* Intervenes infrequently despite won's fast rise
* Inflation a hot issue ahead of elections
* Loosened grip seen as temporary - analysts (Recasts with analysts' comments, details)
By Yoo Choonsik
SEOUL, April 4 (Reuters) - A surprisingly small increase in foreign reserves in March has highlighted South Korea's decision to loosen its grip on the rising won to curb inflation, though Seoul's tolerance of a stronger currency may not last long.
Analysts and traders believe the shift in currency policy was largely a short-term one, aimed at calming public anger over quickening inflation ahead of key by-elections later this month.
The won hit a low for the year on March 17 but has since has risen 4.4 percent on the U.S. dollar to around 1,086. The sharp run-up has surprised hedge funds and other investors who had expected authorities to continue to rein in the Korean currency to ensure robust export growth.
"The pace of appreciation in the past couple of weeks has certainly been impressive, but it will eventually come to a pause and the won will consolidate back to a more sustainable pace of appreciation," Sacha Tihanyi, a senior currency strategist at Scotia Capital in Hong Kong.
South Korea's inflation in February was double the average rate for members of the Organisation for Economic Co-operation and Development (OECD). In March it picked up further to a 29-month high of 4.7 percent.
The government has pledged to keep inflation at around 3 percent on average for the whole of the year, while the central bank has forecast inflation would average at 3.5 percent.
Growing price pressures have emerged as a hot issue as President Lee Myung-bak's party faces tough competition from the opposition in by-elections later this month in several regions, which will be a test for next year's presidential race.
Bitter memories of a near sovereign insolvency in the late 1990s, sparked in part by an overvalued won and big current account deficits, have since led South Korea to maintain zero tolerance to any sharp currency appreciation.
MEMORIES OF 1997-98 CRISIS
But central bank data released on Monday showed some signs of a change in policy. Foreign exchange reserves in Asia's fourth-largest economy rose only $0.95 billion last month even as the won rose the most in six months.
The Bank of Korea attributed the gain to strength in non-dollar assets and investment gains. Central bank officials do not comment on market talk of intervention.
The reserves were at a record $298.62 billion in March, some 30 percent of the country's annual gross domestic product that passed $1 trillion last year.
The country's foreign reserves added $1.71 billion in February and $4.39 billion in January after reports by currency traders of government dollar-buying interventions aimed at smoothing the won's rise.
The small rise in reserves also came as the won rose nearly 3 percent against the dollar in March, making it the best month since September last year.
Traders on Monday reported South Korean authorities were buying dollars as the won rose to its strongest level against the dollar since early September 2008, but intervention was not so strong as to wipe out all of the won's gains.
Analysts said South Korean authorities, mindful of a firmer won's impact on the country's exporters, could turn more active in checking the currency's sharp appreciation should oil and other raw materials prices show signs of easing.
"The authorities will see the need for intervention ease anyway once oil prices rose further above $120 (per barrel) and the yen kept weakening (against the dollar)," a veteran currency trader in Seoul said. Currency traders would comment mostly on condition they are not named.
Even if upward pressure on the won lasted a long time, the government of President Lee Myung-bak would probably tighten its grip on the currency against after the April 27 by-elections, analysts said.
South Korea's foreign reserves ranked seventh in the world at the end of February. (Additional reporting by Kim Yeonhee and Lee Soo-jung in SEOUL, Jongwoo Cheon in SINGAPORE; Editing by Kim Coghill)