Bank of Korea Raises Rate to 5.25% to Curb Inflation

By William Sim
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Aug. 7 (Bloomberg) -- The Bank of Korea unexpectedly raised its benchmark interest rate to an eight-year high of 5.25 percent, saying the fastest inflation in a decade poses a greater threat than slowing economic growth.

Central bank Governor Lee Seong Tae boosted the seven-day repurchase rate by a quarter point in Seoul today, the first increase in 12 months. Just 6 of the 19 economists surveyed by Bloomberg forecast the move, with the rest seeing no change.

Stocks extended losses on concern the highest borrowing costs since early 2001 will cool an economy growing at the weakest pace in a year. Lee, who joins policy makers from India to Indonesia in raising rates as soaring fuel and food costs fan inflation, may now stand pat to avoid further damping consumer spending and company profits.

``Today's decision was a prudent, necessary step to ensure that inflationary expectations remain under control,'' said Robert Subbaraman, chief Asia economist at Lehman Brothers Holdings Inc. in Hong Kong. ``It will be a one-shot increase: policy focus will start to move away from inflation towards growth concerns later this year.''

Consumer prices climbed 5.9 percent in July from a year earlier, overshooting the central bank's target for the ninth straight month. The bank aims to keep inflation between 2.5 percent and 3.5 percent, on average, for the three years to 2009.

``Inflation will likely remain quite high in the coming months,'' Governor Lee told reporters today. He said inflation probably will exceed the bank's forecast of 5.2 percent in the second half of the year.

Government Concern

The government said earlier today the economy is weakening as consumer spending slows. ``We need to place priority in stabilizing ordinary people's lives and creating more jobs,'' the finance ministry said in its monthly report.

The Kospi index of stocks dropped 1.4 percent to 1,556.19 at 12:20 p.m. in Seoul. The won rose 0.1 percent to 1,015.25 against the dollar. The yield on the five-year government bond increased 3 basis points to 5.74 percent.

``Today's decision is likely to do more harm than good,'' said Frederic Neumann, an economist at HSBC Holdings Plc in Hong Kong. ``Economic growth already looks set to decelerate sharply over the second half of the year.''

Ssangyong Motor Co., the South Korean unit of China's biggest automaker, reported that domestic sales slumped 67 percent in June from a year earlier. Local sales at Hyundai Motor Co., Korea's largest carmaker, slipped 0.6 percent in the second quarter.

Mounting Pessimism

Households were at their most pessimistic in almost four years in June and manufacturers' confidence for August sank to the lowest in three years. Factory output increased 6.7 percent in June from a year earlier, the smallest gain in nine months.

Adding to the central bank's concerns, the won's 8 percent decline against the dollar this year has made imported goods more expensive and exacerbated inflation pressures. Import prices surged 49 percent in June from a year ago, the biggest gain in more than 10 years.

``The rate hike should partly help support the currency,'' Lehman's Subbaraman said. ``The weakening won has been adding more import-price pressure and today's rate increase should help ease that.''

The central bank is estimated to have spent more than $12 billion since the end of May to boost the value of the won and cool inflation, said Jung Chan Ho, a currency dealer at Shinhan Bank in Seoul.

``The pace of intervention in itself was clearly unsustainable over the long term, given the BOK's limited reserve pool,'' HSBC's Neumman said. ``The hike in the base rate should therefore be interpreted as a complement to the authorities' policy of supporting the exchange rate.''

The Bank of Korea also boosted the interest rate on the funds it makes available for loans to small businesses by a quarter-point to 3.25 percent.

To contact the reporter on this story: William Sim in Seoul at wsim2@bloomberg.net