* Effect of rise in bond ylds on E. Europe moderate
* Monetary turning point 'not around the corner'
* Exchange rate volatility more damaging for small economies
* Laggards Croatia, Slovenia need bold reforms
By Igor Ilic and Zoran Radosavljevic
ZAGREB, Sept 22 (Reuters) - Eastern Europe should be able to absorb any surge in emerging market bond yields when monetary policy in the west becomes less expansionary, Croatia's central bank governor Boris Vujcic said.
Rising U.S. financing costs "will inevitably impact global capital flows", Vujcic said in a written interview ahead of a Reuters Investment Summit, but added:
"As east European countries have largely corrected pre-crisis imbalances, any immediate effect on their financing costs is likely to remain contained".
The U.S. Federal Reserve defied investor expectations on Wednesday by not starting to wind down its massive monetary stimulus, saying it would wait for more evidence of solid economic growth.
The delay propelled the U.S. stock market to five-year highs, driving down bond yields. Investors immediately returned to higher-yielding emerging markets, which have been boosted by cheap money flows from the U.S. stimulus.
Vujcic - who holds the monetary reins in the EU's newest member - said the Fed's planned tapering was driven by gradual normalisation in the United States, but also in other major economies.
"Overall normalisation is likely to reverse the 'safe haven' effect, which depressed returns on government bonds of the highest rated sovereigns, while the impact on other bonds should be moderate".
A turning point in the current trend of loose policy was "not around the corner", he said, addressing the monetary policy outlook, and major central banks were likely to continue with forward guidance policies.
Exchange rate swings of major currencies caused by the ECB and FED policy shifts were not a major concern for large and relatively close monetary areas, he said.
Many smaller countries - as varied as Switzerland and Croatia - with explicit rate targeting were more vulnerable because, "though for different reasons, excessive exchange rate volatility is clearly damaging for accomplishing the central bank's mandate and for the wider economy."
Croatia and Slovenia, once the most prosperous economies in the former eastern bloc before Socialist Yugoslavia fell apart, were still stuck in recession, Vujcic said, adding they should "continue structural reforms, embark on more bold government expenditure cuts and boost foreing direct investments."
Croatia's economy was driven for years by state investments and personal consumption, both financed by foreign loans.
Slovenia, which is struggling to avoid a bailout, has seen a serious deterioration of its mostly state-owned banking sector, now choked by at least 7.5 billion euros ($10 billion) of bad loans.
Despite recent steps to improve the business environment, much more was needed in Croatia to ignite growth after five years of recession, including a growth model based on exports and investments, Vujcic said.
"The government has identified and addressed some of the key issues, but bold reforms are still needed, especially in improving the public sector efficiency and lowering barriers to investments," Vujcic said.
Croatia, which has lost more than 10 percent of its national output since 2008, is likely to be placed in the Excessive Deficit Procedure (EDP) soon, an EU mechanism designed to make sure the budget gap returns below three percent of gross domestic product (GDP) and public debt below 60 percent of GDP.
"We believe that shortly after next month's Eurostat report Croatia will enter the EDP. This means that significant fiscal consolidation will probably start from 2014," Vujcic said.
Banks in Croatia, more than 90 percent of them in foreign hands, were the best capitalised lenders in the EU and had enough means to extend loans to businesses and households, though both were still wary of taking on new loans, he said.
Although bad loans in Croatia have reached a relatively high level of 15 percent of all loans, they should start tapering off from mid-2014 and the banking system would remain stable.
The central bank would like to see Croatia in the euro zone as soon as possible, given the high level of its openness and euroisation, but the country "first has to do its homework".
"It will be critical to put public finances on a solid footing and revert the increasing public debt trajectory by undertaking a sustainable fiscal consolidation," Vujcic said. ($1 = 0.7402 euros)
(For other news from Reuters Russian and Eastern Europe Investment Summit, click here)
Follow Reuters Summits on Twitter @Reuters_Summits Reporting by Zoran Radosavljevic and Igor Ilic; editing by Ron Askew