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Asia-PacificOctober 3 2016

South Korea moves to reinvigorate limp markets

South Korea’s sound but stagnant capital markets are failing to attract investors. With the main index in the doldrums, the government is now intervening with revitalisation measures such as the launch of a new over-the-counter market. Michael Imeson reports.
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Huntaek Jung

The good news is that South Korea’s capital markets are sophisticated, safe, large and, last year at least, are growing even larger. The not-so-good news is that the equity and debt capital markets are stuck in something of rut, while derivatives trading in particular is still well below its peak of a few years ago.

While the sector’s self-regulatory organisation, the Korea Financial Investment Association (Kofia), tends to accentuate the positive, consultancy firms such as Roland Berger and the Korea Capital Market Institute (KCMI) tend to be more blunt about the negative.

The upside

The current statistics certainly support the view through rose-tinted spectacles. Market capitalisation of the country’s equity capital market (ECM) and debt capital market (DCM) combined rose to Won3,007,705bn ($2683bn) at the end of 2015, up from Won2,792,964bn in 2014, an increase of 7.7%, according to the Korea Exchange Capital Markets Statistics Portal.

The equities and bond markets are roughly the same size, with equities showing a slightly higher rate of growth than bonds in 2015. The statistics are for securities listed on the Korea Exchange, which includes the Korea Composite Stock Price Index (Kospi) for larger company shares, the Korean Securities Dealers Automated Quotations (Kosdaq) for small and medium-sized enterprise (SME) shares, the General Bonds Market and the Korean Treasury Bonds Market.

“Considering capital market growth rates over the past decade, the increase in value [in 2015] was moderate,” says a Kofia spokesman. “There were no particularly sizable initial public offerings [IPOs] or bond issues during 2014-15, nor any significant market events that would have made a significant impact. Higher market capitalisation for the equity market was attributable to the rise in stock indices.”

Success stories

The Korea Exchange is the world’s 14th largest stock market, according to the World Federation of Exchanges, with a market capitalisation of $1259bn at the end of June 2016, up 2.3% on the end of 2015. The exchange is also the world’s 12th largest for derivatives trading, with 794 million futures and options contracts traded and/or cleared in 2015, up 17% on the previous year, according to the Futures Industry Association. This is, however, a significant fall because a few years ago it had one of the world’s biggest exchange-traded derivatives markets by volume of trades.

The country’s first online fund supermarket, Fund Online Korea, which opened in 2014 to allow consumers to invest in a wide range of funds at a reasonable cost, has proved successful. Jointly owned by 41 asset management companies, and based in the Kofia building in Seoul, it had landed 63,138 investors by the end of August 2016, with assets under management totalling Won631.2bn.

Another success has been the Kofia over-the-counter (K-OTC) market, which was designed to revitalise the trading of non-listed securities. “Cumulative trading volume surpassed Won500bn in July 2016, just one year and 11 months after the market’s August 2014 launch,” says a Kofia spokesman.

A total of 136 companies have been traded on the K-OTC market, a 33% rise from when it first opened, and 14 new companies had joined in 2016 as of mid-September. “Efforts to draw more promising SMEs and start-ups to the market will continue, and a variety of investment information, such as corporate analysis reports, will be provided to investors,” adds the spokesman.

Bond caution

Regarding exchange-traded corporate bonds, investors have become more cautious in recent months. “Investors are seeking to minimise risk by investing in bonds with high credit ratings due to Brexit and the possibility of a US interest rate hike,” says Kofia. “Moreover, they are reducing investments in corporate bonds out of concerns over economic uncertainty.”

Korea Treasury bonds worth Won110,100bn will be issued by the government during 2016, a Won800bn increase on 2015, says Kofia. The Ministry of Strategy and Finance is believed to be discussing the issuance of ‘super long-term’ 50-year maturity bonds – to date, the longest maturity for government bonds has been 30 years, issued four years ago.

Despite the growing size and sophistication of the country’s capital markets, several challenges remain, according to the Kofia spokesman. These include, they say, “a stagnant stock market, low return rates for public funds and lack of investor trust, capital outflows, and investments being concentrated in real estate or savings, notwithstanding low interest rates”.

Stagnant Kospi

Huntaek Jung, principal at German strategy consultancy Roland Berger, which has an office in Seoul, explains why the Kospi, the main equities market, is stagnant. “For the past 12 months it has fluctuated inside of the ‘Boxpi’ [boxed-in Kospi] – a term used to describe the long-term stagnant state of the Kospi between 1800 and 2100, with the lowest point of the index at 1835 in February 2016 and the highest at 2066 in September 2016,” says Mr Jung.

“Kospi consists of large South Korean conglomerates such as Samsung Electronics, Hyundai Motors, SK, Posco and LG Electronics, so significant movements outside the Boxpi are unlikely because stocks of conglomerates rarely undergo major fluctuations.”

Another reason why there have been no large movements in the index in either direction is that foreign investors hold nearly one-third of the shares by value, which has had a stabilising influence. So when US interest rates increased and the global oil price fell, the Kospi fell to close to 1800; yet when the oil prices improved, the Kospi rose back up to about 2000.

The Kosdaq, on the other hand, is more volatile and dynamic – with perhaps more potential, consisting as it does of SMEs, many of which are in the technology and biotechnology sector. “Since technology is recognised as a future growth driver, domestic and foreign investors are becoming highly interested in Kosdaq and the index has increased,” says Mr Jung.

Demand for government bonds has remained healthy, despite the South Korea benchmark interest rate having dropped to 1.5% (and being expected to drop below 1%). This is probably because people are anxious about the future of the economy and so want stable investments, “with more domestic investors becoming interested in government bonds”, says Mr Jung. Demand for corporate bonds is less pronounced. It has been undermined to some extent by insolvency fears (Daewoo Shipbuilding and Marine Engineering) and credit rating downgrades (Hyundai Heavy Industry). 

Too rigid

Seiwoon Hwang, head of capital markets at the KCMI, subscribes to the widely held view that the country’s equity market is sound but boring. “There haven’t been many interesting developments in the equity market in the past 12 months,” he says. “The Kospi is trapped between 1800 and 2100. The performance of Korean companies is not bad, but it is not that good either. The market has some downward rigidity, and there is upward rigidity as well. I don’t see big changes ahead, either.”

IPO activity in 2015 was at its highest since 2008, but still not significant, according to Mr Hwang. Bo Yong Ahn, a partner at law firm Kim & Chang, says: “The IPO market was a little slow in the first half of 2016, but we expect it will pick up in the second half.”

The financial authorities took action in March this year to make investing in shares more attractive by introducing a version of the UK’s stocks and shares ISA (individual savings account), which provides tax benefits to investors. “So far, the performance of these ISAs has not been that impressive,” says Mr Hwang. “About 2.5 million people have opened an ISA, but the impact has not been that great.” 

Derivatives down but not out

The prognosis for the derivatives market is downbeat. “Due to investor qualification regulation, Kospi volatility reduction, institutional investor withdrawal and the 2016 derivative transfer tax, domestic derivative trading volume is expected to decrease by more than 100 million transactions relative to the trading volume at the end of 2015,” says Roland Berger’s Mr Jung.

“Moreover, domestic investors have turned their interest to foreign derivatives markets where market-entry regulations [are less restrictive]. Domestic investors' average monthly investment in foreign derivatives has increased to Won250,000bn and is expected to further increase throughout 2016.”

Seo Young Lee, a partner at consultancy firm Oliver Wyman, explains that South Korea used to have the largest listed derivatives market in the world (in terms of the number of contracts traded), the Kospi 200 Options, but it has shrunk considerably in the past five years or so. “It looks like Korea will not, at least in the short to medium term, get to where it used to be in terms of market volume,” he says.

The decline in exchange-traded derivatives in South Korea has happened at the same time as other listed derivatives markets – futures and options exchanges – around the world have grown rapidly as more OTC transactions, many now deemed too risky or too expensive from a capital consumption perspective, have been moved onto exchanges.

The reason for the decline has been action taken by the South Korean authorities, which became concerned at the large numbers of retail investors gambling on derivatives and losing money after the global financial crisis. There was also a scandal in 2011 on the South Korean derivatives exchange, when retail investors again lost out. Regulations were introduced that raised the bar to entry for investors, such as a minimum amount of funds to be held in the trading account and proof that investors were qualified to trade.

“The Korean government is torn as to whether it is a good or a bad thing that market volumes have dropped this much as retail investors have left the market,” says Mr Lee. “Many of these retail investors are gamblers by nature. Just because you shut down one casino doesn’t mean they stop gambling, so they started going to offshore futures and options markets to trade, and they’re losing money in those markets too, which the government has taken note of.

“Maybe it will try to do something to funnel that money back to Korea. But it would be a long shot because once investors start broadening their exposures to international markets, it’s rare that they refocus back on a single market.”

Regulation driving growth?

Financial regulation may have curtailed derivatives trading, but it has been a driver of growth in the equity and bond markets, according to Byunghyun Min, deputy governor of the Financial Supervisory Service (FSS), which regulates and supervises the South Korean financial sector.

 “The market capitalisation of the Kospi is 22 times bigger than it was in 1997 at the time of the Asian financial crisis,” he says. There are many reasons for this, he explains, including the financial and corporate reforms of the past 20 years, such as the Financial Investment Services and Capital Markets Act of 2009. The act consolidated numerous laws and regulations to create more efficiency and strike the “right balance between industry autonomy and investor protection”, says Mr Min.

He agrees, however, that now “the stock markets appear to move only within a narrow range with low volatility” – hence the Boxpi phenomenon. Although this is a challenge it is only to be expected due to the economy maturing, as well as low interest rates, which have discouraged investment in the capital markets.

“Dissatisfied with low returns from traditional investment products, retail investors have started looking for more complex and risky products such as autocallable notes promising high coupon rates,” says Mr Min. “Though the suitability and appropriateness requirements should be met before sales, we are concerned that the number of financial consumers investing in such products is growing. This is more so as banks with more expanded distribution channels than securities firms are allowed to sell some types of financial investment products, such as autocallable notes packaged in a trust contract, which previously used to be available only from securities companies.”

Five initiatives

The government department that oversees the FSS, the Financial Services Commission (FSC), has announced five initiatives to improve the country’s capital markets. The first is structural reform of the Korea Exchange. “The Korea Exchange will be reorganised into a holding company structure where the holding company will go public in an IPO process,” says Mr Min. “The holding company will have four subsidiaries: the Kospi market company, Kosdaq market company, derivatives market company, and market surveillance company.”

The second initiative is helping large securities firms grow even larger. “Securities firms that get bigger in terms of capital size will be offered incentives in the form of easier financing and more businesses,” he says. “Securities firms whose capital exceeds Won4000bn [as of now, only one firm is eligible] will be able to raise funds by issuing bank-type promissory notes directly to public clients, which is similar to banks taking deposits from the public. Securities firms whose capital exceeds Won8000bn [none are eligible now] will be able to operate so-called ‘investment management accounts’ for easier funding.”

The third initiative will improve the marketing and sales of publicly offered funds. For example, distribution channels will be expanded to include post offices, savings banks and credit unions, and performance fees will be paid (currently such fees are paid only in exceptional circumstances).

The other two FSC initiatives are new regulations for listings and public offerings, and new regulations for exchange-traded and OTC derivatives. Details for both have yet to be announced.

Chang Hyeon Ko, a partner in law firm Kim & Chang, believes the conversion of the Korea Exchange into a holding company with a public listing “may have a significant impact on South Korea’s capital markets”. Whether this and the other FSC reforms will revitalise the markets – and in particular allow equities to break out of the Boxpi – remains to be seen.

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