Effective Transaction Costs in the Korean Stock Market

Sung- Hun Kim

Ⅰ. Introduction

Stock traders pay two types of transaction costs: explicit costs and implicit costs. Examples of the former are brokerage fees and trade taxes.  Implicit costs are the difference between the actual transaction price and the fair market value and are not pre- scheduled.  Throughout this paper, implicit costs are called effective transaction costs.  Traders, researchers, and regulators are all interested in effective transaction costs because they directly affect traders' performances and also indicate the relative efficiency of pricing in the market and the regulatory system.  In the literature, however, these costs are usually discussed with relation to the bid- ask spread, and are investigated in terms of their formation and variation across the securities and the market.  Most papers have dealt with the quoted spread, in particular; that is, the spread quoted by the market maker.

While the bid- ask spread discussed in the theoretical papers corresponds to the effective transaction costs, the quoted spread dealt with in the empirical papers is something different.  It is also often different from the effective spread, because many trades are actually made at prices within the quoted bid- ask spread.  For example, when a trader receives new information unknown to the market maker, he 

can offer a bid or ask price better than the market maker's quote.  If such an offer is accepted by other traders on the trading floor of the exchange, the trade will be made at a price between the bid and ask quotes.  An example of such trades is cross- trading.  In the U.S., where there are several stock exchanges, a market maker is obligated to execute an order at the best price available at the time.  Here, the best price means the highest bid or the lowest ask among the bid or ask quotes available at the time across all of the exchanges.  In such a case, an order can be executed at a price better than the market maker's quote.  It is also possible for an order to be executed outside the bid- ask spread.  In the Korean Stock Exchange (KSE) there are no monopolistic dealers similar to the specialists in the New York Stock Exchange.  The quotes are not the representative bid and ask prices, but are simply the best bid and ask prices.  If the bid or ask quote is not deep, in other words, if the number of shares offered at the quote is not large enough, then an order can actually be executed at a price outside the current bid- ask spread.

The effective transaction costs examined in this paper are not always the same as the effective spread.  In an efficient market where the relevant information is fully reflected by the price and the price represents the fair market value at the time, the effective transaction costs may coincide with the effective bid- ask spread.  However, the existence of transaction costs themselves hinders information from being fully reflected by the price.  In addition, irrational psychological factors arising out of uncertainty or instability in the market may affect the price.  In such cases, the effective transaction costs, the discrepancy between the actual transaction price and the fair market value, may differ from the effective spread, the difference between the actual transaction price and the prevailing market price.  Whether the market is informationally efficient is of course an empirical question.  Still, many previous papers provide empirical evidence on the positively serially autocorrelated stock returns in the short- run, and this indicates that the price may not fully reflect all the relevant 

information available at the time. 

The effective transaction costs are a better concept for the implicit costs imposed on traders directly in this respect.  The existence of such costs affects the extent to which the price reflects information, and this demonstrates that the effective transaction costs are strongly affected by the market efficiency and can also be used as an indicator of market efficiency (Hasbrouck (1993)).  Nevertheless, to my knowledge, no evidence has yet been found of the existence of effective transaction costs in the Korean stock market.  Most papers dealt with the quoted spread by analyzing its determinants and documenting its patterns (Jang and Ok (1996)). Recently, Choi (1996) applied Madhavan, Richardson, and Roomans' model (1994) to estimate the implied spread using only the returns data.  The implied spread is conceptually very much the same as the effective spread, but it is still different compared to the effective transaction costs examined in this paper for the several reasons.  In his study, the difference between the actual transaction price and the expected price is regarded as the approximation error, and this error is the one component which is not included in the implied spread.  However, this error term is the component that creates the negative serial autocorrelation in stock returns irrespective of the flow of information, and that is included in the effective transaction costs in this paper.  Two examples of such an error component that must be included in the effective transaction costs but which are not costs imposed by liquidity suppliers are price pressure and overreaction.  Price pressure or overreaction increases as trading volume increases, whereas costs per share arising from liquidity decrease as trading volume increases. 

The purpose of this paper is to develop a new measure of the effective 

transaction costs using only returns data.  The measure is applied to real data for the estimation and investigation of the effective transaction costs.  The results documented in this paper generally support both the order processing cost hypothesis and the adverse selection cost hypothesis in the market microstructure literature. 

This paper is organized as follows:  Two hypotheses of the effective transaction costs are discussed in Chapter 2.  In Chapter 3, a new measure of the effective transaction costs is developed.  An empirical model to estimate the costs is developed in Section 3.1, while an index to test the explanatory power of the model is provided in Section 3.2.  The data used in this paper are explained in Chapter 4.  A number of empirical tests are performed in Chapter 5.  In Section 5.1, the effective transaction costs and model parameters are estimated, and then in Section 5.2, the statistical components of the costs are investigated so that the cross- sectional pattern of the costs found can be explained in terms of these components.  In Section 5.3, further examination to find the determinants of the effective transaction costs is performed, and the validity of the two hypotheses discussed in Chapter 2 is analyzed based on the empirical evidence.  The results of the paper are summarized in Chapter 6. 

Ⅱ. Two Hypotheses of the Effective Transaction Costs

Most theories on the transaction costs in the stock market generally focus on the market maker's bid- ask spread.  The bid- ask spread in these theories actually corresponds to the effective transaction costs rather than the quoted bid- ask spread, and these theories can be extended to explain the behavior of transaction costs in the Korean stock market.

These papers can be categorized into two groups.  The first group, associated with the order processing cost hypothesis, recognizes a market in which there are two types of players, that is, a market maker and liquidity traders.  This group identifies the risk assumed by a market maker in processing orders and holding inventories as a source of the bid- ask spread.  The early papers assume that a market maker's role is simply to assist only those traders who are not informationally motivated.  In a pioneering article, Demsetz (1968) observes that a market maker may act as a trader 

as well as a broker when processing buy and sell orders.  In his role as an order processor, the market maker assumes price risk involved with holding inventory, and imposes the bid- ask spread in order to compensate.  Amihud and Mendelson (1980) and Ho and Stoll (1981) theoretically analyze the optimal behavior of a market maker faced with stochastic order arrivals.  Amihud and Mendelson assume a competitive market maker who sets bid and ask prices based on the arrivals of buy and sell orders, while Ho and Stoll describe a risk- averse market maker who is mainly concerned with providing liquidity services and not well diversified.  In these models, the possibility of temporary discrepancies between buy and sell orders and the obligation to maintain continuous trading induce the market maker to carry either a positive or negative position in inventories.  The market maker set the spread in such a way that he optimizes his order processing and inventory position.  In equilibrium, the spread is always positive and is equivalent to the order processing costs.

It is debatable as to whether or not the traditional order processing cost hypothesis can be applied to the Korean stock market, because market makers carrying inventories do not exist.  However, a liquidity trader who is party to a transaction may ask the spread as compensation for the price risk of the inventory to be held. The compensation increases as trading volume and order size increase, and this leads to the price pressure of transactions.  That is, order processing costs arising from price pressure vary directly with trading volume and order size whereas the traditional order processing costs incurred by a market maker are inversely related to them. 

The second group of papers develops the adverse selection cost hypothesis.  An adverse information effect arises when the market maker deals with unknown informed traders, forcing him to adjust the bid- ask spread.  Bagehot (1971) discusses the economics of market making in terms of three types of players who confront a market maker; those are, informed traders, liquidity traders, and noise traders.  The market maker always loses to informed traders but gains in transactions with liquidity traders.  These two types of traders are largely indistinguishable to the market maker. 

The spread set by the market maker affects his losses and gains in transactions.  The larger the spread, the less is lost to informed traders and the more is made from liquidity traders.  From the market maker's point of view, noise traders are identical to liquidity traders.  In Copeland and Galai (1983), a market maker sets the bid- ask spread to maximize his profit.  As the bid- ask spread widens, the market maker's losses to informed traders decrease.  However, the revenue from liquidity traders does not always increase because the widening of the spread reduces the probability of transactions with liquidity traders.  This means there exists an optimal bid- ask spread. Glosten and Milgrom (1985) assume that a market maker earns zero expected profit on each transaction and faces no transaction costs.  The market maker, who cannot distinguish between informed and uninformed traders, sets the bid or ask price equal to the expected value of the security given that the next order is made at the bid or ask.  In there is zero profit equilibrium, there exists a non- negative bid- ask spread. If adverse selection is possible, the spread is strictly positive. 

This adverse selection cost hypothesis holds when a market maker does not exist. This is because a liquidity trader cannot identify the counterpart trader's type and so asks the spread to compensate for adverse selection costs.  After all, these costs arise due to the uncertainty in the market, and may overreact to the unexpected change in trading volume and order flow.  On the other hand, the overreaction may stimulate additional transactions.

These two perspectives on the bid- ask spread are not mutually exclusive, but are instead complementary.  Neither has yet been fully synthesized, however. 

Ⅲ. Measurement of the Effective Transaction Costs

1. An Estimator of the Effective Transaction Costs

and, therefore,

<The First Step>

<The Second Step>

and the independent variables on the right- hand side of the equation by

2. Explanatory Power of the Model

Ⅳ. Data

The Korean stock data used in this paper are from the PACAP (the Pacific- Basin Capital Markets) databases distributed by the PACAP Research Center at the University of Rhode Island.  The Korean stock market database of the PACAP databases was created with support from the Bank of Korea, the Korea Stock Exchange, and Ssangyong Research Institute of Korea, and it includes data on the daily and monthly stock prices and key economic statistics.  The stock data used in this paper is on daily stock returns, high and low prices, trading volume, total shares outstanding, and total market value. 

The stocks selected for this study are common stocks that were listed on the Korea Stock Exchange during at least the five- year period from the beginning of 1989 through 1993 and which were traded on at least 75% (1,096 days) of the all trading days (1,462 days) during that period.  Among these stocks, there are seven for which the stock information is not complete, so they are not included in the sample. Finally, 421 stocks were selected.

or equivalently 

In addition, the market value of the total volume of shares outstanding is calculated by averaging the monthly market values (the monthly closing price multiplied by the monthly volume of shares outstanding) over the whole sample period. 

Ⅴ. Empirical Analysis

1. Estimation of the Model 

The results from the empirical procedures to estimate the effective transaction costs are summarized in Table 2.  For each stock, the coefficients in Equation (4) are estimated for the five period of 1989 to 1993.  Then, the averages of these coefficient estimates are calculated for each size- sorted quintile and the whole sample. 

2. Statistical Components of the Effective Transaction Costs

3. Determinants of the Effective Transaction Costs

Therefore, the results documented in Table 6 and Table 7 support both of the two hypotheses on the effective transaction costs, the order processing cost hypothesis and the adverse selection cost hypothesis.  This suggests that the size of the effective transaction costs is determined by such factors as the difficulty in processing orders and the level of price uncertainty. 

Ⅵ. Summary

The effective transaction costs discussed above are different from the quoted bid- ask spread, and are likely to differ from the effective spread, too.  This paper provides evidence on the existence of the stock return component showing positive autocorrelation.  It implies that the Korean stock market is slightly inefficient in the sense that stock prices do not reflect all the available past information.  As a result, the effective transaction costs may differ from the effective spread. 

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<Table 1> Summary Statistics

Note: 1) The sample is sized- sorted into five quintile groups.

2) Firm size is the average of the market values of total shares outstanding observed monthly for the sample period, and the unit is one hundred million won.

3) The unit of stock price is the Korean won.

5) Turnover is the ratio of daily trading volume divided by total shares outstanding. 

<Table 2> Parameter Estimates of the Model for the Effective Transaction Costs

Note: 1) The sample is sized- sorted into five quintile groups.

<Table 3> Estimation of the Effective Transaction Costs and the Explanatory Power of the Model

Note: 1) The sample is sized- sorted into five quintile groups.

<Table 4> First- Order Autocorrelation Coefficients of Stock Return Components

Note: 1) The sample is sized- sorted into five quintile groups.

<Table 5> Variances of Stock Return Components¹⁾

2) The sample is sized- sorted into five quintile groups.

<Table 6> Trading Volume, Turnover, and the Effective Transaction Costs

Note:1)The sample is sorted into five quintile groups respectively by daily trading volume and turnover.

Macroeconomic Developments 

Current Status and Prospects

Economic Growth

In spite of the volatility in the various financial variables, including the exchange rate, interest rates, and the stock price index, many of the real macroeconomic variables indicated that the long- awaited recovery finally began during the third quarter, modest though it may be.  The GDP growth rate rose to 6.3 percent yoy (year- on- year), the current account deficit narrowed to 1.9 billion dollars, and the inflation rate, as measured by the CPI, stayed at 4.0 percent.

Evidence of recovery also can be found in the inventory cycle.  Historically, an economy goes into the recovery phase of the business cycle shortly after the shipment growth rate exceeds inventory growth.  This was indeed the case during the last three business cycles in Korea.  After lagging for a period of 20 months, the shipment growth rate began to exceed inventory growth last June, and the differential between shipment and inventory growth has been widening month by month since then. 

<Table 1>                    Economic Growth¹⁾ 

(percent)

Notes:  1) Percentage changes from the previous year.

2) Preliminary

3) Forecasts

Source:  The Bank of Korea, National Income, various issues.

As expected, the recovery of the economy is being led by exports.  Korean firms had to increase their production to meet the strong global demand due to improved price competitiveness and the decline in global inventories of steel and petrochemical products.  The real value of Korea's exports rose by 21.0 percent, helping to narrow the current account deficit.

Despite these strong performances in the external sector, both domestic corporate and consumer demand remained very weak, although the one positive result of this was of course a slowdown in imports, which helped improve the current account balance.  Imports increased only moderately, and capital goods imports declined because firms cut back their outlays for investment.  The slowdown in growth of personal income meant that consumer goods imports rose only slightly.  Demand for equipment investment, both imported and domestic, fell by 1.3 percent (yoy) during the quarter, while the volume of construction orders rose only by 3.8 percent (yoy). 

<Figure 1>                   Industrial Production

Note:  The trend is estimated using the Hodrick- Prescott (HP) filter. 

Source:  The Bank of Korea, Monthly Bulletin, various issues

Consumption growth showed a mild recovery.  The growth in wholesale and retail sales had fallen to its lowest level in five years in January, bottoming out at 1.4 percent (yoy), but it has since been continuously, though slowly, improving to 5.3 percent (yoy) in July and August.  Sales of automobiles, petrochemical products, vegetables, and food items led the increase.  Shipments of domestic consumption goods increased by 8.7 percent in July and August, rebounding from the 3.2 percent decline in January.  Although consumption is rising, it is not doing so quickly enough to substantially help pull the economy out of its recessionary state.

The only major sore spot in real economic activity at present is investment.  The growth in the volume of domestic machinery orders received slowed further in July and August, rising only by 2.0 percent (yoy), and building and construction permits were down by 6.8 percent (yoy).  Machinery imports were down sharply by 22.9 percent (yoy), and there was little investment in new plants.  These figures indicated that firms' equipment investment and construction investment continued to decline in spite of increasing exports. 

<Figure 2>               Inventories and Shipments

The two- year- long slowdown of the economy has precluded much of the need for firms to make outlays for investment of any kind, especially as they had expanded their manufacturing capacities so greatly during the previous economic expansion. Not surprisingly, the manufacturing sector has since had little appetite for investment. Exports and domestic demand will have to rise much further before firms are ready to once again to buy new facilities or pour concrete for new factory space.  To be sure, their reluctance to do so this past year has prolonged the recession and has acted as a significant drag on economic growth, and it will continue to do so in the fourth quarter.

<Table 2>                Industrial Activity Index¹⁾

(percent)

Notes:  1) Percentage changes from the previous year.

2) Seasonally adjusted.

3) Percentage changes from the previous period.

Source:  National Statistical Office, Industrial Activity Review, various issues

The Korean economy is forecast to grow at a 6.8 percent rate in the fourth quarter, mainly due to an expected 14.6 percent rise in exports. Unlike past economic 

recoveries, however, this recovery is not expected to be especially strong because of the extreme weakness in corporate investment.  The growth in investment is in fact decelerating.  This is mainly because of the weak consumer demand and the excess capacity in the heavy and chemical industries.  It is public investment in SOC, not private aggregate demand, which caused overall investment to increase in the first half, but because most of the public investment planned for this year was set aside for the first half to stimulate the economy, less public investment has been earmarked for the fourth quarter.  Private consumption is expected to grow by 5.1 percent, and imports should only grow by 6.4 percent, due to the sluggish investment.

<Figure 3> Capital Stock Adjustment Pressure and Equipment Investment¹⁾

Note: 1)The capital stock adjustment pressure is the difference between the industrial production growth rate and production capacity growth rate.  The figure for equipment investment after the second quarter of 1997 are estimate and forecasts.

Source:  The Bank of Korea, National Account, various issues.

Exports are rising strongly because the depreciation of the won has made Korean goods much more competitive in prices and because global demand for the the 64M DRAM and other products has been increasing.  Even though the 

Korean won started to depreciate in the second quarter of 1995, the real effective exchange rate did not rise significantly until the first quarter of 1997, because the Japanese yen had depreciated more steeply.  In the second quarter of 1997, however, further depreciation of the Korean won and the appreciation of the Japanese yen caused a substantial depreciation of the real effective exchange rate of the Korean won.  Taking into consideration the fact that the full impact of major currency swings do not become manifest until two or three quarters have passed, we can safely predict further strong export growth in the fourth quarter.

<Figure 4>  Real Effective Exchange Rate and Yen/Dollar Exchange Rate¹⁾

Note: 1)As for the actual estimation of the real effective exchange rate, see the Korean Financial Review, Spring 1996, Vol. 6, No. 1.

Source:  The Bank of Korea, Monthly Bulletin, various issues.

IMF, International Financial Statistics, various issues.

<Table 3>             Quantity and Unit Prices of Exports¹⁾

(percent)

Note: 1) Percentage changes from the previous year.

Source:  The Bank of Korea, Monthly Balance of Payments, various issues.

The leading economic indicators support the forecast discussed above.  The composite leading economic indicator had fallen month after month until February, but then rose for six consecutive months.  Seven out of the ten indicators were positive in August.  In particular, arrivals of letters of credit and imports of raw materials for production of export products rose steeply in August, heralding more rapid growth in exports in the months to come.  The investment and consumption index, however, was down as shipments of consumption goods slid, and the production index of intermediate goods for construction and machinery orders received fell, implying that domestic demand remained anemic.

On the supply side of the economy, the factory utilization rate and unemployment rate are expected to hold steady at 80 percent and 2.4 percent, respectively.  In spite of the recession, manufacturing capacity has risen by more than 9.0 percent over the last two years, but production has risen more slowly, thus forcing down the factory utilization rate.  The factory utilization rate is expected to drop further in the coming months.

Prices 

The CPI rose at only a 4.0 percent rate (yoy) in the third quarter.  The weakness in consumers' purchasing power meant that there was little demand- pull inflation. Agricultural product prices rose by 4.3 percent, which was a two percentage point more rapid pace than that in the second quarter.  This was mainly due to the high demand that generally occurs just before the Korean thanksgiving holiday every year. Fees for services rose by 4.6 percent, and prices for manufactured products rose by 4.2 percent.

Prices for all three categories of products should remain flat for the rest of 1997. Due to the good weather conditions during the summer, the supply of agricultural products is expected to be high and prices stable.  The weakness in the Korean won means that the prices of imported goods will be higher, but because imported goods account for less than 10 percent of total consumption, their effect on the CPI is very marginal.  Prices for some commodities should fall as some producers are expected to actively make efforts to sell out their inventories, and the rapid proliferation of discount outlets in Korea means that many goods which have already been available on the domestic market will be on sale at even lower prices.

<Table 4>                  Inflation and Wages¹⁾

(percent)

Notes:  1) Percentage changes from the previous year.

2) Forecasts.

Sources:  National Statistical Office, Consumer Price Index, various issues.

The Bank of Korea, Monthly Bulletin, various issues.

Ministry of Labor, Monthly Labor Survey, various issues.

The major sources of inflation have traditionally been the increases in service fees, land prices, and rents.  At present, the rate of core inflation is lower than the increase rate of the CPI, and the weakness in consumers' purchasing power has greatly eased demand- pull pressure.  The high unemployment should help hold the wage increase rate, and therefore inflation, to a minimum because it has naturally given rise to more widespread job insecurity.

The Bank of Korea eased the money supply to help relieve the financial pressures on financially troubled firms.  Not surprisingly, the M2 growth rate began to accelerate, but it is still very low at present due to the staggered investment.  The BOK should therefore have no difficulty in achieving this year's M2 target growth rate of 19 percent (yoy).  The acceleration in growth of the money supply will of course cause inflationary pressures to increase, but the government has been making great efforts to hold inflation in check by freezing public fees and fares; no increases in these fees and fares will be permitted for the rest of 1997.  As a result, the rate of increase in the CPI is expected to stay at 4.0 percent during the fourth quarter.

<Figure 5>             CPI and Sources of Inflation

Source:  National Statistical Office, Consumer Price Index, various issues.

The producer price index (PPI), on the other hand, could very well begin to rise more quickly.  Partly because the won/dollar exchange rate was very stable from April to July, the PPI rose at only a 2.3 percent rate in the third quarter.  However, the more recent depreciation of the Korean won, which began in August, and the increase in international oil prices will likely push the PPI increase rate up to around 3.3 percent in the fourth quarter.

When the autumn moving season arrived in the third quarter, the prices of apartments began to climb.  However, the rate of increase was typical for this time of year, and the demand for office space in office buildings was actually at a record low due to the recession.  Considering the facts that 1) some 100 thousand new apartments are still unsold throughout the country, 2) consumers' purchasing power is sapped after the two- year- long recession, and 3) the government is focusing its efforts on maintaining price stability, land and housing price should be stable in the fourth quarter.

<Figure 6>                 Import Price Index

Source:  The Bank of Korea, Monthly Bulletin, various issue.

Current Account and Foreign Exchange Rate 

The current account deficit narrowed to 1.9 billion dollars in the third quarter from 2.7 billion dollars in the second quarter.  This significant improvement is seen as a result of not only the recovery in exports but, even more so, of the slowdown in imports.  Thus, the trade account actually recorded a surplus of 0.4 billion dollars after six consecutive quarters of deficits.  The deficit in the invisible trade balance, however, deteriorated further to 2.1 billion dollars.  The capital account recorded a surplus of 3.5 billion dollars, thus bringing the overall account to near equilibrium. This was not enough to prevent the won from sliding 3.0 percent against the US dollar to 914.4 won by the end of the quarter.  Foreign investors and currency traders were obviously greatly dismayed by the latest spate of bankruptcies of large firms in Korea; many foreign investors did their best to withdraw their funds from Korea entirely.

<Table 5>       Balance of Payments and Foreign Exchange Rate

(US billion dollar)

Notes:  1) Forecast.

2) Period averages.

Source:  The Bank of Korea, Monthly Balance of Payments, various issues. 

Exports increased by 16.4 percent (yoy) and were recorded at 34.6 billion dollars during the third quarter.  The recent boom in exports is not only the result of the sharp rise in export volume but also of the slowdown in the fall in unit export prices.  Increased global demand for most of Korea's major export goods- - semiconductors, steel, petrochemical products- - caused the unit export prices to fall at slower rates.  In some cases, the prices have recovered somewhat.  Exports of 

semiconductors, steel, automobiles, petrochemical products, and machinery actually grew at a two- digit rate.  In spite of the fall in the price of the 16M DRAM memory chip, the rising demand for the 64M DRAM memory chip, nonmemory chip, and assembly technology caused electronics exports to skyrocket 44 percent in August.

Imports dropped by 3.0 percent in the third quarter and were recorded at 34.2 billion dollars.  The rise in exports led to a more than 5.0 percent increase in raw materials imports, however.  The weakness in private consumption caused imports of consumption goods to fall, and the continuing decline in corporate investment caused capital goods imports to fall as well.

The deficit in the invisible account widened to 2.1 billion dollars.  This was attributable to the rising burden of interest payments stemming from Korea's rising external debt- - last reported at well over 100 billion dollars- - and the yawning travel account deficit.  A record number of Koreans decided to take their summer vacations abroad, and the depreciation of the Korean won caused Korean travelers' expenses to rise while conversely reducing those of foreign visitors vacationing in Korea.  Not surprisingly, the travel account deficit reached a record high and will almost certainly do so in the near future. 

<Figure 7>        Balance of Payments and Exchange Rate

Source: The Bank of Korea, Monthly Balance of Payments, Foreign Exchange Market Review, various issues.

The capital account surplus fell by nearly half to 3.5 billion dollars in the third quarter from 6.3 billion dollars in the second quarter.  As the concerns over the bankruptcy of Hanbo Steel in January diminished, the flow of foreign capital into Korea resumed; the capital account recorded a surplus of 2.2 billion dollars in July alone.  The announcement of the near- bankruptcy of Kia motor late in July, however, caused the volume of capital inflows to suddenly decline. The problems at Kia were yet another blow to foreign investors' confidence in Korea, so foreign financial institutions seriously hesitated to extend loans to Korean commercial banks.  They were concerned about the possible insolvencies of Korean banks which had incurred massive burdens of non- performing loans due to the bankruptcies of several conglomerates including Hanbo, Sammi, and Jinro etc. in addition to Kia.

<Table 6>  Exports and Imports by Commodity, Purpose, and Region¹⁾

(percent)

Note: 1)Percentage change from the previous year.  The figures in parentheses are percentage shares.

Source:  The Bank of Korea, Monthly Balance of Payments, various issues.

After holding steady in July at the level of about 890 to the dollar, the value of the Korean won declined again in August and September.  In July, there was a slight excess supply of foreign exchange, so the exchange rate was stable.  Only for a brief period in July, after the near- bankruptcy of the Kia Group was announced and the domestic financial markets became unstable, did the won depreciate.  The won then held steady for several weeks.  In August, as the impact of the Kia debacle on the economy became more pronounced, the volume of capital inflows significantly contracted again, causing the won to resume its depreciation.  The Bank of Korea actually intervened on several occasions in an attempt to slow the rate of the won's depreciation.  Its reserves of foreign exchange fell to 31.1 billion dollars by the end of August as a result.

<Figure 8>        Won/Dollar and Won/Yen Exchange Rates

Source:  The Bank of Korea, Monthly Balance of Payments, various issues.

The current account deficit is forecast at 2.0 billion dollars for the fourth quarter. The trade balance will continue to improve substantially, but there will be little change in the invisible trade balance.  The recovery in unit export prices, the acceleration in global economic growth, and the improved price competitiveness of 

Korean products stemming from the stronger yen will all serve to boost exports. Exports of semiconductors, steel, automobiles, petrochemical products, and machinery are all expected to grow strongly.  Imports, on the other hand, should remain flat for the time being.  Seasonal factors, such as the Christmas holiday shopping season in western countries, will also contribute to the improvement in the current account.

The capital account is actually forecast to record a surplus of 5.0 billion dollars in the fourth quarter.  Greater inflows of foreign capital will be encouraged by the government's latest measures for the Korean financial market, which were announced on August 25.  The Korean government will raise the ceiling on aggregate stock holdings by foreigners by three- percentage points on November 3, inducing an additional capital inflow.  The volume of trade credits is especially expected to increase significantly if the won stops depreciating in the fourth quarter.  The government also required the Korea Development Bank and Korea Export and Import Bank to increase their foreign borrowings, and it will permit a greater number of Korean firms to finance their investments through the international financial market.

The won is indeed forecast to stop depreciating against the dollar in the fourth quarter.  While the current account deficit narrows and the capital account surplus increases, there will be an excess supply of dollars in the foreign exchange market. However, due to active intervention by the Bank of Korea, the foreign exchange rate will remain stable.  The BOK's foreign exchange reserves are now below the amount required to cover three months worth of imports, the amount recommended by the IMF, so the BOK will try to replenish them.  Thus, the excess supply of foreign currencies will not cause the won to appreciate much, if at all.  One caveat is in order here, however; if more conglomerates become bankrupt, the won could very well continue to depreciate.

Money and Interest Rates

1. Money

The monetary indicators gave some seemingly contradictory indications during the third quarter.  The figures for MCT showed stable growth of the money supply in the third quarter, but the M2 growth rate was rather high, hovering around 19 percent.  Much of the growth, as measured by M2, was due to an accelerating shift of high volumes of funds from non- banks to banks after the introduction of the very popular MMDA (Money Market Deposit Account).  MCT, on the other hand, showed less rapid growth, partly due to tepid corporate demand for funds.  Firms' lack of interest in investment was completely understandable in light of the continuing bankruptcies.  To be sure, even if they had decided to make significant outlays for investment, they would have experienced difficulties in obtaining funds from financial institutions, which not surprisingly had tightened the reins on lending.  There was also a decline in the net issuance of CDs, which together with the ongoing and steady decline in the balances of trust accounts, also served to restrain the growth in MCT.

The rapid shifting of funds from the non- banks to MMDAs at banks was the one 

major factor which contributed to the higher M2 growth rate in the third quarter; it actually reached 20.3 percent in September.  The new MMDAs attracted a total of 5,421.2 billion won that month, while corporate savings rose by 2,445.7 in August. Other factors which played a significant role was the increase in foreign currency

deposits. With the steep depreciation of the Korean won and the BOK's extension of emergency loans to the near insolvent Kia Group, many Koreans were naturally anxious to preserve the value of their savings, so they moved en masse to transfer funds to deposits in foreign currency.

<Table 7>                 Monetary Growth Rates¹⁾

(Unit : %)

Notes: 1)Changes from the corresponding period of the previous year, average balances.

 2)Reserve Money = bank notes + reserves of deposit money banks

 3)M1 = currency + demand deposits 

 4)M2 = M1 + time and savings deposits + foreign currency deposits

 5)MCT = M2 + CDs + Money- in- trusts

 6)M3 = M2 + deposits in non- bank financial institutions + debentures issued + commercial bills sold + CDs + RPs

Sources: The Bank of Korea,「Current Monetary Statistics」, various issues 

The Bank of Korea, 「Monetary statistics for the third period 1997」 

Overall, the MCT and M2 figures did not indicate any major changes in the monetary situation compared to the second quarter;  The level of market liquidity was about the same, even despite the market jitters sparked by the latest bankruptcies. The money multipliers continued to rise because previous reductions in reserves led to continuous contraction of the monetary base, while the velocity of money changed little, despite the financial turmoil.

A close examination of the sources of monetary growth in the third quarter shows that both the public and private sectors served to increase the money supply, while the foreign and other sectors acted to absorb money.  The level of liquidity in the private sector, via increased bank lending and increased securities investment, rose to 1.48 trillion won.  The public sector contributed to the net increase of the money 

through the continued deferment of fiscal outlays.  Its contribution would be been less, however, if tax revenues had not fallen short of projections.  The foreign sector siphoned off an especially large amount of the money supply, 1,138 billion won.

<Table 8>             Money Multipliers and Velocities¹⁾

(Unit : Times)

Notes:1)Money multipliers are the ratios of each monetary aggregate to the volume of reserve money.  Velocities of money represent the ratios of nominal GDP to each monetary aggregate.  Average balances.

2) Preliminary

3) The figures for July and August are averages.

Sources:  The Bank of Korea,「Current Monetary Statistics」, various issues 

The Bank of Korea, 「Monetary Report for the Second Half, 1997」 

This was of course not a surprising development as the currency crisis in Southeast Asia and the sharp depreciation of Korean won caused Korean firms to experience greater difficulties in obtaining finances overseas.

The striking changes in the dynamics of monetary growth have largely been determined by developments in the financial market.  Just as both Korean firms and financial institutions began to resort heavily to foreign sources for their financing needs, the successive bankruptcies in Korea caused the credit ratings to be downgraded, thus leading to turmoil in the domestic financial market.

The most serious of all recent corporate financial debacles is of course that of the Kia Group.  The Kia Group's near- bankruptcy greatly exacerbated the already serious cash flow problems at financial institutions and prompted the BOK to ease their policy stance through flexible repurchase agreement operations.  The BOK engaged in repurchase agreements seven times in July and 11 times in August in an effort to 

restore financial stability.  The earlier signs of market stability evaporated quickly due

<Table 9>       Recent Deposit Changes at Financial Institutions¹⁾

(Unit: Billion Won)

Notes: 1)Changes during the period

2) Figures for the third period are those of July and August.

Sources:  The Bank of Korea, Monthly Bulletin, various issues

The Bank of Korea, Current Monetary Statistics, various issues

The Bank of Korea, Deposit Changes of Deposit Banks in August

to early withdrawal of fiscal funds by the government and the Kia debacle, while a sharp increase in the M2 money supply raised concerns in the market about future monetary tightening.  Accordingly, the BOK made concerted efforts to help banks accumulate reserves.  This, along with the announcement of special loans to MBCs(merchant bank corporations) and Korea First Bank, did much to relieve the market jitters, at least in the short run.  Nevertheless, the market situation did not improve noticeably; there were no noticeable changes in financial flows, which suggested that another credit crunch had taken hold.  In September, the BOK extended a special loan of 1,000 billion won, to be paid off in full in one year, to ailing Korea First Bank.  However, in order to dispell the public's concern about preferential treatment, loans with a low average interest rate of 8 percent were made available to those financially troubled MBCs which are covered by the Anti- bankruptcy Agreement, and the BOK engaged in open market operations to mop up the excess market liquidity.  The BOK also decided to deposit surplus government funds in the MBCs and to strengthen its foreign currency support to them.  As a 

result of the aid, Korea First Bank is expected to see improved profits of up to 40 billion won a year, and no further decline in its overseas credit rating.

RP operations have been pursued since September to cover the liquidity shortage in the merchant banks.  This is expected to help stabilize the call market rates and further 

<Table 10>                  MCT Supply by Sector¹⁾ 

(Unit : Billion Won)

Notes: 1) End of period, changes from the last quarter 

Sources:  The bank of Korea, Current monetary statistics, various issues 

   The bank of Korea, Monetary report for August 

stem the decline in these banks' overseas credit ratings.

Several significant development were noticed in the financial markets in the third quarter.  First of all, the increasing discrepancies between monetary indicators revealed the limitations of quantity variables as intermediate targets for monetary policy.  As demonstrated by the popularity of the new MMDA and the greater sensitivity of capital flows to changes in overseas market conditions, gauging the proper level of market liquidity based on quantitative measures has become increasingly difficult.  Second, the role of expectations in influencing market sentiment and trends has become strikingly important.  The current financial woes are not attributable to changes in monetary policy or the level of market liquidity, but instead to the government's foot- dragging in resolving the Kia debacle, which resulted in significant declines in foreign capital inflows.  This implies that no additional liquidity would be needed to restore stability to the market if a credible plan were finally announced for handling Kia; the government could dispell the psychological apprehension concerning Kia by dealing with the Group in a serious way instead of adhering to a laissez- faire policy.  Third, shocks 

are being more directly and more strongly transmitted from the foreign exchange market to the domestic financial market.  That is, the mechanism by which financial shocks to the foreign exchange market lead to changes in demand for foreign currency and then touch off a chain reaction in the domestic financial market through increased arbitrage is becoming more visible and having greater effect.  This mechanism has tended to render monetary policy less effective by offsetting changes in capital flows.

<Table 11>    Quarterly Issuance of Monetary Stabilization Bonds

(Unit : Billion Won)

Notes: 1) Preliminary

2) The figures for the third quarter are for July and August only.

Sources:  The Bank of Korea, Monthly Bulletin, various issues

 The Bank of Korea, 「Monetary Report for August」 

Forecast

Taking into account the visible seasonal factors, the MCT is expected to grow at a 15.2 percent rate in the fourth quarter, while M2 growth will remain at about 19 percent.  There should be no significant change in the overall level of liquidity, but the credit crunch will persist.  As has been witnessed, credit crunches can now occur without any changes in market liquidity.  On the demand side, despite obvious signs of recovery in production activity and exports, the extreme lack of corporate interest in investment will mean continued weakness in corporate demand for money, but the BOK will likely ensure an abundant money supply in light of the current financial troubles.  The monetary situation will therefore be determined largely by exchange rate fluctuations, which in turn influence the direction and volume of capital flows. Exchange rate fluctuations largely reflect changes in the market participants' expectations, so they indicate prevailing sentiments of the government's handling of 

the Kia debacle and greatly determine the way in which future situations will evolve. If the difficult situation in corporate Korea is not resolved and becomes more prolonged than it has already, not only will firms find themselves in even worse financial conditions, but domestic financial institutions' effort to raise finances overseas will be further jeopardized.  What is more, the upcoming presidential 

<Table 12>                 Balance of Payments¹⁾

(Unit : Million Dollar)

Notes : 1) The figures for 96 were corrected due to announcement of final figures

2)Preliminary

3) Estimates

Sources : The bank of Korea, Balance of Payments, various issues

election this December will increase the burden on the financial community because elections in Korea tend to influence financial flows in a significant way. 

As to the sources of monetary growth in the fourth quarter, the private sector can be expected to absorb money due mainly to suppressed consumer demand, while the government and overseas sector will contribute to the increase in the money supply. Barring the failure of another major business group, we can expect a steady inflow of foreign capital, but no significant increase in domestic credit is expected in the private sector.

No drastic change in monetary policy is expected since the BOK will continue to work hard to maintain the stability of the financial market, even though monetary 

policy has been flexible for a long period of time to prevent business failures. Fortunately, there should be continued price stability and improvement in the

<Table 13>        Money Growth Rates and Forecasts¹⁾

(Unit : %)

Notes:  1) Changes from the corresponding period, Average balance.

 2) Preliminary

 3) Estimates 

Sources:  The Bank of Korea, Monthly Bulletin, various issues

   The Bank of Korea, Current Monetary Statistics, various issues

<Table 14>     Correlation of Fluctuation of Won/Dollar Exchange Rate

and Corporate Bond Yield

balance, which should act as stabilizing forces in the economy and help cushion against recurrent shocks.  However, the ongoing liberalization and development of the foreign exchange market will pose another challenge to the authorities since additional shocks would give rise to yet more depreciatory pressure and, therefore, more volatility in the won/dollar exchange rate, which would certainly exacerbate the financial conditions of most financial institutions and large corporations.

2. Interest rates

On average, the three- year corporate bond yield was recorded at 12.09 percent in the third quarter.  This was about the same rate as during the previous quarter, yet it 

ratcheted upwards month by month.  As business conditions did not improve as was widely hoped and expected, there was no discernable increase in the demand for money for facilities investment.  Also, the near completion of the downward adjustment in inventories helped ease firms' shortages of short- term working capital. If it were not for the continued financial troubles associated with the succession of business failures, the BOK's flexible monetary policy would have allowed interest rates to go down.  Therefore, despite these favorable changes, the three- year corporate

<Table 15>           Major Interest Rates by Quarter

(Unit : %)

Sources : Korea Investors Service,「KIS- LINE」

bond yield actually rose from 11.86 percent in July to 12.36 percent in September due to the renewed difficulties in raising overseas finances in the wake of the Kia debacle and the mounting burden of bad loans at some financial institutions.  Adverse developments in the financial market forced merchant banks to borrow money in the call market, thus forcing the call rate up from 11.39 percent in July to 13.18 percent in September.

<Figure 9>             Major Long- term Interest Rates 

Among other things, it was widespread expectations of depreciation of the Korean won and rising interest rates, and the steady rise in the volume of non- performing loans at financial institutions that caused interest rates to rise.  What is more, firms had difficulty issuing bonds: investment companies found themselves somewhat short of funds and unable to buy many bonds because customers shifted funds en masse to 

the phenomenally popular new MMDAs offered by banks.  This situation was made all the more difficult as firms happened to increase their issuance bonds because they 

<Table 16>             Discounting of Commercial Paper

(Unit: Billion Won)

Sources:  The Bank of Korea, Current Monetary Statistics, various issues

Association of Merchant Banks, daily money market report

<Table 17>                  Ratio of Dishonored Bills

(Unit : %, Numbers)

Notes:  1) By volume.  The figures in parentheses do not reflect adjustments for electronic settlements

2)July only

Sources:  The Bank of Korea, Current Monetary Statistics

  The Bank of Korea, July Dishonored Bill Report

 Korea Investors Service, ｢KIS- LINE｣

could neither sell CP due to the increased credit risks nor borrow money from banks. However, along with the record number of underwriting requests by firms, the rejection rate rose to 50 percent in September, so many firms were not readily able 

to satisfy their direct financing needs.  Evidently, the stability in demand for money and the significant improvement in the trade balance were not enough to induce lower interest rates.  Particularly damaging was the great excess in demand for dollars which arose in the foreign exchange market due to expectations of instability in the financial market.

<Figure 10>              Major Short- term Interest Rates 

<Table 18>         Daily Absolute Changes in Interest Rates¹⁾

(Unit : %p)

Notes:  1) Average of daily absolute changes

Sources:  Korea Investors Service,「KIS- LINE」

Among non- banks, the volume of bills discounted before the Korean thanksgiving holiday increased.  Yet, as the financial instability persisted, merchant banks began to face serious difficulties in selling bills because investment and trust companies (ITCs) 

and banks sought to avoid the increased credit risks involved with discounting of CP. Discounting activity was also slow at those merchant banks which have been most adversely affected by the exodus of funds from CMAs.  Merchant banks managed their funds conservatively while trying hard to secure stable sources of funds.  In light of their heavier dependence on discounting of bills for smaller firms, the serious conditions at merchant banks easily translated into serious financial troubles for small and medium- sized firms. 

The upshot of the troubles at financial institutions and the general cash- flow problems at both financial institutions and firms during the third quarter was the unexpected rise in interest rates.  The latest series of business failures is expected to have greater impact on the economy because they have, not surprisingly, led to a serious credit crunch, which has greatly paralyzed the flow of funds and put even relatively healthy firms at risk.  Short- term interest rates soared, making the interest rate yield curve become extremely inverted, and the interest rates were much

<Table 19>              Determinants of Interest Rates

(Unit: %, Billion Won)¹⁾

Notes:  1) The units for CB and Stock are in billion won, Unit for Other figures are changes from the corresponding period last year

2)Preliminary 

3) Estimates

Sources:  The Bank of Korea, 󰡔Monthly Bulletin󰡕, various issues

Korea Investors Service, KIS- Line

more volatile as well.  This was in large part due to developments in the foreign exchange market.  The spillover effects from the foreign exchange market to the domestic financial market became increasingly pronounced; recently, the intensity of interest rate arbitrage has varied directly with the volume of currency trading.

<Figure 11>  Term Structure of Interest Rates During the Third Quarter

<Table 20>             Firms' Shortage of Funds¹⁾

Notes:1) The figures from third quarter 1996 are estimates.  Savings denotes current GNP -  final consumption, thus includes foreign investment; Investment = Gross capital formation in the National Income Account 

2) Preliminary

3) Estimates

Sources:BOK, 『The Flow of Funds Account』, 『National Income Account』, Various issues 

Forecast

The fourth quarter interest rate forecast calls for a slight decline from the third quarter, yet the this forecast cannot be made with great certainty in view of the high level of uncertainty surrounding the Kia problem.  If there are more major bankruptcies, the risk premiums will rise further and prevent interest rates from declining, despite the country's sound economic fundamentals. 

The full implementation a new bond issuance system during the quarter may lead to an increase in bond issuance in the short- run and make interest rates more volatile. Since it is expected that new types of bonds, such as financial debentures of commercial banks and securities companies, and bonds for liquidation funds, will be introduced in the fourth quarter, some interest rate volatility is inevitable, despite payment guarantees by financial institutions.  Nevertheless, stability should return to the financial markets toward year end, by which time the foreign exchange market should have regained stability and foreign capital inflows should increase.  In sum, despite the greater uncertainties as to the outcome of the upcoming presidential election and the handling of financially troubled corporations, the sound economic fundamentals will eventually prevail and bring stability to both the financial and foreign exchange markets.  Interest rates should fall to around 11 percent as a result.

On the demand side, we do not expect any significant changes in the fourth quarter.  Corporate investment will remain weak until the current political and financial uncertainties clear up to a significant degree.  Instead of increasing their investment, firms will increase or reduce their production and inventories as changing economic conditions require.  CPI inflation will remain stable at around 4.0 percent, under the assumption that the BOK will not likely pursue a tighter monetary policy. Most worrisome in the financial market are the incessant rumors about further corporate failures: these tend to render financing difficult even for large corporations of good standing and exacerbate the credit crunch.

There are several factors which will have especially strong influence on interest rates in the fourth quarter.  Month by month, exports will continue to exceed last year's exports by about 14 or 15 percent, while demand for imports will languish. 

The resulting improvement in the current account balance would gradually ease the shortage of market liquidity and encourage overseas financial institutions to extend financing to domestic firms and institutions.  The situation will be further helped if a reasonable resolution is brought to the Kia debacle: this alone would prevent the international credit ratings of domestic financial institutions from being downgraded further.  What is more, the next upward adjustment of the ceiling on stock holding by foreign investors will help stabilize the capital market.  And with the normalization of market conditions, the surcharge on foreign financing would be reduced because the risk premiums would be lower.  If the financial turmoil which occurred due to the Kia debacle subsides, the corporate bond yield will soon begin to move downward and fluctuate between 11～12.5 percent, while the CD and CP rates would move between 11.4～12.5 percent.  It should be noted, however, that this projection is contingent on the assumption that there will be no more major bankruptcies.

<Table 21>              Interest Rate Forecasts¹⁾

(Unit : %)

Notes: 1) The figures for interest rates are period averages.  Other figures represent changes from the corresponding period of the previous year

2)Preliminary 

3)Forecasts 

Sources:  The Bank of Korea, Monthly Bulletin, various issues

  Korea Investors Service, ｢KIS- LINE｣

Financial Market Developments

Banking

Deposit Market

By the end of the third quarter this year, the total volume of bank deposits- - which are deposits in cash, CDs, and bills based on commercial and trade papers, and other such deposits- - held by deposit money banks, rose by 3.4 percent from the second quarter to 241 trillion won.  This large increase was primarily due to an enormous influx of funds into time and savings deposits, in particular, into the newly- introduced MMDAs (Money Market Deposit Accounts).  These accounts were so popular with the public that the vast sums of money that were poured into them more than offset the declines in the volumes of newly- issued CDs and bills based on commercial and trade papers.  The introduction of the MMDAs was made possible by the implementation of the Fourth Stage Interest Rate Liberalization Plan: since banks can now offer competitive rates on these new deposits, customers naturally transferred funds into them en masse.

Another factor which was responsible for the rise in total banks deposits was a sharp increase in domestic residents' foreign currency deposits.  These deposits were seen as a safe haven where depositors could protect the value of their funds against the anticipated depreciation of the won against the US dollar.

The volume of demand deposits, however, fell by 4.0 percent to 23 trillion won in the third quarter, wiping out the gain in the second quarter.  This decline was attributable not only to the continuous transfer of funds from demand deposits to high- interest yielding short- term products such as the new MMDAs but also to firms' urgent needs for working capital.  Many firms needed funds to weather the recession because of low profits or even losses, especially as the recession has dragged out for such a long period of time.  There were also seasonal factors as well, such as the beginning of the second half and Chusok, the Korean 

Thanksgiving holiday in September, which normally raise demand for short- term working capital.

As mentioned above, the total volume of time and savings deposits increased sharply during the third quarter.  They reached 161.4 trillion won by the quarter's end, a huge 7.7 percent gain from the previous quarter.  Obviously, the implementation of the Fourth Stage Interest Rate Liberalization Plan has contributed to this increase.  As it allowed banks to offer new, high- interest yielding savings accounts, most notably the MMDAs, the flow of funds from accounts at non- banking financial institutions, such as CMAs at merchant banks and MMFs at investment trust companies, into the savings accounts continued unabated from the previous quarter.  Furthermore, since the new MMDAs offers high liquidity in addition to high interest rates, they naturally attracted a large portion of the funds that had been invested in demand deposits and traditional types of time and savings deposits.  At the end of the third quarter, the volume of MMDAs was reported at 18.3 trillion won, including corporate savings deposits.

In spite of the especially high interest rates that banks offered, the volume of time deposits grew at a slower rate than during the previous quarter.  Some institutions including local governments made huge withdrawals, and time deposits were not so attractive compared to the MMDA and other new products.  Mutual installment savings deposits, which comprises a sizable share of the time and savings deposits, has declined as high- interest yielding products sold temporarily during the second half of last year began to mature.  Tax- exempt, long- term deposits were also less popular among savers compared with the previous quarter.

<Table 1>                     Bank Deposits¹⁾

(billion won, percent)

Notes: 1) End of period. The figures in parentheses are percentage changes from the previous quarter.

2) Estimates.

3) Forecasts

Source: The Bank of Korea, Monthly Bulletin, various issues.

The total volume of CDs issued during the third quarter is estimated to have fallen 12.4 percent from the second quarter to 25.9 trillion won.  The net volume of CDs issued also decreased, reversing the increase of the previous quarter.  This was largely attributable to the facts that 1) banks preferred RPs to CDs because the former are not subject to reserve requirements, and 2) firms avoided buying CDs because of their heightened needs for working capital.  The volume of bills based on commercial and trade papers continued to fall because issuance of them 

was reduced, even though the issuance limits on the amount and maturities of both CDs and bills based on commercial and trade papers had been abolished when the

<Table 2>              Time and Savings Deposits¹⁾

(billion won, percent)

Fourth- Stage Interest rate Liberalization Plan went into effect.

Deposits in foreign currency rose by a strong 10.0 percent in the third quarter, largely due to the great increase in domestic residents' holdings of foreign deposits. The rise was sparked by the latest series of corporate bankruptcies and the expectations it created on further weakening of the Korean won in the foreign exchange market.  As a result,  many firms were reluctant to convert their foreign deposits into won.  Non- residents' deposits in foreign currencies also increased as investment trust companies refrained from investing their funds in securities because 

of the possible meltdown of the Korean stock market.

During the fourth quarter of 1997, the total volume of bank deposits is projected to grow 4.3 percent to 251.2 trillion won.  Deposits in won are expected to increase by 5.4 percent.  This assumes that the rise in the volume of time and savings deposits will continue as a result of the implementation of the Fourth- Stage Interest Rate Liberalization Plan and the introduction of tax- exempt deposits designed exclusively for labor workers.

The volume of foreign deposits is expected to rise steadily by about 5.0 percent unless severe instability is brought about in the domestic financial market and foreign exchange market. The volume of bills based on commercial and trade papers is also expected to increase, while the volume of CDs will most likely decline.

There are several assumptions behind these forecasts, including a recovery in corporate investment and continued stagnation in the stock market, which would result in a continued flow of household and corporate savings into deposit money banks, although credit may become slightly easier in the financial market.  These forecasts also assume that the flow of funds between financial institutions and/or financial assets will continue for a while as the MMDAs and other new products attract more funds, and furthermore, that the issuance of debentures by banks will not significantly affect either the flow of money, the levels of short- term or long- term interest rates, or the profits of financial institutions, that is, if no serious action is taken to deal with the problem of non- performing loans at banks

<Table 3>        Interest Rates on Selected Bank Deposits¹⁾

(percent)

Loan Market

The total volume of bank credits- - which are loans in won, loans in foreign currencies, and loan guarantees and acceptances- - is estimated to have risen to 286.2 trillion won by the end of the third quarter, an increase of 3.7 percent from the previous quarter.  Loans in won, which represented 70 percent of total bank credits in the third quarter, rose by 4.6 percent to 203.8 trillion won, largely because of a huge increase in overdrafts and general loans.  Loans in foreign currencies grew at a sound rate of 5.5 percent from the previous quarter.  However, the volume of loan guarantees and acceptances continued to stagnate and actually declined slightly.

The volume of bills discounted grew only slightly by 2.0 percent in the third quarter to 25.1 trillion won as there was no sign of recovery in business activity and as banks remained reluctant to discount bills out of concerns for more 

bankruptcies of large firms. 

<Table 4>                      Bank Loans¹⁾

(billion won, percent)

The volume of overdrafts rebounded sharply from their slight decline in the previous quarter, rising 12.3 percent and amounting to 11.9 trillion won.  This was partly because the recession has dragged on for so long, but it was also an aftershock of the Kia debacle.  Not surprisingly, many firms found themselves unable to issue commercial bills to raise short- term working funds, so they had to resort to overdrafts. 

General loans in the third quarter recorded sound growth of 5.6 percent, rising to 108.0 trillion won.  This increase was primarily due to large sums of money drawn down by some large- sized firms which wanted to borrow from banks in 

advance at the end of July before the new regulations on cross- lending between affiliates of the same business groups took effect.  In addition to putting caps on such lending, these regulations stipulate that the amounts by which these loans exceeded the limits in July are to be paid down over the next three years. Secondly, banks continuously increased the volume of household loans and loans to small-  and medium- sized firms that have good credit ratings, while doing their best to reduce their exposure to large- sized firms due to understandable fears of another spate of bankruptcies.  It was also true that firms had cut back on their investment outlays.  Finally, the BOK continuously provided financial support for small-  and medium- sized firms according to the Anti- Bankruptcy Accord.

The volume of loans in foreign currencies, which are mainly used for corporate investment in facilities, is estimated to have reached 25.1 trillion won in the third quarter, a sound increase of 2.5 percent from the previous quarter.  Despite the fact that they have been cutting back on investment for a long time, firms have had increasing difficulties in raising new funds overseas and furthermore needed large sums of foreign currency to pay the principals and interest on overseas loans which they had taken out before the recession hit two years ago. 

<Table 5>             Loans with Banking Funds¹⁾

(billion won, percent)

<Table 6>        Interest Rates on Selected Bank Loans¹⁾

(percent)

Loan guarantees and acceptances marked a declining trend because banks tightened their credit standards in anticipation of more bankruptcies of large- sized firms and because the new BIS risk- based minimum capital requirement assigns a 100 percent risk weight to loan guarantees and acceptances.

For several reasons, the total volume of bank credits is projected to rise by 2.7 percent in the fourth quarter to 293.9 trillion won, a sluggish growth rate compared with that of the previous quarter.  Despite the best efforts of the government and financial institutions to stabilize the domestic financial markets, the current situation is not expected to change significantly any time soon.  Corporate demand for loans is not likely to rebound significantly for the time being either, because firms have little reason to invest more heavily in facilities.  Investment in facilities has in fact been weak for much of the past two years and will not likely turn up soon, even if private consumption expenditure may pick up temporarily due to the seasonal factors such as the Christmas holiday shopping season and the upcoming presidential election. What is more, the volume of loans to large- sized firms is not expected to increase, because banks will likely apply stricter lending requirements and will more carefully analyze the financial conditions not only of individual borrowing firms, but also of the entire business groups to which those firms belong.  To be sure, the new caps on cross- lending between affiliates of the same business group and the reduction in loan guarantees and acceptances and so forth will also serve to reduce the volume of loans to large- sized firms.

Bank Trust Market

By the end of the third quarter, the total volume of trust accounts at deposit money banks is estimated to have risen to 164.7 trillion won, a 2.4 percent increase from the previous quarter.  Despite the continuing inflow of funds into specific trusts, the volume of money- in- trusts did not increase so much as during the previous quarter because of the curtailed inflow of funds into corporate trusts, 

<Table 7>                    Trust Accounts¹⁾

(billion won, percent)

household trusts, and specific- purpose installment trusts.  Changes in the volumes of specific trusts and tax- exempt household trusts have had particularly significant influence on the overall change in the volume of bank trusts because they have attracted funds from expiring general nonspecific trusts. 

The total volume of household trusts recorded an 0.8 percent decline during the third quarter, a slower rate of decline than during the previous quarter.  The yield on these trusts has been increased as the market interest rates have edged upwards and as the transaction fees have been reduced to competitive levels, thus making these trusts more attractive.  The volume of corporate trusts fell 10.7 percent during the third quarter primarily due to a sudden outflow of short- term funds from bank trust accounts into savings deposits such as MMDAs.  The fact is that the newly introduced MMDAs have been so popular with customers that they paid 

little heed to specific purpose installment trusts, which offered the relatively high yields.  The volume of general nonspecific trusts decreased by 1.5 trillion won, reflecting the government's efforts to reduce the volume of trusts with fixed returns.  Development trusts did not increase so much, because the issuance limit on them had almost been reached. 

The volume of specific trusts showed relatively sound growth during the third quarter, rising to 41.8 trillion won.  The rates of return on specific trusts are determined by the rates of return on the investments that are specified by the trust investors.  As the short- term market interest rates were high during the quarter, institutional investors including insurance companies invested in specific trusts a large part of their funds that had become available from expired nonspecific trusts. The volume of tax- exempt household trusts, introduced in the fourth quarter of 1996, showed continued growth, reaching 5.9 trillion won in the third quarter. Personal pension trusts also grew steadily because the banks began to offer a wider range of financial services to non- corporate customers. 

The volume of money- in- trusts is expected to rise by 4.0 percent to 171.2 trillion won by the end of the fourth quarter.  This would be a slightly higher rate than that recorded in the previous quarter.  It is believed that the outflow of funds from trust accounts which had been induced by the bank trust reforms implemented in May of 1996 may finally have stopped in the second quarter, and that the volume of personal pensions and tax- exempt trusts will continue to increase. The reasons are: 1) the Supreme Court recently ruled that payment of retirement allowances prior to other liabilities was unconstitutional, and 2) the new tax- exempt workmen's preferential trusts will be available in the fourth quarter.  Furthermore, it is expected that banks will promote specific trusts which offer separately taxed financial products in order to offset losses in the trust management stemming mainly from the low trust management fees.  (Limits had been imposed on these fees when the bank trust reforms went into effect in May.)  Banks are expected to manage their assets conservatively in the fourth quarter, just as they did during the third quarter.  That is, banks would prefer to extend more high- return and low- risk household loans and other such loans but limit their purchases of CP and loan 

guarantees in an increasingly uncertain situations.  The volume of loans to well- performing small to medium- sized firms is expected to rise because the loan market will likely remain highly segmented and because the government is strongly encouraging financial institutions to make loans to such firms. 

<Table 8> Loans Funded by Bank Trusts and Investment in Securities¹⁾

(billion won, percent)

Non- bank Financial Institutions

Overview

In the third quarter of 1997, the total volume of deposits at non- bank financial institutions (NBFIs) grew slightly faster than during the previous quarter, at a 4.4 percent rate.  The issuance of own paper by MBCs (Merchant Banking Corporations) and the volume of CMAs fell sharply, but Commercial Paper (CP) discounting activity at MBCs was up slightly.  The total volume of deposits at Investment and Trust Companies (ITCs) continued to increase due to strong demand for long- term bond funds.  However, Mutual Savings and Finance Companies (MSFCs) continued to experience anemic growth in total deposits because the interest rate differential between their products and those offered by banks continued to narrow.  The total volume of deposits at Credit Unions (CUs) and Community Credit Cooperatives (CCCs) grew slightly more slowly than during the previous quarter.

The rate of growth in total credits at NBFIs changed little from the previous quarter.  During the third quarter, NBFIs were very conservative in their lending to small and medium- sized firms in the wake of the bankruptcies of the Jinro and Kia groups.  Although the volumes of factoring and trade bills fell sharply, the volume of CP discounting recovered slightly.  Many firms resorted to CP in order to satisfy their working capital needs because of low investors' interest in corporate bonds and stocks. The total volume of credits at regional financial institutions, such as Mutual Saving and Finance Companies (MSFCs) and Mutual Credits (MCs), showed sluggish growth since they were also very concerned about the increasing default risks of small and medium- sized firms.

In the fourth quarter, the total volume of deposits at NBFIs is expected to grow at a slightly lower rate than during the third quarter.  Even though the issuance of own paper and the volume of CMAs at MBCs are expected to grow at a fairly high rate, a sharp decline in CP discounting at MBCs will cause a contraction in the total volume of deposits at NBFIs.  The stock market will likely remain stagnant, and the total volume of deposits at ITCs is expected to grow at a slower rate than during the third quarter.

<Table 9>               Deposits and Credits at NBFIs¹⁾

(billion won, percent)

Notes: 1) End of period.  The figures in parentheses are percentage changes from the previous quarter.

2) Deposits at non- bank financial institutions = Merchant Banking Corporations (issuance of their own papers + CMAs + sales of bills) + Investment and Trust Companies (beneficiary certificates + stock savings) + Mutual Savings and Finance Companies (deposits) + Mutual Credits (deposits) + Postal Savings (deposits + RP).

3)Credits at non- bank financial institutions = Merchant Banking Corporations (paper discounts) + Mutual Savings and Finance Companies (loan + paper discounts) + Mutual Credits (loans) + Credit Unions (loans) + Community Credit Cooperatives (loans).

4) Estimates. 

5) KIF Forecasts.

Sources: The Bank of Korea, Association of Merchant Banking Corporations, Association of Mutual Savings and Finance Companies, and Association of Credit Unions, Korea Credit Rating Agency.

Regional financial institutions, such as Credit Unions (CUs) and Community Credit Cooperatives (CCCs), should see some growth in total deposits in the fourth quarter. It is expected that they will strive to develop more personal relationships with regionally based customers.  Due to the narrowed differential in interest rates between banks and regional financial institutions, however, their total deposits will grow more slowly than during the third quarter. 

The total volume of credits at NBFIs is expected to rise about 3.2 percent in the fourth quarter.  As exports and domestic consumption increase, there will be an increase in CP discounting because firms will have greater needs for short- term working capital than during the third quarter.  However, MBCs will continue to be cautious in their lending to firms; they will greatly reduce their CP discounting.  The regional financial institutions, including MSFCs and MCs, will continue to make more loans to households rather than to firms, but this will cause total credits to increase slightly.

Merchant Banking Corporations

During the third quarter of 1997, the total volume of deposits at Merchant Banking Corporations (MBCs) fell by 0.4 percent from the previous quarter.  Despite the rise in discounting of CP, the total volume of deposits at MBCs did not increase appreciably compared with the previous quarter.  The declines in the total balance of CMAs and the issuance of MBCs' own paper were due to the implementation of the Fourth Stage Interest Liberalization Plan and the MBCs' own financial crises. Institutional investors, such as bank trusts and ITCs, not only stopped purchasing newly issued CP but even refused to roll over matured CP due to the higher default risks of many firms including the Kia group.

<Table 10>               Deposits and Credits at MBCs¹⁾

(billion won, percent)