* 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 dropped for the first time in six months in October, underscoring the fragility of a recovery in Europe's largest economy that is widely expected to pick up momentum next year.
The Ifo think tank said on Friday its business climate index, based on a monthly survey of 7,000 firms, dropped to 107.4 from 107.7 in September. The reading fell short of the consensus forecast in a Reuters poll of economists for a gain to 108.0, and nudged the euro lower against the dollar.
Europe's economic powerhouse, which put in a stellar performance during the early years of the euro zone crisis, weakened last year but bounced back between this April and June when it grew by its strongest rate in more than a year.
This recovery should keep going despite Friday's disappointing survey. Ifo economist Klaus Wohlrabe told Reuters the drop was "a small damper and not a trend change".
The fall in business sentiment was sharpest in the retail sector, while a bright spot was a rise in export expectations of German manufacturers to their highest value of the year.
"The leading indicators published this week, including today's Ifo index, all show that while an economic recovery appears to be ahead of us, it should undoubtedly be considered moderate," said Thomas Gitzel at VP Bank.
Political turmoil in Italy, where the government came close to falling, and a row in Washington that raised the risk of the United States defaulting on its debt may have sown some uncertainty among German businesses, along with a strengthening euro.
"The U.S. debt crisis and its possible fallout on economic activity, combined with the stronger exchange rate are not the most favourable mix for the German export sector," said Carsten Brzeski at ING.
A Purchasing Managers' Index (PMI) showed on Thursday that Germany's private sector grew at the slowest pace in three months in October. Weakness among service providers was also the reason for the drop in the PMI, suggesting the domestic economy is underperforming expectations.
Germany's second quarter rebound was largely due to robust domestic demand, helped by a strong labour market, solid wage increases and favourable financing conditions. A spring catch-up on projects delayed by harsh weather last winter also helped.
SLOWER SECOND HALF
Economists expect slower growth in the third and fourth quarters. Ifo's Wohlrabe said the think tank was sticking to its forecast for 0.3 and 0.4 percent growth respectively.
A sub-index for firms' assessment of their current situation fell marginally by 0.1 percentage points but remained above the long-term average. The reading for their business expectations dropped more sharply, to 103.6 from 104.2.
The euro rose on Friday to a two-year high against the 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 its earnings.
Yet the Ifo survey showed firms remained optimistic overall about a pickup in exports as the global economy recovers and manufacturers were upbeat about future business developments.
Data this week showed the British economy grew at the fastest pace in more than three years in the third quarter and Spain pulled out of a two-year recession.
Ifo's Wohlrabe said German exports to the United States were expected to rise despite its budget crisis.
Momentum in German economic growth is forecast to pick up next year. The government said earlier this week it expected expansion of 1.7 percent in 2014 after 0.5 percent in 2013.
Major German firms were mostly upbeat about their outlook this week. Luxury carmaker Daimler forecast higher fourth-quarter profit after posting better than expected results.
"Germany is on a recovery course," said KfW's Joerg Zeuner. "Growth of two percent next year is imaginable."