The parties hoping to form Germany's next government on Tuesday agreed to create a 500 billion euro infrastructure fund and overhaul borrowing rules in a tectonic spending shift to revamp the military and revive growth in Europe's largest economy.

Friedrich Merz's conservatives and the Social Democrats (SPD), who are in negotiations to form a coalition after a national election last month, will put their proposals to the German parliament next week.

The need for more military spending to improve Europe's own defence abilities has become urgent since the return to power of U.S. President Donald Trump, who froze military aid to Ukraine after a clash last week with its President Volodymyr Zelenskiy.

Economists and investors have urged Germany to reform its constitutionally enshrined state borrowing limits known as the "debt brake" in order to free up investment and support an economy that has contracted for the past two years.

"In view of the threats to our freedom and peace on our continent, whatever it takes must now also apply to our defence," said Merz, leader of the CDU/CSU conservatives and likely next German chancellor.

"We are counting on the United States of America to continue to stand by our mutual alliance obligations in the future. But we also know that the resources for our national and alliance defence must now be significantly expanded."

Merz said the CDU/CSU and SPD parliamentary group would submit a motion to the Bundestag lower house of parliament next week to amend the constitution so defence expenditure above 1% of economic output is exempt from the debt brake.

Changing the so-called debt brake and creating a special fund requires a two-thirds majority.

The conservatives and SPD are rushing to get the moves passed in the outgoing parliament, given far-right and far-left parties will have a blocking minority in the new parliament after scoring strongly in last month's election.

"The outcome of the exploratory talks on the special infrastructure fund and the reform of the debt brake is a real game-changer," said Sebastian Dullien of the IMK institute.

"If this succeeds, then the stagnation of the German economy is likely to be overcome quickly. Not only because urgently needed investments will now be made, but also because the overall mood is likely to shift significantly. Germany is once again economically and militarily capable of taking action."

Frankfurt-listed shares in German defence firms Rheinmetall , Hensoldt and Renk all rose on the news in late trading, gaining between 1.5% and 5.2% at 1909 GMT.
Merz said he would meet outgoing SPD Chancellor Olaf Scholz on Wednesday to discuss additional aid for Ukraine.

"Our country is running on wear and tear, and that is why it was important for us to invest, to invest massively, so that our country functions better again. A future government must stop the deterioration of our country," SPD leader Lars Klingbeil said.