* Controls inevitable, but to direct capital flow not stop it
* Emerging Asia equity inflows at $17 bln vs $25 bln in 2008
* Tighter controls not on agenda of South Korea, India
* Indonesia is a major wild card
By Kevin Plumberg, Asia Asset Allocation Correspondent
HONG KONG, Nov 26 (Reuters) - Tighter capital controls in emerging Asia are inevitable if money keeps pouring into the region and interest rates in the developed world remain at rock bottom.
But don't expect a rerun of knee-jerk, Draconian measures of the past, which sent investors to the exits en masse. Asian policymakers appear to have learned that the impact of strict controls to deter foreign speculators can take years to undo and wind up being ineffective over the long term.
Authorities from Brazil to Taiwan have moved over the past month to curb what they say are "hot money" speculative flows into their countries which are pushing up their currencies, making their exports less competitive, and fueling potentially destabilising asset bubbles in stock and property markets.
Russia and Indonesia have also indicated concern that heavy inflows could be economically disruptive. [ID:nLJ437424]
Measures taken thus far, however, have been aimed at slowing and controlling massive capital inflows, not staunching them completely.
Emerging Asia has led the global recovery, but with central bank policy rates currently averaging a low 4 percent, the region's economies have not even begun to normalise.
Higher interest rates will put even more upward pressure on Asian currencies, especially with the Federal Reserve promising to keep U.S. rates near zero for a long time, which is diminishing the value of the dollar.
Still, this is all the more reason for policymakers to avoid pulling the gates down on foreign investment and take more targeted action against "footloose capital," said Bill Belchere, an economist at Mirae Securities in Hong Kong.
"Asia has been adept at absorbing liquidity and handling bubbles in its major countries," he said.
"When economies strengthen further and you begin to reach full employment and you need higher rates, that's when it will become a problem. But we are not there yet."
Indeed, it is one thing for policymakers to identify loopholes and another to actually crack down on speculation with tough measures such as the so-called "Tobin tax" on all global financial transactions, a concept gaining traction in Europe.
But why would they at this point?
Flows into Asia ex-Japan equity funds stand at $17 billion so far this year, not yet offsetting the $25 billion outflow last year, fund tracker EPFR Global says.
Also, officials are more intent on directing foreign investment to where they want the money to go, rather than closing the doors. Taiwan's ban on foreign deposits was meant to shift the money to the domestic equity and bond market.
Officials from India and South Korea, two countries expected to raise interest rates early in 2010, have told Reuters capital controls are not on their agenda at this point.
THAILAND'S BAD EXPERIENCE
Controls on foreign investment, the antithesis of Western free market principles, have long been a fixture of modern Asian financial markets. And, of course, the region has had its fair share of capital control flops.
Thailand's capital controls in late 2006 were similar to Chile's in the 1990s and took the form of a 30 percent tax on portfolio investments of less than a year. The stock market slumped, forcing authorities to repeal some of the measures, and most instruments were gradually exempted from this ruling.
Sriyan Pietersz, head of ASEAN research with JPMorgan Chase, said: "If they (policymakers) do feel the pressure building and they have to adopt bond market measures, which I think is a small risk, they are more likely to address it through non-resident deposit accounts."
Thailand may also look at encouraging outflows, rather than limiting inflows, by enabling local asset managers to invest more in foreign funds, raising limits on foreign currency holdings and increasing the time limit on when exporters are required to remit their proceeds back onshore, Pietersz said.
TOO MUCH OF A GOOD THING?
Reluctance by Asian policymakers to use punitive measures on foreign investment has been on display this week.
In India, where foreign investment has been concentrated in the stock market, the deputy chairman of the government's planning commission told Reuters flatly there was no possibility of increasing taxes to curb capital flows, a move that Brazil made last month. [ID:nBMA006450]
Two officials with India's central bank, who are not directly involved with currency policy but have direct knowledge of policy decisions, said capital inflows are substantial, and the Reserve Bank of India may use more existing tools, such as raising the reserve ratio for banks, to drain liquidity as early as January.
C. Rangarajan, chairman of the prime minister's economic advisory council, said this week that India would need to act if inflows neared $100 billion, but added that expected flows this year would be far less at $57-60 billion. [ID:nBOM105873]
South Korea was careful to target domestic institutions with restrictions this week on currency forwards trading, leaving foreign banks alone.
A senior official with the Bank of Korea said capital controls "would trigger capital flight out of the country. That's not what we want to see. And the forex market situation is not so critical and urgent that we need to introduce such a barrier."
MUDDLED MESSAGE IN INDONESIA
For now, among Asia's big emerging markets, Indonesia is the wild card.
Indonesia's currency, equity and U.S. dollar bonds have been the biggest gainers in the region this year. But investors were spooked last week by central bank studies on limiting foreign ownership of 1-month central bank notes and a new regulation cracking down on tax evasion by domestic bond investors, which was in itself would not be a form of capital control.
The lack of a clear message from policymakers in Jakarta
ultimately triggered the biggest one-day sell-off of the rupiah
Economists at Standard Chartered said in a note that Indonesia is unlikely to slap outright controls on inbound investment for three reasons: the lesson taught by Thailand's recent negative example; most investment is in the country's stock market, not the bond market; and, limits to foreign investment may be illegal according to a 1999 law.
Still, without a clear, unified message by policymakers on where they stand with regard to more controls, investors will keep believing where there is smoke, there will soon be fire.
"It's the expectations of controls that can be just as damaging as the controls themselves," said Sanjay Mathur, Asia economist with Royal Bank of Scotland in Singapore. (Additional reporting by Suvashree Dey Choudhury in MUMBAI, Manoj Kumar in NEW DELHI, Seo Eun-kyung in SEOUL, Lu Jianxin in SHANGHAI and Vidya Ranganathan in SINGAPORE) (Editing by Kim Coghill) ((Reuters Messaging: kevin.plumberg.reuters.com@reuters.net Email: kevin.plumberg@thomsonreuters.com; 852-2843-6370))