beyondbrics

By Nicholas de Boursac

The Korean parliament may soon eliminate the government bond withholding tax exemption, a measure that will have a negative long-term impact on the South Korean government bond market but little, if any, benefit.

This move will result in increased borrowing costs for the Korean government and will deter would-be long-term investors, an unfortunate misstep for Asia’s strongest emerging market.

Foreign investors in South Korean government bonds (KGBs) were exempted from a withholding tax in spring 2009, but the Korean parliament is now considering proposed legislation and may reverse the exemption this month.

Though the government portrays the move as a temporary action aimed at deflecting excess QE2 liquidity flows, ultimately it will prolong the exclusion of KGBs from Citigroup’s World Government Bond Index (WGBI).

Korea’s withholding tax system is complex, and the proposed reinstatement of the tax would effectively disqualify KGBs from the WGBI and also would make offshore settlement and custody of KGBs impossible. In addition to excluding investors tracking WGBI, the reimposition of withholding tax would discourage investments by other long-term investors, as these less liquid KGBs could only be held or settled in Korea.

The key to the WGBI is stability. It’s simply not feasible to add or remove bonds at will. For this reason, the index includes only bonds expected to qualify for many, many years. So, even if the exemption is reinstated, say in spring 2013, the WGBI committee is unlikely to include KGBs immediately and probably would wait 3-4 years, until 2016-2017, to see if another tax policy flip-flop materializes.

The benefits of WGBI inclusion to Korea are real. Estimates vary, but as much as $2,000bn is passively managed by investors tracking the WGBI exactly and another $8,000bn by those who track it approximately.

If Korea were included in the WGBI, investors tracking the index would need to hold about 1.25% of their portfolios in KGBs, an amount that could total $100bn. Such investments are long term and stable, which makes them ideal for funding government deficits. Plus, these won-denominated bonds could be serviced easily and also would help improve the foreign-currency-assets to foreign-currency ratio, a factor often mentioned by rating agencies. Furthermore, the ability to tap into a worldwide investor base would lower government borrowing costs.

The stated purpose of the current measure is to control and reduce fund flows into Korea and dampen the appreciation of the won. Based on experience in other markets, the tax is unlikely to achieve these objectives.

A better way for Korea to address its concerns would be to let the Bank of Korea continue the downward management of the exchange rate and have the sovereign wealth fund expand its capital export program by an amount equal to the portion of inward flows that the Korean government deems excessive. Should a future crisis result in a sudden withdrawal by foreign investors, the capital thus exported could be repatriated.

Regardless, reinstating the withholding tax on government bonds is the wrong move for Korea now and a measure that will penalize Korea’s markets and KGB programs for years to come.

Nicholas de Boursac is the Managing Director and CEO of the Asia Securities Industry & Financial Markets Association (ASIFMA)

beyondbrics – South Korea