By Sarah Marsh

BERLIN (Reuters) - Angela Merkel holds preliminary talks with the Social democrats (SPD) on Friday to sound out the scope for compromises to form a "grand coalition", marking the start of complicated horse-trading that could drag on into next year.

Germany's European partners are watching the coalition manoeuvring in Berlin closely, concerned that delays could push back EU-wide decisions on important financial crisis-fighting measures like the ambitious banking union project.

"Europe is watching us, the world is watching us," Merkel said at an event in Stuttgart ahead of the negotiations. "We have the common responsibility to build a stable government."

The SPD are seen as the conservative chancellor's most likely partner, but they have said they will not be rushed into a deal. Merkel will also hold preliminary talks with the Greens next week, playing potential partners off against each other.

Merkel said the landslide victory of her conservatives in the September 22 election had underscored voters' trust in them. "Now I will obviously try to justify this trust by fair talks."

There is deep resistance among SPD members to entering another "grand coalition" with Merkel, after hooking up with her in her first term only to plunge to their worst post-war result in the 2009 election.

Merkel's outgoing ally, the Free Democrats, suffered the same fate. After four years as her junior partner, they obtained less than 5 percent of the vote and so were booted out of the German parliament for the first time since 1949.

The talks on Friday aimed to examine whether policy compromises are feasible. Once these preliminary discussions are completed, a group of 200 senior SPD officials from across Germany must flash a green light before the party enters more formal coalition negotiations with Merkel's conservatives.

"It is still an open question as to whether or not it will come to formal coalition talks," said Andrea Nahles, general secretary of the SPD, striking a firm negotiating stance.

Nahles has said it could take until December or January for a government in Europe's largest and most powerful economy to be formed.

Political risk analyst Carsten Nickel at Teneo Intelligence said such claims were tactical posturing and he expected a deal earlier, noting that "a prolonged period of partisan bickering would not pay off with Germany's stability-prone electorate."

Moreover no party would want to risk exacerbating the euro zone crisis. Merkel's cabinet will act as caretaker government and "act if immediate decisions were required, for instance on Greek financing needs for 2014", Nickel said.

"Where possible, however, the preference will be to postpone decisions until a new government is in place."

WILLING TO COMPROMISE?

The aim of the formal coalition talks would be to agree a policy blueprint for the next government, as well as the allocation of top cabinet posts.

At the very end, the SPD has said it will have to go back to its 472,000 grassroots members and seek their approval before agreeing to an alliance with Merkel.

This raises pressure on the chancellor to make compromises, but it also poses a serious risk to the SPD leadership.

If the SPD rank and file were to reject a coalition deal negotiated by their leaders, party Chairman Sigmar Gabriel and other senior figures would probably have to step down.

Merkel's Christian Democrats and the SPD appear headed for a showdown over tax policy and bellwether cabinet positions, including the influential finance ministry now led by Merkel ally Wolfgang Schaeuble.

Leading conservatives have sworn to stand by their campaign promise not to increase taxes. The SPD campaigned on a platform of tax hikes for top earners to fund improvements in infrastructure and education.

Schaeuble said that by giving Merkel such strong backing, voters had shown they were against tax rises. In an interview with mass circulation Bild am Sonntag, he said: "We will fight for each and every point in our campaign programme".

(Additional Reporting by Ilona Wissenbach in Stuttgart; Editing by Mark Heinrich)