| BERLIN, June 1
BERLIN, June 1 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.
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)