* Ifo sentiment index drops to 107.4 vs forecast rise
* U.S. fiscal crisis, stronger euro are risks to economy
* Ifo, economists say Germany still on track to recovery
* Export expectations rise to highest this year
By Sarah Marsh
BERLIN, Oct 25 (Reuters) - German business morale droppedfor the first time in six months in October, underscoring thefragility of a recovery in Europe's largest economy that iswidely expected to pick up momentum next year.
The Ifo think tank said on Friday its business climateindex, based on a monthly survey of 7,000 firms, dropped to107.4 from 107.7 in September. The reading fell short of theconsensus forecast in a Reuters poll of economists for a gain to108.0, and nudged the euro lower against the dollar.
Europe's economic powerhouse, which put in a stellarperformance during the early years of the euro zone crisis,weakened last year but bounced back between this April and Junewhen it grew by its strongest rate in more than a year.
This recovery should keep going despite Friday'sdisappointing survey. Ifo economist Klaus Wohlrabe told Reutersthe drop was "a small damper and not a trend change".
The fall in business sentiment was sharpest in the retailsector, while a bright spot was a rise in export expectations ofGerman manufacturers to their highest value of the year.
"The leading indicators published this week, includingtoday's Ifo index, all show that while an economic recoveryappears to be ahead of us, it should undoubtedly be consideredmoderate," said Thomas Gitzel at VP Bank.
Political turmoil in Italy, where the government came closeto falling, and a row in Washington that raised the risk of theUnited States defaulting on its debt may have sown someuncertainty among German businesses, along with a strengtheningeuro.
"The U.S. debt crisis and its possible fallout on economicactivity, combined with the stronger exchange rate are not themost favourable mix for the German export sector," said CarstenBrzeski at ING.
A Purchasing Managers' Index (PMI) showed on Thursday thatGermany's private sector grew at the slowest pace in threemonths in October. Weakness among service providers was also thereason for the drop in the PMI, suggesting the domestic economyis underperforming expectations.
Germany's second quarter rebound was largely due to robustdomestic demand, helped by a strong labour market, solid wageincreases and favourable financing conditions. A spring catch-upon projects delayed by harsh weather last winter also helped.
SLOWER SECOND HALF
Economists expect slower growth in the third and fourthquarters. Ifo's Wohlrabe said the think tank was sticking to itsforecast for 0.3 and 0.4 percent growth respectively.
A sub-index for firms' assessment of their current situationfell marginally by 0.1 percentage points but remained above thelong-term average. The reading for their business expectationsdropped more sharply, to 103.6 from 104.2.
The euro rose on Friday to a two-year high againstthe dollar before slipping when the survey was published.
Earlier this week, Germany's flagship airline Lufthansa said declines also by the Japanese yen and Indian rupee against the euro were hurting itsearnings.
Yet the Ifo survey showed firms remained optimistic overallabout a pickup in exports as the global economy recovers andmanufacturers were upbeat about future business developments.
Data this week showed the British economy grew at thefastest pace in more than three years in the third quarter andSpain pulled out of a two-year recession.
Ifo's Wohlrabe said German exports to the United States wereexpected to rise despite its budget crisis.
Momentum in German economic growth is forecast to pick upnext year. The government said earlier this week it expectedexpansion of 1.7 percent in 2014 after 0.5 percent in 2013.
Major German firms were mostly upbeat about their outlookthis week. Luxury carmaker Daimler forecast higherfourth-quarter profit after posting better than expectedresults.
"Germany is on a recovery course," said KfW's Joerg Zeuner."Growth of two percent next year is imaginable."
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