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Bank of Korea Holds Rates, Keeps FX Markets on Edge

South Korea's central bank kept rates on hold on Thursday as expected, with its battle against inflation now playing out in the currency market where the won jumped as much 1 percent on dollar-selling fears.

Korea, Korean Flag
CNBC.com
Korea, Korean Flag

The Bank of Korea kept its benchmark rate unchanged at 5.0 percent for 11 months now, torn between the challenges of a slowing economy and soaring oil and commodity prices that are propelling inflation to near decade-highs.

The central bank threw down the gauntlet to the currency market on Wednesday, warning it would not let the won weaken beyond 1,000 per dollar after its biggest one-day sale of dollars on record.

The won rose to as high as 994.9 per dollar in Thursday morning trade from Wednesday's domestic close of 1,004.9, buoyed by expectations South Korean authorities would continue to dip into their hefty foreign reserves of nearly $260 billion foreign reserves to support the currency.

South Korea's finance ministry and central bank vowed on Monday to defend the won to its weakness from fuelling already high inflation and traders said they made good on the promise offloading an estimated $7 billion on Tuesday and Wednesday.

Currency dealers estimate South Korean authorities have sold about $17 billion so far this year to prop up the won.

Analysts said the authorities unusually blunt warnings signalled currency intervention was now clearly the authorities' weapon of choice in their battle against inflation, but voiced skepticism whether such strategy could succeed in the long run.

"It is clear that the Bank of Korea is resisting pressures to raise rates and is opting to defend the won, but propping the won is going to be extremely difficult over the next few months," said Sebastien Barbe, Asian senior economist at Calyon.

Most analysts polled by Reuters this week had expected the central bank to keep rates on hold for the rest of the year in the face of evidence that Asia's fourth-largest economy was losing steam.

Barbe and some others, however, believe, the current strategy of propping up the won to tame imported inflation will prove too costly and rates will have to go up at in the next few months.

Economists will wait for the central bank governor's news conference later in the day for more clues about the policy outlook.

September treasury bond futures firmed after an earlier drop and were up 2 ticks at 105.27 in the morning session and the stock market's main index was up 0.2 percent.

The central bank last changed the policy rate in August, when it raised the rate by a quarter of a percentage point in its seventh consecutive rise since October 2005 aimed at pre-empting an anticipated build-up in inflationary pressures.

The won had fallen more than 10 percent for the first half of this year, adding to price pressures and helping propel annual inflation to a near 10-year high of 5.5 percent in June, well above the central bank's target range of 3-5 percent.

The central bank has resisted pressure to raise interest rates on concerns that higher borrowing costs would hurt already faltering domestic demand in Asia's fourth-largest economy.

The finance ministry cut earlier this month its 2008 growth forecast to 4.7 percent from earlier 6 percent and June consumer sentiment data due later on Thursday may offer further evidence of weakness after the index hit a three-year low in May.