South Korean authorities warned markets on Monday they would defend the won aggressively to rein in inflation, boosting the currency and reinforcing expectations the central bank will keep interest rates steady this week.
The won jumped more than 1 percent against the U.S. dollar after the Ministry of Strategy and Finance and the Bank of Korea said in a joint statement they were worried about market "herd behaviour" and would act to underpin the currency.
"The government and the Bank of Korea are of the same opinion that stabilising the foreign exchange market was necessary and agreed to aggressively take concerted action toward it," the statement said.
"The most important thing at this moment is price stability. Foreign exchange policy has to be managed toward it," Choi Jong-ku, head of the finance ministry's international finance bureau, told reporters.
The statement convinced analysts dollar-selling interventions were right now the authorities' weapon of choice in their battle with inflation and that interest rates will remain on hold.
September treasury bond futures rose, but by a relatively small 9 ticks to 104.90 by as bond investors had already priced in steady rates.
"The announcement makes it very clear that the authorities will use foreign exchange policy as a main tool to fight imported inflation rather than interest rate policy," said Lim Ji-won, an economist at JPMorgan Chase.
Annual inflation spiked to a near 10-year high of 5.5 percent in June largely on the back of soaring oil prices. The won's more than 10 percent decline against the dollar so far this year has made things worse by driving up the costs of imports.
Separately, President Lee Myung-bak replaced Vice Finance Minister Choi Joong-kyung, a long-time advocate of a weaker-won policy, with another career bureaucrat Kim Dong-soo on Monday as part of a partial cabinet reshuffle.
The unusually stern warning, however, also stirred worries that the authorities may end up doggedly running down the country's hefty foreign exchange reserves without achieving much.
"I think it will work for some time, but only on condition that oil prices do not rise further sharply from their current levels," said Lim.
South Korea relies on imports to cover almost all of its energy needs and a further climb in crude prices would keep the dollar in high demand and the won under more selling pressure.
While the won jumped as much as 1.4 percent to a session high of 1,036.2 per dollar after the official statement, the cost of protection against a default by South Korea also rose, reflecting worries about the country's currency reserves.
Yet the country's five-year credit default swaps (CDS) widened by almost 10 basis points to 126, a Hong Kong-based debt trader said.
"There's a lot of worries about the stability of the foreign exchange reserves," he said.
Dealers estimate the monetary authorities have sold almost $10 billion to support the won since May.
But while the authorities have repeatedly acted in the currency market, the Bank of Korea has kept interest rates steady since August 2007, concerned that a rise would cool the economy too much at a time when global demand was already faltering.
The central bank is expected to leave its benchmark unchanged at 5.0 percent again when it meets on Thursday.
Some economists say South Korea is one of the few Asian countries where real interest rates are still positive, which allows the central bank to hold off with rate tightening.
But others warn of the growing risk that without the help from a rate rise the won's decline may spin out of control.
"We expect continued tests of the BOK's hitherto stout defence of USD/KRW at 1,050 this week. If it gives way the sky's the limit and all Korean financial assets would suffer from contagion," said Tim Condon, chief Asia economist at ING.