* Oil protest slashed output, vital state revenues
* Govt looking to cut subsidies, public spending
* Political turmoil also delays full budget approval
By Ulf Laessing and Feras Bosalum
TRIPOLI, April 23 (Reuters) - Libya plans deep austerity measures to tackle a budget deficit expected to reach up to 10 billion Libyan dinars ($8 billion) this year due to rebel blockades which have strangled oil production, a senior lawmaker told Reuters.
Mohammed Ali Abdallah, who heads parliament's budget committee, said this year's deficit could be covered by budget surpluses accumulated in past years, a central bank loan and the possible issuance of government bonds.
However, he outlined spending cuts which are likely to be highly unpopular with Libyans, used to subsidised bread loaves costing two U.S. cents, as the government and parliament struggle to control militias which helped oust Muammar Gaddafi in 2011 but kept their guns to claim a share of the oil wealth.
Parliament plans to freeze public salaries, halt new development funding and slash the number of subsidised food and basic products, Abdallah told Reuters in an interview.
"Our budget deficit is looking at around 9 to 10 billion Libyan dinars in 2014," he said.
Libya traditionally runs large surpluses thanks to oil export revenues. But last year the budget slid into an eight billion dinar deficit when a wave of protests cut into the OPEC nation's output.
Nine months of blockages at oil fields and ports have reduced oil production to 220,000 barrels a day (bpd) from 1.4 million bpd before the trouble began last summer.
Earlier this month the government reached a deal with rebels to wind down their occupation of four oil ports, imposed to demand a greater share of Libya's oil wealth. Tankers have already started loading at one port.
But the shutdown has cut oil revenues to less than $4 billion since the start of this year - less than 20 percent of what was budgeted, said Abdallah.
Libya has no need to press the panic button yet as the central bank sits on more than $110 billion in foreign reserves. A fund of previous surpluses worth between 10 and 17 billion dinars was available, plus unspent oil revenues held by the central bank totalling 17 billion.
"The third option - which I hope we don't have to go to because we are not ready for it - is to issue some government (Islamic) bonds," Abdallah said.
"This is an option which we are studying with the IMF and World Bank right now. We could look at doing a limited bond issuance to local private and public banks."
Abdallah felt that Libyan banks, which are largely state-owned and inefficient, were not yet ready for a market in government bonds based on Islamic principles.
Libya hopes to raise oil production after the eastern port of Hariga was reopened under the deal with rebels who want greater autonomy and a share of oil revenues.
Output could rise by 400,000 bpd in the next few weeks thanks to Hariga's reopening, bringing it close to a goal of hitting 600,000 bpd by the end of June under a budget proposal, Abdullah said.
By the end of the third quarter production needs to reach 1 million bpd to reach the budget target and pay back the central bank loan, an uncertain plan as the government is weak and parts of the country remain out of state control.
Libya needed to cut expenditures drastically to end billions of dollars lost to waste, inefficiency, corruption and smuggling of products from bread to petrol, Abdallah said.
The North African country suffers from a dysfunctional public service, a legacy of Gaddafi who put most adults on the payroll to discourage opposition. Many Libyans get two state salaries, but public services remain highly inefficient.
To tackle the loss of oil revenues parliament will for now approve only 44 billion dinars - eight to nine billion less than last year - to cover public service salaries and other government expenditures including subsidy payments, he said.
Total spending would be 55 billion dinars this year, down from 66 billion dinars in 2013.
Libya will hold off on a second budget to cover development plans until a new government had been formed. Prime Minister Abdullah al-Thinni resigned a week ago after just a month in office, saying gunmen had tried to attack his family.
Political groups in the deeply divided parliament, known as the General National Congress or GNC, are negotiating over the name of a new premier.
Abdallah said Libya had the world's highest fuel consumption rate per capita because the subsidised prices encouraged waste and smuggling. The state spends $7 billion on fuel subsidies every year but hopes to save $2 billion by launching later this year "smart cards" for citizens to buy limited amounts of fuel.
Parliament will also cut the number of subsidised food items from 10 - such as rice or sugar - in phases to just grain by the end of March 2015 to cut smuggling of products.
Prices for rice and other products will rise - a hard sell to Libyans used to paying just $0.02 for bread, another idea from Gaddafi to keep people happy.
Parliament wants to shift government work such as running airports and hospitals to private companies under build-operate-transfer contracts, which officials hope will improve efficiency.
Abdallah said Swissport International, Turkey's TAV Airports and Dubai-based Dnata had expressed interest in completing the new Tripoli airport, a project which has been in the works for many years.
($1 = 1.2320 Libyan Dinars) (Reporting by Ulf Laessing and Feras Bosalum; Editing by David Stamp)