STOCKHOLM (Reuters) - Sweden's centre-left Social Democrat leader Stefan Lofven emerged as victor in Sunday's general election after a voter backlash against tax cuts and trimmed welfare by a centre-right government, but faced challenges forming a strong coalition as he fell short of a parliamentary majority.
The Nordic region's biggest economy and one of the few star performers in Europe now faces a weak minority government with a possible political impasse as the anti-immigrant far right emerged as the third biggest party to hold the balance of power.
Lofven's Social Democrats and two other opposition parties, the Greens and Left, garnered 43.7 percent of the vote, against 39.3 percent for Prime Minister Fredrik Reinfeldt's coalition. That means a government with limited clout to pass bills.
Lofven told supporters he would begin coalition talks with the Greens, but also reach out to other parties.
"We are in serious situation. We have thousands of people unemployed, We have school results that are declining more than in any other OECD country," Lofven said. "There is something that is breaking. Now Sweden has answered that we need a change."
After all but two of 5,837 voting districts had been counted, the three centre-left parties - who have not as yet created a formal bloc - won 158 parliamentary seats, short of the 175 needed for a majority. The government coalition won 142.
The far right anti-immigration Sweden Democrats won 12.9 percent in the poll, and 49 seats. Despite holding the balance of power, other parties refuse to work with them.
"You can't avoid taking us into account if you want to run the country," Sweden Democrat leader Jimme Akesson told cheering supporters. "We are holding the absolute balance of power now."
Lofven said the Sweden Democrats had "no right to be king makers" despite their election gains.
"Remember that 87 percent of Swedes didn't vote for them," he told Reuters. "We will have a strong government that won't depend on the Sweden Democrats."
Lofven, a former welder and trade union negotiator, now faces hard and protracted negotiations to form a government. While the Social Democrats are the biggest party, it was one of their worst electoral results in a century.
"It is clear that from a broader perspective that this is difficult for Sweden," said Swedish centre-right Finance Minister Anders Borg. "We go from having one of Europe's strongest governments to having a weak government power with considerable uncertainty about economic policy."
In a blow for the centre-left opposition, the Feminist Initiative Party got 3.1 percent, below the threshold for parliamentary seats.
A win for the centre left in a weak minority government could also be another nail in the coffin for reform in the Nordics, where governments in Norway, Finland and Denmark are holding back on trimming their expensive welfare states.
A defeat for Prime Minister Fredrik Reinfeldt robs the likes of Germany and the United Kingdom of a voice in the troubled bloc for fiscal prudence and reform. Lofven has campaigned for more growth and investment and higher taxes on companies and the wealthy in the European Union.
Under Reinfeldt Sweden lost much of its image as a socialist welfare state. The country's tax burden fell 4 percentage points, to 45 percent of GDP, under France's. Taxes on inheritance and wealth were lowered or abolished. More Michelin star restaurants than ever opened in Stockholm.
"These have been fantastic years where the Alliance have taken responsibility for Sweden," Reinfeldt told party supporters on announcing his resignation. "My hope is that the journey will continue, but it will be without my participation."
Many Swedes are worried that reforms under Reinfeldt have gone too far, weakening healthcare, allowing business to profit from schools at the expense of results and dividing a nation that has prided itself on equality into haves and have-nots.
Voters have been shocked by scandals over privately run state welfare - including one case where carers at a home for the elderly were reportedly weighing diapers to save money - and bankruptcies of privately run schools.
"We need to re-find our values, those that say we take care of each other, that it is not all about the rich getting it better," said Sofia Bolinder, playing with her young daughter in a playground after voting in the suburb of Skarpnack in southern Stockholm. Bolinder, in her 30s, said she voted for a party "on the left."
Widely admired for its triple A-rated economy, stable government and liberal attitude to immigration, Sweden nevertheless faces significant challenges, which a weak government will struggle to deal with.
Unemployment is high at 8 percent, hitting immigrants and young people especially, and a potential housing bubble threatens economic stability. Widespread riots last year in Stockholm's poor immigrant suburbs highlighted a growing underclass in Sweden, which has had the fastest-growing inequality of any OECD nation.
The rise of the far right points to a society starting to question its role as what Reinfeldt calls "a humanitarian superpower".
The number of asylum seekers from countries like Syria is expected to reach 80,000 this year. Even Reinfeldt has said government finances would be strained due to the cost of new arrivals. They were figures that played into the hands of the far right.
The Social Democrats plan to spend around 40 billion crowns ($5.6 billion) to improve education, create jobs and strengthen welfare by raising taxes on restaurants, banks and the wealthy.
The centre-left parties include the Left Party - formerly Sweden's communist party - which wants to raise income and corporate taxes and exclude profit-making businesses from schools and welfare, policies that the Social Democrats and Greens reject.
The other centre-left party, the Greens, have campaigned to end nuclear power in Sweden.
The Liberal and Centre parties, the two smallest in the current government, have snubbed Lofven's call for a broad-based government, raising the threat of deadlock after the election, or, in the worst case scenario, a new vote.
The Swedish crown weakened around 3 ore versus the euro EURSEK= in early Asian trade after it became clear both sides would be short of forming a majority.
"It is going to be very difficult to form a government," said Swedbank economist Knut Hallberg.
(1 US dollar = 7.1247 Swedish crowns)
Additional reporting by Niklas Pollard, Helena Soderpalm, Johannes Hellstrom, Daniel Dickson and Johan Ahlander; Editing by Alistair Scrutton, Niklas Pollard and Eric Walsh