* Turkish deputy PM says upgrade overdue
* Financial markets rally
* Finance minister says move will boost growth
* Turkey needs another agency to follow suit
By Daren Butler
ISTANBUL, Nov 5 (Reuters) - Turkey regained its investment grade credit rating on Monday after an 18 year gap, endorsing an economic transformation achieved in the past decade under Prime Minister Tayyip Erdogan.
Fitch Ratings upgraded Turkey in a move long coveted by Ankara, citing underlying strengths and an easing in near-term risks for the economy, and played down the chances of the country getting drawn into the civil war in neighbouring Syria.
However, Turkey needs at least one of the two other major ratings agencies to follow suit for it to join benchmark investment grade bond indexes, a status that many funds require before investing in a country.
Fitch highlighted Turkey's moderate and declining government debt burden, a sound banking system, favourable medium-term growth prospects and a relatively wealthy and diverse economy.
Turkey's rating was downgraded to junk after an economic crisis in 1994. However, Erdogan's AK Party government has kept the economy growing at an average 5 percent annually since it came to power in 2002. Inflation has also come down to around 8 percent from triple digits in the late 1990s.
Deputy Prime Minister Ali Babacan welcomed the Fitch move, saying the decision was appropriate and overdue, expressing hope that other ratings agencies would follow its lead.
"Turkey's achievement of this credit rating is expected to mark the start of a new era in the access of our public and private sector institutions to international capital markets," Babacan said in a statement.
Fitch upgraded Turkey's long-term foreign currency Issuer Default Rating (IDR) to 'BBB-' from 'BB+' and the Long-term local currency IDR to 'BBB' from 'BB+'. The outlooks on the long-term ratings are stable.
Shares jumped on the news, gaining as much as 2.6 percent to a record high during the day and closing up 1.84 percent. The benchmark bond yield fell as low as 6.8 percent, just above its record low, and the lira strengthened.
There had been growing anticipation of a move by Fitch in recent weeks but analysts had been expecting an upgrade only in the outlook rather than the rating itself.
Turkey's economy was Europe's fastest growing in 2011 but has slowed sharply this year.
"It's important to know that credit markets have been trading Turkey like an investment grade credit for some time," said Manik Narain, emerging markets strategist at UBS. "But at the end of the day this will create actual investment inflows and lower borrowing costs even though it was partially priced in."
However, countries need investment grade ratings from two of the big three agencies to be included in benchmark investment grade bond indexes. Moody's rates Turkey one notch below investment grade, while S&P puts it a rung lower still.
Many economists agreed with Babacan that the Fitch move was overdue. "Turkey should have long been investment grade status, given its proven willingness to pay in difficult circumstances. The external financing risks to the sovereign have long been overstated," said Standard Bank head of EM research Timothy Ash.
"This is a big confidence boost to Turkey, and should help attract a new investor base to Turkey. I would expect Moody's to follow, and eventually S+P - kicking and screaming!" he added.
Moody's, which upgraded Turkey to Ba1 in June, said last week a history of political friction between secular and religious elements of Turkish society remained a credit challenge for the country.
But it said it could consider upgrading Turkey if the government made further progress in reducing its current account deficit, increasing foreign exchange reserves or reducing private sector foreign borrowing.
"Both of the other rating agencies could potentially deliver one notch upgrades with the next 12 months," said JP Morgan Chase economist Yarkin Cebeci.
Fitch predicted a soft economic landing. "Fitch believes that the Turkish economy is on track to return to a sustainable growth rate, having narrowed the current account deficit and lowered inflation after overheating in 2011," it said.
Turkey's external finances remain a weakness, it said, pointing to a current account deficit seen at 7.3 percent of GDP in 2012, albeit down from 10 percent last year.
The economy was expected to remain more volatile than investment grade peers and an external financing shock and recession were likely at some point but its creditworthiness has become more resilient to shocks, Fitch added.
UPGRADE SEEN AS OVERDUE
Finance Minister Mehmet Simsek said the upgrade would positively affect risk perception, and boost capital inflows and the country's performance. The economy grew 8.5 percent last year but growth is expected to slow sharply to 3.5 percent this year as domestic demand weakens, prompting the central bank to ease monetary policy.
Fitch said that among the main risk factors that could lead to negative rating action were a balance-of-payments crisis caused by an external shock or a political shock.
It also highlighted the risk of an escalation in regional instability. Turkey's forces shelled Syrian positions last month after fire from over the border killed five of its civilians.
"Fitch does not expect the civil war in Syria to draw Turkey into a full-scale military conflict. If such an event took place and had a significant economic and fiscal impact it could lead to a downgrade," it said.
Turkish sovereign dollar bonds rallied modestly, with spreads over U.S. Treasuries tightening 5 basis points in contrast to the broader emerging markets index where spreads widened.