UPDATE 3-Turkish growth slows, deeper rate cuts seen

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* Minister urges central bank action

* Excluding exports, economy shrank

* Lira eases, bond yields fall

By Daren Butler and Seltem Iyigun

ISTANBUL, Dec 10 (Reuters) - Turkish economic growth slowed more sharply than expected in the third quarter as domestic demand remained stubbornly weak, data showed on Monday, raising pressure for a deeper cut in interest rates.

Growth slowed to 1.6 percent year-on-year in the third quarter, below a Reuters poll forecast of 2.6 percent, according to the Turkish Statistics Institute. This came despite strong exports and looser monetary policy.

Double-digit export growth has bolstered Turkey's resistance to a slowdown blighting much of Western Europe this year, but weak domestic demand has kept it way below the 8.5 percent growth of 2011.

The economy would have shrunk 1.8 percent in the third quarter were it not for exports, according to the data. Booming gold sales to Iran accounted for a large part of the growth.

"Exports have been the engine of growth in 2012 but in 2013 and beyond domestic demand and net exports must both support growth for it to be sustained," Economy Minister Zafer Caglayan said after the latest figures were announced.

"The central bank must take growth-supporting steps so that growth is stable and sustainable."

Turkey's central bank has been performing a delicate balancing act, trying to reinvigorate slumping domestic demand while preventing loan growth fuelled in part by a surge in global liquidity from getting out of control and stoking inflation.

A gaping current account deficit, Turkey's main economic weakness, has limited the central bank's room to cut rates too aggressively. In a speech to parliament, Finance Minister Mehmet Simsek warned on Monday that an improvement in the deficit would slow in the fourth quarter as domestic demand picks up.

But the central bank said last week it expects 2012 inflation to be below forecast at just over 6 percent, which may leave it space to lower interest rates as soon as this month.

"The rally in the lira and local bond markets in recent weeks may provide cover for near-term rate cuts," said Neil Shearing, chief emerging markets economist at Capital Economics.

"The key point is that substantial easing would add to pressure on the current account ... The big risk for 2013 is that global sentiment sours, putting the lira under renewed pressure and forcing the central bank to tighten policy."

The lira eased to 1.7892 to the dollar after the data from 1.7880 before. The yield on the two-year benchmark bond fell as low as 5.73 percent from 5.77 percent, as expectations of a rate cut this month rose.

GOLD EXPORTS

The central bank's monetary policy committee, which meets on Dec. 18, has been easing monetary conditions since the middle of the year, providing more liquidity to banks through its repo auctions to reduce their funding costs and stimulate loans.

It cut its overnight lending rate for the third month in a row in November and hinted it may also start to cut its overnight borrowing rate and one-week repo rate, its main policy rate, which have been held at 5 percent and 5.75 percent respectively since August 2011.

The latest industrial production figures added to the gloomy picture, slumping 5.7 percent year-on-year in October, a much sharper decline than the 2.5 percent forecast in a Reuters poll, suggesting growth will only recover slowly.

Turkey's gold sales, mostly to Iran, have buoyed growth. Its precious metal exports, which include gold, jumped to $14.3 billion in the first 10 months from $2.7 billion a year ago.

"It's unclear as to how long the surge in gold sales will continue, but without it Turkey would have almost certainly slipped into recession," Shearing said in a research note.

Development Minister Cevdet Yilmaz said the government was more optimistic about the fourth quarter and expected the economy to grow around 3 percent over the year as a whole, softer than its official 3.2 percent forecast but more in line with economists' expectations.

Quarter-on-quarter the economy grew a seasonally-adjusted 0.2 percent in the third quarter. Second-quarter growth was revised to 3.0 percent from 2.9 percent reported in September.

"I have been a Turkish growth bull, but this data surprises even me and suggests that even Turkey is not immune to global trends," said Timothy Ash, head of emerging markets research at Standard Bank.

"A range of factors are coming together to slow the Turkish economy down pretty dramatically, including the global growth slowdown, euro zone crisis, Turkey's own balance-of-payments crisis at the turn of the year, which dented confidence domestically, and the aggressive tightening pursued in response by the central bank," he said.

The central bank pursued tight monetary policy in late 2011 and the beginning of this year to defend the lira, which plummeted 20 percent against the dollar in 2011. It has been loosening policy since the middle of this year.

While it wants a certain level of loan growth to stimulate demand, too sharp an expansion would stoke inflation, increase Turkey's import bill and widen the current account deficit.

But inflation has been slowing - rising less than expected in November as food and transport prices fell - increasing its room to ease monetary policy further.

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