In 1997, when the Asian financial crisis swept through the region, concerns were mounting over the stability of the Asian financial system. The most obvious question was whether countries in the region would be able to withstand the contagious risk afflicting the region at the time. Investors were scared and eventually “flew to quality” in the face of fundamental uncertainty in the region. Abrupt outflows of capital and funds added to the already existing pressures to depreciate each nation’s domestic currency; Korea was no exception.
Many people ascribe one of the main causes of the crisis to the underdevelopment of the local bond market. Prior to the crisis, most firms were taking bank loans. But what really aggravated the problem was that much of the loans extended to the firms were both short term and external. The vulnerability of this financing method—a double mismatch of currency and maturity—employed by many firms came to light once investors started to move their capital to outside of Korea.
Since then, the Korean government has reined in the entire system and came up with various measures to revamp the entire bond market. As a result, the Korean bond market became the second largest market in Asia today (see Figure 1).
The amount of infrastructural development, swelling trading volumes, and the attraction of large numbers of foreign investors (see Figure 2) all define today’s huge success.
Then how did Korea transform a nearly nonexistent market into a well-developed market so quickly? Before going into details, we would like to introduce a brief history of the Korean bond market in this article to explain to you the major phases of its development.
Pre-Asian Financial Crisis
The first government bond issuance traces back to the early 1950s. Before the bond market was fully liberalized in 1997, however, government bond issuances were very limited, a reflection of the government’s conservative fiscal policy. In short, most of the time, their current account balance experienced surpluses, rendering bond issuances unnecessary. On the other hand, companies were issuing bonds actively. However, most of the newly issued bonds were guaranteed by banks and were limited to short maturities. Moreover, a slew of them were issued in major currencies, leaving the bonds vulnerable to a potential currency depreciation.
Post-Asian financial crisis
The 1997 Asian financial crisis was a real game changer for the bond market. To head off a full-scale meltdown in the financial and corporate sectors, the government entered uncharted waters by raising funds directly or indirectly from its government-sponsored agencies on an unprecedented scale. Two agencies, the Korea Deposit Insurance Corporation (KDIC) and the Korea Asset Management Corporation (KAMCO), channeled needed funds to troubled entities and called for needed restructurings to bolster their balance sheets and operations. Aside from these quasi-government bond issuances, Korea Treasury Bond (KTB) issuances increased substantially at the same time (see Figure 3). Today, three-year maturity bonds are the most prominently traded treasury securities. As noted above, foreign investment surged, indicating increased product credit and enhanced risk-return profile that could be aligned with their portfolios.
Corporate issues soared as well, but in the lead-up to and in the wake of the crisis, companies had to issue nonguaranteed bonds as financial firms were reluctant to extend credit guarantees—they themselves were deep in the red. At the time, those firms that were unable to secure sufficient financing issued enormous volumes of asset-backed securities (ABS) to securitize nonperforming loans and credit card receivables; investment trust companies absorbed the bulk of these new ABS issues. However, this eventually fed another bubble: delinquency rates of credit card receivables steeply ascended, and eventually many of them went sour. Concurrently, several large companies’ downgrading of their credit ratings and run on investment trust companies magnified the problem, leading to a precipitate decline in corporate bond trading. Subsequently, mutual savings banks, credit unions and other financial firms filled the void of corporate bond investments left by investment trust companies. That, coupled with recent solid performances of companies, made the need for bond issuances less necessary, as they were stacked with huge cash balances. Today, the ABS market has developed in certain markets, with the securitization of credit card receivables making up only a small portion of the entire market. Furthermore, the corporate bond sector is still dominated by conglomerate companies or their arms, retaining the overall high credit quality of bonds in the market. However, the lack of issuer diversity ultimately leads to limited choices for investors.
Donald Lee (DonaldLee.DLee@gmail.com)