FILE PHOTO: German Interior Minister and Christian Social Union (CSU) leader Horst Seehofer gestures as he speaks to the media after Bavaria election loss, in Berlin, Germany, October 16, 2018. REUTERS/Michele Tantussi/File Photo

MUNICH (Reuters) - German Chancellor Angela Merkel’s Bavarian allies are close to forming a coalition with the centrist Free Voters to govern the wealthy southeastern state of Bavaria, party sources said on Tuesday.

The arch-conservative Christian Social Union’s (CSU) failure to win a renewed outright parliamentary majority in Bavaria was the first of two election setbacks that led to Merkel announcing on Monday that she was preparing her exit from politics.

Party sources said they expected to agree a deal with the Free Voters over the weekend, in time for the opening session of the region’s parliament in Munich on Monday.

The CSU has for decades ruled almost unchallenged in Bavaria, home to major companies like carmaker Daimler and engineering behemoth Siemens. The CSU is a crucial component of the nationwide electoral coalition that makes Merkel’s Christian Democrats the largest bloc in parliament.

The party’s leader, federal Interior Minister Horst Seehofer, is facing calls to follow Merkel in stepping down after the election debacle.

His calculation that a challenge for the far-right Alternative for Germany (AfD) party could be beaten back by adopting a tough line on the immigration that has dominated German politics since 2015, has misfired, with voters deserting the CSU for the Free Voters and the more pro-immigration Greens.