[Editorial] Uphill battle for BOK

Despite mounting concerns about rising inflation, the Bank of Korea has frozen its policy rate for August. The bank’s decision was expected, given the rapid deterioration in the global economic outlook due to rekindled worries about the U.S. economy and a deepening debt crisis in the eurozone.

But the rating decision has put the central bank further behind the curve in fighting inflation. While the bank has left the key interest rate at 3.25 percent for two months in a row, Korea’s inflation is running at an annual pace of 4.7 percent, well above the upper limit of the bank’s 2-4 percent target range.

Furthermore inflationary pressures are likely to strengthen down the road. Producer prices, an indicator for future consumer prices, gained 6.5 percent in July. Fruit and vegetable prices are expected to go through the roof due to the unusually long rainy season this summer. Last month, vegetable prices jumped 21.5 percent from the previous month.

On top of that, electricity rates are set to rise 4.9 percent on average starting this month, with many other public service charges also scheduled to go up. All these factors lead us to doubt that the central bank would be able to attain its inflation target for this year, which was raised to 4 percent last month from 3.9 percent in April.

Despite the grim prospect of inflation, the central bank chose to leave interest rates on hold. The main reason was the increased downside risks to economic growth coming from the U.S. and eurozone.

Earlier this week, the U.S. Federal Reserve pledged to keep its policy rates near zero for at least two years. It was a move designed to allay market jitters fueled by S&P’s downgrade of the U.S. credit rating. But it was at the same time an open acknowledgement that the U.S. economic recovery will likely remain weak for at least as many years.

The poor growth prospects for the world’s largest economy are a cause for concern for Korea as they could put a drag on the nation’s economic growth. Furthermore, the Fed’s loose monetary stance could increase hot money flows into Korea, causing the Korean won to appreciate and weakening demand for Korean products among overseas consumers.

For the central bank, this created a dilemma between inflation fighting and economic growth. To tame inflation, the bank should raise interest rates. But any rate hike by the BOK would broaden the already wide interest gap between Korea and the U.S., further encouraging a dollar carry trade that would add to the pressures on the Korean won.

Faced with this dilemma, the central bank chose to wait and see before it continues tightening its monetary policy. The intensifying turmoil in the eurozone also led it to act cautiously. The sovereign debt crisis in Europe left Korean policymakers worrying about the risk of sudden, large-scale capital outflows from the nation.

Many European banks that invested in bonds issued by Greece and other fiscally troubled countries stand to suffer huge losses as they are likely to be forced to take a haircut on their exposures. These banks need to secure liquidity to cover the expected losses. They are likely to dump Korean stocks and bonds first ― not because they are unattractive but because Korean capital markets are highly liquid. In fact, they have already started unwinding their investment in Korea. According to reports, European banks sold Korean stocks worth more than 2 trillion won on Tuesday and Wednesday alone.

As the eurozone’s sovereign debt crisis is unlikely to end any time soon, European investors are expected to continue to sell their holdings of Korean stocks and bonds, which totaled 147.8 trillion won as of June. Given the huge magnitude of the European portfolio investment in Korea, policymakers will have to take extra care to monitor the moves of European investors.

Despite these unfavorable internal and external conditions, BOK head Kim Choong-soo said he would maintain the tightening stance to attain the inflation target. He played down the chances of the U.S. economy sliding into recession and the Fed promoting a third round of quantitative easing. We only hope he manages to win the uphill battle he is facing. If he loses, he will have to bear the responsibility.