* Government facing by-election defeat, but contest narrows
* Independents to hold the balance of power if govt loses (Updates vote count, adds independent candidate's quote)
By Colin Packham and Alison Bevege
SYDNEY, Oct 21 (Reuters) - As the count from a crucial Australian by-election dragged into Sunday, Prime Minister Scott Morrison faced the possibility that his Liberal party may have been too quick to concede a contest that would reduce his administration to a minority government.
Morrison became Australia's sixth prime minister in 10 years in August after his predecessor Malcolm Turnbull fell victim to infighting among the Liberals, and the suspense over the count in Sydney's affluent Wentworth constituency was in keeping with the unpredictable politics of recent times.
On Saturday, Morrison had surrendered the seat, vacated following Turnbull's retirement from politics, after the early count showed a swing of more than 20 percent away from the Liberals. by Sunday evening, his candidate trailed an independent rival by 1,600 votes with several thousand votes still to be counted, the Australian Electoral Commission (AEC) said.
Still claiming victory, but sounding less sure, the independent candidate Kerryn Phelps described the wait for the result as a "white knuckle ride" in a post on her Twitter account. "Holding our breath for the AEC outcome," she tweeted.
Should the Liberals lose Wentworth, Morrison's conservative coalition will probably have to rely on support from independent lawmakers to survive the next few months, as a general election is due by May next year.
The contest had gathered international attention after Morrison's late attempt to garner support from Jewish voters, who account for 13 percent of Wentworth's electorate, by suggesting Australia could recognise Jerusalem as Israel's capital and move its embassy there from Tel Aviv.
What impact that gambit had was unclear, but with his parliamentary majority hanging by a thread as the count continued, Morrison acknowledged that whatever the outcome, voters were clearly disillusioned with his party.
"The gap has closed by several hundred votes. There are still many postal votes to be counted," Morrison told reporters in Sydney. "But, that said, yesterday Liberal voters expressed their anger."
Morrison said if the vote gets as close as 100 votes an automatic recount would be triggered, giving his conservative coalition a slim chance of retaining its one seat majority in parliament.
It could be some days before the uncertainty is cleared as postal votes received within 13 days after the ballot are still counted.
The Liberals poor showing was partly attributable to Wentworth voters disillusion with the way party rebels had dumped Turnbull, said Morrison. (Editing by Simon Cameron-Moore)