* Moody's upgrades Turkey by one notch
* Turkish bonds and the lira rally
* Moody's says Turkey can absorb shocks, access capital
By Alexandra Hudson
ISTANBUL, Jan 8 (Reuters) - Ratings agency Moody's on Friday upgraded European Union candidate Turkey, citing growing confidence in the country's ability to absorb shocks, bounce back from recession and tap international credit markets.
Analysts said a ratings upgrade for Turkey was long overdue, given the strength of the country's banking system, Ankara's ability to borrow at record low yields in 2009, attract sustained interest from international credit markets, and proceed without funding from the International Monetary Fund.
Moody's, which had put Turkey on positive watch last September, lifted its rating by one notch to Ba2 from Ba3 and changed its outlook to stable from positive. The foundations for long-term growth in Turkey looked robust, it said.
"Although Turkish growth has contracted very sharply ... the resilience of the public finances relative to past such crises has been notable," said Sarah Carlson, the lead analyst for Turkey in Moody's Sovereign Risk Group.
"The ability of the government and the country more generally to regroup when faced with a very significant economic and financial challenge indicates that Turkey has reached a higher level of resiliency."
This week's $2 billion Eurobond issue by Turkey, which was well over-subscribed, showed Turkey had proven access to foreign capital, Moody's said.
"An upgrade from S&P is likely to follow this," said Inan Demir, economist at Finansinvest. "We think rating agencies have been way behind the curve. Turkey CDS are trading below higher rated counterparts such as Romania (BB+) and Hungary (BBB-, investment grade).
The global financial crisis hit Turkey hard last year when the once-booming economy is expected to have contracted by 6 percent. The government borrowed heavily, coming under fire for its lapse in fiscal discipline, but it forecasts the economy will grow by 3.5 percent this year after a steady improvement in recent months.
Talk of Turkey striking a new deal with the IMF returned to the agenda at the end of 2009, a move which many investors would welcome as a policy anchor, although Turkey's base-case scenario for its 2010 budget does not foresee IMF funding, and there is still much scepticism about whether Turkey would actually sign.
News of the upgrade saw the yield on Turkey's benchmark bond fall as low as 8.55 percent from a previous close of 8.85 percent. By 0925 GMT it traded at 8.69 percent.
The lira traded at 1.468 to the dollar on the interbank market, after a close of 1.4785 on Thursday.
Turkish stocks briefly rallied as much as 1.25 percent on news of the upgrade but then slipped after data showed industrial production in November posted a surprise fall of 2.2 percent on the year, reminding that recovery, although under way, will be slow.
Stocks, however, are trading at around two-year highs after nearly doubling last year to be among the best emerging market performers.
FISCAL RISKS
Moody's said downside risks remained such as debt affordability and the lack of policy rules to instil additional financial discipline in the government's spending.
An election due in 2011 could also lead to more policy volatility, it said.
Turkey has a medium-term economic programme in place which aims to reduce its budget deficit, although it has been criticised as unambitious. A fiscal rule law is due in 2011.
"(Policy rules) would make the improvements in debt dynamics more durable and predictable, a decisive factor for any sovereign country to eventually become investment grade," Moody's said.
It added if Turkey kept interest rates in single digits or low double-digits, debt affordability ratios would improve.
Turkey's central bank cut the benchmark overnight borrowing rate by 10.25 percentage points during a 13-month easing cycle, bringing rates to record lows.
Last December Fitch upgraded Turkey two notches to just below investment grade, and expectations of further upgrades were rife. Assets had risen on Thursday on talk of an upgrade by Standard & Poor's.
"The markets had been focusing on rumours of an upgrade by Standard & Poor's, but then Moody's snuck up on the rails ... bit disappointing that Moody's only moved one notch," said analyst Timothy Ash at Royal Bank of Scotland. (Editing by Stephen Nisbet)