* S&P expects lower budget deficits, surplus by 2012
* Banks, productivity, demographics are key risks
* Russian stocks rise, CDS drop
(Adds more quotes from S&P, market reaction)
By Dmitry Zhdannikov
MOSCOW, Dec 21 (Reuters) - Ratings agency Standard & Poor's on Monday raised its outlook on Russia's debt ratings to stable from negative, citing lower-than-expected budget deficits due to strong oil prices and cuts in state expenditure.
The move gives Russia a boost ahead of return to debt markets after a decade's absence with an issue of up to $18 billion in Eurobonds in 2010 as the country seeks to plug budget holes and help the economy out of recession.
Russian stocks extended gains on the news after rising earlier on stronger oil prices. The cost of insuring Russia's debt against restructuring or default fell, with 5-year credit default swaps dropping 14 basis points to 192 bps according to data from Markit.
"The stable outlook balances our opinion of the risks to Russia's public finances from sensitivity to oil prices and the need for additional capital injections into the financial system, against the conservative budgetary stance," it said.
S&P said it had revised its outlook on Russia from negative while affirming its 'BBB' foreign currency rating.
Russia's economy has lost nearly a tenth of its size this year in contrast with its BRIC peers, which continued to grow.
By comparison, the agency has a BBB-minus rating on Brazil with a stable outlook, an A-plus rating on China with a stable outlook and a BBB-minus rating on India with negative outlook.
S&P said ratings could be cut if Russia fails to keep a lid on spending, adding it would study raising them if the government showed stronger commitment to structural economic reforms.
The agency said it forecast Russia's GDP growth to average 3.5 percent in 2010-2012 versus 7 percent before the crisis and an expected decline of over 8.5 percent in 2009.
The agency said it expected that the government's original target of a budget deficit of 8.3 percent of GDP for 2009 would turn out to be lower by at least one or two percentage points.
The same will happen in 2010-2011 with deficit targets of 7.5 percent and 4.3 percent of GDP likely to be outperformed given a conservative average oil price assumption of $59 per barrel.
"In the absence of a sharp decline in oil prices back below $60 per barrel, we would expect the Russian Federation's budgetary position to shift back to surplus by 2012," it said.
The agency also praised the government's efforts to freeze public sector payrolls and cut capital expenditures which will result in a decline in nominal expenditures in 2010 and 2011.
A sharp decline in imports and strong oil prices will result in surpluses of Russia's current account in 2009 and it will remain close to balance in the mid-term, the agency said.
The agency warned that the banking system would remain one of the key risks as the size of bad loans in the system and therefore the amount of money that needs to be spent on shoring up capital in the financial system were still not clear.
"The banking system will continue to drag on growth performance over the medium term, as will Russia's long-standing structural impediments to growth and foreign investment."
The agency also named low productivity levels, poor public services, endemic corruption and poor demographics as the other key risks weighing on public finances in the absence of reform.
S&P's peer Moody's has a Baa1 rating on Russia with stable outlook, Fitch has Russia on a BBB rating with negative outlook. (Reporting and writing by Dmitry Zhdannikov; Additional reporting by Carolyn Cohn; editing by Patrick Graham and Andy Bruce)