korean bond markets

7/29/2019 Korean Bond Markets

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BOND MARKET DEVELOPMENT:THE EXPERIENCE OF THE REPUBLIC OF KOREA

2008

J ae-Ha Park*

* Vice President, Korea Institute of Finance, [email protected]


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Contents

I. Overview of the Korean Economy and Financial System

II. Development of the Bond Market in the Republic of K orea

III. Policy Lessons from Bond Market Development in the Republic of Korea

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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 shortof remarkable. Since facing the economic crisis that erupted in November 1997, theeconomy has recovered from near collapse. During this period, the structure of the onceailing economy was rendered more transparent and upgraded to meet global standards.Although many factors can be attributed to the unexpectedly rapid recovery, the mostimportant factor was the sweeping reform undertaken in all sectors of the economy, butespecially in the financial and corporate sectors. Recognizing that the crisis was caused bylong-standing structural weaknesses rather than merely a temporary shortage in foreignreserves caused by a loss of credibility among international investors, the Korean governmentinitiated drastic economic reform.

In addition, reform measures were implemented in economic policies, such asmonetary, fiscal and foreign exchange polices. Relating to monetary policy, the Bank ofKorea 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 andnon-financial sectors to promote restructuring while playing a greater counter-cyclical role instabilizing the economy after the crisis. In particular, the Korean government reorganizedthe financial system and upgraded the financial infrastructure to strengthen soundness, bystrengthening supervision, relaxing regulations and establishing global standard rules andregulations. For example, the government consolidated separate supervisory authorities intoa single unit. Along with the changes in the institutional framework, the FSC (FinancialSupervisory Committee) and the FSS (Financial Supervisory Service) have strengthenedprudential regulation and supervisory authority to ensure that financial institutions do notrevert to their old practices.

The outcomes of these reforms have been remarkable thus far. Foreign reserves havegrown at an outstanding pace, from 20.4 billion dollars in December 1997 to 261.9 billiondollars at the end of November 2007. The economic growth rate has returned to pre-crisislevels (except in 1998). Also, the current account surplus, which declined between 1998and 2002, has rebounded since 2003. In addition to the rapid economic recovery, Koreasfinancial infrastructure, which includes related legislation and practices, has been upgraded tomatch global standards. These reforms have not only bolstered the management status atindividual 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 seriousproblems resulted in the course of managing the financial crisis. Among others, real estateprices surged as a huge amount liquidity circulated in the economy without being used forinvestment by the corporate sector. After the crisis, government provided enormousamounts of liquidity to boost the sluggish economy and establish a social safety net.However, the corporate sector became very conservative and over-cautious for newinvestment after the crisis, as they struggled to restructure and resolve excess capacity.

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Therefore, funds in the economy rushed into the housing market, which pressured overall realestate 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, thegovernment introduced a series of drastic measures to reduce household debt and stabilize theoverheated housing market. Prolonged economic polarization is an equally seriouschallenge now inhibiting our Koreas future. The Korean economy has becomeincreasingly polarized with booming exports and sluggish domestic demand. The majorreason solid export growth has failed to spur demand is the breakdown of the traditionaleconomic growth pattern, under which export growth usually leads to increased corporateinvestment and employment, which translates into increased private consumption. Recently,however, this vicious circle between exports and domestic demand has failed to materializeas 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 isthe importance of a robust and efficient domestic financial system in maintaining a healthyeconomy. A weak banking system, even less efficient capital markets, inappropriatefinancial regulations, and inadequate monitoring of the financial sector all contributed to themisallocation of resources, leaving the economy susceptible to internal and external shocks,leading to economic failure. The financial crisis ignited debate over how to best maintainthe safety and soundness of the domestic and international financial.

With accelerated financial liberalization and globalization, coupled with a wideapplication of new communications technologies to financial products, threats to financialstability 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 furtherproblems. Financial intermediation is a continuously evolving activity, involving new risks,instruments, and challenges. To remain in command of these ever-changing risks, financialinstitutions and policy makers need to continually upgrade their processes.

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Figure 1. Trend of Economic Growth and Current Account Surplus

(Unit : %, million dollars)

-200000

-100000

0

100000

200000

300000

400000

500000

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

-8

-6

-4

-2

0

2

4

6

8

10

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 relationshipbetween 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 monetaryindicator in the Republic of Korea. Inflation targeting consists of three main elements: atarget indicator, a target level and a target achievement period. Core inflation is used as thetarget indicator. Core CPI (Consumer Price Index) is the CPI excluding; (1) items withprices subject to severe volatility from unexpected external shocks, and (2) prices which areindependent 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 becontrolled by the monetary policy of the central bank. Monetary authorities can principallyinfluence aggregate demand with policy instruments.The target level in the Republic ofKorea is determined by the positive method. By this method, the BOK is to set anachievable target, based on price forecasts, and taking into consideration overall economicconditions within the foreseeable future. To determine the target achievement period, theBank of Korea uses annual inflation targeting. However, annual inflation targeting of thiskind has some problems, such as a time lag and external uncertainty. In order to make up

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for these shortcomings, the Bank of Korea has set a medium-term target, announcing that itwill strive to hold core inflation at the 2.5% level. This is not a rigid target, and it can bemodified in accordance with changes in economic structure and external conditions.

In general, the Bank of Korea uses the overnight call rate to achieve the inflationtarget. Recently, in 2006, the Bank of Korea started to use a reserve requirement policy tosettle the overheated real estate market.

Table 1. Adjustment of Call Rate Target(Unit : %)

Range of Adjustment Call Rate Target

1999 May - 4.75

February 0.25%p 5.002000

October 0.25%p 5.25

February -0.25%p 5.00

July -0.25%p 4.75

August -0.25%p 4.502001

September -0.50%p 4.00

2002 May 0.25%p 4.25

May -0.25%p 4.002003

July -0.25%p 3.75

August -0.25%p 3.502004

November -0.25%p 3.25

October 0.25%p 3.50

2005 December 0.25%p 3.75

February 0.25%p 4.00

June 0.25%p 4.252006

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 foreignexchange supply and demand in the foreign exchange market. In this system, the objectiveis attaining foreign exchange market stabilization through alleviating excessive short-termexchange rate volatility. Under an inflation target monetary system, simultaneouslyestablishing an inflation rate target and exchange rate target is very difficult. However, afloating exchange rate system is the most effective system alongside an inflation targeting

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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 arenow serving in partnership as the exchange rate administrative body. The BOK isauthorized to supervise the money changers and foreign exchange brokers, as well as tooversee foreign exchange transactions. The MOFE has the overall responsibility for foreignexchange policy, including exchange rate operations. In fact, the BOK uses foreignexchange (FX) market intervention in consultation with the MOFE, for the purpose ofstabilizing the FX market. The general objective of FX intervention in the Republic of

Korea is to: mitigate short-term exchange rate volatility, acquire foreign reserves,

and 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 avoidexacerbating the crisis. Verbal intervention and real intervention in the spot market are usedas a tool. In determining the most appropriate timing for intervention, the authorityconsiders the degree of exchange rate misalignment and the permanence of the marketdistortion. Also, intervention depends on the authority's discretionary judgment, rather thanon any implicit rule.

In addition, authorities issued Monetary Stabilization Bonds (MSBs) and ForeignExchange Stabilization Funds to share the burden of managing money aggregates. The tablebelow 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, anindication of an expanding FX market. Because the government no longer used themanaged rate system, which emphasized equilibrium, and began using the free floatingsystem, volatility increased. Surely, this can cause instability in the FX market and thegovernment needs certain tools by which to intervene, tools such as verbal and realintervention.

In the meantime, the increase of foreign reserves is quite rapid. Foreign reservesgrew almost ten times between 1997 and 2006, for use as a safety net in case of a financialcrisis. Nonetheless, authorities maintained the secrecy of FX intervention. While theeconomy may lose transparency in exchange rate operations, it can achieve the positiveeffects of expanding its foreign reserves and the FX market.

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Figure 2. Trend of Foreign Reserves in the Republic of Korea

(Unit : trillion dollars)

0

50

100

150

200

250

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Foreign Reserves

Source: Bank of Korea

(3) Fiscal policy

Prior to the crisis, fiscal policy was not a commonly used economic stabilization toolin the Republic of Korea. Most of the fiscal expenditures on SOC, education and R&D arefocused on economic growth in the Republic of Korea. Furthermore, the Korean governmenthas been reluctant to employ a counter-cyclical fiscal policy, citing the political costsincurred by fiscal deficits.

After the financial crisis, fiscal policy changed drastically. The financial crisis causeda 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 theeconomy after the crisis. In particular, there was a need for public funds to be dispersed tosmall- 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 ManagementCorporation). Also, in order to support SMEs, there was a significant increase in governmentloan guarantees during the crisis.

For financial restructuring, with approval of the National Assembly, the authoritiesearmarked 64 trillion won in public funds to purchase NPLs and support recapitalizationefforts at domestic financial institutions. The table below shows the total volume of public

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funds injected to the financial sector. By the end of August 2007, the total volume grew to239.6 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 129.6 38.7 168.3

Used Recapitalization Depositpayment

AssetPurchase

others Sub-total

42.2 35.2 3.6 0.6 81.6

38.7 168.3

Bank 34.0 13.9 14.4 0 62.3 24.6 86.9

Non-Bank 29.5 34.9 2.3 0.6 67.3 14.1 79.0

Re-couped 34.6 36.7 71.3

Reused 7.6 10.5 6.5 0 24.6 17.4 42.0

Source: Ministry of Finance and Economy

Also, the outstanding guarantees by the Korea Credit Guarantee Fund (KCGF) andthe Korea Technology Credit Guarantee Fund (KTCGF) steadily grew after the financialcrisis. 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 2006.

Table 3. SME guarantees by KCGF and KTCGF(Unit : trillion won, %)

KCGF KDCGF

Outstandingguarantees

Defaultratio(%)

ratio of netpayment in

subrogation(%)

Outstandingguarantees

Defaultratio(%)

ratio of netpayment in

subrogation(%)

1995 8.2 trillion 9.1 8.4 3.5 trillion 9.8 7.5










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Average 21.5 trillion 6.6 5.2 11.2 trillion 8.4 5.3

Source: International Tax and Public Finance, 2006.

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 maintainingsoundness and promoting globalization. These reforms include actively managing unsoundfinancial institutions, injecting public funds, strengthening supervision, developing universalbanking systems, and relaxing remaining regulations on investment.

The financial system in the Republic of Korea is mainly composed of the centralbank, the banking sector, and the non-banking financial sector. The central bank, also knownas the BOK (Bank of Korea) was established for the purpose of maintaining price stabilityand contributing to the sound development of the national economy through effectivemonetary and credit policy. To this end, the BOK undertakes various tasks, including theoperation and management of payment systems, analysis and inspection of financialinstitutions' managers, foreign exchange management, and the issuance of bank notes andcoins. Also, the BOK serves as the government's bank by administering Treasury funds andextending credit to the government. In addition, the BOK undertakes matters relating to theissuance 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 establishedunder 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 cardbusinesses. Specialized banks supply funds to specific fields that the commercial bankswould have difficulty in accommodating. due to the limitations on the sources of funds andprofitability. For example, the Korea Development Bank supplies long-term facilities fundsfor technology development in important industries. The Export-Import Bank of Koreahandles export and import financing exclusively.

The non-banking sector consists of depository institutions, insurance companies, andsecurities companies. Depository institutions include merchant banking corporations, mutualsavings, and credit cooperative institutions. Merchant banks are financial companies thathandle most corporate financing businesses, apart from stock brokerage and insurance.Mutual savings specialize in deposits and lending, having the general public and smallenterprises as their customers. Credit cooperative institutions promote the mutual benefit oftheir members through deposits and lending.

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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, inthe 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 substantiallyenhanced. The governor of the Bank of Korea (BOK), previously appointed by the Ministryof Finance and Economy (MOFE), is now appointed by the President on the deliberation ofthe State Council. The governor of the BOK, instead of the minister of MOFE, now chairsthe Monetary Policy Committee, the supreme policymaking body of the BOK. The latestrevision of the Bank of Korea Act in 2003 allowed the deputy governor of the BOK to serveex-officioon the Monetary Policy Committee, and the Securities Dealers Association lost itsright to recommend a member to the committee. With the participation of the deputygovernor of the BOK as an ex-officiomember on the Monetary Policy Committee, the BOKis 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 ofcurrency value and the soundness of the banking and credit system -- are replaced bymaintaining price stability. Consequently, the Monetary Board is expected to employ moreadvanced central banking techniques for the goal of price stability. Its responsibility forsupervising the banking industry was transferred to the newly established FSC.

Although the BOKs bank supervisory functions were transferred to the FinancialSupervisory Commission (the FSC) and the Financial Supervisory Service (the FSS), it hasthe right to request all banking institutions and any non-bank financial institution to maintaincurrent deposit accounts with the central bank. The bank also may require the FSS toconduct an individual or joint on-site examination of specific banking institutions and todisclose the findings of these examinations, on the basis of which, the bank may ask the FSSto order banking institutions to take corrective actions. When the bank extends emergencycredit to banking institutions, non-bank financial institutions or other profit-makingenterprises, 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 byseparate bodies: The Ministry of Finance and Economy (MOFE), the Bank of Korea (BOK),the Securities Supervisory Board (SSB), and the Insurance Supervisory Board (ISB). Thissystem was a vestige of the government-led economic growth strategy that had been pursuedsince the early 1960s. Since the MOFE always had multiple policy goals and assigned toppriority to the real sector, the safety and soundness or competitiveness of the financial sectorhad been relatively neglected. A complex regulatory structure and inadequate coordination

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between supervisory organizations created a lack of consistency and ineffective supervision.

After the crisis, the government understood the necessity of creating a consolidatedsupervisory body (merging the FSC and FSS). The rationale for unifying the supervisoryauthority is clear. First, separating supervisory authority from the MOFE was a necessarycondition for neutrality and independence in supervision (established under the PrimeMinister's Office). Second, distinctions between financial institutions are increasinglymeaningless due to accelerating financial deregulation, thereby necessitating a consolidatedsupervisory body for effective supervision. Along with the changes in the institutionalframework, the FSC and the FSS have strengthened regulation and supervision to ensure thatfinancial institutions do not revert to their old practices. These strengthened regulationsinclude introducing the Prompt Corrective Action (PCA) System, strengthening assetclassification standards, high standards for accounting and public disclosure, prudent rulesfor 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 thefinancial system. In addition, the organizational structure, such as the relationship betweenthe FSC and the FSS, was not working nearly as efficiently as expected. A series of seriousfinancial problems, most notably the SK Global accounting fraud in March 2003 and thefinancial problems at numerous credit card companies, were not detected or prevented by thesupervisory agencies in advance. The effectiveness of the new supervisory system inimproving the soundness and competitiveness of financial institutions and the financialsystem has been frequently questioned by many experts.

(4) Financial I nstitutions

The Republic of Korea has several types of financial institutions in addition to thebanking, securities, and insurance businesses. The size of major financial institutions' assetsis shown below. Because individuals now prefer safe assets, mainly bank deposits, thebanking industry has grown significantly since the financial crisis. Non-bank depositoryinstitutions include merchant banking corporations, mutual savings corporations, creditunions, and credit-specialized financial companies. As shown below, the proportion ofmerchant banking has dropped since the markets restructuring. In 1996, merchant banksheld 7.5% of total assets at financial institutions, but now hold only 0.1% (June 2007). Othernon-bank depository institutions experienced trends similar to the merchant banking industry.

The insurance industry is comprised of both life insurance and non-life insurancecompanies. The portion of insurance companies increased after the financial crisis for thesame 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 theRepublic of Korea.

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Table 4. Scale of Major Financial Institutions' Assets

(Unit: trillion won)1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007.6

Bank 472.6(67.4%)

606.6(64.3%)

565.1(63.5%)

791.0(70.4%)

829.3(71.6%)

915.1(71.9%)

1043.1(72.2%)

1131.8(74.4%)

1141.7(73.1%)

1232.0(71.8%)

1394.1(71.1%)

1500.1(70.3%)

Merchantbank

52.5(7.5%)

77.9(8.2%)

58.4(6.6%)

38.2(3.4%)

21.3(1.8%)

3.9(0.3%)

3.1(0.2%)

0.8(0.1%)

0.8(0.1%)

1.1(0.1%)

1.1(0.1%)

1.4(0.1%)

MutualSavings

36.3(5.2%)

36.1(3.8%)

32.1(3.6%)

25.9(2.3%)

21.4(1.8%)

22.5(1.8%)

25.5(1.8%)

30.1(2.0%)

35.9(2.3%)

41.7(2.4%)

50.8(2.5%)

53.2(2.4)

Creditunion

16.6(2.4%)

19.3(2.0%)

21.0(2.4%)

19.8(1.8%)

20.5(1.8%)

22.6(1.8%)

19.7(1.4%)

19.6(1.3%)

22.2(1.4%)

24.0(1.4%)

26.2(1.3%)

27.1(1.2%)

Credit-specialized

- 68.3(7.2%)

64.2(7.2%)

54.8(4.9%)

62.4(5.4%)

76.1(6.0%)

101.7(7.0%)

66.5(4.4%)

53.9(3.5%)

58.0(3.4%)

67.8(3.4%)

75.8(3.5%)

LifeInsurance

80.0(11.4%)

92.4(9.8%)

92.3(10.4%)

106.1(9.4%)

120.5(10.4%)

138.0(10.8%)

163.3(11.3%)

183.2(12.1%)

210.0(13.4%)

234.8(13.7%)

265.7(13.5%)

282.7(13.2%)

Non-lifeInsurance

15.4(2.2%)

19.5(2.1%)

22.2(2.5%)

26.7(2.4%)

29.0(2.5%)

33.3(2.6%)

5.3(2.4%)

37.9(2.5%)

42.8(2.7%)

49.0(2.9%)

55.7(2.8%)

59.5(2.7%)

Securities 27.8(4.0%)

23.9(2.5%)

34.7(3.9%)

60.7(5.4%)

52.2(4.5%)

58.9(4.6%)

50.5(3.5%)

48.4(3.2%)

52.4(3.4%)

73.1(4.3%)

92.8(4.7%)

127.8(5.9%)

Futures - - - 0.3(0.0%)

0.5(0.0%)

0.6(0.0%)

0.5(0.0%)

0.6(0.0%)

0.9(0.1%)

1.2(0.1%)

1.3(0.1%)

1.7(0.1%)

AssetManage-

ment

- - - - 1.3(0.1%)

1.4(0.1%)

1.5(0.1%)

1.6(0.1%)

1.6(0.1%)

1.6(0.1%)

2.0(0.1%)

2.1(0.1%)

Total 701.3 943.8 890.1 1123.4 1158.3 1272.5 1444.1 1520.5 1562.0 1716.3 1958.1 2131.8

Source: Financial Supervisory Service (FSS), Monthly Financial Statistics.

(5) Financial Markets

The financial market in which financial institutions participate consists of the depositand 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 negotiablecertificate of deposit market, the bond repurchase agreement market, the MonetaryStabilization Bonds market, and the cover bills market (less than 1 YTM). The capital marketis the market that issues and trades stocks and bonds. The financial derivatives market iswhere interest rate futures, currency futures, stock price index futures, options, and equityoptions are traded (more than 1-year maturity).

The main component of the money market is the call market. The call market grew

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substantially after the financial crisis. As seen below, between 1997 and 1998, the value ofcall transactions almost doubled. Meanwhile, compared to the stock market, bond markettransactions showed quite rapid growth after the financial crisis. The growth of the bondmarket stems from government policies, such as generating the public funds for financialrestructuring and revitalizing the economy.

Figure 3. Trend of Call, Stock, and Bond Transactions

(Unit: trillion won)

0

1000

2000

3000

4000

5000

6000

7000

8000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

BOND STOCK CALL

Source: Bank of Korea, Korea Exchange (KRX).

I I . Development of the Bond Market in the Republic of Korea

I I.1. Overall Status of Korean Bond Market

It is evident that Koreas financial market experienced enormous changes leading upto and following the crisis. Before the crisis, there was a mere semblance of a financialmarket, but no real market to speak of. Immediately after the crisis, the stock marketdeclined sharply while the bond market and call market expanded in size to finance therecovery. As the economy recovered after the crisis, the stock and bond markets grew with

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it. The bond market in particular grew rapidly from 224.1 trillion KRW in 1997 to 819.8trillion KRW in August 2007.

Figure 4. Growth of Bond, Stock, and Money Markets(Unit: billion won)

0

200000

400000

600000

800000

1000000

1200000

1990 1995 1997 2000 2003 2004 2006 2007.9

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 theRepublic of Korea. Because of the conservative fiscal policy and compulsory practice ofunderwriting, 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 thebenchmark bond. The corporate bond market, on the other hand, was quite large in sizecompared to the government bond market. However, since corporate bonds were almostentirely guaranteed by the banks, they were regarded as another form of bank loans. After thecrisis, however, the corporate bond market was faced with serious challenges. When thefinancial crisis erupted in the Republic of Korea, banks became the first targets ofrestructuring. In other words, government evaluated the soundness of banks based on the BIS

capital adequacy ratio, and decided their viability. Consequently, the banks stoppedguaranteeing corporate bonds in order to avoid risks, which caused the collapse of thecorporate bond market.

After the crisis, the Korean government realized that an efficient and well-functioning bond market is essential for preventing another crisis, which can be achieved byenhancing the soundness of financial system, and started reforming and vitalizing the bondmarket. In addition, the economic situation after the crisis also contributed a lot to the

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development of the bond market in the Republic of Korea. Among others, due togovernment policies, such as generating public funds for financial restructuring andeconomic stimulus, there has been outstanding growth in the size of the bond market. Bypriming the pump with a fiscal stimulus, the government financed the economic restructuring,thereby boosting the depressed economy. Also, the Bank of Korea issued more MonetaryStabilization 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 marketgrew from 334.0 trillion KRW at the end of 1998 to 898.6 trillion KRW at the end of 2006.Remarkably, government bonds grew from 42.1 trillion KRW (12.6 per cent) to 257.7 trillionKRW (28.6 per cent) in the same period. Also, MSBs grew from 46.6 trillion KRW (13.9per cent) to 158.3 trillion KRW (17.6 per cent).

The corporate bond market also increased in size by 112 per cent, from 119.4 trillionKRW in 1998 to 134.4 trillion KRW in 2006. Directly after the crisis, companies needed tofinance more funds from the bond market because banks were reluctant to extend loans to thecorporate sector. This situation resulted in issuing large quantities of asset-backed securities(ABSs) during the post-crisis financial restructuring. Between 1999~2002, the corporatebond market grew steadily, helped by massive ABS issuance. As financial restructuring cameto a close after 2003, ABS issuance fell.

Table 5. Outstanding Amount of Bonds

(Unit: billion won, %)Type 1998 1999 2000 2001 2002 2003 2004 2005 2006

Government

42.1

(12.6)

61.6

(16.9)

73.3

(17.3)

82.9

(16.4)

99.0

(17.6)

136.9

(22.5)

178.9

(27.0)

223.2

(30.9)

257.7

(28.6)

Local Gov'7.1

(2.1)9.1

(2.5)9.8

(2.3)9.5

(1.9)9.2

(1.6)10.2(1.7)

10.5(1.6)

11.1(1.5)

11.8(1.3)

MSBs46.6

(13.9)50.8

(13.9)66.9

(15.8)79.1

(15.7)84.3

(14.9)105.5(17.4)

142.7(21.6)

155.2(21.5)

158.3(17.6)

Financial Inst.33.8

(10.1)30.5(8.4)

31.9(7.5)

34.3(6.8)

98.9(17.5)

102.3(16.9)

100.6(15.2)

106.3(14.7)

168.2(18.7)

Specific Law84.8

(25.4)100.9(27.7)

114.6(27.0)

157.4(31.2)

131.2(23.3)

116.2(19.1)

113.0(17.1)

118.8(16.5)

100.4(11.1)

Corporate119.4(35.8)

111.1(30.5)

127.9(30.1)

141.2(28.0)

141.3(25.1)

136.1(22.4)

115.7(17.5)

107.4(14.9)

134.4(14.9)

Total 334.0 364.4 424.7 504.7 563.9 607.5 662.1 722.3 898.6

Note: Number in parentheses shows the proportion of bonds.Source: Korea Exchange (KRX)

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Figure 5. Proportion of Bonds by Type

12.6%16.9% 17.3% 16.4% 17.6%

22.5%27.0%

30.9% 32.9%14.0%

13.9% 15.8% 15.7% 14.9%

17.4%

21.6%21.5%

21.1%

10.1%8.4% 7.5% 6.8%

17.5%

16.8%

15.2%14.7%

18.5%

25.4%27.7% 27. 0% 31. 2%

23.3%

19.1%

17.1%16.4%

13.0%35.7%30.5% 30.1% 28.0%

25.1% 22.4%17.5% 14.9% 13.0%

1.5%1.5%

1.6%

1.7%1.6%1.9%2.3%2.5%

2.1%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

1998 1999 2000 2001 2002 2003 2004 2005 2006

Government Local MSBs Financial Inst. Specific Law Corporate Source: Korea Exchange (KRX)

I I. 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 ofKorea is attributed to the government-led reforms. The table below highlights the majorgovernment reforms that have improved the Korean bond market. Before 2005, Koreanbond market reforms focused on measures to reduce issuing costs by making the benchmarkissue more liquid. After 2005, reform concentrated on measures to reduce issuing costs bymeeting more diverse and sophisticated investment demands. Introducing STRIPS, issuing20-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 to foster the

government bond market, to improve the primary and secondary market, to increase

the supply of bonds, and to build market infrastructure.

Table 6. Reforms of the Bond Market

Year Context of ReformsExpand the limit of corporate bond issuance

1997Open bond market to foreign investors

Demolish arbitrary control of bond issuance1998

Announcement of the Government Bond Market Stimulus Plan

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Inter-Dealer Market

Bond price-valuation method based on market price

Primary Dealer (PD) System

Delivery Versus Payment (DVP) System

Formulation of government bond issuance1999

Government Bond Futures

Inter-Dealer Broker (IDB) System

Reopening System(Fungible Issue System)

Multiple Price Auction to Dutch Auction2000

Issue 10-year maturity government bonds

2002 Mandatory Exchange Trading Requirement for Benchmark Issues2003 Strengthen Obligation of PDs

2006

STRIPS (Separate Trading of Registered Interest and Principal of Securities) SystemIssue 20 year bondsIssue Inflation-Indexed BondsDesign products for retail investors

(1) Fostering the Government Bond Market

First, to foster the government bond market, diverse reform measures wereintroduced, such as the reopening system, the Dutch auction, formulation of the governmentbond issuance, 10-year maturity government bonds, PD system, and a mandatory exchangetrading requirement for benchmark issues.

The reopening system (fungible issue system) enhanced the liquidity of bonds byincreasing 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 instrumentswith the same maturities consequently helped to vitalize the secondary market. In 2003, thegovernment further modified the reopening system to standardize the pricing of governmentbonds to meet global standards. Also, the government introduced a DAS (Dutch AuctionSystem). DAS is an auction in which an item is initially offered at a high price which isthen progressively lowered until a bid is made and the item is sold. This system effectivelyremoves the winner's curse, the tendency for the winning bid in an auction to exceed theintrinsic value of the item purchased.

Furthermore, the government formulated the issuance of government bonds for thepurpose of fostering the bond market. For example, the government announced the required

issuance of government bonds every month and year, generating more accurate expectationswithin the market. By separating monthly issuance by maturity and by discerning the biddate (Monday) from the issue date (Wednesday), the government took positive steps to alignreality with market expectations. In addition, the government started to issue 10-year and20-year maturity government bonds and stopped issuing 1-year KTBs, making it possible toexpand the maturity structure of the government bond market.

The Primary Dealer (PD) system was established in 1999 with the inauguration of 26

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financial institutions, including 13 securities houses and 12 commercial banks. The PDsystem encourages the secondary market for government bonds by providing liquidity andefficiency. PDs are elected by the Minister of Finance and Economy every year and enjoyseveral privileges. The have exclusive participation in government bond auctions, access tosecurities financing facilities for secondary market trading, and regularly consult directlywith the Ministry of Finance and Economy. To balance out these privileges, PDs have anobligation to act as a market maker and follow these guidelines: 1) 5% minimumunderwriting & trading every 6 months, 2) provide bid/ask quotes with minimum volume andmaximum spread constraint, 3) 40% mandatory exchange trading, 4) reporting requirementof position and trading information of government bonds to the Treasury.

To invigorate the KRX market, the government mandated in October 2002 that PDsshould 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 tradingrequirements are not only effective for benchmark issues, such regulations also expand thetrading volume of non-benchmark issues.

(2) Improving the Primary and Secondary Market

Government reforms to advance the primary and secondary bond markets includeexpanding the limit of corporate bond issuance, demolishing arbitrary control of bondissuance and introducing an Inter-Dealer Broker (IDB) system and ABS market. With thesereforms, the government has tried to expand the limit of corporate bond issuance and openthe bond market to foreign investors. For example, companies could have issued two timesover 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 4times net worth. Restrictions on foreign investors were totally removed. Also, to promotebond market growth and proper issuance in the market, the government ended arbitrarycontrol of bond issuance.

The IDB (Inter-Dealer Broker) system creates a fluid market structure wherecorporate, financial, and special bonds are traded. IDB is a brokerage firm operating in thebond market that acts as an intermediary between major dealers to facilitate inter-dealertrades for providing liquidity. In the Republic of Korea, securities companies generally playthe role of IDB.

Finally, the ABS (Asset-Backed Securities) market was introduced as another meansto improve the corporate bond market. Next to Japan, the Republic of Korea has the largestasset-backed securities (ABSs) market in Asia. Right after the financial crisis, it was crucialto increase liquidity to the financial sector and to locate a new source of funding for thecorporate sector. To these ends, KAMCO was established to collect non-performing loans(NPLs) in the financial sector. After collecting NPLs, KAMCO liquidated those NPLs byissuing ABSs through a special purpose company (SPC). ABSs were first issued forfinancial restructuring and securitization of NPLs. After financial restructuring, ABSs were

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used to ease the credit crunch and to be used as financing tools for companies using primarycollateralized bond obligations (CBOs).

(3) Increasing the Supply of Bonds

Increasing the supply of bonds is an integral part of the governments bond marketreforms. After the crisis, expanding the government bond market to meet new demands forissuance became a priority for overall recovery. As the PD system created a market-maker,the government encouraged the dealers to expand the supply of bonds.

In another reform aimed at creating a broader, more sophisticated bond market, thegovernment introduced STRIPS (Separate Trading of Registered Interest and Principal ofSecurities) to the market in 2006. The STRIPS product separates the Korean Treasury Bond(KTB) into its two constituent parts: the interest and the principal. Then, the systemsecuritizes 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 couponprincipal bond and 6 zero coupon interest bonds. This sophistication increases theliquidity of the government bond market by providing new instruments at various maturitiesand yields. In addition, the creation of these new products presents new arbitrageopportunities for advanced trading strategies. Also, a STRIPS yield to maturity is pre-determined, prohibiting re-investment of mid-term interest. This makes it possible forinsurance companies and pension funds to utilize the STRIPS as long-term investmentvehicles. Finally, because this system can lower the cost of purchasing bonds, the demandfor STRIPS is actually concentrated among individuals and small institutions. Finally in2006, the government designed products for retail investors, which will expand the range ofinvestors.

(4) Building Market Infrastructure

Reforms aimed at improving overall market infrastructure include adopting a bondprice-valuation method based on market price, introducing government bond futures andimplementing 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, notmerely a safe asset. This valuation method also eliminates the transferring profit problemby distributing dividends based on actual results. Ultimately, this reform expands the bond

market by inducing transactions based simply on market price fluctuations. In anotherreform-minded move, the government listed Government Bond Futures in the futures marketfor the purpose of hedging long-term interest rate changes.

By introducing the Delivery Versus Payment (DVP) system, clearing and settlementrisk could be relieved by linking the Korea Securities Depository (KSD) and the Bank ofKorea (BOK). Specifically, account transfers from the customer's deposit account in the KSDare connected with the settlement system at the BOK. This makes efficient and effective bondtrade settlement possible.

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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 (KoreanTreasury Bond), foreign exchange stabilization bonds, grain securities, and national housingbonds. The largest are KTBs, which are used to finance central government fiscaloperations. The government issues KTBs with a maturity of 3, 5, 10 and 20 years withdistribution among the four types at approximately 25:40:25:10 (10-year was introduced in2000 and 20-year was introduced in 2006). For the purpose of covering the cost ofrestructuring the financial system, the government drastically increased the size of KTBissuance from 2.1 trillion KRW in 1997 to 60.7 trillion KRW at the end of 2006. As ofAugust of 2007, the total amount of KTBs is 386.2 trillion KRW, or 88 per cent of total

government bonds. Due to rapid KTB growth, the proportion of government bonds grewfrom 12.6 per cent in 1998 to 24.8 per cent in 2006.

Foreign Exchange Stabilization Bonds are issued by the Ministry of Finance andEconomy with the approval of the National Assembly and with 3-month, 3-year and 5-yearmaturities. After November 2003, the issuance of Foreign Exchange Stabilization Bonds isintegrated with KTB issuance. Grain securities were completely retired after 2004,previously issued for the purpose of generating funds to operate Korea's Grain ManagementSpecial Account and the Grain Management Fund. National Housing Bonds are issued bythe Korea National Housing Corporation, and sold to individuals or corporations that makereal estate contracts. They are sold in public offerings via Dutch-style yield auction, and areeither a 3 per cent coupon bond with 5-year maturity (Type 1) or a 3 per cent coupon bondwith 20-year maturity (Type 2).

Table 7. Issuance of Major Government Bonds(Unit: billion won)

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007.9

FX. Stab.Fund

1,294.6 5.0 3,899.8 5,799.9 3,600.1 7,500.0 7,800.0 - - - -

KTB 2,077.0 12,463.0 18,649.5 16,376.821,830.119,350.134,520.055,950.062,550.0 60,668.2 38,628.0

GrainSecurities

1,320.0 1,693.5 2,951.7 - - - - - - - -

NationalHousingBonds

2,780.5 2,512.4 3,575.2 3,738.3 5,439.6 7,617.6 7,090.3 5,539.2 8,209.1 10,621.2 6,253.1

Source: Bank of Korea, Monthly Bulletin.

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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 systemraised the effectiveness of the market, both in quantity and quality. The volume of benchmarkissues 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 higherthan the total bond average turnover ratio (253.1 per cent).

Specifically, the PD system is a critical reform in developing the government bondmarket. The PDs, mainly, are securities companies and banks. The qualifications necessaryto become a PD vary. Banks and merchant banking corporations must meet the following

requirement: BIS8 per cent. For securities companies, their ratio of net capital150 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 ofgovernment bonds on the KRX. Using KRX volume as our measure, the average dailytransaction of government bonds grew from 3.4 trillion KRW in 2001 to 7.9 trillion KRW in2006. 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 2006.

Government bond listings increased after the financial crisis. Especially in 1999, thelisted amount, trading volume, and trading value increased enormously. By the end ofOctober 2007, there were 6221 listed issues, with 723.8 trillion KRW worth of listedgovernment and public bonds.

Table 8. Trends of Listed Government and Public Bonds

(Unit: billion won)

No. of L isted IssuesListed Amount (Par

Value)Trading Volume

(Par Value)Trading Value

1997 7,717 138,092.4 313.0 237.41998 7,090 214,297.5 7,034.9 6,520.01999 5,701 253,297.5 279,528.3 281,921.72000 5,030 296,806.0 23,407.3 23,521.22001 5,585 363,506.0 11,844.4 12,213.62002 6,303 422,629.9 45,949.5 46,062.82003 6,528 471,151.4 211,182.4 214,009.92004 6,273 545,861.7 376,367.9 383,122.52005 5,968 614,488.4 363,530.8 360,824.42006 5,925 677,763.0 294,112.5 293,480.62007 6,221 723,851,0 208,021.1 256,795,9

Source: FSS, Monthly Financial Statistics Bulletin.

Meanwhile, PD-mandated trading expanded the amount of benchmark issues. In

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relation with the PD system, the government executed new policies that increase themandatory exchange trading requirements from 20 per cent to 40 per cent and minimumtrading amounts from 2 per cent to 5 per cent. Those efforts resulted in the growth andeffectiveness of benchmark issues. This means that the government can lengthen the maturityof bonds just by changing the benchmark issues. As seen below, the proportion of benchmarkissue trading on the KRX grew significantly after adopting the mandatory exchange tradingrequirements. The mandatory exchange trading requirement does not decrease tradingvolume in the OTC market, but actually increases it in Koreas case (shown below). The totalvolume and OTC trading volume grew steadily, starting in 2002, right after mandatoryexchange trading was enacted. This means that this system has positive effects on expansionnot 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)

0

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

30,000,000

35,000,000

40,000,000

2001 2002 2003 2004 2005 2006

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 obligedto trade on the KRX, the amount of government bonds trading on the KRX is much biggerthan the corporate market.

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Table 9. Average Daily Transactions in the Government Bond Market

(Unit : billion won, %)

2001 2002 2003 2004 2005 2006Value 3,370.4 2,617.5 4,098.5 6,564.5 7,523.5 6,714.1

OTC% (98.9) (94.6) (83.3) (81.3) (84.0) (85.2)

Value 36.7 150.5 823.9 1,506.6 1,428.1 1,161.9KRX

% (1.1) (5.4) (16.7) (18.7) (16.0) (14.8)

Value 3,407.1 2,768.0 4,922.4 8,071.1 8,951.5 7,876.0Total

% (100.0) (100.0) (100.0) (100.0) (100.0) (100.0)

Source: Korea Securities Dealers Association.

Banks, insurance & pension companies, financial intermediaries, foreigners,domestic individuals, the Bank of Korea, and the Korean corporate sector are thepredominant government bond investors. The proportion of each sector is shown in the figurebelow. Banks and insurance & pension companies account for about 85.2 per cent of the totalshare of bonds in the Republic of Korea. Compared to this, other sectors, such as financialintermediaries, foreigners, domestic individuals, and the corporate sector, are not active ininvesting in government bonds.

Figure 7. Composition of I nvestors

(Unit: %, as of the end of the third quarter, 2006)

financial intermediary4.0% corporate sector1.1%Bank of Korea5.0%

foreign3.6%

individual1.1%

insurance & pension33.9%

banks51.3%

banks insurance & pension individual foreign

Bank of Korea f inancia l in termediar cor orate sector

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Source: Bank of Korea,

(2) Corporate Bond Market

In the decade since the financial crisis, the corporate bond markets have weatheredmany storms -- the financial crisis, the Daewoo Crisis, the Maturity Concentration Crisis andthe Credit Card Crisis. Right after the crisis, the corporate sector desperately tried tofinance with funds not only from the banking sector, but also from the corporate bond market.However, having to meet new Basel capital adequacy ratios, banks were reluctant to lend tothe corporate sector. Therefore, the corporate sector had to issue huge amount of corporatebonds with extremely high rates. In addition, the majority of corporate bonds were issuedas non-guaranteed bonds, because banks were reluctant to provide credit guarantees forcorporate bonds. As a result, when the Daewoo group, which issued huge amount ofcorporate bonds, went bankrupt in 1999, a serious problem was brought about in thecorporate bond market.

In 1999, the Daewoo Crisis occurred, which showed us the importance of a creditrating system and transaction transparency. Daewoo was the second largest corporate groupthat issued a huge amount of corporate bonds directly after the financial crisis. Since thematurities of most of the corporate bonds were 3 years, the serious maturity concentrationcrisis resulted in a credit crunch in 2000. Resolving the credit crunch, the governmentadopted a securitization & credit guarantee system via the Korea Credit Guarantee Fund(KCGF). This system makes credit guarantees for a pool of corporate bonds, combines themechanisms of ABS and credit guarantees, and facilitates corporate financing in a shortperiod of time. In addition, the Daewoo crisis resulted in both the KSDA providing Matrixpricing and the launch of 3 new CRAs (KIS Pricing, Korea Bond Pricing, NICE). For thepurpose of improving post-trade transparency, the KSDA started to require dealers to reportall bond transactions to a KOSCOM CHECK terminal within 30 minutes of the trade.

As the Credit Card Crisis occurred in 2003, the depressed economy squeezedconsumers who were heavily indebted to credit card firms. Many individuals defaulted,leading to a serious liquidity problem for credit card companies. The SK global event in2003 gave a shock to ITC investors. Because of fears over losses, they finally began toredeem investment trust funds. The government started a fund pool to support refinancingcredit card companies debt securities held by ITCs and reconstruct cost structure and assetmanagement. The government reintroduced a loan service ratio, strengthened past due ratiocalculations (including liquidated asset) and adjusted capital ratios. Finally, the government

started credit counseling & recovery services for the purpose of solving personal creditmismanagement.

Those events affected the corporate bond market in the Republic of Korea, inducinga boom and a bust. The amount of corporate bonds outstanding grew steadily after thefinancial crisis. The total amount of corporate bonds grew from 90.1 trillion KRW in 1997to 134.7 trillion KRW in October 2006. Right after the crisis, issuance of corporate bondsgrew 21.7 trillion KRW. However, in 1999 the Daewoo crisis occurred, and caused a

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subsequent decline in corporate bond issuance, from 56.0 trillion KRW in 1998 to 30.7trillion KRW in 1999.

Table 10. Issues, Redemptions and Outstanding Amounts of Corporate Bonds

(Unit: billion won)Issues Redemption Outstanding

Numbers Amount Numbers Amount Numbers Amount1997 2,246 34,322.1 2,887 20,221.4 8,438 90,107.31998 1,097 56,000.3 2,911 23,425.2 6,624 122,682.31999 803 30,671.4 3,306 33,692.1 4,121 119,661.72000 886 58,662.8 2,601 44,675.9 2,406 133,648.62001 1,245 86,194.9 1,153 66,443.1 2,498 154,400.42002 1,580 77,522.0 1,078 51,873.9 3,000 180,048.52003 1,697 61,757.5 1,076 54,450.1 3,621 187,355.9

2004 1,501 50,379.0 1,648 84,451.8 3,474 153,283.12005 1,451 48,103.1 1,564 58,836.6 3,361 142,549.82006 1,250 41,678.2 1,423 49,787.1 3,188 134,440.9

2007.9 845 24,882.0 989 33,401.6 2,983 133,819.1


Meanwhile, the corporate sector issued non-guaranteed bonds. Facing the Baselcapital adequacy ratio, commercial banks were very reluctant to lend money and to providecredit guarantees for the corporate sector. Excluding 1999 because of the Daewoo Crisis,the amount of the non-guaranteed bonds grew enormously from 5.1 trillion KRW (15.0 per

cent) in 1997 to 47.9 trillion KRW (99.4 per cent) in 2006.

Figure 8. Composition of the Corporate Bonds

(Unit : Billion won)

5133.9

29188.338390.9

17513.6

29338.8

1278.657136.2

1461.7

85677.4

1417.5

76737

845

61253.2

399.3

50174.2

224.8

47867.9

235.2

41441.2

237

32735.8

164.5

0

10000

20000

30000

40000

50000

60000

70000

80000

90000

1997 1999 2001 2003 2005 2007.9

Non- guaranteed Guaranteed

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Source: Financial Supervisory Service, Monthly Financial Statistics Bulletin.To recover the non-performing loans (NPLs) and revitalize liquidity in the financial

and corporate sectors, Korea Asset Management Corporation (KAMCO) established andstarted to issue asset-backed securities (ABSs). ABSs are bonds that represent pools ofloans of similar type, duration, and interest rate. By selling their loans to ABS packagers,the original lenders recovered cash quickly, enabling them to make more loans. In 1999,total ABSs were merely 4.4 trillion KRW. By 2002, the market reached 29.0 trillion KRW.After 2002, when the corporate and financial sector restructuring ceased, ABS issuancedeclined to 6.3 trillion KRW in September 2007.

Table 11. Trend of ABS Issuance

(Unit: Billion won)Public Offering of ABS Issues

Numbers Amount1999 68 4,444.72000 545 40,994.42001 659 39,618.92002 651 29,026.42003 896 27,673.62004 772 16,190.22005 736 16,822.92006 632 13,938.7

2007.9 328 6,283.0


In the secondary corporate bond market, most of the corporate bonds are traded OTC,representing 98.2 per cent of daily bond trade (see the table below). The average dailytransactions in the corporate bond market declined from 531.4 billion KRW in 2001 to 210.3billion KRW in 2007.

Table 12. Average Daily Transactions in the Corporate Bond Market

(Unit : billion won, %)

2001 2002 2003 2004 2005 2006 2007

Value 524.4 340.5 316.3 370.7 316.5 278.0 205.7OTC

% (98.7) (96.8) (98.9) (99.0) (97.7) (98.2) (97.8)

Value 7.0 11.3 3.5 3.9 7.6 5.1 4.6KSE

% (1.3) (3.2) (1.1) (1.0) (2.3) (1.8) (2.2)

Value 531.4 351.8 319.8 374.6 324.1 283.1 210.3Total

% (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0)

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Source: Korea Securities Dealers Association.Because of the structural changes in the corporate bond market, the number of listed

issues declined from 8,170 in 1997 to 2,139 in September 2007. Compared to thegovernment bond market, the secondary market for corporate bonds has nearly vanished.Listed amounts and trading volumes in the corporate bonds are, respectively, 15.0% and0.4% of government bonds. The corporate market decline is based on the rapid increase ofcredit risk after the 1999 Daewoo Crisis. Investors preferred the government bonds becauseof their safety. Standardized trades are essential to vitalize the liquidity of the bond market.Unfortunately, the Daewoo Crisis caused a credit crisis leading to more non-guaranteedbonds and a segregation of the bond market by credit rating. As seen below, the proportionof the A-rated or better companies grew from 56.9% in 2001 to 61.9% in 2005. Alternatively,the BB-rated or worse companies decreased from 19.0% in 2001 to 2.5% in 2005.

Table 13. Trends of Listed Corporate Bonds(Unit: billion won)

No. of Listed Issues Listed Amount Trading Volume Trading Value1997 8,170 86,024.2 3,562.7 3,807.11998 6,500 119,434.7 8,004.0 8,968.91999 4,054 111,121.1 9,496.6 11,685.02000 2,436 127,877.6 3,470.9 3,648.42001 2,306 141,223.9 1,970.9 2,012.62002 2,260 141,313.7 1,947.2 1,111.42003 2,422 136,143.1 1,000.1 892.02004 2,441 115,489.7 1,114.8 986.72005 2,434 107,301.4 1,841.6 1,935.12006 2,268 101,001.6 1,337.7 1,452.1

2007.9 2,139 96,018.8 1,017.3 1,181.5


Table 14. Issuance of the Corporate Bond by Credit Rating

(Unit: billion won, %)

2001 2002 2003 2004 2005 2006.6

Total 385,349(100.0) 230,203(100.0) 178,351(100.0) 259,818(100.0) 219,200(100.) 80,234(100.)

A or higher 219,133(56.9) 135,927(59.1) 116,760(65.5) 145,736(66.5) 160,700(61.9) 45,679(56.9)

BBB 93,154(24.1) 77,420(33.6) 44,924(25.2) 71,610(32.7) 92,571(35.6) 31,445(39.2)

BB or lower 73,062(19.0) 16,856(7.3) 16,667(9.3) 1,854(0.8) 6,547(2.5) 3,110(3.9)

Note: Number in parentheses shows the proportion of bonds.Source: FSS.

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Above all, ABSs can be evaluated as the most effective tool for improving the

corporate bond market. The Republic of Korea has the largest asset-backed securitiesmarket in Asia (except Japan). Right after financial crisis, it was crucial to increaseliquidity for the financial sector and to find an additional funding source for the corporatesector. Thus, KAMCO was established to consolidate non-performing loans (NPLs) in thefinancial sector. After collecting NPLs, KAMCO securitized those NPLs by issuing ABSsthrough a special purpose company (SPC).

ABSs were first issued for financial restructuring and securitization of NPLs. Afterfinancial restructuring, asset backed securities became a means to ease a credit crunch andare now financing tools for companies using primary collateralized bond obligations (CBOs).Finally, ABSs have played an important role in the financial system by providing liquidity.

To meet BIS adequacy ratios and to dispose of NPLs, financial institutions utilizedABSs. In addition, KAMCO issued ABSs for in the process of securitizing NPLs. As aresult, by the year 2000, ABS issuance grew substantially, to 69.9 per cent of total corporatebond issuance. In 2001, based on credit card sales and loans, ABS issuance expanded evenfurther. Though ABS issuance decreased to 10.6 trillion KRW in 2006, it still occupies alarge proportion (32.4 per cent) of the corporate bond market.

Table 15. Trend of Total Issuance of ABSs and Corporate Bonds

(Unit: billion won. %)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007.9

ABS(A) - 4,444.7 40,994.4 39,618.9 29,026.4 27,673.6 16,190.2 16,822.9 10,577.6 6,283.0

Corporatebond(B)

56,000.3 30,671.4 58,662.8 86,194.9 77,522.0 61,757.5 50,379.0 48,103.1 32,608.8 32,800.3

A/B - 14.5% 69.9% 46.0% 37.4% 44.8% 32.1% 35.0% 32.4% 19.1%

Note: Excluded private bond subscriptionSource: Financial Supervisory Service, Monthly Financial Statistics Bulletin.

Lately, Korean companies have been securing finance indirectly, which lessens theimportance of ABSs. The ABS market is waning, since it is better to issue normal corporatebonds instead of ABSs, because the interest rate spread between long-term and short-termbonds decreases.

To re-energize the ABSs market, the Republic of Korea needs a regulatoryframework and other supporting infrastructure in place for further development. Also, it is

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essential that the government should find other methods to issue ABSs, because therestructuring market is no longer active. The government released ABS related businessguidelines in May 2005. These guidelines focused on clarifying roles and responsibilities,and strengthening supervision and disclosure. These guidelines minimized instability in theABS market and created an environment favorable to ABS investment.

The government has started to seek out new ABS products. The governmentestablished the Korea Housing Finance Corporation (KHFC) in 2004 and started to issuemortgage-backed securities (MBSs), which originated about 7.6 trillion KRW (104,496mortgages). In addition, ABSs are now issued as a form of real-asset PF (Project Financing)and SLBS (Student Loan Backed Securities). Because MBSs can be a catalyst for the long-term bond market and also can induce the development of the house financing market, MBSsstill have the potential to promote the ABSs market. Also, SLBS are funded from the bondmarket and banks need not hold student loads under their balance sheets anymore, whichrelieves governments excessive burden for subsidization and resolves mismatch in thebanks asset-liability management.

But recently, the possibility of a real estate bubble created a reluctance to invest inreal assets, while fixed interest and redemptions hindered the expansion of SLBS. Therefore,we have to wait before estimating the effectiveness of these policies on the revitalizing theABS market.

(3) Market Infrastructure: Clearing and Settlement System and Rating Agencies

The Securities and Exchange Act is the basic law governing bond issuance, trading,clearance, settlement and access to systems, and risk control arrangements. Practicaloperations of the Act are delegated to self-regulatory institutions and settlements systemoperators such as the Korea Exchange (KRX) through its Stock Market Division, the KoreaSecurities Dealers Association (KSDA), and the Korea Securities Depository (KSD). Underthe Act, the KSD is given the sole right of settling securities on a book-entry transfer basis.

Most bonds are traded through the OTC market and are settled either on a delivery-versus-payment (DVP) or free-of-payment delivery basis. The DVP system functions on adirect link between the securities settlement system of the KSD and BOK -- Wire of the Bankof Korea (BOK). This allows real time and simultaneous settlement on a gross, trade-by-tradebasis. Under the free-of-payment delivery scheme, the securities leg is settled through KSDbook-entry, and the cash leg through the BOK or commercial banks. The structure of the

bond clearing and settlement system in the Republic of Korea is provided in the table below.

The KSD plays major role in the bond market clearing and settlement system. TheKSDs major services include centralized deposit of securities, book-entry transfer, cross-border clearing & settlement, and separate safe custody. Trades performed on the KRX arecleared on the basis of multilateral netting, while trades on the OTC market are cleared on thebasis of gross settlement.

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Table 16. Clearing and Settlement System in the Republic of Korea

Korea Stock Exchange(KRX)

IDM (Inter-dealer Market)General Bond Market

(GBM)

OTC Market

Clearing Entity KRX KRX -Settlement/depository entity KSD KSD KSD

Settlement method central bank money commercial bank money bothSettlement cycle T+0 T+0 T+0

Settlement day Cash transactions (T+0) Cash transactions (T+0)Cash transactions,

negotiable within T+14Method multilateral netting multilateral netting gross settlement

Source: AsianBondsOnline.

In the Republic of Korea, there are 4 credit rating agencies (CRAs): the NationalInformation & Credit Evaluation (NICE), the Korea Information Service (KIS), KoreaRatings (KR), and the Seoul Credit Rating & Information (SCI). Before the financial crisis,no ratings were given to other debt securities, including guaranteed bonds. After the financialcrisis, there was rapid growth of un-guaranteed bonds and ABSs in the corporate bond market,thereby becoming necessary to revise the relevant laws and supervising system to strengthenthe role of the CRAs. The CRAs tried to ally with global credit rating agencies such as Fitchand Moodys to strengthen international competitiveness.

By rating un-guaranteed bonds, ABS, CP, and so on, CRAs give soundness to

financial institutions when they are issuing those bonds. Also, credit ratings are a decisivefactor in deciding the underwriting price between underwriter and issuer. In addition, thecredit rating is used as an objective benchmark by institutional investors in structuringportfolios and can be used to protect investors by easing information asymmetry andmonitoring issuers. In 2006, the Ministry of Finance and Economy plans to lower the barriersto entering the CR industry, so that foreign agencies, such as S&P, Moodys and Fitch caneasily enter the Korean market, which may result in adopting more developed techniques.

I I I . Policy Lessons from Bond Market Development in the

Republic of K orea

Koreas experience in the development of bond markets provides a good benchmarkfor other Asian countries in building their own local bond markets. First, Koreas bondmarket grew robustly, both in size and quality, led by comprehensive government policyreforms. Most importantly, introduction and establishment of systems for marketinfrastructure enhanced the overall liquidity and transparency of the primary and secondarymarkets. Koreas experience demonstrates that other Asian countries with less-developed and

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illiquid bond markets may possibly develop their markets as they foster well-designed reformplans with strong will.

Second, as can be seen in the case of the Republic of Korea, development of anefficient government bond market is the first step in developing a strong local bond market.In reality, most of the Asian countries do not yet have liquid government bond markets thatcan serve as the backbone for fixed-income securities markets, let alone the other essentialinfrastructure, such as a settlement and depository system, a primary dealer system, creditrating agencies, bond pricing agencies, and credit guarantee agencies. More importantly, inmost developing Asian countries, there are not many reputable firms that can issue corporatebonds with high ratings. Therefore, it is an important prerequisite for each Asian country tofoster an efficient government bond market to catalyze the growth of overall domestic andregional bond markets.

Third, essential infrastructure and institutional arrangements are needed fordeveloping efficient bond markets. The Republic of Korea is a successful case of well-knownprescriptions, such as introducing a Dutch auction system, a primary dealer system, a DVPclearing and settlement, a reopening and marked-to-market system, as well as steps todevelop the futures market and the repurchase market for government bonds. Theperformance of the Korean market clearly demonstrates that the government can help create aliquid government bond market within a very short period of time by introducing necessaryinstitutional and legal infrastructures and framework.

Fourth, Asian countries can take advantage of Koreas experience in developinggovernment bond markets. Instead of being satisfied with merely developing an over-the-counter (OTC) market, the Korean government is now trying to promote an electronicexchange trading platform along the lines of the MTS system in Italy. As government bondsare relatively easy to standardize and with Koreas competitive IT industry, Korea hasdecided to introduce an ETS (electronic trading system) for the government bond market,making it mandatory to trade benchmark issues using the system. Rather than following thepath of other countries, the Korean government has decided to adopt the most advancedtrading system in the world from the very beginning. The electronic trading system has notonly improved the transparency of the market but also increased the liquidity of off-the-runissues as well as on-the-run benchmark issues in the Korean government bond market.

Fifth, the Republic of Korea actively used securitization and credit guaranteemethods to overcome credit quality gap problems after the financial crisis. It turned out to be

a very useful tool to significantly enhance credit rating of firms that cannot issue bondsbecause of their low credit ratings. Koreas small and medium-sized corporations couldfinance funds from the domestic and international capital markets by using securitizationmethods. We believe Koreas experience of using securitization methods for SME financecan be a valuable benchmark for other developing Asian countries, where most firms cannotissue bonds because of their low credit ratings.

Lastly, it is important to maintain the liquidity of the benchmark issues. In particular,

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as the government puts emphasis on fiscal balance over the medium-term, the governmentsneed for bond financing will decline, thereby lowering the volume of benchmark bond issues.At the same time, demand for long-term government securities is likely to increase aspension funds and life insurers look to meet the needs of the rapidly aging population. In thecase of the Republic of Korea, it is suggested that some of the Bank of Koreas bonds may beconverted into treasury bonds while at the same time Koreas many quasi-public bonds canbe further consolidated. The lessons from Koreas experience may also be applicable to othercountries looking to implement fiscal consolidation plans over the medium-term, while at thesame boosting liquidity in their bond markets.

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REFERENCE

Arner, Douglas, Jae-Ha Park, Paul Lejot and Qiao Liu (2006). Asia's Debt Capital Markets :Prospects and Strategies for Development edited by, published by Springer.

Asian Development Bank (2000). "Government Bond Market Development in Asia", March.

Dalla, I., and Y. Park (2003). The Korean Bond Market : Post Asian Crisis and Beyond,Korea Stock Exchange.

Ito, Takatoshi, (2003). Promoting Asian Currency Basket (ABC) Bonds, material presentedat the Voluntary Working Group Meeting of the Asian Bond Market Initiative, June 17,Tokyo.

Kang, Kenneth, Geena Kim and Changyong Rhee (2004). Developing the Government

Bond Market in Korea : History, Challenges and Implications for Asian Countries, paperpresented at the Asia Economic Panel (AEP) at Columbia University, September 2004.

Kim, Chin-Woo (2004). The Role of Credit Rating Agencies in Corporate Bond Markets:The Korean Experience, paper presented at the Sixth Annual OECD/World Bank GlobalBond Market Forum, Korean Financial Supervisory Service, May 2004.

Lee, Young, Changyong Rhee and Taeyoon Sung (2005). Fiscal Policy in Korea: Beforeand After the Financial Crisis, International Tax and Public Finance, 2006, August 2005.

Oh, Gyutaeg, Daekeun Park, Jae-Ha Park and Changyong Rhee (2003). Building aSettlement Infrastructure for the Asian Bond Markets: AsiaSettle, paper presented at

Workshop on East Asias Strategy for Regional and Global Financial Cooperation(hosted by Asia Pacific School of Economics and Government, Australian NationalUniversity and Northeast Asian Institute of Business and Economic Research, KoreaUniversity), on 11 October 2003.

Oh, Gyutaeg and Jae-Ha Park (2003). Fostering an Asian Bond Market using Securitizationand Credit Guarantee, paper presented at the ASEAN+3 Informal Session of FinanceMinisters and Central Bank Deputies on Fostering Asian Bond Markets.

Park, Daekeun and Changyong Rhee (2006). Building Infrastructure for Asian BondMarkets: Settlement and Credit Rating, BIS Papers No. 30, November 2006.

Rhee, Changyong (2003). A study on Improving the liquidity of Government Bond Markets,Policy Research Report, Ministry of Finance and Economy and Korea Fixed IncomeResearch. September 2003. (In Korean)

korean bond markets

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