beyondbrics

So near and yet so far. Today South Korea took two steps in the direction of developed market status – one small step forward, and one big step back.

The news that the government will reimpose a 14 per cent withholding tax on foreign holdings of sovereign bonds looks largely priced in. Neither the won nor the Kospi took much notice of a move that many in the market had been expecting.

But it could have been a different headline.

This morning a change to South Korea’s banking law came into effect which would have removed one of the last remaining barriers to an upgrade at MSCI, the indexer. In its most recent report on Korea, MSCI said that two issues remained preventing a status change – the requirement for investors to trade using their real names, and the difficulties they faced in getting access to enough won to actually fund trades.

The change to the law has largely solved the latter problem – enabling foreigners to borrow large amounts of won on the local market at short notice. That would have left only the ID issue to resolve.

But now, it seems, South Korea is as far away from an upgrade as ever. The tax on bonds will not only make a change at MSCI impossible, it’ll also put Korea’s entrance onto the Citigroup World Bond Index in serious doubt.

Aside from that, though, the bond tax is unlikely to make much of an impact. A report earlier this month from Sharmila Whelan and Christy Tan at Bank of America Merrill Lynch – who were among those expecting the tax – points out that there are a number of reasons why this particular capital control will do little to stem inflows, or alter valuations on the won:

The impact of withholding taxes, if introduced would be psychological, although this is debatable as Korea does not have first mover’s advantage. At best the measure is likely to discourage speculation at the margin. For at the end of day investors will consider the withholding tax simply a part of the cost of doing business and will continue to invest as long as the net return is positive.

It’s also worth noting that lots of foreign investors might be exempt anyway, the report says that due to double taxation treaties with Korea, a number of countries might be exempt – last time around, 57 countries were.

It all begs the question – why bother at all? Perhaps because a bump up to developed market status would see large fund inflows, which would no doubt strengthen the won.

(One good thing comes out of all this – beyondbrics can keep South Korea on the list)

Related reading:
S Korea: currency war off, inflation war on, beyondbrics
India’s central banker (1): currency wars and capital flows, beyondbrics
How strong can EM currencies get?, beyondbrics