Bond taxation unlikely to stem capital inflow

The Korea Times

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Bond taxation unlikely to stem capital inflow

Posted : 2010-11-19 16:56

Updated : 2010-11-19 16:56

By Cho Jin-seo

Foreigners have continued to rake in local bonds, particularly short-term state bonds issued by the Korean government, raising fears that the local financial market could be shaken when unexpected shocks hit the nation from abroad.

According to the Financial Supervisory Service (FSS), foreigners purchased a total of 2.3 trillion won worth of monetary stabilization bonds in October, the biggest monthly amount this year. They also bought bonds worth 333.5 billion won in the first 16 days of November.

Foreign holdings accounted for 4.3 percent of the total bond market at the end of 2008, but now their portion has increased to 7.1 percent. The foreign bond holdings hit bottom at around 40 trillion won in early 2009 when many feared that the country was facing another liquidity crisis.

Market experts express concerns that foreigners could pull their money out of the local bond market if the global economy faces another turmoil, which will deal a blow to the domestic market.

In order to dampen foreign capital inflows, the government, as the first in a series of protective measures, decided Thursday to scrap the special tax exemption on foreign investment in government bonds. The decision led to the revival of a 14 percent tax on interest income and 20 percent on capital gains for all purchases made after Nov. 11.

However, re-imposing tax on foreigners’ bond holdings will have a limited effect on prices, financial analysts said.

Prices of government bonds were stable Friday despite Thursday’s announcement of the tax resumption. Many analysts found the measure not enough to dampen the inflow of cheap dollars into Korea, which was spurred by expansionary economic policies and low borrowing costs in the United States and in Europe.

The price of the benchmark three-year government bond was almost stationary on Thursday and Friday, moving less than 0.03 percentage points up or down. Analysts say that market players have already calculated the risk of the tax resumption into bond prices, so not many of them are likely to rapidly pull money out of Korea.

“Short-term capital inflow may be reduced, but long-term flow won’t be affected very much,” said Park Tae-keun of Hanwha Securities. “Long-term investors make investment decisions based on the fundamentals of the economy. Since the Korean market is becoming healthier, the tax won’t have a large impact.”

The yield on three-year bonds had risen to 3.6 percent on Nov. 5, from 3.25 percent at the end of October, as investors began to fear the Korean government’s capital control measures. A rising yield means the bond becomes less attractive to investors. But the yield soon came back down to around 3.3 percent as the reintroduction of the tax became clear to everyone.

The 14-percent tax on the interest income on government bonds means that foreign investors may have to pay about 0.5 percent of their investment in tax, every year.

This looks large, but in fact it can be easily offset if the Korean won’s value rises by only around five won. Many economists and investors believe that the won’s appreciation against the dollar is very likely over the next few years, because the U.S. Federal Reserve has pledged a massive printing of dollars. Furthermore, most foreign investors have tax exemptions from their home countries anyway, because of bilateral agreements between Korea and many other nations on preventing double taxation.

Only funds operating from places that do not impose taxes on capital gains, such as Hong Kong or Luxemburg, will suffer some damage, but that is less than 5 percent of the total foreign holdings, the Hanwha analyst says.

While the market didn’t budge much on Thursday’s announcement, many see that the real test will come next year when the government introduces further capital control measures.

Regulators have already promised the gradual tightening of foreign banks’ positions in foreign exchange derivatives, with a long-term goal of having them abide by the same regulations with local banks. So far, foreign banks are allowed to have far larger positions.

Another option is to introduce a levy on banks’ non-deposit liabilities. Korean banks tend to take out dollar loans from foreign banks when they need more money to invest, so taxing this liability should discourage them from borrowing too much,.

cjs@koreatimes.co.kr