By Daren Butler
ISTANBUL (Reuters) - Turkish shares tumbled 4 percent and bonds and the lira weakened sharply on Monday after Moody's cut its credit rating to "junk", raising risks of an outflow of foreign funds and a squeeze on external borrowing.
Turkey depends on investment to fund its current account deficit - one of the biggest in the G20 - and service its foreign debt. Ratings downgrades could force it to pay more to borrow in international markets.
In its decision late on Friday, Moody's cited worries about the rule of law after a failed putsch and risks from a slowing economy. Gross domestic product (GDP) growth slowed to 3.1 percent in the second quarter from 4.7 in the first and officials see it slowing further.
Standard and Poor's made a two-notch cut by right after the failed putsch. Of the major agencies, only Fitch has Turkey on investment grade and that is due for review at the start of 2017.
Moody's cut will therefore trigger an outflow of funds by foreign investors such as pension funds, who require at least two agencies to rate sovereign debt at investment grade, said Gokce Celik, chief economist at Finansbank.
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That will push "the cost of external borrowing higher while rendering the currency weaker," Celik said in an email.
The main stock index was down 4 percent to 76,511 at 1105 GMT, on course for its biggest one-day decline since the days after the attempted coup of July 15. The losses were driven by banking shares, which fell nearly 6 percent.
Borrowing costs surged with the 10-year benchmark yield rising to 10.01 percent from 9.51 percent on Friday. The lira weakened to 2.9880, after touching 3.0040 in illiquid trade overnight, and was on track for its biggest one-day slide since July 19.
Moody's cut the government's long-term issuer and senior unsecured bond ratings debt to non-investment grade Ba1 from Baa3. It kept its outlook on the rating "stable," saying Turkey's flexible $720 billion economy and strong fiscal track record offset balance-of-payments pressures.
'INEVITABLE DECISION'
"This was an inevitable decision ... Low rates of growth and a poor domestic political backdrop are hardly conducive to a benign investment climate," Commerzbank said, forecasting weakness in the lira and cash bonds.
Prime Minister Binali Yildirim said on Saturday that Moody's was not being impartial nor basing its rating solely on economic factors.
Around $2 billion-$3 billion could flow out after the downgrade, an influential adviser to President Tayyip Erdogan said on Monday. JP Morgan has estimated potential outflows could be much greater, saying in July that a junk rating could prompt the sale of $10 billion in sovereign and corporate bonds.
So far, there has been little outflow and the possibility of is remote, Deputy Prime Minister Numan Kurtulmus said, castigating those who tried to "undermine" Turkey's economic credibility.
"Arguably, the downgrade could make it more difficult for Turkey to attract the foreign financing needed to fund its current account deficit, which could lead to a much weaker lira and slower GDP growth," said William Jackson, an economist at Capital Economics.
"However, I think the ability to attract capital flows will have much more to do with external factors than Turkey's credit rating," he said, referring to U.S. interest rate decisions.
Some say the sell-off offers an entry point for investors.
"Once the sell-off runs its course, opportunistic investors may step in due to attractive yields offered by local bonds," Rabobank economist Piotr Matys said in an e-mail.
"Average GDP growth at around 4 percent (year on year) in the coming years may also prove a valid argument to consider purchasing Turkish assets."
(Additional reporting by Nevzat Devranoglu, Seda Sezer; Editing by David Dolan/Ruth Pitchford)