* Lira down 1.7% after Reuters article, global selloff
* Treasury crafting reserves legislation to boost budget
* Sources said state banks sold some $4.5 bln last week
* Investors also worried over Istanbul election re-run (Updates numbers, adds details)
By Nevzat Devranoglu and Daren Butler
ANKARA/ISTANBUL, May 13 (Reuters) - Turkey's lira tumbled on Monday after Reuters reported the government plans to tap into the central bank's legal reserves to help contain a budget deficit, reversing last week's gains when state banks sold billions of dollars to support the currency.
A global selloff across emerging markets also dragged on the currency as hopes faded for an end to the U.S.-China trade war.
The lira stood at 6.1010 against the dollar, after weakening to as far as 6.13, some 1.7% weaker than Friday's close. On Thursday it hit its weakest level in more than seven months at 6.2460.
Turkey's Treasury ministry is working on legislation to transfer the central bank's 40 billion lira ($6.6 billion) in legal reserves to the government's budget to shore it up, three economic officials told Reuters.
The transfer plan sends a message "that things are worse than first assumed, (and) that the fiscal tightening we expected post March 31 local elections is being put off likely beyond the June 23 local election date," said Timothy Ash, head of emerging market research at Blue Bay Asset Management.
Last week, Turkish state banks sold around $4.5 billion of dollars, according to two sources, including a flurry of selling late on Friday, to stem declines triggered by a decision last week to re-run Istanbul's mayoral election.
A treasury desk dealer at one bank said lira moves in thin overnight trade were being reversed in more robust trade during the day, as was seen occasionally over the last year when the currency weakened sharply overnight.
"We are seeing pricing returning to normal levels when trading volumes increase," the dealer said.
In a separate official effort to support the currency on Thursday, the central bank tightened policy by funding the market at a higher rate.
The lira has lost as much as 15 percent against the dollar this year, with the latest bout of weakness driven by the decision to annul the March 31 Istanbul mayoral election, which the main opposition party narrowly won over President Tayyip Erdogan's AK Party.
The main stock index fell 2.58%, hitting its lowest level since August, while the banking index traded down 2.66%.
The Turkish treasury borrowed with two bond auctions on Monday with yields of 26.12% for a 12-month zero coupon bond and 4.25% for the tap of 5-year CPI-indexed bond.
Finance Minister Berat Albayrak said on Sunday in an interview with broadcaster CNN Turk that the economy will hopefully overcome the impact of a currency crisis last year with just two quarters of contraction.
The economy contracted 3.0 percent in the fourth quarter of 2018 from a year earlier, after a currency crisis knocked some 30 percent off the value of the lira last year. Economists expect two more quarters of contraction year-on-year.
Data from the central bank on Monday showed the current account deficit narrowed to $589 million in March, less than a Reuters poll forecast of $984 million and down from $733 million in February. (Additional reporting by Behiye Selin Taner Editing by Jonathan Spicer and Toby Chopra)