Korea May Raise Key Rate to Stem Won's Drop, Goldman, UBS Say

By William Sim

Sept. 3 (Bloomberg) -- South Korea's central bank may raise interest rates from an eight-year high in this month or next as the weakening won fans inflation, Goldman Sachs Group Inc. and UBS AG said.

The won has slumped 12 percent in the past month and could trigger ``an inflation-depreciation spiral if allowed to persist,'' Kwon Goohoon, a Goldman economist in Seoul, said in a Sept. 2 report.

The won's drop prompted speculation the country may face a financial crisis like that of 1997, when the currency lost half its value and the government was forced to turn to the International Monetary Fund for a $57 billion bailout. Vice Finance Minister Kim Dong Soo said yesterday that such fears are ``groundless.''

A rate increase ``could help restore stability in the currency markets by demonstrating policy credibility for price stability,'' Kwon said. Any drop in domestic demand as a result could be offset by a fiscal stimulus package, he said.

UBS and Goldman Sachs join BNP Paribas Group, Mirae Asset Financial Group and CFC Seymour Ltd. in predicting a rate increase this year because the weaker won may spur inflation even as the price of oil falls.

The weakening of the Korean won puts the balance of risk ``decisively toward inflation,'' said Kwon, who calculates that an 8 percent depreciation of the won would add 1.6 percentage points to the inflation rate, which was running at 5.6 percent in August, near a 10-year high of 5.9 percent in July.

Job Gains

``Exports and job gains from a further sharp depreciation would be relatively small in our view, given that it destabilizes business environments,'' Kwon said.

The won fell past 1,150 per dollar for the first time since August 2004 earlier today, and was trading at 1148.18 per dollar as of 4:53 p.m. in Seoul, from 1,134.00 yesterday.

The won has dropped 19 percent this year, making it Asia's worst performer. The decline could worsen as U.S. and European banks, short of cash because of the global increase in the cost of credit amid U.S. sub-prime mortgage losses, pull their money out, according to Irene Cheung, a Singapore-based strategist at ABN Amro Bank.

The Bank of Korea raised its benchmark interest rate for the first time in a year on Aug. 7 to 5.25 percent, saying that inflation poses a greater threat than slowing economic growth. The bank reviews rates again on Sept. 11.

Restrain Inflation

``The policy rate will be hiked another 25 basis points in the second half of 2008 to restrain inflation and support the exchange rate,'' Duncan Wooldridge, a Hong Kong-based economist at UBS, said in a report today.

The bank may be forced to raise rates by at least 300 basis points over a short period to defend the won if the country faces a currency crisis, said Dariusz Kowalczyk, chief investment officer at CFC Seymour Ltd. in Hong Kong.

``As usually happens with currencies whose external position weakens at a time of slowing growth and rising inflation, the won is coming under speculative attack,'' Kowalczyk said.

South Korea posted its biggest trade deficit in seven months in August. Asia's fourth-largest economy expanded at the slowest pace in more than a year last quarter.

Some investors have been concerned by the increase in the nation's short-term debt. External borrowings that mature in a year almost tripled to $175.65 billion as of June 30 from $65.9 billion at the end of 2005, official figures show.

South Korea's debt levels are in better shape now that they were in 1997, according to Credit Suisse, with corporate net debt-to-equity standing at an estimated 18 percent compared with 218 percent in 1997.

1997 Comparison

Total foreign exchange reserves now exceed short-term external debt by about $72 billion, compared with in 1997 when the short-term external debt was over $40 billion more than the reserves, Credit Suisse said in a note today.

The increase in short-term debt was mainly caused by exporters' locking in dollar rates for their overseas earnings, Bank of Korea Deputy Governor Rhee Gwang Ju said in a July. Korean banks, which provided the services, borrowed dollars to limit their risks, he said.

``Korean corporations and banks are much healthier than they were before the 1997 crisis,'' Thomas Byrne, who helps determine Moody's Investors Service sovereign credit ratings for Asia and the Middle East, said in an e-mail from Singapore.

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