Financial worries ease as scandals, airline troubles become latest preoccupations.

BUENOS AIRES -- The big picture has brightened considerably following the success of the $29.5 billion megaswap two weeks ago and this week's Letes treasury bond auction, which saw rates decline considerably compared to the last sale in May. However, significant economic reforms remain on the agenda, heart surgery for President Fernando de la Rua and a scandal regarding arms sales that has landed former president Carlos Menem in jail all could prove to De distractions.

Investors agreed to swap $29.5 billion in bonds maturing in the next few years for higher-rate instruments with longer maturities. The deal reportedly saves the government 57.8 billion in debt service costs through the end of next year, and has reassured international investors that Argentina can meet its obligations at least through then. In addition, the reduction in debt service payments will give the government more resources to focus on bolstering the economy, which is showing signs of pulling out of a three-year slump.

Interest rates, both for Argentine debt and on local markets, have been dropping since the swap. At Tuesday's auction of $700 million the government sold $350 million of 91-day Letes treasury bills at 7.89% - slightly better than expected- and $350 million of 182-day notes at 9.9%, at the high end of predictions. At the last auction in late May, the government had to pay 12% on three-month notes.

Bank rates for business loans also dropped as the financial sector began to see light at the end of the tunnel. The country's risk rating also dropped to reasonable levels.

The most difficult challenge for Economy Minister Domingo Cavallo now becomes cutting the budget to meet IMF deficit targets. This will be tricky because Cavallo agreed to cut deficit targets to reflect the savings realized by the swap. As a result, this year's deficit target of $6.5 billion will likely drop to the $5.6 billion to $5.9 billion range. Cavallo's check tax and efforts to reduce tax evasion are expected to boost revenues, but he still concedes he will have to reduce government spending by some 5%.

After running a deficit of more than $1.1 billion in May, the first test will be to see whether government predictions of a $200-$300 million surplus - necessary to meeting the second-quarter deficit target - will be reached. May government revenue rose $391 million compared to the same month last year. Unfortunately, government expenditures were $774 million more than May 2000 as a result of higher interests costs and larger transfers to the provinces. Reducing transfers to the provinces and other expenditures will be Cavallo's largest short-term obstacle to restoring the economy.

Distractions unrelated to economics also have cropped up. Menem's arrest on charges he illegally sold arms to Ecuador and Croatia in the early 1990s have grabbed headlines. There is concern that Cavallo, who was Economy Minister under Menem, could be tainted by the scandal. Cavallo's signature reportedly appears on some of the decrees authorizing the arms sales. A number of other Menem relatives and political allies also have been arrested and the investigation could lead to charges of corruption in other areas. The detention of Menem - now under house arrest - follows his high-profile wedding to former Miss Universe Cecelia Bolocco.

There are rumors Menem, who is being investigated by judges he appointed, could be released due to errors in the case against him.

De la Rua, who is still recovering from heart surgery, also finds himself in the middle of the collapse of former state airline Aerolinas Argentinas. Most of the heavily indebted airline is owned by the Spanish government. A strike earlier this year, combined with the poor state of the economy have left the company nearly bankrupt. Workers have not been paid since April and the Spanish government is refusing to inject more money into the company. Flights to seven international destinations were suspended earlier this week, prompting employees to threaten to shut the airline down unless they resumed. The government has threatened to sell the routes to other airlines unless the flights resume, prompting the Spanish owner, SEPI, to resume some flights, while suspending service on others.