* Diesel prices to rise monthly from Friday by 0.4-0.5 rupees
* Subsidies a drain on budget; govt struggling to contain deficit
* Bulk sales will be at market rates (Recasts lead with details of price increase)
By Nidhi Verma and Manoj Kumar
NEW DELHI, Jan 17 (Reuters) - India's government told fuel retailers to raise the price of subsidised diesel in small amounts every month starting Friday in an attempt to prop up public finances without causing a popular backlash before elections.
Fuel subsidies are a drain on India's finances and the government is struggling to bring the deficit within a target of 5.3 percent of gross domestic product for the financial year ending March. India is the world's fourth biggest oil importer.
The government has called for increases of about 1 U.S. cent per litre each month, a source at one of the oil retailers with direct knowledge of the development told Reuters on Thursday.
Bulk buyers will have to pay market rates for diesel, which accounts for 40 percent of fuel consumption in the country, the source, who requested anonymity, said.
According to a government calculation, this step will affect almost a fifth of diesel sales and should boost by some $2.4 billion annually revenues at the companies, which suffer losses selling fuel below cost.
Earlier in the day, Oil Minister Veerappa Moily announced the state-run fuel retailers would be responsible for diesel pricing, a change from the previous system where the cabinet set prices, but he indicated the government will keep some control.
"We cannot abruptly put an end to the subsidy or the under-recovery. Looking into all the economic aspects, we have taken the decision to give oil companies the liberty to make small corrections," he said.
The Congress-led coalition government needs to rein in the budget deficit but is also trying to revive an economy growing at its slowest pace in a decade as well as keep voter support ahead of a general election due by 2014.
The government also loosened a cap introduced in September on the number of subsidised cooking gas cylinders permitted to each household after widespread criticism the quota was unfair on the poor.
The cap will now be nine cylinders per year, up from six. That is expected to add 93 billion rupees ($1.70 billion) to the annual subsidy bill, an oil ministry source said.
Government-set prices are compensated in part by cash from New Delhi to help compensate the oil firms for selling below market rate. The companies also get crude below market price to process from state-owned Oil and Natural Gas Corp.
Deutsche Bank estimated an increase in the diesel price by 0.5 rupees (about 1 U.S. cent) per month would raise oil company revenues by 215 billion rupees, or 120 billion rupees taking into account increased spending on cooking gas.
It is not clear for how long the monthly increases will run.
Petrol prices will be cut by 0.25 rupees per litre from Friday, the source said. These were freed up in June 2010 but have also largely remained under the government's control.
After the government's earlier announcement, share prices for the main oil marketing companies rose sharply.
The rupee hit a one-month high, while yields on Indian bonds dropped in a sign the market expects the new policy will result in lower subsidies in the medium-term.
"This is a brilliant balancing act between politics and economics. This is one step backwards and one step forward," said N.R. Bhanumurthy, professor at the National Institute of Public Finance and Policy.
"While the decision on the LPG cylinder will pacify their political constituency, the decision on diesel sends out a message to the (central bank) that the government is serious about tackling subsidies and controlling the fiscal deficit."
The Reserve Bank of India (RBI) has long called on the government to reduce its fiscal deficit, which drives government borrowing and keeps upward pressure on interest rates. The central bank meets on Jan. 29 to set monetary policy and has signaled that it is likely to cut interest rates.
Ratings agencies had threatened to strip India of its investment-grade credit rating if the government did not take steps to curb the widening fiscal deficit. Finance Minister P. Chidambaram has vowed that the deficit will not exceed 5.3 percent of GDP this financial year.
Prime Minister Manmohan Singh's government, which must hold general elections by early next year, is trying to revive Asia's third largest economy, which is set to grow at 5.7-5.9 percent this fiscal year, its weakest rate since 2002/03.
Singh was the architect of a wave of economic reforms in the 1990s credited with ushering in two decades of fast growth. In a new push since September to liberalise India's economy, he opened sectors, including retail and aviation, to more overseas investment and cut subsidies on fuel and rail fares.
India imports 80 percent of the crude it refines, about 3.7 million barrels per day. Benchmark Brent crude prices were at their highest annual average on record last year at around $111 a barrel, significantly raising the country's energy bill.
State-owned fuel retailers currently lose 9.6 rupees (18 U.S. cents) for every litre of diesel sold.
Diesel demand has been very resistant to price hikes. A 5 rupee per litre price hike in September was followed by month-on-month rises in diesel sales.
Fuel subsidies comprised more than 5 percent of the government's budget spending in previous 2011/12 budget. Asked if raising diesel prices would affect this year's subsidy bill, Chidambaram said the effect was so far unclear.
($1 = 54.7700 Indian rupees) (Reporting by India Treasury, Equities, Markets teams; Editing by Frank Jack Daniel, Miral Fahmy and Ron Popeski)