* Billions in debt outstanding dating from land redistribution
* Court chief says U.S. free-trade pact adds to impetus
* Finance minister says would comply with ruling
LIMA, Nov 2 (Reuters) - Peru's constitutional court plans to require the government to finally honor land reform bonds it issued 40 years ago but in most cases never paid, a ruling that could be worth billions of dollars to bondholders in Peru and abroad.
The court's president, Ernesto Alvarez, said the ruling will probably come out ``in the next three months'' and would aim to clear up a bitter chapter in Peruvian history.
The agricultural bonds were issued as compensation in the 1970s under a land redistribution program started by leftist dictator General Juan Velasco, who sought to take farms from the rich and hand them over to peasants.
But many middle-class planters, banks and even workers were ensnared in the program, which caused Peru's agricultural output to collapse as 5,000 farms were seized between 1969 and 1981.
Alvarez said the court is working on a ruling that would specify how the executive branch should value the bonds and when it should pay them.
``This is our goal,'' he told Reuters on Wednesday. ``(There is) a need to ensure adequate, possibly progressive, compensation so as to avoid hurting the public good while honoring the obligations of the internal debt.''
Alvarez said the land reform, which tried to create a more equal society and redress the legacies of Spanish colonialism, was carried out in an ``abusive, high-handed and arbitrary'' way.
The constitutional court told the executive branch in a 2001 ruling to pay up. But since then a string of former presidents have balked, worried they lacked enough cash to pay.
The finance ministry, meanwhile, has said it doesn't know how to value the bonds because hyperinflation in the late 1980s eroded their worth and the initial ruling was too vague.
It has, however, paid bondholders when lower courts issued judgments with specific monetary awards. Hundreds of claims have been filed in lower courts but many holders have never bothered to sue and most bonds are still outstanding.
Conservative estimates say there are between $1 billion and $3 billion in bonds. Other estimates say the liability is far larger, at between $4.6 billion and $8 billion, or about 4 percent of gross domestic product.
Much hinges on the historical price index used to calculate the value of the bonds and the precise number of bonds outstanding. Detailed records were not kept by the Velasco government.
Since the 1990s, Peru has shed Velasco's left-wing economic model and become one of the world's fastest-growing economies, with free-trade agreements from China to Europe and investment-grade credit ratings.
Still, it is unknown how paying the land bonds would affect Peru's credit ratings. Cleaning up a so-called fiscal skeleton would be seen as a plus but agreeing to pay the land bonds would also put them on the government's books. Right now, they basically don't exist on official ledgers.
Peru has local and foreign debt in dollars and soles equivalent to about $36.6 billion, or some 20 percent of gross domestic product. Peru had a fiscal surplus equal to 7 percent of GDP in the first half of this year.
Asked about the expected ruling, Finance Minister Luis Miguel Castilla said: ``Evidently, we will comply with what the constitutional tribunal says and with all other laws.''
``Right now, as we are in the middle of this process, I'd say it's not appropriate for me to comment as the constitutional tribunal will likely deliberate and carry out its role,'' Castilla told Reuters on Thursday.
U.S. TRADE PACT CREATES IMPETUS
Though local bondholders have pushed for decades to get paid, addressing the controversy has taken on new urgency because foreign investment funds have bought land bonds on an informal secondary market in recent years.
Those funds are protected by Peru's free-trade deal with the United States, which went into effect in 2009, and they could, if they wanted to, sue Peru in a New York court to seek payment.
``There is a worry among some authorities in the executive branch ... that Peru could find itself hurt if complaints were lodged in courts under clauses in the free-trade pact with the United States,'' Alvarez said. ``It's good for Peru to be seen as an entity that respects the law.''
``There's no longer direct resistance from the executive branch but rather a desire to comply (with the ruling) in a way that doesn't hurt the broader public interest,'' he said.
Investors have suggested issuing new paper to holders of land bonds to spread out the liability over decades and avoid putting excessive pressure on the budget in a single year.
An official at the U.S.-based investment fund Gramercy, which owns land bonds, said the firm would like to see a ``market-based solution.''
Alvarez said the court was mulling over whether to give the executive branch specific guidelines on how to pay and value the bonds while also granting it the option of sitting down with bondholders to negotiate an agreement.
``This would be ideal and this is what we want,'' he said.
The court is a young institution with a big mandate. It was set up in the 1990s to depoliticize the judiciary, sit above the Supreme Court, and check the executive branch if it violated the rights of citizens.
Alvarez became its head this year after serving as its vice president. In September, the court affirmed the right of an Amazon indigenous community to block outsiders from entering its lands. The ruling could foil oil and mining projects that the government has promoted in the rainforest.
But the court has also struggled at times to ensure its decisions have compelling weight. Its 2001 ruling on land bonds was criticized for being muddled and lacking the force to bring about payment by the executive branch.
``We need to avoid handing down a sentence that fizzles or that is only declarative, because that would hurt our institution,'' Alvarez said.
(Reporting By Terry Wade and Marco Aquino; Editing by Kieran Murray and Claudia Parsons)