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UPDATE 2-Chile's Pinera suffers quake financing setback

* Senate rejects key royalty provisions in financing bill

* Move sparks worries over regulation in mining powerhouse

* Provision not dead yet, set for further Congress debate

* Government has no plan to water down royalty, sees deal (Adds analyst quote, details on royalty)

By Antonio de la Jara and Alonso Soto

SANTIAGO, June 16 (Reuters) - Chilean President Sebastian Pinera’s bid to fund post-quake reconstruction suffered a setback on Wednesday after the opposition-led Senate scrapped changes to mining royalties included in his first major bill.

If the bill is blocked, the government will be forced to scramble for ways to tap additional funds and Pinera’s popularity may suffer.

The move stokes further worries over the future of mining regulations in the world’s top copper producer.

The royalty provisions will now head to a bicameral commission to try to smooth over disagreements and seek passage. Pinera’s government could also try to make concessions to gain its approval.

Mining Minister Laurence Golborne told Reuters after the vote the government had no plans to water down the royalty proposal, and was optimistic the bill would ultimately pass.

“We are keeping the discussion brief. ... We are not going to have a long period of debate that could generate uncertainty (for investors),” he said. “I think a majority in Congress supports our side.”

Still, some expect the government to have to give some ground.

“At the end of the day the government will have to make concessions,” said Fabian Pressacco, a political science professor at Alberto Hurtado University. “The government is lucky to have other sources of financing, but that also means further negotiations with the opposition.”

The government’s post-quake financing package aims to tap foreign markets by issuing sovereign debt, use copper boom savings and raise taxes on companies, miners and tobacco. The government does not need congressional approval to issue debt.

The government planned to raise royalties on global miners in exchange for shielding them from further changes to the tax code for several years. The royalty hike was aimed at raising 10 percent of the state’s $8.4 billion share of reconstruction after February’s devastating earthquake.

Seventeen senators rejected the bill while 15 supported the proposed legislation.

Opposition lawmakers disagreed over the length of the tax freeze and said global miners should pay a bigger slice of their profits amid booming copper prices, which fueled fears of fresh mining tax hikes in the future.

Global miners have criticized the planned royalty increase, but were widely expected to adopt the new scheme, which is seen much less painful than Australia’s proposed super tax.

Pinera’s government had started an offensive to gather support for the bill, warning that Chileans hit hard by the 8.8-magnitude quake would suffer if the bill were blocked.

Chile extracts a third of the world’s mined copper, used to produce a wide range of products from houses and cars to freezers.

The new scheme sought to replace the fixed rate for a sliding one that ranges from 4 percent to 9 percent, depending on the companies’ margins, in exchange for extending a tax freeze for eight years. (Additional Reporting by Simon Gardner; editing by Todd Eastham)

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