Number 1
It could cause a problem, however it it unlikely. Use the shower a few times, and see what kind of condensation settles on the wall above the tiles. If you can see visible droplets of water beading on the wall, you will have a problem over time. As your house settles, and expands/contracts over time the grout will develop fine cracks. These droplets will over time go behind your tiles, and weaken the structure of your wall. If it was cement board it probably wont even matter, and we are talking decades before damage here, but why take the chance for a $5 tube of caulk? There are several brands of caulking meant for the bathroom that can be painted.
Tip - when you apply caulk and run your finger over the caulk to get a smooth surface, make sure your finger is wet first. Makes a huge improvement to how the caulk spreads and looks.
Number 2
The silicone will affect the drying of the grout, and you will probably find it takes well over a week to match the color of other grout. Depending on how good the seal is (i.e. is the grout exposed to air or a porous surface underneath), it could take a very long time. I wouldn't worry about it other than for cosmetic reasons.
The tile and grout in an all tile shower are not waterproofing materials but long wearing easy cleaning finish ones. IF your shower was built properly it goes like this from top to bottom...
-The tile and grout laid in thin-set tile cement.
-A layer of portland cement or thin-set cement
-A thick rubber waterproofing membrane
-A layer of portland cement or thin-set cement
-Plywood subfloor
The two layers of cement with the waterproofing membrane sandwiched between them is what does all the work of carrying the water from your shower to the drain and keeping it out of the rest of your house. Hopefully this was done properly...It can be tough to know. If you're lucky and you somehow have easy access it is worth inspecting the subfloor and joists underneath the shower. If I inherited such a shower that was having problems I'd cut a small hole in the sheetrock or plaster from the ceiling beneath the shower if it was in the way and I'd have a look or I wouldn't be able to sleep at night. A leaky shower of this kind probably won't pour water all over the place (unless it's really bad...) but let it weep and drip slowly, silently doing damage. The only way to know for sure is to look. I think this should be done first before anything else so you know what you're working with before doing any repair work. If it's anything but dry under that shower you'll sadly want to be redoing the whole thing...or leave it and never use it again...
If it is nice and dry, you should be good to go to replace the grout. It's tough to say why grout fails, as many factors are at work: the quality of the grout, the consistency it was mixed to, the humidity and temperature on the day it was laid in, how well it was laid in, the mineral content and pH of the shower water, and the list goes on and on.
The surest way to repair grout is to replace it. This involves scraping it out by hand first. There are different shaped diamond tipped hand tools for just this operation that ease the process a bit. You want to get absolutely all of the crumbly stuff out of there, and then even sound grout you'll want to gouge out so it's at least half the thickness of the thickness of the tile, and more removed is better. A strong vacuum is a handy tool to have for this process so you can keep the area you're working on free of dust and see what you're doing. Once you're satisfied you can simply mix up some brand new grout and lay it in there. A fine grit grout should be used.
Though there is no complaint of loose or broken tiles in your question, another possibility with these showers is that the structural system (the joists and subfloor) are not doing their job properly and letting the tile and everything beneath them to the subfloor flex, causing cracks. I've seen a shower like this built atop a plywood subfloor whose joints did not land on floor joists (...) so the whole thing was unstable and had to be ripped out and redone after stabilizing the subfloor.
Good luck. These showers can be monsters...hopefully yours was built well and just needs the cosmetic refinishing of the grout.
Best Answer
Caulk is the way to go when there is a change of plane as there are shifts in the structure that will crack regular grout. You should clean all that mess out of there with a utility knife, single edge razor blades, a #10 scalpel, whatever. Clean out with some vinegar to kill any mold residue, let dry and re caulk with quality silicone caulk.
The only time grout would/could be used here is if you use the epoxy grout. It is more expensive and harder to work with but will yield great results.
By the way, all wet surfaces will mold over time without regular cleaning.
You would grout a location like this by placing mixed grout on the floor and ramming it into the crack with a grout float... something like a thick rubber trowel....