South Korea Price Expectations Climb as BOK Lags Behind: Inflation Bonds

Inflation expectations in South Korea are climbing the most since the end of the global crisis, according to the nation’s bond market, signaling the central bank is behind in raising interest rates from a record low.

The gap between yields on seven-year inflation-linked bonds and standard debt, a gauge of expectations for consumer-price gains over the period, has risen 40 basis points since Oct. 1, to 2.6 percentage points Dec. 6. The climb is the second largest among 13 markets tracked by Bloomberg, after the U.S., where Federal Reserve easing has stoked confidence in higher prices.

Bank of Korea policy makers have been forced to admit a government representative at their meetings since January as President Lee Myung Bak sought faster economic growth. The bank will keep its benchmark rate unchanged tomorrow at 2.5 percent, according to all 10 economists in a Bloomberg survey, leaving it below November’s 3.3 percent annual pace of inflation.

“The Bank of Korea isn’t doing its job well in anchoring inflation,” said Kwon Young Sun, an economist at Nomura Holdings Inc. in Hong Kong who previously worked at the central bank for 15 years. “The BOK is behind the curve as it missed its chances to raise interest rates earlier.”

Photographer: Jean Chung/Bloomberg

Inflation expectations in South Korea are climbing the most since the end of the global crisis, according to the nation’s bond market, signaling the central bank is behind in raising interest rates from a record low. Close

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Photographer: Jean Chung/Bloomberg

Inflation expectations in South Korea are climbing the most since the end of the global crisis, according to the nation’s bond market, signaling the central bank is behind in raising interest rates from a record low.

The increase in South Korea’s breakeven rate, or the gap in yields between inflation-linked and standard notes, since the start of October exceeds that of any quarter since April to June 2009, when the world crisis waned with banks’ recapitalizations.

Governor Kim Choong Soo and the policy board have raised borrowing costs only twice this year, by a combined 0.5 percentage point from a record-low 2 percent, even as inflation accelerated and breached their 4 percent ceiling in October.

Fed Impact

The nation’s economic recovery has contributed to the price gains and U.S. monetary easing risks intensifying the pressure, boosting the appeal of investments offering protection against inflation. The Finance Ministry on Nov. 4 said the Fed’s plan to inject $600 billion into the world’s biggest economy will propel more funds into emerging markets.

“Strategically, Korean inflation-linked bonds looked good value because the market has generally underpriced inflation risks,” said Adam McCabe, a Singapore-based portfolio manager at Aberdeen Asset Management Plc, which oversees $267 billion. “Extraordinary” monetary policy looseness in advanced nations is spilling over into South Korea, McCabe said. He expects the breakeven rate to reach 3 percentage points.

South Korean inflation-linked bonds are the top holding in the $538 million Aberdeen Asia Bond Institutional Fund, which has returned 12.7 percent so far this year, according to an Oct. 31 fact sheet on the company’s website.

Yield Gap

South Korea’s 2.75 percent inflation-linked bonds due March 2017 yielded 1.64 percent in Seoul yesterday, near a two-month low, according to Barclays Bank Plc prices. The yield on the 5.5 percent notes due September 2017 that don’t offer protection against inflation was 4.12 percent.

Lee’s government in January started dispatching a vice finance minister to BOK meetings after Kim’s predecessor as governor said the bank shouldn’t be too slow to raise rates. Board members in May sought to have the official leave the room for the vote on rates, a step agreed to in June. The central bank started raising rates a month later.

“It’s like a tug of war as the government wants to keep rates low to promote growth, while the BOK needs to raise them to curb inflation,” said Oh Suk Tae, an analyst in Seoul at SC First Bank Korea Ltd., a unit of Standard Chartered Plc.

Growth Concern

Oh, who has covered the nation’s economy for more than 13 years, said that “South Korea’s annual growth rate could drop to around 3 percent next year if the current economic trend continues, adding pressure on the BOK to keep rates on hold.” Higher rates would risk a stronger exchange rate that makes South Korean exports less competitive.

Exports account for about 40 percent of gross domestic product, making South Korea the second-most export-dependent member of the Group of 20, after Saudi Arabia, International Monetary Fund data show. The won has risen about 39 percent since March 2009, and recovered losses sparked by tensions after North Korea’s deadly shelling of a border island on Nov. 23.

Quarterly economic expansion halved to 0.7 percent in the three months to September as the won appreciated the most in Asia against the dollar and goods shipments moderated.

Governor Kim predicts Asia’s fourth-largest economy will expand about 4.5 percent in 2011 after a 6 percent pace this year, with inflation accelerating to 3.4 percent next year from 3 percent in 2010. The central bank targets inflation of 2 percent to 4 percent on average through 2012.

Pressure on Retailers

The government has sought to stem inflation through other means, saying yesterday it would try to curb inflation with steps including increased food supply and more competition among retailers.

Policy makers are also seeking to counter the impact of inflows of speculative capital in the aftermath of the Fed’s liquidity injections. The breakeven rate tumbled the most in three months on Nov. 18, when the government backed reviving taxes on foreign investors in domestic bonds to slow capital inflows. The proposed legislation would reintroduce a 14 percent tax on interest income from treasury and central bank bonds and a 20 percent capital gains levy on their sale.

Emerging markets from Brazil to Taiwan, Thailand and Indonesia have also taken steps to counter so-called hot money, or speculative capital seeking short-term returns.

Bond Sales

Inflation-linked bonds, versions of which have been sold for centuries, have a shorter history in Asia. South Korea introduced them in March 2007 before scrapping issuance in August 2008 due to low demand, and then restarting the program this year. Japan also issues such securities.

South Korea has sold 1.25 trillion won ($1.1 billion) of bonds whose principal increases in line with the consumer price index since June, said Seo Jung Hyun, an official at the Ministry of Strategy and Finance, which oversees the sales. It sold 213 billion won of 10-year inflation-linked bonds at a yield of 1.67 percent in November.

The 10-year breakeven may reach 300 basis points, or 3 percentage points, in the first quarter of 2011, said Yum Sang Hoon, a fixed-income strategist at SK Securities Co. in Seoul.

“The appeal might rise for these assets, especially if the central bank fails to raise rates much more to control inflation,” Yum said. “I only see one rate hike next year.”

To contact the reporters on this story: William Sim in Seoul at wsim2@bloomberg.net; Frances Yoon at fyoon2@bloomberg.net

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