ISTANBUL (Reuters) - Turkey’s Halkbank said on Wednesday that U.S. charges against it amount to an escalation of Washington’s sanctions on Ankara over its military incursion in Syria, while President Tayyip Erdogan called them an “unlawful, ugly” step.

FILE PHOTO: A street vendor sells roasted chestnuts in front of a branch of Halkbank in central Istanbul, Turkey, January 10, 2018. REUTERS/Murad Sezer/File Photo

U.S. prosecutors on Tuesday charged the state-owned lender with taking part in a multibillion-dollar scheme to evade U.S. sanctions on Iran. In response, Halkbank’s shares plunged as much as 7% on Wednesday despite a new ban on short selling.

The indictment came a day after the United States imposed sanctions on Turkish officials, hiked tariffs and halted trade talks in an effort to persuade Turkey to stop attacks against the Kurdish YPG militia in northeastern Syria.

The indictment in a U.S. district court in New York, which further strains ties between the NATO allies, alleges Turkey’s second-largest state bank conducted fraud, money laundering, and other sanctions offences.

While the U.S. prosecutor did not tie the charges to sanctions over Syria, Halkbank did.

“These were filed as part of the sanctions introduced against our country by the U.S. government in response to Operation Peace Spring, heroically launched by the Turkish army to secure our borders and establish peace in the region,” the bank said of the incursion now in its eighth day.

Halkbank HALKB.IS said it did not engage in sanctions violations as alleged and falls outside of the U.S. Justice Department's jurisdiction since it has no branches or employees in the United States.

“Therefore the decision to indict is an unprecedented legal overreach,” it said.

The case against Halkbank follows from a previous criminal case that came to light in 2016 against Turkish-Iranian gold trader Reza Zarrab, who was accused of playing a central role in the sanctions evasion scheme.

Mehmet Hakan Atilla, a former Halkbank deputy general manager, was arrested in New York the following year and was later sentenced to 32 months in prison. He returned to Turkey in July after serving out his sentence.

Zarrab pleaded guilty and testified for U.S. prosecutors. He said Iran, with the help of Halkbank and Turkish government officials including the president, used a web of shell companies and sham transactions in gold, food and medicine to sidestep U.S. sanctions.

Turkey cast that case as a political plot against Erdogan’s government and said it was an extension of a 2013 domestic corruption investigation, which Ankara says was launched by the network of Fethullah Gulen, a U.S.-based Muslim cleric.

Erdogan told reporters in Ankara the Halkbank issue was “supposedly closed. But now they have taken an unlawful, ugly step with the southern New York prosecutors opening it again.”

“We will see the decision they will take, and we will (respond) accordingly,” he added.

‘POLITICAL LEVERAGE’

Before Turkish markets opened, authorities banned short selling on seven large Turkish bank stocks including Halkbank. Selling shares in the banks only to buy them later in the session was also banned.

State banks - which have sold dollars to defend the lira since the Syria incursion began last week - were on Wednesday squeezing funding in an offshore FX swaps market to cushion the blow from the Halkbank indictment, a bond trader said.

Halkbank stock nonetheless fell as much as 7.2% at the open and was down 5.2% at 1137 GMT.

The main banking index .XBANK, which has fallen more than 16% this month on fears of U.S. repercussions, was down 2.4% while Turkey's broader stock index was off 1.3%.

Turkey’s incursion into northeast Syria has tested its ties with the United States and could imperil its economy’s recovery from last year’s currency crisis. It came after President Donald Trump’s abrupt decision to withdraw U.S. troops from the area.

The Kurdish YPG, which spearheaded the U.S.-backed Syrian Democratic Forces, was a main U.S. ally in the fight against Islamic State.

Turkey's lira TRYTOM=D3 has declined some 10% against the dollar this year, due largely to worries over fraying U.S.-Turkish ties.

But the currency has firmed this week since the U.S. sanctions were announced and deemed lighter than expected. After the Halkbank indictment, the lira was up 0.3% at 5.9015 against the dollar.

A banking analyst who declined to be named said the Halkbank case “has always been on the table as political leverage.”

On Tuesday U.S. prosecutors said: “This is one of the most serious Iran sanctions violations we have seen, and no business should profit from evading our laws or risking our national security.”

Following the charges, the Borsa Istanbul temporarily banned short selling in banking shares within the top BIST-30 Index .XU030. The Capital Markets Board said it would protect investors and promote market stability.

Sadrettin Bagci, another bank analyst, at Deniz Yatirim, said Halkbank had the ability to absorb a possible fine of between $1.3-2.3 billion, depending on the capital measurement.

The U.S. sanctions and increased tariffs risk slowing Turkey’s recovery from recession after last year’s crisis chopped nearly 30% off the value of the lira. The crisis was set off by concerns over deteriorating U.S.-Turkey ties and political interference in monetary policy.

State banks stepped in to sell dollars in March when the lira briefly tumbled, and traders said they intervened again in the last two weeks.

The Turkish stocks covered by the short selling ban are: Akbank AKBNK.IS, Garanti Bank GARAN.IS, Halkbank, Is Bank ISCTR.IS, TSKB TSKB.IS, VAKIFBANK VAKBN.IS and Yapi Kredi Bank YKBNK.IS.

(This story has been refiled with correct legal title in paragraph 5)