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By Vidya Ranganathan
SINGAPORE (Reuters) - Asia's central banks are likely to use heavy currency intervention as their weapon of choice in dealing with regional market turbulence but high debt levels will make them more reluctant than in the past to raise interest rates if tensions escalate.
The central banks are manning their defenses as emerging market currency, bond and stock markets have been whipped by fears that trillions of cheap dollars could leave Asian economies in the face of the biggest inflection point for investors since 2008 - the eventual tightening of U.S. monetary policy.
For now, central banks see the market gyrations as reflective of a balancing by investors of their global portfolios, rather than the start of a full scale Asian exit, and are working on the assumption that the U.S. Federal Reserve will move carefully in adjusting policy to avoid rattling global markets, analysts said.
"Their job is just to sit on the sidelines and smooth volatility," said Mirza Baig, head of currency and rates strategy at BNP Paribas in Singapore.
Still, some voices point to the danger that these assumptions are wrong. If U.S. Treasury yields rise more rapidly than expected, the risk of capital flight is greater and will expose the limitations of Asian central banks' policy tool kits.
"The tapering debate is just about beginning," London-based UBS strategist Bhanu Baweja said in a client note. "I can't see the pressure easing massively."
So far, capital outflows have been heavy but only a fraction of the money that has come into Asia since 2009 as western central banks pumped cheap money into the world economy. Stocks markets and bonds have declined, but the losses are tiny against the gains of the past two years.
The region's economic growth is relatively strong and inflation largely benign. The exports trend is weak but lower currencies can lift overseas sales and indirectly provide an easing of monetary conditions.
Indonesia is an exception. As its currency plunged to its lowest in nearly four years on Tuesday, the central bank raised its overnight borrowing rate to try to underpin its rupiah currency.
"At this stage, I can't see any other cenbank in Asia raising rates," said Singapore-based Credit Suisse economist Robert Prior-Wandesforde, who argues the market slump is nearing its end.
He also reckons the currency weakness will stop central banks from tinkering with interest rates for a while, even precluding the need for the likes of Thailand and India to cut rates to support domestic growth.
"What we are going to see instead is more currency intervention, more jawboning from Asian central banks and no more rate reductions."
Indonesia has seen bond outflows of half a billion dollars in the past week, but foreigners still hold about 34 percent of its government bonds. The picture is the same more broadly. Funds have been pulling billions of dollars from emerging market bond and equity funds in the past month. But that is a fraction of what went in since 2009.
Emerging markets received $450 billion in additional capital flows between 2010 and 2012 as a result of the Fed's expansionary policy, the Institute of International Finance estimates. Emerging Asia received a net $568 billion in private capital flows in 2011 and $548 billion in 2012, it says.
In addition, central banks in Europe and Japan are on a path of substantial monetary easing, which may counter the Fed effect.
Yet, currency volatility is on the rise. Indonesian one-month implied volatility surged from 7 percent to 17 percent in the past 48 hours.
Moreover, corporations and retailers have binged on the central bank largesse. Credit growth is running at double-digits in most parts of Asia. The region's debt-to-GDP ratio rose to 155 percent in the middle of 2012, up from 133 percent in 2008 and was higher than in 1997 during the Asia financial crisis, data from McKinsey Global Institute, a unit of consulting firm McKinsey & Co, shows.
So, while central banks in South Korea and Indonesia have been generously supplying dollars to deal with what they see as temporary currency volatility, their policy options will be far more limited when the Fed actually embarks on monetary tightening and a dollar rally becomes entrenched.
"The constraint here is that we have such high levels of leverage that it is hard to raise interest rates without doing tremendous economic damage," Hong Kong-based HSBC economist Frederic Neumann said. "I would expect them to be more reluctant than in previous cycles to be raising interest rates."
That will limit the options if the region faces full-scale capital flight. With such high debt, the region will struggle to raise rates. Currency intervention would be futile in the face of a full-scale investor exit, even though the region has trillions of dollars in foreign currency reserves.
That may leave capital controls, which Asia famously employed in the 1997/98 crisis, as the only option since the region squandered an opportunity during the years of easy money to structurally improve economies so that foreign investment stays for good.
"Central banks can only do so much," Neumann said.
(Editing by Neil Fullick)