* Iran suspended planned fuel price rise in mid-2012
* Sanctions make cost of subsidies harder to bear
* Iran avoiding external payments crisis but reserves falling
* Inflation above 40 pct complicates subsidy reforms
By Daniel Fineren and Andrew Torchia
DUBAI, Oct 1 (Reuters) - Iran is preparing a politically risky increase in domestic fuel prices, trying to lighten the burden of multi-billion dollar subsidies on an economy severely damaged by Western sanctions.
Oil Minister Bijan Zanganeh said this week the government was 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 and played a role in persuading Tehran last week to accept new talks on its disputed nuclear programme with six world powers.
The government first moved to reduce the subsidy burden on its finances by lifting prices for motorists in December 2010. It then suspended a second wave of price reform, planned for mid-2012, partly out of concern that it could prove too painful with living standards already falling because of the sanctions.
But by shrinking state oil revenues, the sanctions have increased financial pressure on the government to cut the subsidies. Authorities also want to rein in rampant smuggling of cheap fuel to neighbouring countries.
"We are studying gasoline prices and will make a final decision after consultation with parliament," Zanganeh was quoted by the ministry's news service Shana as saying.
"We cannot ignore fuel smuggling but the main reason behind considering the revision is the budget law that has tasked the government with paying subsidies."
The U.S. and European sanctions have largely frozen Iran out of the international banking system, making it difficult to sell oil; the country's oil exports are down by more than half from pre-sanctions levels of about 2.2 million barrels per day.
This has cost Tehran tens of billions of dollars in lost revenues annually and, since oil traditionally provided about two-thirds of state income, undermined its budget.
The government has not fully disclosed the extent of the damage. A devaluation of the rial, which lost about two-thirds of its value against the U.S. dollar in the free market, pushed up inflation but also helped state finances by letting the government sell its dollars to the public at expensive rates.
There are also conflicting signals on how close the sanctions have pushed Iran to an external payments crisis. The International Monetary Fund estimates Iran is still running a surplus in its trade of goods and services and that its foreign reserves will drop only moderately to $85 billion at the end of 2013, from $96 billion in 2011.
Not all of that money is readily available to Tehran, however. New U.S. sanctions introduced in February this year effectively bar Iran from repatriating earnings from its oil exports, requiring customers to pay funds into an escrow account at a bank in the purchasing country and limiting Tehran's use of the proceeds to buying goods in that country.
Iranian-born economist Mehrdad Emadi, of the Betamatrix consultancy in London, said he estimated Iran had about $35-40 billion of accessible reserves, including some money in Indian and South Korean banks.
That amount, equivalent to roughly half of Iran's annual imports of goods and services, would still be comfortable compared with the external positions of many developing economies in the Middle East and North Africa.
Iran can circumvent some of the obstacles to transferring money internationally by using money dealers, although that is expensive, costing on average 5 percent of the amount and sometimes up to 8 percent, Emadi said.
While Iran's economy can continue to operate, however, it is clear that the sanctions have disrupted production of many goods and lowered living standards for millions.
"Our country is one of the most powerful in the region and our missiles can reach thousands of kilometres but we're in need of chicken meat," Mohsen Rezaie, a former head of the Revolutionary Guards and a candidate in July's presidential elections, said during a campaign advertisement.
That leaves the government in a difficult position as it weighs the fiscal cost of maintaining its fuel subsidies with the political cost of reducing them.
Currently, private Iranian motorists can buy a small amount of gasoline at about $0.42 a litre ($1.60 per gallon), up from just $0.10/litre before the first phase of reform. They pay about $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 government finances but also dampen demand, reducing the need for Tehran to use its foreign exchange for imports. Zanganeh said Iran, which cannot refine all the petrol it needs, had imported between 5 and 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 so high that the government has little room for manoeuvre.
With other consumer goods prices already rising so fast, a big rise in the gasoline price could provoke a further jump of inflation. And while the government has softened the blow of subsidy reform in the past with cash payments to poorer Iranians, that strategy may have become too expensive.
"The increase in inflation since 2011, in particular the recent increase in import inflation due to the devaluation of the rial, started to offset the potential medium-term efficiency gains of the subsidy reform," the World Bank said in a report on the Iranian economy earlier this year.
"Rampant inflation would result in rapid erosion of domestic energy prices, thereby eroding the benefits of reform."