BERLIN, June 1 (Reuters) - A key ally of German Chancellor Angela Merkel raised doubts about the future of her government at the weekend, underlining tension in the ruling coalition, which has been hit by an electoral setback and policy disputes.
Europe's largest economy suffered its worst recession since World War Two in 2009, though it has now grown for four straight quarters, and forward-looking indicators suggest the manufacturing sector is recovering fast from the global slump.
Unemployment has remained subdued, thanks in great part to the government's decision to extend subsidies that encourage firms to put staff on reduced hours rather than fire them -- though this has come at a cost.
Germany's budget deficit is expected to swell to more than five percent of gross domestic product (GDP) this year, and the government has begun discussing measures to consolidate public finances to reassure investors about the health of the euro.
However, the discussions are proving contentious amid popular discontent about the billions of euros Germany has pledged to a financial safety net for fellow euro zone members.
Following are some of the key factors to watch:
The main opposition Social Democrats (SPD) have rallied somewhat in polls, and look set to enter the government of the country's most populous state, North Rhine-Westphalia, possibly as senior partner, after a vote on May 9.
This will enable the SPD to block laws drafted by Merkel's centre-right coalition in the Bundesrat upper house of parliament, giving the opposition more say in national government and potentially slowing down the legislative process.
The opposition revival has been accompanied by a slump in the popularity of the ruling coalition, especially the pro-business Free Democrats (FDP), Merkel's junior coalition partners.
A poll in May indicated support for the FDP had dropped to six percent, less than half the 14.6 percent they scored in September's federal election, fuelling criticism of FDP leader Guido Westerwelle from senior figures in the party.
This has led analysts to suggest Westerwelle may pursue a strategy more independent of Merkel that could deepen rifts within the government, raising doubts about its stability.
Merkel has also been hit by the shock resignation on Monday of German President Horst Koehler, a fellow conservative. This has triggered an election for a new president within a month.
Horst Seehofer, head of Bavaria's Christian Social Union (CSU), sister party to Merkel's Christian Democrats (CDU), was quoted as saying the future of the coalition "will be decided in the coming week" in a German media report at the weekend.
What to watch:
-- Analysts say Westerwelle's position as FDP leader could be under threat if his party fails in state elections next year. Three states with a combined population of more than 17 million are due to vote next March, with three others later in the year.
-- Westerwelle has said his party could work together with the SPD to help form a coalition in NRW, breaking with earlier pledges he made. The shape of the NRW government is likely to help set the tone for policy in Berlin in coming months.
-- The NRW outcome may also affect Merkel's majority for the election of a new German president on June 30.
-- State elections in March 2011 in Saxony-Anhalt, Baden-Wuerttemberg and Rhineland-Palatinate.
Disagreements in the coalition over policy could hold up legislation and lead to policy stagnation. Merkel's government has relatively few big plans left for the remainder of its term.
From 2011, it must take into account a "debt brake" law requiring Germany to cut the structural deficit by around 10 billion euros and reduce the deficit-to-GDP ratio to a limit of 0.35 percent by 2016.
Coalition sources have said the government is considering scrapping the discount on sales tax on some products, although the CSU and FDP say they are opposed to higher taxes.
What to watch:
- Spending cuts have been mooted, though details have yet to emerge. A number of subsidies may face the axe. Cabinet holds a special session on June 6/7 to discuss the measures.
- A planned FDP law to consolidate the cash-strapped health service this year faces opposition from both the CSU and the SPD, which could derail a bill in the Bundesrat upper house.
- There may be legal challenges to Germany's contribution to the international 750 billion euro aid plan for the euro zone.
Exports and industrial orders have leapt since the start of the year, spurring a revival in the labour market. Forward-looking indicators and surveys suggest the manufacturing sector continues to recover from the global slump.
Germany is heavily dependent on exports for growth, which has prompted some trading partners to accuse Berlin of not doing enough to boost its own domestic demand.
Some economists also say productivity could suffer if firms use a state subsidy for reduced hours for too long, inflating their cost base by artificially protecting the labour market.
What to watch:
-- Germany's economic recovery may start to sputter if the austerity measures launched during the euro zone debt crisis sap demand in major European trading partners.
-- If Germany continues to profit from the global rebound and countries such as France fail to gain traction, disputes over economic policy in Europe may intensify.
-- The Ifo think tank's latest survey on German business sentiment will be published on June 22, while preliminary data for GDP in the second quarter are due on Aug. 13.
DEBT Bank bailouts, labour market subsidies and stimulus measures to boost growth have all added to Germany's debt burden.
As Europe's benchmark issuer of sovereign debt, the federal government has seen strong secondary market demand for its bonds, lowering the cost of servicing new debt.
However, low coupons on recent issues have hit demand, as shown by an auction of five-year "Bobl" notes on May 26.
Meanwhile at local government level, a number of large western cities are nearing bankruptcy, a situation exacerbated by the fact that until 2019 they must continue paying towards the redevelopment of the former East Germany.
What to watch:
-- The deterioration in municipal finances has deepened splits between Berlin and the regions, and aggravated discontent among westerners who think they have already paid enough for the benefit of the eastern states.
-- Some leading politicians from western Germany have said they will seek to reduce the burden on afflicted municipalities this year when the law governing the so-called "solidarity charge" for the east is debated in parliament.
-- Upcoming bond sales will provide a clearer picture of the impact of the crisis on demand. Two-year Schatz auctions come on June 9 and June 30, with a 10-year Bund sale on June 16.
-- The German Finance Agency's debt issuance calendar for the third quarter is due near the end of June, and Q4 at the end of September. These should give some indication of how borrowing needs for the federal government are developing. (Editing by Kevin Liffey)