* Iran suspended planned fuel price rise in mid-2012
* Sanctions make cost of subsidies harder to bear
* Iran avoiding external payments crisis but reservesfalling
* Inflation above 40 pct complicates subsidy reforms
By Daniel Fineren and Andrew Torchia
DUBAI, Oct 1 (Reuters) - Iran is preparing a politicallyrisky increase in domestic fuel prices, trying to lighten theburden of multi-billion dollar subsidies on an economy severelydamaged by Western sanctions.
Oil Minister Bijan Zanganeh said this week the governmentwas studying plans for the rise, the second in three years,which will affect the welfare of millions of poor people.
Since 2011 the sanctions have slashed Iran's oil exports andplayed a role in persuading Tehran last week to accept new talkson its disputed nuclear programme with six world powers.
The government first moved to reduce the subsidy burden onits finances by lifting prices for motorists in December 2010.It then suspended a second wave of price reform, planned formid-2012, partly out of concern that it could prove too painfulwith living standards already falling because of the sanctions.
But by shrinking state oil revenues, the sanctions haveincreased financial pressure on the government to cut thesubsidies. Authorities also want to rein in rampant smuggling ofcheap fuel to neighbouring countries.
"We are studying gasoline prices and will make a finaldecision after consultation with parliament," Zanganeh wasquoted by the ministry's news service Shana as saying.
"We cannot ignore fuel smuggling but the main reason behindconsidering the revision is the budget law that has tasked thegovernment with paying subsidies."
The U.S. and European sanctions have largely frozen Iran outof the international banking system, making it difficult to selloil; the country's oil exports are down by more than half frompre-sanctions levels of about 2.2 million barrels per day.
This has cost Tehran tens of billions of dollars in lostrevenues annually and, since oil traditionally provided abouttwo-thirds of state income, undermined its budget.
The government has not fully disclosed the extent of thedamage. A devaluation of the rial, which lost about two-thirdsof its value against the U.S. dollar in the free market, pushedup inflation but also helped state finances by letting thegovernment sell its dollars to the public at expensive rates.
There are also conflicting signals on how close thesanctions have pushed Iran to an external payments crisis. TheInternational Monetary Fund estimates Iran is still running asurplus in its trade of goods and services and that its foreignreserves will drop only moderately to $85 billion at the end of2013, from $96 billion in 2011.
Not all of that money is readily available to Tehran,however. New U.S. sanctions introduced in February this yeareffectively bar Iran from repatriating earnings from its oilexports, requiring customers to pay funds into an escrow accountat a bank in the purchasing country and limiting Tehran's use ofthe proceeds to buying goods in that country.
Iranian-born economist Mehrdad Emadi, of the Betamatrixconsultancy in London, said he estimated Iran had about $35-40billion of accessible reserves, including some money in Indianand South Korean banks.
That amount, equivalent to roughly half of Iran's annualimports of goods and services, would still be comfortablecompared with the external positions of many developingeconomies in the Middle East and North Africa.
Iran can circumvent some of the obstacles to transferringmoney internationally by using money dealers, although that isexpensive, costing on average 5 percent of the amount andsometimes up to 8 percent, Emadi said.
While Iran's economy can continue to operate, however, it isclear that the sanctions have disrupted production of many goodsand lowered living standards for millions.
"Our country is one of the most powerful in the region andour missiles can reach thousands of kilometres but we're in needof chicken meat," Mohsen Rezaie, a former head of theRevolutionary Guards and a candidate in July's presidentialelections, said during a campaign advertisement.
That leaves the government in a difficult position as itweighs the fiscal cost of maintaining its fuel subsidies withthe political cost of reducing them.
Currently, private Iranian motorists can buy a small amountof gasoline at about $0.42 a litre ($1.60 per gallon), up fromjust $0.10/litre before the first phase of reform. They payabout $2.60 per gallon for any fuel they need beyond that,according to the U.S. Congressional Research Service.
Raising those prices could not only improve governmentfinances but also dampen demand, reducing the need for Tehran touse its foreign exchange for imports. Zanganeh said Iran, whichcannot refine all the petrol it needs, had imported between 5and 7 million litres a day of gasoline in the past six months.
However, inflation - running above 40 percent annually,according to the latest official data - may now have risen sohigh that the government has little room for manoeuvre.
With other consumer goods prices already rising so fast, abig rise in the gasoline price could provoke a further jump ofinflation. And while the government has softened the blow ofsubsidy reform in the past with cash payments to poorerIranians, that strategy may have become too expensive.
"The increase in inflation since 2011, in particular therecent increase in import inflation due to the devaluation ofthe rial, started to offset the potential medium-term efficiencygains of the subsidy reform," the World Bank said in a report onthe Iranian economy earlier this year.
"Rampant inflation would result in rapid erosion of domesticenergy prices, thereby eroding the benefits of reform."
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