UPDATE 2-Nigeria to take action to slash local debt this year -minister

* Nigeria domestic debt at 6.35 trillion naira

* Total debt to GDP ratio rises to 18.2 percent

* Gov't sets up fund to retire domestic debt

* Africa's top oil producer often squanders oil windfall

By Chijioke Ohuocha

LAGOS, March 18 (Reuters) - Nigeria will take action this year to slash its domestic debt from around 6.35 trillion naira ($40 billion) because double-digit interest rates make the cost of servicing it too high, the Minister of State for Finance said on Monday.

It cost 699 billion naira to service the debt last year, Yerima Lawan Ngama said, addressing delegates at a business conference in Lagos. Interest rates on sovereign debt are around 10-11 percent.

"The cost of domestic debt is still very high. We are discussing with the bankers' committee the high cost of interest rates," he said.

He said Africa's top oil producer had set up a fund starting at 100 billion naira that would begin retiring domestic debt from this year. The overall debt to GDP ratio was 18.2 percent at the end of 2012, he said, up from 16 percent a year earlier.

Africa's second-biggest economy is growing as an investment destination as fiscal stability improves, its currency stabilises and economic growth remains high. But investors are wary of a long-established tendency to mismanage oil revenues, mostly because of massive corruption.

In absolute terms, the budget deficit was expected to fall to 585 billion naira in 2013, from 744 billion last year, he said. The budget office said last month the deficit would fall to 1.85 percent of GDP in 2013, from 2.85 percent last year.

"Nigeria has a very strong balance sheet now, compared with a decade ago," Ngama said.

Nigeria's debt to GDP ratio is low by world standards but high for a nation that still ranks among the top 10 oil exporters - it pumps out 2 million barrels of oil a day, almost all sold abroad. Much revenue is spent on a bloated civil service, and Ngama said 60 percent of government spending was on salaries last year.

OIL THEFT

Yields on Nigerian debt have fallen sharply by around 300 basis points since October, when JP Morgan included Nigeria in its emerging market sovereign bond index, lowering government borrowing costs. Yields are now only a little above inflation, currently at 9.5 percent.

As Nigerian government bonds have rallied, so interest in them from foreign investors has waned, which has hit the naira.

Analysts say if Africa's second biggest economy was better managed, it would have a much lower debt to GDP ratio.

The deficit is to some extent artificial because Nigeria normally saves more than it earns and deposits those savings into its Excess Crude Account (ECA), which can give clearer picture of whether its fiscal position is improving.

There is currently around $8 billion in it, according to the latest figures. This is about double what it was a year ago, but $1 billion less than in December, and under half the $20 billion it contained in 2007.

Finance Minister Ngozi Okonjo-Iweala is keen to save more for investment and to cushion against oil price shocks.

Parliament inflated the 2013 budget, which means Nigeria could save less this year than last.

The country is also losing massive amounts of revenue to oil theft by armed gangs, which Shell this month said was "unprecedented", after its main Nembe Creek pipeline was hit.

"Our biggest challenges are fiscal leakages to oil theft and corruption," Ngama said, adding that around 150,000 barrels a day went missing, equal to more than Ghana's total output.

Businesses are urging the central bank to slash interest rates at its next decision expected tomorrow. Inflation is now under the bank's single digit target, but a shock fall in the naira last week is likely to deter a rate cut.