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Asia-PacificOctober 2 2017

Conflict? Scandal? South Korean investors carry on regardless

South Korea’s capital markets are thriving despite threats of aggression from North Korea, as well as business and political scandals at home, writes Michael Imeson.
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Korea Stock Exchange

The glass is certainly half full rather than half empty for investors in South Korea’s capital markets, judging by the positive way they have reacted to the extraordinary happenings of the past year. Namely, North Korea has been exploding nuclear bombs, firing off intercontinental ballistic missiles, and waging an aggressive war of words with South Korea and the US.

And in August, Jae-yong Lee, the vice-chairman and de facto head of South Korea’s largest company, Samsung, was found guilty of corruption and sentenced to five years in prison, though he is appealing against the verdict. The case has cast a shadow on the business models of the country’s chaebols – the several dozen South Korean family-controlled conglomerates.

Mr Lee was found by the court, among other things, to have offered millions of dollars to former president Geun-hye Park in return for business favours. Ms Park, who was impeached in March this year for her part in this, is also on trial, with a verdict expected in October 2017.

Stock market high

Yet amid this maelstrom of negative events, the Korea Composite Stock Price Index (Kospi), which includes the shares of the largest companies listed on the Korea Exchange (KRX), reached a record high of 2451 on July 24. Although that had slipped to 2346 at the time of writing (September 7), it was still well up on the 2063 of September 8, 2016. Corporate profitability is sharply improving, and investors are more focused on that than anything else.

“I think the North Korea situation is certainly having some impact on foreign investors right now, as well as on the exchange rate volatilities,” says Seo Young Lee, a partner at consultancy firm Oliver Wyman. “But Koreans tend to be somewhat complacent about it, because they have seen many of these threats before. So the core of the country’s capital markets from the domestic investor appetite perspective are not much affected.”

Korean holding companies

The rating agencies are also relaxed about the threat from North Korea. A report by Moody’s Investor Services in September said it believed “the potential for outright military conflict involving South Korea, the US and possibly others in Asia remains low”.

Moody’s says even if war did break out, if short-lived it “would not fundamentally and durably weaken Korea’s economy, government finances or institutions”. And while this would hit financial markets and likely lead to capital outflows, South Korea has significant external liquidity buffers so “the credit implications would be limited”, according to the rating agency. (This scenario, however, seems to be based on a conventional war, not a nuclear one.)

As for the domestic corporate and political scandals, new president Jae-in Moon has had a stabilising effect on the markets by pledging to clamp down on corruption in business and politics, and improve corporate governance, especially in the chaebols.

Out of the box

For 2016 and much of 2015 the Kospi remained stable, 'boxed in' between 1800 at the bottom and 2100 at the top, with frustrated investors referring to it as the “Boxpi” (boxed-in Kospi). The index finally broke out of the top of the box early in 2017 and, as mentioned above, is now around the 2300 mark.

“This was thanks to sharply higher net profits of Kospi large-cap stocks, such as Samsung Electronics, and stronger expectations for better corporate governance on the easing of the political turbulence caused by the presidential impeachment,” says a spokesman from the Korea Financial Investment Association (Kofia), the self-regulatory organisation for market participants. Net profits of Kospi-listed companies rose from Won 33,000bn ($29.3bn) in the second half of 2016 to Won61,000bn in the first half of 2017, an increase of 85% in just six months.

The country’s first online fund supermarket, Fund Online Korea, which opened in 2014, allows consumers to invest in a wide range of funds at reasonable cost. “However, its share in the fund distribution market has yet to meet expectations,” says a Kofia spokesman. At the end of May, Fund Online Korea accounted for only 0.34% of the country’s total distribution of publicly offered funds.

Korea's capital markets

Hype but no progress

Oliver Wyman’s Mr Lee says while the concept of an online fund supermarket was good, “it never really took off”, adding: “There was a lot of hype about the collaboration between the 40 or 50 financial institutions who set it up, but there has not been a lot of progress.”

The market capitalisation of equities on the KRX – which includes the Kospi and Kosdaq (Korean Securities Dealers Automated Quotations, for small and medium-sized enterprise shares) – was $1548.5bn in June 2017, making it the 14th largest in the world, according to the World Federation of Exchanges. This was 23% up on the same month in 2016, giving the KRX the third fastest growth rate of any exchange in the world, though its global ranking was unchanged.

“The most notable events in Korea’s equity capital markets in the past 12 months were the initial public offerings [IPOs] of Doosan Bobcat and ING Life Insurance Korea,” says Myoung Jae Chung, senior attorney at Kim & Chang, the country’s largest law firm. “Doosan Bobcat was the first ‘holding company of foreign entities’, which took advantage of the fast-track listing application process of the KRX.

“The ING Life IPO was the first Korean IPO consummated by a company that was 100% owned by a private equity fund. Before the IPO, ING Life was indirectly owned and controlled by MBK Partners, a private equity fund, through Life Investment Limited.” ING sold the unit to MBK in 2013.

DCM on the rise

The debt capital markets have also been buoyant. Corporate bond issuance rose from Won20,000bn in the second half of 2016 to Won36,000bn in the first half of 2017, a jump of 80%. “The reasons for this include more attractive interest rates relative to government bonds and the higher appeal of corporate bonds, thanks to the bullish results of blue-chip companies,” says the Kofia spokesman.

Corporate bonds traded on the KRX increased from Won1332bn in the second half of 2016 to Won1906bn in the first half of 2017, a 43% increase. “Still, this accounts for a mere 3.2% of the over-the-counter corporate bond trading market,” says Kofia.

As for government bonds, the Ministry of Strategy and Finance successfully issued Won1100bn of 'super long-term' 50-year maturity Korea Treasury Bonds (KTBs) in October 2016, at an annual rate of 1.57%. Previously, the longest had been 30 years, issued in 2012. The ministry says the success of the launch proves “that the country’s capital market is developed enough for super long-term bonds, and so is the government’s debt management”.

The ministry adds it will issue a further Won1000bn of 50-year KTBs in stages in 2017 – the first issuance of Won219bn was in March – but this is only 1% of the planned total issuance when shorter maturity KTBs are taken into consideration. The ministry plans to issue a total of Won103,700bn of KTBs in 2017 (slightly down on 2016’s Won110,100bn), of which about 45% will be three- to five-year maturity, 25% 10-year, and 30% 20-year to 30-year.

Derivatives revival

Derivatives have also seen a comeback. Derivatives trading had been on a downward trend since regulations were introduced about six years ago to deter retail investors from gambling on them and losing money. According to Kofia, “the derivatives market appears to be back on track, with both trading volume and turnover moving in an upward trajectory”. The two key reasons for the revival are the bullish stock market and the tax exemptions for a certain type of arbitrage trading.

In the first half of 2017, 620 million exchange-traded derivatives contracts were traded, valued at Won6,107,000bn. That compared with 690 million contracts valued at Won10,189,000bn for the whole of 2016, and 790 million contracts valued at Won10,153,000bn won for 2015. So if this year’s trend continues, the number and value for 2017 will be significantly higher. This is still well below the levels of 2011, when there were 3.9 billion contracts valued at Won16,442,000bn – but the market then was overheated and unsustainable.

“Trading volumes and values have increased, mainly due to the government’s implementation of new regulations and policies to promote the derivatives market, in particular new regulations introduced in March 2017,” says Mr Chung of Kim & Chang. Retail investors in derivatives have to deposit an initial margin before they can enter the market, and complete an education programme to improve their skills.

“The March regulations lowered the minimum deposit amount and minimum trade volume for options purchase,” adds Mr Chung. “In addition, the required hours of education on options trading have been decreased to 20 hours.”

Other regulatory developments include the introduction in March of an ‘omnibus account’ for foreign investors in shares. Global securities companies and asset managers can open omnibus accounts with South Korean securities companies and conduct transactions in multiple products for their end investors. “It makes trading easier,” says Byunghyun Min, deputy governor at the Financial Supervisory Service. In June, the omnibus account was extended to cover bonds and derivatives.

Short-selling regulations were also tightened in March. If there is a 'sudden and abnormal' increase in the short-selling of a stock on the KRX on any one day, the stock is classified as overheated and a ban imposed on the further short-selling of that stock on the following day. The rules were imposed after retail investors in a pharmaceutical company suffered heavy losses due to short-selling.

Proprietary trading

Exchange-traded funds (ETFs) are currently popular with Shinhan Bank’s proprietary trading desk. “The use of ETFs in proprietary asset management is growing rapidly,” says Moon-Sik Kim, senior manager in the securities management department at Shinhan, the top South Korean bank by assets. “ETFs, with a lower trading cost than beneficiary certificates, have the advantage of timely order execution during the market trading hours and offer diversification of a portfolio when compared with investing in individual stocks. In addition, diversification of ETF products, such as sector ETFs, have contributed to its popularity in proprietary asset management.”

Mr Kim echoes Kofia’s sentiments about the strength of the Kospi. “While the geopolitical risks arising from the tension between North Korea and South Korea remain unresolved, investors are still inclined to invest in the Korean stock market as shareholder returns improve. Foreign capital continues to flow in. In July 2017, foreign ownership of the Korean stock market stood at 37.3%, up from 35.2% at the end of 2016 and 32.2% at the end of 2015," he says.

“Another significant development has been the introduction by the Financial Services Commission of a stewardship code for domestic institutional investors, encouraging them to participate in the management decisions of the companies they invest in. The National Pension Service announced in July that it would introduce the code within the year, and other pension funds and asset management companies are preparing to do the same.”

In the wake of the corporate and political scandals that have hit the country this year, “society is demanding more transparency and responsibility from corporations”, adds Mr Kim.

ISAs, UK-style

To make investing in securities more attractive, the authorities introduced in March 2016 a version of the UK’s Individual Savings Account (ISA), which provides tax benefits to investors. South Korea’s ISAs were initially popular, but interest petered out for several reasons: the tax benefits only apply if the ISA is held for five or more years; ISA applicants have to provide proof of income; and investment yields have been low compared with the rise in the Kospi.

According to Mr Kim of Shinhan Bank, at the end of June this year, there were 2.2 million ISA subscribers, accounting for Won3900bn. “Interest has waned since they were launched, but action has been taken by the authorities to improve their attractiveness,” he says.

These actions include a system that allows customers to transfer accounts between financial institutions to get a higher return, without early termination of the previous account. Other planned changes, announced in August this year, are to increase the tax benefits and to allow cash withdrawals from ISAs prior to maturity.

Not a blip

Most market observers do not believe the revival of South Korea’s capital markets, especially its equity market, is a short-lived blip. “It should be noted that the strong [equities] market we have been witnessing recently is not a one-off event, but a result of expectations for improved market conditions,” says the Kofia spokesman.

“Hopes are high that the long-standing weaknesses that have led to the so-called ‘Korea discount’ of equities [where South Korean companies trade at lower valuations than many of their global peers] – including collusive links between businesses and politicians and the succession-linked illegalities of the chaebols – may be eliminated as a result of recent political developments.

“The new government’s reform efforts are geared at strengthening shareholder return policies and increasing dividend pay-out ratios. This should have a positive impact on the stock market over the mid-to-long term.”

So the prognosis looks healthy – as long as a military conflict with North Korea can be avoided.

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