Insurgents' Iraq advance poses security, economic risk for Turkey
* Iraq a major trade partner, oil supplier to Turkey
* Turkey faces security threat from two southern neighbours
* Immediate priority is release of 80 hostages
* Turkey could play role in any military intervention
ISTANBUL, June 13 (Reuters) - The advance of Sunni militants in Iraq leaves Turkey facing a widening Islamist insurgency in two of its southern neighbours, endangering domestic security, threatening important trade routes and forcing it again to rethink Middle Eastern policies.
Militants from the Islamic State in Iraq and the Levant (ISIL) overran the northern Iraqi city of Mosul, 110 km (68 miles) from the Turkish border, earlier this week and have since thrust southwards towards Baghdad, seat of the Shi'ite Muslim-led central government.
Their lightning ascendancy in Turkey's second biggest export market and biggest oil supplier compounds the challenges confronting Prime Minister Tayyip Erdogan, already contending with a slowing economy and the spillover from Syria's civil war where ISIL has also seized patches of border territory.
Although analysts believe any ISIL encroachment would be quickly spotted by Turkish forces arrayed along the frontier, financial markets have been unnerved. Turkey's lira currency fell to its weakest point in six weeks against the dollar on Friday, while stocks, bonds and the cost of insuring Turkish debt against default have also been volatile.
Turkish officials, from the normally vocal Erdogan down, have made little public comment on events in Iraq. Their top priority, they say, is the delicate process of ensuring the release of 80 Turks, including diplomats, special forces soldiers and children, snatched by ISIL as it seized Mosul.
"We're closely monitoring this situation ... We've mobilized all efforts to get our citizens back," Erdogan told a rally in the Black Sea town of Rize on Friday, saying he had spoken with Turkey's consul general in Mosul, who is among the hostages.
But the developments have reinforced a sense among his critics that Turkey's Middle Eastern policy is in disarray.
"Foreign Minister Ahmet Davutoglu was claiming a few years ago that a leaf could not move in the Middle East without Turkey's consent," wrote Semih Idiz, a columnist at Hurriyet Daily News who has covered Turkish foreign policy for 30 years.
"Today there are forest fires raging there and all Ankara can do is look on."
Davutoglu, touted as a potential future prime minister if Erdogan runs for the presidency as expected in an August election, has seen his declared policy of "zero problems with the neighbours" crumble over the past few years.
Turkey's assumption of the quick demise of Syrian President Bashar al-Assad, a former ally, proved a costly miscalculation, with Ankara underestimating the threat posed by fundamentalists among the rebel ranks as it maintained an open border policy which has allowed fighters and supplies to cross back and forth.
"The weapons in ISIL's hands are sent by Tayyip Erdogan," the leader of the main opposition CHP, Kemal Kilicdaroglu, was quoted as saying by the Cumhuriyet newspaper on Friday.
The government has repeatedly denied arming Syria's rebels or backing radical Islamists. "Did Turkey consciously send people, weapons and financial aid to ISIL? No. We can say definitely no to this and the whole world knows it," Deputy Prime Minister Bulent Arinc told a news conference.
Iraq has risen to become Turkey's second biggest export market after Germany in recent years. Ankara has sought to diversify its trade away from a dependence on Europe, exporting $12 billion of goods to Iraq last year.
Exports to Iraq, mostly to the autonomous Kurdish enclave in the north of the country, have been growing in the double digits since 2005, at times in excess of 30 percent. This has helped to narrow a trade gap that is part of the reason for Turkey's huge current account deficit, the Achilles heel of its economy.
But relations are tense with Prime Minister Nuri al-Maliki's administration in Baghdad, not least because of Turkey's thickening ties with the Kurdistan region, which is at odds with the federal government over oil and land rights.
Diplomats say Ankara will need to intensify its efforts to bring about a thaw in ties not only with Baghdad but also Shi'ite Iran, which is equally perturbed by the ISIL advance.
Turkish businesses are heavily active in Iraq, which is home to around 135,000 Turkish citizens, the vast majority of them in Kurdistan, which curves around north and east of Mosul and, for the moment, serves as a buffer between ISIL and Turkish soil.
"The mountainous area can be easily defended by the peshmerga (Kurdish forces) and any large group of (ISIL) militants would be easily spotted by the Turkish military, which is deployed in large numbers alongside the border," said Wolfango Piccoli of risk research firm Teneo Intelligence.
Turkey has warned its nationals to get out of Iraq and flag carrier Turkish Airlines is scheduling additional flights to Baghdad and Arbil, in Kurdistan, to help them do so.
Ankara has the second largest armed forces in the NATO military alliance after the United States but is seen as highly unlikely to undertake any form of military action other than as part of an international coalition.
U.S. President Barack Obama threatened military strikes against ISIL on Thursday; the United States has a major air base at Incirlik in southern Turkey.
"In the medium-term I do not see any other option than an international intervention in Iraq, which would need to be on the request of the central government in Baghdad," said Sinan Ulgen, head of the Edam think-tank in Istanbul.
"Turkey would also be involved, as a country that has been exposed to all the security spillovers, but Turkey cannot lead. Iraq would not want Turkey to lead because of the strained relationship between the two governments," he told Reuters.
Justice Minister Bekir Bozdag said on Thursday the Turkish government was not working on any new request for parliament to authorise a cross-border operation beyond an existing mandate, which expires in October, that enables Ankara to strike at bases of Kurdish PKK rebels sheltering in the north of Iraq.
(Additional reporting by Humeyra Pamuk and Seda Sezer; Editing by Mark Heinrich)