By Cho Kyung-rae
Managing Director and Chief Executive Officer of HSBC Korea
The Korean stock market indices showed a rapid decline in recent weeks, with the main KOSPI index retreating almost 20 percent from its peak, shaken by unfavorable external conditions including the U.S. credit rating downgrade and concerns that a double dip recession may be lurking around the corner.
The market crashed with over 200 trillion won in terms of market cap disappearing in less than a month. Meanwhile, the Dow Jones showed a relatively moderate fall of less than 10 percent over the same period.
Why is it that the domestic market tends to be more vulnerable to these overseas variables? We are aware that the Korean economy is highly export-oriented with 40 percent of its annual GDP coming from exports, and agree that the potential recession in the U.S., the second largest destination for Korean exports, poses a considerable threat in that it will slow exports. However, we feel the recent plunge in the domestic market is more of a structural issue than a macro-economic one.
Korea’s economy is in respectable condition. Domestic companies’ debt to equity ratio has improved to 99.6 percent in the first quarter of 2011 from 115.8 percent right after the Lehman Crisis.
Auto, semiconductor and shipbuilding names have enhanced their competitiveness and are strengthening their presence in the global markets. This has helped boost Korea’s FX reserves to $312 billion, as of August.
Although there are concerns surrounding the substantially high level of household debt, the Korean economy is deemed to be in good shape compared to the past. Furthermore, from a valuation perspective, the KOSPI is currently trading at 9.0x PE and 1.2x PB, representing a 15 percent discount to the historical average since 2003.
However, in terms of the stock markets, Korea’s ‘immunity’ towards overseas developments has not seen much improvement. The media seems to be convinced the steep losses amid global jitters are mainly due to foreign investors’ trading activities. However, looking at foreign ownership of Korean stocks, we find it has declined considerably, to 32 percent currently from a peak of 44 percent. Moreover, although foreigners sold off over 5 trillion won worth of Korean stocks in August, this only makes up 0.5 percent of the KOSPI market cap of 1,313 trillion won.
Is it really possible for W5 trillion of net foreign selling to wipe out over 200 trillion won of market value?
My view is yes. Foreign ownership of stocks in Korea is concentrated on the large cap names and therefore when these stocks drop, it has a bigger overall impact on the market than when smaller cap stocks decline.
Furthermore, the foreign activity in the stock markets has a big influence in terms of how local investors trade. Big foreign selling or buying, for example, can impact the psychology of how locals will act.
Given its growing role in the global economy and rapid economic growth, I think that the Korean stock markets need to be less vulnerable from such movements and more dependent on the local investor activities. We attribute this volatility to structural problems in the Korean stock market, specifically long-term institutional ownership.
First, the current market circumstances give little room for long-term investments. Institutions and foreigners each account for 18 percent and 16 percent of the trading value in the Korean stock market, while retail investors make up 62 percent.
In other words, the majority of investors are sensitive to short-term returns as retail investors still tend to be more trading-oriented. Thus, the market is subject to wide fluctuations. In the U.S., the proportion of institutional investors gradually climbed following the 23 percent plunge in the Dow Jones Index on Black Monday in 1987. In 2007, it peaked at about 75 percent for the largest 1,000 U.S. corporations. This means the overall investor appetite moved away from short-term speculation and more towards long-term returns.
In this regard, I agree with recent opinions in the media to expand the institutional investor base in Korea for a more robust stock market. This responsibility should come from the market players, with a big onus on the government to provide more incentives to foster such an environment.
I think there are a few ways that institutional ownership of equities can grow further. One is the move in Korea to 401(k) pension plans that will ultimately invest more of the work force’s retirement money in stocks. Perhaps more corporates in Korea can provide matching funds for employee contributions to their retirement plans. This could incentivize employees to allocate a larger share of their incomes to stock investment plans.
Another method could be more tax benefits that would encourage individuals to be longer-term investors. Some specific examples would be tax incentives for investing in the mid- to long-term or for investing in mutual funds..
Finally, to reduce wide fluctuations in the market, having a government-sponsored market stabilization fund would be beneficial. Also, amassing funds from various government-related pension funds could also be a method to raise capital in such an effort.
Also, related to public funds is Korea’s need to have a higher proportion of pension money invested in equities. In the case of Korea’s main pension fund, the National Pension Service (NPS), equities account for only 23 percent of its investment portfolio.
To put this in perspective, Calpers, California’s state pension fund, the figure is 44 percent. The good news is that the NPS has been gradually raising the proportion of equity investments over the past several years.
Korea is flush with liquidity in the money markets and with the improving fundamentals of Korean listed companies, there is a healthy environment for developing an investment culture that is more focused on higher institutional participation and ownership and with this, better long-term returns.