Contributors

Editor-in-Chief Warren Park, Senior Researcher Feature Warren Park, Senior Researcher Bohyeong Jang, Fellow Issues Warren Park, Senior Researcher Jinho Noh, Fellow Wanjoong Kim, Fellow Wongeun Choi, Fellow Yunshin Ju, Senior Researcher Market Watcher Seungryong Kim, Assistant Researcher Yootag Jung, Associate Researcher Kyungshik Yang, Chief Strategist (Hana Daetoo Securities)

Please direct inquiries and comments to Warren Park (warrenpark@hanaif.re.kr).

Table of Contents

Feature

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

Uncertainties
Warren Park & Bohyeong Jang

Issues

| 10 | Assessing the Profitability of Korean Banks

Warren Park & Jinho Noh

| 15 | Unbalanced Foreign Investment in Korean Bonds Poses Potential

Threats
Wanjoong Kim

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

Wongeun Choi

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

Implications
Yunshin Ju

Market Watcher

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

monetary easing
Seungryong Kim

| 34 | Exchange Rate: The Korean won should appreciate, but there are
risk factors
Yootag Jung

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

Kyungshik Yang, Hana Daetoo Securities

Fe a tu re

2012 Outlook: The Korean Economy in the Face of Global Uncertainties

Warren Park, Senior Researcher Bohyeong Jang, Fellow As we approach 2012, the global economy is fraught with uncertainty, and Korea is no exception. In the period of just over three years since the collapse of Lehman Brothers, the global economy has emerged from the abyss and recovered on the back of a massive and coordinated unleashing of policy stimulus across the globe, but more recently finds itself increasingly subject to the whims of major policy coordination. Since Korea is a small, open economy, it cannot be completely immune to turbulence from overseas. But given its improved fundamentals and the small likelihood of a serious US dollar liquidity crunch, any negative external shocks to Korea's economy are likely to have a limited impact.

Global uncertainties spread while the domestic and global growth outlook deteriorates
Global financial turmoil resurfaced this summer, based on fears that the European debt situation was spinning out of control and that the US could experience another recession. To those who
Figure 1 | Global Financial Turmoil Reemerges
90 ( VIX) G lo b al F in anci al C risis 2010 Eu rop e an C ri si s 2011 Eu rop e an C ri si s
1.

thought the recovery from the global financial crisis was complete, or that the sovereign debt ratings in Europe's periphery were being met with forceful and effective coordination, the events may have been an unforeseen blow. The reality, however, is that the market turmoil should not have been entirely surprising. After all,
Figure 2 | Economic Outlook Revised Downward
10 8 6 4 2 0 (% (2011) June Outlook September Revised Outlook 10 (% 8 6 4 2 0
ld or W US ne hina orea zo C K ro Eu ld or W US a a ne in re zo Ch Ko ro Eu

(2012) June Outlook September Revised Outlook

60

30

0 2007

2008

2009

2010

2011

Source : Bloomberg

Source: IMF Dec 2011 Hana Insight 3

F e a tu re
the debt crisis in Europe has been a topic of attention since the end of 2009, albeit the subject of varying degrees of optimism and pessimism, so it is definitely not something that could not have been predicted. As for the US, there has been ongoing concern about the threat posed by its burgeoning fiscal deficits in the midst of slow growth, the longtime forecast of those who believed that the extraordinary policy measures implemented in the wake of the global financial crisis would eventually run out of steam. While bouts of uncertainty, albeit not the timing, could have been predicted in advance, there is the sense that the uncertainty is a greater threat this time around, especially given that the unprecedented measures enlisted to deal with the financial crisis have not produced the sort of sustainable global recovery that had been hoped for.

The most recent turmoil was caused largely by a crisis of confidence in policy
To make matters worse, the major economies are experiencing crises of policy. For one thing, they already used up much of their available ammunition when they lowered policy rates to near-zero level, implemented quantitative easing, or used the government balance sheet to bail out failing financial institutions, housing markets, or even ailing corporations. As as result, there are far fewer resources available for stimulative monetary or fiscal policy. The more serious crisis of policy, however, is the significant weakening of policy credibility. This has been most evident in the lack of policy coordination in both Europe and the United States, and it has added a decidedly political dimension to the direction of the global economy and financial markets that has heightened uncertainties.

Figure 3 | Leading & Coincident Indicators

14 12 10 8 6 4 2 0 -2 -4 -6 2 00 1
Le adin g Indicator (L) C oin cide nt In dicator (R ) (YoY , % ) (C yclical Variable )

Figure 4 | Major Risk Factors in 2012

1 08 1 06 1 04 1 02 1 00 98 96 94 92 90 88
1.

European Crisis

- Default in the periphery - Failures of financial institutions - Contagion from Europe to US - Crunch in money markets - Failure to agree on debt ceiling - Additional sovereign downgrade - Sharp drop in export demand - Local government debt risks - Drop in housing prices - Increased debt burdens

USD Liquidity Crunch

US Sovereign Risk

China Hard-Landing

20 0 3

2 00 5

20 07

2 0 09

2 01 1

Domestic Credit Crisis

Source : Statistics Korea 4 Hana Insight Dec 2011

Source: Hana Institute of Finance

Fe a tu re
Indeed, the current uncertainties stem from the global crisis of confidence, particularly in government policy, and this loss of confidence has fed back into the financial system. An example of this can be seen in the United States and the eurozone, where a lack of trust in the efficacy of government guarantees has led to downgrades across the banking sector. Although such lack of trust in government finances is partially the result of government efforts to socialize financial sector losses in the aftermath of the financial crisis, such fiscal uncertainty has the potential to reverse course and spill back first into the financial system, and subsequently the real economy. It should thus come as no surprise that, with heightened risks on the one hand, and a much smaller range of policy options on the other, there has been a flurry of downward revisions to the global economic outlook. Before August, the general consensus was that the global economic reFigure 5 | Growth Trends of Major Economies
10 8 6 4 2
1.

covery was sustainable enough to commence serious discussions regarding exit strategies from overly accommodative policy. But with such rosy outlooks more the exception than the norm, the focus of debate now revolves around the likelihood of a global depression. Perhaps more important, however, is the growing concern that the global chaos that took hold of financial markets in August could rapidly spill over into the real economy, particularly given the increasing evidence that the degree of interconnectedness between the financial and real sectors has strengthened recently. Indeed, there has been a pronounced slowdown in Korea's growth momentum since 2Q, suggesting the real possibility that its economy could be headed for an economic slowdown.

Figure 6 | Korea's Expt. Dependence & Fin. Openness

10 0 80 60 40 20 (%) Export Dependence Financial O pe nness

(YoY, %)

0 -2 -4 -6 2001 2003 2005 2007 2009 2011 W orld Kore a

0 19 94 19 97 2 00 0 20 03 2 00 6 2 00 9

Source : BOK, IMF

Note: Financial Openness = Foreign Investment/Nominal GDP Source: BOK Dec 2011 Hana Insight 5

F e a tu re
The current environment is a reminder of Korea's vulnerability to external uncertainties
Korea's economy is sensitive to external uncertainties, especially through financial markets, since its economic growth is highly correlated with that of the global economy. Why is this the case? First, Korea is highly reliant on overseas markets, particularly through the channel of exports. As recently as the early 2000s, exports accounted for barely over 30% of Korea's nominal GDP. Now, however, they account for around 50%, which shows the large role that exports play in determining Korea's growth path, as well as just how sensitive Korea's economy has become to the global economic cycle. Indeed, since 4Q 2009, just after the global financial crisis, Korea's economy has grown by an average of 5.3% YoY per quarter, while exports' contribution to growth has averaged 6.5%p YoY per quarter. Second, Korea's financial markets have grown very open to cross-border capital flows. Its degree of financial openness, measured as foreign investments as a percentage of nominal GDP, stood at 40% in the early 2000s, but this figure has more recently risen to above 80%. Such a high rate of for eign investment in Korea is the result of its efforts to develop its financial markets by focusing on financial liberalization. The result, however, is that foreign investment has become a channel through which external risks are transmitted into the domestic markets. Once clear example of this is the FX liquidity crisis that occurred during the global financial crisis. Despite the fact that Korea's direct exposure to subprime-related investments was very minimal, Korea's economy was drawn into the crisis through foreign investment, specifically the sudden and massive withdrawal of short-term

Figure 7 | Growth in Korea's Exports and Imports Figure 8 | Foreign and EU Investment in Korea
60 40 20
1.

(YoY, % )

Ex ports Im ports

(fore c ast)

8 7 6 5 4

($100bn)

Equities

Bonds

Other

0 -20 -40 2007 2008 2009 2010 2011 2012

3 (33.6) 2 1 0 07 EU 08 EU 10 EU 11.6 (29.1) (27.0)

Source : BOK, Hana Institute of Finance

Note: Figures in parentheses represent foreign investment from the EU as share of total foreign investment. Source: BOK (Other includes short-term borrowings)

6 Hana Insight Dec 2011

Fe a tu re
funding. Moreover, Korea's equity and financial markets possess exceptional liquidity, a factor that can also serve as a vulnerability. When external turmoil intensifies, not only do foreign investors look first to Korea to lock-in capital gains or secure liquidity, but because the financial markets of China and other neighboring Asian countries are not as developed or open, Korea's markets are often used as a sort of investment proxy for these other emerging Asian economies. Indeed, the current situation is unlike that which occurred in the aftermath of the Lehman Brothers collapse. Specifically, it is highly unlikely that there will be additional market shocks on the scale of that debacle. Back then, complex structured products such as CDOs, shadow banking, and other complex and opaque products and institutions made it difficult to discern the location of risk. In the current crisis, where sovereign debt is the primary culprit, however, it is possible to identify sovereign debt exposures beforehand, making it easier to ascertain risks and avoid financial panic or relentless and indiscriminate deleveraging. In addition, the collapse of Lehman Brothers was such a shock to global financial markets partially because of a major disruption in US money markets, which are the main source of global US dollar liquidity. Granted, there are serious concerns about a potential liquidity crunch centered around European financial institutions, but this is
Figure 10 | Global Liquidity Indicators
1 08 1 06 1 04 1 02 1 00 98
1.

Spillover effects into Korea's financial sector should be limited

Even now, there is the possibility that foreign capital, especially that from Europe, could be withdrawn in massive amounts in the event of external shocks. However, the likelihood of such an event remains fairly remote at this time. This is because, more than anything, the likelihood of a global dollar liquidity crunch remains fairly low.
Figure 9 | Leading & Coincident Indicators
14 12 10 8 6 4 2 0 -2 -4 -6 2 00 1
Le adin g Indicator (L) C oin cide nt In dicator (R ) (YoY , % ) (C yclical Variable )

400

(bp)

(R e ve rse ax is, pt) U S O IS Spre ad Euribor O IS Spre ad Euro B asis Sw ap (R )

-40 0

300

-30 0

200

-20 0

96 94 92 90 88 20 0 3 2 00 5 20 07 2 0 09 2 01 1
0 2008 0 2009 2010 2011 100 -10 0

Source: Statistics Korea

Source: Bloomberg Dec 2011 Hana Insight 7

F e a tu re
because US money market funds have already cut their exposures to these institutions in order to stem losses. As such, there is little sign of a potential liquidity crunch in either the US or globally, so the potential for a global financial panic remains fairly remote. Korea's improved FX soundness is another reason for optimism. There are some indications that recent financial turmoil abroad may have caused some European financial institutions to withdraw money from Korea. But considering the improvements in Korea's fundamentals -- its level of FX reserves, its ratios of short term to external debt, its current account surplus, as well as the preemptive measures it has taken, such as entering into multilateral swap agreement -- the likelihood of an FX liquidity shortage, a chronic concern of the authorities, remains fairly remote. Of course, this does not mean that there is no reason to be concerned about negative overseas
Figure 11 | Contributions to GDP
15 10 5
Se m icon du ctors
1.

events. Given that foreigners' portfolios investments in Korea have surged, it is inevitable that Korea's stock and bond markets will be volatile during periods of overseas financial turmoil.

Korea will need to remain vigilant of the potential for shocks in the real sector
In the event of contagion, however, the recent crisis is probably more likely to transmit through the real sector than through the financial channel. Indeed, the main reason for Korea's rapid recovery from the crisis has been its robust growth in exports. But overseas turmoil now appears to be exerting severe stress on global demand, the direct result of which could be a contraction in exports. A less direct effect could be that problems in household debt or other domestic weaknesses, which have been veiled to some extent by Korea's robust performance in exports, could develop into serious risks.
Figure 12 | Foreign and EU Investment
40 30 Shipbuildin g P asse n ge r C ars 20 10 ME SE Asia EU C h in a J apan US 10 15 20 0

(YoY, % , % p)

0 -5 -10 2006 E x ports C on struction Inve stme nt F acilitie s Inve stme nt P rivate C on sumption G DP G row th 2007 2008 2009 2010 2011
0

IT Ste e l P rodu cts O il P rodu cts 5

Source : BOK 8 Hana Insight Dec 2011

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

Fe a tu re
Fortunately, external turmoil has begun to ease somewhat recently, owing to coordinated policy efforts in Europe and abroad, as well as rising expectations of a US recovery. Given the weak state of global governance, however, there remain doubts about whether the policy coordination will be implemented, or the durability of the US recovery. Given these factors, there is a significant risk of additional market turmoil going forward, along with the possibility that the underlying risks stemming from Korea's household debt sector could intensify. But these risk variables are still latent and could still be contained depending on the degree of progress made on a variety of domestic and external issues. Thus, despite the existence of latent risk factors, 2012 will likely experience a gradual easing of external uncertainties. Moreover, given that most domestic risk factors are already known, and that there is still plenty of room for domestic policy, the likelihood of significant shocks is not high. Nevertheless, there is the possibility that downward pressure on domestic and external demand could be rather large.

As external turmoil subsides, growth should be low in 1H 2012 but rise in H2

In this context, as Korea's economy absorbs domestic and external stress, it is likely to bottom in 1H 2012 and then recover in 2H, driven by an easing of high oil prices and inflationary pressures, improvement in its terms-of-trade, and a renewed recovery in emerging economies. Since it is likely that turmoil could reassert itself on a limited basis, there is a good chance that the recovery will be gradual and limited in degree. As a result, growth in 2012 may be slightly higher than in 2011, but it will likely be based more on factors such as pent-up demand or the base effect, rather than a recovery based on a healthy economy.
Figure 14 | Key Elements of 2012 Forecast

Figure 13 | Real GDP & GDP Trend

8 6 4 2 0 -2 -4 -6 2006 2008 2010 2012 (% ) G DP G ap Re al G DP (R ) G DP Tre nd (R) (\ tn ) 300 270 240 210
1.

2010 World Growth Rate Advanced Economies Emerging Economies Oil Price (Dubai, avg.) Won/Dollar (avg) TB Yield (3Y, avg) Korean GDP Growth CPI Growth 5.1% 3.1% 7.3% 78.1$ 1,156 3.72% 6.2% 2.9%

2011 (P) 3.8% 1.5% 6.3% 104.7$ 1,105 3.65% 3.7% 4.5%

2012 (E) 3.9% 1.8% 6.1% 94.3$ 1,070 3.70% 3.9% 3.4%

180 150 120 90

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

Source: Hana Institute of Finance

Dec 2011 Hana Insight 9

Issu e

Assessing the Profitability of Korean Banks

Warren Park, Senior Researcher Jinho Noh, Fellow In 1H 2011, Korea's banking industry posted record profits, fueling something of a public backlash aimed at the perceived greed of the financial industry. A closer look at the components of bank profits, however, revealed that they were largely the result of temporary factors, such as the sale of stakes in Hyundai E&C by several banks, as well as a large decline in provisions for loan losses, which were atypically high in 2010. In other words, the performance of banks in 2011 revealed that the profit structures of Korea's banks remain very weak. Improving them will be essential in fostering the development of Korea's financial industry and enhancing its resilience against financial crisis.

Korea's banking sector posted record profits in 1H 2011

In 1H 2011, the net income of Korea's banking sector rose by 4.8tn to 10.4tn, an increase of 86% over the same period in 2010. The main factors contributing to this increase were an increase
Figure 1 | Profit Trends of Korea's Banks 2005 1. Gross Income (Interest Income) (Non-Interest Income) 2. SG&A (cost) 3. PPOP1) (=1-2) 4. Provisions (cost) 5. Operating Income (=3-4) 6. Non-Operating Income 7. Pre-Tax Income (5+6) 8. Income Tax (cost) 9. Net Income (=7-8) 32.1 (28.0) (4.1) 14.6 17.5 5.1 12.4 3.4 15.8 2.2 13.6 2006 33.9 (29.5) (4.5) 15.7 18.2 5.0 13.3 4.2 17.4 3.9 13.5 2007 42.0 (31.2) (10.8) 17.6 24.3 4.5 19.8 1.3 21.1 6.1 15.0

in gross income (3.5tn) combined with a decrease in loss provisions (3.3tn), which had a combined impact of 6.8tn on the bottom line. Interest income increased by 0.5tn YoY, based on an expansion in net interest margins (NIMs), whereas non-interest income rose by 3.0tn YoY, thanks largely to the sale of equity stakes in
(Unit: tn) Impact on

2008 39.6 (34.5) (5.1) 18.2 21.4 10.2 11.2 -0.2 11.0 3.3 7.7

2009 37.5 (32.2) (5.3) 17.7 19.8 12.1 7.7 0.8 8.5 1.6 6.9

2010 1H 2010 45.3 (37.5) (7.8) 18.6 26.7 14.1 12.5 -0.2 12.3 2.9 9.4 22.9 (19.0) (3.9) 8.8 14.1 7.1 7.0 0.1 7.1 1.5 5.6

1H 2011 Net Income

(YoY)

26.4 (19.5) (6.9) 9.2 17.2 3.8 13.4 0.1 13.5 3.1 10.4

+3.5 (+0.5) (+3.0) -0.4 +3.1 +3.3 +6.4 +6.4 -1.6 +4.8

Source: Financial Supervisory Service (FSS) 1) PPOP = Pre-Provision Operating Profit 10 Hana insight Dec 2011

Issu e
Hyundai E&C by a number of banks. Provisions for losses decreased by 3.3tn YoY. This was due partially to the fact that banks set aside greater amounts of loss provisions in 2010 on a precautionary basis, and partially due to a shift to IFRS accounting standards. Meanwhile, increases in SG&A and income tax contributed to a decline in income (2.0 tn). the interest margins and NIMs for US banks with assets of $1bn or greater were 3.24% and 3.80%, respectively, over the same period.

Korean banks continue to rely mostly on interest margins for their profits
Korean banks' profit structures remain inferior to their counterparts in advanced economies, even though the performance of those banks has deteriorated since the financial crisis. That is, their profit structures remain highly dependent on interest margins, which tend to be rather low. As in the United States, regulations separating the operations of Korean banks and securities firms are very strict, restricting banks from trading or investing their own capital, a potential source of non-interest income. Thus, Korean banks have depended on NIM for the majority of their profits. In Europe and the UK, by contrast, the separation between banking, securities firms, and insurance companies is weak. So while interest income accounts for a small proportion of profits and NIMs are small, banks can generate a large proportion of their profits from trading, derivatives, insurance, commis(Unit: %)

Koreans banks' profit-generating capacity remains below pre-crisis levels

Korean banks' gross income margin, a measure of asset efficiency, was 2.98% in 1H 2011, while ROA was 1.18%. Both of these figures were below pre-crisis levels, in spite of an expansion in gross income centered around non-interest income. The structural profit rate, which indicates a bank's fundamental ability to generate profits by eliminating the impact of one-time gains, was at 1.48%, also below pre-crisis levels. Interest income margins and net interest margins, the main components in the profit structure of commercial banks, were also far below pre-Lehman levels, at 2.20% and 2.36%, respectively. By comparison,

Figure 2 | Trends in Profit Indicators of Korea's Banks 2005 Gross Income/Total Assets - Interest Income/Total Assets - NIM2) 3) Structural Profit Rate ROA (Net Income/Total Assets)
1)

2006 2.83 2.46 2.64 1.51 1.13

2007 3.06 2.28 2.44 1.37 1.09

2008 2.44 2.12 2.30 1.29 0.47

2009 2.12 1.82 1.98 1.06 0.39

2010 2.62 2.17 2.32 1.36 0.54

2.98 2.60 2.81 1.63 1.26

1H 2010 2.66 2.21 2.36 1.48 0.65

1H 2011 2.98 2.20 2.36 1.48 1.18

Note: 1) Estimated were used for Total Assets (average balance) for 2011. 2) NIM = (Return on interest-earning assets - Interest paid on borrowed funds) / Interest-earning assets 3) Structural Profit Rate = (Interest Income + Commissions + Income from trust services - SG&A) / Total Assets Source: FSS Dec 2011 Hana Insight 11

Issu e
sions, etc. In Korea, not only are NIMs lower than those of the United States, the UK or Europe, but income from commissions is lower as well. Even with such weak profit structures, however, Korean banks have been posting relatively strong performance because of the relatively solid quality of their assets. In fact, during the 2009-2010 period, the NPL ratio of the Top 4 banks stood at 1.67% in Korea, versus 5.53% in the US, 5.29% in the UK, and 4.51% in Europe. ery and strength in the area of residential lending. On a YoY basis, lending increased by 15.1% in 2007, 14.3% in 2008, 4.5% in 2009, 3.4% in 2010 and 5.6% in 1H 2011, whereas net interest spreads on such loans increased by 3.1% in 2006, 3.0% in 2007, 2.7% in 2008, 2.1% in 2009, 2.7% in 2010 and 3.0% in 1H 2011. However, the net interest spread on new loans has been on a downtrend. Given that these loans will later become existing loans, it is uncertain whether interest income will be able to continue to increase. In 1H 2011, non-interest income increased significantly, but the bulk of it was from gains on the sale of securities, rather than commissions or trust-related income. This suggests that the uptrend will be difficult to maintain. Such a rapid surge in securities-related profits was due to banks' sales of equity stakes that they had acquired in corporations facing serious liquidity problems.

Korea's banks are likely to be hurt by slowing global growth and fewer opportunities for non-interest income
Going forward, it appears that Korean banks will be faced with gradual downward pressure on their profit margins as the demand for credit declines and opportunities to generate non-interest income become more scarce. In the past, net interest spreads on existing loans have been fairly strong on account of the gradual economic recov-

Figure 3 | Profit Structure of the Top 4 Banks in Major Countries (2009-2010 Avg.)
Gross Income/Total Assets POPP Margin Rate of Net Interest Margin (NIM) Gain/Loss Adjusted NIM (Post-NPL writedowns) NPL Ratio Interest Income Subtotal NonShare of Trading & Derivatives Interest Gross Income Income Securities Insurance-related Commissions
Source: Bankscope 12 Hana insight Dec 2011

(Unit: %)
Japan 1.26 0.56 0.97 0.68 1.32 73.5 26.5 8.0 0.1 0.0 18.4

Korea 2.52 1.25 2.42 1.50 1.67 80.4 19.6 2.1 6.3 0.0 11.3

USA 3.62 2.18 3.11 1.61 5.53 75.6 24.4 7.5 4.5 0.6 11.9

UK 1.86 0.75 1.03 0.36 5.29 51.1 48.9 30.6 2.1 -10.0 26.1

Europe 2.36 1.02 1.51 1.03 4.51 57.5 42.5 11.4 1.9 3.1 25.9

China 2.67 1.86 2.44 2.13 1.61 79.5 20.5 0.6 1.0 0.0 18.8

Issu e
Profits were distorted in 1H 2011 by changes in accounting standards and lower loss provisions
Although loss provisioning burdens have eased as a result of changes in accounting standards and unusually large provisions last year, they are likely to increase going forward, especially since losses on real estate PF and other loans are expected to increase. In 2010, as a precautionary measure against corporate restructuring and losses related to real estate PF, the Financial Supervisory Service issued a recommendation calling for increased loss provisions by banks. The banks agreed, greatly expanding their loss provisions. As a result of banks' active asset sales, their NPL ratios declined in 2011. And as a result of changes in accounting standards, the burden to increase loss provisions was significantly eased. Prior to 2011, banks were conservative in setting aside loss provisions, based on expected losses,
Figure 4 | Trends in Korean Banking's NIMs
5 4 3 2 1
0 5
1.

but IFRS accounting standards stipulated that loss provisions were only required in cases where "objective losses" had occurred. Because this was a weakness from the perspective of risk management, corporations and financial in the US were actively in favor of IFRS, whereas the SEC and other regulatory agencies opposed their adoption. However, since downward cyclical pressures are high both in Korea and overseas, and because there is a high likelihood that losses on real estate PF loans will increase, it appears likely that the pressure to raise loss provisions will increase.

Improved bank profit structures will help strengthen Korea's financial industry against crises
Thus, rather than focusing on the temporarily high profit levels of Korean banks, it is more important that more active efforts be made to improve the feeble profit structures of Korea's banks so as to prevent the incidence of financial crises
Figure 5 | Delinquency Rates & NPL Ratios
15 (\tn) FX Derivatives Securities-related Trust-Related Fees/Commissions 10 Total

(%)

3YR KTB - 90D CD NIM on New Loans NIM on Existing Loans Post-Lehman

0 -1 2001 2003 2005 2007 2009 2011

-5 1999 2 001 20 03 2005 2007 2009 11.1H

Source: BOK

Source: FSS Dec 2011 Hana Insight 13

Issu e
and aid in the development of Korea's financial services industry. Although a decrease in loss provisioning and the sales of stakes in Hyundai E&C contributed to the growth of Korean banks' profits in 1H 2011, the reality is that their profitability ratios, and their overall profit structures, which reflect the sustainability of their profits, remain very weak relative not only to peers in other financially advanced countries but even in relation to China. The risk in banks having weak profit structures is that they may be tempted to engage in high-return, high-risk business, or that it could remain difficult to accumulate capital, thus hampering their capacity to expand overseas. If Korean banks are to improve their profit structures, which are currently based primarily on low interest margins, there will be a need not only for banks to put forth greater efforts, but also for greater interest and deeper discussion among the government, academia and the media. After all, he reason why the non-interest income of Korean banks is so low is that strengthened regulations have forced them to reduce their exposure to trading activities and portfolio investment; there are no account maintenance fees; and the principle of separation between banking and industrial firms has created an environment in which banks have no choice but to engage in commision-cutting competition.

Figure 6 | NPLs & Coverage Ratios of Banks

40 (?tn) NPLs (L) Coverage Ratio(R) (%) 3

Figure 7 | Delinquency Rates & NPL Ratios

3 (%) NPL Ratio SME Loan Delinquency Rate Corporate Loan Delinquency Rate Household Loan Delinquency Rate

30 2

20
1.

1 10

0 02 03 04 05 06 07 08 09 10 11

0 06 07 08 09 10 11

Source: FSS 14 Hana insight Dec 2011

Source: FSS

Issu e

Unbalanced Foreign Investment in Korean Bonds Poses Potential Threats

Wanjoong Kim, Fellow On the surface, foreign investment in the Korean bond market appears to be stable, as the amount of capital being withdrawn by Europeans has been exceeded by capital inflows from Asia. However, certain imbalances in the way foreigners invest in Korean bonds, such as their tendency to invest primarily in Korean treasury bonds, at particular maturities, as well as the fact that investment volume by certain institutional investors is very large, pose a latent risk to Korea's bond and currency markets. Thus, it may be worthwhile to devise measures to induce foreigners to invest in a more diverse range of Korean bonds and to foster the development retirement pensions and investment in overseas securities in order to guard against abrupt capital inflows during times of external distress.

Foreign investment in Korean bonds fell sharply after the financial crisis, has been rising ever since
Since 2007, foreign investment in Korean bonds, which includes not only investment in futures but also arbitrage-type investments in the spot market, have exerted increasing influence on

the domestic bond market. The increase in investment in Korean bonds by foreigners was prompted partially by expanded investment in overseas investment funds, spurred by improving conditions in global equity markets and enhanced tax benefits, as well as an increase in the sale of forward contracts by Korea's exporters, both of which re-

Figure 1 | Swap Basis vs. AUM of Overseas Funds Figure 2 | Exch. Rate & For. Holdings of K-Bonds
500 400 300 200 100 0 0 6 .1 0 7 .1 0 8 .1 0 9 .1 1 0 .1 1 1 .1 ( bp) AU M o f O ve rse as In ve stm e n t F u n d s( R ) Sw ap B asis ( L) (\ tn) 100 80 60

100

(\ tn) F o re ig n B on d H o ld in gs( L ) K R W / U SD( R )

900

80 1 ,1 0 0 60

40

1 ,3 0 0
20 0

40

20 0 8 .1 0 8 .1 0 0 9 .7 1 0 .4 1 1 .1 1 1 .1 0

1 ,5 0 0

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

Source: FSS, BOK

Dec 2011 Hana Insight 15

Issu e
sulted in increased arbitrage opportunities as the spread between currency swaps and interest rate swaps widened. During the global financial crisis, there was a massive outflow of foreign capital from Korea as global liquidity disappeared. Once the crisis was overcome, however, attention turned again to the relative merits of Korea's bond market as an investment destination, leading to a large inflow of portfolio investment. Such factors that made Korea appealing as an investment destination are its solid fiscal position, the advanced structure of its markets, and hopes for currency gains based on an expected uptrend in the KRW. The increased participation of foreigners in Korea's bond markets is positive in the sense that there are more potential buyers, but there is also need for caution, considering such participation could also serve as a major source of volatility. In particular, foreigner investment in Korea bonds tends to be overly concentrated in certain maturities and bond categories, which could lead to increased instability when market conditions shift.

Recent events in overseas markets have raised concerns about a sudden outflow of capital
In August, as the European debt crisis worsened and fears of a US double-dip came to the fore, global financial market turmoil spread, inciting concerns about the potential for a massive outflow of capital and a plunge in the KRW similar to what occurred during the global financial crisis, when a lack of global USD liquidity led to a massive outflow of capital from Korea and a plunge in the value of the KRW, as market turmoil spread and exchange-rate volatility soared. During August and September, there was a clear and significant outflow of European capital from Korea's equity market, whereas in the bond

Figure 3 | Capital Flows from Foreign Portfolios Figure 4 | Foreign Holdings of Korean Bonds
4 2 0 -2 -4 -6 11.8 11.9 11.10 11.11 Ne t Equ ity P u rc h a s e Ne t Bon d P u rc h a s e N onEuro Euro (\ tn ) N et Bond Purchases 11.8~9 11.10

KTBs 2007 2008 2009 2010 2011.11.21 25.4 (66.1) 20.1 (53.6) 27.5 (48.8) 47.7 (64.4) 61.1 (70.1)

MSBs 11.9 (31.0) 16.2 (43.2) 28.2 (49.9) 25.4 (34.3) 21.2 (24.3)

Other 1.1 (2.9) 1.2 (3.2) 0.8 (1.3) 1.0 (1.3) 4.9 (5.6)

Total 38.4 (100) 37.5 (100) 56.5 (100) 74.2 (100) 87.2 (100)

Note: Above figures as of 2011.11.21. Figures for bonds are based on rate of increase/decrease of holdings. Source: FSS, Yonhap Infomax 16 Hana insight Dec 2011

Source: BOK, Hana Institute of Finance

Issu e
market, there was no such capital flight. On the contrary, although net inflows into Korea's bond market declined, foreigner holdings of Korean bonds actually increased somewhat. In November as well, as turmoil from the Eurozone began to spread again, investor interest turned again to the merits of Korea's bond market, as central banks from emerging economies and long-term-oriented institutional investors in search of currency gains increased their allocations to Korean bonds, thereby limiting capital outflows. Since August, foreign investment in Korea's equity markets has seen a net outflow of 8.4 trillion, whereas foreign holdings in Korea's bond market have increased by 2.3 trillion (as of November 18). questing financial support, this could give rise not only to turmoil in Europe's financial markets, but also to credit downgrades in the financial sector as well as sector deleveraging, throwing the markets into chaos. Of foreign holdings of Korean bonds, Europeans hold 25.2 trillion, or 29.1%, of the outstanding amount. However, although the outflow of European capital has been replaced by capital from Asian countries, resulting in a rise in foreign holdings of Korean bonds, the risk of further turmoil and capital outflows remains.

The structure of foreign investment in Korean bonds also poses the potential threat of market turmoil
Foreign investment in Korean bonds is tilted toward mostly KTBs and monetary stabilization bonds (MSBs). As a result, every half-year, a massive amount of bonds reach maturity and a high proportion of bonds have to be rolled over, creating that threat of capital outflows and increased volatility. The reason for the disproportionate concentration of foreign investment in KTBs and MSBs is that, as fungible issues, they are highly liquid, and that it is easy to hedge such investments through the futures market, in effect making them risk-free. Because the increase in investment has been centered around benchmark KTBs, there have been market distortions resulting from market squeezes resulting from excessive concentration
Dec 2011 Hana Insight 17

Outflows of European capital have been replaced by inflows from Asia, but risks of further turmoil remain
With yields on Italian government debt rising above 7%, indicating that the fiscal turmoil in certain European countries has been spreading, there are now growing concerns about the possibility that France, Italy's largest creditor, could be downgraded. Indeed, while the PIIGS' external debt is around $2.48 trillion, Italy's is $940 billion. French banks' exposure to these countries was 27.4% and 44.3%, respectively, as of June 2011. If troubled banks in the Eurozone end up re-

Issu e
in certain maturities and a reduction in outstanding volume, as well as a reduction in the efficacy of monetary policy. The sudden drop in the yield of the 3-year KTB maturing at end-2010 was caused by the concentrated volume of rollover purchases by foreigners as well as the decrease in outstanding volume. Though capital flows have become more stable thanks to greater diversification of investing countries and institutional investors, increased investment by certain investment funds that consider exchange positions important could become a risk factor in the event of a sudden change in market conditions. One example of such a potential threat could be Franklin Templeton, which currently holds around 22 trillion worth of Korean bonds through investment funds registered in the United States and Europe.

Changes in bond issuance could distort the market

There are concerns that as the maturity date of a particular issue that foreigners hold in concentrated amounts approaches, there could be a large amount of rollover purchases centered around certain issues, resulting in a distortion of the yield curve along with a weakening in the efficacy of monetary policy. In such a situation, even if the policy rate is hiked, and increase in foreign investment in Korean bonds and a drop in long-term rates stemming from concerns about an economic slowdown could result in an inverse yield curve. In addition, considering the investment behavior of foreigners, a slowdown in the growth of new issuance of KTBs based on the principle of fiscal balance is likely to give rise to market distortions and increased volatility. It is forecast that the net increase in the amount of KTBs will fall significantly beginning in 2013, but if this is not

Figure 5 | Franklin Templeton's Korean Bonds

10 8 6 4
1 6 .5 43 30.5 2 1 1 8 .7 11.1

Figure 6 | Concentration at Certain Maturities

10 8 6 .6 6 4 2 0 1 0 .1 1 0 .7 1 1 .1 1 1 .7 1 2 .1 1 2 .7 (\ tn) 8 .4 R e de m pt io n s 9 .5 8 .0 7 .0

(\ t n )
5 9 .9 6 3 .7 6 4 . 9

7 1 .9

H oldin gs(L ) (% ) P roport ion H e ld( R )

80

60

40

2 0
8-6 M atu rity 9-2

20

0
9-4 10-2 10-6 9-3 11-2 10-5 11-1 11-5

1M 7M

1Y 1Y 2Y 2Y 3Y 3Y 4Y 4Y 1M 7M 1M 10M 7M 10M 4M 10

Source: Bank of Korea (BOK) 18 Hana insight Dec 2011

Source: Bank of Korea (BOK)

Issu e
accompanied by a change in the market structure, it is likely that the reduction in the outstanding volume of KTBs will result in a market with greater demand than supply. On the other hand, an increase in the investment demand for Korean government bonds resulting from regulatory changes in the banking and insurance industry, combined with increased investment by foreigners, will be main factors contributing to a prolongation of the low interest rate environment as well as market distortions. Basel III regulations on liquidity ratios in the banking sector and the introduction of risk-based capital requirements in the insurance sector are likely to increase the demand for safe assets, thus resulting in higher demand for bonds. Considering the negative side-effects that could potentially result from imbalances in Korea's bond market, including increased investment centered around benchmark KTBs, a concentration around certain maturities as a result of fungible bond issuance, and excessive holdings by certain institutional investors, there is a need for appropriate countermeasures. After all, an increase in capital flows resulting from external shocks will inevitably cause greater volatility in the exchange rate and the bond market.

Various methods can be utilized to guard against capital outflows

While it is clear that foreigners' imbalanced preference for investing in KTBs and monetary stabilization bonds is due to their high liquidity and low risk, an indirect cause is the lack of transparency and closed-off nature of Korea's corporate bond markets. Given that long-term-oriented institutional investors are expanding their participation in Korea's bond markets, there will be a need to expand available bond investment options, including in special bonds, such as those of public corporations, or in covered bonds, through further
Figure 8 | Forecast of KTB Issuance and Volume
Issuance 2009 2010 85.0 77.7 78.9 80.9 76.5 77.7 77.0 Amount Repaid 43.4 48.5 48.5 55.6 65.0 70.4 70.9 Amount Net Outstanding Increase 280.9 310.1 340.5 365.7 377.2 384.4 390.6 41.6 29.2 30.4 25.3 11.5 7.3 6.1

Figure 7 | Foreign Holdings of Korean Bonds

10 8 6 4
16.5 43 30.5 21 18.7 11.1 20

(\ tn )
59.9 63.7 64.9

71.9

Ho ldin gs (L) (%) P ro po rtion He ld(R )

80

60

40

2011 2012(E) 2013(E) 2014(E) 2015(E)

2 0
8-6 9-2

0
9-4 10-2 10-6 9-3 11-2 10-5 11-1 11-5

Maturi 1M 7 M 1Y 1 Y 2Y 2 Y 3Y 3 Y 4Y 4 Y 1M 7 M 1M 10 M 7M 10 M 4M 1 0 ty

Source: Yonhap, Infomax

Source: Bank of Korea (BOK) Dec 2011 Hana Insight 19

Issu e
development of that market. In order to deal with potential outflows of foreign capital, there may be a need to pursue measures to foster development of managed investment products, for instance by raising limits on pension contributions eligible for tax deductions, or by creating an environment conducive to institutional investors, so as to expand the base of potential domestic investors in Korean bonds. Fostering the retirement pension market through expanded tax deductions on contributions can aid not only in retirement planning for individuals, by inducing changes in household balance sheets, but can also contribute to the long-term development of the financial industry. Moreover, given the possibility of a sudden outflow of capital caused by the large-scale withdrawal of foreign capital, there is a need to mitigate the cyclical volatility of FX liquidity by fostering investment in overseas markets. With regard to the capital gains of investment funds, in addition to a mitigation of cyclicality through the introduction of measures that completely or partially exempt investors from taxes on investment gains or income, it would be helpful to grant tax deductions for investments in installment fund products.

20 Hana insight Dec 2011

Issu e

Strengthening

the

Soundness

of

Korea's

Derivatives Markets
Wongeun Choi, Fellow Recently, there has been increasing concern that Korea's derivatives markets have become a playground for speculation and improper trading practices, fueling heightened criticism. In response to rising criticism, the regulatory authorities have recently released a reform plan designed to strengthen the soundness of the derivatives market while providing greater protections for individual investors. Though it appears that the objectives and basic direction of the reform plan are appropriate and timely, some of the specific measures may be somewhat excessive, leading to a shrinkage in the markets over the short term. Thus, the authorities should have measures in place to ensure their rapid normalization.

Korea's financial derivatives market has grown at a blistering pace

Despite its short history, Korea's financial derivatives market has grown rapidly. By 2009, the trading volume of listed derivatives had grown to be the largest in the world, an extreme level relative to Korea's cash markets. The notional value of trades of listed and OTC derivatives in Korea totalled 28.537 quadrilion won in 2010, and is projected to exceed 30 quadrillion for the first time in 2011. Derivatives trading volume on the Korea Exchange (KRX) reached 3,752,000,000 contracts in 2010, over double the amount of the second largest exchange, and accounting for 16.8% of the global total. Highly volatility products, which have become cause for concern lately, have displayed particularly explosive growth in recent years, with

several such products already amongst the most traded derivatives products in the world. For instance, in terms of trading volume, the market for KOSPI index options has easily been the largest in the world for while now, accounting for as much as 69% of the global market for stock index options in 2010. In the equity-linked warrant (ELW) markets, the daily average trading value rose to be second-place in the world, behind Hong Kong, since being established at the end of 2005. The market for FX margin trading, which was formed in 2006, posted trading value of only US$76.5 billion in 2007, but then surged to 492.4 billion in the following year. In 2010, that figure had pulled back only slightly, to US$463.8 billion. The equity-linked securities (ELS) market has also been growing at a rapid pace, with issuance volume through October of this year at 20 trillion, an increase of over 30% over the previous year.

Dec 2011 Hana Insight 21

Issu e The rapid growth of Korea's derivatives market has been more of a curse than boon to individual investors
Along with the rapid growth in the market, there has been increasing criticism about the high incidence of speculation and unfair trading practices in Korea's derivatives market, as well as the high level of participation by non-professional, individual investors, many of whom end up suffering significant losses. Individual investors have played a large role in the growth of Korea's derivatives markets, largely by their participation in speculative trading in the quest for higher returns. Given that individuals do not possess the information or expertise of professional investors, and that derivatives can be highly risky by nature, however, individuals investors have consistently suffered significant losses in this market, to the extent that it has now become a societal problem. When it comes to FX margin trading, individual investors account for the majority of market participants yet often do not have an adequate understanding of the payoff structure or risks involved in each trade, and tend to be lured into employing high levels of leverage. As a result, the majority of these individuals (around 90%) suffer losses on such trades that amount to tens of billions of Korean won every year. In the ELW market, which is comprised primarily of individual investors and liquidity providers (LPs), not only is options trading inherently high-risk but individual investors are at a significant information disadvantage to liquidity providers, which dominate the market. In addition, scalper, which comprise a small minority of the market, tend to have an inordinate amount of control over the market. In the ELS market, unfair trading based on price
Figure 2 | Traded Volume of Derivatives
2006 KRX
2

Figure 1 | Traded Value of Korean Derivatives

3 (\10qdn)

2008 2,867 2,165 1,893 602 1,050 17,668

2010 3,752 1,897 1,656 1,616 1,223 22,298

Market Share 16.8% 8.5% 7.4% 7.2% 5.5% 3.9%

2,475 1,527 1,403 194 730 11,882

1.

Eurex (Germany) CME (US) NSE (India) Euronext

0 2006 2007 2008 2009 2010

Total

Source: Korea Exchange, FSS

Note: Unit = million contracts Source: Korea Exchange

22 Hana insight Dec 2011

Issu e
manipulation, as well as the sale of such products based on incomplete communication of the unique risks of each product, have played a role in inflicting significant losses on individual investors. A representative example of such an unfair trading practice is flooding the market with an underlying assets immediately before the expiration of hedge positions. In fact, such a practice occurred in November 2010, when Deutsche Bank was exposed by Korea's regulators for selling massive amounts of equities on the expiry date of a short position in futures index options, enabling them to reap a massive profit. As for ELS products, there are many instances in which sales of such products are made to customer despite inadequate explanation of the risk, including the fact that such products have limited liquidity and that there is the potential for a loss of principal on non-guaranteed products. With respect to KOSPI 200 options, the measures raise the contract multiplier from the current 100,000 won to 500,000 won, which is the current multiplier for KOSPI 200 futures contracts. Wtih regard to futures trading by individuals, the measures raise the cash deposit ratio from 1/3 to 1/2. For the ELW market, the measures limit the submittal of bid-ask prices by liquidity providers to the purpose of liquidity provision only. They also limit the number of listings from the current twice per month to once per month. For the FX margin trading market, the measures raise margin requirements and lower leverage limits to 10 times, while strengthening disclosure
Dec 2011 Hana Insight 23

Korea's financial authorities proposed a detailed reform plan designed to address some of the problem arising from Korea's major derivatives markets through strengthened prudential measures.

The new measures aim to strengthen regulation of the most problematic derivatives markets
The regulatory authorities' new prudential measures are aimed at improving the soundness of Korea's derivatives markets by reining in excessive speculation and strengthening protections for non-professional investors. In particular, they focus on strengthening rules on the most problematic markets, such as KOSPI options and futures, the ELW market and the market for FX trading.

The adverse effects of Korea's derivatives market have spurred calls for market reforms
Because of the high incidence of the problems mentioned above, increased attention has turned to the derivatives markets, along with increased calls on the need to reform the regulatory environment of Korea's derivatives market so as to enhance its stability and sustainability. Indeed, such concerns are reflective of the post-crisis global environment in which societal demands for strengthened consumer protections and more stable financial marekts have become a priority. Thus, on December 1,

Issu e
requirements of trading risks and restricting excessive marketing practices. kets seeks to protect individual investors, who are relatively information-disadvantaged, and also make the markets more sounds, both of which are worthwhile objectives. At the same time, however, it would be wise to consider the interlinkages between the derivatives and cash markets while, if possible, ensuring that market shocks resulting from the implementation of such reforms do not have negative repurcussions beyond the short term. The measures seek to suppress the incidence of speculative behavior on the part of individuals in derivatives markets. They seek to strengthen the system of educating and marketing the risks of derivatives in order to induce the spreading of sound investment practices. Their longer-term objective is to induce investors into the investment fund markets through beneficial measures such as the provision of tax benefits. The measures also seek to strengthen monitoring of improper trading behavior, which keeps becoming more sophisticated because of advances in information technologies and the design of complex structured products. The monitoring and supervision of such activities will have to become more sophisticated and refined. Nevertheless, although the derivatives markets should not become a playground for unbridled speculation, given that the derivatives market is The reform plan for Korea's derivatives martightly interwoven with the cash markets, it is im-

Excesses in the derivatives markets stem from a variety of problems

The problems in Korea's derivatives market stem from factors such as its excessive growth relative to cash markets, the increased variety and complexity of product structures, the tendency of investors to seek high returns, and a lack of understanding of and/or faith in investment fund products. Despite the fact that investors need more education and better risk management in order to deal with the growth in the derivatives market and the increased variety and complexity of products, their lack of understanding has resulted in a growing gap between professionals and non-professionals. Nevertheless, investors are likely to continue to seek higher returns, especially considering that the economy is likely to remain in a low-growth environment and that interest rates will likely remain low as well. Moreover, there has been a lack of progress in efforts to rebuild the confidence in the investment fund market that has been severely damaged by the moral hazard and disappointing returns of the last few years.

Any reforms of the derivatives market should take into account their linkages with their underlying market

24 Hana insight Dec 2011

Issu e
portant to recognize that large amounts of speculative transactions are necessary of the hedging process, a necessary and indispensible function of derivatives markets. Thus, it is important that reform measures do not become overly restrictive of all types of speculative activity, without regard for their purpose. In this vein, it will be necessary to continuously develop a variety of new products that serve a beneficial economic function, such as futures on stock index volatility, while meeting the demands of individual investors so that they do not speculate in a limited number of products. shock the market and prevent its proper functioning beyond the short term. One way of preventing a severe shock to the market might be to phase in the measures instead of implementing them all at once. As for potentially negative effects of the reforms that need to be prevented, two possibilities come to mind. For example, as a result of a sort of balloon effect, investors could move en masse to non-regulated markets or lightly regulated markets overseas. Or, a lack of market liquidity could result in market inefficiencies, potentially leading to greater price volatility or instances of price manipulation. Also, considering that the index futures and options markets are used more often than other derivatives markets for hedging purposes against cash-market positions, it can be said they play an important role in the national economy. Thus, it will be important to minimize or shorten the duration of any market shocks, should they occur.

The derivatives reforms measures are generally appropriate but may diminish the markets over a short horizon
First, the measures aimed at suppressing the indiscriminate participation of small-scale, individual investors in speculative activities are appropriate in principle. But it should be recognized that the simultaneous implementation of broad-reaching or excessive measures could

Dec 2011 Hana Insight 25

Issu e

Recent Changes in Korea's Retirement Pension System and Implications

Yunshin Ju, Senior Researcher Recent revisions to the Employee Retirement Benefit Security Act (ERBSA) and the Regulations on the Supervision of Retirement Pensions are likely to have a significant impact on Korea's retirement pension market. Anticipated changes include an expansion of the potential size of the market, primarily due to growth in Individual Retirement Pensions (IRP), strengthened protections for plan participants, and the expanded role of insurance companies. Combined with the active efforts of various market participants, such changes are expected to help Korea's retirement pension market to grow not only in terms of size, but also in terms of quality and sophistication.

Korea's retirement pension market picks up growth momentum

Since its introduction in 2005, Korea's retirement pension market has grown at a steady pace. More recently, however, such growth has accelerated, as existing tax benefits on legacy severance payments schemes were phased out. Corporate pension assets, which were a modest 14.0 trillion at end-2009, surged by 172% to 38.1 trillion by the end-September 2011. Moreover, with major companies such as KEPCO, Kia Motors and Korean Airlines expected to adopt corporate pension plans in 2H, and with plans to raise the ceiling on tax deductions for contributions to corporate pensions and personal pensions from the current 3 million to 4 million in the current tax year, it is forecast that Korea's corporate pension market could grow to around 50 trillion by end-2011.2)
2) Financial Supervisory Service Press Release (August 2011) 26 Hana insight Dec 2011

Amid this recent surge in growth, recent revisions to the Employee Retirement Benefit Security Act (ERBSA) and the Regulations on the Supervision of Retirement Pensions have been passed, paving the way for changes in the size, quality and dynamics of the market.

The National Assembly ratifies the revised ERBSA

The revised ERBSA was finally passed on June 30, 2011, even though work on it had begun in November 2007 and it had initially been submitted to the National Assembly for legislation in November 2008. The purpose of the revisions are to foster the growth of Korea's retirement pension system by helping Korean citizens to secure their retirement incomes while strengthening the stability of the retirement pension system. Once the

Issu e
amendment receives presidential approval, it will go into effect beginning in July 2012. Given that it specifically seeks to address many of the shortcomings of the current pension system, it is expected to bring about many changes in Korea's pension market going forward. Broadly speaking, the amendment to ERBSA outlines changes in the following areas: Pension Adoption, Design & Administration; Pension Continuity & Benefit Rights; Expansion of the Pension System; and Administrative Infrastructure.3) First, in terms of the Pension Adoption, Design & Administration category, the revised ERBSA permits workers to participate in multiple pension plans, thereby enhancing flexibility in pension design, while also permitting the use of multi-sponsor pensions in order to encourage adoption by SMEs. Under current law, an employee can choose either a DB plan or a DC plan, but not both. In response, the revised ERBSA enhances options for employees by permitting them to participate in DB and DC plans simultaneously. In addition, because administering a single-sponsor pension plan can be a large burden to small businesses, resulting in a low rate of adoption, the amendment lays the framework whereby a representative sponsor may establish a pension plan (DC only) that can be adopted by multiple companies. Second, with regard to Pension Continuity & Benefit Rights, the amendment limits the circumstances under which employees may request early withdrawals of pension benefits, and permits employees who are leaving a particular company to transfer their benefits into an IRP. It also seeks to

Figure 1 | Main Points of the Revisions to the ERBSA

Category Pension Adoption, Design and Administration Description - Permits participation in multiple plans (DB, DC or DB + DC) (Article. 6) - Introduces multi-sponsor pension system (Article 23) - Imposes new restrictions on interim withdrawals of benefits (Article 8, Clause 2) - Strengthens continuity of the pension system (Article 17, Clause 4; Article 19, Clause 2; Article 20, Clauses 5&6) - Ensures sponsor ability to make benefit payments on DB plans (Article 16, Clauses 2&3) - Forces newly established business to adopt pension plans (Article 5) - Expands the Individual Retirement Pension (IRP) System (Article 24, Clauses 2&3) - Specifies those entities permitted to engage in pension plan sales activities (Article 31) - Creates legal basis for the termination of licenses for inactive pension services providers (Article 27) - Provides guidelines for the appropriate disclosure of financial transactions involving pension service providers (Article 37)

Pension Continuity & Benefit Rights

Expansion of the Pension System

Business Practices

Source: Revised version of the ERBSA 3) Ministry of Employment and Labor Dec 2011 Hana Insight 27

Issu e
ensure that minimum pension assets are maintained at appropriate levels. Under the current system, employers are permitted to honor requests for interim withdrawals, leading to a high incidence of employees depleting their pension benefits even before reaching retirement. By limiting the circumstances under which employees may be granted interim withdrawals to, for example, cases where a non-homeowner requires the funds to purchase a home, the revision seeks to improve the odds that the employee will be able to accumulate sufficient savings for retirement. Moreover, given that the average tenure of Korean workers is only 5.7 years, the amendment strengthens the continuity of the pension system by enabling plan participants to transfer their accrued benefits to an IRP, thereby enabling them to preserve their benefits until they are 55 years old, the age at which they become eligible to receive pension payouts. Third, in terms of Expansion of the Pension System, the revised ERBSA makes it obligatory for new businesses to automatically establish pension plans, and includes provisions aimed at fostering the utilization of individual retirement plans (IRP). Under the current system, severance payment plans are mandatory, but the choice of whether to adopt a corporate pension plan is left up to individual companies, based on agreement between management and labor. Given this option, the number of companies adopting pension plans has remained fairly low. As of May 2011, only 29.7% (2.71 million) of 9.13 million regular workers are enrolled in a pension plan. Thus, the amendment seeks to expand participation in retirement pensions by requiring that any company established after the revised ERBSA becomes effective to establish a retirement pension system within one year of its date of establishment. Moreover, under the current system, only employed workers are permitted to enroll in individual retirement accounts (IRAs). As a remedy, the revisions introduce an individual retirement pension (IRP) system. Through this system, employees currently enrolled in a DB or DC plan, as well as self-employed individuals, can establish an

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

Category (A) Pension Plan Sponsors (B) Total Companies Adoption Rate (A/B, %) 10 or fewer employees 58,048 1,277,326 4.5 10-29 employees 30,573 167,033 18.3 30-99 employees 13,769 50,007 27.5 100-299 employees 3,615 10,309 35.1 300-499 employees 572 1,363 42.0 500 employees 706 1,120 63.0 Total 107,283 1,507,158 7.1

Source: Ministry of Employment and Labor (Korea) 28 Hana insight Dec 2011

Issu e
IRP and make contributions into it, thereby providing increased retirement planning options for employed workers who want to accumulate additional retirement funds or for self-employed individuals who do not receive a regular income stream. Fourth, in terms of Business Practices, the revised ERBSA specifies the channels through which pension products can be distributed and creates the legal basis for the termination of licenses for inactive pension services providers. It also permits the Ministry of Employment & Labor to request relevant information in supervising the sound management of the retirement pension system. Although the current ERBSA does not include specific regulations on the sales of pension products, regulators have issued legal interpretations that only permit pension service providers to engage in pension-related sales activities. Insurance agents have continuously requested permission to engage pension sales, claiming that it is unfair and without legal basis to limit such activities to pension service providers. Thus, the revised ERBSA not only reaffirms the legal basis for pension service providers to engage in sales activities, but also outlines the requirements, scope of activity and areas of compliance that must be satisfied by persons who want to be delegated with the authority to engage in such activities.

The Regulations on the Supervision of Retirement Pensions were also revised

Revisions to the Regulations on the

Supervision of Retirement Pensions were approved by the Financial Services Commission this October. Their main impact will be to limit pension allocation to certain types of assets, strengthen the public disclosure requirements of pension service providers, and regulate inappropriate pension sales practices. First, in order to stem excessive competition via abnormally high fixed interest rates, the revisions stipulate that a service provider can allocate no more than 70% of pension plan assets to its own guaranteed investment products. In the case of insurance contracts, however, a company does not invest in its own products during the asset management process, so insurance is exempt from this regulation. In addition, in order to ensure the provision of accurate and transparent information, the revisions seek to improve the public disclosure process for pension service providers, by requiring the disclosure of investment returns and registration documentation, shorter interval between disclosures, as well as corrections or revision by service providers and industry groups. Finally, the amendment seeks to stem the incidence of in apppropriate business practices by offering guidance on actions that can be construed as improper or coercive, such as the provision of gifts or tangible/intangible economies benefits, excessive underDec 2011 Hana Insight 29

Issu e
writing of costs for plan participants, or other such unfair sales practices. As of end-June 2011, domestic IRA assets stood at 3.6 trillion, only 9.8% of the total retirement pension assets. According to a simulation run by the Korea Insurance Research Institute (KIRI), the IRP market is forecast to grow very rapidly as a result of the ERBSA amendment, with the number of participants forecast to climb from around 80,000 currently to around 150,000 in 2015, 290,000 in 2020, and 810,000 in 2030. In the US, where the retirement pension market is highly developed, the range of entities that can join IRA plans is diverse, including not only employees participating in their corporate pension plans, but also individuals who are not eligible to participate in a corporate pension plan. Its IRA market was able to develop so rapidly in part because it developed a diverse range of products to suit the needs of a diverse customer base. As of end-September 2010, IRA assets in the US accounted for an already high 27% of total pension assets, and have been on an uptrend. As such, it ap-

The various changes in the retirement pension system should foster quantitative and qualitative growth in the retirement pension market
To summarize, the various recent changes to Korea's retirement pension system are expected to impact Korea's retirement pension market in a variety of ways. First, new provisions that require newly established businesses to adopt retirement pension plans and that limit interim severance payment withdrawals should serve to expand the potential asset base of the pension market. In particular, given that the revisions permit employees to transfer their pension benefits to an IRP when changing workplaces, and that the IRP system has been expanded to included self-employed individuals, growth in IRPs is expected to be a major driver in the overall growth of the market.

Figure 3 | Private Pension Plan Assets in Korea Figure 4 | Pension Assets by Plan Type
45 40 35 30 25 20 15 10 5 0 07.1 08.1 09.1 10.1 11.1
Note: As of end-June 2011 Source: Financial Supervisory Service Source: Financial Supervisory Service

(\tn won)

10.0%

18.0%

DB DC IRA

72.0%

30 Hana insight Dec 2011

Issu e
pears that the ability for employees leaving a particular company to transfer their retirement benefits to an IRP, as well as the expansion in the range of eligible individuals, will serve as a significant boost to Korea's IRP market. The revisions to the ERBSA and the Regulations on the Supervision of Retirement Pensions should also strengthen protections for participants by strengthening pension benefit rights, and by regulating excessive competition and in appropriate pension sales practices. For example, to ensure that DB plans are adequately funded, the revised ERBSA stipulates that plan sponsors must inform employees whether or not pension funds exceed the required minimum. If the pension assets fall below 90% of that minimum, the sponsor must make a contribution in an amount equal to the shortfall. Ensuring that pension assets are maintained at or above a certain level should help to ensure the pension rights of plan participants. It is also expected that restrictions on the amount of a service provider's own products that can be invested in, as well as guidelines on what constitutes improper gifts or coercion in sales activities, will also help to improve the quality of Korea's pension market by mitigating excesses caused by overheated competition. Finally, it is expected that insurance companies will play a growing role in the retirement pension market through the utilization of their networks of agents. The revised ERBSA provides a legal basis for the delegation of pension plan sales activities, thereby enabling insurance companies to register their agents as authorized sellers of pension products. This will pave the way for insurance companies to place their networks of agents on the front line in selling pension products, and will thereby cause a major shift in the channels through which pension products are sold. In addition, the clause that limits the proportion of pension assets that can be invested in principal-and-interest-guaranteed products of the service provider or its affiliates will likely have a negative impact on banks and securities firms, while benefitting insurance companies. As mentioned above, the various recent regulatory changes are likely to help Korea's retirement pension system to grown in both size and in quality. The revisions should resolve many of the problems inherent in the existing retirement pension system, thus setting the stage for its further development. The market is in agreement that the regulations should be favorable. What is now needed, however, is the efforts of each participant in the pension market, including plan participants, sponsors and service providers, as well as the regulatory authorities. Once the relevant parties contribute in the efficient operation of the reformed retirement pension system, the true potential of Korea's retirement pension system just may be realized.

Dec 2011 Hana Insight 31

M a rk e t W a tch e r n Interest Rates: Yield should fluctuate narrowly on global monetary easing
Seungryong Kim, Researcher

Amid the ongoing low interest rate environment, Korean bond yields faced continued pressure in 4Q, based on global market turmoil stemming from the European debt crisis, further slowdown in the real economy, and the fleeing of investors to safe assets. As the debt crisis in Europe flared up, and as the USD/KRW exchange rate rose, there was increasing concern that European financial institutions could flee Korea's bond markets, creating some upward pressure on bond yields. This concern was extinguished, however, as Asian countries increased their investments in Korea's bond markets. Meanwhile, reflecting global financial turbulence as well as a slowdown in the real economy, the policy rate was held unchanged since July, helping yields to stabilize at slightly lower levels. Moreover, the monetary policy decision-making burden was eased as consumer prices, which had been the main factor in preFigure 1 | Key Interest Rates
8 7 6 5 4 3 2 1 0 9 .1 (% ) C orporate B ond (AA- ) 3 YR KT B 1 0 YR KTB P olicy R ate (O ve rnight C all)

vious rate hikes, fell sharply as increased fears of a global slowdown caused a severe correction in commodity prices, particularly agricultural prices. Inflation fears will ease and the policy rate stance will likely remain on hold for a significant period, but continued uncertainty regarding monetary policy will likely persist. While financial turmoil from the crisis in Europe will likely continue, and global slowdown will likely mitigate inflationary pressures and expectations, the current monetary policy stance of keeping the policy rate unchanged will likely continue for a while, as domestic growth momentum weakens, problems with household debt continue to fester, and the global trend toward monetary policy easing continues. But considering that globally coordinated easing of monetary policy remains a possibility, we cannot rule out the chances of a change

Figure 2 | Changes in Yield Curves of KTB Issues

5 .0 4 .5 4 .0 3 .5 3 .0 2 .5 (%) 201 1-03-30 201 1-06-30 201 1-09-30 201 1-12-08

0 9 .7

1 0 .1

1 0 .7

1 1 .1

1 1 .7

3M

1 YR

3 YR

5 YR

1 0 YR

2 0 YR

Source: Fnguide 32 Hana insight Dec 2011

Source : KOFIA

M ark e t W a tch e r
in the Bank of Korea's monetary policy stance. Meanwhile, it is also likely that external uncertainties and an environment where demand outweighs supply could keep yields at low levels. Given the expectation that the Bank of Korea Monetary Policy Committee's stance of keeping the policy rate on hold is likely to be maintained for a significant period of time, support for bond yields has become strengthened. As such, yields will likely continue to move within a range, influenced more by whether foreigners holding Korean bonds substitute their maturing holdings with new holdings, rather than events out of Europe. In 1Q 2012, domestic bond yields are projected to stay with the 3.2~3.5% range (based on 3-yr KTBs), owing to weaker growth, easing inflationary pressures, buybacks of KTBs and an inflow of foreign investment into Korea's bond market. Demand will likely continue to outweigh supply, given the traditional base of institutional demand, expanded demand for KTBs from banks in preparation for Basel III, continued net purchases by foreigners, and buybacks of KTBs, resulting in limited upward pressure on yields. But given that external risk factors could change, volatility in the bond market could increase, since further downgrades of sovereigns or financial institutions could impact global capital flows, thereby impacting Korea's bond market. Vigilance will be required, however, since major market shocks, such as major downgrades in the US or France, could cause Korean bond yields to rise. As for corporate bonds, they were issued in large volume right after the financial crisis, so many of these issues will need to be rolled over as maturity dates approach, resulting in greater supply. It is forecast that the credit risk premiums on such bonds will become more differentiated, with demand outweighing supply.

Figure 3 | Capital Flows into Korea

1 .5 1 .0 0 .5 0 .0 - 0 .5 - 1 .0 - 1 .5 - 2 .0 Eu rope US Asia 1 1 .8 1 1 .1 0 1 1 .9 1 1 .1 1 (\ tn)

Figure 4 | Monetary Easing at the Global Level

CH (bp) 0 - 2 5 bp - 2 5 bp 8 .2 - 5 0 bp 1 2 .1 - 5 0 bp - 5 0 bp - 5 0 bp 8 .4 1 1 ~1 2 1 1 .4 9 ,1 2 - 7 5 bp -10 0 1 0 ~1 2 -5 0 -15 0 T arge t rate 0 .0 0 5 .7 5 4 .2 5 - 1 5 0 bp 1 0 ~1 2 6 .0 0 4 .2 5 1 .0 0 3 .2 5 1 1 .0 TR IL ID AU EU TH BR

Source : FSS

Note: Target rate is as of 2011.12.08. Source : Thomson Reuters Datastream Dec 2011 Hana Insight 33

M a rk e t W a tch e r n Exchange Rate: The Korean won should appreciate, but there are risk factors
Yootag Jung, Researcher

In 4Q, the USD/KRW exchange rate has been fluctuating in line with developments in the European debt crisis. In early October, as Greece failed to reach its fiscal austerity commitments, there was increasing talk of its impending default. This spurred an increase in the volatility of the USD/KRW exchange rate, pushing it above 1,200 won. But the ECB's move to expand its supply of liquidity and the decision to expand the EFSF helped to soothe market anxieties, causing the rising exchange rate to reverse course. Various other measures aimed at resolving the European crisis, such as raising the haircut on Greek debt, leveraging the EFSF, and recapitalizing the banking system, exerted further downward pressure on the exchange rate. But growing skepticism about the effectiveness of proposed measures, increased wariness about the solvency of Greece and Italy, and concerns about the potential for contagion from
Figure 1 | USD/KRW and EUR/USD
1250 1200 1150 1100 1050 1000 11.1
Source: Infomax 34 Hana insight Dec 2011

the periphery of Europe to its core caused the exchange rate to rise again. Based on concerns about Italy's massive outstanding sovereign debt and related exposures within Europe, yields on French sovereign debt surged, fomenting worries about a sovereign downgrade and instilling the view that core countries were not immune from the crisis. Given the ongoing dialogue regarding support from the IMF, the US, or from other global policy coordination, however, it is likely that much of the uncertainty will subside. Although the liquidity crunch in Europe has shut down a large part of the funding markets for European financial institutions, the recent agreement by the major central banks to lower the interest rate on currency swaps is likely to ease some of the tightness in US dollar funding markets. Although the focus of attention has been on
Figure 2 | Yields on 10-Year Govt. Bonds in Europe

(KRW)

(USD)

1.50 1.45 1.40 1.35

8 7 6 5 4 3

(%)

France Itay

Spain Belgium

Won/Dollar(L) Dollar/Euro(R) 11.3 11.5 11.7 11.9 11.11

1.30 1.25

2 11.1

11.3

11.5

11.7

11.9

11.11

Source: Bloomberg

M ark e t W a tch e r
Europe as of late, there is a need to pay heed to some of the latent global risk factors stemming from the US or China. For example, the United States' recent failure to agree on a fiscal austerity plan and the subsequent action by Fitch to lower it outlook on the United States had a limited impact on the markets, but there remain a number of risks related to sovereign debt, including uncertainty over the feasibility of economic stimulus plans and concerns about deterioration in fiscal soundness. In the case of China, the slowdown in its exports and its ongoing decline in manufacturing activity are causing increased worries about the possibility of economic contraction in China, a major risk that could trigger turmoil across the global economy. Also, if the United States' weak fiscal position causes it to resort to weakening the US dollar to stimulate its economy, such an action could collide with China's attempts to keep the yuan from appreciating in response to a slowdown in China, thus raising the stakes in the competitive battle for devaluation. Thus, the USD/KRW exchange rate is likely to experience a period of volatility as a result of external uncertainties, but based on strengthened hopes surrounding policy measures to fight the European crisis, it may be able to fall below the 1,000 won level in early 2012. Several other factors could exert downward pressure on the exchange rate, including the trend depreciation of the US dollar resulting from US sovereign risk and its policy stimulus measures, Korea's currency swap with China and Japan, favorable domestic FX liquidity conditions and fiscal soundness, and improvements in Korea's external credibility. Of course, one cannot ignore the potential for increased volatility based on the ebb and flow of events out of Europe, the potential for deterioration in domestic fundamentals stemming from weakened global demand, or other latent risk factors. As a result, the general trend in the exchange rate is likely to be down, but stabilizing below 1,100 won will not be easy in the near term.

Figure 3 | China's Export Growth & Mfg. PMI

45 30 15 0 -15 -30 2007 2008 2009 2010 2011
Source: Bloomberg

Figure 4 | Government Debt Levels (2011)

180 150 120 90 (G20 Avg.: 79%) (% of GDP)

(YoY, 3MA, %)

(Index)

65 59 53 47

Export Growth (L) Mfg. PMI (R)

60 30 87 166 121 Itay 32 Korea 67 Spain 100 US 0 France Greece

Source: IMF Estimates (Fiscal Monitor, 2011.09) Dec 2011 Hana Insight 35

41 35

M a rk e t W a tch e r n Equities: Volatility risk remains, but a major correction is unlikely

Kyungshik Yang, Chief Strategist (Hana Daetoo Securities)

Global equity markets suffered a major correction in August, owing to the European debt crisis and the US downgrade, but then entered a up-and down pattern as volatility subsided somewhat. In October, equities staged a solid rally, as the European summit produced favorable announcements and economic indicators out of the United States suggested that a recession was not in the immediate horizon. By November, however, as resolution of the crisis in Greece was delayed, the crisis spread to Italy and Spain, fueling rumors of a potential downgrade of France, and funding problems spread through the European banking sector. As a result, global equity markets were thrown back into disorder, with the KOSPI sliding down as far as the 1760 level at one point. In the United States, economic indicators
Figure 1 | KOSPI Volatility
(%)

showed that employment, consumer spending and the housing market were improving in general, helping to ease pessimism about the economy. Combined with positive expectations for a strong holiday shopping season, global equity markets began to rebound again in early December, with the KOSPI recovering to the 1,900 level. With expectations that European summit in December will produce further plans to resolve the debt crisis, along with high hopes for solid holiday shopping in the United States and the positive economic effects of the Lunar New Year season in China in early 2012, the equity markets appears to have some additional upward momentum, although there is a chance that the debt crisis could still cause Europe's economy to slow. Also, given that the maturity dates on the sovereign debt of Europe's peripheral countries are concentrated in

Figure 2 | Maturity Schedule of PIGS Debt

Lehman Brothers Collapse

30 25 20 15 10 5 0 1997
Asian Crisis

IT Bubble Collapse 9/11 Tripl e

(bn) 120 100

Portugal

Italy

Greece

Spain

41% in 2012

Bear Stearns

European Crisis

80 60 40 20 0

1999

2001

2003

2005

2007

2009

2011

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

Source : Bloomberg, Hana Daetoo Securities 36 Hana insight Dec 2011

Source : Bloomberg, Hana Daetoo Securities

M ark e t W a tch e r
February-April 2012, additional upward moves in equity markets should be limited, leaving open the possibility of a return of volatility. Ironically, as we have experienced before, the more dangerous global financial markets become, the stronger and faster the policy responses, and this is likely to continue into the future as well. To take a recent example, as funding conditions for European banks deteriorated, central banks from the United States and other advanced economies agreed to set up a commodity swap in response to a deterioration in funding conditions at European banks. As global inflationary pressures wane, the major economies are likely to ease their tightening stances. Brazil, Australia and other emerging economies have already lowered their policy rates, China has lowered its reserve requirement ratio, and it appears that the United States may resume discussions on additional quantitative easing measures. Such policy measures are likely to provide support for global equity markets. Though Korea's stock market cannot be immune from volatility, there are two reasons why it is likely to outperform other global equity markets. First, Korean companies' earnings growth (based on MSCI 12-month forward EPS) is higher than the global average or that of emerging economies. Second, despite the ongoing turmoil in global financial markets, the Financial Condition Index is more stable that in the past, reflecting Korea's improved fundamentals.

Figure 3 | Policy Rates of Major Economies

(%) 8 7 6 5 4 3 2 1 0 2000 2002 2004 2006 2008 2010 US Eurozone China UK Australia Korea

Figure 4 | KOSPI & Financial Conditions Index (FCI)

(p) 2300 2200 2100 2000 1900 1800 1700 1600 1500 1400 11.1 11.3 11.5 11.7 11.9 11.11 KOSPI (L) Financial Conditions Index (R) (index) 730 710 690 670 650 630 610 590 570 550

Source : Thomson Reuters, Hana Daetoo Securities

Source: Bloomberg, Hana Daetoo Securities Note: The Financial Conditions Index is an equal-weighted index of daily movements in equities, bonds and FX. Dec 2011 Hana Insight 37

Hana Insight
Vol. 1, No. 2 Published December 14, 2011 Editor-in-Chief: Warren Park Publisher: Choe, Heungsik, President Hana Institute of Finance 27-3, Yoido-dong, Youngdungpo-gu Seoul, Korea 150-705 Tel: 82-2-2002-2200 Homepage: www.hanaif.re.kr Printed by KwangMoonDang Co., Ltd.

The views and opinions contained herein are those of individual authors and do not necessarily reflect the stance of the Hana Institute of Finance.