By Stewart Fleming

If, on 1 May, you were unlucky enough to be an American investor putting money into the Turkish stock market you would currently be looking at a losses of around half your savings.

By the end of last week, according to UK bank HSBC the value of your investment would have slumped by 44%, including a plunge of almost one-fifth in the value of the Turkish currency, the lira, against the dollar.

European investors would have fared similarly badly.

Now, according to Michael Dicks, chief European economist at investment bank LEHMEN Brothers in London, for investors in Turkey "the worst may be over". The "mini-bubble" which had built up earlier in Turkish assets has burst, he says. Barring a sharp global economic slowdown, or worse than expected domestic economic news, valuations seem to have settled back to more reasonable levels.

Michael Emerson at the Brussels think-tank CEPS is not so sure. "Turkey has a monumental public debt and is vulnerable to a financial crisis," he says, adding that it is vital that its politicians avoid making any serious mistakes.

One such mistake would be for Turkey and Cyprus to fail to reach a deal to resolve the stalemate over the Turkish enclave of Northern Cyprus. Last week, ratcheting up the pressure on Turkey, Finnish Foreign Minister Erkki Tuomioja underlined the tough message on domestic reform from this month's EU summit and warned Turkey that failure to fulfil an obligation to open up its ports and airports to traffic from Cyprus "may even endanger the continuation of [EU membership] negotiations". Behind closed doors, officials say, the EU - recognising that resolving the confrontation over Northern Cyprus is an urgent strategic priority - is pressing the Republic of Cyprus to play its part.

It is at this point that politics and economics meet. For an economy which is dependent on foreign capital inflows to finance a swelling current account deficit, a breakdown in Turkey's membership negotiations is the sort of shock which could trigger another negative re-evaluation of Turkish assets, exacerbating the current economic crisis. The political repercussions would be unpredictable and unwelcome in a country which is facing elections next year, witnessing outbreaks of politically inspired violence and which last week tightened its anti-terrorism laws.

Until earlier this year Turkey's economy still looked on the mend after its (latest) financial crisis, in 2001, when inflation surged to over 70% and the International Monetary Fund (IMF) had to be called in again to help restore confidence. Real economic growth has been running at nearly 7% since 2003, compared with only 2.8% in the previous decade.

More importantly, the combination of the carrot of membership of the EU and the stick of IMF conditionality had combined with the election of the Islamist-based Justice and Development Party (AKP) in 2002 to create unprecedented momentum towards political and economic reform. The massive government budget deficit has been cut sharply, although it still requires further surgery, according to the IMF. The government has been cleaning-up a banking sector riddled with corruption and political influence peddling - long the economy's Achilles' heel. It has also been opening up the Turkish economy and privatising state-owned assets.

A sign of the impact these developments were having on confidence in the longer-term future of Turkey's economy came from the data for foreign direct investment (FDI), money which goes into building or buying Turkish businesses and banks for example, and which, by definition, cannot easily be quickly withdrawn. According to Deutsche Bank net FDI inflows increased from $1 billion in 2001 to almost $9bn last year. It had projected that FDI could hit $18bn in 2006, although this must now be in doubt. |The numbers are small relative to Turkey's $361bn gross domestic product (GDP). But the trend was significant.

So what has gone wrong? Part of the answer is that Turkey has been another victim of the globalisation of world financial markets and the super low interest rates in America and elsewhere, which followed the bursting of the dot.com bubble in 2000-01.

Hot money has been pouring into emerging market countries such as Turkey, which were reforming their economies and offering investors high returns too. The Turkish stock market, after rising 65% in 2005, was up a further 12% in the first four months of this year.

Maria Lanzeni, an economist at Deutsche Bank, says that even relatively wary investors were, at the beginning of this year, able to borrow in Japanese yen at interest rates close to zero and invest in Turkish bonds at 14%. This was well above the 3.5-4.5% they would get on US or eurozone government bonds and just one example of the speculativ 'carry trade', whose unwinding around the globe is hitting several emerging market economies.

The panic began quite suddenly in mid-May, as fears about a global economic slowdown, rising inflation rates and tightening monetary policies, especially in the US, helped to trigger a stampede out of emerging market assets.

This has created turmoil, particularly in countries which were perceived to be economically and politically vulnerable. Turkey, with its ominous current account deficit of over 6% of GDP, signs that inflation has accelerated back to double-digit levels and mounting fears that the EU may lack the political will to let it into the club, has been one of the hardest hit. "Given its large external financing needs," says Professor Nouriel Roubini of New York University, "Turkey is vulnerable to changes in international investors' risk aversion." He says it cannot be ruled out that capital inflows might slow to a halt.

In the space of a few weeks, in a bid to defend itself against this threat, the central bank has had to raise its interest rates from 13% to 22%, a move which, at the very least, will put a brake on economic growth. This in turn will sharpen the political battle within the country ahead of the elections.

Quite suddenly, how the EU handles its relations with its prospective member and vital strategic partner, has become even more sensitive, not least because EU member states such as Hungary are also vulnerable.