* Brazil's strong currency key to Argentina's expansion
* Helps Argentina make up for lack of competitiveness
* Inflation threatens to erase Argentina's peso advantage
* Argentine GDP set to grow 9 pct in 2010, Brazil's 7 pct (Adds context on Mercosur trade block paragraph 11)
By Magdalena Morales
BUENOS AIRES, Nov 2 (Reuters) - Brazil's strong currency is giving a competitive edge to the export sector in neighboring Argentina, helping to fuel an economic boom that could hit 9.0 percent this year.
Brazil's currency, the real
Some 85 percent of Argentina's auto exports go to Brazil.
Pushed by sectors such as steelmaking, oil and banking, Argentina's Merval <.MERV> stock index rose 1.85 percent on Tuesday to an intraday record of 3,133.95 points. The index is up 33.8 percent so far this year.
The one-two punch of strong Brazilian demand -- the economy there is set to grow more than 7.0 percent in 2010 -- and Argentina's policy of keeping its peso relatively weak is seen compensating for high consumer prices that are jacking up company costs.
"The only thing that the Argentine economy would not be able to handle would be a weakening of the real. And I don't think that will happen," said economist Javier Gonzalez Fraga, an Argentine economist and former central bank chief.
Indeed, all of Brazil's efforts at controlling the strength of the real, including tax increases on foreign capital, have failed so far.
On the Brazil's side of the border, officials worry that the strong real is opening the floodgates to cheap Chinese imports. The government has sought to curb the real's rally by tripling a tax on foreign purchases of local bonds aimed at slowing the flow of foreign capital into Brazil.
But the measures have had little effect.
Brazil is expected to take more steps in the weeks ahead to tame the local currency. Incoming president Dilma Rousseff, elected on Sunday, admits that the strong real is a problem for Brazil but says her government will not "manipulate" the foreign exchange market to control the local currency.
Brazil and Argentina are the two biggest members of South America's Mercosur trade block, under which tariffs have been lowered, giving Argentina another advantage when it comes to importing into Brazil.
For graphic click on: http://r.reuters.com/ded53q
Argentina's economy is expected by the government to expand 9 percent in 2010, driven by a boom in agricultural commodities prices.
Argentina has issued billions of dollars in GDP warrants, which repay investors at a rate linked to the country's gross domestic product growth. The boom is making the warrants more attractive and providing higher returns for holders.
The country's inflation rate has increased in recent months and could reach 27 percent this year, according to private estimates, which would be the highest rate in Latin America after Venezuela.
As inflation rises, the government may be tempted to push the peso even lower. But the risk of excessive currency weakness would be capital flight, which could cut into bank deposits and reduce the ability of financial institutions to lend money and act as a motor for investment and growth.
The peso trades at about 4.00 to the dollar, controlled by central bank interventions, while the real has flown to 1.7 per greenback as Brazil emerges as one of the world's top investment destinations thanks to sky-high interest rates.
"Argentina has a huge competitive advantage due to the difference in exchange rates. But, eventually, high inflation in Argentina will make that advantage go away," said Jim Barrineau, a New York-based strategist for ICE Canyon, a $2 billion emerging markets hedge fund.
Argentina has long backed state intervention in the economy
to stoke growth and avoid volatility. Argentina's central bank
buys or sell dollars on the local market nearly every day to
keep the peso
"We are doing well thanks to Brazil," said Buenos Aires-based trade expert Raul Ochoa, "But that's not a sustainable policy over time."
Last month Argentine central bank President Mercedes Marco del Pont said Argentina will continue to protect its economy in 2011 by intervening in foreign exchange markets, accumulating foreign reserves and controlling capital flows.
For now, the trade numbers look good. The Argentine government forecasts the trade surplus of $12.73 billion this year and a surplus of $9.68 billion in 2011.
"Exchange rate stability is the only variable that is containing the rest of the big distortions that Argentina has on the fiscal and monetary side," said local economist Jorge Todesca. (Additional reporting by Todd Benson in Brazil, writing by Hugh Bronstein)