By Noah Barkin and Madeline Chambers
BERLIN (Reuters) - German Chancellor Angela Merkel's conservatives and the Social Democrats (SPD) start hammering out compromises on economic, energy and euro policies on Wednesday, the opening day of talks on a coalition government that should be in place by Christmas.
Germany's European partners will be watching the negotiations closely, hoping for a swift deal that allows the bloc to meet looming deadlines for its ambitious banking union.
Some allies are hoping a government that includes the SPD will take a softer approach towards struggling southern euro zone members, but any changes are likely to be more subtle than substantial.
The parties, which ruled together in Merkel's first term from 2005 to 2009, set out a timeline for the negotiations on Tuesday which foresees a deal by the end of November.
That would give the two biggest groups in parliament a fortnight to sell their "grand coalition" agreement to ordinary party members. Merkel could then be formally voted in as chancellor in parliament's last session of the year, the week before Christmas.
Merkel's conservatives easily won elections on September 22 but fell short of achieving a majority. Exploratory talks with the Greens collapsed last week, allowing Merkel to focus on opening formal negotiations with the SPD.
Among the central themes will be agreeing a minimum wage, overhauling a renewables law that has sent energy costs soaring, and finding funds to raise public investment on infrastructure, education and research - a major demand of the SPD.
Europe will also feature, with the SPD expected to push for a European financial transactions tax, harsh rules for creditors to bear the cost of failing banks, and a renewed effort to stem youth unemployment in southern Europe.
"The new government's domestic policy agenda should bring a modest shift to the left with stricter labor market regulation and a minimum wage," Barclays economist Thomas Harjes wrote in a research note this week.
"At the European level, the Social Democrats started to lobby for an economic growth strategy, but they also may be reluctant to push for significantly higher German transfers to other parts of the EU."
Election year in Germany has slowed progress on European banking union, an ambitious plan to restore confidence in the financial system following the crisis that erupted in 2008.
EU finance ministers agreed last week on the first stage, which gives sweeping supervisory powers to the European Central Bank. However, Berlin has dug in its heals over the next stage on dealing with failing banks, fearing that it would have to pick up much of the bill.
Berlin has been reluctant to accept anything that would be unpopular with German voters but other European governments now hope that formation of a new coalition will allow a compromise on the issue.
SCHULZ & SCHAEUBLE
European Parliament President Martin Schulz is slated to be the lead negotiator for the SPD on European themes, sources told Reuters on Tuesday.
Finance Minister Wolfgang Schaeuble will take the lead for Merkel's conservative Christian Democrats (CDU) in a working group focused on finance and budget issues.
Environment minister Peter Altmaier, a loyal Merkel ally, will face off with influential SPD leader Hannelore Kraft in the important energy area. Kraft, premier of Germany's most populous state of North Rhine-Westphalia, is expected to defend the coal industry, which has a sizeable presence there.
A large group of 75, led by Merkel, her Bavarian ally Horst Seehofer and SPD Chairman Sigmar Gabriel is due to meet weekly from October 30 to vet the results of 12 working groups and hammer out compromises.
In the last coalition talks in 2009, the main group had just 27 members, a sign that these talks will be far more complex.
Only at the end of the talks will Merkel, Seehofer and Gabriel divide up cabinet posts. The top prize is the finance ministry, but the SPD is divided over whether to claim that, pushing out the veteran Schaeuble, or go for other high profile portfolios such as the foreign or economy ministries.
A grand coalition would hold 80 percent of seats in the Bundestag lower house, making it easy to push through legislation. But some experts have expressed concern that the right-left partnership could boost fringe groups such as the new Alternative for Germany (AfD), an anti-euro party which nearly made it into the Bundestag and is expected to make waves in European Parliament elections next year.
(Additional reporting by Andreas Rinke, Holger Hansen in Berlin, John O'Donnell in Brussels; Writing by Noah Barkin; editing by David Stamp)