Why Bank of Korea insiders worry about credibility

Unlike most central banks, the Bank of Korea has the pursuit of "harmony" written into its statutes.

But when it comes to harmonizing with the government, South Korea's central bank may have gone too far, undermining its credibility as an effective counterweight in managing Asia's fourth-biggest economy, interviews with current and former Korean policymakers say.

Indeed, those sympathies may draw even closer to those of the government. Almost the entire slate of the central bank's seven-person monetary policy committee is due to be replaced this month, including two who are known for their inflation-fighting bias.

The country's president, Lee Myung-bak, will select the replacements.

Central bank independence is prized as a check and balance to governments and presidents who naturally favor economic growth, especially when elections are coming up, as they are in South Korea.

"The Bank of Korea has much to do to regain its credentials as an independent policymaking organization," said one of the central bank's current board members, who declined to be identified because of the sensitivity of the issue.

"The bank should try real hard to re-establish the 'Say what you do, do what you say' principle," said the member, acknowledging that the central bank had lost significant credibility as an independent policymaker under the president's government.

A pro-growth policy may well help whittle away the country's household debt, which at more than 1.5 times annual disposable income last year is higher than the level in the United States before the global financial crisis in 2008.

Growth left unchecked by a central bank though could encourage yet higher debt and a buildup in inflation.

Equally, a central bank that fails to stand up to a pro-growth government could lay the foundations for a surge in inflation. That could worry investors in the bond market, the third-biggest in Asia, which Asian Development Bank figures show has some $1.2 trillion in outstanding debt.

President Lee introduced a series of steps in the past three years that critics and some insiders say pushed the central bank to operate more like a government agency than its checking and balancing partner.

If he fills the central bank seats this month with people closely aligned with his thinking, the central bank may sound even more like a monotone, favoring growth over price stability.

Since the global financial crisis, Lee has called the Bank of Korea's governor into weekly meetings, has sent a vice finance minister into the central bank's monthly gatherings, has appointed his former policy aide as its chief and refused for two years to fill a vacancy on the BOK's board. It currently has just six members instead of the usual seven.

Lee has never publicly commented on monetary policy committee affairs. Officials at the presidential office, Bank of Korea and the finance ministry declined to explain why Lee was keeping the position vacant or comment on the broader issue of the central bank's credibility.

Current Bank of Korea Governor Kim Choong-soo has repeatedly said there is nothing wrong with leaving the seventh board position open for so long. Other countries including the United States have had lengthy vacancies on their central bank boards too.

But a former board member said that Lee refused to fill the open board position for fear of a revolt.

"At one meeting in late 2005, four members voted to turn down what the governor had proposed on (an) interest rate decision, and I believe President Lee wanted to avoid a repeat," Kim Tae-dong, who was a board member at that time, told Reuters at his office at Sungkyunkwan University in Seoul.

Park Seung, the central bank governor in 2005, who was appointed by Lee's predecessor, confirmed that there was a meeting at which a majority of board members voted against his proposal on interest rate policy, although he did not remember the month.

Some who have attended central bank meetings said that Governor Kim, aided by his deputy and two other pro-government rate setters, effectively dominate.

The incumbent board member who called for more independence said the governor sometimes presented his views even before voting started.

Kim drew criticism soon after winning the governor nomination in early 2010 when he said he would pursue closer cooperation with the government.

Running Against Markets

The central bank's decisions regularly wrong-foot markets. It bucked economists' expectations in half of its 12 rate meetings in 2011, holding interest rates steady when investors had anticipated a hike or raising them when no move had been predicted.

The outcomes underlined the view that the central bank was responding to political interests, rather than making a decision based on the economy's performance.

"There were times last year when traders even completely ignored what the bank said and instead referred to finance ministry remarks to find clues on policy direction," said Yum Sang-hoon, a fixed-income analyst at SK Securities.

Little has changed this year. So far in 2012, the Bank of Korea has held rates steady at each of its three policy-setting meetings. Post-meeting statements looked so similar that economists struggled for any sense of how the policy debate within the central bank was evolving.

Rates look likely to stay on hold at April's meeting and perhaps through all of 2012, economists say.

That makes central bank independence less vital. The real test will come when inflation picks up and the BOK must choose when to hike. Investors have little insight into who will be making that decision.

By naming a new slate of board members, Lee's influence on the BOK can extend beyond the end of his own five-year term in early 2013. Board members serve four-year terms, so this group will be in place until 2016.

Choi Do-soung, one of the four incumbent board members whose term ends this month, said uncertainty surrounding the policy board's policymaking would inevitably increase with so many new members starting work at the same time.

Choi is considered one of the two members of the board most sensitive to inflation risks. He voted against the board's policy decision six times between September 2010 and September 2011, arguing for higher interest rates.

Lee's opponents contend that he is chasing unrealistic growth targets, and wants the central bank's assistance in achieving them. The cost, his critics say, could be higher inflation that is more difficult to dislodge.

"The government kept interest rates extremely low and started to raise them too late to boost economic growth through exports," Lee Yong-sup, chief of the policy committee at the main opposition Democratic United Party, told Reuters in an interview earlier this year.

South Korean inflation began picking up in the middle of 2009 as the economy pulled out of the global financial crisis. The Bank of Korea signaled it was ready to start to raise interest rates from the record low of 2 percent they were pushed to in the crisis, which was welcomed by financial markets.

Still, it took another year until the central bank, having confounded the market's consensus repeatedly, started to raise interest rates. It finally raised them in July 2010 and has since surprised markets on several more occasions.

Higher inflation can hurt businesses by raising operating costs, making them less competitive on the global market. It strains household budgets by eroding buying power.

The central bank's own surveys of consumer inflation expectations indicate they think price pressures will intensify.

Figures released last week showed 12-month inflation expectations dipped slightly to 3.9 percent from 4 percent, but that was still at the top of the BOK's 2 percent to 4 percent target. It was also considerably higher than the current inflation rate of 2.6 percent.

When consumers think inflation is going to pick up, they demand higher wages, which in turn leads companies to raise prices and can trigger a dangerous wage-price spiral.

Lee won the late 2007 presidential election with a slogan known as the "747 pledge" of annual average economic growth of 7 percent, per-capita income of $40,000 and the world's seventh-largest economy over the next 10 years.

Official estimates show the average economic growth for his five-year term would be only 3.1 percent, with per-capita GDP standing at around $25,000 this year. It ranks far below the top 10 economies in the world.

Yum, the SK Securities analyst, kept his BOK wish list short and simple.

"What I would like to see is them raising the rate when they should," he said.

[Source: By Choonsik Yoo, Reuters, Seul, 03Apr12]

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