Sunday, December 19, 2010

S. Korea Takes a Step Backwards by Levying a Tax on Foreigners' Bond Holdings

South Korea Needs to Decide:  Developing or Developed? 
The primary challenge facing South Korea is, in fact, an identity crisis of sorts.  Subjugated by larger nations in the past, Korea has fought and won its war versus nationwide poverty.  No longer is South Korea one of the world's poorest nations. No longer is South Korea a war-torn nation whose children had to forgo their education while escaping artillery fire.  Samsung Electronics, LG Electronics, Hyundai Motors, Posco (Pohang Steel):  these are globally-recognized leaders now, all originating from a country of only 50mm people with limited natural resources.  The Seoul Gyopo Guide has been created to foster one central theme:  Korea has deserved its place among a very few privileged nations, but its social and legal structure must match its fully-developed economy.  This is the critical step necessary in order to be fully recognized by the other leaders of the free world. This is not an easy task, and will not happen overnight.

New Proposals for a Tax on Bonds is Totally Wrong and a Huge Step Backwards
When there are steps taken backwards, then they must be pointed out.  Recently, the Korean parliament re-introduced the notion of a levy on fixed-income investments on KRW-denominated bonds.  This is the type of knee-jerk reaction that Korea has often displayed when there is a foreign influx of capital.  The very point of capital movement is the idea that money goes away from unattractive opportunities to attractive opportunities.  In order to be considered a long-term investment opportunity, however, the laws should not change quickly back and forth depending upon market conditions.  Prices of investments should change due to the market conditions, not laws.  In fact, it is not the tax itself which is the problem.  Many other nations have had similar measures in place.  It is the notion that the law is subject to change on the whim of parliament due to market pressure or political opinion that is the problem.
One might counter-argue that the Bank of Korea changes its mind frequently by changing policies.  The answer to this counterargument is that when the Bank of Korea changes interest rates, then that is a market price.  That is the standard global practice, and the Bank of Korea is fulfilling its duties.  However, when the BOK changes the rules or capital inflows, that is a different matter entirely.  The Seoul Gyopo Guide has criticized the BOK when it has announced that it is considering such steps.

Korea's Changing Policies Confuse Long-Term Investors
Korea has been guilty of this practice on the international stage in the past.  One of the Seoul Gyopo Guide's favorite examples was the Lone Star - KEB debacle.  The Korean government approved, and then attempted to nullify a private equity's buyout of the then-paralyzed Korea Exchange Bank.  One interesting point:  Japan had the exact same situation when Ripplewood Holdings, a U.S. private equity firm bought the Long-Term Credit Bank of Japan, and eventually renamed it as Shinsei Bank.  While the case gained a lot of attention, legal barriers were not instantly erected by the Japanese Diet (parliament) to block that takeover.  Therein lies the problem:  Korea's legal structure and its whimsical policies confuses long-term investors, who can be dissuaded from investing in Korea over the long haul.  As a result, foreigners who are interested in investing in Korea have almost no other choice than to invest in liquid markets, where investors can change their mind rapidly.

Even at Home, Koreans Are Confused
Korea has been guilty of this practice in its own domestic market as well.  It is a well-known fact in Korea that the taxation of residential real-estate has fluctuated from administration to administration, and sometimes within a single presidential administration.  In fact, current thoughts are to weaken the real-estate taxation laws in Korea, because the market has been relatively weak compared to other financial assets.  The lagging real estate market is a drag on consumer sentiment, and thus, consumer demand for products is lower than it would otherwise be.  It is another example of how changing policies confuse investors, even Koreans residing inside Korea.  It is no wonder that foreign investors are confused.

Korea Isn't Brazil, nor China
The counterargument against the Seoul Gyopo Guide's claims above could be that other "emerging" economies, like Brazil's or China's also have a similar set of ever-changing rules.  While those countries do have changing rules, it is clear that foreign investors could invest even more if those nations' legal structure were more stable.  In addition, Brazil and China have two natural advantages that South Korea does not enjoy, natural resources (Brazil) and an enormous population (China).  Therefore, those two countries have the luxury of being able to say to the rest of the world, "Take it or leave it."  Korea does not enjoy these luxuries, and as a result, the changing rules in Korea are more likely to result in the choice, "leave it."  By that same token, Korea is no danger of being compared to Russia, who intentionally, selectively didn't pay foreign borrowers on its national debt.  Korea isn't and shouldn't be compared to this almost-unbelievable example.

Other Aspects of Life are Affected by Korea's Legal Structure
Other, lesser known, aspects exist in which Korea does not adhere to international standards of law.  For example, Korea has not adhered to the Hague Convention on Child Abduction in the past.  That has only recently changed.  Eighty-one other nations around the world had signed this agreement before Korea adopted it.  There have been many well-publicized stories regarding this type of controversy in Korea.

Conclusions: Global In Name Only?
Perhaps the most over-used word in Korea is the word "global."  Global this, global that.  Its companies have produced and delivered products around the world.  There is zero doubt about that, and it has occurred at breakneck speed, relatively speaking.  A plot of land (a huge amount of money then) on the large Tehran-no (street name in the Gangnam district of Seoul) at the end of the Korean War in the 1950s which was worth around $10,000 would be worth no less than $300,000,000 today (with building, obviously).  Its laws have not changed at the same pace:  there are justifiable reasons for that.  Nevertheless, the laws and the procedures need to evolve so that Korea can take even further steps to cement its position in the first world.  The "developing world," or "emerging market" labels no longer fit Korea.  Other countries are considering new withholding tax measures as well.   However, those other countries are Indonesia and Thailand.  Those two countries' economic development are not anywhere close to South Korea's.  They are not valid comparisons, and yet even the influential Financial Times mentions South Korea and those two other nations in the same vein.  If the laws are reliable, stable, and can be understood to be so by foreigners, then and only then will Korea be global. The recently-considered tax on foreign holdings of KRW-denominated bonds is a definite step backward towards this end.


Josh said...

What is the latest on residential property tax reform? Here is to hoping that easing of taxation and not limiting the number of homes one can own in one's name will drive prices upward.........

As far as this levy on borrowings by banks - it will not deter capital inflow in terms of Korean banks taking on debt, but you hit the nail on the head with "the notion that the law is subject to change on the whim of parliament due to market pressure or political opinion that is the problem."

I checked into a personal loan with a bank at which I am considered a VIP. The best rate I could get was double digits. This law will only drive the cost of debt higher.

A lot of great points in this article - how about long or short on the KRW over the next year? Just kidding - don't want to have to flame you for investment advice that didn't work out.....

The Lost Seoul said...

This post addresses just one of the three measures under consideration by the Korean government. The levy you mention is one where Korean banks are restricted from issuing short-term, non-KRW denominated bonds. That is because if the KRW weakens, then Korean banks would owe more in KRW at that time.

Absent an external shock, inflation will continue to weigh more prominently in the coming year, and the Bank of Korea may have no choice to increase the pace of interest rate hikes. Given that, the KRW is probably still too cheap compared to the USD, and most importantly, the JPY (I am 100% certain that Sony and Toyota would agree).

"Absent an external" shock is an enormous caveat.

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