News analysis: S.Korean central bank succumbs to currency war, politics

Bank of Korea (BOK), South Korea's central bank, crossed into an uncharted territory. The bank cut its benchmark seven-day repurchase rate by a quarter percentage point to 1.75 percent, leading the rate to fall below 2 percent for the first time in its history.

Governor Lee Ju-yeol and six other policy board members decided to lower the policy rate in August and October 2014 to 2 percent, a level that was maintained for about one and a half years from February 2009 when the 2008 global financial crisis hit hard the South Korean economy.

Asked about whether South Korea's current economic situations are worse than in the year after the crisis, he said such views would be unreasonable because the 2008 crisis came as a shock, different in nature from trends of the South Korean economy where growth and inflation are subduing over the long run.

"Recovery in domestic demand was far weaker than thought. If this situation continues for an extended period of time, (a long- term) growth potential could be undermined. The rate cut was made to prevent it," Lee told a press conference after the rate-setting decision.

The governor cited sour economic indicators for January and February as a reason for its "risky" preemptive action, saying those data "clearly" detected downside risks to the economy. But, he said such risks cannot be extended to the bank's overall growth outlook for 2015.

Conflicting comments were made by Lee himself when he talked about deflation concerns. Lee said it would not be reasonable to see the economy fall into deflation as lower headline inflation stemmed mainly from supply-side factors, such as cheaper oil, and core inflation stayed at the 2-percent level.

Lee said the economy's current situations "are hard to see as excessive downturn" given the expected 3-percent growth this year. The BOK revised down its 2015 growth outlook for the economy to 3. 4 percent in January from 3.9 percent three months earlier. Its new revision is set to be announced next month.

As Lee indicated, the South Korean economy may have slipped into a period of low growth in the long run as seen in the global economy. But, it mainly came from structural factors such as delayed private consumption in preparations for after-retirement life amid the rapid population aging and the subsequent growth in savings.

The rate cut cannot be the most effective way of tackling the prolonged, structural weakness of domestic demand as consumers do not delay spending because of high interest rates. Furthermore, the 3-percent economic growth does not guarantee any urgency for the central bank's all-time-low policy rate.

What brought the BOK to make an "unreasonable" choice? Answers may be found in currency war and politics.

Fears emerged that currency war may have kicked off in the global economy as Japan opened a door for the race in currency devaluation by printing money. In the past three months, eighteen central banks of major economies cut interest rates, and the European Central Bank (ECB) launched its quantitative easing to print money.

Currency war usually indicates competitive currency devaluation to boost exports and prevent deflation risks. Lee also expressed concerns about recent fall in South Korea's exports to Japan and Europe amid the faster decline in the Japanese yen and the euro versus the U.S. dollar compared with the South Korean currency.

South Korea's exports to the European Union (EU) tumbled 31 percent on-year in February after falling 23 percent in January. The exports Japan dropped 20 percent in January. "The reason for paying attention to currency rate is that the rate affects exports, " Lee said.

Political pressures had been placed on the BOK to cut rates further. Kim Moo-sung, chief of the ruling Saenuri Party, said on March 4 that the current situation should be taken seriously as it is in an early stage of deflation, noting that many experts are putting forward the need for rate cuts.

Finance Minister Choi Kyung-hwan said on the same day that he " has much worry about deflation" caused by the prolonged low headline inflation though he said the economy had yet to slip into deflation.

"BOK's benchmark interest rate, which directly links to the currency rate, was lowered to 1.75 percent today," Kim told reporters Thursday right after the rate-cut decision.

The ruling party chief said that manufacturing industry is very important to the South Korean economy, which depends heavily on exports, in the midst of global currency devaluation competition.

The won/dollar exchange rate jumped to 1,135.5 won per dollar at about 10 a.m. when the BOK decided to lower the policy rate, before closing at 1,126.4 won as the rate-cut decision was already priced in on the market.

Among possible side effects from the rate cut in South Korea is an abrupt foreign capital exodus as the stronger U.S. labor market triggered expectations that the U.S. Fed may raise interest rates as early as in June after having kept the policy rate between zero and 0.25 percent since 2008.

The opposite movement of South Korea's monetary policy to that of the U.S. central bank may trigger an abrupt exodus of foreign capital from the South Korean financial market, prompting the local foreign exchange market to get out of control.

Another uncertainty facing the BOK is South Korea's massive household debts that are keeping a record-breaking trend. Further rate cuts may speed up the debt-driven bubble in assets, especially in real estate as seen in the United States. Endi