Why Korea hasn’t dived with the US economy

Institutional Investor, September 2010

Korea’s economy has always been primarily a story about exports. The world consumes its devices: Samsung phones, Hyundai cars, Daewoo ships, built with Posco steel.

Exporters generally have struggled through the financial crisis, but two trends have helped Korea emerge from global malaise with some vigour: a growing domestic demand story, and a change in the main export destinations to thriving Asian nations rather than flagging western ones.

These are among the reasons Korea defied a lot of bearish expectations during the global financial crisis. “If you look at Korea’s history, whenever there is a global downturn, Korea has problems with its financial sector, so the foreign perception two years ago ahead of the global recession was very negative,” says Seok Yun, head of research for Credit Suisse in Korea. “The fact of the matter is Korea managed the crisis a lot better than most people expected.”

This was partly because the Bank of Korea lowered interest rates heavily and early, and the government pumped about US$10 billion of stimulus into the economy to provide support. But it was also because Korea’s main trading partners were resilient. “Korea remains very much export-oriented but today China and emerging markets, more than the US and Europe, are structurally the most important markets for Korea,” Yun says.

Song-Yi Kim, economist at HSBC, says shipments to China now account for 25% of total exports, and emerging Asia 42% in total, compared to 11% for the US and 12% to Europe. “The China figure is a record high, and has grown from 10% in 2000,” she says. “We are getting the full benefit of this emerging Asia theme and are very well positioned to benefit from rising Chinese consumption.” It is true that roughly half of the emerging Asia figure is ultimately exported to western markets – a trend that has prompted some economists to say that the boom in intra-Asian trade is overstated, since the ultimate reliance is still on western consumers. “But we’ve found that in the last 18 months, more exports go to China to be consumed there, rather than just to be reassembled and exported overseas.”

Others believe the role of emerging markets is even more important than that: Um Taejong, head of global investment at Samsung Asset Management, believes the proportion China and other emerging markets account for may be as much as 60%. “With that structure, I think Korea is less impacted by the global economic crisis,” he says.

On top of that comes a newer domestic story. “We are export-driven, but in recent years we have also had a growing domestic market,” says Kim at HSBC. “We expect per capita income to return above US$20,000 this year, driving product consumption.” She notes that department store sales have been logging double-digit growth this year, while liquid local companies are announcing aggressive domestic investment strategies. “We rely on exports but they’re not the entire story behind the very good growth numbers this year. Even if exports slow, this domestic growth will help.”

This domestic story remains highly relevant even to export-heavy chaebol conglomerates. “These big companies need to try to find ways to keep small to medium enterprises as partners or customers,” says Kim. “It’s important to have a big domestic market. 86% of employment is hired by SMEs: their income and their consumption is important to the big companies as well. And Samsung needs a domestic market to test its own new products before they are sold to the US or Europe.”

That said, others see headwinds for the domestic story, which accounts for about 50% of national GDP (this compares with about 70% in the US). “When the Bank of Korea hikes interest rates there will be some slowing in consumption,” says Um. “Also, Korean consumption growth is strongly related to house prices, and we don’t expect housing prices to go up in the near future. This makes people feel less wealthy – housing accounts for most assets in Korea – so this sort of negative wealth effect tends to make consumption very sluggish.”

Nevertheless, economist opinion on Korea tends to be quite promising. “We are quite bullish on Korea,” says Kim at HSBC. She is calling 5.8% full-year GDP growth for 2010, dropping to 4.4% for 2011. “And the risk for our forecast is to the upside.” Um at Samsung says 5.4% this year and 4.4% next. “Although there will be a decrease in GDP growth next year, 4.4% is still high,” Um says. “The economy will be sustainable, but due to the slow recovery of the global economy our exports will decrease.” The IMF is roughly in line with analysts, expecting 5.7% growth this year.

The currency will have a considerable impact here, but the won looks very different depending on where one views it from. Against the Japanese yen, the won is very weak, which helps Korean exporters relative to Japanese ones. “Korea is the sole beneficiary of the yen appreciation in Japan,” says Um at Samsung. “It gives it a strong advantage against Japan as an export competitor.” Compared to the Chinese renminbi, though, the picture looks different. The HSBC house view, for example, is that the RMB will appreciate more slowly than the won, which disadvantages Korean exporters relative to Chinese ones.

Still, against most currencies the won is weak, and this is one of several reasons that Korean companies appear to be in excellent shape. “Even though the global economy has not recovered fully from the financial crisis, Korean companies’ profit has stayed at record highs,” says Koo Yong Deok, head of research at Mirae Asset Management. “This is because of cost competitiveness stemming from the weak won, and efforts to strengthen their own competitiveness compared to global rivals. I think a sharp appreciation of the won and slow recovery of the global economy could be risk factors in the future, but in corporate cash flow and investment execution Korean companies have already outpaced their rivals.”

Yun agrees, and argues major Korean exporters found opportunity in the crisis. “Some of the big companies in the technology and auto sectors had a very good balance sheet so utilised the global financial crisis as an opportunity to gain greater market share in the global market,” he says. In certain sectors, such as TFT-LCD chips, Korean companies have exited the crisis in a stronger market position than they entered it. “I would say Korean corporate performance has been much stronger than most people expected over the last two or three years. Many Korean companies are entering a period of the highest profitability in their history.”

So how should investors view Korea? On one hand, it’s cheap – it usually is. “The Korean market is always a cheap market, and right now is at about a 20 to 25% discount to non-Japan Asian regional markets,” says Yun. “And that discount range is not a low level. Korea normally moves within a 10 to 35% discount, so this is the middle of the range.” That suggests opportunities: Korean profitability is looking strong, and China, which attracts so much investor attention, has been a major disappointment this year. “Korea is different to China and India: it’s more close to a developed than an emerging market. So investors are looking for an alternative to China to outperform, they may look at Korea.”

This sense of being a middle ground between developed and developing markets is picked up on by other commentators too. “As risk aversion has faded and the US market has stabilised, some risk appetite is coming back, but selectively and with caution,” says Kim at HSBC. “So in terms of the counterbalance between risky and safe assets, Korea sits in a very good position: a developed country, in Asia, yet emerging. Investors see it has a high return market, but less risky than India and China.”

HSBC has Korea as one of its top stock market picks, with Indonesia, and is calling the KOSPI index to pass 2,000 by the end of the year (it was at 1,776 at the time of writing). “Korea is the cheapest market in Asia and has very strong prospects in both the short and long term,” Kim says, saying HSBC’s equity strategists highlight the technology and industrial sectors. Others vary on where they see opportunity: Credit Suisse points to exporters having been the best performers, but expects a period of rotation and profit-taking; Um at Samsung says a major drop in share prices in the IT sector has made valuations there attractive, and points to automobiles as tied to the global recovery story;  and Koo at Mirae declines to name specific holdings and weightings, but does say that new growth industries such as LED, secondary batteries, EV, renewable energy, robot technology and healthcare will attract more and more attention.

On the other hand, Korea has already enjoyed some excellent gains, climbing approximately 50% in 2009 and benefiting from inclusion in the FTSE developed market index that year, prompting a reallocation of assets to Korea. As of August, it was modestly up in 2010 (3.8% year to date by August 13) but the easy gains appear to have gone already.

The Korea Exchange itself sees positive patterns in trading volumes and market activity. Average daily trading volumes are higher in the good times than the bad (W7.4 trillion during the record highs in 2007, compared to W5.5 trillion mid-crisis in March 2008) but now appear to be strong again, averaging W7.3 trillion in the first seven months of 2010, Korea Exchange says. “In 2010, Korea’s real economy and stock markets showed firm ground among Asian emerging markets, attracting not only foreign investors but domestic ones as well,” the exchange says. It logged extremely strong net buying of Korean stocks by foreign investors in 2009, at US$26.2 billion, and a further $8 billion in 2010 to date, despite recent outflows triggered by European debt problems. The exchange says that of portfolio investment in Asian emerging markets by global investors, about 40% came to Korea – though it is not clear how this is quantified – while at home, net buying by the National Pension Service has also helped support the market. A further positive sign is that the exchange has so far attracted 15 foreign companies, mainly Chinese, to list IPOs in Korea itself.

International capital tends to take a straightforward view of Korean exposure. “The way most foreign investors look at Korea is pretty much dependent on global growth,” says Yun. “Because of that, when global growth started tumbling in 2007-8, there was a lot of money outflow from foreign investors, and when it stabilised in 2009, we started to see strong inflows again.”

In 2010 the direction has been less clear: still positive, but more choppy. “Balance of payment data says equity investment is back again in the second quarter after a heavy sell-off in May because of European debt concerns,” says Kim. “But investor sentiment recovers very quickly and we are now seeing investors returning to Korea because they believe in its growth story.” Koo at Mirae agrees. “Once the economy recovery is back on track, Korea will emerge as an attractive investment market given its valuation merits, and will induce inflows of foreign investment again.”

Um is more bearish, and says foreign flows into Korea reflect “more global than Korea-specific” themes. “They come into the market, but their demand for Korean stock is relative to other emerging markets. I don’t think there will be much demand from international investors for Korean stocks for the time being: they came into the market because they thought there would be some Korean won appreciation – and they still see the probability of it – but I think there will be maybe only 5%. So currency, which used to be a strong factor when international investors made decisions to invest in the Korean market, is not a strong factor anymore. “

Um notes that domestically, Korean asset managers have been selling because of redemption requests from retail investors. He reports redemptions of US$3 billion across Korean funds in July alone, and about US$8 billion for the year. “People have suffered major volatility for three years and are sick and tired of it. They have tried to redeem their investments when they reached par value,” which for many of them has come recently as the Kospi has passed 1700 points.

One question investors have long had about Korea is corporate governance. Particularly given the power of the vast chaebol conglomerates, investors have not always felt that companies look after their best interests. “Generally, compared to five or six years ago, corporate governance standards have improved, although in Korea it is still relatively poor by international standards,” says Yun. “But the general direction has been OK. Not a strong improvement, but gradual.”

“Investors generally look at Korean corporate governance as one reason for trading at a discount. But for me, the governance level in Korea compared to other markets is not so bad,” Yun adds.

Um agrees. “Some people say the reason the Korean stock market is discounted is because of the Korean corporate governance structure. I don’t think that theory can be applied to chaebol because there are so many interest groups and watchdogs monitoring the chaebols’ behaviour and activity. There is very slim room for them to cheat the market.”

He adds: “If there is a problem in Korea when it comes to corporate governance issues, it is more related to small enterprises than big conglomerates.”

Nevertheless, it still weighs on the mind of international investors. Hugh Young, who runs the Asian portfolios of Aberdeen Asset Management, says: “governance and management focus remain issues compared to elsewhere, although price is not expensive.” Clearly, the big names overseas still need a little convincing.

BOX: The sovereign fund

The Korea Investment Corporation is not the biggest sovereign wealth fund, but it is one of the most widely talked about, particularly among fund managers. It stands out for a dynamic approach which is likely to include a major allocation to alternative asset classes.

Formed in 2005, the KIC was launched to “increase the long-term purchasing power of sovereign wealth through the efficient management of Korea’s public funds in the international financial markets.” It is given mandated chunks of assets from Korea’s foreign exchange reserves and the Foreign Exchange Stabilization Fund. As a knock-on effect, it is hoped the KIC will help stimulate the development of the local financial industry and help to turn Korea into a regional financial centre, with a talent pool with experience in international financial markets.

It is somewhat unusual among sovereign funds in that it has two sources of funding: the Bank of Korea, the country’s central bank, which gave it its original US$17 billion of funds in June 2006; and the Ministry of Strategy and Finance, which has so far chipped in US$12.77 billion in a series of chunks. As an agency mandated to manage money on behalf of those sponsors, which specify the benchmark and portfolio weightings, it is believed to face quite a challenge in that those two sponsors often have quite different views of appropriate investment, with the Bank of Korea considered more conservative.

When last disclosed at the end of 2009, KIC had US$30.06 billion under management, and is believed to have been given another US$5 billion during the year, although that will not become clear until the publication of the next annual report. It has the potential to be bigger still: Korea has about US$280 billion in foreign exchange reserves, and as Korea’s economy matures, it is likely to be comfortable allocating more assets towards seeking returns.

Fund managers are particularly interested in the fund partly because it outsources, and partly because it is doing some interesting things with asset allocation. It started out with a benchmark calculated on a 40/60 equities/bonds split, but in late 2009 shifted to a new allocation of 50/46/3, equities/bonds/inflation-linked bonds. It runs traditional and alternative portfolios, with traditional assets accounting for 93.2% of the fund at the end of 2010, but there are indications that this may change quite markedly. Chief investment officer Scott Kalb – a rare example of a westerner in a senior position in a Korean state institution – has spoken at conferences in 2010 of trebling the allocation to alternatives assets to 20% of the portfolio, arguing that illiquid alternative assets are in the early stage of a positive cycle and are becoming attractively valued relative to liquid public markets. This could see the fund invest in hedge funds, private equity, distressed real estate and credit, among other things.

While the KIC is big, it is dwarfed by the National Pension Service, the state pension fund – believed to be the fourth largest in the world. It is believed to have over W300 trillion under management, and had W289.5 trillion when last disclosed in March. It covers 18 million people, or 40% of the national population, and its leaders have spoken of hoping to reach US$400 billion in assets.

BOX: Sentiment and North Korea

People tend to assume that when anything edgy happens involving North Korea – most recently the torpedoing of the South Korean warship Cheonan in March – Korean markets nosedive amid capital flight.

In fact, that’s not quite true. “There were occasions when stock prices of the day temporarily fluctuated, but the prices soon recovered to the normal level,” says Korea Exchange, which studied data for Institutional Investor. “Foreign investors have also not been very sensitive to North Korean matters.”

In fact, if anything, foreigners appear to embrace uncertainty. When North Korea conducted its first nuclear missile test in October 2006, and its second in May 2009, foreign investment was net positive: by US$496 million on the first occasion and US$170 million on the second. On the first day after the Cheonan sinking (which took place at 9.30pm, after trading hours) the net buy was $289 million.

And the bourse itself has shrugged off these events. Within three days of the Daepodong missile test in July 2006, KOSPI was back above the level before the test; and within a single day of the Cheonan sinking.

“Investors did not react in a way that would panic the markets, and KOSPI showed little changes in price,” the exchange says. “It is assumed that the geopolitical risks related to North Korea pose an insignificant impact on the Korean market.”