FACTBOX-Key political risks to watch in Britain

LONDON, June 1 (Reuters) - Britain's Conservative-Liberal Democrat coalition outlined its first legislative programme last week, promising to put budget deficit reduction and economic growth at the top of its priority list. [ID:nLDE64O0VZ]

Analysts have warned a large government borrowing bill -- close to 11 percent of GDP -- could drag Britain into the fiscal crisis engulfing the euro zone, although debt markets have warmed to cuts already announced by the coalition.

The economy, which emerged from an 18-month recession at the end of last year, grew only slowly in the first quarter of 2010.

So far gilts have been an attractive option for investors who want to pull money out of riskier bets in southern Europe. However, sterling has fallen in value against the safe haven dollar since the start of May.

Below are the key political risks to watch in the coming months.

GOVERNMENT MAKE-UP, POLICY

Markets are on alert for any sign of cracks in Britain's first coalition since the Second World War. A worst outcome would see the Conservative-led coalition fall apart within months which would trigger another election and possibly hamper action to reduce the budget deficit.

At best, the coalition lasts a full five-year term, cutting borrowing swiftly but also in a way that gives the recovering economy room to breathe.

Those who have made it into the coalition cabinet, including five Liberal Democrats, have extolled the virtues of a tie-up that looked far from natural before the May 6 election.

Coalition leaders even clubbed together to voice support for Lib Dem Chief Secretary to the Treasury David Laws, who resigned on May 29 over reports he claimed tens of thousands of pounds from the taxpayer for renting a room in his boyfriend's home.

While the top team is putting on a united front, there have already been unhappy murmurings from within both parties -- particularly among Conservatives disappointed at the party's failure to achieve an outright majority.

The litmus test will come when any potentially divisive legislation goes through parliament, particularly on the Lib Dem-sponsored referendum on voting reform which has next to no backing among Conservatives.

What to watch:

-- Indications for a stable government for at least a couple of years to address the deficit, and any signs of disputes over Europe and electoral reform.

-- The ousted Labour party. Former Prime Minister Gordon Brown is standing down as party leader, which means there will be a leadership battle over the coming months, with a winner to be announced in September. The speed at which Labour can reassert itself as a credible power will influence expectations of how long the current government can last.

ADDRESSING THE DEFICIT

The coalition has announced more than six billion pounds of spending cuts for this year -- not enough to make much of a dent in a deficit well over 150 billion pounds ($216 billion), but a gesture to reassure markets Britain is on the right track.

Importantly, the Conservatives have persuaded the Lib Dems of the need to get to work on the deficit early to avoid a downgrade to Britain's triple-A credit rating.

The coalition's first budget on June 22 is likely to outline the scale of spending cuts and tax rises needed -- Conservative finance minister George Osborne wants to significantly reduce the deficit over the course of the parliament, i.e. by 2015.

The Lib Dems seem to have convinced the Conservatives to adopt an approach to taxation that shields the poor but it is yet to be seen whether a rise in VAT sales tax from 17.5 percent will be needed.

Laws' resignation will have no impact on the coalition's deficit reduction plan but his exit may disappoint some analysts who had been impressed with his work so far alongside Conservative finance minister George Osborne.

What to watch:

-- A properly costed tax plan, a clear spending envelope and a clear strategy to reduce the deficit on June 22. The Conservatives have talked the talk on deficit reduction but must now meet high market expectations.

-- Credit rating agencies have held off any moves until after the election, but any downgrade or outlook change could seriously hurt sterling, gilts and filter through to stocks.

TACKLING THE BANKS

The Bank of England will be given powers to oversee macroprudential regulation of the banks and an independent commission will look into ways to separate retail and investment banking activities.

A clampdown on bonuses is also expected and some type of banking levy will be introduced, with or without international approval. Media have speculated that the government could raise as much as 8 billion pounds a year from such a tax.

What to watch:

-- An interim report on splitting banks is expected within a year. Any swift move to change banks' structures could be negative for shares in banks such as Barclays (BARC.L) and HSBC HSBC.L.

-- The sector will also be worried about how much money the coalition pulls in from a bank tax and any clampdown on bonuses.

-- Can the new government get credit flowing again? On the table for consideration are net lending targets for nationalised banks such as RBS and a possible major loan guarantee scheme.

EXTERNAL, INTERNAL STRAINS

Conservative David Cameron takes over a country fighting a war in Afghanistan, an issue which could become a dividing point within the coalition. The Lib Dems are less enthusiastic about the war and might oppose any increase in troop numbers.

The coalition might also face an upsurge in dissident republican violence in Northern Ireland -- although Cameron has more freedom on Northern Ireland policy than if he was locked in a minority government dependent on Ulster Unionists for support.

Social and labour unrest is a worry, given the scale of austerity measures facing Britain. Companies such as British Airways are already mired in industrial action, which could spread to the public sector where job losses, pay freezes and other cuts will play a key role in deficit reduction.

The largely eurosceptic Conservatives and more Europe-friendly Lib Dems could also fracture over relations with the European Union.

What to watch:

-- Does the EU agree further bailout packages for troubled fringe euro economies? Any worsening in relations with the EU could imperil Lib Dem support for the coalition.

-- Does NATO request more troops for Afghanistan?

-- How does the new administration cope with the public sector industrial action that is likely to accompany the "age of austerity" for public spending?

For political risks to watch in other countries, please click on [ID:nEMEARISK] (Editing by Sonya Hepinstall)