Autumn 2013

INSIDE VIEW: Why Korea needs to change

KoreaKorea should introduce a multi-year currency liberalisation framework, argues Aaron H Kwon of Summit International Capital, as MSCI further delays an upgrade to developed market status. Another year has passed inconclusively. Korean asset managers are downplaying MSCI’s decision not to upgrade Korea from emerging market to developed market status so much so that news coverage on the announcement has gone almost unnoticed. The reaction by the Korean government is even more muted. This year marks the fifth since MSCI has reviewed the case. The lengthy review is puzzling because it is in the interests of both parties to see Korea upgraded sooner rather than later. The upgrade would mean an additional inflow of foreign capital for Korea, estimated anywhere between $4 billion and $17 billion over time. Capital inflows are likely to stem from passive funds, whose popularity as an investment strategy has been gaining renewed interest since the 2008 global financial crisis.
Korea could enjoy a more permanent inflow of higher quality foreign capital – as opposed to speculative, short-term money that can bring disruptive effects to the local market. The upgrade could also become a harbinger for Korea Composite Stock Price Index, commonly referred to as Kospi, to command a higher market premium and graduate from what is known as the perennial “Korea discount”. MSCI and FTSE are the two major global investment index providers that are competing for business from asset managers. In 2009, FTSE upgraded Korea to advanced market status; this year, Vanguard switched Korea from MSCI emerging markets to FTSE advanced markets. The upgrade would allow Korea a bigger share of the global capital, which in turn translates into higher index volumes and fee revenue MSCI can charge to asset managers.    The protracted negotiation for a win-win subject matter is interesting.  Broadly speaking, MSCI evaluates a country’s status based on a framework of four pillars, supported by 18 measures, from which market accessibility levels are examined across the investment universe. Those pillars are openness to foreign ownership, ease of capital flows, operational efficiency, and stability of institutional framework. Over the years, MSCI and the Korea Stock Exchange (KRX) have narrowed down a host of outstanding issues to two items: the investor identification system and, more importantly, limited convertibility of the Korean won in the offshore currency market. The investor identification system should not be a deal-breaker. Every investor trading through the KRX is required to open an investor identification code, which allows the market trading volume to flow into individual, local institutional and foreign investor buckets. Local institutional investors are further classified into eight sub-buckets. The information is electronically made available to the public in real time, promoting a greater transparency of buyers and sellers. WORLD STANDARD
MSCI argues the local investor identification system is operationally cumbersome and foreign investors should be exempted from the rule. The logic is that no advanced market requires it and, therefore, it is not a world standard. Korea’s investor identification system should be treated as the new world standard and MSCI should move towards it. It is technologically made possible because Korea has become the most internet-savvy country in the world. For instance, no other open electronic trading system in the US is as sophisticated as the one investors take for granted in Korea. Because the local rule applies to all investors, it would be unfair to grant a special treatment to foreign investors. The investor identification system is engrained in the fabric of the KRX framework. MSCI will eventually embrace the Korean model. The limited convertibility of Korean won in the offshore currency market is a legitimate issue. Convertibility itself is not the problem because foreigners can engage local brokers and convert cash into Korean won, and vice versa, during the local business hours. What MSCI is saying is that the current convertibility arrangement falls short of the developed market standard, which is true. Korea boasts the 11th largest economy in terms of GDP, but it has the world’s largest offshore non-deliverable forward foreign exchange market, because the country still imposes many restrictions on foreign capital and current account transactions. It should migrate to the free currency regime by promoting a liquid offshore spot market that external investors can tap for currency management.      The currency regime issue, however, is not something MSCI and the KRX can resolve by themselves. It is a sovereign decision and would require a major deregulation at governmental level. It is a complicated political issue and has become even more so since the 2008 global financial crisis. In dealing with policies as important as the currency regime, policymakers should take the country’s economy and financial markets into account. The Korea Securities Exchange Commission has not taken any action on MSCI’s demand. The regulator does not want to lose control of financial regulation. If the spot market expands to US and Europe, it cannot control the global currency market for Korean won. Many national economies are also considering a tighter currency control because speculative fund flows and quantitative easing policies are causing side-effects as well as greater market volatility. COMPROMISE
Sooner or later, Korea will be upgraded to developed market status. When, however, will depend on how soon MSCI and KRX are willing to manage a compromise. MSCI cannot put the upgrade off for long because Korea needs to be bumped up in order for the Chinese A-shares market to be included in the MSCI Emerging Market Index. China wants to join it and MSCI knows it is a new business opportunity for them. The Korean government believes the country is already a developed economy even without an offshore spot market. It is true to a large extent. Yet Korea cannot become a truly developed economy until it has an efficient offshore spot currency market. MSCI and KRX may need to dance around a little longer and come up with a solution acceptable to both parties. Korea should work on a roadmap to introduce a multi-year currency liberalisation framework; MSCI should upgrade Korea on the grounds that the government will need time to work around the regulation and eventually migrate to the free currency regime. Aaron H Kwon is the founder and chief executive officer at Seoul-based Summit International Capital ©2013 funds global asia

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