BERLIN, April 4 (Reuters) - Chancellor Angela Merkel is facing a turbulent period after a series of election routs, a bitter internal party battle over nuclear energy and a power struggle that is convulsing her junior coalition partner.
The euro zone debt crisis is also straining her centre-right government, which has been heavily criticised in the media and by the opposition for zig-zag policies, and continues to fall in voter surveys after 16 months in power.
The economic outlook remains bright, with unemployment falling to a record low [ID:nLDE72U0RE] and growth slated to remain robust. The economy's strong performance this year follows impressive growth of 3.6 percent in 2010 -- the fastest in two decades [ID:nLDE70A1OB].
Following is a summary of the main risks for Germany:
Merkel, whose conservative Christian Democrats (CDU) have now been swept from power in the two of four state elections so far this year, has hit a rough patch.
Guido Westerwelle, the unpopular leader of her coalition partner Free Democrats (FDP), resigned on Sunday, jumping before he was pushed but not before he proposed handing control over to an untested new guard of 30 year-olds he hand-picked.
Although he plans to stay on as foreign minister, some officials within the party are calling for a cabinet reshuffle that could also claim the head of Economy Minister Rainer Bruederle, a member of the FDP old guard.
Long unable to separate herself from her least popular minister, as Westerwelle became known, Merkel managed to lose the most popular figure in her cabinet when the defence minister quit in early March, rattling her government just weeks before three important regional elections. [ID:nLDE7200Z5]
She had hoped to hold onto Karl-Theodor zu Guttenberg in the hope of avoiding the batterings at the polls, but a plagiarism scandal ultimately cost him his job.
The CDU lost the conservative bastion of Baden-Wuerttemberg on March 27 after 58 straight years of rule. The Greens are set to lead a state government for the first time with the Social Democrats (SPD). [ID:nLDE72Q0KS]
The election was overshadowed by worries about nuclear power following the disaster in Japan [ID:nLDE72Q0LE]. Merkel's government had strongly backed nuclear power and wrote a law last year to extend the lifetime of the country's 17 reactors.
That hurt her party and it is now split by a destructive debate on whether to stick with those plans or pull the plug on nuclear power, as planned, by 2022 or sooner. It is also divided over Germany's U.N. abstention on military action in Libya.
There have been rumblings in the CDU about the state election defeats -- they have now lost power in both Hamburg [ID:nLDE71K0SU], and Baden-Wuerttemberg while holding onto Saxony-Anhalt and falling short again in Rhineland-Palatinate.
The good news for Merkel is that the CDU does not lead the governments of any of the three states holding elections for the rest of this year and thus cannot lose any more seats in the Bundesrat, or upper house.
Bremen (May 22), Mecklenburg-Vorpommern (Sept. 4) and Berlin (Sept. 18) are all controlled by the SPD. The CDU has little chance of winning any of those states.
What to watch for:
- The row over nuclear energy within the CDU that could ultimately cost the four nuclear power plant operators E.ON, RWE, EnBW and Vattenfall Europe hundreds of millions of euros every year in lost profits.
- Rumblings in the CDU rank and file over Merkel's leadership
- A destabilising leadership shake-up in the FDP that will likely see plenty of new and inexperienced faces taking over top posts in both the party and the parliament.
EUROPEAN DEBT CRISIS
The euro debt crisis played a key role in the state elections. Wary of a backlash from voters, Merkel long resisted calls to expand the 440-billion euro ($570 billion) European Financial Stability Facility (EFSF). The FDP was especially adamant in its opposition to raising the size of the EFSF.
What to watch:
- Merkel's public comments about the euro zone debt crisis and any change in fundamental reservations about increasing the EFSF.
Germany suffered its biggest postwar recession in 2009 when the economy contracted by 4.7 percent. Driven mainly by exports and helped by a pick-up in domestic demand, it has emerged from the slump. Business morale is currently at a record high and consumer sentiment at its most optimistic for years.
As monetary and fiscal stimulus is gradually withdrawn from the global economy and some euro zone trading partners pursue strict austerity measures, Germany's red-hot export growth is expected to cool off and return to a more sustainable level.
Barring any major shocks from China, Germany should remain one of the pre-eminent suppliers of high-quality capital goods to dynamic emerging markets looking to improve their infrastructure and boost productivity.
Many economists argue healthy corporate earnings and a tightening labour market will mean employers will have to raise wages to retain skilled workers. This should feed through into domestic consumption but could fuel inflationary pressures.
Last week, chemical companies agreed to hike wages for the 550,000 Germans employed in the industry by 4.1 percent over a 15 month period -- above the current harmonised annual inflation rate of 2.2 percent in March.
What to watch:
- Whether demand for German goods among EU trading partners drops as a result of the sovereign debt crisis
- Whether major export market China, in an attempt to throttle inflationary pressures from an overheating economy, ends up suffering a hard landing.
- If unemployment continues to fall, this should support growth in consumer spending.
Bank bailouts, labour market subsidies and stimulus measures to boost growth have added to Germany's debt burden, partly offset by rising tax receipts that have sprung from an economy that has performed better than expected. Berlin estimates its total outstanding public debt at 82 percent of overall economic activity, a figure Kiel-based think-tank IfW estimates will grow to 84.3 percent in 2011 -- well above the Maastricht criteria of 60 percent of GDP.
This 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.
Government sources say the strong economic recovery means this target may be hit a year early.
What to watch:
- Auctions should signal continued steady demand for Europe's benchmark debt, but the market could seek higher compensation in the coming months to offset inflationary risks.
- Germany officially targets federal net new borrowing of 48.4 billion euros for this year but aims to come in below 40 billion. For 2012 it foresees net new borrowing of 31.5 billion euros before reducing this to just 13.3 billion by 2015 to comply with the debt brake law.
For political risks to watch in other countries, please click on [ID:nEMEARISK]