April 30 (Bloomberg) -- Turkey's lira fell the most in seven months and bonds and stocks slumped after the military threatened to block the ruling party's presidential candidate because of his support for Islamist causes.

The lira fell 2.43 percent, trading at 1.3678 to the dollar at 6:16 p.m. in Istanbul. Yields on lira-denominated government debt maturing in February 2009 rose 81 basis points to 19.14 percent. The benchmark stock index declined 4 percent, erasing $7.8 billion in stock market value.

Hundreds of thousands of people rallied in Istanbul yesterday to protest the candidacy of Foreign Minister Abdullah Gul, who was a member of the pro-Islamic Welfare Party ousted from government by the army in 1997 and subsequently banned. The army, which has forced four governments out of office since 1960, accused Prime Minister Recep Tayyip Erdogan's administration of using the presidential election to undermine the country's secular tradition. Gul has refused to back down from his candidacy.

``We're experiencing a dilemma of democracy,'' said Baris Sozen, who helps manage about $10 billion of Turkish bonds at Akbank TAS in Istanbul. ``We're seeing a reaction from foreign investors because they weren't expecting anything like this.''

Erdogan stressed his government's economic achievements in a pre-recorded televised address to the nation today, calling for national unity and making no reference to the army's criticism or the presidential election.

``We have taken a step forward greater than any in our country's experience,'' Erdogan said. ``Let's not destroy the stability that we worked so hard to achieve.''

Since taking power in 2002, Erdogan's Justice and Development Party has reduced government debt as a proportion of economic output, narrowed the budget deficit, broadened freedom of speech and eliminated the military's chairmanship of the National Security Council, all measures aimed at strengthening the economy and meeting conditions for European Union membership.

EU Watching

In Brussels, European Commission spokesman Johannes Laitenberger said the bloc continues ``to follow the current situation in Turkey very closely.'' EU Enlargement Commissioner Olli Rehn on April 28 said the army's reaction was a ``clear test case'' of whether it could respect the 27-nation bloc's ``democratic values.''

Economy Minister Ali Babacan, Turkey's chief negotiator with the EU, said in an interview with CNN Turk today that the army's intervention had raised ``question marks'' over Turkey's democracy and EU aspirations, adding that Turkey's democracy faces a ``great test.''

State Department spokesman Sean McCormack said in Washington that the U.S. has ``confidence in Turkey's democratic institutions and Turkey's democratic constitutional processes to work out any questions that may surround the election of the next Turkish president.''

The lira's drop today pares a gain of 5.4 percent since the start of the year and the benchmark National 100 Index of the biggest stocks was up 20 percent on the year before its slump today. Turkiye Is Bankasi AS, the nation's biggest bank, dropped 45 kurus, or 6.4 percent, to 6.55 liras, and Koc Holding AS, the biggest Turkish company, fell 35 kurus, or 5 percent, to 6.75 liras.

Record Investment

Turkey's economic growth has averaged 7 percent a year since 2002, compared with 1.6 percent in the countries sharing the euro. The country attracted a record $19.8 billion in foreign investment last year, twice the previous year's figure and another $11 billion in the first quarter of this year. Its benchmark stock index, which reached a record April 25, has been the world's 11th best performer this year among 90 global indexes tracked by Bloomberg.

Political crises in the past year have led investors to pull money out of emerging economies such as Thailand, where the army seized power in September and Hungary, where tens of thousands demonstrated against the government in the same month.

Gul came within 10 votes of winning the required two-thirds majority in parliament in the first round of presidential voting April 27. The second round of voting is scheduled for May 2 and a third round, which Gul, 56, has enough backing in parliament to win as a simple majority of votes is sufficient, on May 9.

Secular Guardian

The election may be halted by courts before then. The main opposition party boycotted the poll and asked the Constitutional Court to annul it on the grounds that less than two-thirds of lawmakers attended. The court said it may issue a ruling on the appeal by May 2.

``If the constitutional court cancels the first round of voting, then we're headed for early elections and that looks like the good option right now,'' said Levent Guven, head of foreign currency trading at lender Turk Ekonomi Bankasi in Istanbul. ``If it doesn't, then the election process will move ahead and it's unclear what the military response to that would be.''

Turkey's population is 99.9 percent Muslim and the army sees itself as the guarantor of the country's secular system.

``Arguments over secularism are becoming a focus during the presidential election, and the Turkish armed forces are following the situation with concern,'' the military general staff said on its Web site late on April 27. ``It must not be forgotten that the armed forces are the determined defenders of secularism.''

Early Election

Gul would be the country's first president with an Islamist past after he served in a government ousted by the army in 1997 on the grounds it was seeking to undermine secularism. He has pledged to maintain secular values and Erdogan denies his government has an Islamist agenda.

State secularism was established eight decades ago after the Ottoman Empire collapsed and the state runs religious institutions including mosques and schools.

Opposition parties and the country's biggest business grouping Tusiad called for early general elections after the army's intervention. Political instability may complicate accession talks with the European Union.

``Turkey is heading toward probably the tensest election in recent history, and we will see a prolonged period of political uncertainty weighing on financial markets,'' Inan Demir, economist at Finansbank AS in Istanbul, said in a note to clients April 28.

Turkey's inflation rate, at 10.9 percent, is almost six times that of the EU. The nation's central bank is targeting a rate of 4 percent by year-end under a $10 billion loan accord with the International Monetary Fund.

``Turkey has a lot of momentum as foreign direct investment pours in,'' said Katinka Barysch, chief economist for the London- based Center for Economic Reform. ``While any drastic moves would be really worrying, I don't see a real potential right now for an economic crisis.''

To contact the reporter on this story: Ayla Jean Yackley in Istanbul at ayackley@bloomberg.net; Steve Bryant in Ankarat .

Last Updated: April 30, 2007 14:46 EDT