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Asia-PacificOctober 1 2015

South Korea's capital markets advance with caution

South Korea’s booming capital markets and robust legislation show that the Asian crisis of 1997 had some beneficial long-term effects, which even neighbouring China’s recent wobbles cannot derail.
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South Korea’s capital markets have come a long way since the infamous Asian financial crisis of 1997. The events that rocked the country back then stick in the memory for many South Koreans and have spurred changes to the system in the intervening years. Capital markets in South Korea have seen both a high level of growth and an increasing sophistication as they have evolved to meet the needs of market participants from corporates to foreign investors. 

Every government around the world with a significant financial sphere has had to deal with the capital markets industry becoming ever more complex, and formulate a regulatory and legal strategy to best deal with this new reality. But in a country such as South Korea, past history means extra pressure to take the right approach and ensure that any future shocks are averted as far as possible. The general public knows all too well the potential cost if another crisis were to hit the country.

According to a recent report on capital markets by the Korea Financial Investment Association (Kofia), the country’s domestic capital market was worth Won2,792,000bn ($2401bn) at the end of 2014, 11 times its value in 1994. But this increase in enthusiasm for the use of capital markets in South Korea has brought with it the need to surround them with a strong legal framework and ensure that the regulation and market structure that are in place meet the demands of a burgeoning market.

Significant legislation

South Korea’s most significant piece of legislation in recent times was the Financial Investment Services and Capital Markets Act (FSCMA), which brought together several pieces of past legislation on capital markets in order to create a more coherent system and reassure investors of its robustness. According to the Kofia report, the act enabled securities companies to engage in other financial services and also allowed for the creation of new financial products. Some of the subsequent amendments allowed for the introduction of South Korean hedge funds and the nurturing of advanced investment banks, the report adds.

“From a regulatory perspective, the Korean market has become much more aligned with international practices and standards than, say, a decade ago,” says Myoung Jae Chung, a partner and senior member of the capital markets practice at South Korean law firm Kim & Chang.

The promulgation of the FSCMA in 2009 and subsequent amendments thereto have been aimed at advancing Korean capital markets and bolstering the domestic investment banking industry. Although there will be many more changes, regulatory and otherwise, broadly speaking the enactment of the FSCMA has been a success, as there has been robust capital markets activity in Korea since 2009.

“We expect this trend to continue since the Korean government has stated that it will seek to continue to support and grow the domestic finance industry and capital markets.”

Bond worry

In South Korea’s primary bond market, the value of bonds issued jumped by about 237% between 2000 and 2014 to Won1,589,000bn, according to the Kofia report. In 2014, government bonds accounted for the largest share of the market with 31%, it says. While the trading of bonds happens both on- and off-exchange in the secondary market in South Korea, the majority of trading takes place over the counter, it adds.

“Trading is very focused on Korean government bonds, which is definitely the largest part of the market,” says Seiwoon Hwang, chief economist, capital markets division, at the Korea Capital Market Institute (KCMI).

Government bonds are very actively traded on the secondary market. My only concern about the government bond market is that the growth of balance outstanding is too high. I think the government is issuing too many bonds in comparison with the gross domestic product [GDP]. It’s almost twice as fast as GDP growth and market players are signalling some alarm on this, but the Korean government does not have much choice. So far it’s under control, but if it continues, the Korean government bond market could be in trouble.”

In 2014, corporate bonds accounted for about 14.2% of the market, according to the Kofia report, and Mr Hwang believes there is a certain level of imbalance in this area.

“I think my main concern about bond markets is around corporate bonds,” he says. “The Korean bond market is growing, but it’s mainly focused on big companies. It needs to supply funds to smaller companies too. This market for smaller companies does exist, but it’s not really functioning. It used to be possible for smaller companies around the early 2000s but these days if they try, it’s not really possible.”

An active market

But overall, Mr Hwang is positive about the state of the South Korean bond market, despite its lack of size compared with some of the markets in south-east Asia. “I think the Korean bond market is in quite good condition with quite a high level of development,” he says. “I think the primary and secondary markets are quite well-functioning. If we compare the size of the Korean bond market with China and Japan, it’s smaller, but I think it’s more active. Trading is pretty lively and there is a lot of issuance.”

According to Mr Chung, 2014 was also a very active year for South Korean debt capital markets (DCM), largely due to low interest rates, the refinancing needs of South Korean companies, and the regulatory needs of banks and financial holding companies to issue securities in compliance with Basel III in South Korea.

“As a result of the Basel III implementation in Korea, Korean banks issued contingent capital securities, or CoCo bonds,” he says. “Many other Korean banks followed suit, and issued CoCo bonds in the Korean market. In 2015, due to credit market and equity market volatility, the year-on-year volume of foreign currency denominated bonds has been reduced by roughly 33%. Korean DCM bankers say they are hopeful that volume will pick up in the latter half of 2015, on the back of reduced volatility in markets.

“By far the biggest influence on bond issuances in Korea in 2015 has been the relatively low interest rates of Korean won-denominated bonds compared with foreign currency-denominated bonds. Given the gap in interest rates, many Korean issuers have chosen to issue bonds domestically while avoiding international markets.”

China falters

In South Korea’s equity capital markets in 2014, there were eight Kospi market initial public offerings (IPOs) worth Won3500bn, while on the Kosdaq there were 74 IPOs worth Won1200bn, according to the Kofia report. There were also 27 rights offerings. The Kospi is an equity platform provided by the Korea Exchange for larger companies, while the Kosdaq is also a Korea Exchange platform, but for small and medium-sized enterprises.

This year has seen fear sweep through the equities world in Asia as Chinese stocks showed a level of weakness that no one in the market was used to. This prompted panic not only across the region but much further afield as one of the globe’s major growth engines threatened to stall. China’s jitters naturally affected nearby markets, including South Korea, but according to some, the latter seemed to come off better than its regional competitors.

“More recently, Korea’s stock market is undergoing challenging times with growing concerns over external factors such as China’s stock market plunge, the Chinese yuan devaluation and the prospect of the US Federal Reserve's rate hike,” says Mr Chung. “Korea’s stock market, however, fell less than other major Asian markets, which is some evidence that market participants in Korea and abroad see Korea’s market fundamentals as being sound at the moment. That said, the pipeline for IPOs still remains quite active, if not full.”

According to Mr Chung, there have been efforts to internationalise the Korea Exchange with respect to the domestic equity capital markets. “Notably, certain Chinese issuers have listed on the Korea Exchange. We expect there will be efforts by the Korea Exchange to incentivise and encourage other international issuers to list on the Korea Exchange to make it more a regional market than a purely domestic market,” he says.

Derivatives under fire

Despite the reputational damage done to derivatives during the financial crisis, the sector has still remained strong in many markets throughout the financial world. The enthusiasm may have cooled somewhat from certain market participants, keen not to get burned again, but derivatives remain a big draw and a good source of profit for many banks and funds. However, while the debt and equity markets have shown strong signs of growth and development in South Korea, the derivatives markets have been showing worrying signs of weakness, marking a decline in popularity for the securities that may or may not be recoverable in the future.

In an opinion piece published early in September, Hyo Seob Lee, a research fellow at KCMI, said: “Unlike the global trend, Korea’s derivatives market has contracted significantly.

“Korea’s exchange-traded derivatives market used to be the world’s first or second largest in terms of turnover, but has been driven out of the world’s top 10 since the increase of option multipliers caused a dramatic drop in turnover. The trading value of Korea’s flagship Kospi 200 futures and options dropped by more than 50% from 2011 and now hovers around the level achieved a decade ago. As trading of interest rate and currency derivatives decreased, the over-the-counter derivatives market also saw the trading value decline for three consecutive years as of 2014.”

Mr Lee highlights the regulatory environment as a major factor in the decline of South Korea’s derivatives market, comparing it unfavourably with the approaches taken in the US and Europe after the financial crisis.

“The problem is that Korea’s recent regulatory moves are unprecedented in the global markets,” he says. “Although stronger investor protection is a common goal, Korea and developed countries take [a] different regulatory approach.”

“Since Korea tightened its regulation, several adverse effects have been observed. The first of them is abruptly falling trades in the exchange-traded derivatives market, which undermined the market’s international competitiveness. Also, the rising proportion of foreign investors in the market leads to frequent incidents where the tail wags the dog. Above all, Korea’s retail investors are exposed to the increasing risk of losses as their direct holdings in foreign derivatives markets are on the rapid rise.”

Domestic focus

Since the global financial crisis, many international investment banks have retreated from some traditional businesses in Asia, giving regional players an opportunity to fill the void. Banks from key markets such as Singapore have demonstrated a willingness to expand and take some of the business that was abandoned or lost by the global names. But it seems South Korean companies have been less aggressive in expanding abroad to capture capital markets business, preferring instead to concentrate on the home market for now.

“Domestic investment banks perform similar roles as their international counterparts when it comes to domestic capital markets offerings, both equity and debt,” says Mr Chung.

“While certain domestic investment banks have tried in recent years to become more of a regional player or play a more international role in capital markets offerings, other than on certain transactions they have experienced mixed results. That said, we believe domestic investment banks will continue to serve an important function in domestic capital markets, and continue their efforts to become bigger players in international capital markets.”

On the whole, South Korea’s capital markets have seen high levels of growth and continue to develop, despite some areas of concern. Ambitious legislative changes have laid the groundwork for a more robust and coherent system, while allowing for the introduction of new elements to the financial sphere. Debt markets may not compare in size to some of the country’s larger neighbours, but still provide a lively environment. Equities, as is the case in most in Asia, have been hit by China’s slowdown this year, but confidence remains in the fundamentals. The weakest point seems to be in the derivatives markets, where the regulatory environment may have choked off some of the potential for now.

Taking this into account, it would be safe to assume the South Korean capital markets will continue to develop, but memories of past crises are bound to make sure that the system, along with the rest of the financial sector, develops in the right way. While some market participants will always call for faster growth, what is good for South Korea may not always chime with what is good for banks and finance professionals. As a result, careful development is more likely to be the order of the day.

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