* Rio de Janeiro government suspends payments in protest
* Main oil producing states appeal to Supreme Court
* Feds say Rio "bluffing," putting investment grade in peril
By Anthony Boadle
BRASILIA, March 7 (Reuters) - Brazil's Congress overturned a presidential veto on parts of an oil royalty bill on Thursday, setting up a prolonged legal battle with producer states and prompting oil-rich Rio de Janeiro to order a suspension of payments on the state's obligations in protest.
Rio's state government, which calculates a loss of 3.1 billion reais ($1.58 billion) this year because of the new legislation, ordered the suspension of all except legally mandated expenses like salaries to public employees and transfers to municipalities, until Brazil's Supreme Court can rule on the royalty dispute.
While originally aimed at giving non oil-producing states a fair share of Brazil's future oil wealth, the bill reduces royalties received from existing production contracts. That would take existing revenue streams from states and cities bordering maritime fields and redistribute them among all 27 states and 5,560 municipalities.
The override was a defeat for President Dilma Rousseff, who had committed herself to limiting the impact of her government's oil industry reform on producing states.
It was not immediately clear from the Rio de Janeiro order whether the suspension would include debt payments to the federal treasury or just suppliers and contractors. But economists and federal officials said the state has little leeway to apply pressure by halting payments because many of its expenses are considered obligatory by law.
"If Rio de Janeiro stops debt payments that would trigger default clauses leading the federal government to stop transfers of funds to the state," said a federal government source who asked to remain anonymous. "Rio would be shooting itself in the foot."
The suspension order comes as Rio builds roads, stadiums and other infrastructure ahead of the World Cup of soccer next year and the 2016 Olympics. As it is, the state is scrambling to finish its famed Maracanã soccer stadium in time for the Confederations Cup, a World Cup warmup in June.
State governor Sergio Cabral has said the loss of revenue will undermine plans to host the World Cup and the Olympics.
The state government said it suspended 82 million reais in payments due on Thursday and that a total of 470 million reais would be withheld for the month. It did not specify which payments were halted, though it stressed that salaries for civil servants and transfers to municipalities were not affected.
The suspension of payments raises myriad legal and fiscal questions for Brazil, a country whose current economic stability in large part is thanks to major reforms that, among other measures, imposed strict debt and budgetary regulations on states, many of which had a long history of erratic finances.
Brazilian states do not have much wiggle room when it comes to financial obligations. In addition to the debt it holds with the federal government, Rio is constitutionally required to make investments in health and education, two other big expenditures.
While suppliers to the state may be forced to wait for payments if Cabral, the Rio governor, stands firm on the suspension, the ensuing crush of legal claims and other complications would likely cause more trouble than they are worth in the long term.
Even more worrisome for Rio, the state would endanger its hard-won investment grade credit rating obtained in 2010 if it suspended debt payments to Brasilia, according to another federal official, who said such a move would be tantamount to "shooting itself in the head."
Bond investors, many of whom had to deal with a moratorium declared by Minas Gerais and Rio Grande do Sul states in 1999, took a wait-and-see approach as they sought more details of Cabral's decision. The perception of Brazil's country risk fell after positive economic indicator readings around the world fanned demand for riskier emerging market assets.
Cabral's announcement had little impact on Brazilian bonds. The yield on the government's 12.5 percent global bond due in 2022 was little changed at 6.14 percent on Thursday from the prior session. JPMorgan Chase & Co's EMBI+ country risk index for Brazil - or the difference between Brazilian bond yields relative to U.S. Treasury debt of comparable maturities - fell 3 basis points to 164 on Thursday.
FALLING OIL OUTPUT
The new royalty legislation has soured relations between Brazil's states and became one of the most divisive issues of Rousseff's two-year-old presidency.
It most affects the states of Rio and Espirito Santo, which are responsible for about 80 percent of Brazil's oil output.
Espirito Santo on Thursday said it will appeal to the Supreme Court to challenge the constitutionality of the law. The state estimates it could lose 10 billion Brazilian reais ($5.10 billion) in royalty income between now and 2020.
"The decision by the majority of non-oil producing states undermines the nation's federal balance and the business climate," the Espirito Santo state government said.
The battle over royalties is the last thing Brazil's troubled oil industry needs. Delays and cost overruns in new offshore fields and declining production and maintenance in older fields have caused Brazil's oil output to fall for 10 consecutive months through January, despite the discovery of giant new reserves south of Rio.
Oil analysts do not expect the royalty dispute to disrupt Brazil's plans to resume oil concession auctions this year.
Rio and neighboring Espirito Santo received 86 percent of all oil and gas royalties and windfall profits taxes given directly to states and municipalities in 2012, according to Brazil's oil regulator, the ANP.
Total royalties and windfall profits taxes in 2012 were 31.6 billion reais, with about half going to the federal government and the rest directly to states and municipalities.
Under the new legislation, producing states' royalties will shrink to 20 percent of the total royalty take by 2019 from 40 percent today. Producing municipalities share will drop to 4 percent in 2019 from 10 percent of the total take today.