* German ruling on bailouts, budget rules on Sept 12
* Constitutional Court seen giving qualified "yes"
* May demand more consultation, limited liability
By Stephen Brown
BERLIN, Sept 3 (Reuters) - Germany's Constitutional Court holds the fate of the euro in its hands when it rules next week on whether a crucial euro zone financial rescue fund can go ahead.
A negative ruling, considered improbable by legal experts, would cast the 17-nation European single currency area into turmoil, spurring panic on bond markets by raising doubt over any more rescues of debt-laden southern states.
But if, as expected, the court gives a green light on Sept. 12 to the euro zone's permanent bailout mechanism and a pact on stricter budget discipline, it may add conditions that constrain Berlin's power to pursue further European integration.
The court based in Karlsruhe in western Germany, one of the country's most trusted institutions, is unlikely to let Chancellor Angela Merkel completely off the hook.
Few experts expect the eight red-robed judges to reject the European Stability Mechanism (ESM)and fiscal pact outright, not least because of the devastating impact on financial markets.
"If they were to surprise us by striking down Germany's participation, I would think it'd be an utter bloodbath in markets," UniCredit global chief economist Erik Nielsen said.
But the sages may well demand more parliamentary consultation before Germany agrees to any further European integration, or signal that the process has gone as far as can be permitted without rewriting Germany's Basic Law.
"I don't think the court will block the ESM or the fiscal pact, so European integration of the euro will not come to an end on Sept. 12," said Franz Mayer, a professor of European Union and constitutional law at Germany's Bielefeld University.
"But it is unlikely there will just be one paragraph saying 'no problem at all, just go ahead'. As in the past, it will be foggy, open to interpretation and all parties involved will say 'We won'," Mayer told Reuters.
The ESM was meant to succeed the existing temporary European Financial Stability Facility (EFSF) from July and erect a 700 billion-euro firewall to prevent the euro zone's sovereign debt crisis from spreading further.
But Karlsruhe threw a spanner in the works by deciding in mid-July to take two months to look into complaints that the ESM and the fiscal pact that gives EU institutions intrusive powers to enforce the currency area's budget rules violate the German constitution.
That left the fate of the new rescue fund in limbo. Without ratification by the biggest economy it cannot go into force.
On Sept. 12 the court's Second Senate will rule on requests for an injunction from over 12,000 plaintiffs, who include eurosceptics from academia and Merkel's own coalition as well as the hardline Left Party.
They essentially argue that these treaties undermine German lawmakers' constitutional right to decide on the budget and expose Germany to potentially unlimited financial liability for the ESM risks.
Rulings on the EU's Lisbon Treaty in 2009 and on the Greek loans and the EFSF in 2010 earned the court a reputation as a thorn in the side of the euro for insisting on the Bundestag's (lower house of parliament) rights as a condition for approval.
"For Germans this is nothing new, every major decision on European integration is contested domestically so we are pretty much used to it and not overly worried," said economist Klaus Deutsch of Deutsche Bank.
"Given the fact that they decided positively on the EFSF, I'd be surprised if they came out clearly against the constitutionality of the ESM," he added.
SOFT AND HARD OPTIONS
Set up in 1951 to avoid a return to Nazi tyranny, the court has a history of testing the patience of chancellors such as founding father Konrad Adenauer, who called it "the dictator of Germany".
The ruling comes amid frantic diplomacy over proposed action by euro zone governments and the European Central Bank (ECB) to cap Spanish and Italian borrowing costs, which is conditional on the ESM being deployed.
Merkel says it is "of the utmost importance" that the court approve the ESM. The worst-case scenario for euro zone leaders would be Karlsruhe rejecting it, leaving them in the short term with only 150 billion euros left in the EFSF.
German ECB board member Joerg Asmussen has said a 'No' from the court would just require "changes to the construction" of the ESM. But Morgan Stanley economists, rating the chances of a 'No' verdict as high as 40 percent, said one impact of this would be to permit "only cosmetic" ECB bond-buying via the EFSF.
"We believe that markets are not priced appropriately for the downside tail risk of a possible 'no' verdict," the investment bank said in a note.
Still, the most likely scenario is that the court allows Germany to ratify the ESM and fiscal pact - but with qualifying comments that could range from mere formalities to fundamental observations about European integration that could reverberate for years to come.
The "soft" options include reiterating the need to consult lawmakers, splitting hairs about where the ESM treaty belongs in the constitution, or tinkering with details of the fiscal pact.
It could slow down the ESM by insisting that the upper house (Bundesrat), representing the federal states, also vote on new rescue requests or on new powers such as granting the ESM a banking license.
Constitutional experts have also speculated that the court could demand that a reservation be attached when President Joachim Gauck signs Germany's ESM ratification.
This would address concerns about exposure to the ESM being open-ended - for example, if other euro zone states are unable to pay their share, or if there is an attempt to raise the maximum capital - by setting in stone the interpretation of "limited liability".
The court could even force an unprecedented referendum on deeper EU integration by rejecting the treaties outright or by stating that no more sovereignty can be transferred to European authorities or courts under the current German constitution.
"A change of the German constitution would be a big game-changer on the future of the euro," wrote Morgan Stanley.
This would take Germany into uncharted territory. The constitution does not permit nationwide plebiscites, which got a bad name in the Weimar Republic and under the Nazis. Neither is there any guarantee that the public, let alone the increasingly eurosceptic media, would back deeper political and fiscal union.
"You can imagine that if there were an aggressive ruling, meaning at least a referendum and possibly much more, the result could be a huge economic depression unseen in Germany or Europe since World War Two," said Humboldt University's Matthias Kumm.
But the law professor believes the judges, especially 48-year-old court President Andreas Vosskuhle, are "finely-tuned" enough politically to avoid such a bombshell.
While Vosskuhle and court rapporteur Peter Huber, who drafts the ruling, are known to lean towards the idea of a referendum on Europe, as does Finance Minister Wolfgang Schaeuble, the judges will not want to sign away their powers or complicate the 2013 election, when Merkel will seek a third term in office.
But the referendum debate will not go away. Opinion polls suggest seven out of 10 Germans would like to have a direct say in how much more sovereign power - especially regarding how their taxes are spent - should be surrendered to Brussels.
Katinka Barysch at the Centre for European Reform said this debate "suits both the opposition and government", giving the Social Democrats an easy platform and enabling Merkel to "put off hard decisions until after the 2013 election".