LONDON (Reuters) - The row over Europe inside David Cameron’s Conservative party may have thwarted the ambitions of staunchly pro-EU finance minister George Osborne to succeed him as prime minister.

Britain's Chancellor of the Exchequer George Osborne arrives for a Cabinet meeting in Downing Street in London, Britain February 20, 2016. REUTERS/Toby Melville

Just three months before a June 23 referendum on EU membership, Europe is causing mayhem within Cameron’s divided party and has now damaged Osborne, his closest political ally.

Once cast as heir apparent to Cameron who plans to step down ahead of the 2020 general election, Osborne had sought to use his annual budget to heal rifts over Europe, an issue that helped sink the Conservative premierships of Margaret Thatcher and John Major.

But such is the tension within the party that a clash over spending on welfare for the disabled developed into a full blown party crisis within two days, culminating in the sudden resignation of former party leader Iain Duncan Smith

from government on Friday.

The affair graphically highlighted the depth of feeling within Britain’s Conservatives over the “Brexit” debate, with Osborne seen as the “remainer in chief” in cabinet, and Duncan Smith a committed Eurosceptic.

On the face of it, Duncan Smith resigned as welfare minister over cuts in benefits for the disabled, but his dramatic exit was immediately seen by commentators as intended to destabilize Cameron and Osborne as the Europe debate intensifies.

Cameron and the “In” camp argue Britons are better off in Europe for financial, diplomatic and military reasons while the “Out” camp says membership undermines national sovereignty.

Political uncertainty about the turmoil in the Conservative Party meant sterling fell sharply against the dollar and the euro on Monday.

“Politics is going to be more important than economics for the next three months in the UK and so far,” said Kit Juckes, strategist at Societe Generale.

“The resignation of Iain Duncan Smith will simply add another layer of political risk to sterling’s prospects.”

Bookmakers offered odds of 2/1 on Osborne being replaced as finance minister this year.

“SHEER HATRED”

“This has brought out the sheer degree of hatred, I’m afraid it is hatred, of Osborne in the Conservative Party,” said Andrew Gimson, who writes for grassroots website ConservativeHome.

“Once your system of power and patronage crumbles then you can very easily discover there isn’t much left. I think it’s now extremely unlikely that the Tory (Conservative) party will choose Osborne as their next leader.”

Many grass-roots members, who will choose its next leader, are angry at his pro-EU stance.

Europe has divided the Conservative Party for three decades.

A cartoon in The Telegraph newspaper showed a red boxing glove on a spring emerging from an EU box punching in the face first Thatcher, then Major and now Cameron. “It’s deja vu all over again..., ” it read.

The EU inflames such passions that Cameron warned in 2006 that the party had to stop “banging on” about Europe.

But just seven years later, under increasing pressure from eurosceptics and from lawmakers who feared the electoral success of the anti-EU UK Independence Party, Cameron promised a referendum on membership.

Now Cameron must fight a referendum with such a deeply divided party that some lawmakers have questioned privately how the party - let alone Cameron or Osborne - can survive the referendum, no matter what its result.

A Brexit would shake the EU to its core, ripping away its second largest economy and one of its top two military powers.

Pro-Europeans warn an exit from the EU would hurt Britain’s economy and could trigger the break-up of the United Kingdom by prompting another Scottish independence vote. Opponents say simply Britain would be better off out.

DISUNITY DAMAGING

But such is the strain within the party that even the close relationship between Cameron and Osborne has come under scrutiny: “Cameron: I blame Osborne” read The Times newspaper’s front-page headline.

Downing Street denied the report of a rift and a spokeswoman for Cameron said the prime minister “absolutely” has confidence in his finance minister.

But Matthew Parris, a former Conservative lawmaker and a columnist with The Times, said the suggestion of disunity was a damaging one.

“It weakens the whole Cameron-Osborne axis and that axis is critical - not just to the success of the government but to George Osborne’s leadership hopes,” he said.

If he is to recover, Osborne faces several big challenges, assuming that he and Cameron see off the risk of Britain voting to leave the EU which could end both their careers.

First, Osborne has to find a way out of the straitjacket he made for himself by promising to turn Britain’s budget deficit into a surplus by the end of the decade. Osborne has stuck to the target, despite a sharp cut to forecasts for economic growth which make it all the harder to hit.

Britain’s leading budget analysts at the Institute for Fiscal Studies have said Osborne will have to raise taxes or go further with his unpopular spending cuts if the growth outlook for the economy weakens again.

And he will still have to overcome his persistent image problem among voters in general, many of whom see him as a “posh” out-of-touch member of Britain’s elite.

“When the focus of the general public is on George Osborne’s negative ... (attributes) ... it makes it incredibly difficult for the Conservative Party as a whole to feel comfortable with itself about putting him forward,” a Conservative member of parliament said, speaking on condition of anonymity.