellor, will also have to overcome differences on the size and timing of tax cuts in tough coalition talks over the coming weeks.

Given the budget constraints facing the new government, it may have to put off some of its more ambitious fiscal plans until next year or beyond.

The new government will face some of the most difficult challenges we've seen over the last 50 years, said Andreas Rees, an economist at Unicredit.

FDP BIG WINNER

The vote took place against a backdrop of heightened security after al Qaeda issued several videos last week threatening to punish Germany if voters backed a government that kept German troops in Afghanistan.

Projections from ARD and ZDF public television showed Merkel's conservative bloc -- the Christian Democratic Union (CDU) and the Bavarian Christian Social Union (CSU) -- on 33.8 percent, down from a score of 35.2 percent in 2005, and their second-worst result in the post-war era.

But the FDP, a party which saw its support rise in the wake of the financial crisis, compensated for those losses, surging to 14.5 percent, its best score ever, and putting the center-right 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 over 11 points to 23.1 percent, its 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.

CAUTIOUS CAMPAIGN

Germany's first woman chancellor and the first to have grown up in the former communist east, Merkel ran a cautious campaign that steered clear of the bold economic reform plans she advocated before the 2005 vote and sought to leverage her high personal popularity ratings.

Despite criticism for her slow reaction to the financial crisis, consensus-hungry Germans have welcomed her steady, low-key style. Unlike voters in Japan and the United States, they showed no signs they wanted a change of leadership.

She now faces a long list of challenges that will test her new coalition.

The future of 25,000 German workers at carmaker Opel is riding on Berlin's ability to push through a sale of the General Motors unit to Canadian car parts group Magna.

Within months of taking power, the new government will have to renew a parliamentary mandate for German participation in the unpopular NATO-led mission in Afghanistan in the face of a more powerful leftist opposition.

The result means that we will see more confrontation at the federal level because the SPD will move to the left, said Uwe Andersen, a political scientist at the University of Bochum.

(Writing by Noah Barkin; Editing by Mark Trevelyan)