* S&P cites rebalancing economy in upgrade
* Keeps Turkey one notch below investment grade
* Sees Kurdish peace process as encouraging sign
By Luciana Lopez and Nick Tattersall
NEW YORK/ISTANBUL, March 27 (Reuters) - Ratings agency Standard & Poor's raised Turkey to within a whisker of investment grade on Wednesday, citing a rebalancing economy and progress in a Kurdish peace process, but the move failed to impress the country's finance minister.
The ratings agency lifted Turkey's sovereign credit rating to BB-plus from BB with a stable outlook, noting that its external financing requirements had declined thanks to strong exports and a drop in domestic demand.
"The Turkish economy appears to be slowly rebalancing, without undermining its relatively strong fiscal performance," S&P said in a statement.
S&P has had a rocky relationship with Turkey, which reacted angrily last year to the rating agency's downward revision of its outlook to stable from positive. The agency converted its ratings on Turkey to "unsolicited" in January, meaning it is not paid by the country to provide cover but does so anyway.
Finance Minister Mehmet Simsek said in a statement the S&P upgrade was "encouraging" but that Turkey still deserved better.
Fitch upgraded Turkey to investment grade at BBB- in early November, and the country 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.
Moody's said in January Turkey needed to improve its resilience to external shocks by narrowing its current account deficit or boosting foreign reserves before it would consider an investment grade rating.
Analysts said S&P appeared to be catching up with the two other main ratings agencies with its latest move.
"The joke is that S&P had Turkey on BB in the first place. I guess (it will be) easier now to move to investment grade over the next 12-24 months," said Timothy Ash, head of emerging market research at Standard Bank in London.
"S&P will be kicking and screaming to get Turkey over the investment grade hurdle, especially if the current account deficit is widening as we expect. Moody's is probably a more likely contender to give Turkey the prized second investment grade status," he said, but doubted that would come this year.
S&P said the upgrade partly reflected Turkey's progress in trying to end a three-decade war with Kurdish militants in its southeast, a conflict that has killed 40,000 people and consigned the region to poverty.
The jailed leader of the Kurdistan Workers Party (PKK), considered a terrorist group by the United States and European Union as well as Ankara, ordered his fighters last week to cease fire and withdraw from Turkish soil in what is shaping up to be the most serious peace bid yet.
"We expect this to be more lasting than previous efforts: if so, security-related costs would decline and the regional economy, as well as cross-border trade flows, would be boosted," the ratings agency said.
Turkey is a major trading partner for northern Iraq's autonomous Kurdistan region, importing crude oil in exchange for diesel and exporting grains and construction materials like sandstone and marble, trade which could flourish if peace lasts.
But S&P also noted risks from municipal and presidential elections in 2014 and parliamentary elections in 2015.
Prime Minister Tayyip Erdogan's government has built its reputation on strong economic growth over the past decade and is eager to consolidate that record as the polls approach.
It has criticised the central bank for too cautious a monetary policy stance, raising concern about political interference.
The bank has been trying to reinvigorate domestic demand while preventing loan growth from accelerating so quickly that it stokes inflation and widens the current account deficit.
"Historically, economic policies have tended to prioritize growth, with less focus on its composition," S&P said.