* Govt raises cap on subsidised cooking gas cylinders
* Decision to cost exchequer around $800 mln
* RBI chief cautions from expanding "misdirected" subsidies
* Govt battling weak finances due to high subsidy spending
By Nigam Prusty and Rajesh Kumar Singh
NEW DELHI, Jan 30 (Reuters) - India's coalition government on Thursday increased the subsidy on cooking gas, acceding to popular demand as it approaches a national election due by May.
The decision to increase the cap on annual sales of subsidised cooking gas cylinders to 12 from 9 per household was made days after Rahul Gandhi, vice president of the ruling Congress party, demanded a raise in the ceiling.
The move, which will cost the exchequer 50 billion rupees ($800 million), comes at a time when federal finances are under pressure in the face of weak tax receipts in a slowing economy and high public spending.
Weak public finances have not only limited policy options to revive Asia's third largest economy, which is growing below its slowest pace in a decade, but have also put its investment grade credit rating under threat.
Little wonder the subsidy increase came into question from India's central bank which is trying to stabilise a wobbly economy in a bid to prevent a repeat of last summer's sell-off by foreign investors.
Raghuram Rajan, governor of the Reserve Bank of India (RBI), cautioned the government against expanding "misdirected" subsidies.
"We have to be very careful because we need to spend on very important things we are not spending on," he told television channel, CNN-IBN, late Thursday.
Under the subsidies, households will be entitled to buy the cylinders at less than half the market price. It is a highly popular, and sometimes vital, scheme in this country of 1.2 billion people.
Prime Minister Manmohan Singh's decision to hike cooking gas subsidy flies in the face of his commitment to trim spending on fuel subsidies, which is at the heart of his struggle to balance the federal budget.
But Manish Tewari, information and broadcasting minister in Singh's cabinet, said the government would not shy away from taking consumer-friendly decisions.
"Let there be no ambiguity that the UPA (coalition)government will not put any consumer to any hardship at all," he said.
The Congress party is racing against time to win back voters disenchanted by a slew of corruption scandals and a dramatic decline in the country's economic fortunes.
It is trailing in opinion polls and many analysts believe it is unlikely to win a third term in power. It is also seeking to protect its turf from the Aam Aadmi - or Common Man - Party (AAP), which is threatening to draw support away from the poor, Congress's main voters.
The AAP government in the national capital has slashed power and water prices, sparking demands by lawmakers in other states for similar reductions.
In the lead-up to the national election, investors fret that Congress, known for its penchant for populist welfare schemes, will shun tough reforms needed for economic revival.
Its government in the western state of Maharashtra last week decided to cut electricity tariffs by a fifth with immediate effect.
High government spending on subsidies such as food, fuel and fertiliser coupled with slower-than-budgeted tax receipts have made it tougher for Singh to keep the government's pledge to narrow the fiscal deficit to 4.8 percent of gross domestic product (GDP) in the fiscal year to March 2014.
The fiscal deficit by November had reached nearly 94 percent of the government's full-year target, piling pressure on Singh to find alternative sources of revenue.
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