Editor

Hae Wang Chung

Associate Editor

Haesik Park

English Editor

Emily Adler

Contributors 

Lead Article

Bon- Sung Gu and Jieun Lee

Macroeconomic Developments

Gongpil Choi

Sang Whan Kim and Han- Yung Jung 

Financial Market Developments

JaeYoun Lee

Bung Duck Kim

Jieun Lee

Bon- Sung Gu

Copyright by

Korea Institute of Finance 

Seoul, Korea

Printed by Orom System Co.

Ministry of Culture & Public Information

Registration No. Ba -  1891

Registration on April 17, 1993 

KOREAN FINANCIAL

REVIEW

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

QUARTERLY ANALYSIS & FORECAST

Vol. 8, No. 2                                Summer 1998

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

CONTENTS 

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

Lead Article: An Empirical Investigation on the

Interrelationship Between KOSPI 200 and

KOSPI 200 Option 󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜

President and Publisher

Macroeconomic Developments 󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜 

Hae Wang Chung

Current Status and Prospects

Money and Interest Rates 

Financial Market Developments 󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜

Banking 

Non- Bank Financial Institutions 

Money and Capital Markets

Insurance 

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏 

Korean Financial Review: Quarterly Analysis & Forecast is published by the Financial Outlook Team of the Korea Institute of Finance (KIF). The views expressed are those of the authors, and do not necessarily reflect official positions of the KIF.

For subscriptions, please direct requests and inquiries to the Financial Outlook Team, Korea Institute of Finance, Seoul, Korea; Telephone, (82- 2) 3705- 6327, Fax, (82- 2) 3705- 6309. 

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An Empirical Investigation on the Interrelationship 

Between KOSPI 200 and KOSPI 200 Option

Bon- sung Gu and Jieun Lee*

I. Introduction

In the complete market, the stock index and any financial derivatives based on it must exhibit simultaneity with respect to price changes. A lead- lag relationship between those prices may arise, however, if any financial market restrictions exist which limit or prevent arbitrage transactions. Many of the empirical studies about lead- lag relationships focus on the phenomenon where the change in the price in one market consistently occurs before or after that in another market over time. Such studies have been done in the case of stock indices and their futures. For example, Stoll and Whaley (1990), Chan (1992), and Huang and Stoll (1994) give empirical evidence documenting that the return on stock index futures led the return on the cash market by 5 to 45 minutes. On the other hand, Kawaller, Koch and Koch (1987) use the S&P 500 and the S&P 500 index option to show that the stock return led the futures return, even if the relationship is far weaker. 

The purpose of this study is to empirically investigate the lead- lag relationships between the KOSPI 200 and the KOSPI 200 Option. This information will be used to evaluate the informational roles of KOSPI and KOSPI Option in the price discovery of the Korean Stock Exchange. For data, the call option whose maturity is the nearest- the- month is used for the KOSPI Option, for the period from July 1, 1997 to June 30, 1997. The reason that the nearest- the- month option is taken is twofold. First, this option is the most actively traded call option in the option market, and 

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second, data on this option were available for the entire sample period. Both these conditions are necessary for analyzing the stable interrelationship over time. 

In this paper, we derive the simple econometric model directly from the Black- Scholes option pricing formula to test the lead- lag relationships between the KOSPI and the KOSPI Option. The empirical results show that the KOSPI leads the KOSPI Option by one day for several reasons. Among them are the high simultaneity in the daily price changes and the gap in trading hours. The KOSPI Option market closes 15 minutes after the stock market in the afternoon session. Such factors gave rise to the simultaneity of the two prices at the end of day, weakening the lead- lags in the price discovery process for more than one day. The use of closing prices also contributes to the KOSPI lead. Our analysis shows that the high simultaneity is partly due to increased risk- aversion of market participants in the KOSPI Option market, which minimizes long- term commitment in the leveraged options. In part our results are similar to the tick theory, although other statistical properties similar to the martingale property of option price changes also play a role.

This paper is organized as follows. Section II addresses the previous theoretical and empirical research on the interrelationships between the stock index and stock index option prices. In Section III, we present empirical evidence on the lead- lag relationship between the two markets. In doing this, we examine the correlation structures between out- of- money and in- the- money options, as well as regressions based on the fundamental equation arising from the Black- Scholes option pricing model. The concluding remarks follow in Section IV. 

Ⅱ.Causality between the Stock Index Option and the Stock Index

1. Theoretical Framework

In the complete market, the call option on the stock index is equal to a leveraged long position in the stock index. This means that any implicit price of the stock 

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option can be inferred from the trading price of the stock index. Assuming no transaction costs and non- stochastic interest rates, the Black- Scholes option price formula can be written as:

where 

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where the partial derivatives are :

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or 

2. The Causal Relationship Between Stock- Index Option and Stock- Index 

One of the major benefits of option trading is that it completes incomplete markets. Several authors such as Ross (1976) and Hakansson (1982) show that in an incomplete market, the option can increase the utility of investors by creating new investment opportunities and diminishing price volatility in the cash market. The introduction of an option market makes an asset market more efficient, particularly if the asset market is subject to asymmetry of information, restrictions on financial innovation, or illiquidity. 

The existence of a stock option market may offer informed market participants an opportunity for speculative trade. Black (1975) argued that in the presence of an option market, informed traders prefer trading in the option market to trading in the underlying asset market. Option trading reduces the cost of hedging, and the leverage effect minimizes the cost of capital and provides more flexible investment opportunities. Thus when these sorts of microeconomic effects are prevalent, it is more likely that the option market will lead the cash market. 

As previously mentioned, the option market may enhance the efficiency of the underlying asset market. By using the microstructure approach, John, Koticha, and Subrahmanyam (1993) show that the investment strategy of option market traders who utilize the short sale and leverage effect may help reduce the asymmetric information problem between traders in the underlying asset market. This is achieved by reducing the bid- ask spread and by increasing the amount of liquidity under uncertainty. In particular, the informational effect on underlying assets will enhance the informational efficiency in the underlying asset market. This implies that price changes in the option of a stock index may lead to a price change of the stock index. 

On the other hand, opening an option market may cause adverse effects as well. 

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Large institutional traders or hedge fund managers, for instance, may increase the volatility of the cash market by taking high leverages in the option market and seeking arbitrage opportunities through program trading. Thus, they may use their power in the cash market to intentionally create arbitrage gains. Frequent arbitrage trading may distort the efficient functioning of the cash market and increase the price volatility when the market is too thin or too illiquid.

3. Previous Empirical Studies

As discussed in the previous section, the interrelationship between the underlying asset market and its option market crucially depends on the reaction of investors to the flow of information. Volumes of literature investigate the price relationship between an individual stock and its option. For instance, Bhattacharya (1987) and Anthony (1988) show that the price of an individual stock option leads that of the underlying assets, and a similar relationship is also observed with a change in trade volume.  This result can be inferred from Black (1975)'s conjecture that the prices of financial derivatives should lead those of underlying assets.

Stephan and Whaley (1990), on the other hand, use stock options traded in the Chicago Board of Option Exchange during the first quarter in 1986 to show that the stock prices lead by about 15 minutes, which contradicts the informational role of options. Concerning this result, Chan, Chung and Johnson (1993) note that if the minimum tick size of an option is far bigger than that of the individual stock, it causes such a relationship by limiting the frequency of option trading. Therefore, the informational role of the option market is highly dependent on the microstructure of the option market, actual trading hours, and the characteristics of traders. 

Most existing empirical studies that employ data in five minute intervals in a specific trading day, however, do not investigate the dynamic adjustment on the stock option price such as the maturity effect and the effect of interest rate change. It is also necessary to take into account the microstructure of both option and underlying asset markets. Also, the option on the stock index is quite different from the 

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individual stock option, in the sense that the stock index cannot be determined solely by private information on the individual stock, but requires additional information on the economy as a whole. So the lead- lag relationship of the KOSPI and the KOSPI Option will be more evident only if longer trading intervals are considered. 

III. Empirical Analysis 

1. A Model of Lead- Lag Relationship 

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2. Data

The data used are the closing prices from the Korea Stock Exchange on the KOSPI 200 and the KOSPI 200 Option from July 1, 1997 to June 30, 1998. Every month there are options available maturing in March, June, September, and December, and two nearest- the- months. The first four options can be traded up to a year, but the others are traded only for three months. The KOSPI Option closes on weekdays at 15:15, though the stock market closes at 15:00.  The last trading day of each option is the second Thursday of the month when the option expires. 

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In the sample period, the limit on the daily price change for stocks listed on the Korea Stock Exchange was 8 percent before March 2, 1998 and was increased to 12 percent thereafter. There is no daily limit on the KOSPI Option price, except if a change is more than 10 percent of the tick price, in which case the option price is restricted to the theoretical price published by the Korea Stock Exchange. The minimum tick prices for stocks are within 0.1～1.0 percent of their prices.  That for the KOSPI Option is 0.05 point equal to 1.67 percent of the option premium for options over three points, and 0.01 point equal to 0.33 percent for the option premium below three points.

We use option data with upcoming maturities for empirical analyses, since these are more actively traded than distant options. Therefore, we use the data on options within a month of maturity. In addition, we have taken the data whose exercise prices are most widely quoted during the whole sample period, since there are many strike prices in the KOSPI Option throughout the sample period. Sometimes, we also select sample periods when options are actively traded since some options experience long periods of inactivity that would be of little use for the study.

Figure 1 shows the trend of the estimated theoretical prices and market premiums of the KOSPI Option whose exercise prices are 52.5, 55.0, and 57.5 for the sample period between October 29, 1997 and June 27, 1998. Whatever the exercise prices are, both the theoretical and market prices seem to have simultaneity in the statistical sense, perhaps because most of the call options have been in- the- money options and there has been a strong expectation of a continuous fall in the KOSPI. It can also be seen that both the trading volume and the open interest tend to rise when the gap between the theoretical prices and the market prices of the KOSPI Option narrowed. 

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<Figure 1> The Trend of the Gap Between Market Price and Black- Scholes Price Of KOSPI Options (X=52.5, 55, 57.5)

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3. Interrelationship

<Figure 2>  Option- Price Model with Path- Dependent Probability Distribution 

( p+q = r′+s′ = r″+s″ = 1)

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<Table 1>      Correlations Between Option Prices and KOSPI Variables

Note: 1) Number of observations where a higher than average exercise price is recorded.

2) Number of observations where a lower than average exercise price is recorded.

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4.Estimation of the Lead- Lag Relationship between KOSPI and KOSPI Option 

As a first attempt to investigate the lead- lag relationship between the KOSPI and the KOSPI Option, we estimated the following regression equation using exercise prices ranging from 50.0 to 70.0. The options data are daily and taken from the periods when trading volumes and open interests are consistently observed. Our study looks for the lead or lag over a one day period, since most previous studies used high frequency data or real time data. 

Table 2 summarizes the estimation results using equation (7)

calculated by using the heteroskedasticity- autocorrelation consistent covariance matrix suggested by Newey and West (1987). 

implies that the price changes in the KOSPI and the KOSPI Option occur more or less simultaneously, although this result could be because daily data were used for the empirical analysis, facilitating ex- post adjustment of the KOSPI Option premium in response to the daily change of the KOSPI. 

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- 16 -

Figure 1 also shows that the conditionally expected value of the gap between the intrinsic value and the market premium of the KOSPI Option nearly converges to zero. Such a property can be viewed as the average market premium of the KOSPI Option approaching its intrinsic value over time, which can be the case when excess returns on the KOSPI Option are not available to the public.

To resolve this difference, equation (7) can be interpreted as the case in which the rate of increase in the call option price falls as the KOSPI rises.  For example, if the KOSPI rose yesterday, then we would expect the price of the KOSPI Option today to rise. If such change is larger than expected, however, then the KOSPI Option could be over- valued. In that case, the change may not be sustainable in the long run and the market premium could fall. Therefore, if the option market is overrun by traders who maximize their short- term trading gains or heavily depend on the program trading, such long- term arbitrage opportunity would fail. Then the KOSPI 

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<Table 2>    Main Regression Results on the Lead- Lag Relationship 

Note: 1) ( ) is p- value and * is significant at the 5 percent confidence level 

2) [ ] denotes the average KOSPI in the sample periods

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3) The standard errors are estimated by the Newey- West (1995) method

<Table 3>    Further Regression Results on the Lead- Lag Relationship

Note: 1) ( ) is p- value and * is significant at the 5 percent confidence level 

2) [ ] denotes the average KOSPI in the sample periods

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3) The standard errors are estimated by the Newey- West (1987) method

Option price would decrease faster than its intrinsic value. Therefore, this kind of reversal observed in our test is only possible if there is an opportunity for short- term arbitrage or high risk of exposure from an overpriced option. This observed reversal would be more prominent in the absence of excess expected returns, i.e. if the martingale property holds. 

Table 3 provides further verification of equation (7), since the explanatory variables do not include the value of the partial derivatives. Equation (7) can be written as follows:

Ⅳ. Concluding Remarks

This study has been an investigation into the interrelationships between the KOSPI 

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200 and the KOSPI 200 Option, using daily data from July 1, 1997 to June 30, 1998. Due to the leverage effect, the KOSPI Option enhances informational efficiency in the KOSPI. In spite of the mixed results of our empirical analysis, we still believe that the option market must lead the underlying asset market. 

Our empirical analysis led us to the opposite result, namely that the KOSPI leads the KOSPI Option. The study goes on to explain how this reversal is caused by institutional factors, such as differences in the trading hours, and also by specific characteristics of the option market, such as the high risk- aversion of market participants and the high proportion of short- term trading. Each of these factors diminished the informational role of option market towards the cash market, though we do believe that the options market has an intrinsic role of disseminating information on future price movements of the KOSPI. 

This study is not complete, however; it does not consider the very short- term interactions between the two markets, since only daily data are used, and also does not fully account for strategic trading effects of large traders and long- lived information.  In future studies, it will be necessary to consider the implications of the trading volume, the size of open interest, and the effects of listing the put option, individually and in combination.

- 21 -

References

Anthony, J. (1988), "The Interrelation of Stock and Option Market Trading-  Volume Data," Journal of Finance, 43(4), 949- 964.

Bhattacharya, M. (1987), "Price Changes of Related Securities: The Case of Call Options and Stocks," Journal of Financial and Quantitative Analysis, 22, 1- 15.

Black, F. (1975), "Fact and Fantasy in the Use of Options," Financial Analysts Journal 31, 36- 41.

Chan, K. (1992), "A Further Analysis of the Lead- Lag Relationship between the Cash Market and Stock Index Futures Markets, Review of Financial Studies, 5, 123- 152.

Chan, K., Y. P. Chung, and H. Johnson. (1992), "Why Option Prices Lag Stock Prices: A Trading- Based Explanation," Journal of Finance, 48(5):1957- 1967.

Cox, J. C. and M. Rubinstein. (1985), Options and Markets, Prentice- Hall.

Huang, R. and H. Stoll. (1994), "Market Microstructure and Stock Market Predictions," Review of Financial Studies 7, 179- 213.

Kawaller, I. G., R. D. Koch and T.W. Koch. (1987), "The Temporal Price Relationship between S&P500 futures and the S&P500 index," Journal of Finance, 46, 1309- 1329.

Kumar, R., A. Sarin, and K. Shastri. (1998), "The Impact of Options Trading on the Market Quality of the Underlying Security: an Empirical Analysis," Journal of Finance, 53(2), 717- 732. 

Hakansson, N. (1982), "Welfare Aspects of Options and Supershares," Journal of Finance, 37, 977- 1004.

John, K., A. Koticha, and M. Subrahmanyam. (1993), "The Microstructure of Options markets: Informed Trading, Liquidity, Volatility and Efficiency," Working Paper, New York University.

Merton, R. (1973), "Theory of Rational Option Pricing," Bell Journal of Economics and Management Science, 4, 141- 83.

- 22 -

Newey, W. K. and Kenneth D. West (1987), "A simple, positive semi- definite, Heteroskedasticity and Autocorrelation consistent covariance matrix", Econometrica, vol. 55, 703- 708

Ross, S. (1976), "Option and Efficiency", Quarterly Journal of Economics 90, 75- 89.

Safvenblad, P. (1997), "Lead- Lag Effects When Prices Reveal Cross- Security Information," Working Paper, Stockholm School of Economics.

Stephan, J. and R. Whaley. (1990), "Intraday Price Change and Trading Volume Relations in the Stock and Stock Option Change," Journal of Finance 45(1), 191- 220. 

Stoll, H. R. and R. E. Whaley. (1990), "The Dynamics of Stock Index and Stock Index Futures Returns," Journal of Financial and Quantitative Analysis 25, 441- 468.

- 23 -

Macroeconomic Developments

Current Status and Prospects

Economic growth

Korea's sharp economic contraction continued into the second quarter, bringing the growth rate down to - 4.9 percent. Among other factors, a severe credit crunch and economic shocks associated with the widespread restructuring efforts explain the severity of the ongoing recession. As shocks from the financial crisis gradually spread into the real sector of the economy, the decline in growth became increasingly visible across broad sectors of the economy. Many observers now begin to worry whether whole industrial base may be in jeopardy due to the continued severity of the recession, which goes far beyond the usual shedding of excess capacity that typically takes place during economic contractions. For example, investment in equipment and construction shrank by 43.1 and 25.6 percent, respectively, while private consumption also contracted by 11.8 percent from the previous year. The current account surplus that has surfaced since the crash was largely the result of falling imports, which mirrors falling domestic demand.

During the second quarter, Korea's external economic environment gradually deteriorated below what was experienced during the first and second oil shocks in the 70s. Internally, unemployment is climbing at an alarming rate; externally, the yen is weakening and reforms throughout Asia are stalled. The severity of the economic depression in the area demonstrates the need to combine Korea's recovery efforts with substantial restructuring efforts in other Asian countries as well.

In Korea, the banking sector poses the most serious problem. Massive non- performing loans place a serious burden on the already fragile financial system, and also aggravate the credit crunch problem that has been paralyzing

the corporate sector. Unless this vicious circle is broken, Korea's economic vitality and long- term prospects of economic recovery may be hurt.

- 24 -

<Table 1>                   Economic Growth¹⁾ 

(percent)

Note: 1) Percentage changes from the previous year. The figures for the second quarter of 1998 are estimates. The figures after the second quarter of 1998 are forecasts.

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

the corporate sector. Unless this vicious circle is broken, Korea's economic vitality and long- term prospects of economic recovery may be hurt.

It should be emphasized that the dramatic drop in growth rates for the second quarter is primarily due to weakening domestic demand. In particular, equipment investment dropped 43 percent from the corresponding period in the previous year, mainly due to a severe credit crunch in the financial market as well as poor sales and the low level of capacity utilization. Also, the decline in public sector construction projects created a 25 percent cut in construction investment.

During the second quarter, industrial production of automobiles, equipment facilities, and machinery suffered a drop in sales of more than 10 percent, though the shipbuilding industry was still enjoying backorders from previous years. The depression in sales is most acute for small and medium- sized firms, which do not have sufficient reserves or alternative financing sources to absorb continuing losses. The operating ratio in the manufacturing sector approached 60 percent as work hours have been cut, and further dismantling may be necessary. 

- 25 -

<Figure 1>           Contribution to Economic Growth

Source: The Bank of Korea, National Accounts, Various issues. 

<Figure 2>             Industrial production index

Source: National Statistical Office, Monthly Statistics of Industrial Production, various issues.

- 26 -

As of yet there are no signs of even a modest recovery, as leading investment indicators continue to fall. Orders for machinery, for example, fell 44.4 percent during the two months of April and May. The most noticeable contraction in investment occurred in the construction industry, where domestic construction orders and applications for building permits plunged 60 percent from April to May. Furthermore, simultaneous reductions in shipping and inventory signal increasing chances of a prolonged recession, following a pattern similar to that in Japan.

<Table 2>                 Industrial Activity Index

(percent)

Note: 1) end of period 

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

- 27 -

Also contributing to the depressing economic situation was the lack of a consumption effect to counter the business decline; private consumption declined 11.8 percent, which is more than the decline in income. All significant determinants of consumption, including disposable income, wealth effect, and liquidity constraint also showed sharp deterioration. This excessive sensitivity of consumption to changes in economic conditions underscores the seriousness of current situation; households see the deep wage cuts, increased unemployment, asset deflation, and increased uncertainty as leading to a drastic decline in permanent income.

In the overseas sector, export volume continued to expand at 23.3 percent, aided by the won's depreciation relative to other competing currencies in Asia. Imports fell by 24.8 percent, reflecting continued low levels of domestic demand. Since the Korean won has appreciated against the U.S. dollar over the first two quarters, and domestic financial institutions are reluctant to extend trade credit, overall trade remained sluggish. Trade financing was also hurt by the overall contraction of bank lending and the discounting of trade bills. Especially for small and medium- sized traders, increased insurance fees and guarantee premiums for their trade- related financing, combined with banks' practice of discounting trade bills, effectively made any overseas trade impracticable. Korean trade was also hurt by the recession in Southeast Asian countries, traditionally a major export market for Korea.

<Figure 3>               Real Effective Exchange Rate 

Source: J.P.Morgan

- 28 -

Another cause for concern is the depression of real estate prices, which can lead to a downward spiral in asset prices. The authorities' commitment to structural reform has forced firms to sell off their non- business related real estate in large volumes, depressing prices. This development is particularly disruptive for those banks who accepted real estate as the sole collateral for their loans to businesses, and now see the value of their assets declining. 

Increasing numbers of business bankruptcies have also resulted in a real estate price decline, which further dampens consumption through negative wealth effects. Real estate deals did pick up slightly in June, but that hopeful sign turned out to be just a short- term rebound after the initial stage of sell- offs was completed. Measures of real estate market pressure, that focus on the gap between the long- term equilibrium price and the current price, indicate that the first half of the year showed continuous deflationary pressure, signalling further delays for recovery in the real estate market.

<Figure 4>                Inventories and Shipments

Note: 3- month moving average

- 29 -

According to measures of the current depth of recession (CDR), the current downturn in Korea is unprecedented, far surpassing those caused by the oil shocks during the 70s. The current contraction is distinctive not only for the speed of collapse, but also for its breadth and severity of impact.

<Figure 5>        Asset Deflation Pressure and Real Estate Prices 

Note: Asset deflation pressure index = land price -  potential land price. Potential land prices are estimated using the following equation based on data from the first quarter of 92 to the fourth quarter of 97.

Change of land price = f(yearly dishonored bill rate, money growth rate, stock price, time lag variable of land price growth rate)

<Table 3>              Oil shocks vs. Currency Crisis

(percent)

Note: The figures are yearly rates in percentages. The figures in parentheses are maximums and minimums for the period. Figures for 1998 are estimates. All data were transformed into growth rate form before combining them into a composite number.

- 30 -

The widespread nature of the recession is also shown by measures of industrial activity that take into account production, inventory, shipment, operating ratio, and number of days worked per month. This measure of severity shows a rapid scaledown of industrial activity across the whole spectrum of industries, with the exception of the shipbuilding and communications industry. The slowdown is also evidenced by increasing business failures. In prior recession periods, the average number of failures was 2 to 2.5 times greater than during a period of expansion. In the current crisis, business failures are 10 times their level during the 1990- 91 expansion. Regional studies of Pusan, Inchon, and Kwangju show that this pattern of business failures is also present in provincial areas.

<Table 4> Indicator of the Depth of Manufacturing Recession (Period Average)

(percent)

Note: 1) Severity of contraction is measured by an unweighted average of year- to- year percentage changes in industrial output, inventory, shipment, utilization and monthly working days, which are included in the quarterly release by the government statistical office. 

2) The figures in parentheses show maximums and minimums for the period 

- 31 -

<Figure 6>             Current Depth of Recession (CDR)

Note: CDR indicates the severity of recession. 

<Table 5>      Average Number of Firms with Dishonored Bills

During the third quarter, business is expected to contract further with the strong push for structural reforms in both the banking and corporate sectors. Continued recession in Southeast Asia frustrates Korea's hopes of increasing exports, which will begin to show signs of weakening in the second half. The economy is expected to contract by 5.2 percent in the third quarter, mainly due to financial instability and demand contraction. Investment in equipment and construction will fall by 37.5 and 24.5 percent, respectively. General economic recovery will depend on the degree of success in the export drive, since domestic demand will most likely remain weak

- 32 -

<Figure 7>                    Recession by region

Note: 1) Industrial production growth rate is the average from January to May 98, ratio of dishonored bills is the average from January to April, unemployment rate is the average from January to May, CPI is the average from January to June.

2) SE(Seoul), PU(Pusan), TA(Taegu), IC(Inchon), KJ(Kwangju), TJ(Taejon), UL(Ulsan), KG(Kyonggi), KW(Kangwon), CB(Chungbuk), CN(Chungnam), JB(Chonbuk), JN(Chonnam), KB(Kyongbuk), KN(Kyongnam), CJ(Cheju)

despite strong expansionary measures. For instance, a 12.1 percent contraction in private consumption will pull down the overall growth rate during the quarter. Unfortunately, net export to growth will also decline, as exports are projected to increase by only 16.2 percent, while imports will shrink by 20.5 percent. 

Korea's investment environment will continue to be unfavorable during the third quarter, since the increased uncertainty generated by closure of financial institutions and increased mergers and acquisitions will hardly foster investor confidence. On the positive side, the Korean government has reached an agreement with the IMF to allow the fiscal deficit to expand up to 4 percent of GDP (7.9 trillion won). This money will mainly be used to support the social safety net and increase social overhead capital (SOC) expenditure. Given the time lag of 2 to 3 quarters, however, positive effects from an expansionary fiscal policy cannot be expected before early next year.

Other indicators also give little hope for recovery in the next two quarters. 

- 33 -

Specifically, orders and imports of machinery, a leading investment indicator, give no indication of economic recovery in the next two quarters. Especially hard hit is the construction sector; building permits and domestic construction orders are expected to fall by 61.7 percent and 60.5 percent, respectively. Consumption decline is by far the most disturbing development, since in addition to actual falls in income, future prospects for continued income decline create negative expectations, and completely paralyze the smoothing property of consumption. Consumption decline is directly related with the severity of recession, and the severity of this recession is evidenced by the recent decline of the marginal propensity to consume (MPC).

<Figure 8>           Capital Stock Adjustment Pressure

Note: Capital stock adjustment pressure = production growth rate -  production capacity growth rate. The (+) sign forecasts the expansion of investment in facilities and, the (- ) sign forecasts the reduction of investment in facilities.

On the external account, the growth rate of export volume will shrink gradually due to sluggish demand in Asian countries. By the year end, this pattern will cause a decline in net exports.

In the labor market, continued economic depression will manifest itself through 

- 34 -

rising unemployment. Extensive financial restructuring is likely to cause payroll cuts of up to 30 percent, as well as unemployment figures even in excess of scheduled layoffs. Unemployment in the third quarter is expected to reach 1.6 million workers, since as of June the unemployment rate had already reached 7.7 percent without even including the newly unemployed in the banking sector.

Prices and Wages

The CPI index showed signs of a moderate increase during the second quarter. The stable won/dollar exchange rate and drastic cuts in domestic demand contributed to low inflation rates. Manufactured goods recorded a price jump of 12.3 percent, while agricultural products showed only a modest hike of 5.0 percent. Services prices were also quite stable, increasing at the moderate rate of 6.0 percent. The PPI index also exhibited a similar pattern, recording an increase of only 15 percent in June. With stable or declining commodity prices, the PPI tends to decrease. Nominal wages recorded the first negative growth since 1970, sparking concerns of deflation.

<Table 6>                     CPI and Wage¹⁾

(percent)

Note: 1) Percentage changes from the previous year. 

 2) The figures after the second quarter of 1998 are forecasts

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

 The Bank of Korea, Monthly Bulletin, various issues

 Ministry of Labor, Report on Monthly Labor Survey, various issues

- 35 -

<Figure 9>       CPI inflation Rate and Sectoral Contributions

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

Given the stabilized won/dollar exchange rate, the most important factors for price movements in the third quarter will be dwindling domestic demand, a serious labor market situation, and unfavorable world market developments. The surplus situation in the commodities market will continue to put downward pressure on prices, even taking into account possible erratic behavior in food and energy prices associated with the phenomenon known as El Ñino. It is striking that the depressed economy is actually lowering services prices, since in previous episodes lower productivity in the non- tradable sectors brought about services price- induced inflation.

The PPI index during the third quarter will decrease by 14.1 percent, thanks to a combination of stable agricultural prices, low oil prices and wage cuts that contribute to import price stability. The time lag of approximately one quarter between currency depreciation and PPI inflation is another factor that should cause the PPI to moderate in the third quarter. Wages that will continue to slide in the presence of ever increasing unemployment will also have an dampening effect on the PPI.

The increase in CPI index will also be moderate in the second half, projected to reach just 7 percent due to depressed consumption and stability in commodity prices, 

- 36 -

particularly those commodities used for producing export items. Far from worrying about inflation, it is likely that significant deflationary pressure is mounting throughout Southeast Asia as crisis countries try to boost exports by driving down their export prices. Since inflationary factors are already well taken into account in the CPI during the first half, the second half price movements will be dominated by deflationary forces that result from sheer lack of demand. Overall, the likelihood of inflationary pressure in the current recession is quite small.

Balance of Payments

Korea recorded a record trade surplus of 11.7 billion dollars during the second quarter, largely due to a drastic cut in import demand. Similarly, current account surplus reached 11.9 billion dollars as the trade balance improved and transfer payments from overseas Korean residents increased significantly. The capital account recorded a 2.1 billion dollar surplus. Surpluses in both the current and capital accounts helped foreign reserves climb by 11.1 billion dollars to increase available foreign reserves to 37 billion dollars by the end of the second quarter. Increased reserves in turn helped stabilize the won/dollar exchange rate at 1,373 won by the end of June.

Despite the current account surplus, exports did suffer some losses compared to the previous quarter, as the crisis gradually spread to the rest of Asia, reducing demand for Korean products. Since exports to Asia comprise more than 50 percent of Korea's exports, a decline in foreign demand caused real export growth to fall 0.7 percent during the quarter. Export volume, however, continued to growth at a healthy 20 percent, even though export unit prices decreased through April by 50.3, 20.9 and 39.0 percent for semiconductors, petrochemicals, and electronic goods, respectively.

While imports of raw materials began to stabilize, imports of consumption and capital goods continued to shrink to a level 36.6 percent lower than the corresponding period of the previous year. This drop in imports is largely due to lower overall spending as well as severe financing difficulties faced by international traders. Many traders have been unable to obtain financing from paralyzed domestic financial institutions.

- 37 -

<Table 7>                  Balance of Payments¹⁾

(billions of US dollars)

Note: 1) The figures for the first quarter of 1998 are estimates, and figures after the second quarter of 1998 are forecasts.

Source: The Bank of Korea, Balance of Payments, various Issues.

<Table 8>    Exports and Imports by Commodity, Purpose, and Region¹⁾

(percent)

Note: 1) Custom clearance basis. Percentage changes from the previous year; the figures in parentheses are the component ratio.

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

- 38 -

Exports to Europe, the U.S., Latin America and the Middle East did improve in the second quarter, but were unable to compensate for the weakened demand from Korea's Asian neighbors. Imports from the U.S. and Europe experienced an especially sharp decline due to lack of demand for capital goods and luxury items from this part of the world.

<Table 9>               Capital and financial account 

Note: The Bank of Korea, Balance of Payments, various issues

Korea did experience a slight increase in capital flow, despite a lower interest rate and an appreciating won, due to loans from international organizations. Since the nature of capital inflow into Korea in the wake of financial crisis have been largely speculative, improving financial conditions tempted investors take their gains and pull their money out of the country. The IMF recipe of achieving stability in the foreign exchange market through high interest rates began to take effect, and the contraction of the economy contributed to the seemingly stable financial market performance. More recently, the disparity between the real and financial sectors of the economy calls for a swift transition of policy focus from stabilization to growth, but the authorities have been slow to react.

The won/dollar exchange rate proved relatively stable in the second quarter, despite serious external shocks such as a weakening yen and the worsening Indonesian crisis. Despite weak demand, a sizable trade surplus assured a smooth supply of dollars. In fact, the foreign exchange market even exhibited an excess supply of dollars, thanks 

- 39 -

to the authorities' commitment to raising foreign reserves, the successful overseas issuance of national bonds (amounting ot 4 billion dollars) and increased balances of foreign currency denominated deposits. By the end of June, usable foreign reserves amounted to 37 billion dollars, far exceeding the IMF target. This oversupply of dollars in the foreign exchange market resulted in an 11.6 percent decline in transactions from the previous quarter, to 91.4 billion dollars. The appreciation of the won/dollar exchange rate needs to be interpreted with caution, since an overvalued won may result in reduced capital inflows and sluggish exports, especially given the tendency for other competing nations to depreciate their currencies.

<Table 10>       Won/dollar Exchange Rate Volatility

(won/dollar)

Note: 1) intra- day volatility = {(daily maximum -  daily minimum)/daily average exchange rate} × 100(%) 

Source: The Bank of Korea, Foreign Exchange Market Review, various issues

<Figure 10>    Won/Dollar Exchange Rate and Won/Yen Exchange Rate

- 40 -

<Figure 11>  Won/Dollar Exchange Rate Trading volume (5 day moving average)

Source: The Bank of Korea, Foreign Exchange Market Review, Various Issues

During the third quarter, trade and current account balances are expected to record a surplus of 6.4 billion and 5.6 billion dollars, respectively. While imports will remain weak due to domestic demand compression, export volume is likely to shrink further as the Asian crises continue to be transmitted throughout the world. The capital account is projected to show a surplus of around 1 billion dollars, although portfolio investment is unlikely to materialize.

The growth rate of export volume will continue to shrink during the third quarter, registering a 9.5 percent drop, as the appreciation of the won that started early this year begins to take effect. Continued economic depression in Japan and sluggish demand for Korean products from other Asian countries will continue to hinder export recovery. Imports, on the other hand, are likely to show a slight recovery in light of the improving foreign liquidity of most financial institutions and major exporters. Foreign demand elasticity for Korean products will remain at low levels due to a worldwide slump in import demand, thus failing to satisfy the Marshall- Lerner condition for a currency depreciation to improve the trade balance. 

The capital account is expected to record only a slight surplus as domestic 

- 41 -

economic conditions are hardly favorable for a sizable capital inflow. The won/dollar exchange rate is projected to fluctuate between 1,300 and 1,400. With the weakening of the Japanese yen, however, the won/dollar rate could easily climb to 1,500 if the yen/dollar rate exceeds 145.

<Table 11>                   Exports and Imports

(custom clearance basis, USD(million), percent)

Note: The figures in parentheses are percentage changes.

- 42 -

The current account surplus for the second half of 1998 is projected to reach 10.2 billion dollars, a sizable cut in comparison with the first half year. Exports will decline gradually due to worldwide contraction of demand and the damage done to the real sector of the economy.

While the import decline can be accounted for by poor domestic demand, export performance will be mediocre due to the yen depreciation and overall demand contraction in other parts of the world. The services balance, including transportation, travel, and royalty payments is expected to record a slight surplus, while the incomes balance, including investment income and wage payments, is expected to register a deficit of more than 3.5 billion dollars.

- 43 -

Money and Interest Rates

1. Money

1) Review

The Bank of Korea (BOK) took a flexible monetary stance in the second quarter, accommodating the foreign exchange market and real economic activities. Even though the quarter started out with a tight monetary policy, the BOK slowly loosened its monetary stance, catering to the financial needs of businesses and households. The major stimulus for this transition to a flexible monetary policy was an agreement between the Korean government and the IMF to gradually lower the market interest rates to prevent an excessive contraction of business activities. Unfortunately, such an accommodative monetary policy did not yield the expected results. This is because additional liquidity created by the loosened monetary policy was largely used by financial institutions to purchase RPs and MSBs.

<Table 12>               IMF Monetary Targets in 1998¹⁾

(billion won, percent)

Notes:1)End of period, target growth rates from the same period last year in ( ), realized value in [ ]. 

2) Indicative floor. 

3) Usable Reserves = TIR -  Deposit in foreign branch. 

Sources: Ministry of Finance and Economy, Letter of Intents and Agreement (98.5.22)  The Bank of Korea, Money and Banking Statistics, various issues. 

- 44 -

The monetary base (MB) decreased 7.2 percent per annum during the second quarter, only slightly less than the 7.5 percent drop in the previous quarter. These two consecutive drops brought the MB to 20.8 trillion won, well below the target level set in the agreement with the IMF. Failure to achieve the agreed flexibility in money supply can be explained by two factors. First, the financial institutions maintained their restrictive loan policy, exhibiting greater concern for raising their own capital adequacy ratios than in extending new loans. Second, the high interest rates and sluggish business activities reduced the demand for funds.

Over the first half of 1998, the M2 growth rate steadily increased, reaching 18.4 percent per annum in June, while the growth rate of MCT (M2+CD+Money- in- Trust) continued to fall from 14.7 percent in Dec. 1997 to 8.4 percent in June 1998. This 

<Table 13>             Trends of Monetary Growth Rates¹⁾

(percent)

Notes:1)Per annum average period percentage changes. Second quarter 1998 figures are preliminary. 

2) Monetary Base = bank notes + reserves of deposit money banks. 

3) M1 = currency + demand deposits. 

4) M2 = M1 + 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, Money and Banking Statistics, various issues. 

The Bank of Korea, Monetary Movements during the second quarter of 1998. 

- 45 -

drastic contrast is attributable to the shifts in investors' portfolios. The simultaneous growth of M2 and decline in MCT reflects the declining market interest rates, which causes savings to shift from short- term marketable financial products such as CDs, RP and Money- in- Trust, components of MCT, into time deposits, a component of M2. The decline of MCT also reflects a portfolio shift away from the trust accounts of the banking sector into the high- return products in the investment- trust companies. Specifically, money- in- trusts decreased 8,892 billion won in the second quarter. On the other hand, the continued decline of M1 in the second quarter reflects both the decreased transactional demand for money by firms and households and the shift of private money holdings from non- interest to interest- bearing demand deposits.

<Table 14>                Multipliers and Velocities¹⁾

(times)

Notes: 1)Money Multipliers are the ratios of each monetary aggregate to the volume of the monetary base. Velocities of money represent the ratios of seasonally adjusted nominal GDP of each monetary aggregate. The velocities reported in this issue of the KFR are annual velocities; the velocities reported in the last issue were quarterly velocities.  Seasonal adjustments also make a slight difference. 

2) Velocities are Estimates. 

Sources: The Bank of Korea, Money and Banking Statistics, various issues. 

The Bank of Korea, Monetary Movements during the second quarter of 1998. 

- 46 -

The money multiplier for all monetary indicators except M1 continued to increase during the second quarter. This reflects that the cash circulation in the private sector decreased as high interest rates raised the cost of holding cash, and that the recession caused the transactional demand for money to shrink. On the other hand, the lower money multiplier for M1 shows that the portfolio shift out of demand deposits dominated the decrease in circulating cash. Although multipliers for such monetary indicators as M2 and M2+CD increased, the velocity of these factors continued its downward trend, while the MCT velocity remained virtually unchanged.

Analyzing MCT growth by sector during the second quarter shows that money was supplied primarily by governmental, foreign and other sectors, while the private sector absorbed 21 trillion won, the first time in the 90s. This significant money-  absorption in the private sector reflects the fact that banks disposed of their securities 

<Table 15>      Recent Deposit Changes at Financial Institutions¹⁾

(billion won)

Note: 1) Average period changes. 

2) New types of installment trusts. 

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

The Bank of Korea, 1998 Second Quarter Monetary Trends. 

- 47 -

and withdrew their loans rather than lend money to the business sector, a course of action that improved their BIS capital adequacy ratios. The current account surplus contributed to the foreign sector's supply of 4,550 billion won. One noticeable fact observed in the second quarter is that while the other sector, which encompasses all the channels of money supply except through private, government and foreign sectors, has consistently absorbed money in the past, it supplied 21.9 trillion won to the MCT, primarily through massive cutbacks in RP regulation and call loans to the nonbanking financial institutions.

One distinctive feature of the second quarter already briefly noted is that the MB continued to shrink despite the government's resolution to ease monetary policy. One reason given for this is that banks tended to use their greater liquidity in other ways than financing new loans. One such alternative for banks and financial institutions included the purchase of MSBs and call loans. The BOK's RP sales and the issuance of MSBs in the second quarter saw a steep rise of 89 and 97 percent, respectively. In the case of RPs, even this increase in sales was not enough to compensate for the matured volume. The net issue of MSBs amounted to 9,860 billion won. 

<Table 16>             MCT Money Supply by Sector¹⁾ 

(billion won)

Note: 1) End of period changes from the previous period. 

2) Preliminary 

Sources: The Bank of Korea, Money and Banking Statistics, various issues. 

The Bank of Korea, Monetary Movements during the second quarter of 1998. 

- 48 -

<Table 17>       Trend of Residents' Foreign Currency Deposits (M2)¹⁾

(billion won)

Note: 1) Averages period changes. 

Source: The Bank of Korea, Money and Banking Statistics, various issues. 

2) Forecast

Given the lack of success in lowering market interest rates sufficiently enough to revive the real economy in the second quarter, the policy priority of the BOK in the third quarter will be easing the credit crunch rather than focusing on the foreign exchange market. Efforts to stabilize the foreign exchange market have been quite successful in the preceding two quarters; Korea's official foreign reserves at the end of June, 1998 were 40.9 billion dollars. Usable official foreign reserves (official foreign reserves less the Bank of Korea's deposits at overseas branches of domestic banks) amounted to 37.0 billion dollars, well above the IMF target level of 32.0 billion dollars. Based on this success, the switch in priority from the foreign exchange market to easing the credit crunch is underscored by the expectation of continuous stability in the foreign exchange market. In negotiations with the IMF on May 22, the IMF agreed with the Korean government for a change in focus, and approved additional fiscal deficits and greater flexibility of monetary and interest rate policies. The stable foreign exchange market and the flexible attitude of the IMF will allow the BOK more maneuverability in formulating monetary policy.

With both governmental and IMF approval, it is therefore reasonable to expect that money will be injected into the market in a flexible manner, actively responding to market demand. The government has already announced the injection of 4 trillion won to avoid the worsening of credit crunch after the Financial Supervisory Committee's decision in mid- June to close 55 insolvent corporate firms. In addition, 

- 49 -

<Table 18>           Trend of the BOK's RPs Operation

(100 million won)

Sources: Korea Investors Service, INC., KIS- LINE 

<Table 19>           Monetary Stabilization Bonds Issued

(billion won)

Note: 1) Preliminary Figures. 

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

The Bank of Korea, 1998 Second Quarter Monetary Trends. 

the money supply from the foreign sector will increase following successive months of current account surpluses and growing foreign direct investment. Unfortunately for small and medium- sized businesses, however, the rising money supply does not automatically imply easier access to financing, since financial institutions view new loans as risky in a credit crunch period. To make sure some benefits of the expanding monetary policy reach these businesses, the BOK will occasionally employ direct controls on the loan policies of banks. For example, the BOK has already arranged for the commercial bills of the small and medium- sized companies to be rolled over and for exporters to be granted access to credit insurance.

- 50 -

<Table 20>               Inflow of Foreign Capital

Sources: 1) Ministry of Finance and Economy, Foreign Investment Trends, 98. 1～6. 

2) Korea Securities Supervisory Board, Foreign Investment Trends, various issues.

Overall, the MB is expected to shrink at the slower speed of - 3.6 percent rather than - 7.5 percent in the second quarter. Continued shrinkage of the MB means that the balance at the end of the third quarter will be below the target of 25 trillion won set by the IMF agreement, since that target was based on a second quarter growth rate of 13.5 percent instead of the recorded 0.3 percent growth rate. 

<Table 21>           Monetary Growth Rate and Forecasts¹⁾

(percent)

Notes: 1) Annual growth rate of the average balance.

2) GDP rates and monetary rates are preliminary values.

3) KIF forecasts.

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

The Bank of Korea, Money and Banking Statistics, various issues.

The Bank of Korea, Monetary Movements during the second quarter of 1998.

- 51 -

Part of the BOK's expansionary policy in the third quarter will include supplying sufficient liquidity to circumvent the possible credit crunch following the closure of five banks. Following that ambitious startoff, any increases in MB supply will be modest in August due to the weak demand for funds at that time of year. The money supply will likely rise again in September, in response to the extensive restructuring of financial institutions and massive issuance of state bonds.

Plans for the third quarter also include higher growth of M2, despite the weakened demand for financing from a sluggish business sector. The higher growth rate is intended to smooth any unstable fluctuations in financial markets which might occur in the process of restructuring financial institutions. To provide adequate liquidity for this purpose, the M2 growth rate in the third quarter is expected to reach 18.0 percent, or 14.6 trillion won additional supply, twice as much as the previous quarter. This growth of M2 will positively effect MCT, causing 11.8 percent growth, but negatively impact M1, which is expected to shrink by - 13.2 percent.

The growth in MCT will come primarily through money supplied by the government and foreign sectors, while money supplied by the private sector will be modest. The money supply in the government sector will increase due to a combination of rising expenses from constructing a social safety net and recapitalizing ailing banks, and falling tax revenues. Money in the foreign sector will come from the large current account surplus and the continuing inflow of foreign capital. The private sector, however, is unlikely to generate much money because banks will continue their restrictive loan policy and firms' demand for money will decrease. MCT growth will be checked by the other sector, which will actually absorb money since the BOK will issue MSBs to control the growing supply of money. 

Thus, the focus of monetary policy during the third quarter will be on supporting business activity through expansionary monetary policy. The BOK emphasizes, however, that monetary policy cannot solve the current financial difficulties if unaccompanied by rapid completion of reforms in financial and industrial sectors. In the first two quarters of 1998, some experts maintained that such restructuring was all that was necessary to revive the economy. Yet, the unprecedented poor economic 

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performance in the first two quarters pushed overall consensus towards supporting business stimulus packages. The Ministry of Finance and Economy now emphasizes that both fiscal and monetary measures are essential to prevent the faltering economy from sinking further. 

2. Interest Rates

1) Review

During the second quarter of 1998, both long term and short term market interest rates dropped sharply in comparison to the previous quarter. This drop was a product of an agreement between the Korean government and the IMF to stimulate the flagging economy. Alleviating the high interest rate policy became possible as the won/dollar exchange rates were stabilized significantly. The interest rate drop by the BOK was accomplished by gradually lowering the RP selling rates from 23.0 percent at the end of March to 14.5 percent at the end of June.

Market interest rates fell at the beginning of the quarter in response to the successful flotation of global bonds by the Korean government, which led to inflows of foreign capital. This drop was accomplished in spite of the controversial restructuring of firms and financial industries, and the threat of labor strikes. Interest rates, however, increased slightly at mid- quarter. This was attributable to several reasons: the downgrading of Korean banks' credit rating by Moodys'; widespread concerns over Southeast Asian countries' ongoing economic crises; the extensive restructuring of financial institutions and firms; instability of call loans following the suspension of Sae- Han Merchant Bank; and the bankruptcy of the Gu- Pyung Group. At the end of the quarter, interest rates began to decline again as the uncertainties surrounding the market were reduced. In addition to the BOK's lowering of open market operation rates, the government announcement to shut down nonviable firms and financial institutions significantly improved the credibility of future restructuring plans. In fact, such a strong determination on the part of the government, it appears, 

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outweighed the instability in the money market heightened by the announcement to close down the five nonviable commercial banks.

At the beginning of the second quarter, most market analysts had anticipated that the restructuring of firms and financial institutions would be accompanied by an increase in market interest rates. The fact that this increase did not occur was because most business conglomerates had already secured their operating funds through borrowing and improved their internal cash flows through an increase in exports. In addition, the only banks to be shut down were provincial banks and small banks with a short history in business lending, which helped minimize the impact on the market. Finally, the BOK supplied some money in advance to prepare for banks' shortage in liquidity, and also extended CP maturities until the Chu- Sok holidays. All these factors contributed to the maintenance of stable market conditions.

Three year corporate bond rates rose temporarily from 18.14 percent to 18.5 percent at the beginning of the quarter, reflecting the IBRD's disapproval of the Korean government's use of overseas funds to finance restructuring. The rates then dropped to 17.7 percent at the end of April with a decline of issuances of corporate bonds and continuously decreasing short- term rates. Throughout May, the rates periodically rose above 18 percent, either because of the downgrading of domestic banks' credit ratings by Moodys, or because of the Southeast Asian countries' ongoing economic crises. After the government and the IMF agreed to lower the interest rates, however, the rates resumed a downward trend. Aided by abundant market liquidity, the downward trend was maintained in June, despite a weakening yen and concerns over labor strikes.

Long term investments, which are considered safe investments, also largely followed the overall market trend. The rates of financial debenture, fell from 19.56 percent in the first quarter to 17.62 percent in the second quarter, reflecting the overall downward trend of interest rates. The national housing bond rates actually decreased 0.75 percentage point to 14.89 percent from the previous quarter as their trading volume decreased rapidly. On the other hand, the call rates, which had been above 20 percent throughout April, plummeted to 17.08 percent in the middle of the 

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quarter. This sharp fall was attributed to the continuous decrease in the BOK's RP rates in May, the agreement to lower interest rates between the government and the IMF, and salary payments to teachers and local officials. By the beginning of June, the call rates soared to 18.96 percent on fears over local elections and ongoing instability from restructuring efforts. Rates fell off sharply to 14.6 percent by the end of June with the BOK's flexible monetary policy and the government's dedication to cutting interest rates. CP rates, on the other hand, increased in the middle of the quarter due to the suspension of the Sae- Han Merchant Bank, but later returned to the 16 percent level, reflecting a combination of the overall downward trend of interest rates, the decreased CP issuances of large corporates, and the government's financial market stabilization package.

The most noticeable feature of financial market development in the second quarter was the distorted flow of funds. The restructuring of financial institutions and firms made the credit risk higher, since the restructuring process involved frequent

<Figure 12>                 Major Long- term Interest Rates 

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<Figure 13>            Major Short- term Interest Rates 

bankruptcies and delinquent interest payments. The financial institutions therefore became reluctant to lend to firms and restricted the use of their funds to inter- market trading, creating a distorted flow of funds. In the second quarter, the credit crunch became worse in the sense that the interest rate spread between lending rates and borrowing rates widened further and lendings of banks and trust accounts to firms decreased significantly. As a result of these developments, the big five conglomerates with less credit risk did not have any difficulty borrowing new money, while other large conglomerates and small-  and medium- sized firms with higher credit risks experienced difficulty in floating bonds and borrowing money.

In addition to distortions in flows of funds, the second quarter also saw remarkable fluctuations in flows. As market liquidity flocked to the short- term financial products with high return in the first quarter, total deposits at banks decreased 6,200 billion won, while time deposits with maturities less than one year increased 21,791 billion won. Also, deposits in money trusts decreased 6,400 billion 

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<Table 22>                   Major Interest Rates by Quarter

(percent)

Source: Korea Investors Service, INC., KIS- LINE.

won from the end of the last year, whereas deposits in new installment trusts at banks, a short- term financial product, increased 21,100 billion won. At investment and trust companies, deposits in short term bonds increased 12,935 billion won, or 72 percent of the total increase in deposits at those companies. Probably, money flows fluctuated more in the second quarter, as more money moved to healthy financial institutions or those short- term financial products with a fully guaranteed principal. This movement was facilitated by the enforcement of the depositor protection system and the shutdown of nonviable financial institutions.

With so much change in interest rates, there has been criticism that the three year corporate bond rate, a traditional benchmark rate, is failing to reflect the actual market liquidity. For instance, while the corporate bond rate decreased to the 16.0 percent level in June, the lending rate did not fall nearly so much, particularly for firms with lower credit ratings. So although the drop in the three year corporate bond rate indicates improvement in the money market, in actuality the situation did not improve much at all. This can be explained by the fact that the corporate bond rate is announced based on the rates of healthy companies, and therefore hardly reflects the overall market liquidity. In fact, the corporate bond rate only reflects the liquidity of those few conglomerates which are successful in issuing their bonds. Based on the inadequacy of the corporate bond rate, three methods have been suggested to capture actual market rates. The first method is to use the national housing bond rate (type 1) as a benchmark and add the interest rate spread for other bonds according to their 

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credit risks.  The second method is to calculate a weighted average of several lending rates based on the trading volume. The third suggestion is to announce a market rate of healthy bonds with AA credit rating and above.

<Table 23>       RP Sales Rates and Volume of CPs Discounted 

(percent, billion won)

Note: 1) The last RPs rate during the month.

2) Average period changes.

Sources: The Bank of Korea. 

The ratio of dishonored bills in the second quarter decreased only slightly compared to the previous quarter. Regarding smaller movements within the quarter, the nationwide rate fell from 0.47 in March to 0.42 percent in April because of decreasing interest rates, but rebounded somewhat to 0.45 percent in May, reflecting the suspension of the Sae- Han Merchant Bank. All three of these monthly rates are much higher than those levels that prevailed a year ago, before the foreign exchange crisis broke out. On the positive side, the number of bankruptcies of firms has shown a downward trend since March.

The term structure of interest rates in the second quarter followed a typical low long- term and high short- term pattern except in June. The CD rates in April decreased significantly, making the yield curve flatter than in March. In May, the term structure of interest rates showed a relatively less pronounced low long- term and high short- term pattern, since short- term rates for bonds of less than one year maturities fell significantly against corporate bond rates. In June, the CD and three year corporate 

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<Table 24>       Bank Deposits and Loans and Interest Rate Spread¹⁾

(100 million won)

Note: 1) Average period changes.

2) Deposits include demand deposits, time and savings deposits, and net CD issuances

3) Loans of deposit money in banks are in won. 

4) Loans of trust accounts are until June 15.

5) Interest rate spread = average bank loan rate -  average bank deposit rate

Source: The Bank of Korea

bond rates were set higher than the call and financial debentures rates, respectively. Thus, the term structure of interest rates in June was substantially different from the typical high short- term and low long- term pattern. National housing bond rates, on the other hand, did support the typical pattern. After remaining at relatively high levels from March to May, they abruptly fell to a lower level in June with the help of an overall decrease in interest rates.

The overall volatility of interest rates decreased significantly in the second quarter as the foreign exchange market regained its stability and trade volume rose in the capital market. In particular, the volatility of the corporate bond rates and CD rates approached their pre- crisis levels. The financial debenture rates, which recorded the lowest volatility last quarter, yet showed higher volatility than the corporate or CD rates this quarter.

One particularly visible change in the financial system in the second quarter was that short- term financial products such as CDs and RPs were fully opened to foreign 

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<Table 25>               Determinants of Interest Rates

(percent, billion won)

Notes: 1)Per annum growth rates.

2)CPI inflation is a realized value; other figures are preliminary.

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

Korea Investors Service, INC., KIS- LINE

<Table 26>              Rate of Dishonored Bills

(percent, number)

Notes: 1)By value, the figures in parentheses do not reflect adjustments for electronic settlements.

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

The Bank of Korea, Ratio of Dishonored- Bills in February.

Korea Investors Service, INC., KIS- LINE.

investors as of May 25. This move was made in an effort to alleviate shortages of funds for firms and to solidify financial conditions in preparation for an additional lowering of interest rates. Unfortunately, the newly available products attracted little notice from foreign investors. International investors still regard Korea's sovereign 

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credit rating as ‘improper’. Many foreign investors anticipated difficulties in recovering the principal of their investment from financial institutions undergoing extensive restructuring, even though the government pledged to guarantee full payment. So instead of moving towards these new investment markets, over 70 percent of foreign capital coming into Korea was placed in monetary stabilization bonds and financial debentures issued by Korea Development Bank, both of which are assessed as risk- free bonds.

<Figure 14>          Yield Curves during the Second Quarter

<Table 27>          Daily Absolute Change in Interest Rates¹⁾

(percent point)

Note: 1) By absolute value, period averages.

Source: Korea Investors Service, INC., KIS- LINE.

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2) Forecasts

In the third quarter, market interest rates are expected to continue to show a decreasing trend. The BOK will loosen its monetary policy to supply more money to financial institutions, and firms' demand for money will be sluggish due to the ailing economy. The change in the BOK's monetary stance comes as a result of an agreement between the government and the IMF to expand market liquidity to stimulate the economy, as well as the belief that the foreign exchange market will remain stable.

The market interest rates, however, are expected not to decrease significantly. RP selling rates have already decreased remarkably to 14.5 percent at the end of June, and overall market interest rates have also significantly decreased. One reason that rates are not expected to come down further is that most financial institutions, awash with liquidity, will be reluctant to purchase corporate bonds or lend to firms under severe credit crunches. Another reason for maintaining current rates is that exports are likely to go down further, reducing the internal financing of healthy conglomerates, which will in turn resist further lowering of market interest rates. Interest rates will be affected by some seasonal factors, however: the VAT in July; the pre- payment of corporate taxes in August for companies which will submit fiscal statements at the end of December; the self- assessed payment of corporate taxes in September for companies which have submitted fiscal statements at the end of June; and money demand in September for Chu- Sok holidays.

Although market interest rates may not decrease further, market liquidity during the third quarter is expected to be sufficient since money supply is likely to expand while the firm's demand for money will not be large. Those financially unsound and marginal firms that do wish to borrow money, however, will likely have difficulty doing so. Financial institutions will likely be quite conservative in issuing new loans. In particular, since the government is planning to issue massive amounts of government bonds to boost the economy and support the unemployed, financial institutions with abundant liquidity are likely to purchase safe government bonds, rather than issuing loans or purchasing corporate bonds. 

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<Table 28>                Interest Rate Forecasts¹⁾

(percent)

Notes: 1) Reported interest rates are period averages.  The other figures are year- on- year  growth rates.

2) CPI and interest rates are reported figures, other figures are preliminary ones.

3) Forecasts.

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

Korea Investors Service, INC., KIS- LINE.

Unfortunately, plenty of unfavorable factors will overshadow progress made in market liquidity. Some of these problems are as follows: snowballing non- performing loans and soaring unemployment rates exacerbated by restructuring efforts; huge government bond issuances to finance the fiscal deficit; dampened money movement among financial institutions as a result of the revised Depositor Protection Law; and concerns over a financial crisis in Japan and China. 

Other factors are expected to pull down interest rates in the third quarter. Contracting corporate investment and price stability will act to cut interest rates. Prices are expected to be stable, despite a sharp rise in the import prices of public goods and hikes in public utility charges. These inflationary factors will be offset by the ongoing recession and falling wage rates, causing the consumer price index to grow 7.4 percent, a 0.8 percent slower than in the previous quarter. The foreign exchange market, which regained its stability during the second quarter, is expected to continue to be stable given that the trade surplus will continue. The revised Foreign Exchange Management Law on July 1 will facilitate both overseas borrowing and foreign direct investment. 

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Reflecting positive developments in the third quarter, three year corporate bond rates are expected to decrease to the range of 11～15 percent, lower than the previous quarter. Short- term rates are also expected to decrease from the previous quarter to 11～14 percent. Based on this, the term structure of interest rates will likely move toward an upward slope pattern. At least in the beginning of the quarter, chances are that the market rates will be stable, though they will fluctuate somewhat toward the end of the quarter owing to the restructuring of financial industries and firms, massive government bond issuances, and increased money demand for Chu- Sok holidays.

Economists will be closely observing the ongoing decrease in open market operation rates, to see whether a decrease there may help lower the market interest rates. As is well known, the monetary authorities have been successful in lowering domestic market rates through artificially cutting down the RP rates in order to ease credit crunches. It is uncertain, however, if an additional cut in RP rates can further decrease market rates. The structural weaknesses in the economy will not allow the market equilibrium interest rate to fall below pre- crisis levels of 11～12 percent, regardless of how low RP rates are. For one, a credit risk rating at 1.3 percentage points higher than before the IMF bailout will certainly keep rates higher than pre- crisis levels.  Second, given the current condition that the Korea Development Bank is paying the interest rate spread equal to the LIBOR in the international capital market, domestic funds would move to the international market if the domestic interest rates fall below the current levels, causing another round of instability in the foreign exchange market. 

<Table 29>             Risk Premium of Interest Rates¹⁾

(percent)

Notes: 1) Risk Premium = Corporate Bond Rate -   National Housing Bond Rate

Sources: Korea Investors Service, KIS- LINE.

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Another noticeable change in the third quarter is that starting on August 1, corporate bonds guaranteed by credit guarantee firms will be excluded from the financial products protected by the Depositor Protection Law. This exclusion is made for two reasons. One is that protecting depositors for the above financial products, which are paid based on the realized return, can give rise to a moral hazard problem on the part of the depositors. Therefore, if the government is responsible for protecting depositors who purchase corporate bonds, it will be an excess burden to the public and will go against market principle. The other reason is that the non- performing loans that the two ailing credit guarantee firms held reached 3,600 billion won at the end of March, while their capital loss had already reached 1,250 billion won. Therefore, severe doubts about these companies' ability to guarantee were justified. As a result of this new action, corporate bonds issuances are expected to decrease, while the portion of non- guaranteed bonds will increase, though naturally these conditions will vary from firm to firm. Those companies that have lower credibility and have difficulty accessing the capital market will fall into a deep credit crunch. To appreciate the significance of the problem, it is important to realize that guaranteed bonds accounted for 84.9 percent of total corporate bond balances in April, while the portion of corporate bonds guaranteed by the two credit guarantee firms stood at 62.8 percent.

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Financial Market Developments

Banking

Deposits

By the end of the second quarter this year, the total volume of bank deposits held by money banks, including deposits in won, CDs, and bills based on commercial and trade papers, rose 3.4 percent to 251.7 trillion won from the previous quarter. Several factors contributed to this increase in deposits. First, the Financial Supervisory Commission (FSC) decision to close certain troubled banks caused large volumes of funds to shift to sound banks. This shift, in turn, caused excessive liquidity in the small number of sound banks. Second, depositors developed a preference for time deposits with fixed interest rates, because of the uncertainty of market interest rates. Market rates continued to fall in the second quarter as a result of the Bank of Korea (BOK)'s loose monetary stance and firms' decreasing demand for capital. Third, since the revision of the Deposit Protection Act excluded deposits in bank trust accounts from protection, a sizable amount of funds in bank trust accounts moved to other savings accounts. Fourth, as household income decreased with the recession being prolonged, those small- sum depositors cancelled installment deposits in order to have their money more readily accessible for living expenses and other purposes. Finally, a great deal of foreign currency from exports and asset sell- offs to foreigners were deposited in foreign currency accounts on fears of renewed instability in the foreign exchange market.

The volume of demand deposits rose by 3.0 percent to 16.9 trillion won in the second quarter. This increase was attributable to the fact that declining market interest rates made demand deposits more attractive. In addition, lots of money was deposited temporarily in demand deposits during the restructuring of financial institutions.

Time and savings deposits increased by 6.5 percent during this quarter, reaching 167.3 trillion won by the quarter's end. This growth resulted mainly from the increasing preference for the high fixed interest rates, as well as protection under the 

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deposit insurance system offered by time deposits that are not offered by bank trust accounts. In particular, the money market deposit accounts (MMDAs) also sharply increased, mainly in stand- by deposits. On the other hand, traditional types of time and savings deposits, such as the installment savings and mutual installment savings deposits, declined significantly, since both firms and households cancelled them due to the deteriorating financial condition.

The volume of marketable financial products, such as negotiable certificates of deposits (CDs), repurchase agreements (RPs) and cover bills, declined by 12.0 percent.

<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.

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Such products became less attractive with the declining market interest rates. The supply of CDs decreased because banks could not find suitable places to employ the funds, while demand also decreased due to the lowering rates of return. Declining sales of RPs were also due to the exclusion of RPs from the government deposit protection. Moreover, sales of cover bills fell, largely due to the shortage in underlying bills (commercial and trade bills) to absorb the outflowing money from RPs.

<Table 2>              Time and Savings Deposits¹⁾

(billion won, percent)

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

2) Estimates.

3) Includes MMDAs.

4) Includes household preferential installment savings deposits.

5) Includes mutual installment savings, housing installments savings, workmen's long- term savings, and workmen's property formation deposits.

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

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The balance of foreign currency deposits rose by 27.8 percent compared to the previous quarter, largely due to the great increase in residents' and non- residents' holdings of foreign deposits. Many residents retained foreign currencies from export and asset sell- offs to foreigners in the foreign currency deposits. Non- residents' deposits in foreign currencies also rose; funds for foreign currency- denominated beneficiary certificates were deposited in stand- by funds instead of stocks, as a result of the continuing stock market depression.

Deposit interest rates fell with the reduction of the BOK's open market operation rates and excessive liquidity in the small number of banks. Furthermore, since the government differentiated between sound banks and troubled banks, there was less need to offer higher rates to compete for depositors.

During the third quarter of 1998, the total volume of bank deposits is forecast to grow 3.5 percent to 260.4 trillion won. Deposits in won are projected to increase by 5.0 percent with flows of funds into saving accounts. These projections are based upon the following expectations. First, the trend of fund flight to sound banks will continue in the next quarter with expectations of additional restructuring of banking 

<Table 3>        Interest Rates on Selected Bank Deposits¹⁾

(percent)

Notes: 1) End of period and weighted average interest rates.

2) Estimates.

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3) Standard maturities.

Source: The Bank of Korea.

and non- banking industries. Second, the volume of marketable financial products will decrease as a result of lowered competition between banks to attract depositors. 

Foreign deposits are forecast to rise steadily by 24.5 percent due to the following factors. First, foreign residents' holdings of foreign deposits are expected to rise as a result of the sell- off of private and public firms' assets to foreign investors. Second, the stable foreign exchange rate should cause an increase in foreign investment.

Loan Market

The total volume of bank credits offered by deposit banks, including loans in won, loans in foreign currencies, and loan guarantees and acceptances, is estimated to have fallen to 290.6 trillion won in the second quarter, a decrease of 4.6 percent compared to the 1.4 percent decrease recorded in the previous quarter. 

Such a shrink in bank credits was caused by several factors.  First, since the bank resolution would be determined based on the BIS capital adequacy ratio, banks not only ceased new loans but also withdrew some existing ones. This was done based on the need to balance accounts for the first half of the year in preparation for the bank assessment by the Bank Appraisal Committee. Second, firms and households decreased the demand for loans due to continuously deteriorating economic conditions and the income reduction under the credit crunch and high lending rates. Third, the credit crunch meant that excess funds from the sound banks were used not for new loans to firms but for call loans between financial institutions and RPs from the BOK.  Fourth, the financial sector reform caused banks to stiffen credit control on large firms and to refuse to expand loans. Finally, firms' demand for loans slackened because the recession caused decreasing investment.

Loans in won, which represented about 70 percent of total bank credits in the second quarter, decreased by 2.0 percent, while loans in foreign currencies fell by 1.9 

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percent. The volume of bills discounted declined by 16.2 percent this quarter, reaching 18.6 trillion won, because banks were reluctant to discount bills in fear of lowering their BIS capital adequacy ratio. Furthermore, the number of bills discounted decreased due to the recession. The volume of overdrafts, which had increased dramatically

<Table 4>                       Bank Loans¹⁾

(billion won, percent)