Can Seoul Serve as an International Financial Center?*

Transcription

1 Can Seoul Serve as an International Financial Center?* S. Ghon Rhee, Ph.D. K. J. Luke Distinguished Professor of International Finance and Banking University of Hawaii 2404 Maile Way (#C-304) Honolulu, HI Tel No.: (808) Fax No.: (808) st Draft: April 2003 *To be presented at the Fourth Seoul International Financial Forum The Road to Financial Hub in North East Asia: An Opportunity and Challenges on May 14-15, 2003 in Seoul, Korea

2 Can Seoul Serve as an International Financial Center? I am honored to speak at this conference to share my thoughts on the feasibility of Seoul serving as an international and/or regional financial center. I left Korea over 30 years ago to study for an advanced degree in the United States and pursue an academic career in the area of finance. As a result, I consider my presentation represents an outsider s view rather than an insider s perspective. I would like to pose the following two questions regarding the future of Seoul as a financial center because the role of a financial center is not very welldefined: Would you like Seoul to serve as a financial center where corporate and sovereign borrowers issue long- and short-term bond instruments or common equity shares exactly the same way London and New York serve as international financial centers? Would you like Seoul to serve as a financial center where many international financial institutions conduct banking and securities businesses exactly the same way Hong Kong and Singapore serve as regional financial centers? In the first part of my presentation, I will address these questions. While so doing, we will be able to self-assess the current standing of Seoul in positioning itself as a financial hub for the North-East Asian region. This exercise will allow us to consider what must be done to attain the goal of making Seoul a financial center. 2

3 A. Can Seoul Be Developed into a Full-Fledged Financial Center Like London and New York or a Regional Financial Center Like Hong Kong and Singapore? Before I answer these questions, let us think about the current status of the Korean economy. We have a 10-trillion dollar economy in the United States as measured by Gross Domestic Product (GDP), followed by Japan with a 5- trillion dollar GDP. The size of China s economy is about one-tenth of the U.S. size, whereas the Korean economy is only about one-twentieth of the U.S. economy. When we compare the size of Korean government bond markets with those of the Japanese and U.S. government bond markets, the Korean market is extremely small. With this in mind, I cannot stop asking a question: Is the Korean financial market large enough to meet the international demand for funds? One set of factual information about Japan also forces me to raise a question about Korea s ability to serve as an international/regional financial center. Let us review the summary statistics of Japan s gaisai bonds markets between 1991 and Gaisai bonds are referred to as bonds issued by foreigners in Japan. If denominated in yen, they are called samurai bonds and if denominated in foreign currencies, they are called shogun bonds. The last time shogun bonds were issued in Japan was in The volume of samurai bonds peaked in 1996 with 3.8 trillion prior to the Asian financial crisis but it declined drastically afterwards. Although recently the issuance of shogun bonds increased substantially, thanks to lower interest rates in Japan, it did not reach the pre-crisis level. During the Asian financial crisis period of 1998 and

4 when gaisai bond market activities should have been most active, we had a very slow market in Japan. At the peak of the Asian financial crisis, Japan s Ministry of Finance announced the New Miyazawa Initiative that could have paved the way for the creation of regional bond markets to serve sovereign borrowers and state-owned enterprises from the Asia-Pacific region for their financing needs. Acquisition of sovereign bonds issued by Asian countries by the Japan Bank for International Cooperation (formerly Export-Import Bank of Japan) Support for Asian countries in raising funds from international financial markets through the use of credit guarantee and/or interest subsidies. Possible creation of regional credit enhancement agency. Although the New Miyazawa Initiative was intended to serve as important vehicles for promoting the regional role of Tokyo, the majority of sovereign bonds and public sector bonds of the crisis-affected countries could not be issued in Tokyo. Instead, they moved to the Eurobond and Yankee bond markets. I believe that the failure of the Tokyo market in gaining any significant momentum from the New Miyazawa Initiative can be attributed to two major factors. First, it is difficult for Japan to play the role of a regional or international financial center with its government bond market not fully developed. 1 Second, Japan alone cannot create a truly regional bond market. Regional issuance and trading activities must be a group effort supported by the region s economies. Japan has the capital base and huge savings that could be channeled to 4

5 international demanders of capital. Nevertheless, Japan has been struggling in establishing Tokyo as an international and regional financial center. Can Korea become a financial hub for the North-East Asia region? It is not impossible, but it will be an uphill battle to attain this goal. That leads us to think about Seoul s role as a financial center in the same manner as Hong Kong and Singapore serve the region. When we compare the Korean financial system with those of Hong Kong and Singapore, it becomes clear that Korea must improve its financial system to compete with Hong Kong and Singapore in attracting banking and securities market activities of international financial institutions and securities companies. For example, banks assets amounted to US$769 billion in Hong Kong, US$672 billion in Singapore, and $700 billion in Korea in 2002, respectively. Because the size of the Korean economy is about 3 times and 5 times greater than those of Hong Kong and Singapore, respectively, the relative size of Korea s bank assets is approximately one-third and one-fifth of those in Hong Kong and Singapore. Foreign currency-denominated deposits represent 45 percent of total deposits in Hong Kong, but they are only 8 percent of Korea s total deposits. The comparable number is not available for Singapore, but approximately 70 percent of bank assets in Singapore are the assets of Asian Currency Units that operate Asian Dollar Market. 1 For details, please refer to Rhee, S. Ghon, 2001, Further Reforms after the BIG BANG : The Japanese Government Bond Market, in Bond Market Development in Asia (Paris, France: Organization for Economic Co-Operation and Development, 2001),

6 Table 1. Summary Statistics of Commercial Banks No. of Banks Bank Assets Bank Deposits Unit: US$ Billion Total LC FC Hong Kong 224 $769 $425 $ (55%) (45%) Korea 57 $700 $548 $503 $45 (92%) (8%) Singapore 120 $672* $224** - - *Of which 70% represents Assets of Asian Currency Units that operate Asian Dollar market. **Includes non-bank customer deposits only. : Notes: LC = local currency FC = foreign currency B. Outsiders Perception of Korea Three weeks ago, I attended the inaugural dinner and symposium of the U.S. Asia Pacific Council (USAPC) in Washington, D. C. The USAPC was newly created under the sponsorship of the U.S. Department of State and the East-West Center as a single umbrella organization serving two existing networks, the U.S. Committees of Pacific Economic Cooperation Council (USPECC) and the U.S. Pacific Basin Economic Council (USPBEC). In addition to providing a secretariat for these networks, the USAPC also supports and strengthens the U.S. National Consortium of APEC Study Centers. 6

7 Mr. Robert B. Zoellick, the U.S. Trade Representative, was one of keynote speakers at the inaugural symposium. I am duplicating one of his presentation slides in Table 2 below to share with you how outsiders perceive Korea when compared with other Asian economies. Since the U.S. Trade Representative Office is a part of the Executive Office of the President of the United States, what is shown below is an official (rather than private) outsiders view of Korea. Korea Table 2. Future Tasks in North-East Asian Countries Advocating Openness & Market Reforms Japan Promoting Economic Growth & Market Reforms China WTO Implementation and Its Further Integration within the Global Trading System Taiwan WTO Implementation & Resolving Key Bilateral Trade Issues Source: U.S. Trade Representative Office 7

8 Not surprisingly, WTO implementation and its further integration within the global trading system are the major tasks expected of China and the promotion of economic growth and market reforms are the major challenges facing Japan. For Korea, advocating openness and market reforms represent the urgent tasks to be undertaken by Korea. Mr. Zoellick specifically referred to the importance of gains from not only exports but also imports in connection with advocating openness. Even though he advocated openness and market reforms on the trade front, I felt that the same outsiders perception also applied to the openness and reforms on the Korean financial markets. C. How Transparent Is the Korean Financial Market? To talk about how the Korean financial markets are perceived by outsiders in terms of openness, please allow me to jump onto the most fundamental question on the transparency in financial reporting. I would like to show you three graphs that are borrowed from my on-going research paper on earnings management. 2 Over a 12-year study period from 1989 to 2000, we computed earnings scaled by total assets for all US listed companies. The total number of observations is over 43,000. Reported earnings deflated by market value of common equities are standardized and the frequency distribution of these standardized earnings is presented in this graph for large-, medium-, and smallsized firms. 2 Refer to University of Hawaii s Asia-Pacific Financial Markets Research Center Working Paper entitled The Relation of Earnings Management to Firm Size (2003) by Yangseon Kim, Caixing Liu, and S. Ghon Rhee. 8

9 First, the distribution curve is shifted to the right-hand side such that the zero-mean value is no longer on the mid-point of this frequency distribution. The shifting of the curve to the right-hand side implies that the earnings are padded or inflated using whatever acceptable accounting practices. For example, the recognition of expenses can be delayed, while the recognition of sales can be advanced. The firm can decelerate depreciation, decrease deferred taxes, realize unusual gains early. Second, the distribution curve is no longer smooth and bell-shaped. The curve is broken at the zero-mean and the number of small positive earnings in the immediate neighborhood of the zero-mean value is much larger than that of small negative earnings. From this, we may infer that firms manage earnings to avoid reporting negative earnings. The next two graphs illustrate the distribution of scaled earnings for smalland medium-sized firms, respectively. Large-sized firms have a tighter and more peaked earnings distribution than small-sized firms. The drastic contrast is the difference in the magnitude of the standard deviations. This is an indication that large size firms engage more in earnings smoothing than small size firms, and that is why the earnings distribution is tighter for large-sized firms. When we control for confounding effects from earnings performance in past years, sales growth, operating cycle, capital intensity, status of auditors, the same results are confirmed. From the three graphs, what we observe is there are three types of earnings management: earnings inflation; loss avoiding; and earnings smoothing. 9

10 A recent paper published in the Journal of Finance, illustrates outsiders perception of earnings management practices among listed companies. 3 Based on earnings smoothing, loss avoiding, and earnings inflating activities, Bhattacharya et al. (2002) rank earnings opacity for more than 30 countries. Korea along with Japan, India, and Indonesia are ranked at the bottom in terms of transparency in accounting earnings reported in the financial statements of listed companies. Korea and Japan are ranked at the same level of India and Indonesia? Definitely a dubious honor deserving a serious consideration. The next set of countries with earnings opaqueness include Malaysia, Singapore, and Taiwan. Among the various Asian economies, only Hong Kong and Thailand are ranked in the mid-level group. After a series of recent financial disclosures involving Enron, Worldcom, Tyco, Xerox, Global Crossing, I am not sure whether the U.S. market deserves to be ranked number one, but we observe that some selected countries like Canada, Belgium, and Norway along with the United States are ranked high for their transparencies in financial reporting. D. The Regulatory Philosophy Must Change to Improve the Transparency of the Korean Financial Market What do we do to improve the transparency in financial reporting? I believe that this question has close bearing on the regulatory philosophy adopted by financial market regulators. There are two distinct regulatory philosophies: A merit-based regulatory approach and a disclosure-based regulatory approach. Merit-based regulation assumes that the market regulators are better informed 3 Refer to Bhattacharya, Utpal, Hazem Daouk, and Michael Welker, 2002, The World Price of 10

11 than investors and can better decide the merits of transactions on their behalf. In contrast, disclosure-based regulation is built on the principle that the market, rather than the regulators, is best equipped to determine the merits of a transaction. Under the merit-based regulatory approach, market regulators are responsible for collecting information and seeking assurance of the information quality from the regulated, thus increasing the cost of monitoring and compliance. Market regulators are inclined to delay deciding the merits of transactions in the effort to gather more quality information, which result in undue delays, operating inefficiency, corruption, and missed opportunities. Moreover, merit review adversely affects the attitude of market participants. Believing that government requirements are met, market participants lose the incentive to comply. Unless they are specifically asked, they do not disclose relevant information. The regulator and the regulated often engage in a never-ending cat-and-mouse game because market participants, always reluctant partners in this regulatory game, disclose as little as possible. The cost of enforcement thus escalates to exacerbate the degree of the moral hazard problem, while market regulators tend to rely on micro-managing the economy or the market because they do not trust market participants. I am afraid that we have observed this kind of regulatory trend in Japan and many Asian countries and I believe that the Asian financial crisis epitomize the worst of the merit-based regulatory approach. An alternative to the merit-based approach is disclosure-based regulation. Under the disclosure-based regulatory approach, investors are required to Earnings Opacity, Journal of Finance 57,

12 assume responsibility for their own investment decisions and should not be protected from poor judgments. Responsibility for compliance is upheld by market participants, especially securities market institutions. Market regulators are not trapped in the cat-and-mouse game in their search for additional information on which to base their merit assessment. Market discipline determines the merits of transactions as better-informed investors exercise greater vigilance. I would like to see that financial market regulators shift away from the costly merit-based regulatory approach that is typical of traditional, top-down regulatory regimes and embrace the disclosure-based regulatory approach that is consistent with market-based regulation widely adopted by advanced capital markets. In well-developed disclosure-based environments, institutional investors and self-regulatory organizations help raise the standard of corporate disclosure and market discipline. In a merit-based environment, however, market regulators must set up necessary standards and impose market discipline on the participants. As a result, enforcement and compliance become very costly in merit-based regulation. Furthermore, innovations by participants and efficiency in the market as a whole are not encouraged. Disclosure-based regulation, on the other hand, can achieve the opposite. E. Looking Forward for the Korean Financial Market We need a concerted effort to achieve the goal of making Seoul a regional and international financial center. The Korean regulatory authorities must adopt 12

13 the disclosure-based regulatory approach and avoid any misleading impression that the markets and the economy are micro-managed. Market transparencies must be promoted by market regulators, financial institutions, and listed companies. Perceptions of the Korean financial market have to change among foreign institutions and investors. Otherwise, attaining the goal of serving as an international financial center is difficult to attain. 13

14 Panel A Frequency Distribution of Scaled Earnings for Small-Sized Firm Group Frequency Scaled Earnings Intervals Panel B Frequency Distribution of Scaled Earnings for Medium-Sized Firm Group Frequency Scaled Earnings Intervals Panel C Frequency Distribution of Scaled Earnings for Large-Sized Firm Group frequency Scaled Earnings Intervals Figure 1 Frequency Distribution of Earnings Scaled by the Beginning Market Value 14