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Tackling Korea's Household Debt Problem

Wanjoong Kim, Fellow Unlike in most major economies, which have been undergoing household deleveraging since the global financial crisis, household debt in Korea has continued to grow to burdensome levels. Much of this growth has come in the form of home mortgages, which pose a somewhat unique threat because the majority of mortgages in Korea come with variable interest rates, are not amortized, and require full payment of principal at maturity. This makes them particularly vulnerable to falling home prices, declining incomes, financial market turmoil, or rising interest rates, particularly as they reach maturity. As such, the financial authorities and the financial sector will need to address this issue with care.

Korea's household debt continues to climb even in the wake of multiple financial crises
Korea's household debt grew consistently following the Asian financial crisis and has continued to do so since the global financial crisis, even while most major economies have been undergoing the process of deleveraging. In the years following the Asian financial crisis (1999-2002), it rose by

30-40%, as tax incentives and loosened regulations encouraged increased lending to households by non-banks and credit card companies. During the housing boom of 2005-2006, the growth trend continued on the back of rising home prices and heated competition in the banking sector to expand mortgage lending. In the wake of the global financial crisis, the growth in household lending did slow briefly, but policy support

Figure 1 | Key Periods in the Growth of Korea's Household Debt

Household Debt (Household Financial Debt) 19992002 20032004 20052006 20072010 24.3 (N/A) 4.0 (4.5) 10.7 (11.1) 8.1 (8.7) GDP (Disposable Income) 9.5 (5.6) 7.1 (8.2) 4.8 (4.4) 6.6 (5.3) Reasons for Growth in Household Debt

(Unit: %)

Sharp drop in interest rates Rise in market liquidity Demand for corporate loans Greater demand for household loans Weakening household balance sheets Falling savings rates Credit crunch resulting from credit card crisis (Decrease in non-bank household lending) Overheating in housing (Lending migrates to housing market) Strengthened housing regulations, recovery in corporate demand for funds (Further expansion centered around residential mortgages)

Note: Household financial debt based on Flow of Funds data from the Bank of Korea. Source: Bank of Korea (BOK), Financial Supervisory Service (FSS) Sep 2011 Hana Insight 1

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such as ultra-low interest rates and the expanded provision of liquidity contributed to increased lending to low-income earners and the self-employed, as weak domestic demand pushed them to borrow more from non-bank financial institutions for living and/or operating expenses. In response to growing concerns, the government recently announced its Comprehensive Measures on Household Debt, which were devised to counter the growing potential for household distress in a preemptive and comprehensive manner, and which were designed to address issues particular to Korea. For example, not only does Korea have high levels of household debt, relative to its economic size and income levels, but such debt has continued to grow for quite some time. And in contrast to advanced economies, where ratios of household debt to disposable income have been falling since the global financial crisis, Korea's household debt has continued to rise.
Figure 2 | Household Debt in Key Countries
220 190 160 13 2 130 100 70 40 US UK Japan OECD Avg. Korea

Korea's total household credit, which includes household loans and credit card debt, grew from 214 trillion at end-1999, the tail-end of the Asian financial crisis, to 876 trillion by end-June 2011. Of this amount, residential mortgages account for 48.5%, having grown at an average annual rate of 13% over the same period, much higher than the comparable rate of 7.3% for nominal GDP. The ratio of household debt to disposable income also stood at 146% as of end-2010, a high level compared to the major economies. Household lending by savings banks and non-bank finance companies has been expanding rapidly since 2007. Much of the increase has been focused around home mortgages, but there has also been an increase in lending for the living or operating expenses of lower-income, less-creditworthy individuals, as well as small proprietorships. Some observers believe that the probability of large-scale distress in the household sector is low,
Figure 3 | Household Debt & Disposable Income
160 (%) Household Debt (R) (\ tn) 1,20 0


Household Debt/G DP Household Debt/Disposable Income 172 153 130 110 80 77 86 134


Household Debt/Disp. 14 6.1 Income (L) 1 43 13 8.8 136 .4 12 8.8

1,00 0




11 7.8

120 .4 600

1 13.7 521 543 602 671 744 802 861 937 949 20 03 200 5 200 7 2 009

400 20 11.1Q

Note: Individual debt data from Flow of Funds report (Bank of Korea, end-2009). Japan data as of end-2008. Source: Statistics Korea 2 Hana Insight Sep 2011

Source: Bank of Korea (BOK)

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since overall delinquency rates on home mortgages across the entire financial sector are only 1.68%, while average loan-to-value ratios (LTVs) are only 47%. These ratios are lower than respective household delinquency rates in the US (8.2%), or LTVs in France (80%), the US (75%), or the UK (61%). Also, borrowers from quintiles 4 and 5 of the income distribution (top 40%) account for 66% of total household debt. These comparisons suggest that these debts should be relatively sound, and that a drop in housing prices would have relatively limited impact on Korea's financial sector.1) their ability to pay off their debts, particularly in the event of rising interest rates or other economic shocks. As of end-2010, 93% of outstanding home mortgages were variable-rate. As the reset frequency for most of these mortgages is only three months, many mortgage borrowers are highly vulnerable to changing interest rates. Moreover, bullet-type mortgages, which require full payment of principal upon maturity, accounted for 41.3% of outstanding loans as of end-2010, the risk of such structures being that the repayment burden spikes at maturity. Furthermore, the bottom 40% of income earners (quintiles 1 & 2), many of whom do not have much in terms of assets, have debt-service ratios of 12-20% and loan-to-income ratios in the 300-600% range. Needless to say, such individuals are particularly vulnerable to not being able to handle their bullet payments as they become due. Finally, it is important to note that household deleveraging has been occurring even
Figure 5 | Comparison of LTVs Across Countries
90 80
1 .9 4 1 .9 1 1 .7 6

Korea's housing finance sector has certain structural weaknesses

But the structure of Korea's mortgage market poses some unique risks: the majority of home mortgages are variable-rate and bullet-type, and lower-income households appear to be strapped in
Figure 4 | Household Debt Delinquencies
3 (%) 2 .4 4 2 1 .6 8 Banks Total

(%) 80 75 74 (Average = 71) 64 61

70 60

0 .7 0

0 .5 5 0 .6 0 0 .6 1 0 .4 2


40 30

0 2006 2007 2008 2009 2010







Source: Financial Services Commission

Note: Avg. of 5 countries excluding Korea, as of end-2009. Source: Financial Services Commission

1) Quintile 5 is the top 20% of the income distribution; Quintile 1 is the bottom 20%. Sep 2011 Hana Insight 3

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in countries where high-income earners hold larger proportions of household debt than they do in Korea. Thus, it would not be safe to assume that the highest-income households will be immune to falling into distress. Another factor raising the probability of growing distress in the household debt sector is the recent surge in the number of self-employed persons, many of whom are financially weak. Somewhat ironically, the number of self-employed persons surged following the Asian financial crisis, and this is now one of the major causes of rising household debt. In Korea, self-employed persons comprised 31.3% of the workforce, far higher than the OECD average of 15.8% (as of end-2008). Data shows that self-employed persons have higher average debt levels and debt-to-financial asset ratios than those who are employed as wage earners, suggesting that they There are also many households that have taken out mortgage debt beyond their means, resulting in situations where their mortgage debt-service burdens comprise a large portion of their living expenses, making them vulnerable to default. Although accurate and consistent data on these types of households (known as "house poor") is not readily available, it has been estimated that they comprise about 10% of Korean households.2) House poor households make up a large portion of the 3rd and 4th quintiles, whereas debt-to-disposable income ratios are high in the 1st and 2nd are more vulnerable to macroeconomic shocks. Moreover, they face greater risk of household insolvency because their income levels are generally lower than those of wage earners, and their businesses tend to be concentrated in sectors that are sensitive to the economic cycle, such as restaurants, lodging, retail, and real-estate leasing.

Figure 6 | DSRs & Household Debt Distribution Figure 7 | Additional Interest for 1%p Rise in Rates
30 25 20 15 1 4 .7 10 5 3.8 0
Quint 1 Quint 2 Quint 3 Quint 4 Quint 5 Total


Debt Service Ratio (L) Distribution of Household Debt (R) 49.5


60 50 40

20 16

(\10,000) 16.1 3 .2

Disposable Income Ratio (R) N et Interest Expense (L) 13.0 9 .8 9 .0 1.0 0.4 0.4

(%) 17.1

5 4 3 2 1

2 0 .4

30 1 2 .0 14.8 9.6 22.2 9 .4 9 .1 10 0

1 1 .5 20

4 0
Q uint 1

0 .3 0
Q uint 5

Q uint 2

Q uint 3

Q uint 4

Source: 2010 Survey of Household Finances

Source: 2010 Survey of Household Finances

2) Kim, Jae-Young (2010) estimates 1.98 million households. Hyundai Research Institute (2011) estimates that 1.08 million households (10.1% of all households) have (interest + principal)/(disposable income) ratios of 10% or higher. 4 Hana Insight Sep 2011

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quintiles, showing that debt-service burdens are relatively high for those in the lower income brackets. It is estimated that 8.4% of house poor households cannot service their mortgage debt, much higher than the 2.4% estimate for non-house poor households. Furthermore, since 74.5% of the house poor need their income to make debt payments, there is a high likelihood that a drop in incomes or home prices could make it much more difficult for them to service their debts. As shown above, in the event of a shock such as an economic downturn or higher interest rates, the surge in household debt could have a particularly negative impact on households that are already financially strapped, including those with lower incomes or weak credit, or those who are self-employed or house poor, and this could have knock-on effects on the broader economy. In this way, the government's recent measures for dealing with rising household debt burdens are welcome in that they were designed so as to prevent a financial crisis stemming from Korea's household sector while improving the structural weaknesses of household lending.

Korea's financial regulators have released a broad set of measures to stem the risks of household debt
Near the end of June, Korea's financial authorities revealed the Comprehensive Measures on Household Debt, which are aimed at keeping the growth in household debt at sustainable rates and improving the structure of household debt. The measures were formulated to counter concerns about the growing possibility of rising defaults on household debt in a manner that is comprehensive and ahead of the curve. Broadly speaking, they have four main objectives: (1) Manage the growth of household debt at stable rates, (2) Improve the

Figure 8 | Distribution of House Poor

Quintile 1st 2nd 3rd 4th 5th Overall Proportion of (Principal+Interest)/ Quintile that is Disposable Income House Poor 4.6 11.0 13.9 12.9 8.0 10.1 121.0 77.6 45.9 40.1 33.2 41.6

Figure 9 | Debt-Servicing Capacity of House Poor

Capacity & Method Category Repayable within original term Repayable if loan term extended Not repayable Income Source of Funds for Debt Repayment Sale of real estate Change of residence Percentage(%) 61.2 30.4 8.4 74.5 5.2 7.3

Debt Repayment Capacity

Source: 2010 Survey of Household Finances, Hyundai Research Institute

Source: 2010 Survey of Household Finances, Hyundai Research Institute Sep 2011 Hana Insight 5

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structure of household loans, (3) Strengthen protections for borrowers, and (4) Enhance financing opportunities for lower-income households. With regard to banks, the policy seeks to slow their lending to households by raising BIS risk-weights on variable-rate, bullet-type mortgage loans, and provides incentives to eliminate household lending from internal sales performFigure 10 | Key Points of Korean Government's Comprehensive Measures on Household Debt
Objective Category Details
Apply higher BIS risk-weights to loans that are high-risk or overly concentrated in certain sectors Remove household lending from sales-performance assessments of bank employees Banking Strengthen assessments of borrowers' repayment ability, including stricter DTI standards Shorten deadline for meeting 100% cap on loan-to-deposit (LTD) ratios from end-2013 to end-June 2012 Place limits on growth in credit card performance metrics (credit card assets, new credit card issues, marketing expenses, etc. Non-Banking Introduce stronger regulations on leverage at finance companies to be phased in over several years; Eliminate special treatment for corporate bonds Strengthen loss-provisioning requirements on credit-based loans on a phase-in basis Check Cards Increase share of fixed-rate, amortized mortgages Provide support for fixed-rate, amortized mortgages Offer tax incentives and other inducements to facilitate a shift from the use of credit cards to check cards Expand share to 30% by end-2016, enhance tax incentives Reduce fee to Housing Finance Credit Guarantee Fund for fixed-rate, bullet mortgages Promote banks' issuance of MBS and covered bonds through the Korea Housing-Finance Corporation Waive prepayment penalties for borrowers that refinance from variable-rate to fixed-rate mortgages Reduce risk of variable-rate mortgages by utilizing rate ceilings or encouraging the lengthening of reset periods Expand supply of financing for low-income borrowers (Smile MicroCredit, Sunshine Loans, New Hope Loans) Assist low-income borrowers in restructuring or refinancing their debts

ance assessments. It also brings forward the dates on which regulations on loan-to-deposit ratios go into effect from end-2013 to end-June 2012. With regard to the non-banking sector, including finance companies and especially credit card companies, the policy seeks to contain excessive competition by restricting growth in credit card assets, new credit card issuance, and marketing expenses,

Manage growth of household debt at sustainable levels

Improve soundness of household loans

Strengthen Reduce risks of protections for variable-rate mortgages financial consumers

Enhance low-income Make household loans access to household more accessible for loans low-income borrowers Source : Financial Services Commission 6 Hana Insight Sep 2011

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as well as leverage ratios (total assets/paid-in capital). Surprisingly, the measures use indirect measures to suppress household lending growth in the banking sector, but apply direct measures in limiting the activities of credit card firms and other finance companies. For the banks, however, the financial authorities clarified their policy objective of improving the structural weaknesses in household lending by providing incentives for banks to expand the overall share of fixed-rate, amortized loans. The financial authorities have set a target for raising the share of fixed rate, amortized loans to 30% of residential mortgages by the end of 2016. To achieve this goal, they will require individual banks to submit annual targets while monitoring their progress. Follow-up provisions to the Measures, which were announced on July 27, will require that fixed-rate mortgages have maturities of three or more years, and that reset dates be in intervals of at least five years. They also stipulate that the government, through the Korea Housing Finance Corporation (KHFC), will support purchases and MBS issuance of fixed-rate, amortized loans, and foster the issuance of covered bonds by banks. Finally, they will require that at least 20-50% of the underlying assets of bonds receiving guarantees by KHFC be fixed-rate, amortized loans. The plan also seek to strengthen protections against changes in interest rates by waiving prepayment penalties in cases where variable-rate
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loans are refinanced into fixed-rate loans or rate reset periods are lengthened. It also lays out measures to strengthen the supply of financing to low-income households, in the form of programs such as Smile MicroCredit, Sunshine Loans and New Hope Loans. Furthermore, it will monitor trends in household lending and policy effects going forward, and it may institute supplementary measures such as imposing direct limits on household lending or lowering LTD ratios.

An abrupt contraction in household debt or lending is not likely

As mentioned above, the Comprehensive Measures on Household Debt are intended to slow down growth in household debt, with greater attention paid to non-banks than banks, particularly credit card companies and other finance companies. For the savings bank sector, which has grown rapidly in recent years, they establish standards of soundness, raise minimum provisioning requirements, and strengthen lending standards. For commercial banks, they focus on providing incentives to change the structure of the household debt on their balance sheets by increasing the proportion of fixed-rate, amortized loans. This is not only because banks account for a large amount and proportion of overall household loans, but because direct efforts to regulate growth in household loans could have a negative impact on the broader economy and bring unwanted side effects as well.

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Overall, it appears unlikely that these measures will result in a sudden decline in the balance of household loans in the banking sector. The deadline for complying with LTD ratios of 100% or lower was pulled forward from end-2013 to end-June 2012, but as of the end of March this year the LTD ratios of commercial banks were already at 97.1%, so the impact of the measures should be minimal. Moreover, rather than expanding regulations on DTI standards for lending, the measures leave credit assessments to the discretion of each individual bank, so banks are not under immediate pressure to reduce their housing-related lending. But because of the incentives to increase the share of fixed-rate mortgages, it is likely that new lending will decrease somewhat. In order to expand fixed-rate, amortized mortgages, which currently account for less than 5% of total household loans, into 30% of overall residential mortgages by 2016, over half of new bank loans will have to be made in fixed-rate, amortized form at relatively high interest rates. It thus appears that a reduction in new lending and housing demand are inevitable. If anything, the lack of a mechanism that assists in the transition to a higher proportion of fixed-rate, amortized mortgages may be a problem. As mortgages are shifted into fixed-rate, amortized form, debt-payment burdens will surge. Though there are attempts to strengthen incentives for borrowers to switch from variable-rate to fixed-rate mortgages such as waiving prepay8 Hana Insight Sep 2011

ment penalties or providing tax deductions on the interest portion of mortgage payments it does not appear that such measures will be highly effective.

The proposed measures will require support from follow-up measures

In order for this round of measures to achieve its stated policy goal of preventing a crisis stemming from surging household debt and improving structural weaknesses in the system, a few additional policy considerations must be kept in mind. First, there is a high likelihood that the measures could result in the reduced provision of credit to low-income borrowers with weak credit.

Fortunately, the government has recognized this problem and has established supplementary measures to expand financing opportunities for low-income earners, or provide debt reduction or refinancing opportunities. Such short-term tactics, however, may have their limits. In order to fundamentally improve the debt repayment capacity of households, additional policies to stimulate domestic demand and create new jobs will have to be pursued more actively. Such need will be particularly great in the services sector, which consists of a large percentage of small business owners who are financially weak yet offer high potential for job generation. Second, in order to expand the proportion of fixed-rate, amortized loans to 30% by 2016, the

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government could require that individual banks submit annual plans to increase the share of such loans, either through new lending or through refinancing of existing customers' mortgages. It could also make changes to current tax laws to relieve the immediate spike in payment burdens that would accompany a shift into amortized loans, which would require installment payments of both principal and interest. Under current law, tax deductions for interest payments apply only to homes costing 300 million or less, making the benefit out of reach for most mortgage borrowers in the Seoul Metro Area. Expanding the tax deduction on interest payments to homes costing more than 300 million would provide additional incentive for a greater number of borrowers to refinance into fixed-rate, amortized mortgages. Third, in order to foster the issuance of MBS and covered bonds by banks, additional policy support will be needed. In countries where the proportion of long-term, fixed-rate loans is high, such as the US, Germany or France, banks are able to raise long-term funding through asset-backed products such as MBS or covered bonds, thereby enabling them to reduce market and liquidity risk stemming from duration mismatching. In the U.K., where short-term loans are relatively common, the government passed special covered bond legislation in 2008 in order to foster the use of long-term, fixed-rate loans. Likewise, to foster Korea's covered bond market, related laws will need to devised promptly, particularly with regard to clarification of collateral claims and guaranteeing of dual recourse for investors. And because it is difficult to expand funding through the issuance of covered bonds under current loan-to-deposit regulations, which are based on deposit levels, there is a need to reform this system as well. Finally, there is a need to expand the potential investor base through measures that ease investment restrictions for pension funds or investment funds, or that seek to attract foreign investors.

Figure 11 | Structure of New Mortgage Loans in Major Countries

Proportion of Loans Maturity: 10 yrs Medium-tolong-term & fixed-rate Maturity: 6-10 yrs Maturity: 2-5 yrs. Variable rate or short-term, fixed-rate
Note: As of end-2007 Source: HM Treasury, EMF, ECB

(Unit: %) Denmark 51 49 0 Japan 17 12 61 10 Korea 3 7 90

US 52 2 35 11

UK 1 3 60 36

Germany 28 38 15 19

France 46 12 13 29

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Introducing Covered Bonds to Enhance Housing Finance in Korea

Youngbae Moon, Fellow The continued growth in Korea's household debt has become cause for concern. One way of mitigating the problem would be to shift mortgage loans into long-term, fixed-rate, amortized structures, but this would require that such loans be maturity-matched with long-term funding. Enacting a special law for covered bonds could be helpful in this regard. Covered bond issuance is a funding method that enables issuers to securitize mortgages at a relatively low cost, which thereby helps lower interest rates on home mortgages and reduces debt interest burdens for households. Introducing covered bonds will also help advance the development of Korea's capital markets.

Growing concern about distress in Korea's household debt sector

The growth momentum of the US and other advanced economies has slowed markedly since the global financial crisis, with ongoing turmoil and stress in the global financial markets. In such an environment, there has been growing concern that Korea's household debt may be reaching unsustainable levels. According to multiple press reports, a growing number of households only repay the interest portion of their mortgages, while their capacity to repay principal has dwindled severely. Even in the case of amortized loans, which usually come with a principal-deferral period at the beginning, it has become common practice for the majority of loans to be refinanced as they approach

the point where the bullet principal must be repaid. It is estimated that around 80% of all bank mortgages are interest-only.3) And there is little evidence to suggest that this situation can be easily changed. As such, there is the growing risk that an upward move in interest rates could impair the ability of households to repay even the interest portion of their debt, leading to higher delinquency rates. Even credit-rating firm Moody's has warned that Korea's growing household debts could become a risk for financial institutions.

Long-term lending requires long-term funding

One effective way of reducing some of the risk associated with household debt would be to pro-

3) Financial Supervisory Service. Estimates are based on bank-loan data as of end-September 2010. Commercial banks account for about 75% of all lending in Korea's financial sector. 10 Hana Insight Sep 2011

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vide incentives to urge the refinancing of the existing interest-only residential mortgages into long-term, fixed-rate, amortized loans. But to achieve this goal, it will be necessary to secure adequate funding to satisfy the demand for long-term loans, and to use such funding to extend the term structure of mortgage loans in a manner that minimizes the added burden of having to repay amortized principal. Korean banks have traditionally used deposits with maturities of less than two years to finance their mortgage lending. Consequently, they have not had the incentive to shift from short-term, variable-rate residential mortgages to long-term, fixed-rate ones. The problem with financial institutions using short-term deposits to fund long-term, fixed-rate loans is that it elevates the risk of negative margins and exacerbates liquidity risk stemming from asset-liability mismatching. After all, it is well-known that asset-liability mismatching was one of main causes of the 1997 Asian financial crisis. ferred method in Korea because such a system would not only cost less, but also have a more positive impact than MBS.4) Covered bonds are bonds backed by a cover pool of assets that the issuing financial institution designates as collateral. Covered bonds grant investors dual recourse to both the issuer and the cover pool, thereby enhancing the transparency of the issuance process and providing stronger protections for investors. If the underlying asset becomes distressed, the bank becomes responsible for paying the investors, which means that the credit rating of the bonds is strengthened by the credit of the issuer. Issuers of covered bonds must further grant covered bond investors payment priority over all other liabilities, including deposits. Even if the issuer goes bankrupt, covered bonds maintain utmost seniority in the capital structure, which means that covered bonds generally carry very high credit ratings, higher than those on senior unsecured bonds of the same issuer. Another benefit of residential mortgage securitization is that it helps transfer interest rate risk and prepayment risk to the investor, thus enhancing the creditworthiness of the issuer.

Covered bonds can be a secure way of securing long-term funding

As a solution, residential mortgages can be securitized in order to raise longer-term funding for long-term loans. Broadly speaking, there are two methods of securitizing such mortgages: MBS and covered bonds. Covered bonds would be the pre-

Korea's current legal system is not conducive to covered bonds

One main problem with covered bonds, however, is that their unique features, such as dual recourse or the assignment of preferential collateral

4) A framework for MBS, such as that in the US, would require higher public costs in the form of institutions that would provide public guarantees, such as Fannie Mae and Freddie Mac, or in other types of infrastructure. Sep 2011 Hana Insight 11

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claims on the underlying mortgages to covered bond investors, have collided with the existing legal systems in several countries.5) With dual recourse, if the bonds in the cover pool default, the investor can request repayment from the issuer, and if the issuer goes bankrupt, the investor can request repayment from the borrower. If this right of dual recourse is not guaranteed, however, there remains some uncertainty as to whether the debt will be repaid, making it difficult for the covered bond to receive the highest level of credit rating. In countries where the covered bond markets are developed, such as Germany, France, Spain or Italy, special laws have been enacted to resolve this issue. These special laws have enabled these countries to prevent conflicts with existing legal systems and lower the cost of issuance by providing further assurance to investors. In Korea, it is possible to issue covered bonds within the bounds of the current legal framework. But because there is no applicable law that can provide certainty for investors regarding conflicts with current civil law such as the current limits on how collateral claims can be reassigned, or the lack of means for preventing moral hazard on the part of commercial banks it is difficult for banks to lower the cost of issuing covered bonds. KB

Bank issued covered bonds in May 2009, but they received a credit rating not much different from their own senior unsecured bonds, so there was little benefit in issuing covered bonds. Such high issuance costs have the eventual effect of causing interest rates on long-term home mortgages to rise.

A special covered bond law is needed to reform the long-term housing finance system
There is a need to enact a special law on covered bonds that will establish a system for supplying a variety of long-term, fixed-rate home mortgage products at low cost. The special law must clarify dual recourse rights, the management and liquidation of collateral assets, administrative procedures, and the scope and procedures for the prioritization of investor protections. It should also require banks to establish special accounts for covered bonds, so as to retain their unique advantages, while minimizing any potential disorder that they might create for the current Korean financial system. The shift to long-term, fixed-rate, amortized loans can help to soften the potentially negative impact of Korea's growing household debt problems by helping revamp the system in a preemptive manner.6) The financial authorities will

5) If a financial institution makes a mortgage loan, it maintains possession of the mortgage bond, which means it simultaneously holds the bond and the collateral claim. With covered bonds, the issuer cannot transfer collateral claims because they are inseparable from the underlying bond. Issuing a covered bond entails separating collateral claims from the bonds and passing them on to the investor, which would be in conflict with existing Korean law. 6) For example, if a household with an annual income of 60 million takes out a loan for the full amount of a 300 million home (LTV 100%) at 5% annual interest and is only paying interest, the average monthly financial burden would be 1.25 million, which compared to a monthly income of 5 million would result in a DTI of 25%. If this loan is changed to a 30-year, 12 Hana Insight Sep 2011

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need to expand macro-prudential incentives to borrowers and financial institutions for the smooth functioning of the covered bond market. Based on current LTVs, the asset quality of bank loans is still at safe levels, but there is a high likelihood that household debt conditions will deteriorate, resulting in higher rates of default on bank loans. Thus, in order to preemptively eliminate latent threats to their asset quality, banks will need to play an active role in the establishment of a covered bond market in Korea. For households, long-term, fixed-rate loans will offer greater stability than variable-rate loans. Households can refinance their short-term, variable-rate, bullet-type mortgages into less expensive long-term, fixed-rate, amortized loans using the current tax refund system. ered bonds, banks can reduce the volatility of the assets on their balance sheets, thus enabling them to improve their risk-weighted profitability by enhancing their ability to comply with the Basel 3 liquidity requirements that will go into effect in 2012.

Covered bonds can benefit financial markets and the broader economy
Shifting from variable-rate mortgages to fixed-rate mortgages without a plan for elongating the maturities of mortgages could leave banks more exposed to the risk of negative margins. And since the majority of funding for home mortgages is in the form of deposits or bank bonds with maturities of three years or less, there would be an increased risk of maturity mismatch between deposits and loans as mortgage loan maturities increase. The benefit of covered bonds is that they enable long-term borrowing and would thereby help banks make the transition to a greater proportion of mortgages that are long-term and fixed-rate. Moreover, through the increased issuance of cov-

The establishment of a framework for covered bonds can improve financial-market efficiency by enhancing the transparency of bond issuance, bring about greater diversity of domes-

tically-issued bonds, and increase the volume of transactions, thereby enabling greater portfolio diversification and higher returns for domestic investors through various types of cost savings. The major objectives of domestic investors such as pension funds or insurance companies are not only to achieve improved portfolio diversification and higher returns, but also to increase the duration of their portfolios via investment in longer-term bonds. Covered bonds can provide such institutions with long-term assets that can deliver higher returns that are also more stable.

5% amortized loan, one year after receiving the loan, the average monthly payment including principal would be 1.61 million, which would raise the DTI to 32.2%. In other words, the cost of shifting into an amortized loan would be 360,000 won per month. However, under current laws, tax deductions would apply, so the majority of the increased costs could be received as a year-end tax refund, thus minimizing the actual increase in debt servicing burden. If we apply the income-tax rates of 24% and 15% to this household's 360,000 monthly increase in repayment burden, about 290,000 would be refunded at year-end. Thus, the actual monthly increase in payment burden would be only 70,000 won. Sep 2011 Hana Insight 13

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Recently, foreign investors have been increasing their allocations to Korean bonds, reflecting Korea's strengthened credibility and expectations for a stronger KRW. As of yet, however, the bonds that foreign investors tend to trust the most are government bonds, which provide returns that are not only relatively low but also volatile. Increased issuance of covered bonds can provide these investors with an alternative in the form of long-term bonds offering higher returns with reduced volatility. This would contribute to Korea's efforts to further globalize its bond markets. Korea's current system of home mortgage finance carries high levels of risk not only for specific entities but also for the overall economy. Due to borrowers' credit risk (variable rates and bullet payments) and banks' liquidity risk (short-term deposits, long-term loans), market sensitivity to macroeconomics shocks can be high. In particular, changes in interest rates can have a large impact on the ability of households to service their debts, as they not only magnify household interest-payment burdens, but also tend to reduce the efficacy of monetary policy. But the introduction of a covered bond framework could ease interest rate risk and dampen macroeconomic shocks stemming from banks' liquidity problems. The shift to longer-term interest rates can help transfer the risk of variable rates to investors who are less sensitive to interest rate risk, thereby limiting the impact on borrowers. For
14 Hana Insight Sep 2011

banks as well, liquidity risks would be eased, thereby reducing the impact of exogenous shocks not only on banks but on the financial system as a whole. Moreover, banks can transfer interest rate and prepayment risk to the investor through the issuance of covered bonds, enabling them to reduce interest-rate hedging costs and thereby enhancing the stability of financial markets.

Measures to stabilize the bond market are also needed

As shown above, the introduction of covered bonds to Korea will provide additional incentive for foreign investors to invest in domestic bonds, but this could have both positive and negative effects. On the one hand, issuing corporate bonds in KRW can help domestic corporations keep their funding costs down, while offering KRW-denominated bonds overseas can reduce exchange-rate risk. On the other hand, the larger the proportion of foreign investors in domestic bonds, the greater the potential that monetary policy could lose some of its effectiveness. And just as the sudden flight of foreign exchange by foreign-owned banks during the global financial crisis raised the instability of domestic financial markets to extreme levels, a sudden reversal of portfolio flows through the bond markets could potentially increase FX liquidity risk. Thus, it will be important to monitor market conditions closely, and to find a proper equilibrium between these diverging potential outcomes.

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Savings Banks' Troubles Unlikely to Fade Soon

Jinho Noh, Fellow At the beginning of this year, eight savings banks in Korea had their operations suspended, stirring anxiety among depositors as they scrambled to protect their deposits. Though the initial panic was swiftly stemmed by the government's swift provision of massive liquidity and restructuring plan for the industry, it is too early to say that the problem is behind us. The troubles in Korea's mutual savings banks are unlikely to be resolved over the short term. In fact, the potential for renewed trouble remains high, particularly in light of the relatively high levels of bad debts, the low quality of these institutions' capital, and their excessive exposure to Korea's real estate sector.

Government suspends savings banks and implements measures to stabilize the sector
Early this year, in just over one month, Korea's Financial Supervisory Commission suspended the operations of eight savings banks, beginning with Samhwa Savings Bank on January 14 and ending on February 22. Upon suspending Samhwa's operations, the government stepped in and provided 3 trillion in liquidity support to the Korea Federation of Savings Banks to stem potential runs on savings banks' deposits. In March, it embarked on a restructuring of the savings bank sector by establishing a special-purpose account funded from KDIC bonds and financial institutions' deposit insurance premiums. It then encouraged savings banks to stabilize their operations by loosening regulations and permitting them to engage in business areas such as installment financing. As a result of the government's strong measures, Korea's

savings bank crisis has remained in a period of temporary calm.

Many savings banks short of capital

Despite the government's active im-

plementation of measures to stabilize financial markets, it appears likely that we have not seen the end of savings-bank suspensions. As of end-2010, the assets of Korea's savings banks stood at 86.8 trillion. Of this, loan assets stood at 61.0 trillion, or 70% of assets, and NPLs (defined as loans over 3 months in arrears) stood at 7.0 trillion, or 8.1% of assets. Assets considered difficult to recover, those in the Doubtful or Estimated Loss categories, amounted to 2.4 trillion, or 2.8% of total sector assets. The BIS capital ratio of Korea's savings banks stands at 8.6%, and of this 7.5 trillion of capital, subordinated debt accounts for 1.2 trillion, or 1.3% of total assets. Thus, even if there is no increase in NPLs, no additional capital raised,

Sep 2011 Hana Insight 15

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and no extension of maturities on subordinated debt, if the value of all current NPLs were written down 100 percent, the BIS ratio for the industry would fall into negative territory. Of course, some of these NPLs are adequately secured by collateral, so it would be unrealistic to assume that all NPLs will end up being classified as non-recoverable. But compared to other financial sectors in Korea or savings banks overseas, the degree of financial weakness at Korean savings banks is at serious levels. This is true for the following reasons. First, Korean savings banks' ratio of NPLs to loan assets stood at 11% as of end-2010, a level much higher than other financial sectors as well as similar institutions overseas, such as such as regional savings banks in the US and Japan, which stood at 1.5-2.4% and 2.8%, respectively.

Second, the amount of NPLs at Korea's savings banks exceeds both their total capital and their core capital, a phenomenon that is difficult to find in other sectors of financial services in Korea or in savings banks abroad. To be specific, the NPL-to-assets ratio of Korea's savings banks stands at 8.1%, which is more than 2%p higher than the total capital-to-assets ratio of 5.6%, or the core capital-to-assets ratio of 5.8%. Compare this with the situation abroad, where NPL-to-asset ratios of regional savings banks in the US and Japan are more than 8%p and 1.5%p below their total capital-to-asset ratios, respectively. Third, compared to the average of the past five years, capital raising by Korea's savings banks has been on a downward trend. To illustrate, the average ratios of total capital and core capital to assets at Korea's savings banks has been 6.4% and 6.2%,

Figure 1 | Combined Balance Sheet of Korea's Mutual Savings Banks (as of end-2010)
Assets:86.8tn Liabilities: 82.0tn (94.5% of Assets) Deposits: 76.8tn

Loans: 61.0tn (70.3% of Assets)

BIS Regulatory Capital: 7.5tn (8.6% of Assets)

NPLs: 7.0tn (8.1% of Assets) Doubtful + Estimated Loss: 2.4tn (2.8% of Assets)
Source: Financial Supervisory Service (FSS) 16 Hana Insight Sep 2011

Supplementary Capital: 2.4tn

(Subordinated Debt : 1.2tn)

Core Capital 5.1tn

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respectively, over the past five years, but had declined to 5.6% and 5.8%, respectively, by end-2010. In contrast, as can be seen in Figure 2, the capital adequacy ratios of Korea's commercial banks, as well as savings banks in the US and Japan, have generally been either on the rise or in line with five-year averages. While it is true that the BIS ratios of Korea's savings bank industry have risen somewhat recently, this has been the result not of a rise in core capital such as common equity, but in supplementary capital such as subordinated debt. Thus, if the soundness of savings banks deteriorates, making it harder for them to refinance their subordinated debt, they will find it much more difficult to maintain their BIS ratios at current levels. In general, savings banks focus their operations in a particular geographical area and focus
Figure 2 | Comparison of Korean and Overseas Financial Institutions' Ability to Withstand Losses
Loan-to-Assets NPL-to-Assets NPL Ratio (A) Total Capital Ratio (B) Ratio (AB) Ratio All Banks Banks Korea (end2010) Large Regional Credit Cooperatives Savings Banks Savings Banks: Total US Assets < $100mn (end2010) $100mn > Assets < $1bn Assets > $1bn 1.9 (1.2) 2.0 (1.2) 1.5 (1.1) 3.7 (4.3) 10.8 (10.8) 2.71 (1.74) 1.53 (1.14) 2.38 (1.60) 2.76 (1.76) 71.7 (70.2) 69.0 (70.5) 66.6 (67.0) 56.4 (60.1) 70.3 (73.2) 52.9 (55.5) 58.5 (61.0) 64.3 (67.7) 51.7 (54.1) 1.4 (0.9) 1.4 (0.9) 1.0 (0.7) 2.1 (2.6) 8.1 (7.9) 2.71 (1.74) 1.53 (1.14) 2.38 (1.60) 2.76 (1.76) 7.3 (6.7) 7.3 (6.8) 6.8 (6.0) 8.9 (8.8) 5.6 (6.4) 11.32 (10.44) 11.43 (12.34) 10.05 (10.04) 11.44 (10.45) Capital Ratios BIS Capital Subordinated Core Capital Adequacy Ratio Debt 8.8 (9.0) 8.7 (9.0) 10.0 (9.0) 8.6 (8.4) 10.45 (9.83) 7.3 (6.5) 7.3 (6.5) 7.3 (6.2) 5.8 (6.2) 8.57 (7.77) 1.3 (-) -

Further Trouble in Real Estate Will Exacerbate the Problems at Savings Banks
Despite the host of concerns surrounding savings banks as described above, if the economy improves, leading to a reduction in the NPL ratios of savings banks, or if the savings banks are able to recover a portion of their NPLs thanks to adequate collateral, concerns about inadequate capital at savings banks may be mitigated. But if economic conditions weaken, leading to a rapid rise in savings banks' NPLs, the bad debt problems at Korea's savings banks could grow more severe than they are currently.

11.74 (12.62) 11.00 (11.88) 10.35 (10.23) 10.44 (9.74) 9.48 (9.36) 8.45 (7.54)

Japanese Regional Savings 2.77 (3.19) 69.6 (69.9) 2.77 (3.19) 4.45 (4.45) Banks (end-Sept 2010) Note: 1) Figures in parentheses are 5-year averages 2) Figures for Korea and the US are as of end-2010; Figures for Japan are as of end-September 2010. Source: Financial Supervisory Service (FSS)

Sep 2011 Hana Insight 17

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on strengthening their operations in a way that is relatively neutral to the economic cycle. But because Korea's savings banks' lending is overly concentrated in real estate, they are highly sensitive to the economic cycle, especially real estate. Corporate loans surged as a percentage of savings banks' total loans from 57% in June 2003 to 86% in June 2010, with close to half of these concentrated in real-estate related industries. As a result, the profitability and soundness of Korea's savings banks have become highly sensitive to the domestic real estate market. In other words, of 62.4 trillion of total loans of Korea's savings banks as of end-June 2010, real estate PF loans accounted for 12 trillion (19.2%); real estate and real-estate leasing, 11.3 trillion (18.1%); and construction loans, 6.9 trillion (11.1%). As a result of such imbalances, savings banks have become highly sensitive to the direction of the real estate market. Based on data from December 1999 to June 2010, the NPL ratio of Korea's savings banks

showed a correlation with domestic real estate prices of around -0.4, compared to -0.2 for banks and -0.07 for credit cooperatives. This suggests that, if the real estate market improves, the distressed debt ratios of savings banks will improve faster than other financial sectors, but if the real estate market grows weaker, the bad debt levels of savings banks will rise at a faster rate than other financial sectors. Housing prices bottomed in October 2010 and have been recovering ever since, and from end-2009 through May of this year, the number of unsold housing units declined for seventeen consecutive months. But in the Seoul Metro Area, where most savings banks are concentrated, the number of unsold units remains at high levels (27,225 units in June), despite having bottomed in April 2011 at 25,008 units. Moreover, it is expected that housing orders from two years ago will have a significant impact on housing supply in the near future, as a large volume of housing that was ordered in the second half of 2009 and first half of 2010 will flood the market in the second half of

Figure 3 | Correlations Coefficients Linking Housing Prices to NPL Ratios of Korea's Savings
Home Price Index (t) NPL Ratio of Savings Banks -2 (1 year ago) -1 (6 months ago) 0 1 2 Commercial Banks -0.06 -0.14 -0.19 -0.15 0.01 Nationwide Banks -0.05 -0.14 -0.20 -0.18 -0.01 Regional Banks -0.15 -0.17 -0.19 -0.11 0.11 Credit Cooperatives -0.16 -0.14 -0.07 0.05 0.42 Savings Banks -0.42 -0.44 -0.41 -0.18 0.06

Note: Calculations based on half-year data from Dec. 1999 to June 2010 Source: Financial Supervisory Service (FSS) 18 Hana Insight Sep 2011

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2011 and first half of 2012. Furthermore, interest rate hikes to counter rapidly rising inflation will result in increased housing debt burdens, thus reducing housing affordability. In conclusion, the real estate market is more likely to worsen than improve going forward, which will result in higher levels of NPLs.7) As we have already seen in the initial savings-bank turmoil, if the NPLs ratios at Korea's savings banks remain at current levels or rise, even those savings banks with BIS ratios of 10% or higher cannot be complacent or they may end up having their operations suspended as well.

Figure 4 | Lagged Housing Orders & Inventory

200 (YoY, %) Housing Orders (lagged 2 years, 3MA) 150 Housing Inventory

Figure 5 | Housing Inventory & Prices

-100 (YoY, %) Housing Inventory (L, reverse axis) Housing Prices (R) (YoY, %) 20

-50 0




50 5 100 0


150 200 2002

-100 2003

-5 2004 2006 2008 2010






Source: Bank of Korea (BOK)

Source: Bank of Korea (BOK)

7) On September 18, 2011, the Financial Services Commission suspended the operations of seven more savings banks, including Jeil and Tomato, the second and third largest. As recently as six months ago, the BIS ratios of most of these savings banks was above 5%, but as deteriorating conditions in the real estate sector became reflected on their balance sheets, most of their BIS ratios dropped below 1%. Sep 2011 Hana Insight 19

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Building a Hedge Fund Industry in Korea: Issues & Concerns

Seonghak Ahn, Senior Researcher Warren Park, Senior Researcher As evidenced by the draft amendment on local hedge funds and prime brokers that has recently been released for public review, Korea is on the verge of having its own homegrown hedge fund industry. Many of the overly restrictive regulations that had previously stifled the development of Korean hedge funds are set to be eliminated or eased, while other areas have been given greater clarity. Because of these positive steps, many industry participants are sanguine about the potential for the industry, but some of the optimism may be excessive. This article attempts to outline some potential pitfalls for the industry in its early stages and show how financial regulators and institutional investors must continue to play an important role in ensuring that the industry develops in a manner that is not only sustainable but that promotes financial system stability and investor protections.

New rules on hedge funds and prime brokers are scheduled for enactment
On June 20, proposed revisions to an enforcement decree of the Financial Investment Services and Capital Markets Act (FSCMA) for the fostering of hedge funds and prime brokers in Korea were posted publicly in preparation for passage this October. These revisions were drafted by the financial authorities in response to concerns that the current form of the FSCMA is too restrictive and unable to achieve its stated objectives of promoting the development of Korea's capital markets and "financial investment" (asset management and brokerage) industries. As the financial

authorities have made it their goal to lay the groundwork for the launch of the first onshore Korean hedge fund by the end of this year, these revisions were written to establish a road map for such a process. Supplementary details, such as specifics on required standards for prime brokers, were released on July 26. Now that relevant laws and standards have been established, we can soon expect to witness the launching of a homegrown hedge fund industry in Korea. Based on the current state of Korea's capital markets, however, it is unlikely that the process will be seamless. More likely, the hedge fund industry will go through a process of trial-and-error as it develops in a way that suits Korea's unique circumstances.

20 Hana Insight Sep 2011

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Hedge funds and prime brokers in Korea
Since the passage of the Financial Investment Services and Capital Markets Act in early 2009, offshore hedge funds have been sold to local investors, but there has been a distinct lack of onshore hedge funds. One reason is that, while the FSCMA permitted the establishment and management of onshore hedge funds, it prescribed overly restrictive conditions. For instance, it required onshore hedge funds to invest at least 50% of their assets in companies that are being restructured, and designated only financial institutions or pension funds as eligible investors.8)9) But under the recent revisions, the requirement that at least half of a hedge fund's assets be invested in companies undergoing restructuring was eliminated. Hedge fund assets can now be invested in a discretionary manner into securities, derivatives, real assets, or any other assets with economic value. In addition, individual investors ("qualified general investors") are now permitted to invest in hedge funds as long as they invest 500 million won or more into one fund. With regard to funds of hedge funds (FOHFs), the financial authorities are planning to release guidelines in the third quarter that will cover minimum investment amounts, diversification Asset management firms, securities firms and investment advisory firms will be allowed to manage hedge funds as long they satisfy certain requirements with regard to capitalization, management track records, and relevant hedge fund experience of employees. This new type of onshore hedge fund will be allowed to invest in a wide variety of financial products and assets in a relatively unrestricted and discretionary manner. Moreover, the revisions establish a minimum capitalization requirement at 6 billion, based on consideration of expected costs for employee compensation and facilities, as well as a comparison with other fund categories within the asset management industry. Required hedge-fund management experience standards were set based on investment performance as well as capitalization (in the case of securities firms), and funds under management (in the case of asset management firms).12) As for regulations on hedge-fund expertise, the rules require requirements, etc.10) Moreover, to boost manager autonomy, the amendment proposes looser restrictions on hedge funds' use of short selling or leverage. For instance, it raises the ceiling on leverage from 300% of fund assets to 400%, and raises derivative position limits from the current 100% of fund assets to 400%.11)

8) The FSCMA categorizes private collective investment schemes into three categories: (1) funds offered to 49 or fewer investors (private funds), (2) private-equity funds (PEFs) and (3) private funds for qualified professional investors (onshore hedge funds). 9) "Qualified professional investors" include banks, insurance companies, asset management firms, brokerages, and pension funds and tax-exempt organizations. 10) The Financial Services Commission (FSC) has released material recommending that FoHF investments be at least 100-200 million each and be spread across five to ten single-name hedge funds. 11) The derivative positions limit is the current standard for private funds. Sep 2011 Hana Insight 21

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that each hedge fund be managed by at least three employees with relevant experience in either a domestic or overseas hedge fund. They also provide for additional educational/training programs through the Korea Financial Investment

submit, on a quarterly basis, reports to the FSC on its major strategies, the types of assets it invests in, current leverage and derivatives positions, etc. Finally, prime brokers, which provide comprehensive services to hedge funds and are an inseparable part of a thriving hedge fund industry, are defined by the enforcement decree as entities responsible for securities lending, financing, cus-

Association or other organizations in order to develop specialized personnel in a systematic manner. In line with the global trend toward strengthened oversight of hedge funds, the revisions also strengthen requirements for reporting to the proper authorities in order to enhance investor protections and guard against systematic risk, without jeopardizing the autonomy of the hedge fund manager. Hedge fund managers will be required to

tody, clearing and reporting on investors. The revisions to the enforcement decree legally distinguish prime brokers from regular securities firms by creating a new category, "integrated financial investment provider," otherwise known as an investment bank. Only these investment banks are granted permission to engage in the prime bro-

Figure 1 | Key Aspects of the Newly Proposed Rules for Hedge Funds
Category Investor Qualifications Qualified investors such as financial companies or pension funds In addition to qualified investors, individual investors may now invest in a hedge fund as long as they invest at least 500 million Investment Strategy Restrictions Leverage Limits Derivatives Exposure Limits Hedge Fund Manager Qualifications Reporting Requirements Elimination of requirement that 50% of the hedge funds' assets be invested in a company undergoing restructuring 300% of fund assets 400% of fund assets Derivatives Position Limits: 100% of fund assets 400% of fund assets Securities firms, asset management firms and investment advisory firms are eligible, provided they meet certain standards of capitalization, track record and expert staffing. In parallel with global trend toward stronger regulation of hedge funds, the authorities will require detailed reporting on leverage, derivative positions, strategies, assets invested, etc.

Source: Financial Services Commission (FSC) 12) The FSC has proposed preliminary standards such as 4tn in AUM for asset management firms, paid-in-capital of 1bn for securities firms, and 500bn in discretionary accounts for investment advisory firms. 22 Hana Insight Sep 2011

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kerage business.13) In order to become an investment bank under Korean law, a firm must: (1) be a corporation under commercial law, (2) be engaged in securities underwriting, (3) have at least 3 trillion in paid-in-capital, and (4) possess adequate risk management and other capabilities. analysis is based on the assumption that a certain portion of demand in the existing alternative investment industry in Korea which includes regular private funds, PEF funds, wrap accounts, and discretionary management accounts will migrate toward hedge funds. Rather than looking at the issue in this manner, however, it would probably be more accurate to forecast the potential size of Korea's hedge fund The size of the hedge fund industry will determine the number of asset management firms that enter the space as well as the extent of participation by prime brokers, whereas the extent of participation by capable and well-known prime brokers will also influence the scope of hedge fund activity. Analysis by certain brokerage firms concludes that Korea's hedge fund industry will grow to 42 trillion within the first three years. Such industry based on a comparison of the global hedge fund industry with the global mutual fund industry. Because the global mutual fund and hedge fund industries are very mature, their relative sizes have been relatively stable, even during periods of volatility such as the financial crisis. Between 2005 and 2010, the global hedge fund industry was 7-8% of the global mutual fund industry.14) If we apply this ratio to the domestic

The hedge fund industry will probably start out smaller than expected

Figure 2 | Growth of Alternative Investment Figure 3 | Relative Size of Global Hedge Fund and Vehicles in Korea Mutual Fund Industries
Investment Advisors P rivate Funds (\ tn) 1 4 .6 9 .0 9 5 .7 1 2 1 .8 Discretionary Managers P EF 2 6 .6 2 0 .0 1 0 8 .2 1 2 0 .2

450 400 350 300 250 200 150 100 50 0

30 25 20 15

G lobal Mutual Fund Hedge/Mutual Ratio ($tn)

G lobal Hedge Fund (%) 9.0 8.0







7.0 6.0

1 7 7 .3

1 9 6 .8

2 1 1 .4

2 5 6 .1

10 5

4 2 .7 2007

3 4 .8 2008

3 1 .8 2009

2 3 .3 2010

0 2 005 20 06 20 07 20 08 200 9 201 0


Source: FSS, KOFIA, Hana Institute of Finance

Source: KOFIA, TheCityUK

13) Investment banks will be permitted not only to engage in prime brokerage, but also corporate lending and the settling of orders of non-listed equities without going through an exchange. 14) The ratio was in the 7.42-8.21% range from 2005 to 2010, averaging 7.83%, and was 7.77% at the end of 2010. Sep 2011 Hana Insight 23

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market, based on end-2010 numbers, we derive an expected size for the domestic hedge fund industry that is no more than 18.5 trillion.15) Considering that Korea's capital markets and regulatory system are not as developed as those advanced economies where global hedge funds are most active, however, it appears likely that even this estimate may prove to be overly optimistic, especially for the early stages of Korea's hedge fund industry. Though hedge funds are a potential new source of profit for securities firms and asset managers, it is not clear that the market will be large enough to support these firms' ambitions. Only the largest brokerage firms will be permitted to provide prime brokerage services, but hedge funds can only do business with prime brokers, so this may limit growth of the industry. Other factors that could limit growth of the industry include a potential dearth of prime brokers with the requisite skills and experience to meet hedge funds' needs, limits in the scope of hedge fund strategies that can be carried out in the domestic markets, and a shortage of experienced hedge fund professionals. In particular, Korea's capital-market conditions may restrict the ability of onshore hedge funds to carry out a variety of common hedge fund strategies, so they are likely to be limited to either equity long-short or CTA (managed futures) strategies.

Furthermore, the cost of hiring experienced hedge fund professionals with the requisite overseas experience may be prohibitive, especially in the early stages of the industry, when there are no assurances of profitability. In addition, while it is true that these revisions will probably improve many aspects of the FSCMA, there remain other policy and regulatory factors that could hamper development of the industry. For example, as we have seen during recent episodes of financial market turmoil, Korea's financial regulators are quick to ban short-selling. Such directives may appear to be effective in putting a floor under equity prices in the short-term, but such actions could damage the longer-term development not only of domestic capital market but also the domestic hedge fund industry. Also, the Financial Services Commission is currently in the process of imposing limits on the performance fees that can be charged by investment advisors and discretionary investment managers, another action that could potentially reduce incentives for hedge funds. Finally, current regulations require that short-sellers borrowing shares must put up collateral twice, an obstacle that may be removed later but that currently poses obstacles in carrying out equity long-short strategies.

15) The AUM of public retail funds has been declining recently on account of increased withdrawals. But if we take the average annual growth rate of 7.5% between 2005 and 2010 and apply it to 2013, we can get an expected figure of around 23.8 billion. If we apply this to the global ratio of 7.77%, we can estimate the size of the Korean hedge fund market at around 18.5 trillion. 24 Hana Insight Sep 2011

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Regulatory policy must be consistent, and institutional investors must play a crucial role in self-governance
Despite active efforts to set up a hedge fund industry, a number of impediments may keep the industry from growing as anticipated, particularly at the get-go. Thus, the financial authorities will have an important role to play in helping the industry get off the ground and on the proper path to growth. For example, they will need to be monitor against potential fraud or market-overheating, which could stymie longer-term growth. They will also need to enable fair and healthy competition through a consistent set of regulations and policies. They might also regulate prime brokers in such a way that is conducive to the management of potential systemic risk posed by hedge funds. Over the longer term, the domestic hedge fund industry is likely to grow significantly, as Korea's capital markets continue to evolve. At that point, institutional investors will need to take on a greater role in helping the industry to self-regulate, rather than relying on regulatory authorities to guide its development. As we have seen with global hedge funds, the investor base has been steadily shifting from wealthy individuals to institutional Above all, policy will have to be consistent. As we saw recently, Korean regulators sometimes respond to market turmoil by banning short-selling. While such actions may seem necessary in the short term, they can also damage the integrity and attractiveness of Korea's equity market, particularly for hedge funds that rely on short sales as part of their strategies. To take another example, the financial regulator last year proposed measures to establish a ceiling on performance fees of investment advisors and discretionary investment managers. Such measures are likely to deter many qualified individuals from entering the Korean hedge fund industry.16) Thus, in order for Korea's hedge fund industry to grow successfully, in an environment built on trust, regulators will need to devise policies that reconcile the pursuit of growth with sound risk management, while ensuring that regulations are consistent, credible and conducive to sustainable, market-driven growth. transparency. In Korea as well, the high investment hurdle for individual investors makes it likely that institutional investors will play a much bigger role than individual investors, assuming the restrictions are not eased. Thus, institutional investors will have to play an important role in ensuring that those hedge funds with solid, consistent performance, and strong risk management capabilities, will be able to compete on merit.

investors. Such a trend is beneficial in that such institutions conduct more detailed due diligence and monitoring of hedge funds and demand greater

16) The hedge fund industry already has self-regulation mechanisms. For instance, the use of high watermarks is a way of ensuring that hedge fund managers do not get paid their management fees unless they are performing well. Sep 2011 Hana Insight 25

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The Korea-US FTA and Its Impact on Korean Industry

Gwisoo Jung, Fellow Yoojin Kim, Associate Researcher A renegotiated form of the Korea-US Free Trade Agreement (KORUS FTA) was finally agreed in December 2010. Under the terms of the final agreement, Korea is likely to benefit in the areas of automobiles and textiles, but is likely to remain at a disadvantage in the areas pharmaceutical products and medical devices. As for Korea's pork and food-processing industries, the effects are likely to be more mixed. As the KORUS FTA is expected to be ratified by the Korean and US legislatures in the coming months, now appears to be a good time to review key aspects of the final agreement, with particular attention paid to how changes from the original version signed in April 2007 will impact particular industries.






The net impact of the agreement on Korea's automobile sector should be relatively minor
Since Korea's automobile industry has already built up its ability to compete in the US market, the impact of the KORUS FTA on Korea's automobile industry should be limited. Under the terms of the revised agreement, the planned elimination of 2.5% tariffs on imports of Korean passenger cars has been delayed for four years. This in itself might not seem like a positive. But the Hyundai-Kia Automotive Group has already made significant inroads in its ability to compete in terms of quality and value in certain segments of the US car market, consistently increasing its market share. And based on its typical product lifecycle, its new models can be expected to maintain their com-

KORUS FTA awaits ratification

Negotiations for the KORUS FTA were originally concluded in April 2007 and the treaty formally signed in June 2007. Korea submitted the signed agreement to its National Assembly in January 2008, where it was passed by the Foreign Affairs, Trade and Unification Committee in April 2009, and was awaiting ratification by the entire Assembly. Because of lack of agreement on certain issues, however, the entire process had to be tabled until Presidents Obama and Lee were able to restart the process. The KORUS FTA was renegotiated and finally signed in its revised form in December 2010. It is expected to be ratified by each country's legislature by the end of this year.

26 Hana Insight Sep 2011

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petitiveness for four to five years. Moreover, Hyundai-Kia's plans to further expand its production capacity within the US will make it less reliant on exports, another factor that will mitigate the effects of the delay in the removal of tariffs. Furthermore, although Korea will have to lower its tariffs on imports from 8% to 4%, Korea's domestic market is probably too small to justify large layouts in terms of fixed expenses for US automakers. As such, it is unlikely that the reduction in duties will enable US automakers to make significant inroads into the Korean market. As for safety standards, the revised agreement increased the volume of US autos eligible for self-certification from 6,500 vehicles to 25,000 vehicles. Considering the small volume of US imports, however, the positive impact for US autoFigure 1 | Key Changes to KORUS FTA Provisions Related to the Auto Industry
Category Original Terms (2007 FTA) Renegotiated Terms (December 2010) Korea: Eliminate all tariffs immediately All tariffs eliminated after four years US: Eliminate immediately on vehicles - Korea: Reduce from 8% to 4% on effective date 3000cc or smaller; Phase out on - US: 2.5% for 4 years from effective date, then eliminated vehicles over 3,000cc over 2 years Korea: Phase out over 9 years US: Phase out over 9 years US: Phase out over 9 years Korea (4%) and US (2.5%) will phase out tariffs in equal increments over 4 years - Korea: Reduce from 8% to 4% on effective date US will phase out tariffs (currently 25%) over 9 years, beginning 7 years after effective date Introduction of new safeguard provisions - 10 years beyond full elimination of tariffs; Can be imposed for up to 4 years an unlimited number of times. (Such safeguards have never been used) Korea agreed to recognize and/or accept US safety regulations for imported US cars for up to 25,000 vehicles per automaker

makers should be relatively insignificant. The revised agreement also eases fuel-economy regulations for US imports. This should not be a major plus, however, since US automobiles are generally not as competitive in this area as Korean-made cars. In summary, Korea's auto industry has greatly enhanced its competitiveness and increased its share of the US auto market, and by expanding its local production capacity in the US and thus reducing its dependence on exports, the impact of the delay in the elimination of tariffs should be limited. Moreover, because US automakers' penetration into the Korean car market remains relatively insignificant, it is unlikely that the revised KORUS FTA will have a negative impact on Korea's automakers.

Passenger Cars

Electric Cars

Light Trucks



Safety Standards

Raised from existing standard of 6,500 vehicles

Fuel Economy Source: Press releases

Korean government will adopt fuel Korea agreed to 19% more lenient standards for each US efficiency and emissions standards automaker that sold more more than 4,500 in the 2009 starting in 2012 base year

Sep 2011 Hana Insight 27

Issu e Korea's pharmaceutical products and medical device industries are likely to be disadvantaged by the new agreement
Under the revised KORUS FTA, the grace period for Korea's implementation of the pharmaceutical patent linkage system has been extended from eighteen months to three years. Historically, Korean pharmaceutical firms have focused on producing generic drugs. Since the patent-linkage system could hinder Korea's drug manufacturers from marketing a generic drug while the original patent is still in effect, the FTA revision is somewhat positive for Korea's drug manufacturers in that they will now have an additional 18 months before their marketing of generic drugs is subject to closer legal scrutiny. Once the patent-linkage system goes into effect, however, Korea's drug makers will likely be at a disadvantage, since it will cause delays and make it

For Korea's auto parts suppliers, the FTA should have a positive effect in terms of helping them reduce their production costs and diversify their revenues. In the case of overseas subsidiaries, the majority of auto parts are delivered to Hyundai-Kia's Alabama and Georgia production centers, so the FTA's elimination of tariffs on auto parts will enable cost savings. Hyundai-Kia should also benefit in that reduced tariffs for its suppliers can be shared as cost-cuts that it can use toward its marketing efforts. This benefit should also apply to US automakers such as GM and Ford, which have not only been using but which are likely to increase their use of Korean-made parts going forward, another factor that should work in favor of Korean auto parts manufacturers. Ultimately, the elimination of tariffs on auto parts should have positive effects for Korea's auto parts suppliers in terms of reducing their costs and helping them to diversify their sources of revenue.

Figure 2 | Estimated Pharmaceutical Losses from FTA Figure 3 | US Market for Expiring Patents
2,000 1,600 1,200 800 400 0 2007 2008 2009 2010 2011
Source: KHIDI (2007 publication), Daeshin Securities 28 Hana Insight Sep 2011

(\100mn) Minimum Maximum

200 160 120


Market Size (L) % of Product Categories (R)


12 10 8 6

80 4 40 0 2009 2010E 2011E 2012E 2013E 2014E 2 0

Source: Shinyoung Securities

Issu e
more difficult to market generic drugs, force Korean firms to spend more on R&D for new drug development, and create a greater burden for the management and marketing departments. In the area of medical devices, US and European manufacturers already have high market shares. Now that Korea has agreed to FTAs with both Europe and the US, it is likely to be further disadvantaged, since their counterparts possess more advanced technology and technological regulations. The US currently levies either no tariffs or tariffs of 2.5-3.7% on domestically produced medical devices, but Korea applies tariffs of 8% on average. One positive, however, is that large Korean companies such as SK and Samsung Electronics are attempting to make inroads into the pharmaceutical and medical device businesses. The entry of these large firms which have significant capital resources, technological knowhow and ability to forge new markets provides With the KORUS FTA set to eliminate tariffs on textile exports to the US, there is hope that Korean textiles will become more hope that Korean medical-device makers may one day be able to compete at a global level.

Textiles should be boosted by enhanced price-competitiveness

price-competitive. The agreement will eliminate 63% (in terms of value) and 87% (in terms of textile categories) of tariffs immediately. Since a large number of Korea's key products are included in the cuts, Korean textiles should become more competitive, since the tariff cuts are expected to result in final price reductions of around 15.8% on a weighted-average basis. If we examine recent trends in exports of Korean textiles to the US, they are growing at about 20% YoY based on data through 2010, but with the passage of the KORUS FTA, tariffs on textiles, which were as high as 32%, will be eliminated. This should significantly

Figure 4 | Korean Textile Exports to US

40 35 30 25 20 15 10 5 0 2000 2004 2008 2012E 20 21 21 ($100mn) Exports to the US (L) Ratio Exported to US (R) 20 19 17 15 12 11 99 9 10 10 25 20 (%) 30

Figure 5 | Textile Imports to US by Country

20 16 12




10 5 0

4 0 2009 2010E 2011E

Source: KOTIS, Hana Institute of Finance (forecast) Sep 2011 Hana Insight 29

Source: KOTIS, Hana Institute of Finance (forecast)

Issu e

boost exports. In addition, the FTA contains strengthened prevention of circumvention provisions, which should help in enhancing the brand image of Korean-made textiles. Considering that a large share of Korea's textile exports goes to the US, and that competition with China is intense, it is likely that the FTA will a particularly positive impact in boosting Korea's textile industry.

processing industry is highly dependent on domestic demand, the impact of the FTA is likely to be minimal.

Though the overall impact of the KORUS FTA is not negative, Korean industry will need to make efforts to enhance its competitiveness
Although there is some disagreement about the ramifications of the FTA, the general consensus is that its impact on Korean industry is not entirely negative. Even in the automotive market, where concerns about the impact were the greatest, any negative effects of the KORUS FTA should be manageable, since Korean automakers have already raised their global competitiveness by increasing their localization of production and enhancing their ability to compete in terms of technology, quality and price. The KORUS FTA contains a number of general provisions related to trade remedies and dispute settlements, and it is not easy at this point to to estimate their impact on potential damages, assignment of responsibility or reparations. But considering that Korea's economy is highly dependent on exports, the KORUS FTA especially since it follows on the heels of the Korea-ASEAN and Korea-EU FTAs is likely to provide a highly positive boost to Korea's manufacturing sector over the long term, in that it will provide a new growth driver in the form of a very large market

Korea's pork industry will be impacted negatively over the long term, but the impact on the food processing industry should be minimal
Imports of US frozen pork amount to US$170 million annually, so the impact of the FTA on related domestic industry will be large. According to the revised agreement, the 25% Korean tariff on imports of US frozen pork will be phased out by January 2016 instead of January 2014, and will be phased out over time: 16% in 2012, 12% in 2013, 8% in 2014, 4% in 2015, and 0% in 2016. The new agreement gives Korea's pork industry two more years of price-competitiveness and less competition in the domestic market, but as the tariffs are phased out, Korea's pork industry will probably not be able to remain competitive over the long-run. Meanwhile, the food processing industry, which uses imported livestock in its products, had hoped that lower tariffs would result in immediate cost reductions, but the delay in the elimination of the tariffs in the renegotiated terms has stymied such hopes. Nevertheless, considering that the food
30 Hana Insight Sep 2011

Issu e
that is relatively unfettered by trade walls. Given that China, India and countries in Southeast Asia and South America have been fast gaining ground on Korea in terms of export competitiveness, the recent series of FTAs involving Korea should help Korea to strengthen the global competitiveness of its major industries over the long term. Indeed, there are those Korean industries that still lack global competitiveness, and they will need to make put forth extra efforts or restructure themselves in order to survive. But such a process should be viewed as a necessary step if Korean industry is to enhance its overall competitiveness in preparation for an increasingly connected and global future.

Sep 2011 Hana Insight 31

M a rke t W a tch e r Interest Rates: Yields fall on overseas turmoil

Seungryong Kim, Assistant Researcher

Throughout the first half of the year, high levels of consumer inflation and rising inflationary expectations continued to apply upward pressure on interest rates. The CPI climbed to 5.3% in August, its highest level in three years, as monsoons and heavy rains took their toll on the supply of agricultural goods. In July, interest rates continued to rise as Greece passed its austerity plan and was granted a second aid package, but as we entered August, concerns about a double-dip in the US and the potential for contagion in the Eurozone caused turmoil across global financial markets, leading to a sharp drop in domestic interest rates. Though the US agreed to raise its debt ceiling in early August following intense negotiations, markets realized that fiscal tightening could lead to a slowdown in the economy. Meanwhile, US GDP growth failed to meet expectations in both Q1 and Q2, at 0.4% and 1.0%, respectively, and weak emFigure 1 | CPI & Expected Inflation Rate
(YoY, %) 6
Perso nal Servic es Servic es (ex-Perso nal) Oil Ind ustrial Pro d uc ts (ex-Oil) Ag ric ultural & M arine CPI E xp ec ted Inflatio n (R)

ployment numbers led to heightened concerns that the US could be headed for another recession. In the Eurozone, weak policy coordination led to delays in providing an aid package to Greece, and markets fretted that fiscal contagion could spill over into Spain or Italy or that France's sovereign-debt rating could be downgraded. Such ongoing risks stemming from the fiscal crisis kept domestic interest rates from rising. Despite ongoing inflationary pressures, the Monetary Policy Committee of the Bank of Korea decided to keep the policy rate on hold in August, concerned that ongoing overseas turmoil could lead to a slowdown in growth, resulting in lower yields at the short end of the curve. At the same time, concerns about a growth slowdown have pushed long-term rates downward, resulting in a flattening yield curve as the spread between yields
Figure 2 | Yield Curves of Korean Treasury Bonds
5.0 4.5 4.0 3.5 2010.12.31 (%)

(YoY, %) 5

2 3 0

3.0 2.5

2011.03.31 2011.07.31 2011.08.31 3M 1YR 3YR 5YR 10YR 20YR

-2 2 0 0 9 .7 2 0 1 0 .1 2 0 1 0 .7 2 0 1 1 .1 2 0 1 1 .7


Source: Bank of Korea, Statistics Korea 32 Hana Insight Sep 2011

Source: KOFIA

M a rk e t W a tch e r
on 10-year and 3-month Korean Treasury Bonds (KTBs) narrowed from 89bp in July to 61bp in August. Though Korea's equity markets continued to experience massive outflows as a result of the global financial turmoil, the bond markets experienced inflows. In particular, in July through August, foreigners' net purchases of bonds with maturities of one year or less fell, whereas their purchases of bonds with maturities of five to ten years increased, the apparent result of increased demand by foreign central banks to diversify their foreign-exchange reserves. Growing purchases of long-term KTBs by foreigners are applying downward pressure on long-term rates. As it is forecast that the recent downgrade of the US will lead to a downward trend in the USD, it is likely that foreigners' purchases of Because it is unlikely that the global financial turmoil or economic slowdown will be resolved in the short term, it will be difficult for domestic interest rates to rise significantly. Also, due to recent concerns about Korea's slowing exports, the potential for an economic slowdown, and lower inflation after September, there is little likelihood that interest rates will increase, particularly at the long end of the curve. Going forward, it is likely that the outcome of policy overseas, such as whether the Eurozone can coordinate effective policy or whether the Federal Reserve will announce an additional round of quantitative easing, will have a greater influence over the direction of interest rates than will domestic economic fundamentals. domestic bonds will continue.

Figure 3 | Foreigners' Net Purchases of KTBs

24 18 12 6 0 -6 9 -2 1 0 -2 1 0 -6 9 - 1 1 0 -1 1 1 -1 8 -5 1 0 -3 0 .9 y 1 .7 y 2 .2 y 2 .4 y 3 .2 y 4 .1 y 5 .8 y 7 .2 y (\ 1 0 0 bn) 2 0 1 1 .5 (%) 2 0 1 1 .6 2 0 1 1 .7 2 0 1 1 .8 P roportion He ld (R) 80 60 40 20 0 -2 0

Figure 4 | Foreigners' Net Purchases of KTBs

50 40 30 20 10 0 1 YR or Less 2 YR 3 YR 4 -5 YR 6 -1 0 YR (%) 2 0 1 1 .4 -2 0 1 1 .6 2 0 1 1 .7 -2 0 1 1 .8

Note: Figures on x-axis are bond numbers and maturities. Source: Infomax

Source: Infomax

Sep 2011 Hana Insight 33

M a rke t W a tch e r Exchange Rate: KRW should regain strength as overseas uncertainties ease
Yootak Jung, Associate Researcher

The USD/KRW exchange rate had been dropping rapidly for over a month since end-June, on account of solid fundamentals and a weakening of the dollar on global uncertainties. Indeed, as a result of favorable news domestically and overseas, including continued strength in Korean exports, an agreement for a second aid package for Greece, and the US agreement on its debt ceiling, the exchange rate even plummeted to 1,050 won at one point in early August. Since then, however, due to concerns over additional contagion in the Eurozone and the potential for a double-dip in the US, it started back upwards again, reaching 1,090 won in the wake of S&P's downgrade of the US and rush to safe assets that ensued. Nevertheless, thanks to the government's capital control measures and improving domestic FX liquidity conditions, the weakening of the won was less severe than the drop in equity markets.
Figure 1 | USD/KRW and Transaction Volume
1160 1140 1120 1100 1080 1060 1040 2 0 1 1.1 (\ ) Exchange Rate (L) Volume (R) ($bn) 9 8 7 6 5 4
0 .0

On balance, it appears that the current overseas turmoil is likely to be brought under control gradually as the advanced economies come together in implementing appropriate policy measures.

Indeed, we have seen signs that the market volatility may be waning somewhat as a result of improving market confidence on the back of policy measures such as the Fed's decision to maintain ZIRP for two more years, hopes for additional monetary stimulus at the FOMC meeting in late September, and hopes that President Obama will unveil positive additional fiscal stimulus and employment generation measures in his upcoming speech in early September. The recent weakness in the US economy appears to have been caused largely by direct shocks such as damage to supply chains from the Japanese earthquake and rising oil prices from unrest in the
Figure 2 | Equity & Exch. Rate Volatility in Crises
3 .0 2 .5 2 .0 1 .5 1 .0 0 .5 Equity Volatility Ex ch. Rate Volatility

3 2 01 1 .3 2 0 1 1 .5 2 0 1 1 .7

Sep-0 8 May-10 Aug-11 (2 00 8.9.16 -1 0 .9 ) (2 0 10 .5 .3 -5 .2 7) (2 01 1.8.1 -8.24 )

Source: Infomax 34 Hana Insight Sep 2011

Source: Hana Institute of Finance

M a rk e t W a tch e r
Middle East, but hopes for a gradual recovery have increased as these factors weaken. In the Eurozone as well, positive developments such as strengthened intra-regional cooperation to overcome the sovereign debt crisis and the ECB's purchases of peripheral countries' sovereign debt should also have a positive impact. And the enhanced efforts of individual countries such as France and Spain in securing fiscal soundness will also help in holding back further contagion. The recent decision by the Fed and the Swiss National Bank and the ECB to reintroduce currency swaps should also help in easing concerns about short-term funding problems in the Eurozone. Considering these factors, our base case is that the USD/KRW exchange rate will return to a gradual downward trend, although lingering external uncertainties, limits to the impact of policy, and market disappointments could still give rise to bouts of increased volatility. Also, since Korea's economy is highly dependent on exports, concerns about a global recession could lead to a drop in exports, which could hurt domestic demand, thereby weakening the economic recovery and potentially limiting upside in the won. Thus, while volatility in the USD/KRW exchange rate is likely to continue over the near term, assuming that external uncertainties ease somewhat and that domestic FX liquidity conditions do not deteriorate further, it will likely find some stability below 1,100 won in the latter part of the year.

Figure 3 | VIX Index vs. Dollar Index

90 80 70 60 50 40 30 20 10 20 08 70 200 9 20 10 20 11 80 75 VIX(L) Dollar Index(R) 95 90 85

Figure 4 | OECD LI Index & Korean Exports

20 15 10 5 0 -5 -1 0 -1 5 2008 OECD+6 N ME(L) Exports(R) 2010 2011 (YoY, %) (YoY, %, 3 MA) 40 30 20 10 0 -1 0 -2 0 -3 0


Source: Bloomberg

Source: Bank of Korea, OECD Sep 2011 Hana Insight 35

M a rke t W a tch e r Equities : Markets fall on European crisis and fears of US double-dip
Kyungshik Yang, Chief Strategist (Hana Daetoo Securities)

Global financial markets were swiftly overtaken by confusion and panic as the resurfacing of sovereign debt troubles in Europe in May continued to take their toll, and the political game of chicken in the U.S. over the debt ceiling resulted in a historic downgrade. Moreover, as Greece went to the brink of default, financial markets in Europe suffered a credit crunch, resulting in severe distress across the European banking system and a massive correction across global equity markets. In the US, the debate over the debt ceiling became a political battle, resulting in a sovereign downgrade by S&P. Moreover, QE2 came to an end at the end of June, and the economy showed enough signs of weakness to cause growing concerns that the US was headed back into a recession. These factors combined to throw global equity markets into a tailspin. In response to such jitters,

Fed Chairman Bernanke announced that the fed funds rate would be maintained its current low levels at least through the first half of 2013, while Obama announced a new stimulus plan worth $447 billion. On the contrary, doubts about the strength of the US recovery and Europe's sovereign debt crisis caused investors to seek shelter in asset classes other than equities. US Treasury yields dropped sharply, gold prices soared to record levels, and the Swiss franc and Japanese yen surged. How the equity markets will perform in the latter part of the year is likely to be largely determined by events during the months of September and October. Whether Europe reaches agreement on a concrete plan to resolve its crisis, or whether Greece ends up defaulting on its debt, it is likely that we will have

Figure 1 | CDS of Europe's Peripheral Countries Figure 2 | Japanese Yen(JPY) and Swiss franc(CHF)
Italy CDS 600 500 400 3000 300 2000 200 100 0 08.1 1000 0 08.7 09.1 09.7 10.1 10.7 11.1 11.7 110 120 1.2 1.1 130 1.3 (bp) Spain CDS Greece CDS (R) 4000 140 (bp) 5000 150 (YEN/EURO) YEN/EURO CHF/EURO (R) (CHF/EURO) 1.6 1.5 1.4

1.0 100 09.9 09.11 10.2 10.4 10.6 10.9 10.11 11.2 11.4 11.6 11.9

Source: Bloomberg, Hana Daetoo Securities 36 Hana Insight Sep 2011

Source: Bloomberg, Hana Daetoo Securities

M a rk e t W a tch e r
more clarity by the end of October. Also, it is likely that the initial impact of the United States' recent monetary and fiscal stimulus measures will more evident in the by the second half of 4Q, thus giving greater clarity on the direction of financial markets in the last part of the year. Domestically, inflation and corporate earnings will be the focus. If the authorities try to control inflation by raising the policy rate, this could cause a spike in household debt burdens. Slow growth in Europe and the US will likely lead to downward revisions in corporate earnings, which will make it difficult to be particularly optimistic about Korean equities in 4Q. Furthermore, periods of inflation tend to lead to lower valuations. Thus, it is important to remember that, although equities may appear to be unEven if domestic factors are stable, considering the high degree of linkages among financial markets, there is a high likelihood that overseas instability could have a negative impact on foreign demand for Korean equities. We expect that some of the uncertainties will be revealed by October, which could cause some temporary pain, but that could also lay the foundation for better prospects in the equity markets going forward. derpriced at this point, the flow of funds into the equity markets is plagued by uncertainty at the moment, so it will be difficult to expect liquidity-driven improvements in valuations.

Figure 3 | 12-M Forward P/E Ratio & CPI

(X) 14 13 12 11 10 9 8 7 6 12MF P/E CPI (R) (%,YoY) 7 6 5 4 3 2 1

Figure 4 | 12-M For. P/E & Foreigner Buying Trend

12MF P/E 14 12 10 8 6 4 2 0 03.1 03.12 04.11 05.10 06.9 07.8 08.7 09.6 10.5 11.4 -40 -60 0 -20 (X) Net Cumulative Foreigner Purchases (R) 40 (tn) 20

5 0 01.9 02.9 03.9 04.9 05.9 06.9 07.9 08.9 09.9 10.9 11.9

Source : Thomson Reuters, Hana Daetoo Securities

Source : Thomson Reuters, Hana Daetoo Securities Sep 2011 Hana Insight 37