By Madeline Chambers and Matthias Williams

BERLIN (Reuters) - Germany's Social Democrats (SPD) said on Wednesday they had agreed to start talks on a possible coalition with Friedrich Merz's conservatives but stressed their support was not automatic and hit out at his negotiating style.

The SPD met to elect new parliamentary party leader Lars Klingbeil after the party crashed to its worst post-war defeat in Sunday's election following the collapse of Chancellor Olaf Scholz's unpopular SPD-led coalition last November.

Investors are watching what price the SPD will demand to join a government and whether parties will agree to a massive new defence fund and reforms to borrowing limits known as the "debt brake" either in the outgoing parliament or the next.

Economists and investors want a rapid easing of the debt brake to lift Europe's largest economy out of the doldrums and fund an overhaul of Germany's military, which has taken on urgency with Donald Trump back in the White House and dealing with Russia over the heads of Europe on ending the Ukraine war.

Parliamentary arithmetic means the centre-left SPD is the most likely ally to help Merz's conservatives form a new governing majority in Berlin but there is ill feeling between the parties after a bruising election campaign.

Klingbeil said the SPD wanted quick talks and to agree a timetable for negotiations on issues ranging from security to jobs and welfare but stressed it was now also up to Merz to ensure that the discussions bear fruit.

The SPD has bristled at the prospect of Merz agreeing to ramp up defence spending via a special fund after he stalled on such a move while in opposition, and also accused the conservatives of negotiating sensitive topics in public.

"We have an interest in strengthening the Bundeswehr (military)," Klingbeil said. "We have an interest in ensuring that there is much more investment in our country than is the case today."

The SPD was prepared to discuss whether such moves were achievable in the outgoing parliament.

"But what won't work is for us to hear public proposals now from newspapers and internet portals," Klingbeil said. "If we want to talk seriously, then we will talk seriously, and then that also means confidentiality and not public staging."

Merz congratulated Klingbeil after his election. "I look forward to working together in the coming legislative period. It all depends on us in the parliamentary centre," Merz wrote on X.

PUBLIC SUPPORTS MORE DEBT

But Merz's underwhelming election win, with just 28.5% of the vote, left him facing the spectre of an obstructive parliament given the surge in public support for far-right and far-left parties.

Some lawmakers want a vote to loosen the debt brake or approve the defence fund, or both, in the outgoing parliament.

However, Merz has already ruled out a quick change to the debt brake and also said it was "difficult" to find a deal for a defence fund potentially worth hundreds of billions of euros.

The debt brake reform and defence fund would each require two-thirds support in parliament, meaning success could depend on the composition of small parties which will change when the newly elected lawmakers are sworn in by March 25.

Both moves reflect anxieties about German security and the future of the transatlantic alliance since the re-election of Trump, as well as a hostile Russia and assertive China.

According to a poll by INSA, 49% of Germans support loosening the debt brake while only 28% are against. Among conservative voters, 56% support loosening it.

(Reporting by Madeline Chambers, Andreas Rinke and Matthias Williams; writing by Matthias Williams; editing by Mark Heinrich)