Oct. 29 (Bloomberg) -- No prime minister in Turkey's modern history has done more to turn the lira into the strong man of the foreign exchange market than Recep Tayyip Erdogan. Traders now bet his threat to invade northern Iraq will turn it into a laggard.

The currency has fallen 0.6 percent since Oct. 9, when Erdogan told the military to prepare to strike bases of the Kurdistan Workers' Party. The order ended the biggest rally in Turkey's lira since before the 1970s, breaking the momentum that made it the best performer this year among 26 emerging markets tracked by Bloomberg. Trading in options shows the lira is now the riskiest currency over the next two months.

The lira's 19 percent appreciation this year to a record 1.18 versus the dollar reflects Erdogan's success in attracting investors and tourists to Turkey, America's stalwart Islamic ally. The economy more than doubled since he was elected in 2003, and the benchmark ISE National 100 Index of stocks has risen five-fold. Now, traders are growing concerned because more than 80,000 troops are poised near the Iraq border, prepared to hunt down Kurdish militants after an Oct. 21 firefight killed more than 35 people.

``Caution will increase and hurt the currency,'' should the nation start ``a large-scale ground offensive and it becomes an operation of several months,'' said Reinhard Cluse, a senior economist in London at UBS AG. The Zurich-based firm is the biggest underwriter of Turkish bonds, according to data compiled by Bloomberg.

Currency Tumbles

The currency tumbled 2.4 percent on Oct. 22 when Erdogan, 53, said an attack on Kurds in Iraq would come within days. The decline was the biggest since a 4.9 percent slump on Aug. 16, when investors around the world fled high-risk assets as losses on securities tied to U.S. subprime mortgages began to contaminate global credit markets. The lira fell for the first day in five today, dropping to 1.1917 from 1.1889 on Oct. 26.

``I can see the lira taking quite a beating'' if the conflict escalates, said Lars Christensen, senior emerging- markets analyst in Copenhagen at Danske Bank A/S, Denmark's biggest lender. The lira will weaken to 1.28 per dollar by year- end, according to the median of 23 forecasts from economists and strategists compiled by Bloomberg.

The difference in the costs between two-month lira puts, which grant the right to sell the lira, and calls, which allow for purchases, has risen to 3.62 percentage points. The so- called option risk-reversal rate, used as an indicator of sentiment in the foreign-exchange market, shows traders are more bearish on the lira than any of the 33 currencies tracked on that basis by Bloomberg.

`Pressure is Mounting'

``The pressure is mounting,'' said Jon Harrison, a currency strategist in London at Dresdner Kleinwort, the third-biggest underwriter of the country's bonds this year. The falling lira ``should be used to build strategic positions in Turkish assets,'' said Harrison, who forecasts the lira will drop to 1.27 per dollar this year.

Traders love the lira because of Turkey's 16.75 percent benchmark interest rate. The currency is used for so-called carry trades, where investors buy assets in countries with high yields financed with loans in low-yielding currencies such as the yen. The Bank of Japan's base rate is 0.5 percent.

``I would continue to see sell-offs prompted by politics as an opportunity to buy,'' said Caroline Gorman, a fund manager at August Asset Managers Ltd., which oversees $9 billion of assets in London. ``It would take a lot for me to stop believing in the lira as a carry play.''

Carry Trade

Investors who sold U.S. dollars to buy lira in carry trades earned 20 percent in the past six months, Bloomberg data show. The return for those who sold Japanese yen to buy lira was more than 17 percent.

The Kurdish PKK, designated a terrorist organization by the U.S. and the European Union, has fought a two-decade war for independence from Turkey at a cost of almost 40,000 lives.

The fighting reignited earlier this month when militants based in northern Iraq killed 15 Turkish soldiers. Turkey sent 300 soldiers into Iraq's Kurdish-controlled region on Oct. 21 to attack the PKK.

``The Iraqi government should know that we can use the power vested in us to conduct a cross-border operation at any time,'' Erdogan said at a news conference in London on Oct. 23.

Erdogan will meet President George W. Bush in Washington next month to discuss the crisis, according to Gordon Johndroe, a spokesman for the White House National Security Council. Turkish military chief General Yasar Buyukanit said in Ankara on Oct. 26 that based on the Washington meeting, his country would assess how to proceed with the military operation against the PKK, the state-run Anatolia News Agency said.

First Annual Gain

A gain for the lira against the dollar this year would be the first since the government changed the denominations on Turkish currency notes in 2005, converting old lira into new at a rate of 1 million to one. The decision was a key to improving the economy, Erdogan said.

When the inflation rate rose above 100 percent in the 1990s, ``we used to have citizens in Turkey who carried U.S. dollars in their pockets and people who would go to exchange houses to convert their salaries,'' Erdogan said. ``Now those exchange houses are almost out of business.''

During the July election campaign, Erdogan, the leader of the Islamic-leaning Justice and Development Party, reminded voters how 21 straight quarters of growth had pushed per capita gross domestic product to $5,500 a year and promised to increase that to $10,000 in a second five-year term.

Foreign Investors

Foreign direct investment in Turkey surged to almost $20 billion last year, double the amount in 2005 and 20 times the annual average in the decade before Erdogan came to power.

Economic growth averaged about 7 percent during Erdogan's first term. The current account deficit widened to a record $32.8 billion, or 8.2 percent of GDP, as the lira's strength encouraged companies to invest in imported machinery and consumers to buy foreign cars and appliances.

Inflation fell to a 37-year low of 6.9 percent in July from a peak of 150 percent in 1995. The budget deficit is 0.7 percent of gross domestic product, lower than that of Germany and France.

The nation's foreign debt was about $213 billion at the end of the first quarter, according to central bank data, up from $207 billion in the final quarter of 2006.

A slump in the lira ``is likely to significantly increase the debt burden'' of Turkish borrowers, Moody's Investors Service said in an Oct. 1 report. That will translate ``into significant asset-quality problems,'' Moody's said.

To contact the reporters on this story: Yon Pulkrabek in Prague at ypulkrabek@bloomberg.net ; Ewa Krukowska in Warsaw at ekrukowska@bloomberg.net