Turkey's row with U.S. over Iraq may hit lira hard

ANKARA (Reuters) - A row between Turkey and its most powerful ally the United States over Ankara's plans to send troops into northern Iraq to fight Kurdish rebels could dent much-needed foreign investment and hit the lira hard.

The high-yielding lira has fallen 3.3 percent this week against the dollar from six-year highs due to the Iraq issue, but economists say it could drop much more if Turkey defies Washington and sends its forces across the border.

Turkey lured a record $20.1 billion (9.81 billion pounds) FDI last year, and hopes to attract a similar amount this year.

Investors know an incursion into northern Iraq would further test relations with Washington, already strained after a U.S. Congress committee branded the 1915 killing of Armenians by Ottoman Turks as genocide, a view Ankara firmly rejects.

"If Turkey launches a large-scale operation, defying American opposition, then all markets will be hit by this... The markets believe the tensions are a good excuse to sell at the moment but the price of a serious clash will be higher," Fortis bank chief economist Haluk Burumcekci.

Emotions are running high in Turkey after a sharp rise in the number of Turkish soldiers killed in Kurdish rebel attacks. Parliament is due on Wednesday to approve a cabinet request to allow troops to enter Iraq if this is deemed necessary.

Washington's backing has been crucial for Turkey receiving International Monetary Fund loans to recover from a deep economic crisis in 2001 and for building energy pipelines that cut cross Turkey from the Caspian region to Europe.

Turkey in turn has served U.S. interests as a strategic partner in the turbulent Middle East region and as a model of stable democracy for the wider Muslim world. Washington relies heavily on Turkey for logistical support for its operations in Iraq and Afghanistan.

"If relations with the United States deteriorate permanently, then this could lower foreign direct investment. If this is coupled with a souring in global liquidity conditions, then Turkey will be hit harder," said Garanti Bank's head of research Ali Ihsan Gelberi.

A large balance of payments deficit leaves Turkey dependent on foreign investments.

It is not possible to predict the level of the lira in the event of a serious spat with Washington, economists said.

"The figures will depend on how many billions of lira foreigners will sell and more important than that, on how many dollars Turkish residents will buy," said Gelberi.

Traditionally, many Turkish savers keep deposits in foreign exchange to shield from sharp shifts in the lira.

A foreign exchange dealer said the lira may weaken to the 1.4-1.5 level at least if Turkey defies America over Iraq.

MANY STILL BULLISH

Some investors view the current fall in Turkish markets as a modest correction that will send the lira only as far as the 1.25-1.26 level. They say a significant setback is unlikely.

"We are very bullish on Turkey in the longer term. We have seen most geopolitically-motivated sell-offs as a buying opportunity. People look at the politics and misprice the economic story," said Werner Gey van Pittius, emerging markets analyst at Investec Asset Management in London which manages about $300 million in emerging market assets.

If the tanks rolled across the border, investors' natural instinct would be to sell Turkish assets but it would do little to alter what remains a positive medium-term picture, with inflation set to continue to fall while the government presses ahead with a reformist agenda, said analysts.

"Short-term volatility then should provide investors with an opportunity to add to lira (assets) at cheaper levels. It is a tried and tested method that has served them well over the past 18 months or so," said Nicholas Kennedy, head of emerging markets at 4Cast.

The pace of emerging markets' recovery from August's subprime mortgage wobble shows that investor sentiment remains bullish, analysts said.

"In simple terms you get paid for buying weakness in Turkey," Kennedy added.

Turkey pays well for the risk with yields on the benchmark bond of 16 percent, versus an inflation rate of 7 percent.

"The current situation between Turkey and the United States is unlikely to derail the market environment for Turkey... They are not going to go against the will of the U.S. in a major way, the U.S. is their big brother," said Jason Hepner, strategist at Standard Life Investments in Edinburgh. Standard Life manages 1.6 billion sterling in emerging markets.

Analysts say Washington, stuck in a quagmire in Iraq, is in no position to react heavy-handedly to Turkey over the Kurds.

"The U.S. and Turkey will not destroy such a strategic partnership. Turkey will not go too far and the U.S. will turn a blind eye to a limited incursion," Gelberi said.

(Additional reporting by Carolyn Cohn in London)