How credible is Korea's inflation targeting?

Regional head of research & senior economist, Treasury and Capital Markets, with Standard Chartered Bank in Hong Kong, Chi Lo questions the credibility of Bank of Korea''s inflation policies.

The Bank of Korea (BoK) announced recently that monetary policy would target price stability, and set an inflation target range of 1.5-3.1% yoy for this year and an average target of 2.1% yoy for 2001.
It also said it would adopt pre-emptive stance on interest rates to rein in inflationary pressures.

If all this means explicit inflation targeting, the pledge will eliminate the "price signal extraction problem" that inflation brings, which distorts decision-making that drives economic growth. So it should be good news for the Korean markets. But how credible is the BoK's pledge?

No track record

There is no history of inflation targeting by the BoK, and its policy independence has yet to be tested. The President, on the recommendation of the Finance Minister and the Financial Supervisory Commission, appoints six of the seven members on the Monetary Board of Korea. The Finance Minister's approval is still needed for the BoK's operating budget.

Seoul has also used the BoK as a fiscal tool by disguising some borrowing as the Bank's money market operations. For example, the BoK is sometimes required to provide liquidity to small businesses and exporters. It then mops up this liquidity by issuing the monetary stabilisation bonds (MSBs), which are mostly bought by banks. Since they are not treasury bills, they are not recorded in the public debt figures.

The amount of MSBs issued has soared since the Asian crisis (Chart 1), partly reflecting the quasi-fiscal expansion to bail out the economy. To service the MSBs, the BoK must either roll them over or print money. It is this choice that will test the BoK's new anti-inflation pledge.

With the output gap closing fast, it is unlikely that inflation will stay at the lower end of the BoK's target range. It may be even difficult for inflation to stay within the target range. Recent government surveys also showed that price expectations were rising.

BoK striving to be credible

The BoK hiked the closely-watched overnight rate by 25 bps, to 5%, in early February, a move that came earlier than we (and the market) had expected. It was also the first hike in two years.

The move seems to suggest that the BoK is eager to establish its anti-inflation credibility. This should be good news for the economy and the local financial markets going forward. The BoK will not achieve its stated goal of narrowing the gap between short- and long-term rates if it cannot convince the markets that inflation would be kept at bay.

The liquidity threat of massive redemption by Daewoo bondholders did not materialise in February. This presumably prompted the BoK to reverse the liquidity it pumped into the system since late last year on the concerns about potential massive bond redemption.

The fast shrinking trade surplus, with January recording a $400 million trade deficit, the first since October 1997, could also be a factor prompting the BoK to raise rates earlier than expected. The declining surplus has been a result of soaring imports that have overwhelmed respectable export growth (Chart 2). With an inflation-targeting policy, the BoK is unlikely to risk a rising trade deficit that would weaken the KRW and thus heighten inflation risk.

An intellectual ploy?

The difference between the BoK's GDP forecast of 7.2% yoy for this year and the Finance Ministry's forecast of 6% may reflect that a policy debate might be underway. The BoK's higher forecast may even be an intellectual ploy to pursue a tighter monetary policy than Seoul wants. If it succeeds in convincing the markets that the inflation monster would be beaten, we could see a flatter yield curve this year.

While the BoK has expressed concerns about a rising won, which will help curb inflationary pressures amid robust domestic demand, we think its worry lies in the won's rapid ascent propelled by large portfolio inflow. From the view of economic stability, portfolio-driven won strength on the back of a falling current account surplus may not be desirable.

Hiking interest rates will slow the rise in asset prices, and hence reduce the portfolio-induced pressures on the won exchange rate. A tighter monetary policy at this point of the economic cycle will also help improve allocation of economic resources. The burden of slowing the economy has been put solely on the currency. This will eventually hit the export sector hard, which is undesirable as this sector is probably more efficient than the domestic corporate sector.

The BoK's test

There should be more interest rate hikes if the BoK sticks to its anti-inflation pledge. Obstacles for holding back the BoK are disappearing.á The National Assembly election is out of the way. The BoK used to worry that higher rates would pressure the banking system that is burdened by high bad debts. However, Seoul is fully backing the banking system so that the systemic risk from bank failures should be low. The absence of the much-feared Daewoo bond redemption in both November 1999 and this February suggests that the risk in the investment and trust companies have been contained.

Finally, to see if the BoK lives up to its anti-inflation pledge, watch out for what it is going to do when the mountain of MSBs matures later. The surge in foreign exchange reserves has also led to a surge in MSBs issued (see Chart 1), due to BoK's attempt to sterilise the impact of foreign exchange inflow on domestic money supply.á (Sterilisation is a process whereby the BoK issues MSBs to mop up the won it sold when intervening in the foreign exchange market to curb the strength of the won).

As these MSBs mature later, the BoK has to either roll them over or monetize them (i.e. print money to pay them off).á If the BoK is being pre-emptive, we should not see monetization creeping into faster monetary growth numbers.á Time will tell.

Early indications seem to suggest that the BoK wanted to establish its inflation-fighting credibility.á A flatter yield curve could result by year-end, with the long yield easing if the BoK succeeds in convincing the market with its anti-inflation stance.

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