* Dispute over gov't debt repayment fund weighs
* Local banks hit as they major Argentine bond holders
* Sell off limited on high expectations behind '09 rally (Updates to close)
By Jorge Otaola
BUENOS AIRES, Jan 8 (Reuters) - Argentina's financial markets closed down on Friday as investors reacted to a deepening dispute over the president's plan to use Central Bank foreign reserves to guarantee debt payments this year.
The benchmark MerVal stocks index .MERV closed down 1.53 percent to 2,352.76 points, pressured by banking sector losses as locally traded sovereign debt fell. Local banks are major holders of Argentine bonds and their stock tends to fall when debt prices are hit.
The country's biggest financial conglomerate Grupo Financiero Galicia GFG.BA was among the biggest losers on the stock market, falling 2.28 percent to 2.14 pesos per share.
Bond prices slipped by 1.2 percent on average in over the counter trade in Buenos Aires, as political tensions rose over the government plan to tap $6.6 billion in foreign reserves. The Boden 12 bond denominated in dollars ARBODEN12D=RASL dropped 2.5 percent.
An Argentine judge blocked the president's plan on Friday and ordered the bank chief's reinstatement, a day after President Cristina Fernandez fired him for refusing to hand over the reserves. For details see [ID:nN08233593]
"The government's decision muddies the political scenario ... people who are taking positions are trying to take advantage of the volatility," said Horacio Corneille, director of Corneille brokerage in Buenos Aires.
The risk spread on Argentine bonds widened by 2 basis points to 670 basis points over comparable U.S. treasuries, according to the benchmark J.P. Morgan Emerging Market Bond Index 11EMJ. Earlier in the day the spread jumped to 701 basis points, a three week high.
Last year, Argentina's international debt was in strong demand and returned a 132.8 percent gain, according to the JP Morgan EMBI Plus .JPMEMBIPLUS.
That made Argentina the best 2009 performer among EMBI components. The overall index showed a 25.948 percent return.
Double-digit debt investment yields, roughly $48 billion in reserves and movement toward cleaning up leftover fallout from its huge 2001/02 debt default were factors behind the rally.
"A lot of expectations were behind the rally, and Argentina has not sold off that much when you compare it to other credits," said David Spegel, ING's global head of emerging markets strategy in New York.
On the foreign exchange market, the interbank peso weakened by 0.13 percent to 3.7975/3.8000 per U.S. dollar ARS=RASL. In informal trade between foreign exchange houses, as measured by Reuters, the peso ended down by a similar margin at 3.8675/3.8725 per U.S. dollar.
Additional reporting by Daniel Bases in New York; Writing by Luis Andres Henao and Fiona Ortiz Editing by Theodore d'Afflisio