FACTBOX-Key political risks to watch in Germany

BERLIN Tue Jan 4, 2011 12:48pm EST

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BERLIN Jan 4 (Reuters) - Europe's sovereign debt crisis and possible heavy defeats in several of the seven regional elections in 2011 are two areas of potential trouble for German Chancellor Angela Merkel and her centre-right government.

The turmoil in her junior coalition partners, the Free Democrats (FDP), over their steep fall in opinion polls and the unpopularity of party leader Guido Westerwelle could also cause turbulence in Merkel's government. [ID:nLDE6BG0OS]

Even though the economy is roaring ahead, with projected growth of 3.4 percent in 2010 and domestic demand picking up, the public give the Merkel government no credit for the upturn. Worries about the euro zone's debt crisis are also lingering.

Following are some of the factors to watch:

EUROPEAN DEBT CRISIS

Merkel and Finance Minister Wolfgang Schaeuble may have unwittingly exacerbated the sovereign debt crisis that hit Ireland after engulfing Greece earlier in 2010 with comments that unnerved markets.

But they had in the back of their minds a German public sceptical about rescuing profligate euro zone countries when they insisted that banks and investors should share in the risk of sovereign bond default from 2013.

It has been a difficult balancing act for Merkel. Under former chancellor Helmut Kohl, her Christian Democrats (CDU) were unflinchingly dedicated to European unity, but the German electorate has since become more volatile and less tolerant about footing the bills.

What to watch:

- Merkel's public comments about the euro zone debt crisis may now become more cautious, but her fundamental reservations are unlikely to change.

STATE ELECTION DEFEATS

The collapse this week of Germany's first and only Christian Democrat-Greens government in the city-state of Hamburg was another setback to Merkel, whose conservatives will likely lose power in Hamburg in a snap February election [ID:nLDE6B00XA].

The CDU also looks like losing the industrial heartland state of Baden-Wuerttemberg in March, where it has held power for nearly 60 unbroken years, to a centre-left alliance of the Greens and Social Democrats.

The coalition has already lost control of the Bundesrat upper house of parliament after losing a regional election in May in North Rhine-Westphalia, meaning that left-wing opposition parties can now block or interfere with much of Merkel's planned legislation.

Some analysts warn that the loss of two more key states in quick succession would cause rumblings in the CDU rank and file.

But they do not expect Merkel to face any serious challenge to her leadership -- especially because a half dozen potential rivals took themselves out of politics in 2010.

After slumping for much of 2010, her conservatives have stabilised in opinion polls lately at about 34 percent, their level in the 2009 election. But their coalition partners, the Free Democrats, have plunged to 3-5 percent from almost 15 percent a year ago -- near or below the 5 percent threshold needed to win seats in parliament.

The opposition SPD and the Greens are both at about 22 percent. The SPD got 23 percent in last year's election and the Greens were at 10.7 percent. The Left party has been hovering steady at 10 percent after winning 11.9 percent in 2009.

What to watch:

- The weakness of the FDP under Westerwelle, who is also foreign minister, will be a source of coalition tension in the early months of 2011 [ID:nLDE6BE1NX]

- Any sign of rumblings within the CDU about Merkel's leadership.

ECONOMY

Germany suffered its biggest postwar recession in 2009 when the economy contracted by 4.7 percent. Driven by exports and helped by stronger-than-usual consumer sentiment, it emerged from the slump, leaving many of its euro zone peers trailing.

Hurdles do remain for the export sector, however, traditionally the economy's main growth engine.

An expected slowdown in global growth next year will likely reverberate in German industry, although it is not yet clear to what extent. Germany's specialised products are likely to remain in high demand in emerging markets.

Economists expect rising domestic investment and private consumption to help drive the economy in 2011, and many have raised their growth forecasts for this year and next.

The Bundesbank now sees the economy growing 3.6 percent in 2010 and r%aching pre-crisis levels by 2011. The government expects growth of 3.4 percent in 2010 and 1.8 in 2011, although other private sector economists have an even brighter outlook.

The forecasts reflect growing evidence that the domestic economy is contributing more to the recovery as confidence grows.

Consumer morale rose going into December to its highest since October 2007, and retailers expect the strong growth in sales during the Christmas shopping season to extend into 2011.

Germany's stronger-than-expected recovery has helped to pull the euro zone along in recent quarters, but it also raises concerns that divergence from struggling states on the periphery may complicate policy making for the bloc as a whole.

What to watch:

-- Domestic consumption and investment trends will be important areas to monitor as foreign demand slows; if Germany manages to diversify its sources of growth further, it could prove better insulated from any external slowdowns.

-- If unemployment continues to fall, this should continue to support growth in consumer spending.

-- If Germany continues to profit from the global rebound and other big countries such as France fail to benefit as much, disputes over economic policy in Europe may intensify.

DEBT

Bank bailouts, labour market subsidies and stimulus measures to boost growth have all added to Germany's debt burden, which will be the largest in its post-war history.

European Union data collected by Eurostat suggest that total debt will hit 1.9 trillion euros in 2010, or 75.4 percent of gross domestic product. Germany is still considered the top safe haven for bond investors within Europe's single currency area.

It plans to issue less debt in 2011 due to the strength of its recovery, and authorities say they are not concerned that the euro zone debt crisis will raise German borrowing costs.

The secondary market for federal government bonds has seen generally strong demand, lowering the cost of servicing new debt. But some issues have seen lacklustre demand, underlining the fact that Germany is not entirely immune from wider euro zone debt worries.

Next year marks a turning point for Germany's state finances, as a new "debt brake" law comes into effect, forcing the federal government to reduce the gap between its annual revenue and spending to under 10 billion euros by 2016.

The legislation, which is anchored in the constitution, also means that Germany's regional states -- known as Laender -- will probably no longer be able to create new net debt from 2020.

At the local government level, a number of large western cities are nearing bankruptcy and their finances have been further weakened by having to contribute to the redevelopment of the former East Germany until 2019.

What to watch:

-- Auctions early in the year may give a sign of steady demand for Europe's benchmark debt, or a creeping malaise from the euro zone's periphery states.

-- Splits between Berlin and the regions could intensify as federal funding grows scarcer and local services are cut back. A deterioration in local finances has also fuelled discontent among westerners who say they have paid enough for the east.

For political risks to watch in other countries, please click on [ID:nEMEARISK] (Additional reporting by Brian Rohan; Editing by Kevin Liffey)

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