(Adds details from hearing, background on litigation)
By Joseph Ax and Nate Raymond
NEW YORK, Sept 29 (Reuters) - In a rare move, a U.S. judge held Argentina in contempt on Monday, saying the country is taking "illegal" steps to evade his orders in a longstanding dispute with hedge funds over defaulted debt.
A source at Argentina's central bank nevertheless said the country plans to deposit an interest payment at a local bank on Tuesday, in direct defiance of U.S. District Judge Thomas Griesa's admonitions.
Griesa, who has overseen the litigation in New York for years, put off a decision on imposing sanctions on the South American country, which defaulted in July for the second time in 12 years after failing to reach a deal with the hedge funds.
But Griesa issued a clear warning that the country must stop efforts to get around his rulings by making payments in Argentina.
"These proposed steps are illegal and cannot be carried out," Griesa said, his voice rising, during a court hearing in lower Manhattan.
Those steps, he said, include legislation Argentina passed that would allow it to replace Bank of New York Mellon Corp as trustee for some restructured debt with Banco de la Nacion Fideicomiso while allowing a swap of that debt for bonds payable in Argentina under its local laws.
Despite his ruling, Argentina plans to deposit an interest payment of at least $200 million with Banco de la Nacion Fideicomiso on Tuesday, the central bank source said.
The developments followed a familiar pattern in the litigation, in which Griesa criticizes Argentina for disobeying his orders and Argentine officials defiantly continue to do so. They also underscored the uncertain impact of a contempt ruling on a foreign government.
Argentina missed a bond coupon payment in late July after Griesa ruled it could not be made unless the country also paid more than $1.3 billion to a group of U.S. funds that rejected previous bond restructurings and are demanding full repayment, led by Elliott Management Corp's NML Capital Ltd and Aurelius Capital Management.
Despite the interest payment scheduled for Tuesday, it is far from clear the country will be able to locate bond holders in order to pay them.
Instead, the payment may allow Argentina to continue to maintain it has made its payments as required and is therefore not in default. Argentine officials have made a similar argument since Griesa blocked Bank of New York from processing a $539 million payment Argentina deposited in June.
NML did not immediately respond to a request for comment on the Reuters report regarding Tuesday's interest payment.
Griesa's decision to hold a foreign government in civil contempt of court is a rare but not unprecedented move. In typical cases, U.S. judges can hold parties in contempt and issue sanctions in order to force compliance with their orders.
The hedge funds had proposed a daily fine of $50,000.
However, Argentina might simply ignore any monetary sanction, the hedge funds conceded in court. In that case, said Robert Cohen, a lawyer for the hedge funds, Griesa could consider non-monetary sanctions that would coerce Argentina into compliance.
Cohen did not indicate what those sanctions could be. They might, for instance, include barring Argentina from doing business with U.S. banks, though such a ruling would likely engender fresh litigation over whether Griesa has the authority to do so.
Griesa has called on Argentina to reach a settlement with the holdouts, appointing a mediator to oversee talks that have thus far been unsuccessful.
Carmine Boccuzzi, a lawyer for Argentina, told Griesa during the hearing that a contempt order was "legally inappropriate" and "would just make things worse."
Griesa did not set a specific schedule to consider sanctions. (Additional reporting by Hugh Bronstein and Richard Lough in Buenos Aires; editing by Andrew Hay)