KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

Policy Study KOR Short-Sale Restrictions and Market Quality in the Korean Stock Market after the 2008 Global Financial Crisis

Since 2008, a number of regulatory authorities have disallowed short sales, considering their negative impact on the market. The short selling ban in Korea lasted exceptionally longer than that of other major countries for both financial and non- financial stocks. This is surprising because Korea is one of countries whose markets were stabilized from the 2008 financial crisis relatively early and its market instability did not last long during the European financial crisis in 2011.
We analyze whether the short selling ban contributed the early market stabilization by controlling price depreciation and volatility in Korea or whether it negatively affected the stock market efficiency and quality by enforcing restriction on the stock market for an excessively long period of time.

Our paper differs from existing papers in the following senses. First, we analyze the effect of a short selling ban using the stock market order book, making it possible to use intraday prices and analyze the effect of a short selling ban using the spread, bid residuals, and order imbalances from the order book. Second, our research focuses not only on a time series analysis of the market quality before and after short selling, but also deals with cross-sectional analysis. Third, we evaluate the short selling ban and market efficiency of many leading countries.

We find the followings. First, short selling ban could not reduce market volatility. Moreover, in the case of the non-financial stocks, market volatility decreased even though the short selling ban was lifted. These results suggest no evidence that short selling increases market volatility.

Second, spread did not decrease when compared to the period before the ban even though the volume increased moderately during the ban period. Also, decreasing amount of spread was more noticeable for non-financial stocks than financial stocks after lifting the short sales ban. These results suggest that short sellers have emerged as a liquidity provider, contributing to the market efficiency.
Third, as a result of the short selling ban, ask price residual quantity decreased relatively more for non-financial stocks. In other words, the imbalance of ask residual quantity decreased significantly during short selling ban period, in which the bid submission of short sellers was banned. Short sellers contribute to the market depth and asymmetry of the order imbalance.

Overall, we conclude that short selling provides liquidity to the market and improves market quality, suggesting that short selling restriction leads to costs that hamper market efficiency.

Based on results from the empirical analysis, this paper suggests that regulatory authorities consider short sale ban on a certain stock rather than on the whole sector such as non-financial and financial stocks. In this way, the risk of the regulation acting as a hindrance to market efficiency can be minimized. The period of short sale ban should also be restricted to a minimum length of time, and the effect of the prohibition should be evaluated after a certain period of time to decide whether to extend the ban period.

Summary

Policy Study KOR Risks in International Capital Flows: Foreign Investors’ Behavior in Korean Stock and Bond Markets

This paper studied the pattern of international capital flows in Korean financial markets to analyze their risks. In particular, this paper focused on foreign investors’ behavior responding key investment factors in Korean stock and bond markets, in which capital flows have become more volatile recently. It was found that foreign investors tended to retrieve their investment when global risk aversion (VIX) was high or when global liquidity (the U.S. short- term interest rate for stock markets and global money supply for bond markets) was reduced. The response to VIX was statistically significant in stock markets, but the significance level in bond markets was relatively low. This result reflects that foreign investors consider Korean bonds to be safer than Korean stocks are. This paper, in addition, founded that the significance levels are different across global liquidity indices, which implies that each index reflects different aspects of investment factors and hence investors respond accordingly. For domestic economic fundamentals, rather, foreign investors tended to retrieve their investment when the coincident indicator of business cycle improved. It is interpreted as domestic economic fundamentals are more important investment factors to domestic investors than to foreign investors. That is, in adjusting portfolios foreign investors put more weights on global factors whereas domestic investors on domestic factors.

Next, this paper explored the association between capital market openness and the pattern of international capital flows. In Korean stock and bond markets, foreign investors’ response to global risk aversion (VIX) is not significantly associated with capital market openness; that to global liquidity (the U.S. short-term interest rate for stock markets and global money supply for bond markets), however, was greater as capital markets were more integrated. It suggests that as capital markets are integrated, foreign investors’ response to some global factors might increase.

This paper also showed that foreign investors’ behavior in Korean stock and bond markets might be different by their nationality. In particular, it was found that it is difficult to identify the risks by looking just at relative volumes or relative volatilities across investors’ nationality. This paper, therefore, suggested that it is insufficient to analyze only total international capital inflows and it is necessary to understand the specific properties of international capital flows with disaggregated data.

Summary

Policy Study KOR A Study on Treasury Bond Auction

In June, 2009, Korean Government has shifted the method of issuing treasury bonds, mainly from the single price sealed-bid auction to the 'step price sealed-bid auction,' which combines some features of the discriminatory auction. The purpose of this change is to cure the potential problem in the issuing market due mainly to the recent trends of decrease in the bid-cover ratio, and frequent occurrences of negative auction spreads inversions of the successful bid rate to the rate in the secondary market). This study evaluates the effect of the scheme shift, both theoretically and empirically.

Theoretically, in multi-unit auction such as the treasury bond auction, the superiority of the methods of determining successful bids cannot be judged ex-ante. This is because the bid-shading and the resulting demand reduction occur for different reasons for each method. In discriminatory auction, bidders shade their bids to evade the 'winner's curse,' while in single price auction, they do so to reduce the auction clearing price. Thus, the allocative efficiency is not achieved and the relative auction revenue with respect to the method is not determined. This logic is also applicable to the step price auction. In addition, the single price auction reduces the risks of bidders, while the discriminatory auction provides more incentive for the bidders to acquire information.

The empirical study shows that after the scheme shift, the bid-cover ratio was increased and the profitability of primary dealer was improved. Furthermore, the gab between bid rates was reduced. This can be interpreted as the more active bids, or the increased coupling of bids. In addition, it could be resulted from the change of other relevant system, including the change of the range of obliged take-over. We also find that on the mark-up of primary dealers, the effect of the volatility in the secondary market became insignificant and the effect of rate-spread was reduced. In sum, the scheme shift was successful in that it induces more bids, but it could results in the reduction of government's auction revenue.

Summary

Policy Study KOR Asset Prices, Household Wealth and Consumption

This study aims to analyze the effect of asset value fluctuation on consumption, with its focus on the following: empirical and quantitative understanding of long-term effect as well as the dynamic reaction of actual consumption; whether asset values other than gross income, a usual determinant of consumption, are capable of explaining consumption behavior; and the estimation of full effects on private consumption caused by asset fluctuations. In addition, this study ponders on the asymmetrical reaction of consumption to asset fluctuations taking into account the possibility that consumption reaction might be different depending on which cyclical phase the economy is in. Then, the study analyzes the long-horizon predictability for the consumption growth rate as suggested by the estimated model.

According to the analysis, in the case where gross income is controlled, the long-term effect of asset price fluctuation on private consumption seems to show statistically low significance, while the short-term effect of the asset price shocks on private consumption gradually disappears and almost vanishes within two years. Meanwhile, the cointegration error from the long-term equation for consumption?in other words, consumption error?is confirmed to have long-horizon predictability for the consumption growth rate, which is consistent with the error correction model that incorporates the adjustment process of consumption. In addition, the study analyzes whether consumption reactions caused by income and asset price impacts turn out different in the course of cyclical phases of the economy, such as expansionary and contractionary phases. In this analysis, the impact of the fall in income and assets in the contractionary phase is confirmed to cause a larger effect than the impact of their rise in the expansionary phase. Meanwhile, the MPC (out of asset wealth) is estimated at approximately 0.02, which indicates the effect that when the asset rises by 1,000 won, the consumption rises by 20 won.

Given that this analysis is based on estimations of an empirical model, it is necessary to be mindful of its limitations as well, when it comes to the interpretation of results.

Summary

Policy Study KOR Analysis on the Effectiveness of Bond Price Information for Economic Forecast

In general, interest rate spread in the bond market is divided into expectation on the changes in short-term rate of the future and term premium according to liquidity preference and market volatility. Based on this structure, this study intends to see how meaningful the rates of return in the bond market are to forecasting economic fluctuations. To that end, the study reviews whether the expectations hypothesis is applicable and derives the return forecasting factor through the excess holding period return. Then it theoretically proves that the factor is a concept relating to volatility of the bond market. It also studies the leading effect that the factor has on macroeconomic indicators and the significance of the factor as a recession forecasting indicator.

An examination of the expectations hypothesis using data on Korean bonds empirically proves that like the US, the expectations hypothesis does not hold in Korea, either. This means that there are some factors that could explain excess return. Based on this, the study assumes the return forecasting factor as a measure for term premium, and examines how important the factor is in predicting changes in economic fluctuation and cycle. The empirical analysis reveals that the factor has forecasting power of 20~50% for the business cycle indexes; industrial production gap, and inflation. Also, in the probability model of recession forecasting that uses a Probit model, the factor shows different patterns according to different economic cycle, proving that the return forecasting factor is useful as recession forecasting indicator compared to the stock return that changes similarly regardless of which economic cycle.

This study has two important contributions. First, unlike preceding studies, it explicitly describes the financial meaning of the return forecasting factor derived from the excess holding period return. Second, it empirically proves the return forecasting factor has a significant leading effect on macroeconomic indicators. It is found that the stock return used for comparison is an indicator only to present short-term outlook, while the return forecasting factor is useful in portraying around one-year outlook.

With the Capital Market Consolidation Act taking into effect, this study could provide implications on how to use the information on stock and bond markets. In particular, considering that information on the bond market has a stronger forecasting power when it comes to long-term outlook, it is expected that the bond market information could be actively used as a predictor that complements the current leading economic indicators.

Summary

Research Monograph KOR Analyses of Housing Markets and Policy Issues

1. Introduction

The research on housing and related policy is important. However, it is of most importance for Korea, where land is scarce and population is large. As of the end of 2003, the market value of houses and residential land in Korea exceeded as much as 781trillion won, which was larger than nominal GDP of the nation that year. The weight of real estate in household asset in Korea is also greater than that in many other countries.

In addition, it has been one of the most important tasks of the government to secure residential stability and thus, this justifies the government intervention in the housing market. Nevertheless, it is also true that the government intervention in the market has been frequently criticized, as it is believed to distort market mechanism.
This research concentrates on certain aspects of the housing market and policy issues in Korea. Consisting of six research fellows from KDI and five experts from outside, the team completed ten reports, which contain independent but related issues. Although independently organized there is a running consistency in all ten reports such as the effort to compromise special characteristics of housing market that called for government intervention, and the market mechanism that maximizes the efficiency.

2. Synopsis

The report is comprised in ten chapters. The first chapter introduces readers to the main topics of the report, summarizes government policy for housing market and provides an overview of nine chapters that follow. The second chapter reviews how the residential environment in Korea has been changed or evolved in recent years, and then forecast demand for housing up to 2030. Mankiw-Weil model and revised Mankiw-Weil model are used for forecasting.

Part II of the report consists of three chapters, which lay focus on housing market and critical variables. Chapter 3 analyzes the role of determinants of housing prices and chonsei prices in Korea. Such variables as land prices, expected increase rate of housing prices, interest rate, and GDP are used as well as government policy to estimate the effect on housing price though vector error correction model. Chapter 4 focuses on the housing tax system in Korea and reconfirms that the housing tax system should be implemented for two purposes: one, to improve the efficiency of collecting tax and two, to enhance the social equity. Chapter 5 concentrates on housing prices and chonsei prices, where chonsei is a unique house rental system in Korea. The chapter argues that the most important variables to determine the ratio of the two prices, housing prices and chonsei prices, are interest rate and inflation rate. A set of policy implications is derived from this finding.

Part III, mainly discusses the environmental and institutional system to assist in house purchasing or renting. In particular, Chapters 6 and 7 investigate the financial system and Chapter 8 sheds light on the government policy for low-income groups. Chapter 6 reviews the long-term housing finance system that was introduced recently in Korea and stresses that the system contributed to the expansion and stability of housing finance market in Korea. This chapter also suggests several ways to improve the finance market. Chapter 7 draws attention on the National Housing Fund (NHF), which was established recently to efficiently provide funds to households and construction companies. As recent changes in the real estate and related financial markets have highlighted the need to reassess the role and functions of the NHF, this chapter reviews the performance and achievement of the fund, and recommends a desirable future direction. Chapter 8 systematically reviews current housing conditions, policies for low-income households, and institutional arrangements for low-income housing, and offers suggestions relating to future policy directions.
As indicated in some of the previous researches, one of the critical weaknesses in Korea’s housing market is frequent malfunctioning of supply mechanism. The last two chapters in Part IV treat topics relevant to this issue. Chapter 9 recognizes that the supply of land has persistently been a problem in regards to housing construction in Korea, and critically evaluates the land development and housing construction in Korea. While a drastic deregulatory measure was introduced in the mid-1990s, there still remained a public backlash against deregulation, which led to a revision of the system of planning laws in 2002. The chapter reviews these changes and suggests what should be done to improve land development and supply for housing construction. Chapter 10 looks at other methods of providing land for housing construction aside from new land development. In short, this chapter briefly reviews, and provides recommendations on three major urban and residential improvement programs: Redevelopment, reconstruction, and improving the environment.

3. Conclusion

As this report covers a wide spectrum of topics relating to housing markets and policy issues, providing complete findings and policy suggestions are not possible. However, most findings show that the fundamental market variables such as interest rate are becoming more important in determining the market price of houses. In contrast, the effects of the government policy and expectation for the future price of houses are not yet clear. Further, it is suggested that a simple and clear tax system should be applied, and that a house should not be considered different from any other personal asset, unless house is considered to be distinctively different from other types of assets. This requires more normative consideration on the basic characteristics of houses.

It is also argued that a variety of policies on housing and land have been improved and even seen more deregulation in the past. The living environments have been found to improve significantly, where government policies played an important role. In this regard, it can be concluded that policy measures achieved one of the aims to provide better residential conditions through pro-market oriented policies.

Nevertheless, the chapters in this report find that there are more ways to improve the system further, and provides more detailed policy suggestions in regard to housing finance, housing subsidy, land development, redevelopment, and reconstruction. It is also frequently argued in the report that government policy must be prepared carefully, and, once it is implemented, it should be continued without being disrupted by other factors such as concerns over business cycles and political considerations.

Chapter 1. Overview - Issues in the Housing Market and Policy Studies

MoonJoong Tcha and Jay-young Son

1. Introduction

Chapter 1 introduces the entire report, consisting of ten individual chapters, on analysis of the housing market and the policy issues. This chapter concentrates on research issues regarding the various aspects of the housing market. The research takes into account the special and general characteristics of the houses, compared to other general goods. It also details the relevant issues and their implications, particularly in the context of the themes touched in the following nine chapters.

The most critical issues related to the housing market, which are introduced in this chapter, are explained and analyzed in depth in individual chapters. The issues explored include: (i) the long term trend of quantitative and qualitative changes in houses and residential environment; (ii) the determinants of the prices of houses; (iii) what the government can do to enhance the quality of houses and residential environment, and; (iv) what should be done to improve the residential land supply system and urban redevelopment.

2. Synopsis

Most previous studies on the housing market in Korea acknowledge that “while the importance of fundamental market variables is increasing, market inefficiencies are still frequently observed.” This statement, in fact, lies between two very critical and long held views: “The house is important but not seriously different from other normal goods” and “the house is a different and special good.” Given that the orientation or extent of government policy depends on which statement policymakers tend to believe, this chapter points out that the existence and extent of “inefficiencies” is the most crucial concept in approaching the housing market.

A review of government policies reveals that the two main policy pillars until 1997 were the regulation of initial sale prices of houses and public sector-led land development. The supply of homes was largely regulated during this period. It is worthwhile noting that, unlike other Asian economies, the real estate sector did not cause the crisis in Korea in 1997. In contrast, it was real estate, both residential and commercial, which helped the nation to recover from the economic crisis. Firms sold their real estate and improved their financial status, and the real estate boom contributed to increasing employment and income through large linkages.

The following nine chapters in this report are the outcomes from the efforts to reconcile the market mechanism of the housing market, and the government’s policy intervention to remove inefficiencies and secure residential welfare.

3. Conclusion

The entire report maintains consistent themes: To understand the housing market better, and to explore how the government policy can improve the quality of residential welfare. In other words, each chapter assesses the important and relevant issues in the housing market, while accepting the need for the government to implement policies to improve standards of residential welfare. This chapter summarizes the contents of each chapter in this report, and relates the relevant parts in a harmonized context.

Chapter 2. Trends in Residential Environments and Long-Term Forecasts for Housing Demand

Moon Joong Tcha , Jay-young Son, and Eui-Chul Chung

1. Introduction

The aim of this chapter is to investigate the trend of quantitative and qualitative changes in the housing sector and understanding future trends in demand for houses. This chapter provides an overview of changes in the housing sector, concentrating on the welfare-related issues. The chapter also adopts Mankiw-Weil model to forecast the future demand for houses until 2030. Further, a revised model of Mankiw-Weil model is used for this forecast, and the results from the two models are compared.

2. Synopsis

First, there has been a dramatic increase in homeownership in Korea. In spite of the rapid increase in population and households, the rate of homeownership has improved due to the strenuous efforts of the government to provide new housing. The figures show that without a government-initiated effort to provide more than 2 million homes in the 1990s, the nation would have faced instability in the housing market owing to rapid increases in demand and shortage in supply.

However, there still remain some problems such as the shortage of houses in Seoul and the outlying area, and the increase in older developments. The changes in home preferences should be observed closely and considered in regards to future supply.

The rent-to-income ratio (RIR) is highest for wolsei (monthly rent) tenants and lowest for chonsei tenants, while in time series, all participants’ RIR have decreased. RIR is higher for those with lower levels of income, but the overall level itself is still low, hovering at roughly 15%. However, the more critical problem is not the level of the burden, but the low quality of service to residents.
This chapter also forecasts long-term housing demand. Use of the Mankiw-Weil model found that demand would increase by a maximum of 1.5%, and then begin to decrease from 2025. Demand for rental houses reached a maximum for the 40-44 year old bracket, while homeownership is highest for those between 45-54 years of age. However, the Mankiw-Weil model has its limits as it only considers the structure of the population. This chapter revises the model, considering the expense on homes and income and re-estimates future demand. The results reveal that the rate of change in housing demand is lower than in the case of Mankiw-Weil. With all else being equal, the increasing rate of demand will decline from 1.11% in 2005, and reach 0.05% in 2030. It also finds that the demand for houses responds more sensitively to changes in income rather than expenses.

3. Conclusion

There have been prominent changes in the housing sector in Korea recently. These changes include both quantitative and qualitative improvement in residential environment. However there are still more needs to enhance the quality of living environment. It is forecast that the demand for housing will be stabilize in the long-run. The Korean government frequently intervened market with a variety of purposes. Deregulation implemented after the crisis contributed to the recovery of real estate prices since 1999. However, this deregulation, low interest rates, and reduced supply of new homes due to the crisis all accelerated the rapid increase of house prices in the early 2000s, which called for newer, policies in 2003.

Chapter 3. Determinants of Housing Prices and Policy Issues

Moon Joong Tcha

1. Introduction

Overheating in the housing market in Korea occurred at least three times in the last 30 years: In the late 1970s, early 1990s and early 2000s. Rapid increases in house prices magnify the sense of alienation among those unable to afford homes, and include the risk of inflation. In contrast, a bursting of the real estate market bubble also causes problems such as deflation and instability in financial markets. The real estate market, and housing in particular, is of tremendous importance to countries such as Korea, which have very limited residential areas together with high population densities.

This study analyzes the effect of important variables, including policy variables, on housing prices in Korea, using quarterly data from 1987 to 2004. Housing prices and chonsei prices for the entire nation, Kangnam and Kangbuk areas in Seoul are also investigated. The vector error correction model is employed for quantitative analysis.

2. Synopsis

The aims of the study are as follows: (i) Investigate the effects of fundamental economic variables to prices, (ii) Discuss the stability of the market, (iii) Investigate the role of the expected rate of price increases, (iv) Analyze the effectiveness of government policy, and (v) Suggest policy options and implications.

Vector error correction model is used to find the relationship between variables. Impulse response analysis is also used to investigate the effect of each variable to housing prices. The results of the study indicate that: (i) The importance of some fundamental variables such as the interest rate and GDP has increased, (ii) The long-term relationship is found among the house prices and relevant variables, (iii) The expected rate of price increases does not work properly, and (iv) Government policy to encourage or discourage the housing market has not been very effective.

3. Conclusion

Several policy implications are examined in this study. First, while the effect of the interest rate is crucial, the effect of GDP or the quantity of money is relatively limited. This indicates that it is a challenge for authorities to implement an effective policy, since the interest rate, the most critical element, is already very low in Korea.

Second, the policy to discourage the housing market is found to be pro-cyclical. This implies that either the government’s policy is not trusted, or it is not properly implemented.

Third, the Kangnam and Kangbuk areas in Seoul show different responses to variable shocks, which are in turn, different from responses in the national housing market. This demonstrates that more accurate data for disaggregated markets should be collected and utilized to forecast reactions in each market when economic variables or policies change.

Fourth, the effect of the chonsei rate to housing prices is significant and long lasting. If one of the most important aims of the government’s housing policy is to improve the welfare of residents, more attention must be paid to the chonsei market. Given that this market is based on practical and not speculative demand, the most fundamental approach should be to enhance a balanced development in residential areas with a focus on education and social amenities for all residential areas.

Fifth, though limited, price fluctuations in the Kangnam area influence the Kangbuk area, supporting the view that there is a spillover effect in price changes.

Chapter 4. The Current Situation and Theoretical Analysis of Housing-Related Taxes in Korea

Suk-Kyun Hur

1. Introduction

Reforming the tax system for real estate is one of the most important issues in Korea. The reform effort should aim to achieve two simple objectives: Securing tax revenue and enhancing fairness.

At present, the tax system concerning real estate has several
weaknesses. First, actual housing prices involved in transactions in the market are not properly reported. In addition, concerning the capital gain tax, the range of tax deductions or exemptions is too wide. Second, revenue from acquisition and registration taxes make up too large a portion of local government's revenue adding to inequality among local governments. Third, property and land synthesis tax rates are excessively progressive.

Reform of the tax system should consider the system’s current weaknesses as discussed above, while also discussing whether it is efficient to redistribute the right to impose taxes across governments at different levels, such as the central, prefecture, county and city governments.

2. Synopsis

This study investigates the problems stemming from the current tax system and its management. From a comparison of the system with different goods, the discriminative nature of taxes across different goods is revealed. The analysis of foreign tax systems also enables the report to consider the policy implications for Korea.

Also examined is the theoretical background of the debate on the tax system, using the No-Arbitrage Pricing Model, concentrating on the purchase and possession of homes. By incorporating capital gains, possession and transaction taxes into the model, it analyzes how changes in these taxes affect the purchasing behavior of economic agents. The optimal tax rate is also explored using the Ramsey Model.

Based on tax revenue data across local governments, this study also discusses whether it is appropriate and fair to fine-tune the right to impose taxes across governments.

Last but not least, based on all the findings in this chapter, the appropriateness of the recently announced new real estate tax policy is reviewed, and the means to improve the system are suggested.

3. Conclusion

The theoretical analysis supports the current direction of tax reform, which aims to reduce transaction taxes and increase possession taxes. It also concluded that the capital gains tax should be more strictly imposed, on the assumption that a considerably high rate of transaction tax is inevitable and a discriminative rate of capital gains tax is imposed depending on the length of possession. This is contrary to the general belief that a high rate of capital gains tax will freeze the market.

In addition, it is not desirable to provide favorable conditions for select assets, as this will distort investment behavior.

Chapter 5. Chonsei and Sale Prices of Houses and their Relationships with Interest and Inflation Rates

Dongchul Cho

1. Introduction

This section focuses on the chonsei system which is widely used in Korea, unlike in other economies. In general, the literature attributes the popularity of this system to the underdevelopment of formal financial services (mortgage services in particular) and the government’s intervention in interest rates. During the period of government-led development, the government kept interest rates low for business groups. These interventions inevitably imposed higher-than-equilibrium interest rates on consumer credit and housing finance in the formal financial market. In this environment, chonsei is an informal financial instrument that satisfies various household credit demands for landlords, while allowing tenants to afford homes that would not be possible with outright cash purchases.

2. Synopsis

Rather than detailing this microeconomic aspect of the chonsei system, this chapter emphasizes its macroeconomic strengths. First, it provides a back-of-the-envelope calculation for the total amount of chonsei deposits to show that its size is sufficiently large to draw the attention of policymakers. That is, a drastic change in chonsei prices may by itself destabilize the Korean economy. More important than the chonsei price, however, is the ratio of sales to chonsei prices. This ratio is often interpreted as an indicator of affordability for potential homebuyers, because relatively young and/or poor households commonly live on chonsei contracts until they accumulate sufficient savings in addition to the chonsei deposit for the purchase of their own homes.

In this regard, this section examines various factors that affect the ratio of sales to chonsei prices, stressing the characteristics of houses as assets. Therefore, speculation on future sale prices becomes important in the determination of current sales prices, often generating bubbles. In contrast with the sales price, however, there exists no room for speculation in chonsei prices. This difference in sales and chonsei prices can be important in assessing the housing price levels.

However, the ratio of sales to chonsei prices depends critically on macroeconomic conditions --- most importantly, the inflation and interest rates. As long as inflation persists, nominal home prices will rise over time, and this expectation of increases ensures sale prices to remain above chonsei prices. If the real interest rate is low, the gap between the sales and chonsei prices widens even for the same rate of (expected) inflation.

3. Conclusion

Based on this conceptual framework, a rough calculation suggests that the recent sale to chonsei price ratio, around 1,75 nationwide, may be justifiable by the extremely low real interest rate and a 3 percent inflation rate. Nevertheless, the recent decline of chonsei prices as well as the extremely low current (real) interest rate seems to put some risk in sale prices. Sales prices in some areas that have soared to levels around 3 times chonsei prices may be interpreted as an overreaction to recent declines in interest rates unless there exists other fundamental reasons.

From the viewpoint of housing markets, the rapid decline of the real interest rate is worrisome. Of course the most desirable solution would be the revitalization of investment that could boost demand for resources and raise the real interest rate naturally. If this is not feasible, however, and if the stabilization of sales to chonsei price ratio is a desirable policy objective, then a downward adjustment of an inflationary target and/or an upward adjustment of real estate taxes would be consistent between achieving both the right policy direction and objective.

Chapter 6. Recent Developments in the Housing Finance Market in Korea

Kwan-young Kim

1. Introduction

The housing finance system in Korea has been undergoing major reforms since 1998. This was triggered by the financial crisis in 1997. The main thrust of the reform, as emphasized by several recent studies, was in converting the system toward one that is: (i) More market-oriented, (ii) More responsive to consumer needs, (iii) Involves risk and cost-based pricing, (iv) More efficient underwriting, and (v) More wholesale based funding through securitization. This chapter critically summarizes these changes and suggests directions for future developments.

2. Synopsis

Traditionally, Korea's housing finance sector has been used as an instrument of national housing policy while basic market principles governing resource mobilization and its allocation were repressed. It was routinely claimed that long-term housing loans be provided at below market rates in order to be affordable. Such a policy stance and the public perception were not conducive to the development of a market-based housing finance system. Instead, the system remained fragmented and detached from the rest of the financial system, which was itself heavily regulated.

The establishment of KoMoCo (Korea Mortgage Corporation) opened a new era for the housing finance market in Korea. KoMoCo bought housing loans from NHF (The National Housing Fund), Kookmin Bank, other commercial banks, and life insurance companies, then packaged and sold them using Mortgage Backed Securities (MBS). Korea's housing finance system gradually gained ground in terms of efficiency in 1999.

However, contrary to the expectations of policymakers, there was very little issuance of MBS by KoMoCo. And long-term fixed-interest rate housing loans remained unpopular. Thus, the housing finance market has not yet matured and was still dominated by home equity loans provided by major commercial banks. Such loans have 3-month variable interest and a relatively short maturity of 3 years.
The issuance of home equity loans caused several problems, chief among them were housing speculation, instability in financial markets, and an unstable housing market. In response, the government established a new agency, the Korea Housing Finance Corporation (KHFC) in March 2004 to redirect the housing finance market towards more stability with long-term mortgage instruments. KHFC absorbed KoMoCo and provided long-term loans to homebuyers. Since its inception, KHFC has provided more than 300 billion won in mortgage credit, widely considered a resounding success.

The mortgage loan option has turned out to have many desirable characteristics such as a more than 50% loan-to-value ratio (LTV), longer-term maturity options, and a 30% payment to income ratio. As KHFC mortgage loans penetrated the market, the spread between mortgage and home equity loans has decreased. It is expected that the expansion of long-term mortgage loans contributes to long-term stability of financial and housing markets in Korea.

3. Conclusion

This paper concludes with four policy recommendations to encourage a more rapid expansion of the MBS market. First, a resale market for MBS should be developed through the lifting of MBS investments by pension funds and introducing a mortgage-MBS swap program in preparation for Basel II. Second, a new distribution channel for mortgage loans such as mortgage brokers, banks and companies should be established. Third, mortgage insurance should be introduced to reduce credit risk. And finally, measures to convert current home equity loans to long-term mortgage loans should be designed.

Chapter 7. Restructuring the Role of the National Housing Fund and Policy Recommendations

Hyeon-Wook Kim, Chang Park and Kyung-Mook Lim

1. Introduction

The National Housing Fund was established to efficiently provide funds to households and construction companies. Recent changes in the real estate and related financial markets have highlighted the need to reassess the role and functions of the NHF. That is, as interest rates declined, so did the operational environment of the NHF, which provides low-rate financing. In response, early loan payments have occurred. Even though the extension of maturity of housing loans is not an original goal of the NHF, it is desirable to take a major role in stimulating the mortgage market considering the private mortgage market is still in its infancy.

2. Synopsis

This study analyzes various NHF loan programs and provides policy recommendations to enhance their efficiency and legitimacy. First, the analyses on household loan programs revealed that there exists a discrepancy between target households (total income of households is lower than the 6th decile) and actual beneficiaries. This is due to the fact that loan eligibility has been determined not by total household income but by the income of the head of the household. On the other hand, analyses on the financial status of construction companies, which were approved for loans from the NHF, show that the profitability of construction companies is not sound. Finally, financial institutions that have acted as NHA agents have not efficiently monitored loans.

Based on the above evaluation and operational changes, the policy recommendations are as follows: First, financial support for housing construction should focus on the construction of rental housing. Second, financial support of the NHF to households should target lower-income groups and accessibility to NHF programs should be improved. Finally, to mitigate the potential risk of short-term collateralized housing loans, NHF programs should focus on the long-term mortgage market.

This study also proposes detailed operational improvements based on the analyses of existing NHF programs. First, loan eligibility should be modified to warrant the original NHF mission. In the long run, eligibility should be based on the total income and wealth of households. In the short run, eligibility should be based on total household income. Second, NHF programs for the construction of mid-size rental units should be modified to enhance the efficiency and soundness of the Fund. In addition, concerns that NHF programs for defaulted housing construction might overcompensate successor builders should be addressed. Finally, an ex-post monitoring system should be established to continuously improve NHF programs.

3. Conclusion

In order to address the public interest and financial soundness of the NHF and to guarantee various opportunities to loan applicants, this study suggests that the NHF should be operated by efficiently utilizing the market mechanism of agencies (financial institutions). In addition, this study recommends that the operational structure of the NHF be changed from maintaining low interest rate funds to reimbursing interest rate differences between the targeted low interest rate offered by the NHF and the market interest rate, which is a cost to private financial institutions that operate NHF programs.

Chapter 8. Housing Policies for Low Income Households

Eui-Chul Chung

1. Introduction

In this chapter, current housing conditions, policies for low-income households, and institutional arrangements for low-income housing are systematically evaluated while suggestions are offered regarding future policy directions.

2. Synopsis

For decades, the direct provision of public rental housing has been the main low-income housing policy in Korea in which favorable treatment is provided in terms of land acquisition, long-term below-market-rate financing, and tax deductions and exemptions. There has been a steady increase in the volume of Chonsei deposit loans for low-income households from the National Housing Fund. In 2003, the loan volume was approximately 12 times larger than in 1996. With the enactment of the National Basic Livelihood Security Act in 1999, a new housing allowance program was introduced in which housing allowances were issued based on the number of household members.

In spite of these efforts, conditions of low-income households have not improved as expected and the gap in housing conditions between income classes is still large. Analysis of data from the Population and Housing Census in 2000 show that about 3.3 million households, approximately 23 percent of the total number of households, are living in deteriorating and very poor dwellings which do not meet the minimum housing standard. In addition, their burden of housing costs has grown due to a sharp increase in housing prices after 2001, while the inequality of wealth from homeownership versus income distribution has worsened.

Approximately 15% of newly constructed housing units as of 1982 are public rental units. The ratio of these units to the total number of newly constructed housing units was higher from 1996 to 2001.

However, as of 2003, the total units of public rental housing was
roughly 8.3% of total housing units in the nation. If long-term rental units are strictly taken into account, the units make up just 2.4% of total housing units. Policies for the direct provision of public housing have faced several problems, including the implementation of inconsistent and unsystematic policies, the provision of public rental housing with short-term rental periods, and the resulting shortage of long-term public rental units.

This was the inevitable result of policies that failed to carefully target household groups. Moreover, because regional and household characteristics have not been fully taken into account in assistance criteria, benefits from public rental housing have been distributed unequally.

In terms of demand-side policies, in spite of a steady increase in the volume of Chonsei deposit loans for low-income households, the volume of loans are insufficient compared to the total volume of the National Housing Fund, making up only 18% of total volume. Despite the fact that the introduction of the housing allowance program provided a new dimension for low-income housing policies, the current level of allowances does not guarantee minimum housing costs, take account of regional differences, nor consider specific household needs.

Recently, the governmen has put more of an emphasis on low-income housing policies. Enactment of the Housing Act, the subsequent establishment of long-term housing plans and the minimum-housing standard are good examples. The introduction of a housing support system based on affordability and plans for increasing long-term public rental units are regarded as equally important.

3. Conclusion

While these efforts should strongly contribute to improving welfare levels for low-income households, there remain many issues to be addressed: (i) A specific action plan should be prepared to reduce the number of households living below the minimum housing standard by as much as 1 million households within five years, (ii) The possibility of providing 1.5 million public rental units within 10 years should be carefully examined in terms of demand, (iii) The possibility of securing sufficient residential land at appropriate locations in addition to proper financing, (iv) Public rental units should be integrated into one large public program with recipient households selected based on their economic ability, and (v) Rent should be determined not by construction costs but by their affordability.

These changes will eventually improve vertical and horizontal equities of the program. Further efforts should also be made to set the housing allowance amount at a more realistic level. In the long run, the housing allowance system should be separated from the general public assistance program.

Chapter 9. Analysis of Land Supply System

Yong-Bum Lee and Jay-young Sohn

1. Introduction

The supply of land has persistently been a problem in regards to housing construction in Korea. In the mid-1990s, the government tried to solve this problem once and for all by adopting a drastic deregulatory measure. This succeeded in addressing housing construction and supply concerns, but its side-effects were also significant in lacking proper public services and infrastructure in urban fringes, such as schools, roads, safe water supplies, and sewage treatment. A public backlash against deregulation led to a revision of the system of planning laws in 2002.

2. Synopsis

The newly enacted "National Planning and Land Use Law" aims to promote the principle of ‘No-development-without-proper-planning.’ Under the new law, all parcels of land in Korea are classified by their aptitude for preservation or development. New planning zones will be drawn according to this classification, and land use planning will be established. Developments are allowed only in zones that are pre-planned as such. For exceptional cases in which non-urban zones are to be developed, case-by-case development permits must be obtained.

The new law virtually prohibits private developers from developing land and building houses as they had done in the 1990s. Development by public sector developers such as the Korea Land Corporation and local governments is also affected by stringent restrictions imposed by the new law. The net effect will be a lack of development and supply and diminished housing construction. Given that Korea still needs a large number of houses to meet growing demand, this situation needs to be resolved.

3. Conclusion

We propose that regulations on land development be relaxed while maintaining the spirit of the new law. For example, the minimum size of an area of land allowed to be developed residentially within the Managed Development Zone is too large for private developers to handle. The current minimum needs to be lowered. We also propose a system that would force local governments to rezone land when the housing market shows certain signs of a shortage. Local differences in the rates of housing price increases will be a good trigger mechanism. If housing prices rise too quickly in one zone compared to a neighboring area, this mandatory rezoning requirement would be turned on and a supply in housing would increase.

In the mid to long-term, an overall rationalization of regulatory laws is needed. Too many laws impose restrictions on land development and construction. Local governments should be given more power to determine how to use land according to local endowments and needs. In the meantime, we consider the so-called ‘enterprise city’ favorably. This type of private development would provide jobs as well as houses and sufficient infrastructure outside the congested Capital region. Considering its potential social benefits, we believe the government may well give some incentives to developers.

Chapter 10. A Critique of Urban and Residential Improvement Programs

Jeong-Ho Kim

1. Introduction

This study has briefly reviewed, and made a set of recommendations on three major urban and residential improvement programs: Redevelopment, reconstruction and environmental improvement.

Redevelopment projects have been undertaken since 1955 as part of efforts to clear squatter settlements, but residential redevelopment activities have significantly slowed in recent years, replaced largely by reconstruction. The latter two projects started in 1989 to complement the Two Million Housing Unit Construction Plan of 1988-1992. The reconstruction program was intended to expand new housing developments within inner city areas and a residential environment improvement program, to facilitate housing conservation and neighborhood preservation in areas where low and moderate-income households were concentrated.

2. Synopsis

Of the three, only the reconstruction program has proven to be successful primarily because it has served as a vehicle for investors and developers to make sizeable profits. The Housing Construction Promotion Law allowed property owners to demolish units over 20 years in existence and to reconstruct condominium units in their place at a maximum density as measured by the floor to area ratio (FAR). FAR once reached 480% when the program was actively promoted in late 1990s. The reason behind such action was to expand housing in a city where a housing shortage was serious enough to incur periodic home price inflation. But units eligible for reconstruction have been targets for speculation, thus causing housing prices to sharply increase. Various anti-speculative measures announced over the last two years have zeroed in on preventing speculation with respect to reconstruction projects.

The government passed the Urban and Residential Environment Realignment Law last year, primarily designed to integrate the three programs in a concerted manner and to better coordinate housing development activities with those of urban development. The new law places an emphasis on improvements to residential communities than reconstruction. It makes reconstruction much more difficult by requiring cities with a population of over 500,000 to develop a comprehensive urban and residential realignment plan and to designate priority areas for improvement while specifying development phases, land use, and FAR. They are also mandated to raise safety standards for buildings eligible for reconstruction to prevent structurally and architecturally sound units from being destroyed for speculative purposes. The law actively promotes conservation and neighborhood preservation.

Reconstruction has made a solid contribution to the increase in new housing units within inner city areas, substantially easing the housing shortage problem. It also helped intensify residential land use and improve community facilities and residential infrastructure. A subsequent increase in property values has also benefited local governments with larger tax bases.

Notwithstanding these positive effects, there have been some serious problems in implementing the reconstruction program. Most critical is the high cost. All stakeholders, homeowners, landowners and developers alike want prices of reconstructed units to increase to the extent at which they can be sold on the market. This practice largely benefited landowners and absentee homeowners by doubling or even tripling prices upon the completion of a project. Consequently, tenants and less wealthy homeowners must leave the area due to sharp increases in rent and living costs as upper middle-income earners move into what were originally low and moderate-income neighborhoods.

In fact, over 70% of homeowners and 99 % of tenants, on average, left project areas once a new community emerged. The largest gainers were the absentee owners who invested in old units and waited for reconstruction to occur. This explains why units have been such easy targets for speculation. Unfortunately, a large portion of the capital gains has largely gone untaxed. Another serious problem was the intensity of development. Developers and homeowners want to take advantage of the maximum allowable FAR at the expense of open spaces and a neighborhood’s overall livability. Most are only interested in maximizing profit and hardly concerned about improving the community. Problems of this nature have led to new legislation, but their effectiveness remains to be seen.

3. Conclusion

Reconstruction must continuously prevail because it is the only alternative means to expand housing units for middle-income households who wish to remain in inner city areas. But its development technique must be drastically revised: It requires multi-purpose development whereby a portion of profits generated from high-density commercial use can be used to cross-subsidize the provision of low and moderate-income housing units. The project area must be large enough to accommodate multiple uses and construction funds must be mobilized through formal sources of financing. The current financing method is too costly and geared to speculation. Housing density must be controlled in a way that high-rise structures can be permitted in return for larger open spaces. Finally, some incentives should be provided to low and moderate-income households so they may also enjoy living in newly created and modern residential environments.

Summary

Research Monograph KOR Policy Recommendations for the Capital Markets: Asset Management Industry and Long-Term Government Bond Market

1. Policy Recommendations to Improve the Role of Asset Management Industry in Aging Korea

Most countries adopt private and public pension systems as aging progresses and accumulation of pension fund usually plays an important role in the development of capital markets and asset management industry. But this effect crucially depends on the soundness of capital markets and the existence of competitive market mechanism in the asset management industry. This study conducts an empirical analysis on the performance and competitiveness of asset management industry to check whether Korean asset management companies can provide quality services to investors that save for their retirement. Based on the analysis results, we propose policy directions to improve the role of asset management industry in Korea. It is especially considered in the study, the fact that the Korean stock market has been rapidly institutionalized as the increased presence of foreign stock investors that are mostly institutional investors were seen in the market.

As aging progresses, most countries adopt private and public pension systems and accumulation of pension fund usually plays an important role in the development of capital markets and asset management industry. Institutional investors in the developed countries have grown steadily since the 1980's and the pace of growth has been accelerated since the 1990's. Institutional investors in Korea have also grown in terms of size but the proportion of stocks in total asset has declined after the financial crisis in opposite to the case of institutional investors in the developed countries. Hence, this study focuses on the role of institutional investors in the stock market. The declining proportion of stock holding of institutional investors in Korea is partly due to the conservative asset management strategy of institutional investors after the financial crisis. But the main force behind this phenomenon seems to be low confidence of households on the stock market , who lost fortune during the KOSDAQ market bubble and fund industry boom-bust between 1999 and 2000. Meanwhile, the foreign institutional investors have increased their ownership in the Korean stock market with confidence that they would act as the restraining forces to managements of listed companies. To cope with increased market presence of foreign institutional investors and market demand of asset management service for the retirement savings of households, it is desirable to enhance the role of domestic institutional investors.

The empirical analyses of this paper are composed in two parts: Performance and persistence of performance of asset management companies, current market competition mechanism of asset management companies, and evaluation of government policy to induce long-term investment in the stock market. First, while the underperformance of actively managed fund of the fund industry in the United States does not appear in the Korean fund industry, the persistence of fund performance is significantly observed. Second, the relationship between past performance and fund inflow gets stronger since the financial crisis. This implies that, in addition, this phenomenon is mainly led by "independent" asset management companies, which are affiliated to neither commercial banks nor investment banks.

Moreover, it is necessary to check whether fund selling institutions, especially banks, are abiding by required information provision given that there seems to be no relationship between the past performance and fund inflow in the case of bank-owned asset management companies.
Given the fact that the growth of long-term retirement savings has played a crucial role for the development of asset management industry in the developed countries, it is necessary to promote long-term retirement savings to be invested in the asset management markets. In the United States, the successful growth of asset management industry is mainly due to the following three factors: Sound capital market, various long-term retirement savings programs, and continuous improvements of asset management regulation and enhancements of information disclosure on investment products. Taking the case of the United States, we propose the following policy directions. As for the inducement of long-term investment, we recommend the following policies. First, to promote the IRA (individual retirement account) programs in Korea as a major retirement savings tool, we propose to link the IRA with monthly allotting fund, which received increased popularity recently. Second, the targeted savings programs with tax benefit (housing, education etc.) should be allowed in the asset management industry to alleviate the current concentration of financial assets of households on bank deposit. Meanwhile the regulation around institutional investors including asset management companies should be modified to provide reliable investment environments to investors. First, we propose more detailed portfolio holdings of institutional investors including foreign investors to cope with their increasing market power as the SEC does through 13-F rule. Second, we propose to allow asset management companies to sell funds directly to individual investors and to strengthen supervision on the operation of sales activities. In addition, the information relevant to the fund investing such as fees, past performance, prospectus, etc. should be provided more efficiently. Third, the enforcement of regulator on illegal activities should be strengthened to warrant confidence of investors.

The economic and social burden will increase rapidly as aging progresses in Korea. To provide stable income and minimum level of livelihood for the elderly, it is unavoidable to establish social safety nets such as the public pension system. But, if households themselves try to prepare for their retirement periods the economic and social burden would be alleviated in the future. Thus, it is desirable to induce households to save for the retirement voluntarily in diversified way through appropriate policy support. In addition, the financial regulators should warrant sound and transparent asset management markets for investors by imposing strict enforcement on illegal activities in the market and enhancing information flow of investment products.

2. Policy Agenda to Encourage Long-term Government Bond Market in Korea

Long-term bond market in Korea, especially the long-term government bond market is still in its infancy, although there have been many researches to argue the necessity to promote long-term government bond market. It is obviously true, even there have recently been significant shifts in policy stance concerning the government bond market toward promoting long-term government bonds, that ten-year maturity government bonds are rarely traded in the secondary market and there is practically no market for the bonds with maturities over ten years.

On the other hands, the almost unprecedented progress of aging in Korea has brought up the importance of the long-term bonds. Even though the long-term bond does not necessarily mean long-term government bonds, few entities but the government and government-sponsored enterprises can issue these bonds considering various risk factors, especially the credit risk, related to managing portfolio mainly consisting of long-term bonds. Therefore, the paper aimsto recommend policy prescriptions to promote long-term bond markets with the special reference to the long-term government bond market.

The paper argues that there are at least three important reasons to firmly institute well-functioning long-term bond market in Korea. First, it is expected that the long-term bonds play an important role in facilitating necessary saving devices for the aging population.

The advancement of aging society along with the growing economy increases demand for the contractual savings such as pensions and long-term life insurances. Due to fundamental characteristics of such financial instruments that they are mainly employed to finance smooth consumption after retirement, it is required that the portfolio should be managed with relatively long time horizon. Long-term bonds, especially the long term government bond is a quite suitable device to meet the demand. In Korea, it is now a well-known proposition that the asset under the management of the National Pension Fund (NPF) will increase with unimaginable speed so that the NPF will completely dominate the domestic capital market unless some dramatic changes occur sooner rather than later. Even with recent endeavors to diversify its portfolio by NPF, the lion's share of its portfolio will be assign to fixed income securities and that further reinforces the necessity of developed long-term government-bond market. Second, along with deepening of the capital markets and advancing portfolio management skills, the demand for long-term bond has been significantly increased stemming from various financial institutions.

Third, though it is generally accepted that the yield curve is one of the most important infrastructure in modern finance, it is practically impossible to draw a reliable yield curve mainly due to the lack of well-functioning long-term bond market.
Since the introduction of primary dealer system and competitive auction in the primary market for the government bonds in 1999, many policy measures have been taken to improve the institutional structure of both in the primary and secondary markets for government bonds so that no significant overhaul except for some fine tuning is urgently required in the institutional arrangements. The analysis based on international comparison reveals that in spite of recent rapid expansion in its size, the government bond market in Korea is still small. The paper suggested two factors as the reasons: Historically hostile atmosphere against the expansion of government debt and conservative fiscal stance. The paper, therefore, argues that it is very difficult to expect a swift expansion of government bond market exceeding the current trend unless some fundamental changes happen in the two problem areas. Moreover, the analysis indicates that in spite of recent policy shift to promote long-term government bond market, the supply and trading of those bonds are not satisfactory in terms of international standards.

With the presumption that the development of long-term government bond is closely related to the development of overall government bond market, the paper examines several important policy agenda to support the development of government bond market: Reforming the primary dealer system to encourage competition among primary dealers, promoting when-issued market to enhance the efficiency of price discovery and market liquidity, inducing wider participation of foreign investors in Korean government bond market, re-evaluating the current policy stance on the relationship between secondary market operated by the Korean Stock Exchange and inter-dealer broker market operated on OTC basis.

In terms of developing the long-term bond market, the paper proposes three important policy agenda: Taking a cautious approach in increasing the supply of long-term bond not to impair the liquidity of shorter-term government bond markets, introducing STRIP and futures for the long-term government market to meet diverse demand of investors, promoting mortgaged-backed securities to compliment long-term government bond in dealing with demand for long-term savings.

Summary

Policy Study KOR Herding and Positive Feedback Trading by Foreign Investors in Korean Stock Market: Analysis with TAQ Data

1. Introduction

The abolition of ownership restrictions, applied to the listed companies held by non-residents in Korea Stock Exchange (KSE), reached the completion stage in May 1998. Along with liberalization of capital movement, the measure has steadily encouraged non-resident foreign investors into increasing investment activities in the KSE so that the proportion of foreign ownership measured in market capitalization is estimated to exceed 40% at the end of 2004.

Many pros and cons are brought up on increases in foreign ownership in the listed companies. Advocates for extensive foreign ownership emphasize the beneficial effects of transparency, shareholder-oriented management and improved corporate governance stimulated by foreign ownership. On the other hand, many skeptics argue that most of the foreign investors active in the Korean stock market are international speculators pursuing short-term capital gains and having no interest in the long-term viability of the companies. This paper does not intend to take sides in the controversy, but aims to provide some solid empirical facts on the investment behavior of foreign investors and to infer the economic implications of the empirical findings. Specifically, we examine the existence of herding and positive feedback trading among foreign investors. Herding indicates collective buying or selling among a particular group of investors in excess of overall market trends and positive feedback trading means buying the winners, that is, shares that showed good past performance and selling the poor performers. Neither herding nor positive feedback trading implies irrationality of investors by itself. The main reason we are interested in these kinds of behavior is that they could result in undesirable consequences on market stability under certain circumstances.

2. Synopsis

This paper utilizes transactions and quotes (TAQ) data files provided by the KSE to measure herding and positive feedback trading by foreign investors. TAQ files provide us with a unique research opportunity in that they contain all the details of orders submitted and transactions executed on the KSE. We do not claim that the paper is the first body of research to investigate herding and positive feedback trading by foreign investors in the Korean stock market. We were able to find at least two preceding examples of research examining the same topics with TAQ files. However, they focused on the window period around the foreign exchange crisis in 1997. It would be very interesting to investigate the changes, if at all, in the investment behavior of foreign investors in recent years as they by all means play a major role in the Korean stock market.

We found little or extremely weak evidence of herding by foreign investors. The result is at odds with the findings in previous research concentrating on the occasion of the crisis in 1997. Though one can guess that increases in trading activities and ownership of foreign investors may accompany changes in the composition of investors and their investment strategy to bring about the differences, we should wait for further research for a more plausible explanation. A cautionary note should be added that we should not extrapolate the result to claim that a significant shock to the market, such as the crisis in 1997, would not provoke fierce herding behavior among foreign investors. Though not statistically meaningful, we found higher degrees of herding among shares with a large market capitalization, and higher sensitivity to overall market changes. Widening the length of the observational window from day to week, month, and quarter also results in stronger herding patterns.
We found limited evidence of positive feedback trading by foreign investors. The tendency was a little more conspicuous in shares with lower volatility and smaller trading volumes.

3. Conclusion

The findings in this paper should not be cited as evidence for or against the destabilizing role of foreign investors in the Korean stock market. Here is the conclusion we can draw from the analysis; considering the measures we take in the analysis such as the H-index and D-index, we cannot find sufficient evidence to reject the null hypothesis that foreign investors do not do harm to market stability.

Summary

Policy Study KOR Empirical Investigation on Economic Roles of Derivative Markets I: Analysis on the Efficiency of Price Formation in the KOPSI 200 Futures Market

This study was conducted with an aim to systematically, comprehensively, and empirically analyze the efficiency of the prices in the futures market of Korea which is over six years old now.

Korea’s futures contract that began by using the KOSPI 200 on May 1996 has grown in size and in terms of trading volume and it is already one of the world’s top markets.

Apart from the growth of its size, now is the time to conduct a systematic and comprehensive review of the development of the economic expectation effect made by the introduction of futures market—including the effective price formation through price discovery, provision of adequate hedging methods, and acceleration of capital formation.

This study attempts to conduct an empirical analysis of the efficiency of price discovery that a futures market implements using the five-minute sample interval and daily samples of the KOSPI 200 futures market.

The analysis of the efficiency of price formation in the futures market through the difference between theoretical and actual prices reveals negative evidence, though indirect.

According to the evidence, the price discrepancy has a strong autocorrelation as well as systematic correlation with variables, such as remaining period, volatility of spot and futures, rate of return, and trading volume.

Even in the case of explicitly considering transaction costs, the proportion of the cases of exceeding price limit of futures prices required by theoretical prices is approximately 53% of the total samples. It is also possible to establish a statistic model that could explain the cases in a systematic manner.

Another negative result was found regarding the establishment of theoretical relationship which is expected to exist among the three asset prices of spot and futures & options.

In response to the reception of new information affecting the asset prices, evidences show that there is a strong tendency that the futures market leads the spot market and that the information flow between the two markets tends to move more smoothly as the experiences of market operation become accumulated.

The analysis using various statistics instruments showed that futures returns tend to lead spot returns in a consistent pattern.

More active transactions and higher earning rates in the sport market translate to mean higher speed of information transmission between futures market and spot market.

It is also found that the accumulated experiences of operating the futures market resulted in further actions in the information transmission between the futures and spot markets.

The analysis of the time lag of information transmission based on separate samples of 1996 and 2001 revealed that relatively short time lag was found in 2001 samples.

These findings indicate negative implications of the efficiency of price formation in Korea’s futures market, but such result is not only confined to the cases in Korea.

The phenomenon of a certain degree of systematic discrepancy between theoretical and actual prices of futures is observed in advanced countries including the U.S.

The information transmission between futures and spot markets of Korea is operating well enough to be equally comparable with that of other countries with much experience in the operation of the futures market.

Along with this, price discovery and efficiency in the futures market appear to improve over time as the experiences accumulate through operating the markets.

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