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Immediately after the G20 summit, Seoul has defied the currency hawks by raising local interest rates -- revealing that at least in this country, inflation is still more of a threat. South Korea was one of the earliest countries to join the currency wars, buying dollars on the open market as the won appreciated over the summer.

This recent track record of aggressive intervention in the foreign exchange markets makes another interest rate hike relatively surprising; since August, the central bank has repeatedly -- and often, unexpectedly -- voted to leave rates unchanged explicitly because a rate increase would encourage even more global capital to flow into won-denominated assets.

In the meantime, Korean inflation has edged up to an annualized 4.1% as a weakening dollar pushes up commodity prices worldwide. This, in turn, put the Bank of Korea in a tough predicament: either raise local rates in order to curb inflation, while accelerating the won's ascent, on the one hand, or else leave rates alone and suffer inflation.

The fact that central bankers chose the former route this time around indicates that they are unwilling to countenance inflation above their stated 2% to 4% target, even if it means strengthening the won and robbing Korean exporters of a competitive edge in a global marketplace.

In any case, traders are gearing up to see new policy measures -- like a tax on foreign bond investments -- designed to restrain the won while not interfering with the delicate balance between inflation and local interest rates. The central bank could always move back in to the forex market to depress the won directly. Previous intervention has come at around the 1,107 won to the dollar level, which is roughly where we are now, so the near future could get "interesting."

Rising rates could theoretically slow Korea's economy to a crawl. Although Seoul still expects growth to come in at 6% for 2010 and around 4% next year, on a sequential basis GDP expansion is already down to 0.7%.

In the meantime, Korea's interest-starved banks can benefit from the rising rate environment. Look to a rising trend ahead for KB Financial (KB), Woori Finance (WF) and maybe even Shinhan Financial Group (SHG):

But higher rates may well act as a drag on the iShares MSCI South Korea Index ETF (EWY) and especially the rate-sensitive IQ South Korea Small Cap ETF (SKOR):

Disclosure: No positions

Source: South Korea Raises Interest Rates: Stocks to Watch