Korean Country Experience - World Bank

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Korean Country Experience - World Bank

Structural Change in theCorporate Bond Marketin Korea After theCurrency CrisisBySungmin KimThe Bank of Korea


Introduction Local bond markets before the currency crisis: small and under-developedMarkets for government bonds and government-guaranteed bondswere not well-developedCorporate bond market was relatively large, but• Predominated by guaranteed-corp. bonds• Yield on 3-yr. corp. bond used for the proxy benchmark yield Local bond markets after the currency crisis: Remarkableincrease of the market size for many reasonsGovernment: Public fund for financial restructuring and boosting the depressed economy by fiscal pump primingBOK: More MSBs for absorbing the expansionary effects of the rapid increase of its foreign reservesCorporate sector: To raise more funds from bond markets due to financial institutions’ reluctance to extend loansABSs: During financial and corporate sector restructuring


(continued)As of end-2001, the total outstanding volume has doubled to 480 tril. KRW from 223 tril. KRW atend-1997Outstanding Volume of Bonds in Korea(end of, tril. KRW)Gov. BondsMSBsCor p. BondsAgency bondsFi n. I nst . bondsLocal gov. bondsTot al bonds( A)No mi n a l GDP( B)A/ B( ) shows shar es of t he bond mar ket ( %)1997 1998 1999 2000 200128. 4 41. 5 61. 2 71. 2 82. 4 ( 16. 7)23. 5 45. 7 51. 5 66. 4 79. 1 ( 16. 1)90. 1 122. 7 119. 6 133. 6 154. 4 ( 31. 4)38. 4 80. 4 103. 1 108. 1 140 ( 28. 4)39 42. 8 36 36. 4 33. 5 ( 6. 8)3. 1 3 3 3. 1 3. 1 ( 0. 6)222. 5 336. 1 374. 4 418. 8 479. 7453. 3 444. 4 482. 7 517. 1 ¡¤ ¡¤49. 1 75. 6 77. 6 81 ¡¤ ¡¤


(continued) Main features of the bond markets after the crisisModernization of government bond markets• Across the three major pillars of the market: primary market,secondary market and market infrastructureVery popular issuance of ABSsPredominance of non-guaranteed corp. bondsFrequent outbreaks of turmoil in the corporate bond market since July 1999• The liquidity troubles of ITCs and government measures• Difficulties in rolling-over the maturing bonds of low-rated firms and further measures from mid-2000The purpose of the presentation:• To explain the details of the recent developments of corporate bond markets and policy responses after the currency crisis– To attempt to draw policy implications based on these recent Korean experiences


Development of the Corporate Bond Market and Policy Responses Three phases of development of the corporate bond market after the crisis:The first phase (the end of 1997 until June 1999): Massive surge of corporate bond issuance and swift change to a predominance of non-guaranteed bondsThe second phase (from July 1999 until June 2000): Liquidity crisis of ITCs and the subsequent sharp deterioration of financing conditions of the marketThe final phase (from July 2000 until quite recently):Difficulties faced by lower-rated firms in rolling over their maturing bonds


Boom in corp. bond issuance A challenge for the corporate sector in the aftermath of the crisis:FIs’ extreme reluctance to extend loans and provide credit guarantee for corporate bond issuance Had to rely heavily on bond financing via issuing non-guaranteed corporate bondsBut, government measures were not very effective …Increase of an individual firm’s ceiling on its bond issuance : from double its equity capital to four timesElimination of restrictions on foreigners’ investment in domestic bonds


(continued) Only market-driven factors worked effectivelySharp decline of interest rates from the peak in mid-February 1998 under historical cost accountingCorrespondent huge surge of fund inflows to ITCs into their bond-type beneficiary certificates(BCs)• BCs were increased from 62 tril. KRW at end -1997 to179 tril. KRW at end-June 1999Active investment of ITCs on corporate bonds(In trillio n K R W ) (In trillio n K R W )18301410Net increase of ITC'deposits(bond- types, right- side axis)106-1 02-3 0-2-6Net issuance of corporate bonds(left- side axis)-5 0-1 01 4 7 1 0 1 4 7 1 0 1 4 7 1 0 1 4 7 1 01998Y 1999Y 2000Y 2001Y-7 0


A puzzle: Why did investors invest such a huge amount of money in ITCs, even though ITCs are not subject to deposit insurance? A possible explanation on this puzzle:A combination of declining interest rates with the thehistorical cost valuation accounting principle for assetsin the bond-type certificates of ITCs: High yieldsA widely held view: Restructuring of the ITCs wouldbe implemented at the final stage( In trillio n KR W ) (%4025.003020Net inflow of bond- type funds of ITCs(left- side axis)20.001015.00-Jan- 98 Jun- 98 Nov- 98 Apr- 99 Sep- 99 Feb- 00 Jul- 00 Dec- 00 May- 01 Oct- 0110.00-10-20Benchmark corporate bond yield(right- side axis)5.00-300.00


(continued) Consequently, substantial increase of the proportion of bond financing in private enterprises’ funding sourcesTrends of Financing by Private Enterprises( end of , tril. KRW)1997 1998 1999 2000 2001Loans 311. 4 290. 8 289. 4 307. 2 335. 6( 42. 9) ( 41. 1) ( 41. 1) ( 41. 7) ( 40. 6)[ Loans f r om banks] [ 150. 2] [ 147. 6] [ 162. 4] [ 177. 1] [ 191. 9]( 20. 7) ( 20. 8) ( 23. 0) ( 24. 1) ( 23. 2)Cor por at e Bonds 121. 3 157. 7 148. 2 123. 7 179. 9( 16. 7) ( 22. 3) ( 21. 0) ( 16. 8) ( 21. 7)Commercial Papers 68.8 55.6 40.3 33.9 44.1( 9. 5) ( 7. 9) ( 5. 7) ( 4. 6) ( 5. 3)Ot her s 224. 5 204 226. 7 271. 4 268( 30. 9) ( 28. 8) ( 32. 2) ( 36. 9) ( 32. 4)Tot al 726 708. 1 704. 6 736. 2 827. 6( ) shows shares in the total( %)Positive effects: the corporate bond market acted as “ spare tire”in the face of the credit crunch in bank loan marketAdverse effects : hampering the corporate restructuring• Some chaebols (e.g. Daewoo Group) kept pursuing expandingtheir scope and scale of their businesses• Continuous survival of some non-viable firms


The crisis of ITCsThe collapse of Daewoo (in mid-July 1999): A complete turnabout of the favorable conditions in the corporate bond marketThe associated liquidity problems of ITCsLarge losses of ITCs associated with dishonored Daewoo bondsInvestors’ concerns over the soundness of ITCsITCs’ liquidity problem caused by huge withdrawalof funds from ITCsITCs’ bond-type beneficiary certificates decreased from 179 tril. KRW (June 1999) to 53 trillion won (June2000)


(continued)The impact of ITCs’ problems in the bond markets raise new concerns for ITC investorsSubstantial rises in bond yields caused by the increasing selling pressure of marketable liquid bondsResulting in more capital loss and further deterioration of the asset quality of ITC fundsTriggering further acceleration of fund outflows from ITCsGovernment’s measures on ITC crisisStabilizing the bond yields in the secondary marketPreventing a massive outflow of funds from ITCsRestoring investors’ confidence in ITCs by implementing structural reforms


(continued) A series of government measures Measures for stabilizing bond yields: Introduction of ”Bond Market Stabilization Fund”Purchasing bonds with the funds contributed from banks and insurance companies Initial fund size of 2 tril. KRW increased to 3 tril.KRW later Very effective in bringing down yields, recordingcapital gains at the dissolution(% )12.0011.00Es ta b lis h m e n t o f "Bo n dM a rk e t S ta b iliz a tio n F u n d "10.009.00Dissolution of "BondM a rk e t S ta b iliz a tio n F u n d "8.00The Collapse of Daewoo7.0099.6.30 99.7.30 99.8.28 99.9.30 99.10.29 99.11.27 99.12.28 00.1.29 00.3.2 00.3.31


(continued) Measures for preventing a outflow of funds fromITCs: Discouraging redemption of funds and attracting more fundsProhibiting early redemptions of FIs and introducing ascheme of gradually increasing payout ratios for Daewoo papers for individuals and non-FIsProviding more incentives to ITC deposits and introducing new products with tax incentives Measures for restoring investors’ confidence in ITCs : Structural reforms on ailing ITCsRecapitalization of ailing ITCs including the injectionof 7.7 tril. KRW public fundsCleaning-up their non-performing assetsStrengthening transparency of their asset managementincluding mandatory adoption of the mark-to-market accounting principle


The crisis at maturity The long-lasting & profound impacts of the collapse of Daewoo and subsequent ITC problems on the local corporatebond market : A widespread “flight-to-quality” Flight-to-quality matters because it was combined with ...A rapid slowdown of economy since 2H 2000Bunching of maturing bonds since 2H 2000 Extreme difficulties of firms with lower credit ratings in rolling over their maturing bonds Government’s measures for lower-rated firms in their rolling over maturing bonds ( 2H 2000):Introducing primary collateralized bond obligations (P-CBOs) and undertaking partial guarantees on senior tranches of P-CBOs by two state-owned guarantee fundsEstablishing a 10 tril. KRW “Bond Fund” for the purchase of P-CBOs


(continued) Additional supporting measures for relatively larger firms with lower credit ratings(2001):Introduction of a second 10 tril. KRW “Bond Fund”Introduction of “the Korea Development Bank (KDB)prompt underwriting scheme” RESULTS: Financing conditions of the corporatebond market improved substantially thanks to 12.7 tril. KRW of P-CBO and 2.6 tril. KRW of bondsunderwrtten by KDBIssuance of Primary CBOs( dur i ng, billion KRW)Un d e r l yi ng assets by grade Cr e di tAmo unt s SeniBBB+¡-BB a nd Gu a r a n t e et ranche A BBB0 BBB- lower Ra t i o 1) ( %)2000Y 73, 073 70, 108 2, 850 20, 368 28, 341 21, 490 34. 1(3. 9) (27. 9) (38. 8) (29. 4)2001Y 55, 734 53, 710 2, 290 18, 476 13, 605 21, 351 53. 2(4. 1) (33. 2) (24. 4) (38. 3)Tot a l 128, 807 123, 818 5, 140 38, 844 41, 946 42, 841 42. 41) The rat i o of t he amount of credi t guar ant ee t o t hat of seni or t r anche( ) shows shar es of under l yi ng asset s by grade( %)


Current Status of the Market and the Causes of its Problems The size of the corporate bond markets in Korea is by no means smallThe second largest one in terms of nominal GDP( end of , bi l . US$ or t r i l . KRW)U. S. A J a pan U. K Germany France Ko r e a1998 1998 1998 1998 1997 2000Cor por at e bonds( A) 1, 621. 80 625. 8 223. 6 51. 2 18. 1 89. 9 ( 133. 6)No mi n a l GDP( B) 8, 511 3, 783 1, 398 2, 159 1, 412 ( 521e) ( 521e)A/ B( %) 19. 1 16. 5 16 2. 4 1. 3 17. 3 ( 25. 6)Sour ce: Bank of Japan ( 1999) and Bank of Kor ea ( 2000)( ) i ncl udes ABSThe market became predominated by nonguaranteedbonds Potential problems :Cyclical appearance of hardship in rolling over ahuge amount of maturing bonds


(continued)Increasing vulnerability to external factors such as,• Macroeconomic fundamentals which may affect credit quality of the issuers• The demand and supply conditions in the market includingliquidity conditions of major investors• The size of overhang of corporate bonds waiting roll over Fundamental causes underlying the rolling-over problems of lower-rated issuers :– The lack of progress in corporate sector restructuring– Poor investor protection on non-guaranteed corporate bond• No practice of inserting protective bond covenants to safeguard the interests of corporate bondholders– Very low recovery ratio of the value of defaulted bonds ( muchless than 30% of face value), reflecting:• The long and complicated process of bankruptcy due to complexities of the legal arrangements associated with bankruptcy and liquidation of insolvent firms


(continued)– Unreliable credit ratings provided by local credit rating agenciesHistorical Default Rate by Credit Ratings from 1991 to 2000AAA AA A BBB BB B0.00% 2.30% 5.00% 5.20% 4.30% 11.20% Unsustainable nature of the recent governmentmeasures to support the roll over of maturing bonds: the case of P-CBOs,• The majority of P-CBOs were absorbed by the “Bond Fund”• Sole reliance of credit enhancement scheme for P-CBOs on the government-backed guarantees• Moral hazard problem of originators of P-CBOs and the predominance of private placed bond (A typical adverse selection problem)


(continued) In the secondary market, the liquidity of corporate bonds remains very poor comparedwith government bondsTrading volume of corporate bonds shrank sharply afterthe collapse of Daewoo in July 1999Trends of Transactions in the Secondary Markets(during, billion KRW, %)1997 1998 1999 2000 2001[ Daily Volume]Corp. Bonds(A) 444 1,272 1,456 929 882Gov. Bonds(B) 44 223 2,310 2,031 3,266Total bonds 798 2,288 4,678 6,317 9,366A/B ( %) 1,009.10 570.4 63 45.7 27.3[ Turnover ratio]Corp. Bonds(A) 1.48 3.7 3.6 2.1 1.7Gov. Bonds(B) 0.6 1.6 11.3 8.6 11.7A/B(%) 2,466.70 231.3 31.8 24.4 14.5


(continued) The low liquidity of the local corporate bond market reflects:A nascent stage of development in market-making intermediation in the secondary market• No position taking of major dealers and simply matching their clients’ orders in a labor-intensive and less transparent brokerageprocess• Inefficient price discovery function ofsecondary market due to the absenceof two-way quotationsOthers23.5%Banks27.5%Less diversified investorbasePension funds7.7%Insurancecom panies5.5%Mutu albanks3.4%Investm ent trustcom panies32.4%


Conclusion and Policy Implications A sudden and large increase in corporate bond islikely to imposes a substantial burden in maintaining financial stability subsequently An important implication of the prevailing creditquality of corporate bonds on maintaining financial stability of the economyThe more “zombies”, the more difficulty in keeping financial stability via financial and operational side Critical role of the weak institutional settings in triggering turmoil in the corporate bond market and amplifying its magnitudeIncluding poor accounting practice, a weak investor protection and an inefficient liquidation process


(continued) Under highly risk averse investors with the increasing credit risk of bonds supplied, the securitization of corporate bonds by pooling risky bonds proves to be very effective in bridging the wide gap in preferences between investors and issuersIn the case of Korea, however, it is important to allowmarket forces to play a larger role in the entire process of their issuance from the design to the final sale ofthe products Importance of the well-developed secondary market in reducing the magnitude of the impact onthe bond market caused by any external shocks


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