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ISTANBUL (Reuters) - Fitch Ratings upgraded Turkey to investment grade on Monday, a move long coveted by Ankara, citing underlying strengths and an easing in near-term risks for the economy.
The credit ratings agency highlighted a moderate and declining government debt burden, a sound banking system, favourable medium-term growth prospects and a relatively wealthy and diverse economy.
The upgrade, Turkey's first investment grade rating since 1994, triggered a rally in financial markets. Shares jumped 2 percent to a record high, the benchmark bond yield fell to a near record low and the lira strengthened.
There had been growing anticipation of a move by Fitch in recent weeks but analysts had only been expecting an upgrade in the outlook rather than the rating itself.
Fitch's decision was likely to boost the Turkish economy, Europe's fastest growing last year but slowing sharply this year, making the country more attractive to foreign investors.
"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."
Deputy Prime Minister Ali Babacan welcomed the 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.
Turkey will not automatically be included in benchmark investment grade bond indexes because other agencies would have to follow suit. Moody's rates Turkey one notch below investment grade, while S&P puts it a rung lower still.
Prime Minister Tayyip Erdogan, who has presided over the transformation of Turkey's economy in the last decade, has long argued that the ratings agencies have underestimated Turkey.
"The upgrade to investment grade reflects a combination of an easing in near-term macro-financial risks as the economy heads for a soft landing," Fitch said. "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."
Turkey's external finances remain a key rating weakness, said Fitch, pointing to a current account deficit seen at 7.3 percent of GDP in 2012, 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.
Finance Minister Mehmet Simsek said the upgrade would have a positive impact on risk perception and boost capital inflows and the country's growth 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.
Erdogan's AK Party government has kept the economy growing at an average 5 percent annually since it came to power in 2002, inheriting a basket-case which had just suffered a major financial crisis. Inflation has also come down to around 8 percent from triple digits in the late 1990s.
Turkey was downgraded to junk after a home-made economic crisis in 1994.
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 remains a credit challenge for the country.
But it said it could consider upgrading Turkey if the government makes further progress in reducing its current account deficit, increasing foreign exchange reserves or reducing private sector external borrowing.
"Both of the other rating agencies could potentially deliver one notch upgrades with the next twelve months," said JP Morgan Chase economist Yarkin Cebeci.
Fitch said 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.
"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.
Additional report by Seltem Iyigun and Ece Toksabay in Istanbul, Sujata Rao in London; writing by Daren Butler; editing by Jeremy Gaunt and Philippa Fletcher