Korea: Damned If They Do, Damned If They Don't...

While other Economies face the threat of deflation, South Korea faces a rate dilemma driven by devaluation

The Bank of Korea (BOK) reported Monday that import prices grew 3.91% in February M/M, the first monthly gain since October when prices increased 4.1%. On a year-over-year basis, the increase in February registered at 18.03%, up from January’s 16.7%.

The weakness in the won is driving this import cost pressure. In 2008 the won declined 25.7% against the dollar, with the slide continuing into 2009. Despite the Won rally coming out of this weekend’s G20 meeting the expectation must be that import prices will continue to increase into March, driving consumer prices higher. CPI rose in February increasing 4.1% Y/Y, up from a 3.7% gain in January.

The one bright spot in import data was raw materials, which decreased 5.5%, Y/Y, following a 3.5% decrease in January, as aggregate commodity prices have continued the downward trend from last summer’s highs. This is a critical data point for Korea, the fourth largest oil importer globally which imports 97% of its energy needs. The rising price levels for crude so far this month suggest that this silver lining may soon disappear in the face of reflation.

Last week the BOK Monetary Policy Committee decided to maintain the Base Rate at 2.0%, after 6 consecutive rate cuts totaling 325 bps from October to February. The committee cited weakening domestic and export demand as downside risks to economic growth and a moderating factor in the run up in consumer price inflation generated by the won depreciation. YTD the won has weakened nearly 13% against the dollar, the largest depreciation among the region’s major economies, which has interesting ramifications for Chinese exchange rate policy.

The question is which effect will dominate the politics of policy going forward, the rate of increase in inflation driven by the collapse of the won or the contraction of Korean economic growth, as income and consumer sentiment continue to fall. We have a negative bias on the South Korean equity market and will continue to seek tactical opportunities to short into strength.

Andrew Barber
Director