Q&A-Is South Korea's economy ready for higher rates?

By Yoo Choonsik

SEOUL, June 16 (Reuters) - Bond investors in South Korea are raising their bets on an early interest rate increase after the central bank said that Asia's fourth-largest economy had stopped sliding but warned that inflationary pressures are building.

The 1-year treasury bond yield has jumped more than half a percentage point over the past three sessions to a 5-month closing high of 3.2 percent by the close of Tuesday in reaction to the central bank's comments last week. [ID:nSEO257805]

Following are main questions and answers on how the economy is faring and which signals the Bank of Korea is trying to send on future monetary policy:

HOW STRONG IS THE RECOVERY?

South Korea, unlike many developed economies which are suffering steep economic contractions, just missed falling into recession in the first three months of the year.

Key areas -- exports, consumption and construction -- have all started to show quarterly growth, prompting markets to begin factoring in a rate increase late this year or early in 2010, though the figures are still below year-ago levels. [ID:nSEO260913]

GDP growth was a scant 0.1 percent in the first quarter, but a big improvement on the 5.1 percent drop in the previous quarter.

Officials are optimistic of reasonable quarterly GDP growth in the second quarter, due out in late July, and some analysts believe that annual growth will be back to a pre-crisis pace of around 4 percent by early next year, further fueling expectations of rate rises.

HOW SERIOUS A THREAT IS INFLATION?

A jump in inflation expectations, even before a spike in the actual inflation rate, will likely be the key factor behind the timing and aggressiveness of any policy tightening campaign.

Consumer inflation is expected to remain low for a few more months, but rising oil prices, recovering consumer demand, anticipated rises in public utility charges and a market flush with cash could quickly boost prices.

The narrow M1 money supply measure has been growing by around 17 percent over a year earlier, the fastest since mid-2002, on the back of efforts by the authorities to flood the financial system with cash to revive sputtering growth.

Consumer and business confidence indicators are also rising fast, suggesting that companies may be getting ready to increase prices of their products.

The 10-year breakeven inflation rate -- the yield spread between nominal and inflation-linked treasuries -- has risen to a near 1-year high of around 2.75 percentage points this month from around 1 point in late 2008, Reuters data shows.

The Bank of Korea may not take a big lead over others in the region in being among the first to raise interest rates, but is more likely to employ a more measured approach, starting first by gradually absorbing money liquidity from the markets to avoid a market panic.

HOW SERIOUS ARE JOB LOSSES?

May job losses were the biggest in a decade at 219,000 over a year earlier, which could hurt consumer confidence and leave consumption weak, factors which the central bank has cited previously for being cautious on rates.

But the data includes the self-employed, many of them with only marginal income.

Reuters calculations show that the number of salaried workers -- important for private consumption -- has grown every month despite the global economic crisis.

Another relatively positive sign is that South Korean households have not been taking on more debt this year while their financial assets, helped by rising share prices, have grown modestly.

Less encouraging for future job growth and in turn for a quicker recovery in consumption, corporate capital expenditure has been shrinking by more than 20 percent every month over a year earlier since last December.

IS THE GOVERNMENT OPTIMISTIC?

It depends who you talk to.

The central bank says the slump is over, predicting a slow-paced recovery. But the finance ministry, under more political pressure and forced to raise funds on the bond market to pay for its stimulus packages, is more cautious.

Finance Minister Yoon Jeung-hyun says he will not talk of recovery until he sees companies start to invest at home, arguing that the rise in consumer spending is the result of a rush of fiscal speding to cushion the economy from the global downturn.

There are also doubts that the export recovery will be sustained if U.S. consumers do not increase spending. The recent export increases have been largely on the back of China's own stimulus measures and a sharp fall in the won which has since recovered much of its lost ground. (Editing by Jonathan Thatcher & Kim Coghill)