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By Hugh Bronstein and Alejandro Lifschitz BUENOS AIRES, Jan 24 (Reuters) - Argentina said on Friday it would relax currency controls it had long defended as essential, a policy reversal forced by high inflation and a sharp fall in the country's currency. The peso currency's official rate has fallen 20 percent against the dollar so far this month, pressuring inflation even higher as confidence falls in Latin America's No. 3 economy. The surprise policy shift was announced at the end of a week in which central bank reserves had fallen to under $30 billion, a level suggesting the bank's interventions in support of the anemic peso had become unsustainable. A day after the peso had its hardest drop in more than 12 years, Cabinet Chief Jorge Capitanich said Argentina would reduce the tax rate on dollar purchases to 20 percent from the current 35 percent and allow the purchase of dollars for savings accounts, measures that would go into effect on Monday. He said the move "reflects the government's belief that in the context of a floating exchange rate, the price of the currency, i.e. the dollar, has reached an acceptable level." Analysts said the government was forced to abandon one of its signature policies due to its inflationary consequences as consumer prices are expected to rise by 30 percent in 2014. The currency controls had largely backfired by fueling a scramble for dollars on the black market, which in turn contributed to one of the highest inflation rates in the world. The spike in inflation has revived memories of the country's 2002 financial crisis that threw millions of middle class Argentines into poverty. Auto dealers have stopped selling new cars because inflation expectations are so volatile that prices are difficult to set. The price of household appliances shot 20 percent higher between Thursday night and Friday morning after the peso's Wednesday and Thursday plunge. Stores were nonetheless full of buyers eager to lock in prices before they rose still further. Latin American currencies slumped Friday in part due to worries over a looming foreign exchange crisis in Argentina. Wall Street welcomed Argentina's announcement of loosened foreign currency controls, but analysts said more needs to be done to combat Argentina's key problem of inflation. "If they do not complement this week's decisions with further announcements that anchor inflation and devaluation expectations, we should expect more inflation and foreign exchange volatility," said Ignacio Labaqui, who analyses Argentina for New York-based Medley Global Advisors. "The announcement of a coherent strategy to tame inflation is still missing," he added. On Thursday, the peso interbank exchange rate fell 11 percent to 8 to the dollar, its biggest one-day percentage fall in 12 years. On Friday it closed virtually unchanged after erasing a drop of 1.23 percent early in the session. Argentina's black market peso fell 7.25 percent on Thursday to close at 13.1 per dollar. On Friday it roared back 11.97 percent to close at 11.7 per greenback. GRAINS TRADE PARALYZED Argentina's key grains sector has held back exports as farmers hoard their crops rather than expose themselves to the swooning local currency. This contributed to the scarcity of dollars that has debilitated the peso. The country is the world's top exporter of soymeal and soyoil as well as its third biggest soybean and corn supplier. The currency controls were imposed more than two years ago to curb capital flight as confidence in the economy fell following years of heavy stimulus spending. The peso's long slide has aggravated inflation, which ran about 25 percent in 2013, according to analysts' estimates although discredited official data clocks inflation at less than half that. "The key to a more fundamental improvement in competitiveness lies in bringing down the inflation rate," Capital Economics said. "This would require a significant tightening of fiscal and monetary policies, including cutting a reliance on money-printing by the central bank to finance government spending." "But as things stand," it added, "measures that would support a longer-lasting improvement in Argentina's competitive position do not seem to be on the table." The policies announced by the government should help Argentina's finances by halting the drain on central bank reserves, said Walter Molano, emerging markets analyst at U.S.-based BCP Securities. "This is a measure that should have been done a year ago," he said, adding that more reforms were needed to tame inflation and open the country to the foreign investment it needs to exploit its promising shale oil and gas resources. Central bank foreign reserves were at $29.3 billion at the end of business on Thursday, having tumbled more than 30 percent last year. This week's decline in reserves to below $30 billion helped prompt the decision to relax currency controls, a policy switch "that has the hallmarks of being an ad hoc decision that reflects the government's tendency towards policy improvisation," according to a note from Teneo Intelligence. A CRISIS-PRONE ECONOMY Every time President Cristina Fernandez has tightened capital controls to shore up the country's wobbly balance of payments, it increased the scramble for dollars. This contributed to inflation and the fall in the value of the black market peso. The controls meant that the black market was the only way for average Argentines to get their hands on dollars amid high inflation. If Argentina reports 30 percent inflation this year, as private-sector economists expect, it would be the highest rate since the 2002 crisis, which was punctuated by a mammoth sovereign bond default and 41 percent inflation. Argentina has relatively little internationally traded debt, having been locked out of the capital markets since the default. Inflation is a growing worry among Argentines. There have been no mass protests over the problem in recent months but tensions could rise as labor unions demand pay hikes in line with private economists' 2014 inflation estimates. Fernandez has mentioned neither inflation nor the peso's plight in recent speeches, leaving her cabinet to announce policy changes. The next presidential election will be held next year with Fernandez unable to seek a third term and the main early candidates offering more market-friendly policies.