Liberalisation of Korean Financial Markets: An International Perspective

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by Warren Edwardes (right) with Leland Rhee of Arirang TV Korea

This speech was given to The Financial Services Committee of The American Chamber of Commerce in Korea link on Wednesday, 5 March 1997. The speech updated an article published in the Korea AmCham Journal of July/August 1996 which was reprinted in The Korea Times on 19 August 1996. link

"Corea - mercados financieros", 16 Oct. 96, CincoDías, Madrid link

Professor Warren Edwardes is Visiting Professor of financial innovation, engineering and derivatives at the Korea Banking Institute where he helped set up and deliver the International Academy of Banking's MBA in Finance programme.

He is CEO of London-based Delphi Risk Management Limited, the consulting and training firm in financial product innovation, engineering, communication and risk management. He was previously on the Board of Charterhouse Bank and has worked in the treasury divisions of AAA corporation, British Gas, Barclays Bank and Midland Bank. He first researched into what were later to be called "derivatives" in 1975. Since then he has devised and transacted several structures that form part of the history of derivatives. He has also written "Derivitiphobia", which demystifies derivatives, published in the Bridge Guide to Corporate Treasury in Asia 1997.

Plaque of thanks and appreciation from Dr. Kim Si-Dam, President, Korea Banking Institute. 

Liberalisation: External and Internal

The process of capital market liberalisation in Korea consists of moves to globalise and internally liberalise. Globalisation would free up the market to inward and outward investment and financing, allow foreign firms to operate in Korea and allow Korean firms to operate abroad. Internal market liberalisation would allow Korean banks a free hand to operate without the current permit system. Approval is currently needed even for a change in the interest rate on a new product.

external and internal liberalisation and are taking place simultaneously

The two processes of external and internal liberalisation and are taking place simultaneously in Korea. This puts Korean institutions at a severe disadvantage. Being British, it is natural for me to compare the developments in Korea with my own experience in the London market. The UK’s, "Big bang", The Financial Services Act, was felt in 1986. This was typified by the establishment of self-regulatory authorities and the purchase by banks of stock market brokers and jobbers. A mini-bang occurred a decade later as all the significant independent UK merchant banks were bought by large German and Swiss Commercial banks. But the process of UK liberalisation started in 1970. Under "Competition and Credit Control" free domestic competition was ushered in and a variety of financial products were developed to meet customer demand. It was only in 1979 that the UK’s exchange controls were totally lifted. Before that holidaymakers could only take 35 Pounds out of the country!

To put this external liberalisation into perspective, this was before the development of the rapidly changing financial markets we see today with exotic derivatives and structured bonds. LIFFE started trading in 1981. I executed a currency swap in 1980 but as swaps had not yet been invented we called it an "exchange equalisation account"! So internal product liberalisation in the UK started a decade before external liberalisation, well before derivatives and fifteen years before "big-bang".

UK’s former merchant banks and stockbrokers are now owned by foreign commercial banks

Most of the UK’s former merchant banks and stockbrokers are now owned by foreign commercial banks - so what? The employment and skills are still in London which is regarded as the world's international financial capital.

A Big Bang?

What form does Liberalisation take in the Korean Capital Markets? Has it so far amounted to much? Some commentators are already referring to the steady stream of changes in financial market regulations as a Korean "big bang" to compare the process to London’s own market’s opening-up or the US May Day. Despite the very many measures taken, the authorities exhibit an extreme reluctance to release control and rely on market forces. Many a bold step forward has quickly been countered by retrograde measures.

On Jan 7, President Kim Young-Sam announced the formation of a committee to oversee the financial market’s deregulation. The head of the panel, Mr. Park Seoung-Young, is a former head of one of the Korean Chaebols. We heard at our last month’s meeting about the various layers of sub-committees and working parties formed under the Presidential Financial Reform Committee (PFRC).The Ministry of Finance & Economy (MOFE) will not directly participate in the process which will put forward interim proposals this month and medium and long-term proposals by next January 1998. MOFE, however, has submitted proposals to the committee. Far from a "big bang" the opening of the markets has so far been a step-by-step process. Furthermore, Deputy Prime Minister and Finance and Economy Minister Han Seung-soo has ruled out any possibility of such a "big-bang". The Korean financial market eagerly awaits the results of the panel’s deliberations. What changes are we likely to see given the imminent replacement of finance and economy ministers tainted with the Hanbo episode? Just last week, the Korea Fair Trade Commission (KFTC) suggested to the PFRC that the government should not "prod merchant banks to specialise in a given sector". The KFTC also suggested that MOFE should not "tell leasing companies, insurance companies and investment companies what types of services they can offer".

to attract the interest of foreign investors and financiers so as to stabilize the Korean equity market

The Korean authorities are trying one the one hand to attract the interest of foreign investors and financiers so as to stabilize the Korean equity market and meet the requirements laid down by the OECD. On the other hand, there are numerous Korean interests in private industry and government who do not seek a market opening, rapid or otherwise.

External Liberalisation: Joining the club

Much of the impetus toward liberalisation has come externally. The OECD has asked for reform to the financial system to allow the market to become integrated with world markets. It specifically called for the liberalisation of international capital flows. Whilst, to a large extent, Korea has reacted favourably to the OECD’s comments, a Korean government official has recently been quoted as saying that "regulations on the outflow of funds to foreign countries will be toughened to prevent capital flight". The OECD has also called for the abolition of controls on the asset portfolios of financial institutions, the desegmentation of the industry, the removal of restrictions on trade credits and bond transactions and the lifting of barriers to take-overs by foreign companies.

The Equity Market

On 12 July last year, The Ministry of Finance & Economy issued a revised policy aimed at relinquishing its rigid control of the equity market. Eligible private corporations will be able to freely issue shares into the market - Initial Primary Offerings (IPOs) or rights issues - when they wish without having to join any form of supply queue. They may do so, of course, provided that the share issue does not conflict with the government’s privatisation schedule or market conditions. This is now somewhat hypothetical because of the weak Korean stock market. There is also the question of the pricing of IPOs. The pricing is currently regulated as in some other Asian countries. It is to be determined by negotiation between the issuing firms and their lead underwriters.

To counteract this liberalisation, the eligibility restrictions on who can issue into the market will be severely tightened. Issuing firms will have to have a return on paid-up capital of at least 50 % over the previous three years and at least 25 % over the latest year. This will exclude the majority of currently qualified corporations and is looking increasingly stringent.

The authorities have also declared that they will no longer intervene in the market. The daily price fluctuation limit will be expanded from plus and minus 6 % to plus and minus 10 % by the first quarter of this year. "The Stock Market Stabilization Fund" is also being closed. Brokerage houses will also be set free to fix their commissions, currently set at 0.6 % of the transaction amount.

Every time the limit is raised, foreign buyers rush in only to be greeted by an avalanche of Korean investors very eager to sell

Then there is the step-by-step raising of the aggregate limit on foreign share ownership of any individual company. The limit was raised from 15% to 18% last April and on 1 Oct. to 20%. A MOFE official said on Monday that the ceiling will rise "to 23% before June this year". An individual investor’s ceiling is 5% of any firm. At the projected rate of 3% p.a. it will be another 27 years before the limit reaches 100%! However, the stated plans are to abolish the limit by the year 2000. It seems that every time the limit is raised, foreign buyers rush in only to be greeted by an avalanche of Korean investors very eager to sell stock! They are showing increasing signs of resisting the bait!

The Debt Market

Foreigners will not be allowed to invest in the new issue market for government and public debt until interest rates fall "to within 2% of international levels or when the macroeconomy shows stability". Will the door be slammed shut again when Korean rates rise or when the economy shows instability? Investors will not invest unless they see stability in regulations.

Foreigners may, on the other hand, purchase convertible bonds (CBs). The illiberalism here is that the eligible CBs may only be those issued by SMEs and the foreign ownership limit on such debt is set at 30%, due to be raised to 50%, with individual foreign investors limited to 5% of any issue. SMEs, i.e. higher-risk organisations that do not have ready access to domestic lenders, will soon be permitted to issue bonds for exclusive sale to foreigners.

Derivatives

Futures have recently arrived in Korea, long after the establishment of futures markets in Shanghai and Shenzen in "Communist" China. Futures on the Korea Stock Price Index (KOSPI) are now being traded on the Korea Stock Exchange. A rival futures exchange, Korea Futures Association (KOFA) is also being set up to also trade KOSPI, short-term Korean interest rates and the Dollar / Won exchange rate.

Turf problems!

The Stock Exchange futures market is controlled by the securities companies whilst KOFA is owned by the banks. Turf problems! The two futures bodies should merge as they have in the UK, Spain and in most other countries.

Liquidity will continue to be a problem until domestic firms become more comfortable with derivatives and foreign houses are given free access to the market. Foreigners are currently allowed to make investments of upto 15 % of the daily average open interest or gross position over the previous three months. This translates to the total for world-wide investors of about KRW 25,000 million ($30 million). Options on KOSPI are scheduled for July of this year. Derivatives such as FRAs, Swaps and Options have been transacted but liquidity is mimimal. Corporations have to have a specific underlying commercial need to use ordinary forward exchange contracts.

Product development in Korea is difficult as all products require prior approval by the Authorities. Even a slight variation on a product in terms of its price has to be cleared. There is therefore little incentive to invest in research and development. A major hindrance to the development of derivatives in Korea is the lack of a free market or liquidity in the underlying cash instruments. An FRA, swap or interest rate futures market requires a continuously quoted yield curve rather than the set of 3 or 4 rates currently quoted.

Liberalisation - Korean style

Gentle Liberalisation should continue provided that the trade deficit does not continue to deteriorate. Koreans have discovered the joys of foreign travel and the government has decided to impose a travel tax. A prominent Korean newspaper admonished imports and the new rich: "traders should .. resist the impulse to jump at every chance to make profits by bringing .. luxury items into the country and catering to the vanity of some consumers". Measures made to join the OECD have been criticised and a backlash to liberalisation and is being whipped up by willing nationalistic newspapers, the strong farmers lobby and opposition politicians. Anyone passing through Kimpo airport can see at first hand the long queue of Koreans waiting to be cleared by customs. There are numerous bureaucratic ways in which financial liberalisation and globalisation can be slowed down.

Korean financial institutions are showing increasing signs of ingenuity and they will, no doubt, generate innovative solutions to make the most of any market environment. These institutions invest considerable sums in staff training both in Korea and overseas. But unless the Korean financial market is opened up soon, the numerous PhDs and MBAs in Korean banks and securities houses are going to find their advanced degrees a poor substitute for several years of first-hand experience when the market opens up to external competition. Korean financial institutions can regard the opening of markets as a threat or as a challenge. If they grasp the challenge and the global opportunities afforded by open markets, Korean institutions will have to follow the Japanese lead by borrowing foreign ingenuity, experience and expertise with an international perspective to serve their increasingly global client-base - the Chaebols.

two steps forward and one step backward

Liberalisation Korean-style looks like it may mean the abolition of many market controls and the imposition of new ones. The process may be similar to an old-fashioned dance - two steps forward and one step backward; but the quick-stepped amongst the foreign and local financial community will be sure to continue to reap large rewards through the subtly changing Korean financial scene.

everything is illegal unless it is legal

And finally, the Hanbo Steel episode could well prove a blessing in disguise. It will probably act as a catalyst for bank mergers. Hopefully it will do away with the government’s numerous directives to the financial system. But only if Korea moves from a system of bank regulation where everything is illegal unless it is legal; and where every slight product variation requires a permit; will Korean Financial Institutions be in a position to compete and serve their customers efficiently and innovatively.

related article: Study history for liquidity lesson link

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