Argentina has defaulted on its debt for the second time in 12 years after hopes for a midnight deal with holdout creditors were dashed.

After a long legal battle with hedge funds that rejected its debt restructuring following a 2002 default, Latin America's third-biggest economy failed to strike a deal in time to meet a deadline for a coupon payment on exchange bonds.

Even a short default will raise companies' borrowing costs, pile more pressure on the peso, drain dwindling foreign reserves and fuel one of the world's highest inflation rates.

Argentina had sought in vain to win a last-minute suspension of a ruling by US District Judge Thomas Griesa in New York to pay holdouts of $1.33bn plus interest. 

He ruled Argentina could not service its exchange debt unless it paid holdouts at the same time.

A proposal for Argentinian banks to buy out the hedge funds' non-performing debt also fell through, sources told Reuters.

However, Argentina's Cabinet chief, Jorge Capitanich, has insisted the country was not in default.

He said holders of its performing debt should demand their money from the US judge who blocked a 30 June interest payment.

Mr Capitanich also called mediator Daniel Pollack "incompetent" and said the country would maintain its policies to stimulate the economy.

"This is a very particular default, there is no solvency problem, so everything depends on how quickly it is solved," said analyst Mauro Roca of Goldman Sachs.

As dire as it is, the situation is a far cry from the mayhem following the country's economic crash in 2001/2002 - when the economy collapsed around a bankrupt government. Millions of Argentines lost their jobs.

This time the government is solvent. How much pain the default inflicts on Argentina, which is already in recession, will depend on how swiftly the government can extricate itself from its obligations.

Buenos Aires had argued that agreeing to the hedge funds' demands to pay them in full would break a clause barring it from offering better terms than those who accepted steep write-downs in the 2005 and 2010 swaps.

However, that clause expires on 31 December, after which the government would be able reach a deal with the funds.

Many investors and economists still hope for a separate solution before then between the holdouts and private parties.

"Our base case is that a default would be cleared by January 2015," said Alberto Bernal, a partner at Miami-based Bulltick Capital Markets.

He projected that a default would cause the economy to shrink 2% this year compared with a previous market consensus for a 1% contraction.

Failure to strike a deal will not cause financial turmoil abroad because Argentina has been isolated from global credit markets since its 2002 default on $100bn, but domestic markets that had rallied on hopes of a deal in recent days will probably reverse course.

Yields on Argentina's key dollar bond due 2033 fell to the lowest level in about three-and-a-half years yesterday, and the country's MerVal index hit a record.

"The correction will depend on perceptions of how long the default will take to solve," said Roca.

The default could get much messier and take longer to clear up if creditors force an "acceleration" for early payment on their bonds.

"How bad the outcome ends up being depends on whether bondholders accelerate," said Alejo Costa, strategy chief at local investment bank Puente.

"Acceleration would open a new legal battle for the government that could end up in a new restructuring."

Argentina has foreign currency restructured debt worth about $35bn while its foreign exchange reserves stand at $29bn.

US ratings agency Standard & Poor's yesterday downgraded the country's long- and short-term foreign currency credit rating to "selective default". 

The default rating will remain until Argentina makes its overdue 30 June coupon payment on its discount bonds maturing in 2033, the agency said.

After two days of talks with holdouts in New York, Argentine Economy Minister Axel Kicillof told reporters that Argentina was not in default because it had made the June $539m interest payment to holders of exchanged bonds - even if this had not reached creditors by 30 July, at the end of the month-long grace period.

Judge Griesa called the payment illegal and blocked the funds' onward transfer to creditors. It remains in limbo in the Buenos Aires account of trustee agent Bank of New York Mellon.