* Investors ignored political risk in stable high-growth years
* Corruption scandal now rattling government ahead of elections
* AK Party unlikely to lose power but could be weakened
* Pressure for less market-friendly populist policies may grow
By Seda Sezer and Sujata Rao
ISTANBUL/LONDON, Dec 31 (Reuters) - Reeling from a corruption scandal in the upper levels of the Turkish government, investors in the country's financial markets may face many more months of instability as they price in political risks they have ignored for years.
While politics is often centre-stage for investors in emerging markets, it became something of a sideshow during Turkey's economic miracle of the past decade, thanks to red-hot growth rates and the firm grip of Prime Minister Tayyip Erdogan's AK Party on power.
As the possibility of a change in government appeared remote, so did the likeliood of a major change in economic policy. Conservative banking regulation and prudent fiscal policy convinced many investors there was minimal policy risk.
But last week three ministers, including the economy minister, resigned after their sons were among dozens of people detained as part of a probe into corruption and bribery; in response, Erdogan sacked half his cabinet and appointed loyalists.
Such events are forcing investors to look again at the potential impact of politics on asset prices, just as the approach of elections next year makes that process more uncertain, fund managers and analysts say.
Few expect the AK Party to lose power, but its exercise might not be so smooth, with perhaps more changes in the party's leadership and pressure to adjust market-friendly policies.
"In recent years political risk was almost non-existent in Turkey, so the market did not normally price this," said Murat Toprak, emerging markets strategist at HSBC in London.
"Now the central bank has to manage a situation where the market is re-pricing political risk, plus we are in an environment where interest rates are looking too low to compensate for the risk."
A political threat to the markets first emerged this summer, when plans to redevelop a park in Istanbul led to anti-government demonstrations that were violently suppressed. The lira and the stock market tumbled.
The underlying reason for that bout of market volatility was concern that the U.S. Federal Reserve would soon start cutting its monetary stimulus. This month's corruption scandal is potentially more serious because it strikes close to the heart of the AK Party's policy-making elite.
Turkey will face local government elections next March and presidential elections in August, and one AK Party official has said parliamentary elections could be brought forward from 2015 if the current political crisis persists.
"Investor perceptions of Turkey have deteriorated significantly this year. While this was mostly Fed-influenced, it's now domestically driven," said Nicholas Spiro, head of Spiro Sovereign Strategy, a London-based consultancy.
"Investors don't quite know what to make of this corruption probe, but it adds to the perception that Turkish politics is becoming a lot more volatile and unpredictable as elections loom."
Though Turkey's weak and divided opposition forces still seem incapable of wresting power from the AK Party at the national level next year, they could pose a threat at the local level, in major cities such as Istanbul.
That prospect might conceivably push the party towards more populist and less market-friendly tactics, such as a looser fiscal policy designed to win votes.
Officials have so far insisted they will not let politics affect fiscal policy. But Erdogan has played the populist card in the past few months, accusing an "interest rate lobby" of financiers and investors of stirring up uncertainty in an effort to profit from higher interest rates.
Many analysts argue the pricing of Turkish political risk is being made more painful by the country's monetary policy; just as U.S. interest rates look set to rise as the Fed withdraws stimulus, Turkey's central bank is refusing to hike rates.
Central bank governor Erdem Basci is operating a complex policy in which he has tightened money market liquidity in an effort to stabilise the lira, but has denied there is any need to lift benchmark interest rates.
This policy appeared to work in 2012 and early 2013, when global interest rate trends were more benign, but it is now seen as dangerous by many local and foreign investors.
"The risk premium is yet to be restored and must be restored via higher interest rates. The appropriate response must be a rate hike," said Toprak.
Investors suspect the central bank is reluctant to raise interest rates because it could crimp economic growth - something the government will become increasingly eager to avoid as the elections approach.
"Anything which draws attention to the central bank's stubborn refusal to mount an interest rate defence of the lira is bad news for Turkish assets," said Spiro.
"The central bank is trying to strike the right balance in monetary policy, and the jury is still out as to whether it can continue to tighten monetary policy 'by the back door' without raising the main policy rate."
Many investors say Turkey remains a good long-term bet, given its dynamic industrial growth and its young and growing population. But with both politics and policy now uncertain, they see little reason to prefer it over more predictable emerging markets elsewhere in the world.
"Longer-term it's a good time to be adding positions. But it is quite concerning because this seems to be a struggle within the government, so I would say it's not a time to be making brave decisions (to invest in Turkey)," said Julian Mayo, fund manager at Charlemagne Capital in London.
Mayo said he was still slightly overweight in Turkey, but in companies that would benefit from a weak lira such as car maker Tofas, white goods maker Arcelik and airport operator TAV.
A Reuters survey of 15 Middle Eastern fund managers, published on Tuesday, found that among six major stock markets in the region, funds were least positive towards Turkey. None of them expected to raise their allocations to Turkish equities in the next three months; two expected to cut them, while the others had already reduced them in recent months.