Crunch time for Turkey's central bank as rate hike pressure mounts
* Central bank rate decision due on Tuesday
* Lira at record low, default insurance cost at 18-mo high
* New economy minister says no need for rate hike
* Most analysts expect no change on Tuesday
By Ece Toksabay and Seda Sezer
ISTANBUL, Jan 20 (Reuters) - Turkey's central bank faces a big credibility test on Tuesday, with markets baying for an interest rate hike to prop up a crumbling lira but the government strongly opposed to any move that could crimp growth ahead of elections.
The lira hit the latest in a series of record lows on Monday while the cost of insuring Turkish debt rose to 18-month highs, as uncertainty about the central bank's readiness to lift rates raised fears of a deeper slide in the currency.
A corruption scandal shaking the government has hit investor appetite for Turkish assets, compounding concerns about the impact of cuts to U.S. stimulus that has flooded Turkey and other emerging markets with cheap cash.
Despite the lira's rapid fall and rising inflation, the central bank has so far been reluctant to raise rates, with Prime Minister Tayyip Erdogan's government bent on maintaining growth at all costs as an election cycle gets underway in March.
Speaking on Turkish television on Monday, Erdogan's new economy minister said the lira volatility posed no threat to the economy and he saw no need for a rate hike, a view not shared by markets.
"No other major emerging market central bank is under more pressure to hike interest rates than Turkey's," said Nicholas Spiro, managing director of Spiro Sovereign Strategy.
"This is crunch time for the central bank, whose rate-setting meeting ... will be one of the most closely watched in emerging markets since the sell-off began in late May."
A Reuters poll of 24 economists last week forecast that the bank will have to increase its overnight lending rate by a full percentage point to 8.75 percent by the end of March to shore up the lira.
But in a separate poll, only five out of 15 expected the bank to make any move on the lending rate on Tuesday, its first monetary policy meeting of the year.
Both the government and central bank officials reject the notion that the central bank is anything other than independent. However, Erdogan and his ministers have repeatedly lashed out against what they call an "interest rate lobby" of speculators pushing for higher rates, saying speculators are trying to destabilise the economy.
This has left the central bank stuck between a rock and a hard place.
"Unfortunately by descending into this kind of rhetoric Erdogan has pushed himself into a corner, or more particularly the central bank, and any hike now would be seen also as a political defeat," said Timothy Ash, head of emerging markets research at Standard Bank.
New Economy Minister Nihat Zeybekci, appointed in a cabinet reshuffle last month, came out on Monday to underline the government's position a day before the rate decision, saying that the lira's weakness posed no threat, even if it fell to 2.35 or 2.40 to the dollar.
The currency, which sank 17 percent against the dollar in 2013, hit a record low of 2.2515 earlier on Monday. It has weakened almost 10 percent since mid-December when the corruption scandal shaking the government first erupted.
Default insurance costs in the five-year CDS market rose to 18-month highs, Markit data showed.
"As I don't see a risk or danger from the current lira volatility to the economy, I believe our central bank should not raise interest rates," Zeybekci said on CNBC-e television.
"Current forex levels won't have a permanent impact on the economy, it's going through a fluctuation."
Foreign portfolio investors shovelled cash into Turkey and other emerging markets while they were booming and global interest rates soft. But the Federal Reserve's plans to gradually withdraw help for the U.S. economy have raised the prospect of higher U.S. yields, encouraging investors to pull back from emerging markets.
Turkey is particularly vulnerable, dependent on foreign capital flows to finance its gaping current account deficit, running at around 7 percent of national output.
The graft scandal, which broke a month ago with the arrest of businessmen close to the government and has led three ministers to resign, has further knocked investor confidence in Turkey after widespread street protests against the government last summer, triggered by the planned redevelopment of Istanbul's Gezi Park.
"The combination of the Gezi Park protests and the recent corruption scandals have introduced political uncertainty into Turkey that has not been present for a number of years, with consequences for domestic sentiment and domestic capital flows," analysts at UniCredit said in a note to clients. (Additional reporting by Sujata Rao in London; Writing by Nick Tattersall; Editing by Susan Fenton)