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UPDATE 1-Argentina holds last-minute debt talks with mediator

(Adds break in mediation session with plan to resume talks, IMF comment on default, analyst comment, bond market reaction, background)

NEW YORK/BUENOS AIRES, July 29 (Reuters) - Argentine debt negotiators held talks in New York on Tuesday with the U.S. mediator in the South American country's battle with holdout investors, in a last-ditch attempt to avert a default.

After a series of setbacks in U.S. courts, Argentina has until the end of Wednesday to either pay the New York hedge funds in full their defaulted bonds resulting from the country's 2001/02 financial crisis or cut a deal to stave off a fresh default.

Argentine debt negotiators took a break from the mediation meeting on Tuesday afternoon and planned to resume talks in a couple of hours, Argentina's state-run Telam news agency said, citing sources close to the case.

Negotiations between Argentina and the funds, which it calls "vultures," have made scant progress in the past three weeks.

If the deadlock persists, U.S. District Judge Thomas Griesa will prevent Argentina from making the July 30 deadline for a coupon payment on exchanged bonds.

A default would hurt Argentina, Latin America's No. 3 economy, which is already in recession and grappling with dwindling foreign reserves and soaring inflation.

"Argentina's current weak fiscal, monetary and external conditions make the probability of the situation spinning out of control quite high," Marcos Buscaglia at Bank of America said in a research note.

"The main issue we see is money demand, which we expect is likely to become unstable under a default scenario," he said, referring to expectations for increased demand by Argentines for U.S. dollars as a way to protect their savings against inflation or a currency devaluation, putting further pressure on the local peso.

A weaker peso would weigh on Argentina's foreign reserves, which are used to cover debt payments in foreign currency.

Yet a default would unlikely prompt broader market repercussions given the country's relative isolation from the financial system, the head of the International Monetary Fund Christine Lagarde said on Tuesday.

Argentina has been cut off from international credit markets since its 2002 default on $100 billion, which plunged millions of Argentines into poverty.

MAKING MONEY FROM DEFAULTS

For many years, the country declined to negotiate with the holdouts who bought its distressed debt on the cheap, slamming them as "vultures" picking over the carcass of its default.

Argentina sent a delegation of technical, financial and legal representatives to meet court-appointed mediator Daniel Pollack at his office on Tuesday, rather than Economy Minister Axel Kicillof, who sealed a number of deals with foreign investors and creditors in past months.

Kicillof was attending a meeting of the South American trade bloc Mercosur in Caracas with President Cristina Fernandez.

One of the lead holdout creditors, hedge fund Elliott Management, said in a letter to investors obtained by Reuters that Argentina must now decide whether to default on its external debt.

"With only two days left (as of this writing) for Argentina to make that decision, the situation is fluid, and Elliott is limited in what we can say," the letter, dated July 28, said.

"The path forward is uncertain. No matter what happens, thousands of bondholders, including Elliott, will continue to pursue our rights, attempting to generate a rational discussion with someone on the other side and trying to forge a solution."

Analysts say a last-minute deal with holdouts cannot be discounted but a default looks increasingly likely as the deadline approaches.

Argentina's dollar-denominated Par bonds rose strongly on Tuesday on the over-the-counter market as investors who expected bondholders could accelerate the series in the case of a default and call for immediate payment piled into the paper.

"If there is a default, and given the Par is the cheapest series, they are acquiring these bonds," said Roberto Drimer at the local consultancy VatNet.

Par bonds were up 4 percent at $51.90 by 1524 local time (1824 GMT) while Discount bonds were down 1.68 percent to $82.15.

(Additional reporting by Svea Herbst-Bayliss in Boston; Writing by Sarah Marsh in Buenos Aires; Editing by Leslie Adler)