(Corrects date Citibank opened its first branch to 1914, paragraph 11)
By Jorge Otaola
BUENOS AIRES, March 18 (Reuters) - Argentina will not allow Citigroup Inc. to exit its local custody business, a senior source in the government said on Wednesday, setting up a possible showdown between the leftist government and the banking giant over sovereign debt payments.
The government is demanding Citigroup process a March 31 coupon payment on its sovereign debt to avoid its latest default on foreign law bonds spilling into local debt.
However, the bank said on Tuesday it planned to quit the custody business, in which it acts as custodian of some Argentine bonds and processes payment for the ultimate security holder, after a U.S. court barred it from passing on the funds.
President Cristina Fernandez' has threatened to cancel Citibank Argentina's operating license if it refuses to process a March 31 interest payment, putting at risk the group's retail banking business in Latin America's No. 3 economy.
"There is no way we will let them exit their (custody) business," said the source, who is familiar with President Cristina Fernandez' view on the matter.
Citigroup has found itself at the center of a bitter court battle between Argentina and a group of New York-based hedge funds that were awarded full payment on their defaulted sovereign bonds by U.S. District Judge Thomas Griesa.
Griesa ruled Argentina must settle with the funds before it continue paying interest to the large majority of investors who accepted significant writedowns on the debt holdings after the country's record default on $100 billion in 2002.
Ranked one of the world's leading custodian banks, Citigroup portrayed itself as an innocent third party faced with the untenable choice of ignoring Griesa and being held in contempt of a federal U.S. court, or putting its license in jeopardy.
Its decision may hamper the government's efforts to pay bondholders and return to global markets.
Fernandez denigrates the holdout creditors as "vultures" bent on pursuing astronomical profits. The funds say she is turning her back on legitimate debt obligations.
Citibank Argentina opened its first branch in 1914. It is the country's 12th largest bank by deposits with 22.82 billion pesos ($2.67 billion) as of December, about 2.6 percent of all deposits in the Argentine banking system, central bank data showed. The bank employs 2,800 staff and has 71 branches.
Argentina's capacity to block Citibank's plans may hinge on the small print of the bank's contract with the economy ministry confirming it as custodian of local law restructured bonds, an official at a state bank said.
Under Argentina's banking regulations, it would be the Central Bank of Argentina that suspends or cancels Citibank Argentina's operating license.
Fernandez' political opponents have long complained about the central bank's diminished independence during her leadership and one banking industry source said such a decision would be a political one.
"That would be the perfect scenario for Fernandez to present herself as the victim," the official at a state bank said.
Fernandez has already shown herself willing to act tough. In August, Argentina stripped Bank of New York Mellon of its authorization to operate as an intermediary for payments on foreign law restructured bonds after it obeyed Griesa and refused to pass on payment to creditors.
Argentina set a Wednesday deadline for the bank to inform authorities whether or not it planned to process the upcoming coupon payment, worth about $3.7 million on its 2038 dollar-denominated Par bonds held under Argentine law.
If it refuses to handle the payment, and the funds do not reach creditors, Argentina's default on its restructured debt held under foreign law will spread to the local law bonds. Griesa had previously allowed Citibank Argentina to make three one-time payments on local law paper.
Citigroup's decision to sell parts of its custody business or end some of its client relationships is without precedent in Argentina, some bankers said.
Belgium-based clearing house Euroclear, which distributes Argentine interest payments to bondholders, said last week it had opened an account in Argentina, as part of an expansion into new markets. However, it said it would not handle bond payments affected by Griesa's ruling.
Earlier on Wednesday, Argentina filed a motion in Griesa's court opposing claims by more than 500 "me-too" creditors seeking payment on debt worth $5.4 billion, owed since the country's 2002 default.
These creditors' claims, filed by March 3, are separate from the $1.33 billion plus accrued interest awarded to the hedge funds by Griesa. Argentina had insisted payment of that debt would unleash a torrent of claims it could not afford.
"As predicted by the Republic, the flood-gates have now opened," Argentina said in a motion filed in the court.
Argentina said there was now $10 billion in judgments and claims before Griesa, making "compliance even more unattainable." (Additional reporting by Eliana Raszewski in Buenos Aires and Nate Raymond in New York; Writing by Richard Lough; Editing by W Simon, Dan Grebler and Andrew Hay)