Capital markets play catch-up to South Korea’s real economy

South Korea’s export economy has produced big-name brands such as Hyundai and Samsung, but the country’s banking industry lags behind. The sector has been dominated by commercial banks – which are no longer able to support the financing needs of the conglomerates – and securities companies have been limited in their scope. That is set to change, however, as legal reforms to South Korea’s capital markets aim to unleash the potential of the local investment banks. 

“Compared with the real sector, the financial sector is yet to develop,” says Dr Hyoung-Tae Kim, president of the Korea Capital Market Institute (KCMI), and this is one of the drivers for the changes in South Korea’s policy and legal framework. 

Byoungjo Chun, senior executive vice-president at KB Investment & Securities, also draws comparisons between the two sectors. “The financial sector is less competitive than the real sector,” he says. Compared to the size of the commercial banks, South Korean investment banks are less exposed to international business. “The Korean investment banks are small and cannot support Korea’s real sector,” Mr Chun adds. 

At KDB Daewoo Securities, CEO Kibum Kim says: “Korea needs investment banks to invest in riskier businesses – such as high-tech industries and renewable energy – but because of the risk, commercial banks cannot cover that demand." He believes that such investment is critical for the future of South Korea’s economy. “If [this trend continues] then Korea will lose its competitiveness in the global market,” he says. 

Creative vision

This is what South Korea's new government, under president Park Geun-hye, aims to address. At her inauguration in February 2013, she outlined her vision for a ‘creative economy’, which moves South Korea away from its dependence on manufacturing and the industrial might of the chaebol – the country's conglomerates – and aims to spur innovation and support venture companies. In June, the government finalised its Creative Economy Action Plan, which aims to build on South Korea’s strengths in science, technology and information and communications technology. 

The Ministry of Strategy and Finance has outlined its vision for “realising a new era of happiness for the Korean people through a creative economy”. The government has set three goals: to create new jobs and markets through creativity and innovation, to strengthen South Korea’s global leadership through a creative economy, and to create a society where creativity is respected and manifested. 

Such ideals need the support of South Korea’s capital markets, however. Soohyun Choi, governor of the country's Financial Supervisory Service (FSS), says: “I would argue that a sound and transparent capital market that cultivates and rewards creative ideas is critical to the success of the creative economy we seek.” 

At a global level, South Korea’s capital markets are already sizable, as Mr Choi explains. “Last year, Korea’s stock markets were the world’s ninth largest in terms of transaction amount. The bond markets were the fifth largest and the derivatives market the third largest,” he says. 

While South Korea’s financial assets are low in proportion to the size of its real economy, Mr Choi highlights the positives. “Korea is the world’s eighth largest trading economy, but the proportion of financial assets relative to gross domestic product remains smaller than that of the world’s major economies, which suggests significant growth potential.”

Mr Choi adds that while the size of the capital markets does not reflect the capacity of South Korea’s real economy, it also means that the country has many promising, yet undervalued, companies. “The price-earning ratio for Korean stocks for this year is estimated at 8.56, compared with 13.8 for US companies, 13.2 for Japanese companies, and 12.8 for Taiwanese companies. For foreign investors, this obviously represents many new attractive investment opportunities," he says.

Good standing

Another positive, notes Mr Choi, is that South Korea’s capital markets rank well in terms of openness and, according to the Milken Institute’s Capital Access Index, South Korea ranks 12th out of 122 countries for access to finance, with only Hong Kong and Singapore ranked higher in Asia. 

This is a key characteristic of the market, says Jeong-Soo Lee, managing director of the securities services division at the Korea Financial Investment Association. “Korea’s market has a high level of openness and a high level of foreign investment,” he says. 

Mr Kim notes that the proportion of foreign investors in South Korea has increased, particularly in the bond market. “Five to six years ago, foreign investors in the bond market were less than 1% [of the total], now foreign investors make up 17% to 18%,” he says.

Such openness to foreign investment, however, is associated with the volatility in South Korea’s capital markets. Mr Kim says that because South Korea currently relies on the overseas market as an export-driven economy, there is a high volume of capital inflows and outflows. However, he counters that volatility is not necessarily a negative point, as it shows that the market is active and vibrant. The reason that the derivatives market is particularly active, he says, is because it is taking advantage of that volatility. 

On the subject of volatility, Mr Lee says: “One of the challenges that the industry needs to address is that the proportion of institutional investors is still very low and there is a high level of volatility.” 

High alert

Volatility has become a key issue since the US Federal Reserve announced its intention to taper its quantitative easing (QE) programme in May 2013. There are fears that the reversal in the US’s QE will trigger financial distress in emerging markets, which could in turn have an impact upon South Korea’s capital markets. 

Mr Choi says the FSS is monitoring the global market carefully for sudden capital inflows or outflows. "Korea has the full capability to deal with a crisis resulting from external shocks, with its sound economic fundamentals as well as capital buffers in response to sudden capital flows," he says. However, given the current environment of emerging market woes, Mr Choi admits: “These days we cannot find any negative trend or impact of those movements.”

Aside from overseeing and monitoring the market, Mr Choi – South Korea’s chief regulator – has also been working on improving the country's underlying infrastructure. “We have been improving and fine-tuning our regulatory and market infrastructures to measure up to the highest global standards. We have more work to do in some areas, so we very much remain focused on continually making the necessary improvement so that we can have effective and transparent capital markets that investors can trust,” he says. “My goal is very simple: to upgrade the FSS to become a world-class financial regulator.” 

Mr Choi explains that the regulation is currently being rationalised. “We imposed many strong regulations on financial companies and they have had some difficulties meeting these rules. So, we are now thinking we can soften and eliminate some regulation if these measures do not hurt the soundness of the financial companies. I would not call this deregulation, but making the regulation more efficient," he says. 

Time for change

The most significant legal framework for the industry is the Financial Investment Services and Capital Markets Act, which was revised in August 2013. The new measures aim to invigorate the capital markets and enable the growth of South Korea’s investment banks.

Dae-Suk Kang, president and CEO of Shinhan Investment Corp, says that a key feature of the South Korean financial markets has been the separation of commercial banks and investment banks. “Due to this strict separation of roles of the two industries, coupled with broadened regulatory measures, the local investment banks’ business scope has been limited compared to the global investment banks. However, the government has recently taken initiatives to allow investment banks to expand their business scope through a series of regulatory changes.”

Prior to these measures, South Korean securities companies acted as agency brokers and did not engage in the risk-taking activities usually pursued by investment banks. Securities companies are now able to pursue investment banking, which observers hope will lead to the emergence of a global South Korean investment bank with an internationally recognised brand that compares to the likes of Samsung and Hyundai in the industrial sector. 

Mr Kim at KCMI says: “Until the revised version of the Capital Markets Act, securities companies were structurally regulated from doing more aggressive business. Now they are ready to do it.”

Mr Chun at KB Investment & Securities says that the architecture of South Korea’s capital markets has witnessed huge change over the past year. One such change is in the scope of the capital markets business, through the approval of hedge funds and prime brokerage. Another major change is that securities companies are now able to get involved in lending. 

Securities companies with capital of more than Won3000bn ($2.7bn) are now able to lend. There are currently five companies that meet this minimum requirement: KDB Daewoo Securities, Woori Investment & Securities, Samsung Securities, Korea Investment & Securities and Hyundai Securities. 

Divisions remain

The strategy of the local players is now changing. “Local investment banks are expanding their business scope from traditional businesses in equities, fixed income and merger and acquisition advisory to principal investments, prime brokerage and corporate lending," says Mr Kang at Shinhan Investment Corp. He adds that although there have been measures to allow investment banks to engage in more activities, the trend in South Korea is not going towards a universal banking model. 

Byoungho Kim, deputy president and group head of the corporate banking group at Hana Bank, says that while it may seem that the recent reforms are blurring the lines between the activities of commercial banks and securities companies, the degree of separation between the two is still high. 

Mr Kim, who works in the investment banking division at Hana Bank – a commercial banking subsidiary of Hana Financial Group – notes that the investment banking activities of Hana Bank are only related to lending. “The investment banking activities by the commercial bank are structurally limited to lending and not securities-related activities. If you are involved in any type of securities activity, you have to have a securities licence,” he says. 

Hana Bank’s investment banking department is unable to be involved in securities issuance, but within the financial holding company structure it can refer business and co-operate with Hana Daetoo Securities, the securities company within Hana Financial Group. 

Next generation

Aside from the changes regarding securities companies, there have also been reforms to South Korea's capital markets infrastructure, which allow alternative trading systems (ATS) and other securities exchanges to rival the Korea Exchange (KRX). The opening up of competition is expected to bring new entrants to the market and, in August 2013, the Financial Times reported that Chi-X Global and SBI Japannext were considering setting up an ATS in South Korea. 

Aside from increasing the number of exchanges to boost competition in market infrastructures, there have also been other efforts to mobilise capital for smaller companies. KRX, which operates the benchmark Kospi market for large companies and Kosdaq – South Korea’s equivalent to Nasdaq in the US – has now introduced a third exchange. In July, KRX launched Korea New Exchange, or Konex, which is aimed at younger companies. The move is in line with the government’s initiative to build a creative economy and help start-ups through investment, rather than financing. 

For companies that are even younger and smaller, KCMI's Mr Kim says that there is the intention to establish a crowdfunding platform. Crowdfunding is already possible through the internet, but the Ministry of Strategy and Finance has stated that it is now being institutionalised. 

The mobilising of capital for such companies will hopefully spur innovation to enable South Korea’s next generation of economic growth. And with the changes in legal framework, South Korea’s capital markets are now in a stage of transition, which is pushing local investment banks to rethink their strategy in this new environment.