BOND MARKET DEVELOPMENT: THE EXPERIENCE OF THE REPUBLIC OF KOREA

Transcription

1 BOND MARKET DEVELOPMENT: THE EXPERIENCE OF THE REPUBLIC OF KOREA 2008 Jae-Ha Park* * Vice President, Korea Institute of Finance, jhpark@kif.re.kr

2 Contents I. Overview of the Korean Economy and Financial System II. Development of the Bond Market in the Republic of Korea III. Policy Lessons from Bond Market Development in the Republic of Korea 2

3 I. OVERVIEW OF THE KOREAN ECONOMY AND FINANCIAL SYSTEM I.1. Rapid Economic Recovery from the Crisis The performance of the Korean economy over the past decade has been nothing short of remarkable. Since facing the economic crisis that erupted in November 1997, the economy has recovered from near collapse. During this period, the structure of the once ailing economy was rendered more transparent and upgraded to meet global standards. Although many factors can be attributed to the unexpectedly rapid recovery, the most important factor was the sweeping reform undertaken in all sectors of the economy, but especially in the financial and corporate sectors. Recognizing that the crisis was caused by long-standing structural weaknesses rather than merely a temporary shortage in foreign reserves caused by a loss of credibility among international investors, the Korean government initiated drastic economic reform. In addition, reform measures were implemented in economic policies, such as monetary, fiscal and foreign exchange polices. Relating to monetary policy, the Bank of Korea abandoned the previous monetary targeting regime and introduced inflation targeting. The fiscal policy was actively used as a means to inject public funds into the financial and non-financial sectors to promote restructuring while playing a greater counter-cyclical role in stabilizing the economy after the crisis. In particular, the Korean government reorganized the financial system and upgraded the financial infrastructure to strengthen soundness, by strengthening supervision, relaxing regulations and establishing global standard rules and regulations. For example, the government consolidated separate supervisory authorities into a single unit. Along with the changes in the institutional framework, the FSC (Financial Supervisory Committee) and the FSS (Financial Supervisory Service) have strengthened prudential regulation and supervisory authority to ensure that financial institutions do not revert to their old practices. The outcomes of these reforms have been remarkable thus far. Foreign reserves have grown at an outstanding pace, from 20.4 billion dollars in December 1997 to billion dollars at the end of November The economic growth rate has returned to pre-crisis levels (except in 1998). Also, the current account surplus, which declined between 1998 and 2002, has rebounded since In addition to the rapid economic recovery, Korea s financial infrastructure, which includes related legislation and practices, has been upgraded to match global standards. These reforms have not only bolstered the management status at individual financial institutions, but also increased the stability of the entire financial system. In contrast to these positive outcomes of the reform efforts, a couple of serious problems resulted in the course of managing the financial crisis. Among others, real estate prices surged as a huge amount liquidity circulated in the economy without being used for investment by the corporate sector. After the crisis, government provided enormous amounts of liquidity to boost the sluggish economy and establish a social safety net. However, the corporate sector became very conservative and over-cautious for new investment after the crisis, as they struggled to restructure and resolve excess capacity. 3

4 Therefore, funds in the economy rushed into the housing market, which pressured overall real estate prices. More seriously, excess liquidity resulted in a surge of household debt. Recognizing the risks relating to the real estate bubble and surge of household debt, the government introduced a series of drastic measures to reduce household debt and stabilize the overheated housing market. Prolonged economic polarization is an equally serious challenge now inhibiting our Korea s future. The Korean economy has become increasingly polarized with booming exports and sluggish domestic demand. The major reason solid export growth has failed to spur demand is the breakdown of the traditional economic growth pattern, under which export growth usually leads to increased corporate investment and employment, which translates into increased private consumption. Recently, however, this vicious circle between exports and domestic demand has failed to materialize as only a few export products, mainly IT products, have been in high demand overseas. The general lesson to be learned from the financial crisis in the Republic of Korea is the importance of a robust and efficient domestic financial system in maintaining a healthy economy. A weak banking system, even less efficient capital markets, inappropriate financial regulations, and inadequate monitoring of the financial sector all contributed to the misallocation of resources, leaving the economy susceptible to internal and external shocks, leading to economic failure. The financial crisis ignited debate over how to best maintain the safety and soundness of the domestic and international financial. With accelerated financial liberalization and globalization, coupled with a wide application of new communications technologies to financial products, threats to financial stability are even greater and have become more diverse than in the pre-crisis period. However, no one set of measures can be expected to ensure against the recurrence of further problems. Financial intermediation is a continuously evolving activity, involving new risks, instruments, and challenges. To remain in command of these ever-changing risks, financial institutions and policy makers need to continually upgrade their processes. 4

5 Figure 1. Trend of Economic Growth and Current Account Surplus (Unit : %, million dollars) CA.Surplus Economic Growth Source: The Bank of Korea. I. 2. Policy and Regulatory Environment after the Crisis (1) Monetary Policy The Republic of Korea maintained a monetary targeting regime up until the mid- 1990s, even though many countries had abandoned similar programs when the relationship between monetary aggregates and inflation started to break down. After the financial crisis, the effectiveness of monetary policy targeting monetary aggregates declined. Then, in 1998, the central bank introduced inflation targeting as an alternative target to monetary aggregates. This method is a form of monetary targeting using M3, the broadest monetary indicator in the Republic of Korea. Inflation targeting consists of three main elements: a target indicator, a target level and a target achievement period. Core inflation is used as the target indicator. Core CPI (Consumer Price Index) is the CPI excluding; (1) items with prices subject to severe volatility from unexpected external shocks, and (2) prices which are independent of the movements of other prices, such as grains, fruits and petroleum products. The reason to exclude these items is that external shocks on the supply side can not be controlled by the monetary policy of the central bank. Monetary authorities can principally influence aggregate demand with policy instruments. The target level in the Republic of Korea is determined by the positive method. By this method, the BOK is to set an achievable target, based on price forecasts, and taking into consideration overall economic conditions within the foreseeable future. To determine the target achievement period, the Bank of Korea uses annual inflation targeting. However, annual inflation targeting of this kind has some problems, such as a time lag and external uncertainty. In order to make up 5

6 for these shortcomings, the Bank of Korea has set a medium-term target, announcing that it will strive to hold core inflation at the 2.5% level. This is not a rigid target, and it can be modified in accordance with changes in economic structure and external conditions. In general, the Bank of Korea uses the overnight call rate to achieve the inflation target. Recently, in 2006, the Bank of Korea started to use a reserve requirement policy to settle the overheated real estate market Table 1. Adjustment of Call Rate Target (Unit : %) Range of Adjustment Call Rate Target 1999 May February 0.25%p 5.00 October 0.25%p 5.25 February -0.25%p 5.00 July -0.25%p 4.75 August -0.25%p 4.50 September -0.50%p May 0.25%p 4.25 May -0.25%p 4.00 July -0.25%p 3.75 August -0.25%p 3.50 November -0.25%p 3.25 October 0.25%p 3.50 December 0.25%p 3.75 February 0.25%p 4.00 June 0.25%p 4.25 August 0.25%p 4.50 Source: Bank of Korea (2) Foreign Exchange Policy In 1990, the Republic of Korea adopted a market average exchange rate system. Under this system, daily exchange rate movement was limited to a certain range, or band. After the financial crisis, the Republic of Korea switched to a floating exchange rate system. The exchange rate in this system is supposed to be determined by the interaction of foreign exchange supply and demand in the foreign exchange market. In this system, the objective is attaining foreign exchange market stabilization through alleviating excessive short-term exchange rate volatility. Under an inflation target monetary system, simultaneously establishing an inflation rate target and exchange rate target is very difficult. However, a floating exchange rate system is the most effective system alongside an inflation targeting 6

7 monetary regime. In the Republic of Korea, exchange rate operations are executed by two authorities: the Ministry of Finance (MOFE) and the Bank of Korea (BOK). The MOFE and the BOK are now serving in partnership as the exchange rate administrative body. The BOK is authorized to supervise the money changers and foreign exchange brokers, as well as to oversee foreign exchange transactions. The MOFE has the overall responsibility for foreign exchange policy, including exchange rate operations. In fact, the BOK uses foreign exchange (FX) market intervention in consultation with the MOFE, for the purpose of stabilizing the FX market. The general objective of FX intervention in the Republic of Korea is to: 1 mitigate short-term exchange rate volatility, 2 acquire foreign reserves, and 3 play the role of market maker. After the financial crisis, intervention was used to increase international reserves in order to enhance Korea's credit rating and avoid exacerbating the crisis. Verbal intervention and real intervention in the spot market are used as a tool. In determining the most appropriate timing for intervention, the authority considers the degree of exchange rate misalignment and the permanence of the market distortion. Also, intervention depends on the authority's discretionary judgment, rather than on any implicit rule. In addition, authorities issued Monetary Stabilization Bonds (MSBs) and Foreign Exchange Stabilization Funds to share the burden of managing money aggregates. The table below shows the trends of the daily won/dollar exchange rate volatility and foreign reserves. As seen below, after adopting the exchange rate system, volatility increased significantly, an indication of an expanding FX market. Because the government no longer used the managed rate system, which emphasized equilibrium, and began using the free floating system, volatility increased. Surely, this can cause instability in the FX market and the government needs certain tools by which to intervene, tools such as verbal and real intervention. In the meantime, the increase of foreign reserves is quite rapid. Foreign reserves grew almost ten times between 1997 and 2006, for use as a safety net in case of a financial crisis. Nonetheless, authorities maintained the secrecy of FX intervention. While the economy may lose transparency in exchange rate operations, it can achieve the positive effects of expanding its foreign reserves and the FX market. 7

8 Figure 2. Trend of Foreign Reserves in the Republic of Korea (Unit : trillion dollars) Foreign Reserves Source: Bank of Korea (3) Fiscal policy Prior to the crisis, fiscal policy was not a commonly used economic stabilization tool in the Republic of Korea. Most of the fiscal expenditures on SOC, education and R&D are focused on economic growth in the Republic of Korea. Furthermore, the Korean government has been reluctant to employ a counter-cyclical fiscal policy, citing the political costs incurred by fiscal deficits. After the financial crisis, fiscal policy changed drastically. The financial crisis caused a credit crunch and financial market breakdown, hindering monetary policy's effectiveness. For this reason, fiscal policy had to play a greater counter-cyclical role in stabilizing the economy after the crisis. In particular, there was a need for public funds to be dispersed to small- and medium-size enterprises (SMEs) for financial restructuring. To these ends, the authorities increased issuance of government guaranteed bonds managed by the KDIC (Korea Deposit Insurance Corporation) and KAMCO (Korea Asset Management Corporation). Also, in order to support SMEs, there was a significant increase in government loan guarantees during the crisis. For financial restructuring, with approval of the National Assembly, the authorities earmarked 64 trillion won in public funds to purchase NPLs and support recapitalization efforts at domestic financial institutions. The table below shows the total volume of public 8

9 funds injected to the financial sector. By the end of August 2007, the total volume grew to trillion won (168.3 from the start, and 71.3 re-couped). Table 2. Public Funds Used for Financial Restructuring (Unit: trillion won, as of August 2007) KDIC KAMCO Total Raised Used Recapitalization Deposit payment Asset Purchase others Sub-total Bank Non-Bank Re-couped Reused Source: Ministry of Finance and Economy Also, the outstanding guarantees by the Korea Credit Guarantee Fund (KCGF) and the Korea Technology Credit Guarantee Fund (KTCGF) steadily grew after the financial crisis. For each fund in 1997, guarantees were merely 11.3 trillion won and 5.7 trillion won, but grew to 28.3 trillion won and 11.1 trillion won, respectively, in Outstanding guarantees Table 3. SME guarantees by KCGF and KTCGF (Unit : trillion won, %) KCGF KDCGF Default ratio(%) ratio of net payment in subrogation(%) Outstanding guarantees Default ratio(%) ratio of net payment in subrogation(%) trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion

10 trillion trillion trillion trillion Average 21.5 trillion trillion Source: International Tax and Public Finance, I. 3. Financial System in the Republic of Korea (1) Composition of the Financial System The financial system after the crisis was re-organized based on maintaining soundness and promoting globalization. These reforms include actively managing unsound financial institutions, injecting public funds, strengthening supervision, developing universal banking systems, and relaxing remaining regulations on investment. The financial system in the Republic of Korea is mainly composed of the central bank, the banking sector, and the non-banking financial sector. The central bank, also known as the BOK (Bank of Korea) was established for the purpose of maintaining price stability and contributing to the sound development of the national economy through effective monetary and credit policy. To this end, the BOK undertakes various tasks, including the operation and management of payment systems, analysis and inspection of financial institutions' managers, foreign exchange management, and the issuance of bank notes and coins. Also, the BOK serves as the government's bank by administering Treasury funds and extending credit to the government. In addition, the BOK undertakes matters relating to the issuance and redemption of government bonds of foreign exchange, stabilization fund bonds, public site compensation bonds, and treasury bonds. The banking sector is the main body of the Korean financial system. Among banks, there are commercial banks regulated by the Banking Act and specialized banks established under special legislation. Commercial banks conduct business including deposit-taking, lending, and payments and settlements. These banks also dabble in the securities business, subject to certain limitations. In addition, they manage trusts and operate credit card businesses. Specialized banks supply funds to specific fields that the commercial banks would have difficulty in accommodating. due to the limitations on the sources of funds and profitability. For example, the Korea Development Bank supplies long-term facilities funds for technology development in important industries. The Export-Import Bank of Korea handles export and import financing exclusively. The non-banking sector consists of depository institutions, insurance companies, and securities companies. Depository institutions include merchant banking corporations, mutual savings, and credit cooperative institutions. Merchant banks are financial companies that handle most corporate financing businesses, apart from stock brokerage and insurance. Mutual savings specialize in deposits and lending, having the general public and small enterprises as their customers. Credit cooperative institutions promote the mutual benefit of their members through deposits and lending. 10

11 Insurance companies receive insurance premiums from the insured, invest them in securities, loans, real estate, and other assets, and make insurance payments to the beneficiary. This sector consists of life insurance companies and non-life insurance companies. Securities companies underwrite and issue securities, including stocks and bonds, in the capital market and operate brokerage businesses. (2) Enhanced Independence of the Central Bank According to the new Bank of Korea Act, central bank independence is substantially enhanced. The governor of the Bank of Korea (BOK), previously appointed by the Ministry of Finance and Economy (MOFE), is now appointed by the President on the deliberation of the State Council. The governor of the BOK, instead of the minister of MOFE, now chairs the Monetary Policy Committee, the supreme policymaking body of the BOK. The latest revision of the Bank of Korea Act in 2003 allowed the deputy governor of the BOK to serve ex-officio on the Monetary Policy Committee, and the Securities Dealers Association lost its right to recommend a member to the committee. With the participation of the deputy governor of the BOK as an ex-officio member on the Monetary Policy Committee, the BOK is able to play the leading role in deciding the course of interest rate policy. In addition, the link between policy decision-making and policy implementation has been tightened. What is more, the previous dual objectives of the central bank -- maintaining the stability of currency value and the soundness of the banking and credit system -- are replaced by maintaining price stability. Consequently, the Monetary Board is expected to employ more advanced central banking techniques for the goal of price stability. Its responsibility for supervising the banking industry was transferred to the newly established FSC. Although the BOK s bank supervisory functions were transferred to the Financial Supervisory Commission (the FSC) and the Financial Supervisory Service (the FSS), it has the right to request all banking institutions and any non-bank financial institution to maintain current deposit accounts with the central bank. The bank also may require the FSS to conduct an individual or joint on-site examination of specific banking institutions and to disclose the findings of these examinations, on the basis of which, the bank may ask the FSS to order banking institutions to take corrective actions. When the bank extends emergency credit to banking institutions, non-bank financial institutions or other profit-making enterprises, it may check to confirm their operations and the status of their assets. (3) Integrated Financial Regulatory System Before the crisis, financial supervision in the Republic of Korea was performed by separate bodies: The Ministry of Finance and Economy (MOFE), the Bank of Korea (BOK), the Securities Supervisory Board (SSB), and the Insurance Supervisory Board (ISB). This system was a vestige of the government-led economic growth strategy that had been pursued since the early 1960s. Since the MOFE always had multiple policy goals and assigned top priority to the real sector, the safety and soundness or competitiveness of the financial sector had been relatively neglected. A complex regulatory structure and inadequate coordination 11

12 between supervisory organizations created a lack of consistency and ineffective supervision. After the crisis, the government understood the necessity of creating a consolidated supervisory body (merging the FSC and FSS). The rationale for unifying the supervisory authority is clear. First, separating supervisory authority from the MOFE was a necessary condition for neutrality and independence in supervision (established under the Prime Minister's Office). Second, distinctions between financial institutions are increasingly meaningless due to accelerating financial deregulation, thereby necessitating a consolidated supervisory body for effective supervision. Along with the changes in the institutional framework, the FSC and the FSS have strengthened regulation and supervision to ensure that financial institutions do not revert to their old practices. These strengthened regulations include introducing the Prompt Corrective Action (PCA) System, strengthening asset classification standards, high standards for accounting and public disclosure, prudent rules for foreign exchange liquidity and exposure, and trust accounts, to name just a few. During the eight years since the establishment of the new supervisory system, however, it has not been considered very successful in maintaining the soundness of the financial system. In addition, the organizational structure, such as the relationship between the FSC and the FSS, was not working nearly as efficiently as expected. A series of serious financial problems, most notably the SK Global accounting fraud in March 2003 and the financial problems at numerous credit card companies, were not detected or prevented by the supervisory agencies in advance. The effectiveness of the new supervisory system in improving the soundness and competitiveness of financial institutions and the financial system has been frequently questioned by many experts. (4) Financial Institutions The Republic of Korea has several types of financial institutions in addition to the banking, securities, and insurance businesses. The size of major financial institutions' assets is shown below. Because individuals now prefer safe assets, mainly bank deposits, the banking industry has grown significantly since the financial crisis. Non-bank depository institutions include merchant banking corporations, mutual savings corporations, credit unions, and credit-specialized financial companies. As shown below, the proportion of merchant banking has dropped since the market s restructuring. In 1996, merchant banks held 7.5% of total assets at financial institutions, but now hold only 0.1% (June 2007). Other non-bank depository institutions experienced trends similar to the merchant banking industry. The insurance industry is comprised of both life insurance and non-life insurance companies. The portion of insurance companies increased after the financial crisis for the same reasons the banking sector expanded: a flight to safety. Relatively, securities, futures, and asset management institutions own a small portion of the financial system in the Republic of Korea. 12

13 Table 4. Scale of Major Financial Institutions' Assets (Unit: trillion won) Bank (67.4%) (64.3%) (63.5%) (70.4%) (71.6%) (71.9%) (72.2%) (74.4%) (73.1%) (71.8%) (71.1%) (70.3%) Merchant bank Mutual Savings Credit union Creditspecialized Life Insurance Non-life Insurance 52.5 (7.5%) 36.3 (5.2%) 16.6 (2.4%) 77.9 (8.2%) 36.1 (3.8%) 19.3 (2.0%) (7.2%) 80.0 (11.4%) 15.4 (2.2%) Securities 27.8 (4.0%) 92.4 (9.8%) 19.5 (2.1%) 23.9 (2.5%) 58.4 (6.6%) 32.1 (3.6%) 21.0 (2.4%) 64.2 (7.2%) 92.3 (10.4%) 22.2 (2.5%) 34.7 (3.9%) 38.2 (3.4%) 25.9 (2.3%) 19.8 (1.8%) 54.8 (4.9%) (9.4%) 26.7 (2.4%) 60.7 (5.4%) Futures (0.0%) Asset Management 21.3 (1.8%) 21.4 (1.8%) 20.5 (1.8%) 62.4 (5.4%) 3.9 (0.3%) 22.5 (1.8%) 22.6 (1.8%) 76.1 (6.0%) 3.1 (0.2%) 25.5 (1.8%) 19.7 (1.4%) (7.0%) 0.8 (0.1%) 30.1 (2.0%) 19.6 (1.3%) 66.5 (4.4%) 0.8 (0.1%) 35.9 (2.3%) 22.2 (1.4%) 53.9 (3.5%) 1.1 (0.1%) 41.7 (2.4%) 24.0 (1.4%) 58.0 (3.4%) 1.1 (0.1%) 50.8 (2.5%) 26.2 (1.3%) 67.8 (3.4%) 1.4 (0.1%) 53.2 (2.4) 27.1 (1.2%) 75.8 (3.5%) (10.4%) (10.8%) (11.3%) (12.1%) (13.4%) (13.7%) (13.5%) (13.2%) 29.0 (2.5%) 52.2 (4.5%) 0.5 (0.0%) (0.1%) 33.3 (2.6%) 58.9 (4.6%) 0.6 (0.0%) 1.4 (0.1%) 5.3 (2.4%) 50.5 (3.5%) 0.5 (0.0%) 1.5 (0.1%) 37.9 (2.5%) 48.4 (3.2%) 0.6 (0.0%) 1.6 (0.1%) 42.8 (2.7%) 52.4 (3.4%) 0.9 (0.1%) 1.6 (0.1%) 49.0 (2.9%) 73.1 (4.3%) 1.2 (0.1%) 1.6 (0.1%) 55.7 (2.8%) 92.8 (4.7%) 1.3 (0.1%) 2.0 (0.1%) 59.5 (2.7%) (5.9%) 1.7 (0.1%) 2.1 (0.1%) Total Source: Financial Supervisory Service (FSS), Monthly Financial Statistics. (5) Financial Markets The financial market in which financial institutions participate consists of the deposit and loan market, the money market, the capital market, and the financial derivatives market. The money market includes the call market, the commercial paper market, the negotiable certificate of deposit market, the bond repurchase agreement market, the Monetary Stabilization Bonds market, and the cover bills market (less than 1 YTM). The capital market is the market that issues and trades stocks and bonds. The financial derivatives market is where interest rate futures, currency futures, stock price index futures, options, and equity options are traded (more than 1-year maturity). The main component of the money market is the call market. The call market grew 13

14 substantially after the financial crisis. As seen below, between 1997 and 1998, the value of call transactions almost doubled. Meanwhile, compared to the stock market, bond market transactions showed quite rapid growth after the financial crisis. The growth of the bond market stems from government policies, such as generating the public funds for financial restructuring and revitalizing the economy. Figure 3. Trend of Call, Stock, and Bond Transactions (Unit: trillion won) BOND STOCK CALL Source: Bank of Korea, Korea Exchange (KRX). II. Development of the Bond Market in the Republic of Korea II.1. Overall Status of Korean Bond Market It is evident that Korea s financial market experienced enormous changes leading up to and following the crisis. Before the crisis, there was a mere semblance of a financial market, but no real market to speak of. Immediately after the crisis, the stock market declined sharply while the bond market and call market expanded in size to finance the recovery. As the economy recovered after the crisis, the stock and bond markets grew with 14

15 it. The bond market in particular grew rapidly from trillion KRW in 1997 to trillion KRW in August Figure 4. Growth of Bond, Stock, and Money Markets (Unit: billion won) Bond Market Stock Market Money Market Source: Bank of Korea, Korea Exchange (KRX) During the pre-crisis era, there had been virtually no government bond market in the Republic of Korea. Because of the conservative fiscal policy and compulsory practice of underwriting, bond issuance was not sufficient to activate primary and secondary markets. As a result, 3-year corporate bonds were regarded as the benchmark bond in the market, which was very different from other countries, where they use government bonds as the benchmark bond. The corporate bond market, on the other hand, was quite large in size compared to the government bond market. However, since corporate bonds were almost entirely guaranteed by the banks, they were regarded as another form of bank loans. After the crisis, however, the corporate bond market was faced with serious challenges. When the financial crisis erupted in the Republic of Korea, banks became the first targets of restructuring. In other words, government evaluated the soundness of banks based on the BIS capital adequacy ratio, and decided their viability. Consequently, the banks stopped guaranteeing corporate bonds in order to avoid risks, which caused the collapse of the corporate bond market. After the crisis, the Korean government realized that an efficient and wellfunctioning bond market is essential for preventing another crisis, which can be achieved by enhancing the soundness of financial system, and started reforming and vitalizing the bond market. In addition, the economic situation after the crisis also contributed a lot to the 15

16 development of the bond market in the Republic of Korea. Among others, due to government policies, such as generating public funds for financial restructuring and economic stimulus, there has been outstanding growth in the size of the bond market. By priming the pump with a fiscal stimulus, the government financed the economic restructuring, thereby boosting the depressed economy. Also, the Bank of Korea issued more Monetary Stabilization Bonds (MSBs) to balance the rapid increase in foreign reserves. As a result, the bond market has matured in both size and in quality. The total balance of the bond market grew from trillion KRW at the end of 1998 to trillion KRW at the end of Remarkably, government bonds grew from 42.1 trillion KRW (12.6 per cent) to trillion KRW (28.6 per cent) in the same period. Also, MSBs grew from 46.6 trillion KRW (13.9 per cent) to trillion KRW (17.6 per cent). The corporate bond market also increased in size by 112 per cent, from trillion KRW in 1998 to trillion KRW in Directly after the crisis, companies needed to finance more funds from the bond market because banks were reluctant to extend loans to the corporate sector. This situation resulted in issuing large quantities of asset-backed securities (ABSs) during the post-crisis financial restructuring. Between 1999~2002, the corporate bond market grew steadily, helped by massive ABS issuance. As financial restructuring came to a close after 2003, ABS issuance fell. Table 5. Outstanding Amount of Bonds (Unit: billion won, %) Type Government (12.6) (16.9) (17.3) (16.4) (17.6) (22.5) (27.0) (30.9) (28.6) Local Gov' (2.1) (2.5) (2.3) (1.9) (1.6) (1.7) (1.6) (1.5) (1.3) MSBs (13.9) (13.9) (15.8) (15.7) (14.9) (17.4) (21.6) (21.5) (17.6) Financial Inst (10.1) (8.4) (7.5) (6.8) (17.5) (16.9) (15.2) (14.7) (18.7) Specific Law (25.4) (27.7) (27.0) (31.2) (23.3) (19.1) (17.1) (16.5) (11.1) Corporate (35.8) (30.5) (30.1) (28.0) (25.1) (22.4) (17.5) (14.9) (14.9) Total Note: Number in parentheses shows the proportion of bonds. Source: Korea Exchange (KRX) 16

17 Figure 5. Proportion of Bonds by Type 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 35.7% 25.4% 10.1% 14.0% 12.6% 2.1% 30.5% 30.1% 28.0% 27.7% 27.0% 31.2% 8.4% 7.5% 6.8% 23.3% 17.5% 13.9% 15.8% 15.7% 14.9% 2.5% 2.3% 1.9% 16.9% 17.3% 16.4% 17.6% 25.1% 22.4% 1.6% 19.1% 16.8% 17.4% 22.5% 1.7% 17.5% 14.9% 13.0% 17.1% 15.2% 21.6% 27.0% 1.6% 16.4% 14.7% 21.5% 1.5% 13.0% 18.5% 21.1% 30.9% 32.9% Government Local MSBs Financial Inst. Specific Law Corporate Source: Korea Exchange (KRX) 1.5% II. 2. Efforts Made by the Government to Develop the Bond Market The rapid growth of both the primary and secondary bond market in the Republic of Korea is attributed to the government-led reforms. The table below highlights the major government reforms that have improved the Korean bond market. Before 2005, Korean bond market reforms focused on measures to reduce issuing costs by making the benchmark issue more liquid. After 2005, reform concentrated on measures to reduce issuing costs by meeting more diverse and sophisticated investment demands. Introducing STRIPS, issuing 20-year bonds and inflation-indexed bonds, and designing products for retail investors are standout examples of such reform. The main purpose of these reforms are 1 to foster the government bond market, 2 to improve the primary and secondary market, 3 to increase the supply of bonds, and 4 to build market infrastructure. Table 6. Reforms of the Bond Market Year Context of Reforms Expand the limit of corporate bond issuance Open bond market to foreign investors Demolish arbitrary control of bond issuance Announcement of the Government Bond Market Stimulus Plan 17

18 Inter-Dealer Market Bond price-valuation method based on market price Primary Dealer (PD) System Delivery Versus Payment (DVP) System 1999 Formulation of government bond issuance Government Bond Futures Inter-Dealer Broker (IDB) System Reopening System(Fungible Issue System) 2000 Multiple Price Auction to Dutch Auction Issue 10-year maturity government bonds 2002 Mandatory Exchange Trading Requirement for Benchmark Issues 2003 Strengthen Obligation of PDs 2006 STRIPS (Separate Trading of Registered Interest and Principal of Securities) System Issue 20 year bonds Issue Inflation-Indexed Bonds Design products for retail investors (1) Fostering the Government Bond Market First, to foster the government bond market, diverse reform measures were introduced, such as the reopening system, the Dutch auction, formulation of the government bond issuance, 10-year maturity government bonds, PD system, and a mandatory exchange trading requirement for benchmark issues. The reopening system (fungible issue system) enhanced the liquidity of bonds by increasing the size of each issue. This system also eased trading by matching bonds of identical maturities and coupon rates. Expanding the size of bond issuance for instruments with the same maturities consequently helped to vitalize the secondary market. In 2003, the government further modified the reopening system to standardize the pricing of government bonds to meet global standards. Also, the government introduced a DAS (Dutch Auction System). DAS is an auction in which an item is initially offered at a high price which is then progressively lowered until a bid is made and the item is sold. This system effectively removes the winner's curse, the tendency for the winning bid in an auction to exceed the intrinsic value of the item purchased. Furthermore, the government formulated the issuance of government bonds for the purpose of fostering the bond market. For example, the government announced the required issuance of government bonds every month and year, generating more accurate expectations within the market. By separating monthly issuance by maturity and by discerning the bid date (Monday) from the issue date (Wednesday), the government took positive steps to align reality with market expectations. In addition, the government started to issue 10-year and 20-year maturity government bonds and stopped issuing 1-year KTBs, making it possible to expand the maturity structure of the government bond market. The Primary Dealer (PD) system was established in 1999 with the inauguration of 26 18

19 financial institutions, including 13 securities houses and 12 commercial banks. The PD system encourages the secondary market for government bonds by providing liquidity and efficiency. PDs are elected by the Minister of Finance and Economy every year and enjoy several privileges. The have exclusive participation in government bond auctions, access to securities financing facilities for secondary market trading, and regularly consult directly with the Ministry of Finance and Economy. To balance out these privileges, PDs have an obligation to act as a market maker and follow these guidelines: 1) 5% minimum underwriting & trading every 6 months, 2) provide bid/ask quotes with minimum volume and maximum spread constraint, 3) 40% mandatory exchange trading, 4) reporting requirement of position and trading information of government bonds to the Treasury. To invigorate the KRX market, the government mandated in October 2002 that PDs should trade benchmark issues of government bonds only on the KSE. By January 2003, PD obligations were made stricter by increasing the trading requirement from 20% to 40% and minimum trading amounts from 2% to 5%. Introduction of exchange trading requirements are not only effective for benchmark issues, such regulations also expand the trading volume of non-benchmark issues. (2) Improving the Primary and Secondary Market Government reforms to advance the primary and secondary bond markets include expanding the limit of corporate bond issuance, demolishing arbitrary control of bond issuance and introducing an Inter-Dealer Broker (IDB) system and ABS market. With these reforms, the government has tried to expand the limit of corporate bond issuance and open the bond market to foreign investors. For example, companies could have issued two times over their net worth and foreign investors could have invested 10% per investor and 30~50% for each corporate bond. After the 1997 reforms, company investment limits were raised to 4 times net worth. Restrictions on foreign investors were totally removed. Also, to promote bond market growth and proper issuance in the market, the government ended arbitrary control of bond issuance. The IDB (Inter-Dealer Broker) system creates a fluid market structure where corporate, financial, and special bonds are traded. IDB is a brokerage firm operating in the bond market that acts as an intermediary between major dealers to facilitate inter-dealer trades for providing liquidity. In the Republic of Korea, securities companies generally play the role of IDB. Finally, the ABS (Asset-Backed Securities) market was introduced as another means to improve the corporate bond market. Next to Japan, the Republic of Korea has the largest asset-backed securities (ABSs) market in Asia. Right after the financial crisis, it was crucial to increase liquidity to the financial sector and to locate a new source of funding for the corporate sector. To these ends, KAMCO was established to collect non-performing loans (NPLs) in the financial sector. After collecting NPLs, KAMCO liquidated those NPLs by issuing ABSs through a special purpose company (SPC). ABSs were first issued for financial restructuring and securitization of NPLs. After financial restructuring, ABSs were 19

20 used to ease the credit crunch and to be used as financing tools for companies using primary collateralized bond obligations (CBOs). (3) Increasing the Supply of Bonds Increasing the supply of bonds is an integral part of the government s bond market reforms. After the crisis, expanding the government bond market to meet new demands for issuance became a priority for overall recovery. As the PD system created a market-maker, the government encouraged the dealer s to expand the supply of bonds. In another reform aimed at creating a broader, more sophisticated bond market, the government introduced STRIPS (Separate Trading of Registered Interest and Principal of Securities) to the market in The STRIPS product separates the Korean Treasury Bond (KTB) into its two constituent parts: the interest and the principal. Then, the system securitizes these new instruments into zero coupon bonds. For instance, if a KTB with a 6- month interest payment period and 3-year maturity is stripped, the result is 1 zero coupon principal bond and 6 zero coupon interest bonds. This sophistication increases the liquidity of the government bond market by providing new instruments at various maturities and yields. In addition, the creation of these new products presents new arbitrage opportunities for advanced trading strategies. Also, a STRIPS yield to maturity is predetermined, prohibiting re-investment of mid-term interest. This makes it possible for insurance companies and pension funds to utilize the STRIPS as long-term investment vehicles. Finally, because this system can lower the cost of purchasing bonds, the demand for STRIPS is actually concentrated among individuals and small institutions. Finally in 2006, the government designed products for retail investors, which will expand the range of investors. (4) Building Market Infrastructure Reforms aimed at improving overall market infrastructure include adopting a bond price-valuation method based on market price, introducing government bond futures and implementing the Delivery Versus Payment (DVP) system. The government adopted a new bond price valuation method, based on market price. The market price valuation method gives bonds appeal as an appreciable investment, not merely a safe asset. This valuation method also eliminates the transferring profit problem by distributing dividends based on actual results. Ultimately, this reform expands the bond market by inducing transactions based simply on market price fluctuations. In another reform-minded move, the government listed Government Bond Futures in the futures market for the purpose of hedging long-term interest rate changes. By introducing the Delivery Versus Payment (DVP) system, clearing and settlement risk could be relieved by linking the Korea Securities Depository (KSD) and the Bank of Korea (BOK). Specifically, account transfers from the customer's deposit account in the KSD are connected with the settlement system at the BOK. This makes efficient and effective bond trade settlement possible. 20

21 II. 3. The Current Status of the Bond Market (1) Government Bond Market The government bond market in the Republic of Korea consists of the KTB (Korean Treasury Bond), foreign exchange stabilization bonds, grain securities, and national housing bonds. The largest are KTBs, which are used to finance central government fiscal operations. The government issues KTBs with a maturity of 3, 5, 10 and 20 years with distribution among the four types at approximately 25:40:25:10 (10-year was introduced in 2000 and 20-year was introduced in 2006). For the purpose of covering the cost of restructuring the financial system, the government drastically increased the size of KTB issuance from 2.1 trillion KRW in 1997 to 60.7 trillion KRW at the end of As of August of 2007, the total amount of KTBs is trillion KRW, or 88 per cent of total government bonds. Due to rapid KTB growth, the proportion of government bonds grew from 12.6 per cent in 1998 to 24.8 per cent in Foreign Exchange Stabilization Bonds are issued by the Ministry of Finance and Economy with the approval of the National Assembly and with 3-month, 3-year and 5-year maturities. After November 2003, the issuance of Foreign Exchange Stabilization Bonds is integrated with KTB issuance. Grain securities were completely retired after 2004, previously issued for the purpose of generating funds to operate Korea's Grain Management Special Account and the Grain Management Fund. National Housing Bonds are issued by the Korea National Housing Corporation, and sold to individuals or corporations that make real estate contracts. They are sold in public offerings via Dutch-style yield auction, and are either a 3 per cent coupon bond with 5-year maturity (Type 1) or a 3 per cent coupon bond with 20-year maturity (Type 2). Table 7. Issuance of Major Government Bonds (Unit: billion won) FX. Stab. 1, , , , , , Fund KTB 2, , , , , , , , , , ,628.0 Grain 1, , ,951.7 Securities National Housing 2, , , , , , , , , , ,253.1 Bonds Source: Bank of Korea, Monthly Bulletin. 21

22 As briefly mentioned in a previous chapter, intensive and extensive reform efforts driven by the government induced positive effects on the government bond market. Expanding the size of bond issuance, adding fungibility, and implementing a PD system raised the effectiveness of the market, both in quantity and quality. The volume of benchmark issues grew about 3.5 times after introducing fungibility and is still growing. In addition, the turnover ratio of government bonds in 2005 was 623 per cent, or about 2.5 times higher than the total bond average turnover ratio (253.1 per cent). Specifically, the PD system is a critical reform in developing the government bond market. The PDs, mainly, are securities companies and banks. The qualifications necessary to become a PD vary. Banks and merchant banking corporations must meet the following requirement: BIS 8 per cent. For securities companies, their ratio of net capital 150 per cent. Now, 24 financial institutions, including 15 securities companies and 9 banks, are chartered as PDs in the Republic of Korea. Primary dealers trade benchmark issues of government bonds on the KRX. Using KRX volume as our measure, the average daily transaction of government bonds grew from 3.4 trillion KRW in 2001 to 7.9 trillion KRW in Also, the transaction volume of the KSE grew from 0.04 trillion KRW (1.1 per cent) in 2001 to 1.2 trillion KRW (14.8 per cent) in Government bond listings increased after the financial crisis. Especially in 1999, the listed amount, trading volume, and trading value increased enormously. By the end of October 2007, there were 6221 listed issues, with trillion KRW worth of listed government and public bonds. Table 8. Trends of Listed Government and Public Bonds (Unit: billion won) Listed Amount (Par Trading Volume No. of Listed Issues Value) (Par Value) Trading Value , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,851,0 208, ,795,9 Source: FSS, Monthly Financial Statistics Bulletin. Meanwhile, PD-mandated trading expanded the amount of benchmark issues. In 22

23 relation with the PD system, the government executed new policies that increase the mandatory exchange trading requirements from 20 per cent to 40 per cent and minimum trading amounts from 2 per cent to 5 per cent. Those efforts resulted in the growth and effectiveness of benchmark issues. This means that the government can lengthen the maturity of bonds just by changing the benchmark issues. As seen below, the proportion of benchmark issue trading on the KRX grew significantly after adopting the mandatory exchange trading requirements. The mandatory exchange trading requirement does not decrease trading volume in the OTC market, but actually increases it in Korea s case (shown below). The total volume and OTC trading volume grew steadily, starting in 2002, right after mandatory exchange trading was enacted. This means that this system has positive effects on expansion not only of trades in the KRX, but also of total trades. Figure 6. Government Bond Trading Volume in the KSE and OTC Market (Unit: billion Won) 40,000,000 35,000,000 30,000,000 25,000,000 20,000,000 15,000,000 10,000,000 5,000, OTC Exchange Total Source: Korea Securities Dealers Association. Bonds are traded either on the Korea Exchange (KRX) or the over-the-counter (OTC) market. Trading on the KSE is limited to securities, while OTC trading includes both listed and unlisted bonds. Most government bonds are traded on the OTC market, representing 85.2 per cent of daily trades, shown in the table below. Because PDs are obliged to trade on the KRX, the amount of government bonds trading on the KRX is much bigger than the corporate market. 23