UPDATE 2-Rouble pares gains as Russia hands Kremlin critic Navalny jail sentence

(Updates with reaction to court decision, adds analyst comment)

MOSCOW, Feb 2 (Reuters) - The Russian rouble pared earlier gains driven by higher oil prices on Tuesday after a Moscow court handed prominent Kremlin critic Alexei Navalny a 3-1/2-year jail term.

Navalny’s lawyer said he would spend only two years and eight months behind bars, because of time already served under house arrest, Interfax news agency reported.

Navalny, one of Putin’s most prominent critics, was arrested at the Russian border on Jan. 17 for alleged parole violations after returning from Germany where he had been recovering from being poisoned with a military-grade nerve agent.

His imprisonment is seen straining already poor ties with the West, which is expected to consider imposing new sanctions on Moscow.

The rouble was 0.4% stronger at 75.85 against the dollar at 1737 GMT, away from Tuesday’s peak of 75.31. Versus the euro, the rouble firmed 0.7% to 91.15.

Although the risk of fresh sanctions has increased, the real impact of possible penalties could be limited.

“This case should not lead to rising risks of wide-scale, tough sanctions for the Russian market,” Sofia Donets, chief economist at Renaissance Capital, said ahead of the court ruling.

Still, the political unrest is a headache for Putin, who has dominated Russian politics for over two decades and faces possible tensions with U.S. President Joe Biden and his administration.

The rouble looks undervalued given fundamental factors, but its price reflects geopolitical pressure, Otkritie bank said.

On the upside, the Russian economy shrank by just 3.1% during the COVID-19 pandemic in 2020, data showed late on Monday. While the sharpest contraction in 11 years, it was shallower than predicted by analysts and the Russian government.

Russian stock indexes finished the day higher, pricing in a 1.8% advance in Brent crude oil, a global benchmark for Russia’s main export, to $57.37 a barrel, near a one-year high.

The dollar-denominated RTS index was up 2.6% at 1,398.99 points, while the rouble-based MOEX Russian index was 2.1% higher at 3,360.25 points. (Reporting by Andrey Ostroukh and Alexander Marrow; Editing by Mark Potter/Mark Heinrich/Barbara Lewis)