OREANDA-NEWS.   Fighting in Iraq may slow Turkey's gradual economic rebalancing, analysts say, with higher oil prices set to push up inflation and the collapse of a key export market weighing on Turkey's efforts to narrow its yawning current account deficit.

A weaker lira and high interest rates have helped moderate domestic demand and bolstered exports in recent months. That has reduced the current account gap, Turkey's main economic weakness, and helped the economy get back on an even keel after a credit-fuelled boom.

But the lightning advance of Islamist insurgents in Iraq threatens to dismember Turkey's second-biggest export market and its main oil supplier.

Oil prices rose close to a nine-month high above USD 115 a barrel on Friday on concerns that heavy fighting could limit oil supplies from Iraq, OPEC's second-biggest producer.

Turkey buys 90 percent of its crude oil from foreign producers, helping swell a current account deficit that hit USD 65 billion in 2013.

Economists estimate every USD 10 rise in oil prices triggers a 0.5 percent increase in Turkish inflation and a USD 4 billion rise in its current account deficit.

"Turkey is clearly on the frontline, geographically, and from a balance of payments perspective," wrote Benoit Anne, head of emerging markets strategy at Societe Generale, in a note to clients this week.

"To me the oil price has become the key risk indicator for emerging markets," he said, adding that his bank had decided to sell the lira "to hedge the mounting geopolitical risks".

Finance Minister Mehmet Simsek said this month that he expected the country's energy import bill to reach USD 61 billion in 2014, compared with USD 56 billion last year.

On Tuesday he acknowledged that developments in Iraq could slow Turkey's progress in narrowing the current account gap this year.

The deficit shrank to USD 16.37 billion in the first four months of this year and stands at just under USD 57 billion on a 12-month cumulative basis.

OIL INFLATION
The inflationary impact of rising oil prices also poses a dilemma for Turkey's central bank, which meets to set interest rates next Tuesday.

Central bank governor Erdem Basci said on Monday the bank could cut rates as soon as next week if it is convinced the inflation outlook is improving significantly.

Economists doubted whether this was the case, however.

The annual inflation rate stood at 9.66 percent in May, well above the central bank's year-end forecast for 7.6 percent and its 5 percent medium-term target. The bank has repeatedly said it expects inflation to start falling from June.

"The latest developments will make reducing already high inflation and narrowing the large current account deficit even more difficult," said William Jackson, a London-based economist at Capital Economics.

"It seems difficult to justify further interest rate cuts. And if the central bank does lower rates, the lira might become more vulnerable to a sell-off," he said.

The lira has weakened 3.5 percent in the past two weeks, underperforming other emerging markets currencies, as investors worry over the fallout from the Iraq violence. It was trading at 2.1421 to the dollar by 1200 GMT.

Jackson forecast the currency could weaken to 2.25 to the dollar by the end of the year. A Reuters survey predicted the lira would weaken slightly to 2.22 per dollar in 12 months time.

The central bank cut rates for the first time in a year last month, despite high inflation, after calls for such a move from Prime Minister Tayyip Erdogan, eager to maintain growth ahead of an August presidential election in which he is expected to run.

A Reuters survey of 20 economists forecast a 50 basis point cut in its main one-week repo rate next Tuesday as well.

With its one-week repo rate at 9.5 percent, Turkey has the second-highest interest rate among the "fragile five" economies of Brazil, India, South Africa, Turkey and Indonesia seen as prone to heavy investment inflows and outflows.