hana insight (hana institute of finance)_issue#2

Contributors

Editor-in-Chief

Warren Park, Senior Researcher

Feature


Bohyeong Jang, Fellow

Issues


Jinho Noh, Fellow

Wanjoong Kim, Fellow

Wongeun Choi, Fellow

Yunshin Ju, Senior Researcher

Market Watcher

Seungryong Kim, Assistant Researcher

Yootag Jung, Associate Researcher

Kyungshik Yang, Chief Strategist (Hana Daetoo Securities)

Please direct inquiries and comments to Warren Park ([email protected]).

Table of Contents

Feature | 03 | 2012 Outlook: The Korean Economy in the Face of Global

Uncertainties

Warren Park & Bohyeong Jang

Issues | 10 | Assessing the Profitability of Korean Banks

Warren Park & Jinho Noh

| 15 | Unbalanced Foreign Investment in Korean Bonds Poses Potential

Threats

Wanjoong Kim

| 21 | Strengthening the Soundness of Korea's Derivatives Markets

Wongeun Choi

| 26 | Recent Changes in Korea's Retirement Pension System and

Implications

Yunshin Ju

Market

Watcher

| 32 | Interest Rates: Yields should fluctuate narrowly on global

monetary easing

Seungryong Kim

| 34 | Exchange Rate: The Korean won should appreciate, but there are

risk factors

Yootag Jung

| 36 | Equities: Volatility risk remains, but a major correction is unlikely

Kyungshik Yang, Hana Daetoo Securities

Dec 2011 Hana Insight ･ 3

Feature

Global uncertainties spread while the

domestic and global growth outlook

deteriorates

Global financial turmoil resurfaced this

summer, based on fears that the European debt sit-

uation was spinning out of control and that the US

could experience another recession. To those who

thought the recovery from the global financial cri-

sis was complete, or that the sovereign debt ratings

in Europe's periphery were being met with forceful

and effective coordination, the events may have

been an unforeseen blow.

The reality, however, is that the market turmoil

should not have been entirely surprising. After all,

2012 Outlook: The Korean Economy in the Face

of Global UncertaintiesWarren Park, Senior Researcher

Bohyeong Jang, Fellow

As we approach 2012, the global economy is fraught with uncertainty, and Korea is no exception.

In the period of just over three years since the collapse of Lehman Brothers, the global economy has

emerged from the abyss and recovered on the back of a massive and coordinated unleashing of policy

stimulus across the globe, but more recently finds itself increasingly subject to the whims of major

policy coordination. Since Korea is a small, open economy, it cannot be completely immune to turbulence

from overseas. But given its improved fundamentals and the small likelihood of a serious US dollar

liquidity crunch, any negative external shocks to Korea's economy are likely to have a limited impact.

Figure 1 | Global Financial Turmoil Reemerges Figure 2 | Economic Outlook Revised Downward

0

3 0

6 0

9 0

2 0 07 20 08 2 00 9 2 01 0 20 11

(VIX) G lobalF inancial

C risis

2 0 10

Europe anC risis

2 0 11European

C risis

1 .

0

2

4

6

8

10

World US

Euro

zone

China

Korea

JuneOutlook

SeptemberRevisedOutlook

(% (2011)

0

2

4

6

8

10

World US

Eurozo

neCh

ina

Kore

a

JuneOutlook

SeptemberRevisedOutlook

(% (2012)

Source : Bloomberg Source: IMF

4 · Hana Insight Dec 2011

Feature

the debt crisis in Europe has been a topic of atten-

tion since the end of 2009, albeit the subject of

varying degrees of optimism and pessimism, so it

is definitely not something that could not have

been predicted. As for the US, there has been on-

going concern about the threat posed by its bur-

geoning fiscal deficits in the midst of slow growth,

the longtime forecast of those who believed that

the extraordinary policy measures implemented in

the wake of the global financial crisis would even-

tually run out of steam.

While bouts of uncertainty, albeit not the tim-

ing, could have been predicted in advance, there is

the sense that the uncertainty is a greater threat this

time around, especially given that the un-

precedented measures enlisted to deal with the fi-

nancial crisis have not produced the sort of sustain-

able global recovery that had been hoped for.

The most recent turmoil was caused

largely by a crisis of confidence in pol-

icy

To make matters worse, the major economies

are experiencing crises of policy. For one thing,

they already used up much of their available am-

munition when they lowered policy rates to

near-zero level, implemented quantitative easing,

or used the government balance sheet to bail out

failing financial institutions, housing markets, or

even ailing corporations. As as result, there are far

fewer resources available for stimulative mone-

tary or fiscal policy. The more serious crisis of pol-

icy, however, is the significant weakening of poli-

cy credibility. This has been most evident in the

lack of policy coordination in both Europe and the

United States, and it has added a decidedly politi-

cal dimension to the direction of the global econo-

my and financial markets that has heightened

uncertainties.

Figure 3 | Leading & Coincident Indicators Figure 4 | Major Risk Factors in 2012

-6

-4

-2

0

2

4

6

8

10

12

14

2001 2003 2005 2007 2009 2011

88

90

92

94

96

98

100

102

104

106

108

Leading Indicator (L)

Coincident Indicator (R )

(YoY, % ) (C yclical Variable)

1.

European Crisis- Default in the periphery

- Failures of financial institutions

USD Liquidity Crunch- Contagion from Europe to US

- Crunch in money markets

US Sovereign Risk- Failure to agree on debt ceiling

- Additional sovereign downgrade

China Hard-Landing- Sharp drop in export demand

- Local government debt risks

Domestic Credit Crisis- Drop in housing prices

- Increased debt burdens

Source : Statistics Korea Source: Hana Institute of Finance


Feature

Indeed, the current uncertainties stem from the

global crisis of confidence, particularly in govern-

ment policy, and this loss of confidence has fed

back into the financial system. An example of this

can be seen in the United States and the eurozone,

where a lack of trust in the efficacy of government

guarantees has led to downgrades across the bank-

ing sector. Although such lack of trust in govern-

ment finances is partially the result of government

efforts to socialize financial sector losses in the af-

termath of the financial crisis, such fiscal un-

certainty has the potential to reverse course and

spill back first into the financial system, and sub-

sequently the real economy.

It should thus come as no surprise that, with

heightened risks on the one hand, and a much

smaller range of policy options on the other, there

has been a flurry of downward revisions to the

global economic outlook. Before August, the gen-

eral consensus was that the global economic re-

covery was sustainable enough to commence seri-

ous discussions regarding exit strategies from

overly accommodative policy. But with such rosy

outlooks more the exception than the norm, the fo-

cus of debate now revolves around the likelihood

of a global depression. Perhaps more important,

however, is the growing concern that the global

chaos that took hold of financial markets in August

could rapidly spill over into the real economy, par-

ticularly given the increasing evidence that the de-

gree of interconnectedness between the financial

and real sectors has strengthened recently. Indeed,

there has been a pronounced slowdown in Korea's

growth momentum since 2Q, suggesting the real

possibility that its economy could be headed for an

economic slowdown.

Figure 5 | Growth Trends of Major Economies Figure 6 | Korea's Expt. Dependence & Fin. Openness

-6

-4

-2

0

2

4

6

8

10

2001 2003 2005 2007 2009 2011

W orld Korea

(YoY, %)

1 .

0

20

40

60

80

100

1994 1997 2000 2003 2006 2009

Export Dependence

Financial Openness

(%)

Source : BOK, IMFNote: Financial Openness = Foreign Investment/Nominal GDPSource: BOK


Feature

The current environment is a reminder

of Korea's vulnerability to external un-

certainties

Korea's economy is sensitive to external un-

certainties, especially through financial markets,

since its economic growth is highly correlated

with that of the global economy. Why is this the

case?

First, Korea is highly reliant on overseas mar-

kets, particularly through the channel of exports.

As recently as the early 2000s, exports accounted

for barely over 30% of Korea's nominal GDP.

Now, however, they account for around 50%,

which shows the large role that exports play in de-

termining Korea's growth path, as well as just how

sensitive Korea's economy has become to the

global economic cycle. Indeed, since 4Q 2009,

just after the global financial crisis, Korea's econo-

my has grown by an average of 5.3% YoY per

quarter, while exports' contribution to growth has

averaged 6.5%p YoY per quarter.

Second, Korea's financial markets have grown

very open to cross-border capital flows. Its degree

of financial openness, measured as foreign invest-

ments as a percentage of nominal GDP, stood at

40% in the early 2000s, but this figure has more re-

cently risen to above 80%. Such a high rate of for

eign investment in Korea is the result of its efforts

to develop its financial markets by focusing on fi-

nancial liberalization. The result, however, is that

foreign investment has become a channel through

which external risks are transmitted into the do-

mestic markets. Once clear example of this is the

FX liquidity crisis that occurred during the global

financial crisis. Despite the fact that Korea's direct

exposure to subprime-related investments was

very minimal, Korea's economy was drawn into

the crisis through foreign investment, specifically

the sudden and massive withdrawal of short-term

Figure 7 | Growth in Korea's Exports and Imports Figure 8 | Foreign and EU Investment in Korea

-40

-20

0

20

40

60

2 00 7 2 0 08 20 09 2 01 0 2 01 1 20 12

Ex ports

Imports

(YoY, %) (forecast)

1.

0

1

2

3

4

5

6

7

8

07 EU 08 EU 10 EU 11.6

Equities Bonds Other($100bn)

(33.6)

(29.1)

(27.0)

Source : BOK, Hana Institute of FinanceNote: Figures in parentheses represent foreign investment fromthe EU as share of total foreign investment.Source: BOK (Other includes short-term borrowings)


Feature

funding.

Moreover, Korea's equity and financial mar-

kets possess exceptional liquidity, a factor that can

also serve as a vulnerability. When external tur-

moil intensifies, not only do foreign investors look

first to Korea to lock-in capital gains or secure liq-

uidity, but because the financial markets of China

and other neighboring Asian countries are not as

developed or open, Korea's markets are often used

as a sort of investment proxy for these other

emerging Asian economies.

Spillover effects into Korea's financial

sector should be limited

Even now, there is the possibility that foreign

capital, especially that from Europe, could be

withdrawn in massive amounts in the event of ex-

ternal shocks. However, the likelihood of such an

event remains fairly remote at this time. This is be-

cause, more than anything, the likelihood of a

global dollar liquidity crunch remains fairly low.

Indeed, the current situation is unlike that

which occurred in the aftermath of the Lehman

Brothers collapse. Specifically, it is highly un-

likely that there will be additional market shocks

on the scale of that debacle. Back then, complex

structured products such as CDOs, shadow bank-

ing, and other complex and opaque products and

institutions made it difficult to discern the location

of risk. In the current crisis, where sovereign debt

is the primary culprit, however, it is possible to

identify sovereign debt exposures beforehand,

making it easier to ascertain risks and avoid finan-

cial panic or relentless and indiscriminate

deleveraging.

In addition, the collapse of Lehman Brothers

was such a shock to global financial markets parti-

ally because of a major disruption in US money

markets, which are the main source of global US

dollar liquidity. Granted, there are serious con-

cerns about a potential liquidity crunch centered

around European financial institutions, but this is

Figure 9 | Leading & Coincident Indicators Figure 10 | Global Liquidity Indicators

-6

-4

-2

0

2

4

6

8

10

12

14

2001 2003 2005 2007 2009 2011

88

90

92

94

96

98

100

102

104

106

108

Le ading Indicator (L)

Coincident Indicator (R )

(YoY, % ) (C yclical Variable)

1 .

0

10 0

20 0

30 0

40 0

2 00 8 20 09 2 010 2 011

-40 0

-30 0

-20 0

-10 0

0

US O IS Spread

Euribor O IS Spread

Euro Basis Swap (R)

(bp) (Re verse

ax is, pt)

Source: Statistics Korea Source: Bloomberg


Feature

because USmoney market funds have already cut

their exposures to these institutions in order to

stem losses. As such, there is little sign of a poten-

tial liquidity crunch in either the US or globally, so

the potential for a global financial panic remains

fairly remote.

Korea's improved FX soundness is another

reason for optimism. There are some indications

that recent financial turmoil abroad may have

caused some European financial institutions to

withdraw money from Korea. But considering the

improvements in Korea's fundamentals -- its level

of FX reserves, its ratios of short term to external

debt, its current account surplus, as well as the pre-

emptive measures it has taken, such as entering in-

to multilateral swap agreement -- the likelihood of

an FX liquidity shortage, a chronic concern of the

authorities, remains fairly remote.

Of course, this does not mean that there is no

reason to be concerned about negative overseas

events. Given that foreigners' portfolios invest-

ments in Korea have surged, it is inevitable that

Korea's stock and bond markets will be volatile

during periods of overseas financial turmoil.

Korea will need to remain vigilant of

the potential for shocks in the real

sector

In the event of contagion, however, the recent

crisis is probably more likely to transmit through

the real sector than through the financial channel.

Indeed, the main reason for Korea's rapid recovery

from the crisis has been its robust growth in

exports. But overseas turmoil now appears to be

exerting severe stress on global demand, the direct

result of which could be a contraction in exports.

A less direct effect could be that problems in

household debt or other domestic weaknesses,

which have been veiled to some extent by Korea's

robust performance in exports, could develop into

serious risks.

Figure 11 | Contributions to GDP Figure 12 | Foreign and EU Investment

-10

-5

0

5

10

15

2006 2007 2008 2009 2010 2011

Exports

Construction Inve stment

Facilit ie s Inve stmentP rivate Consumption

G DP G rowth

(YoY, %, %p)

1.

0 5 10 15 2 0

010203 04 0

Shipbuilding

Passenge r Cars

Semiconductors

IT

Stee l P roducts

Oi l P roducts US

Japan

China

EU

SE Asia

ME

Source : BOK Source: Statistics Korea (Bottom axis is for product categories)


Feature

Fortunately, external turmoil has begun to ease

somewhat recently, owing to coordinated policy

efforts in Europe and abroad, as well as rising ex-

pectations of a US recovery. Given the weak state

of global governance, however, there remain

doubts about whether the policy coordination will

be implemented, or the durability of the US

recovery. Given these factors, there is a significant

risk of additional market turmoil going forward,

along with the possibility that the underlying risks

stemming from Korea's household debt sector

could intensify.

But these risk variables are still latent and

could still be contained depending on the degree of

progress made on a variety of domestic and ex-

ternal issues. Thus, despite the existence of latent

risk factors, 2012 will likely experience a gradual

easing of external uncertainties. Moreover, given

that most domestic risk factors are already known,

and that there is still plenty of room for domestic

policy, the likelihood of significant shocks is not

high. Nevertheless, there is the possibility that

downward pressure on domestic and external de-

mand could be rather large.

As external turmoil subsides, growth

should be low in 1H 2012 but rise in

H2

In this context, as Korea's economy absorbs

domestic and external stress, it is likely to bottom

in 1H 2012 and then recover in 2H, driven by an

easing of high oil prices and inflationary pres-

sures, improvement in its terms-of-trade, and a re-

newed recovery in emerging economies. Since it is

likely that turmoil could reassert itself on a limited

basis, there is a good chance that the recovery will

be gradual and limited in degree. As a result,

growth in 2012 may be slightly higher than in

2011, but it will likely be based more on factors

such as pent-up demand or the base effect, rather

than a recovery based on a healthy economy.

Figure 13 | Real GDP & GDP Trend Figure 14 | Key Elements of 2012 Forecast

-6

-4

-2

0

2

4

6

8

2006 2008 2010 2012

90

120

150

180

210

240

270

300G DP G ap

Real G DP (R )

G DP Trend (R)

(%) (\ tn)

1 .

2010 2011 (P) 2012 (E)

World Growth Rate 5.1% 3.8% 3.9%

Advanced Economies 3.1% 1.5% 1.8%

Emerging Economies 7.3% 6.3% 6.1%

Oil Price (Dubai, avg.) 78.1$ 104.7$ 94.3$

Won/Dollar (avg) 1,156₩ 1,105₩ 1,070₩

TB Yield (3Y, avg) 3.72% 3.65% 3.70%

Korean GDP Growth 6.2% 3.7% 3.9%

CPI Growth 2.9% 4.5% 3.4%

Note: HP filtering was used for the trend and GDP gap.Source : BOK, Hana Institute of Finance

Source: Hana Institute of Finance

10 ･ Hana insight Dec 2011

Issue

Korea's banking sector posted record

profits in 1H 2011

In 1H 2011, the net income of Korea's banking

sector rose by 4.8tn to 10.4tn, an increase of￦￦

86% over the same period in 2010. The main fac-

tors contributing to this increase were an increase

in gross income ( 3.5tn) combined with a de￦ -

crease in loss provisions ( 3.3tn), which had a￦

combined impact of 6.8tn on the bottom line.￦

Interest income increased by 0.5tn YoY, based￦

on an expansion in net interest margins (NIMs),

whereas non-interest income rose by 3.0tn￦

YoY, thanks largely to the sale of equity stakes in

1) PPOP = Pre-Provision Operating Profit

Assessing the Profitability of Korean BanksWarren Park, Senior Researcher

Jinho Noh, Fellow

In 1H 2011, Korea's banking industry posted record profits, fueling something of a public backlash aimed

at the perceived greed of the financial industry. A closer look at the components of bank profits, how-

ever, revealed that they were largely the result of temporary factors, such as the sale of stakes in

Hyundai E&C by several banks, as well as a large decline in provisions for loan losses, which were atypically

high in 2010. In other words, the performance of banks in 2011 revealed that the profit structures

of Korea's banks remain very weak. Improving them will be essential in fostering the development

of Korea's financial industry and enhancing its resilience against financial crisis.

Figure 1 | Profit Trends of Korea's Banks (Unit: tn)₩

2005 2006 2007 2008 2009 2010 1H 2011

Impact on

Net Income

(YoY)1H 2010

1. Gross Income 32.1 33.9 42.0 39.6 37.5 45.3 22.9 26.4 +3.5

(Interest Income) (28.0) (29.5) (31.2) (34.5) (32.2) (37.5) (19.0) (19.5) (+0.5)

(Non-Interest Income) (4.1) (4.5) (10.8) (5.1) (5.3) (7.8) (3.9) (6.9) (+3.0)

2. SG&A (cost) 14.6 15.7 17.6 18.2 17.7 18.6 8.8 9.2 -0.4

3. PPOP1) (=1-2) 17.5 18.2 24.3 21.4 19.8 26.7 14.1 17.2 +3.1

4. Provisions (cost) 5.1 5.0 4.5 10.2 12.1 14.1 7.1 3.8 +3.3

5. Operating Income (=3-4) 12.4 13.3 19.8 11.2 7.7 12.5 7.0 13.4 +6.4

6. Non-Operating Income 3.4 4.2 1.3 -0.2 0.8 -0.2 0.1 0.1 -

7. Pre-Tax Income (5+6) 15.8 17.4 21.1 11.0 8.5 12.3 7.1 13.5 +6.4

8. Income Tax (cost) 2.2 3.9 6.1 3.3 1.6 2.9 1.5 3.1 -1.6

9. Net Income (=7-8) 13.6 13.5 15.0 7.7 6.9 9.4 5.6 10.4 +4.8

Source: Financial Supervisory Service (FSS)

Dec 2011 Hana Insight ･11

Issue

Hyundai E&C by a number of banks. Provisions

for losses decreased by 3.3tn YoY. This was due￦

partially to the fact that banks set aside greater

amounts of loss provisions in 2010 on a precau-

tionary basis, and partially due to a shift to IFRS

accounting standards. Meanwhile, increases in

SG&A and income tax contributed to a decline in

income ( 2.0 tn).￦

Koreans banks' profit-generating ca-

pacity remains below pre-crisis levels

Korean banks' gross income margin, a meas-

ure of asset efficiency, was 2.98% in 1H 2011,

while ROAwas 1.18%. Both of these figures were

below pre-crisis levels, in spite of an expansion in

gross income centered around non-interest

income. The structural profit rate, which indicates

a bank's fundamental ability to generate profits by

eliminating the impact of one-time gains, was at

1.48%, also below pre-crisis levels. Interest in-

come margins and net interest margins, the main

components in the profit structure of commercial

banks, were also far below pre-Lehman levels, at

2.20% and 2.36%, respectively. By comparison,

the interest margins and NIMs for US banks with

assets of $1bn or greater were 3.24% and 3.80%,

respectively, over the same period.

Korean banks continue to rely mostly

on interest margins for their profits

Korean banks' profit structures remain inferior

to their counterparts in advanced economies, even

though the performance of those banks has deter-

iorated since the financial crisis. That is, their prof-

it structures remain highly dependent on interest

margins, which tend to be rather low. As in the

United States, regulations separating the oper-

ations of Korean banks and securities firms are

very strict, restricting banks from trading or inves-

ting their own capital, a potential source of non-in-

terest income. Thus, Korean banks have depended

on NIM for the majority of their profits. In Europe

and the UK, by contrast, the separation between

banking, securities firms, and insurance compa-

nies is weak. So while interest income accounts for

a small proportion of profits and NIMs are small,

banks can generate a large proportion of their prof-

its from trading, derivatives, insurance, commis-

Figure 2 | Trends in Profit Indicators of Korea's Banks (Unit: %)

2005 2006 2007 2008 2009 2010 1H 20111H 2010

Gross Income/Total Assets1)

2.98 2.83 3.06 2.44 2.12 2.62 2.66 2.98

- Interest Income/Total Assets 2.60 2.46 2.28 2.12 1.82 2.17 2.21 2.20

- NIM2) 2.81 2.64 2.44 2.30 1.98 2.32 2.36 2.36

Structural Profit Rate3)

1.63 1.51 1.37 1.29 1.06 1.36 1.48 1.48

ROA (Net Income/Total Assets) 1.26 1.13 1.09 0.47 0.39 0.54 0.65 1.18Note: 1) Estimated were used for Total Assets (average balance) for 2011.

2) NIM = (Return on interest-earning assets - Interest paid on borrowed funds) / Interest-earning assets

3) Structural Profit Rate = (Interest Income + Commissions + Income from trust services - SG&A) / Total Assets

Source: FSS


Issue

sions, etc. In Korea, not only are NIMs lower than

those of the United States, the UK or Europe, but

income from commissions is lower as well. Even

with such weak profit structures, however, Korean

banks have been posting relatively strong per-

formance because of the relatively solid quality of

their assets. In fact, during the 2009-2010 period,

the NPL ratio of the Top 4 banks stood at 1.67% in

Korea, versus 5.53% in the US, 5.29% in the UK,

and 4.51% in Europe.

Korea's banks are likely to be hurt by

slowing global growth and fewer op-

portunities for non-interest income

Going forward, it appears that Korean banks

will be faced with gradual downward pressure on

their profit margins as the demand for credit de-

clines and opportunities to generate non-interest

income become more scarce. In the past, net inter-

est spreads on existing loans have been fairly

strong on account of the gradual economic recov-

ery and strength in the area of residential lending.

On a YoY basis, lending increased by 15.1% in

2007, 14.3% in 2008, 4.5% in 2009, 3.4% in 2010

and 5.6% in 1H 2011, whereas net interest spreads

on such loans increased by 3.1% in 2006, 3.0% in

2007, 2.7% in 2008, 2.1% in 2009, 2.7% in 2010

and 3.0% in 1H 2011.

However, the net interest spread on new loans

has been on a downtrend. Given that these loans

will later become existing loans, it is uncertain

whether interest income will be able to continue to

increase.

In 1H 2011, non-interest income increased sig-

nificantly, but the bulk of it was from gains on the

sale of securities, rather than commissions or

trust-related income. This suggests that the up-

trend will be difficult to maintain. Such a rapid

surge in securities-related profits was due to banks'

sales of equity stakes that they had acquired in cor-

porations facing serious liquidity problems.

Figure 3 | Profit Structure of the Top 4 Banks in Major Countries (2009-2010 Avg.) (Unit: %)Korea USA UK Europe China Japan

Rate of

Gain/Loss

Gross Income/Total Assets 2.52 3.62 1.86 2.36 2.67 1.26

POPP Margin 1.25 2.18 0.75 1.02 1.86 0.56

Net Interest Margin (NIM) 2.42 3.11 1.03 1.51 2.44 0.97Adjusted NIM

(Post-NPL writedowns)1.50 1.61 0.36 1.03 2.13 0.68

NPL Ratio 1.67 5.53 5.29 4.51 1.61 1.32

Share of

Gross Income

Interest Income 80.4 75.6 51.1 57.5 79.5 73.5Subtotal 19.6 24.4 48.9 42.5 20.5 26.5

Non-

InterestTrading & Derivatives 2.1 7.5 30.6 11.4 0.6 8.0

Income Securities 6.3 4.5 2.1 1.9 1.0 0.1Insurance-related 0.0 0.6 -10.0 3.1 0.0 0.0Commissions 11.3 11.9 26.1 25.9 18.8 18.4

Source: Bankscope


Issue

Profits were distorted in 1H 2011 by

changes in accounting standards and

lower loss provisions

Although loss provisioning burdens have

eased as a result of changes in accounting stand-

ards and unusually large provisions last year, they

are likely to increase going forward, especially

since losses on real estate PF and other loans are

expected to increase. In 2010, as a precautionary

measure against corporate restructuring and losses

related to real estate PF, the Financial Supervisory

Service issued a recommendation calling for in-

creased loss provisions by banks. The banks

agreed, greatly expanding their loss provisions.

As a result of banks' active asset sales, their

NPL ratios declined in 2011. And as a result of

changes in accounting standards, the burden to in-

crease loss provisions was significantly eased.

Prior to 2011, banks were conservative in setting

aside loss provisions, based on expected losses,

but IFRS accounting standards stipulated that loss

provisions were only required in cases where

"objective losses" had occurred. Because this was

a weakness from the perspective of risk manage-

ment, corporations and financial in the US were

actively in favor of IFRS, whereas the SEC and

other regulatory agencies opposed their adoption.

However, since downward cyclical pressures

are high both in Korea and overseas, and because

there is a high likelihood that losses on real estate

PF loans will increase, it appears likely that the

pressure to raise loss provisions will increase.

Improved bank profit structures will

help strengthen Korea's financial in-

dustry against crises

Thus, rather than focusing on the temporarily

high profit levels of Korean banks, it is more im-

portant that more active efforts be made to im-

prove the feeble profit structures of Korea's banks

so as to prevent the incidence of financial crises

Figure 4 | Trends in Korean Banking's NIMs Figure 5 | Delinquency Rates & NPL Ratios

-1

0

1

2

3

4

5

2001 2003 2005 2007 2009 2011

3YR KTB - 90D CD

NIM on New Loans

NIM on Existing Loans

(%)

Post-Lehman

1 .

-5

0

5

10

15

1999 2001 2003 2005 2007 2009 11.1H

FX Derivatives

Securities-related

Trust-Related

Fees/Commissions

Total

(\tn)

Source: BOK Source: FSS


Issue

and aid in the development of Korea's financial

services industry. Although a decrease in loss pro-

visioning and the sales of stakes in Hyundai E&C

contributed to the growth of Korean banks' profits

in 1H 2011, the reality is that their profitability ra-

tios, and their overall profit structures, which re-

flect the sustainability of their profits, remain very

weak relative not only to peers in other financially

advanced countries but even in relation to China.

The risk in banks having weak profit structures is

that they may be tempted to engage in high-return,

high-risk business, or that it could remain difficult

to accumulate capital, thus hampering their ca-

pacity to expand overseas.

If Korean banks are to improve their profit

structures, which are currently based primarily on

low interest margins, there will be a need not only

for banks to put forth greater efforts, but also for

greater interest and deeper discussion among the

government, academia and the media. After all, he

reason why the non-interest income of Korean

banks is so low is that strengthened regulations

have forced them to reduce their exposure to trad-

ing activities and portfolio investment; there are

no account maintenance fees; and the principle of

separation between banking and industrial firms

has created an environment in which banks have

no choice but to engage in commision-cutting

competition.

Figure 6 | NPLs & Coverage Ratios of Banks Figure 7 | Delinquency Rates & NPL Ratios

0

10

20

30

40

02 03 04 05 06 07 08 09 10 11

0

1

2

3

NPLs (L) Coverage Ratio(R)

(?tn) (%)

1.

0

1

2

3

06 07 08 09 10 11

NPL Ratio

SME LoanDelinquency Rate

Corporate LoanDelinquency RateHousehold LoanDelinquency Rate

(%)

Source: FSS Source: FSS


Issue

Foreign investment in Korean bonds

fell sharply after the financial crisis,

has been rising ever since

Since 2007, foreign investment in Korean

bonds, which includes not only investment in fu-

tures but also arbitrage-type investments in the

spot market, have exerted increasing influence on

the domestic bond market. The increase in invest-

ment in Korean bonds by foreigners was prompted

partially by expanded investment in overseas in-

vestment funds, spurred by improving conditions

in global equity markets and enhanced tax bene-

fits, as well as an increase in the sale of forward

contracts by Korea's exporters, both of which re-

Unbalanced Foreign Investment in Korean Bonds

Poses Potential ThreatsWanjoong Kim, Fellow

On the surface, foreign investment in the Korean bond market appears to be stable, as the amount

of capital being withdrawn by Europeans has been exceeded by capital inflows from Asia. However,

certain imbalances in the way foreigners invest in Korean bonds, such as their tendency to invest primar-

ily in Korean treasury bonds, at particular maturities, as well as the fact that investment volume by

certain institutional investors is very large, pose a latent risk to Korea's bond and currency markets.

Thus, it may be worthwhile to devise measures to induce foreigners to invest in a more diverse range

of Korean bonds and to foster the development retirement pensions and investment in overseas secur-

ities in order to guard against abrupt capital inflows during times of external distress.

Figure 1 | Swap Basis vs. AUM of Overseas Funds Figure 2 | Exch. Rate & For. Holdings of K-Bonds

0

100

200

300

400

500

0 6 .1 0 7 .1 0 8 .1 0 9 .1 1 0 .1 1 1 .1

(bp)

0

2 0

40

60

80

100(\ tn)

AU M ofOverseasInve stmentFunds(R )Swap Basis(L)

2 0

4 0

6 0

8 0

1 0 0

08 .1 0 8 .1 0 0 9 .7 10 .4 1 1 .1 1 1 .1 0

(\ tn) 9 0 0

1 ,1 0 0

1 ,3 0 0

1 ,5 0 0

Fore ign Bond Holdings(L)

KR W /U SD(R )

Note: Swap basis is the spread between the currency swaprate and the interest rate swap rate.Source: KOFIA, FnGuide

Source: FSS, BOK


Issue

sulted in increased arbitrage opportunities as the

spread between currency swaps and interest rate

swaps widened.

During the global financial crisis, there was a

massive outflow of foreign capital from Korea as

global liquidity disappeared. Once the crisis was

overcome, however, attention turned again to the

relative merits of Korea's bond market as an in-

vestment destination, leading to a large inflow of

portfolio investment. Such factors that made

Korea appealing as an investment destination are

its solid fiscal position, the advanced structure of

its markets, and hopes for currency gains based on

an expected uptrend in the KRW.

The increased participation of foreigners in

Korea's bond markets is positive in the sense that

there are more potential buyers, but there is also

need for caution, considering such participation

could also serve as a major source of volatility. In

particular, foreigner investment in Korea bonds

tends to be overly concentrated in certain matur-

ities and bond categories, which could lead to in-

creased instability when market conditions shift.

Recent events in overseas markets

have raised concerns about a sudden

outflow of capital

In August, as the European debt crisis wors-

ened and fears of a US double-dip came to the fore,

global financial market turmoil spread, inciting

concerns about the potential for a massive outflow

of capital and a plunge in the KRW similar to what

occurred during the global financial crisis, when a

lack of global USD liquidity led to a massive out-

flow of capital from Korea and a plunge in the val-

ue of the KRW, as market turmoil spread and ex-

change-rate volatility soared.

During August and September, there was a

clear and significant outflow of European capital

from Korea's equity market, whereas in the bond

Figure 3 | Capital Flows from Foreign Portfolios Figure 4 | Foreign Holdings of Korean Bonds

-6

-4

-2

0

2

4

11.8 11.9 11.10 11.11

(\tn)

Ne t Equ ityPu rchas e

Ne t BondPu rchas e

■

11.8~9

■ 11.10

Non-

Euro

Net Bond Purchases

Euro

KTBs MSBs Other Total

200725.4

(66.1)

11.9

(31.0)

1.1

(2.9)

38.4

(100)

200820.1

(53.6)

16.2

(43.2)

1.2

(3.2)

37.5

(100)

200927.5

(48.8)

28.2

(49.9)

0.8

(1.3)

56.5

(100)

201047.7

(64.4)

25.4

(34.3)

1.0

(1.3)

74.2

(100)

2011.11.2161.1

(70.1)

21.2

(24.3)

4.9

(5.6)

87.2

(100)

Note: Above figures as of 2011.11.21. Figures for bonds arebased on rate of increase/decrease of holdings.

Source: FSS, Yonhap InfomaxSource: BOK, Hana Institute of Finance


Issue

market, there was no such capital flight. On the

contrary, although net inflows into Korea's bond

market declined, foreigner holdings of Korean

bonds actually increased somewhat.

In November as well, as turmoil from the

Eurozone began to spread again, investor interest

turned again to the merits of Korea's bond market,

as central banks from emerging economies and

long-term-oriented institutional investors in

search of currency gains increased their alloca-

tions to Korean bonds, thereby limiting capital

outflows. Since August, foreign investment in

Korea's equity markets has seen a net outflow of

8.4 trillion, whereas foreign holdings in Korea's￦

bondmarket have increased by 2.3 trillion (as of￦

November 18).

Outflows of European capital have

been replaced by inflows from Asia,

but risks of further turmoil remain

With yields on Italian government debt rising

above 7%, indicating that the fiscal turmoil in cer-

tain European countries has been spreading, there

are now growing concerns about the possibility

that France, Italy's largest creditor, could be

downgraded. Indeed, while the PIIGS' external

debt is around $2.48 trillion, Italy's is $940 billion.

French banks' exposure to these countries was

27.4% and 44.3%, respectively, as of June 2011.

If troubled banks in the Eurozone end up re-

questing financial support, this could give rise not

only to turmoil in Europe's financial markets, but

also to credit downgrades in the financial sector as

well as sector deleveraging, throwing the markets

into chaos. Of foreign holdings of Korean bonds,

Europeans hold 25.2 trillion, or 29.1%, of the￦

outstanding amount. However, although the out-

flow of European capital has been replaced by cap-

ital from Asian countries, resulting in a rise in for-

eign holdings of Korean bonds, the risk of further

turmoil and capital outflows remains.

The structure of foreign investment in

Korean bonds also poses the potential

threat of market turmoil

Foreign investment in Korean bonds is tilted

toward mostly KTBs and monetary stabilization

bonds (MSBs). As a result, every half-year, a mas-

sive amount of bonds reach maturity and a high

proportion of bonds have to be rolled over, creat-

ing that threat of capital outflows and increased

volatility. The reason for the disproportionate con-

centration of foreign investment in KTBs and

MSBs is that, as fungible issues, they are highly

liquid, and that it is easy to hedge such investments

through the futures market, in effect making them

risk-free.

Because the increase in investment has been

centered around benchmark KTBs, there have

been market distortions resulting from market

squeezes resulting from excessive concentration


Issue

in certain maturities and a reduction in outstanding

volume, as well as a reduction in the efficacy of

monetary policy. The sudden drop in the yield of

the 3-year KTBmaturing at end-2010 was caused

by the concentrated volume of rollover purchases

by foreigners as well as the decrease in outstanding

volume.

Though capital flows have become more sta-

ble thanks to greater diversification of investing

countries and institutional investors, increased in-

vestment by certain investment funds that consid-

er exchange positions important could become a

risk factor in the event of a sudden change in mar-

ket conditions. One example of such a potential

threat could be Franklin Templeton, which cur-

rently holds around 22 trillion worth of Korean￦

bonds through investment funds registered in the

United States and Europe.

Changes in bond issuance could dis-

tort the market

There are concerns that as the maturity date of

a particular issue that foreigners hold in con-

centrated amounts approaches, there could be a

large amount of rollover purchases centered

around certain issues, resulting in a distortion of

the yield curve along with a weakening in the effi-

cacy of monetary policy. In such a situation, even

if the policy rate is hiked, and increase in foreign

investment in Korean bonds and a drop in

long-term rates stemming from concerns about an

economic slowdown could result in an inverse

yield curve.

In addition, considering the investment be-

havior of foreigners, a slowdown in the growth of

new issuance of KTBs based on the principle of

fiscal balance is likely to give rise to market dis-

tortions and increased volatility. It is forecast that

the net increase in the amount of KTBs will fall

significantly beginning in 2013, but if this is not

Figure 5 | Franklin Templeton's Korean Bonds Figure 6 | Concentration at Certain Maturities

43

59 .963 .764.9

71.9

30.5

16.521 18.7

11.1

0

2

4

6

8

10

8-6 9-2 9-4 10-2 10-6 9-3 11-2 10-5 11-1 11-5

(\ tn )

0

20

40

60

80(%)Holdings(L)

P roport ion He ld(R )

M aturity 1M 7M 1Y

1 M

1Y

7M

2Y

1M

2Y

10M

3Y

10M3Y

7M

4Y

10

4Y

4M

8 .0

9 .5

8 .4

6 .67 .0

0

2

4

6

8

1 0

1 0 .1 1 0 .7 1 1 .1 1 1 .7 1 2 .1 1 2 .7

(\ tn ) R e de m pt ion s

Source: Bank of Korea (BOK) Source: Bank of Korea (BOK)


Issue

accompanied by a change in the market structure,

it is likely that the reduction in the outstanding vol-

ume of KTBs will result in a market with greater

demand than supply.

On the other hand, an increase in the invest-

ment demand for Korean government bonds re-

sulting from regulatory changes in the banking and

insurance industry, combined with increased in-

vestment by foreigners, will be main factors con-

tributing to a prolongation of the low interest rate

environment as well as market distortions. Basel

III regulations on liquidity ratios in the banking

sector and the introduction of risk-based capital re-

quirements in the insurance sector are likely to in-

crease the demand for safe assets, thus resulting in

higher demand for bonds.

Considering the negative side-effects that

could potentially result from imbalances in

Korea's bond market, including increased invest-

ment centered around benchmark KTBs, a con-

centration around certain maturities as a result of

fungible bond issuance, and excessive holdings by

certain institutional investors, there is a need for

appropriate countermeasures. After all, an in-

crease in capital flows resulting from external

shocks will inevitably cause greater volatility in

the exchange rate and the bond market.

Various methods can be utilized to

guard against capital outflows

While it is clear that foreigners' imbalanced

preference for investing in KTBs and monetary

stabilization bonds is due to their high liquidity

and low risk, an indirect cause is the lack of trans-

parency and closed-off nature of Korea's corporate

bond markets. Given that long-term-oriented in-

stitutional investors are expanding their partic-

ipation in Korea's bond markets, there will be a

need to expand available bond investment options,

including in special bonds, such as those of public

corporations, or in covered bonds, through further

Figure 7 | Foreign Holdings of Korean Bonds Figure 8 | Forecast of KTB Issuance and Volume

43

59.963.764.9

71.9

30.5

16.521 18.7

11.1

0

2

4

6

8

10

8-6 9-2 9-4 10-2 10-6 9-3 11-2 10-5 11-1 11-5

(\tn )

0

20

40

60

80(%)Holdings (L)

P roportion He ld(R)

Maturi

ty

1M 7M 1Y

1M

1Y

7M

2Y

1M

2Y

10M

3Y

10M3Y

7M

4Y

10

4Y

4M

IssuanceAmount

Repaid

Amount

Outstanding

Net

Increase

2009 85.0 43.4 280.9 41.6

2010 77.7 48.5 310.1 29.2

2011 78.9 48.5 340.5 30.4

2012(E) 80.9 55.6 365.7 25.3

2013(E) 76.5 65.0 377.2 11.5

2014(E) 77.7 70.4 384.4 7.3

2015(E) 77.0 70.9 390.6 6.1

Source: Yonhap, Infomax Source: Bank of Korea (BOK)


Issue

development of that market.

In order to deal with potential outflows of for-

eign capital, there may be a need to pursue meas-

ures to foster development of managed investment

products, for instance by raising limits on pension

contributions eligible for tax deductions, or by cre-

ating an environment conducive to institutional in-

vestors, so as to expand the base of potential do-

mestic investors in Korean bonds. Fostering the

retirement pension market through expanded tax

deductions on contributions can aid not only in re-

tirement planning for individuals, by inducing

changes in household balance sheets, but can also

contribute to the long-term development of the fi-

nancial industry.

Moreover, given the possibility of a sudden

outflow of capital caused by the large-scale with-

drawal of foreign capital, there is a need to mitigate

the cyclical volatility of FX liquidity by fostering

investment in overseas markets.With regard to the

capital gains of investment funds, in addition to a

mitigation of cyclicality through the introduction

of measures that completely or partially exempt

investors from taxes on investment gains or in-

come, it would be helpful to grant tax deductions

for investments in installment fund products.


Issue

Korea's financial derivatives market

has grown at a blistering pace

Despite its short history, Korea's financial de-

rivatives market has grown rapidly. By 2009, the

trading volume of listed derivatives had grown to

be the largest in the world, an extreme level rela-

tive to Korea's cash markets. The notional value of

trades of listed and OTC derivatives in Korea to-

talled 28.537 quadrilion won in 2010, and is pro-

jected to exceed 30 quadrillion for the first time in

2011. Derivatives trading volume on the Korea

Exchange (KRX) reached 3,752,000,000 con-

tracts in 2010, over double the amount of the sec-

ond largest exchange, and accounting for 16.8% of

the global total.

Highly volatility products, which have be-

come cause for concern lately, have displayed par-

ticularly explosive growth in recent years, with

several such products already amongst the most

traded derivatives products in the world. For in-

stance, in terms of trading volume, the market for

KOSPI index options has easily been the largest in

the world for while now, accounting for as much as

69% of the global market for stock index options

in 2010. In the equity-linked warrant (ELW) mar-

kets, the daily average trading value rose to be sec-

ond-place in the world, behind Hong Kong, since

being established at the end of 2005. The market

for FXmargin trading, which was formed in 2006,

posted trading value of only US$76.5 billion in

2007, but then surged to 492.4 billion in the fol-

lowing year. In 2010, that figure had pulled back

only slightly, to US$463.8 billion. The equi-

ty-linked securities (ELS) market has also been

growing at a rapid pace, with issuance volume

through October of this year at 20 trillion, an in￦ -

crease of over 30% over the previous year.

Strengthening the Soundness of Korea's

Derivatives MarketsWongeun Choi, Fellow

Recently, there has been increasing concern that Korea's derivatives markets have become a playground

for speculation and improper trading practices, fueling heightened criticism. In response to rising criti-

cism, the regulatory authorities have recently released a reform plan designed to strengthen the sound-

ness of the derivatives market while providing greater protections for individual investors. Though it

appears that the objectives and basic direction of the reform plan are appropriate and timely, some

of the specific measures may be somewhat excessive, leading to a shrinkage in the markets over the

short term. Thus, the authorities should have measures in place to ensure their rapid normalization.


Issue

The rapid growth of Korea's de-

rivatives market has been more of a

curse than boon to individual investors

Along with the rapid growth in the market,

there has been increasing criticism about the high

incidence of speculation and unfair trading practi-

ces in Korea's derivatives market, as well as the

high level of participation by non-professional, in-

dividual investors, many of whom end up suffer-

ing significant losses. Individual investors have

played a large role in the growth of Korea's de-

rivatives markets, largely by their participation in

speculative trading in the quest for higher returns.

Given that individuals do not possess the in-

formation or expertise of professional investors,

and that derivatives can be highly risky by nature,

however, individuals investors have consistently

suffered significant losses in this market, to the ex-

tent that it has now become a societal problem.

When it comes to FX margin trading, in-

dividual investors account for the majority of mar-

ket participants yet often do not have an adequate

understanding of the payoff structure or risks in-

volved in each trade, and tend to be lured into em-

ploying high levels of leverage. As a result, the

majority of these individuals (around 90%) suffer

losses on such trades that amount to tens of billions

of Korean won every year.

In the ELW market, which is comprised pri-

marily of individual investors and liquidity pro-

viders (LPs), not only is options trading inherently

high-risk but individual investors are at a sig-

nificant information disadvantage to liquidity pro-

viders, which dominate the market. In addition,

scalper, which comprise a small minority of the

market, tend to have an inordinate amount of con-

trol over the market.

In the ELSmarket, unfair trading based on price

Figure 1 | Traded Value of Korean Derivatives Figure 2 | Traded Volume of Derivatives

0

1

2

3

2006 2007 2008 2009 2010

(\10qdn)

1 .

2006 2008 2010Market

Share

KRX 2,475 2,867 3,752 16.8%

Eurex

(Germany)1,527 2,165 1,897 8.5%

CME

(US)1,403 1,893 1,656 7.4%

NSE

(India)194 602 1,616 7.2%

Euronext 730 1,050 1,223 5.5%

Total 11,882 17,668 22,298 3.9%

Source: Korea Exchange, FSSNote: Unit = million contractsSource: Korea Exchange


Issue

manipulation, as well as the sale of such products

based on incomplete communication of the unique

risks of each product, have played a role in inflict-

ing significant losses on individual investors. A

representative example of such an unfair trading

practice is flooding the market with an underlying

assets immediately before the expiration of hedge

positions. In fact, such a practice occurred in

November 2010, when Deutsche Bank was ex-

posed by Korea's regulators for selling massive

amounts of equities on the expiry date of a short po-

sition in futures index options, enabling them to

reap amassive profit. As for ELS products, there are

many instances in which sales of such products are

made to customer despite inadequate explanation

of the risk, including the fact that such products

have limited liquidity and that there is the potential

for a loss of principal on non-guaranteed products.

The adverse effects of Korea's de-

rivatives market have spurred calls for

market reforms

Because of the high incidence of the problems

mentioned above, increased attention has turned to

the derivatives markets, along with increased calls

on the need to reform the regulatory environment

of Korea's derivatives market so as to enhance its

stability and sustainability. Indeed, such concerns

are reflective of the post-crisis global environment

in which societal demands for strengthened con-

sumer protections and more stable financial mar-

ekts have become a priority. Thus, on December 1,

Korea's financial authorities proposed a detailed

reform plan designed to address some of the prob-

lem arising from Korea's major derivatives mar-

kets through strengthened prudential measures.

The new measures aim to strengthen

regulation of the most problematic

derivatives markets

The regulatory authorities' new prudential

measures are aimed at improving the soundness of

Korea's derivatives markets by reining in ex-

cessive speculation and strengthening protections

for non-professional investors. In particular, they

focus on strengthening rules on themost problem-

atic markets, such as KOSPI options and futures,

the ELW market and the market for FX trading.

With respect to KOSPI 200 options, the meas-

ures raise the contract multiplier from the current

100,000 won to 500,000 won, which is the current

multiplier for KOSPI 200 futures contracts. Wtih

regard to futures trading by individuals, the meas-

ures raise the cash deposit ratio from 1/3 to 1/2.

For the ELW market, the measures limit the

submittal of bid-ask prices by liquidity providers

to the purpose of liquidity provision only. They al-

so limit the number of listings from the current

twice per month to once per month.

For the FX margin trading market, the meas-

ures raise margin requirements and lower leverage

limits to 10 times, while strengthening disclosure


Issue

requirements of trading risks and restricting ex-

cessive marketing practices.

Excesses in the derivatives markets

stem from a variety of problems

The problems in Korea's derivatives market

stem from factors such as its excessive growth rel-

ative to cash markets, the increased variety and

complexity of product structures, the tendency of

investors to seek high returns, and a lack of under-

standing of and/or faith in investment fund

products. Despite the fact that investors need more

education and better risk management in order to

deal with the growth in the derivatives market and

the increased variety and complexity of products,

their lack of understanding has resulted in a grow-

ing gap between professionals and

non-professionals. Nevertheless, investors are

likely to continue to seek higher returns, especially

considering that the economy is likely to remain in

a low-growth environment and that interest rates

will likely remain low aswell. Moreover, there has

been a lack of progress in efforts to rebuild the con-

fidence in the investment fund market that has

been severely damaged by the moral hazard and

disappointing returns of the last few years.

Any reforms of the derivatives market

should take into account their linkages

with their underlying market

The reform plan for Korea's derivatives mar-

kets seeks to protect individual investors, who are

relatively information-disadvantaged, and also

make the markets more sounds, both of which are

worthwhile objectives. At the same time, how-

ever, it would be wise to consider the interlinkages

between the derivatives and cash markets while, if

possible, ensuring that market shocks resulting

from the implementation of such reforms do not

have negative repurcussions beyond the short

term.

Themeasures seek to suppress the incidence of

speculative behavior on the part of individuals in

derivatives markets. They seek to strengthen the

system of educating and marketing the risks of de-

rivatives in order to induce the spreading of sound

investment practices. Their longer-term objective

is to induce investors into the investment fund

markets through beneficial measures such as the

provision of tax benefits.

Themeasures also seek to strengthen monitor-

ing of improper trading behavior, which keeps be-

comingmore sophisticated because of advances in

information technologies and the design of com-

plex structured products. The monitoring and su-

pervision of such activities will have to become

more sophisticated and refined.

Nevertheless, although the derivatives mar-

kets should not become a playground for unbridled

speculation, given that the derivatives market is

tightly interwoven with the cash markets, it is im-


Issue

portant to recognize that large amounts of spec-

ulative transactions are necessary of the hedging

process, a necessary and indispensible function of

derivatives markets. Thus, it is important that re-

formmeasures do not become overly restrictive of

all types of speculative activity, without regard for

their purpose. In this vein, it will be necessary to

continuously develop a variety of new products

that serve a beneficial economic function, such as

futures on stock index volatility, while meeting the

demands of individual investors so that they do not

speculate in a limited number of products.

The derivatives reforms measures are

generally appropriate but may dimin-

ish the markets over a short horizon

First, the measures aimed at suppressing the

indiscriminate participation of small-scale, in-

dividual investors in speculative activities are ap-

propriate in principle. But it should be recognized

that the simultaneous implementation of

broad-reaching or excessive measures could

shock the market and prevent its proper function-

ing beyond the short term. One way of preventing

a severe shock to the market might be to phase in

the measures instead of implementing them all at

once.

As for potentially negative effects of the re-

forms that need to be prevented, two possibilities

come to mind. For example, as a result of a sort of

balloon effect, investors could move en masse to

non-regulated markets or lightly regulated mar-

kets overseas. Or, a lack of market liquidity could

result in market inefficiencies, potentially leading

to greater price volatility or instances of price

manipulation.

Also, considering that the index futures and

options markets are used more often than other de-

rivatives markets for hedging purposes against

cash-market positions, it can be said they play an

important role in the national economy. Thus, it

will be important to minimize or shorten the dura-

tion of any market shocks, should they occur.


Issue

Korea's retirement pension market

picks up growth momentum

Since its introduction in 2005, Korea's retire-

ment pension market has grown at a steady pace.

More recently, however, such growth has accel-

erated, as existing tax benefits on legacy severance

payments schemes were phased out. Corporate

pension assets, which were a modest 14.0 tril￦ -

lion at end-2009, surged by 172% to 38.1 trillion￦

by the end-September 2011. Moreover, with ma-

jor companies such as KEPCO, Kia Motors and

Korean Airlines expected to adopt corporate pen-

sion plans in 2H, and with plans to raise the ceiling

on tax deductions for contributions to corporate

pensions and personal pensions from the current

3 million to 4 million in the current tax year,￦￦

it is forecast that Korea's corporate pension market

could grow to around 50 trillion by end-2011.￦ 2)

Amid this recent surge in growth, recent re-

visions to the Employee Retirement Benefit

Security Act (ERBSA) and the Regulations on the

Supervision of Retirement Pensions have been

passed, paving the way for changes in the size,

quality and dynamics of the market.

The National Assembly ratifies the re-

vised ERBSA

The revised ERBSA was finally passed on

June 30, 2011, even though work on it had begun

in November 2007 and it had initially been sub-

mitted to the National Assembly for legislation in

November 2008. The purpose of the revisions are

to foster the growth of Korea's retirement pension

system by helping Korean citizens to secure their

retirement incomes while strengthening the stabil-

ity of the retirement pension system. Once the

2) Financial Supervisory Service Press Release (August 2011)

Recent Changes in Korea's Retirement Pension

System and ImplicationsYunshin Ju, Senior Researcher

Recent revisions to the Employee Retirement Benefit Security Act (ERBSA) and the Regulations on the

Supervision of Retirement Pensions are likely to have a significant impact on Korea's retirement pension

market. Anticipated changes include an expansion of the potential size of the market, primarily due

to growth in Individual Retirement Pensions (IRP), strengthened protections for plan participants, and

the expanded role of insurance companies. Combined with the active efforts of various market partic-

ipants, such changes are expected to help Korea's retirement pension market to grow not only in terms

of size, but also in terms of quality and sophistication.


Issue

amendment receives presidential approval, it will

go into effect beginning in July 2012. Given that it

specifically seeks to address many of the short-

comings of the current pension system, it is ex-

pected to bring about many changes in Korea's

pension market going forward.

Broadly speaking, the amendment to ERBSA

outlines changes in the following areas: Pension

Adoption, Design & Administration; Pension

Continuity & Benefit Rights; Expansion of the

Pension System; and Administrative

Infrastructure.3)

First, in terms of the Pension Adoption, Design

& Administration category, the revised ERBSA

permits workers to participate in multiple pension

plans, thereby enhancing flexibility in pension de-

sign, while also permitting the use of multi-spon-

sor pensions in order to encourage adoption by

SMEs. Under current law, an employee can

choose either a DB plan or a DCplan, but not both.

In response, the revised ERBSA enhances options

for employees by permitting them to participate in

DB and DC plans simultaneously. In addition, be-

cause administering a single-sponsor pension plan

can be a large burden to small businesses, resulting

in a low rate of adoption, the amendment lays the

framework whereby a representative sponsor may

establish a pension plan (DC only) that can be

adopted by multiple companies.

Second, with regard to Pension Continuity &

Benefit Rights, the amendment limits the circum-

stances under which employees may request early

withdrawals of pension benefits, and permits em-

ployees who are leaving a particular company to

transfer their benefits into an IRP. It also seeks to

3) Ministry of Employment and Labor

Figure 1 | Main Points of the Revisions to the ERBSA

Category Description

Pension Adoption, Design

and Administration

- Permits participation in multiple plans (DB, DC or DB + DC) (Article. 6)

- Introduces multi-sponsor pension system (Article 23)

Pension Continuity &

Benefit Rights

- Imposes new restrictions on interim withdrawals of benefits (Article 8, Clause 2)

- Strengthens continuity of the pension system (Article 17, Clause 4; Article 19, Clause 2;

Article 20, Clauses 5&6)

- Ensures sponsor ability to make benefit payments on DB plans (Article 16, Clauses 2&3)

Expansion of the

Pension System

- Forces newly established business to adopt pension plans (Article 5)

- Expands the Individual Retirement Pension (IRP) System (Article 24, Clauses 2&3)

Business

Practices

- Specifies those entities permitted to engage in pension plan sales activities (Article 31)

- Creates legal basis for the termination of licenses for inactive pension services providers

(Article 27)

- Provides guidelines for the appropriate disclosure of financial transactions involving pension

service providers (Article 37)

Source: Revised version of the ERBSA


Issue

ensure that minimum pension assets are main-

tained at appropriate levels. Under the current sys-

tem, employers are permitted to honor requests for

interimwithdrawals, leading to a high incidence of

employees depleting their pension benefits even

before reaching retirement. By limiting the cir-

cumstances under which employees may be grant-

ed interim withdrawals to, for example, cases

where a non-homeowner requires the funds to pur-

chase a home, the revision seeks to improve the

odds that the employee will be able to accumulate

sufficient savings for retirement.

Moreover, given that the average tenure of

Korean workers is only 5.7 years, the amendment

strengthens the continuity of the pension system

by enabling plan participants to transfer their ac-

crued benefits to an IRP, thereby enabling them to

preserve their benefits until they are 55 years old,

the age at which they become eligible to receive

pension payouts.

Third, in terms of Expansion of the Pension

System, the revised ERBSA makes it obligatory

for new businesses to automatically establish pen-

sion plans, and includes provisions aimed at fos-

tering the utilization of individual retirement plans

(IRP). Under the current system, severance pay-

ment plans are mandatory, but the choice of

whether to adopt a corporate pension plan is left up

to individual companies, based on agreement be-

tween management and labor. Given this option,

the number of companies adopting pension plans

has remained fairly low. As of May 2011, only

29.7% (2.71 million) of 9.13 million regular work-

ers are enrolled in a pension plan. Thus, the

amendment seeks to expand participation in retire-

ment pensions by requiring that any company es-

tablished after the revised ERBSA becomes effec-

tive to establish a retirement pension system with-

in one year of its date of establishment.

Moreover, under the current system, only em-

ployed workers are permitted to enroll in in-

dividual retirement accounts (IRAs). As a remedy,

the revisions introduce an individual retirement

pension (IRP) system. Through this system, em-

ployees currently enrolled in a DB or DC plan, as

well as self-employed individuals, can establish an

Figure 2 | Adoption of Retirement Pensions by Number of Employees in Company

Category10 or fewer

employees

10-29

employees

30-99

employees

100-299

employees

300-499

employees

500

employeesTotal

(A) Pension Plan

Sponsors58,048 30,573 13,769 3,615 572 706 107,283

(B) Total Companies 1,277,326 167,033 50,007 10,309 1,363 1,120 1,507,158

Adoption Rate

(A/B, %)4.5 18.3 27.5 35.1 42.0 63.0 7.1

Source: Ministry of Employment and Labor (Korea)


Issue

IRP and make contributions into it, thereby pro-

viding increased retirement planning options for

employed workers who want to accumulate addi-

tional retirement funds or for self-employed in-

dividuals who do not receive a regular income

stream.

Fourth, in terms of Business Practices, the re-

vised ERBSA specifies the channels through

which pension products can be distributed and cre-

ates the legal basis for the termination of licenses

for inactive pension services providers. It also per-

mits the Ministry of Employment & Labor to re-

quest relevant information in supervising the

sound management of the retirement pension

system. Although the current ERBSA does not in-

clude specific regulations on the sales of pension

products, regulators have issued legal inter-

pretations that only permit pension service pro-

viders to engage in pension-related sales activities.

Insurance agents have continuously requested

permission to engage pension sales, claiming that

it is unfair and without legal basis to limit such ac-

tivities to pension service providers. Thus, the re-

vised ERBSA not only reaffirms the legal basis for

pension service providers to engage in sales activ-

ities, but also outlines the requirements, scope of

activity and areas of compliance that must be sat-

isfied by persons who want to be delegated with

the authority to engage in such activities.

The Regulations on the Supervision of

Retirement Pensions were also revised

Revisions to the Regulations on the

Supervision of Retirement Pensions were ap-

proved by the Financial Services Commission this

October. Their main impact will be to limit pen-

sion allocation to certain types of assets, strength-

en the public disclosure requirements of pension

service providers, and regulate inappropriate pen-

sion sales practices.

First, in order to stem excessive competition

via abnormally high fixed interest rates, the re-

visions stipulate that a service provider can allo-

cate nomore than 70% of pension plan assets to its

own guaranteed investment products. In the case

of insurance contracts, however, a company does

not invest in its own products during the asset man-

agement process, so insurance is exempt from this

regulation. In addition, in order to ensure the pro-

vision of accurate and transparent information, the

revisions seek to improve the public disclosure

process for pension service providers, by requir-

ing the disclosure of investment returns and regis-

tration documentation, shorter interval between

disclosures, as well as corrections or revision by

service providers and industry groups. Finally, the

amendment seeks to stem the incidence of in app-

propriate business practices by offering guidance

on actions that can be construed as improper or co-

ercive, such as the provision of gifts or tangible/in-

tangible economies benefits, excessive under-


Issue

writing of costs for plan participants, or other such

unfair sales practices.

The various changes in the retirement

pension system should foster quanti-

tative and qualitative growth in the

retirement pension market

To summarize, the various recent changes to

Korea's retirement pension system are expected to

impact Korea's retirement pension market in a va-

riety of ways. First, new provisions that require

newly established businesses to adopt retirement

pension plans and that limit interim severance pay-

ment withdrawals should serve to expand the po-

tential asset base of the pension market. In partic-

ular, given that the revisions permit employees to

transfer their pension benefits to an IRP when

changing workplaces, and that the IRP system has

been expanded to included self-employed in-

dividuals, growth in IRPs is expected to be a major

driver in the overall growth of the market.

As of end-June 2011, domestic IRA assets

stood at 3.6 trillion, only 9.8% of the total retire￦ -

ment pension assets. According to a simulation

run by the Korea Insurance Research Institute

(KIRI), the IRP market is forecast to grow very

rapidly as a result of the ERBSA amendment, with

the number of participants forecast to climb from

around 80,000 currently to around 150,000 in

2015, 290,000 in 2020, and 810,000 in 2030.

In the US, where the retirement pension mar-

ket is highly developed, the range of entities that

can join IRA plans is diverse, including not only

employees participating in their corporate pension

plans, but also individuals who are not eligible to

participate in a corporate pension plan. Its IRA

market was able to develop so rapidly in part be-

cause it developed a diverse range of products to

suit the needs of a diverse customer base. As of

end-September 2010, IRA assets in the US ac-

counted for an already high 27% of total pension

assets, and have been on an uptrend. As such, it ap-

Figure 3 | Private Pension Plan Assets in Korea Figure 4 | Pension Assets by Plan Type

0

5

10

15

20

25

30

35

40

45

07.1 08.1 09.1 10.1 11.1

(\tn won) 10.0%

18.0%

72.0%

DB

DC

IRA

Source: Financial Supervisory Service Note: As of end-June 2011Source: Financial Supervisory Service


Issue

pears that the ability for employees leaving a par-

ticular company to transfer their retirement bene-

fits to an IRP, as well as the expansion in the range

of eligible individuals, will serve as a significant

boost to Korea's IRP market.

The revisions to the ERBSA and the

Regulations on the Supervision of Retirement

Pensions should also strengthen protections for

participants by strengthening pension benefit

rights, and by regulating excessive competition

and in appropriate pension sales practices. For ex-

ample, to ensure that DB plans are adequately

funded, the revised ERBSA stipulates that plan

sponsors must inform employees whether or not

pension funds exceed the required minimum. If

the pension assets fall below 90% of that mini-

mum, the sponsor must make a contribution in an

amount equal to the shortfall. Ensuring that pen-

sion assets are maintained at or above a certain lev-

el should help to ensure the pension rights of plan

participants. It is also expected that restrictions on

the amount of a service provider's own products

that can be invested in, as well as guidelines on

what constitutes improper gifts or coercion in sales

activities, will also help to improve the quality of

Korea's pension market by mitigating excesses

caused by overheated competition.

Finally, it is expected that insurance compa-

nies will play a growing role in the retirement pen-

sion market through the utilization of their net-

works of agents. The revised ERBSA provides a

legal basis for the delegation of pension plan sales

activities, thereby enabling insurance companies

to register their agents as authorized sellers of pen-

sion products. This will pave the way for insurance

companies to place their networks of agents on the

front line in selling pension products, and will

thereby cause amajor shift in the channels through

which pension products are sold. In addition, the

clause that limits the proportion of pension assets

that can be invested in principal-and-inter-

est-guaranteed products of the service provider or

its affiliates will likely have a negative impact on

banks and securities firms, while benefitting in-

surance companies.

As mentioned above, the various recent regu-

latory changes are likely to help Korea's retirement

pension system to grown in both size and in

quality. The revisions should resolve many of the

problems inherent in the existing retirement pen-

sion system, thus setting the stage for its further

development. The market is in agreement that the

regulations should be favorable. What is now

needed, however, is the efforts of each participant

in the pension market, including plan participants,

sponsors and service providers, as well as the regu-

latory authorities. Once the relevant parties con-

tribute in the efficient operation of the reformed re-

tirement pension system, the true potential of

Korea's retirement pension system just may be

realized.


Market Watcher

Amid the ongoing low interest rate environ-

ment, Korean bond yields faced continued pres-

sure in 4Q, based on global market turmoil stem-

ming from the European debt crisis, further slow-

down in the real economy, and the fleeing of in-

vestors to safe assets. As the debt crisis in Europe

flared up, and as the USD/KRW exchange rate

rose, there was increasing concern that European

financial institutions could flee Korea's bond mar-

kets, creating some upward pressure on bond

yields. This concern was extinguished, however,

as Asian countries increased their investments in

Korea's bond markets. Meanwhile, reflecting

global financial turbulence as well as a slowdown

in the real economy, the policy rate was held un-

changed since July, helping yields to stabilize at

slightly lower levels. Moreover, the monetary pol-

icy decision-making burden was eased as consum-

er prices, which had been the main factor in pre-

vious rate hikes, fell sharply as increased fears of

a global slowdown caused a severe correction in

commodity prices, particularly agricultural prices.

Inflation fears will ease and the policy rate

stance will likely remain on hold for a significant

period, but continued uncertainty regarding mone-

tary policy will likely persist. While financial tur-

moil from the crisis in Europe will likely continue,

and global slowdown will likely mitigate infla-

tionary pressures and expectations, the current

monetary policy stance of keeping the policy rate

unchanged will likely continue for a while, as do-

mestic growth momentum weakens, problems

with household debt continue to fester, and the

global trend toward monetary policy easing

continues. But considering that globally coordi-

nated easing of monetary policy remains a possi-

bility, we cannot rule out the chances of a change

Figure 1 | Key Interest Rates Figure 2 | Changes in Yield Curves of KTB Issues

1

2

3

4

5

6

7

8

09 .1 09.7 10.1 10 .7 11 .1 11 .7

(%) Corporate Bond (AA-)

3YR KTB

10YR KTB

Policy Rate (Overnight Call)

2 .5

3 .0

3 .5

4 .0

4 .5

5 .0

3M 1YR 3YR 5YR 10YR 20YR

(%)

201 1-03-30

201 1-06-30

201 1-09-30

201 1-12-08

Source: Fnguide Source : KOFIA

n Interest Rates: Yield should fluctuate narrowly on global monetary easing

Seungryong Kim, Researcher


Market Watcher

in the Bank of Korea's monetary policy stance.

Meanwhile, it is also likely that external un-

certainties and an environment where demand out-

weighs supply could keep yields at low levels.

Given the expectation that the Bank of Korea

Monetary Policy Committee's stance of keeping

the policy rate on hold is likely to bemaintained for

a significant period of time, support for bond

yields has become strengthened. As such, yields

will likely continue to move within a range, influ-

enced more by whether foreigners holding Korean

bonds substitute their maturing holdings with new

holdings, rather than events out of Europe.

In 1Q 2012, domestic bond yields are pro-

jected to stay with the 3.2~3.5% range (based on

3-yr KTBs), owing to weaker growth, easing infla-

tionary pressures, buybacks of KTBs and an in-

flow of foreign investment into Korea's bond

market. Demand will likely continue to outweigh

supply, given the traditional base of institutional

demand, expanded demand for KTBs from banks

in preparation for Basel III, continued net pur-

chases by foreigners, and buybacks of KTBs, re-

sulting in limited upward pressure on yields. But

given that external risk factors could change, vola-

tility in the bond market could increase, since fur-

ther downgrades of sovereigns or financial in-

stitutions could impact global capital flows, there-

by impacting Korea's bond market. Vigilance will

be required, however, since major market shocks,

such as major downgrades in the US or France,

could cause Korean bond yields to rise.

As for corporate bonds, they were issued in

large volume right after the financial crisis, so

many of these issues will need to be rolled over as

maturity dates approach, resulting in greater

supply. It is forecast that the credit risk premiums

on such bonds will become more differentiated,

with demand outweighing supply.

Figure 3 | Capital Flows into Korea Figure 4 | Monetary Easing at the Global Level

-2 .0

-1 .5

-1 .0

-0 .5

0 .0

0 .5

1 .0

1 .5

Europe US Asia

(\ tn)

11 .8 1 1 .9

11 .1 0 1 1 .1 1 -15 0

-10 0

-5 0

0

(bp)

-50 bp

8 .4

-2 5bp

8 .2-50 bp

9 ,12

-15 0bp

10~1 2

-50bp

1 1 .4

-7 5bp

10~12

-2 5bp

12 .1-5 0bp

11~12

CH TR IL ID BRAU EU TH

0 .0 0 5 .75 4 .25 6 .00 11 .04 .25 1 .00

Target

rate 3 .25

Source : FSSNote: Target rate is as of 2011.12.08.Source : Thomson Reuters Datastream


Market Watcher

In 4Q, the USD/KRW exchange rate has been

fluctuating in line with developments in the

European debt crisis. In early October, as Greece

failed to reach its fiscal austerity commitments,

there was increasing talk of its impending default.

This spurred an increase in the volatility of the

USD/KRWexchange rate, pushing it above 1,200

won. But the ECB's move to expand its supply of

liquidity and the decision to expand the EFSF

helped to soothemarket anxieties, causing the ris-

ing exchange rate to reverse course. Various other

measures aimed at resolving the European crisis,

such as raising the haircut on Greek debt, leverag-

ing the EFSF, and recapitalizing the banking sys-

tem, exerted further downward pressure on the ex-

change rate. But growing skepticism about the ef-

fectiveness of proposed measures, increased wari-

ness about the solvency of Greece and Italy, and

concerns about the potential for contagion from

the periphery of Europe to its core caused the ex-

change rate to rise again.

Based on concerns about Italy's massive out-

standing sovereign debt and related exposures

within Europe, yields on French sovereign debt

surged, fomenting worries about a sovereign

downgrade and instilling the view that core coun-

tries were not immune from the crisis. Given the

ongoing dialogue regarding support from the IMF,

the US, or from other global policy coordination,

however, it is likely that much of the uncertainty

will subside. Although the liquidity crunch in

Europe has shut down a large part of the funding

markets for European financial institutions, the re-

cent agreement by themajor central banks to lower

the interest rate on currency swaps is likely to ease

some of the tightness in US dollar funding markets.

Although the focus of attention has been on

n Exchange Rate: The Korean won should appreciate, but there are risk factors

Yootag Jung, Researcher

Figure 1 | USD/KRW and EUR/USD Figure 2 | Yields on 10-Year Govt. Bonds in Europe

1000

1050

1100

1150

1200

1250

11.1 11.3 11.5 11.7 11.9 11.11

1.25

1.30

1.35

1.40

1.45

1.50

Won/Dollar(L)

Dollar/Euro(R)

(KRW) (USD)

2

3

4

5

6

7

8

11.1 11.3 11.5 11.7 11.9 11.11

France Spain

Itay Belgium

(%)

Source: Infomax Source: Bloomberg


Market Watcher

Europe as of late, there is a need to pay heed to some

of the latent global risk factors stemming from the

US or China. For example, the United States' recent

failure to agree on a fiscal austerity plan and the

subsequent action by Fitch to lower it outlook on

the United States had a limited impact on the mar-

kets, but there remain a number of risks related to

sovereign debt, including uncertainty over the fea-

sibility of economic stimulus plans and concerns

about deterioration in fiscal soundness. In the case

of China, the slowdown in its exports and its on-

going decline in manufacturing activity are caus-

ing increased worries about the possibility of eco-

nomic contraction in China, a major risk that could

trigger turmoil across the global economy. Also, if

the United States' weak fiscal position causes it to

resort to weakening the US dollar to stimulate its

economy, such an action could collide with China's

attempts to keep the yuan from appreciating in re-

sponse to a slowdown in China, thus raising the

stakes in the competitive battle for devaluation.

Thus, the USD/KRW exchange rate is likely to

experience a period of volatility as a result of ex-

ternal uncertainties, but based on strengthened

hopes surrounding policy measures to fight the

European crisis, it may be able to fall below the

1,000 won level in early 2012. Several other fac-

tors could exert downward pressure on the ex-

change rate, including the trend depreciation of the

US dollar resulting from US sovereign risk and its

policy stimulus measures, Korea's currency swap

with China and Japan, favorable domestic FX liq-

uidity conditions and fiscal soundness, and im-

provements in Korea's external credibility. Of

course, one cannot ignore the potential for in-

creased volatility based on the ebb and flow of

events out of Europe, the potential for deterio-

ration in domestic fundamentals stemming from

weakened global demand, or other latent risk

factors. As a result, the general trend in the ex-

change rate is likely to be down, but stabilizing be-

low 1,100 won will not be easy in the near term.

Figure 3 | China's Export Growth & Mfg. PMI Figure 4 | Government Debt Levels (2011)

-30

-15

0

15

30

45

2007 2008 2009 2010 2011

35

41

47

53

59

65

ExportGrowth (L)

Mfg. PMI (R)

(YoY, 3MA, %) (Index)

87 166 121 32 67 1000

30

60

90

120

150

180

France Greece Itay Korea Spain US

(% of GDP)

(G20 Avg.: 79%)

Source: Bloomberg Source: IMF Estimates (Fiscal Monitor, 2011.09)


Market Watcher

Global equity markets suffered amajor correc-

tion in August, owing to the European debt crisis

and the US downgrade, but then entered a up-and

down pattern as volatility subsided somewhat. In

October, equities staged a solid rally, as the

European summit produced favorable announce-

ments and economic indicators out of the United

States suggested that a recession was not in the im-

mediate horizon.

By November, however, as resolution of the

crisis in Greece was delayed, the crisis spread to

Italy and Spain, fueling rumors of a potential

downgrade of France, and funding problems

spread through the European banking sector. As a

result, global equity markets were thrown back in-

to disorder, with the KOSPI sliding down as far as

the 1760 level at one point.

In the United States, economic indicators

showed that employment, consumer spending and

the housing market were improving in general,

helping to ease pessimism about the economy.

Combined with positive expectations for a strong

holiday shopping season, global equity markets

began to rebound again in early December, with

the KOSPI recovering to the 1,900 level.

With expectations that European summit in

December will produce further plans to resolve the

debt crisis, along with high hopes for solid holiday

shopping in the United States and the positive eco-

nomic effects of the Lunar New Year season in

China in early 2012, the equity markets appears to

have some additional upward momentum, al-

though there is a chance that the debt crisis could

still cause Europe's economy to slow. Also, given

that the maturity dates on the sovereign debt of

Europe's peripheral countries are concentrated in

n Equities: Volatility risk remains, but a major correction is unlikely

Kyungshik Yang, Chief Strategist (Hana Daetoo Securities)

Figure 1 | KOSPI Volatility Figure 2 | Maturity Schedule of PIGS Debt

0

5

10

15

20

25

30

1997 1999 2001 2003 2005 2007 2009 2011

(%)

Asian

Crisis

IT Bubble

Collapse

9/11

Tripl

e Bear Stearns

Lehman

Brothers

Collapse

European

Crisis

0

20

40

60

80

100

120

11. 11 12. 1 12. 3 12. 5 12. 7 12. 9 12. 11 13. 1

Portugal Italy Greece Spain(€bn)

41% in 2012

Source : Bloomberg, Hana Daetoo Securities Source : Bloomberg, Hana Daetoo Securities


Market Watcher

February-April 2012, additional upward moves in

equity markets should be limited, leaving open the

possibility of a return of volatility.

Ironically, as we have experienced before, the

more dangerous global financial markets become,

the stronger and faster the policy responses, and

this is likely to continue into the future as well. To

take a recent example, as funding conditions for

European banks deteriorated, central banks from

the United States and other advanced economies

agreed to set up a commodity swap in response to

a deterioration in funding conditions at European

banks.

As global inflationary pressures wane, the ma-

jor economies are likely to ease their tightening

stances. Brazil, Australia and other emerging

economies have already lowered their policy rates,

China has lowered its reserve requirement ratio,

and it appears that the United States may resume

discussions on additional quantitative easing

measures. Such policy measures are likely to pro-

vide support for global equity markets.

Though Korea's stock market cannot be im-

mune from volatility, there are two reasons why it

is likely to outperform other global equity

markets. First, Korean companies' earnings

growth (based onMSCI 12-month forward EPS) is

higher than the global average or that of emerging

economies. Second, despite the ongoing turmoil in

global financial markets, the Financial Condition

Index is more stable that in the past, reflecting

Korea's improved fundamentals.

Figure 3 | Policy Rates of Major Economies Figure 4 | KOSPI & Financial Conditions Index (FCI)

0

1

2

3

4

5

6

7

8

2000 2002 2004 2006 2008 2010

US UK

Eurozone Australia

China Korea

(%)

1400

1500

1600

1700

1800

1900

2000

2100

2200

2300

11.1 11.3 11.5 11.7 11.9 11.11

550

570

590

610

630

650

670

690

710

730

KOSPI (L)

Financial Conditions Index (R)

(p) (index)

Source : Thomson Reuters, Hana Daetoo Securities Source: Bloomberg, Hana Daetoo SecuritiesNote: The Financial Conditions Index is an equal-weightedindex of daily movements in equities, bonds and FX.

Hana Insight

Vol. 1, No. 2

Published December 14, 2011

Editor-in-Chief: Warren Park

Publisher: Choe, Heungsik, President

Hana Institute of Finance

27-3, Yoido-dong, Youngdungpo-gu

Seoul, Korea 150-705

Tel: 82-2-2002-2200

Homepage: www.hanaif.re.kr

Printed by KwangMoonDang Co., Ltd.

The views and opinions contained herein are those

of individual authors and do not necessarily reflect

the stance of the Hana Institute of Finance.

hana insight (hana institute of finance)_issue#2

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