The hedge funds that the Korean government intends to introduce will be much different from those in developed countries like the US and UK in that they will be very limited. We plan to introduce hedge funds within this year, and we are now in the process of laying the institutional foundation for that. In particular, we have established a limitation on borrowing and payment guarantee related to excessive borrowing and derivatives transaction, which are pointed to as causes of side-effects of hedge funds.

< first-phase introduction of hedge funds >

① Hedge funds shall be managed only by asset management companies approved by the Financial Services Commission.

② Asset management companies must operate within clearly set regulations that pertain to borrowing, derivatives trading, debt guarantee and collateral.

③ A minimal regulatory mechanism shall be established that requires reports on current debt level and derivatives transaction status.

Korea already has various supervisory mechanisms in place, including the mandate to report the current status of borrowing and derivatives transaction.

Thus, considering the need to increase market liquidity, finance new growth engine industries and to offer a variety of investment options, it is not desirable to postpone the introduction of hedge funds.

As complicated derivatives are not yet actively traded in the Korean financial market, Korean financial institutions' exposure to derivatives is meager compared to institutions in the US or UK. Unlike exchange-traded derivatives like KOSPI 200 futures and options, but over-the-counter (OTC) derivatives have not been traded actively. Particularly, credit derivatives, which have contributed to the global financial crisis, only account for less than 0.07% of the total notional amounts outstanding in the Korean OTC derivatives market. As of end of June 2008, the notional amounts outstanding of OTC derivatives in Korea was approximately 5.9 trillion dollars, amounting to only 3.4% of the US volume (172 trillion dollars) and 23.0% of the Japanese volume (25.7 trillion dollars).

< notional amounts outstanding of otc derivatives in korea >

(as of June 30 2008, trillion won)

The average ratio of derivatives assets to total assets for domestic financial institutions remains at a remarkably low level of 2.0 percent compared to 19.7 percent of US commercial banks.¹⁶

< the ratio of derivatives assets to total assets >

(as of March 31 2008, trillion won, %)

Sources: Office of the Comptroller of the Currency (OCC) (as of year-end 2007), Financial Supervisory Service (FSS)

¹⁶ The fair value of gains on derivatives contracts can be counted as derivatives assets according to ISDA Standards.

Prudent risk management by the financial authorities has allowed Korean banks to weather the worsened economic climate better than those in many other countries. As of September 2008, key soundness indicators, including the BIS ratio (10.86%), the NPL ratio (0.82%) and the coverage ratio (175.1%), all stood in good shape. In contrast to the losses and bankruptcies experienced by foreign financial institutions, Korean banks are still posting net profits. ¹⁴

< asset soundness of korean banks >

Unit: %

Note : At end-Sep. 2008, US commercial banks had an SBL ratio of 2.23% and a delinquency ratio of 3.64%.

¹⁴ From Q1 2008 to Q3 2008, net profits totaled 8.3 trillion won (compared with 15 trillion won in 2007 and 13.6 trillion won in 2006)

Foreign bank losses: Citi $68.1 billion, Wells Fargo $17.7 billion, RBS $12.7 billion, UBS $44.2 billion, Bank of America $27.4 billion.

If the global financial crisis raises volatility in exchange rates, equity prices, interest rates and other asset prices, and if this prolongs the global economic slump, there is a real possibility that the BIS ratios of Korean banks will worsen.

Taking this into account, the financial authorities are implementing various measures, of which the Capital Expansion Fund is one.

Banks themselves are intensifying restructuring efforts, for instance by issuing equities and hybrid securities, in order to shore up capital and ensure stability.

¹⁵ KAMCO is issuing 400 billion won in equities to purchase bad loans, while authorities are restructuring construction companies as well as small and medium-sized companies in the shipbuilding industry

It has been frequently said that no matter how much money the government puts into the financial markets, it does not flow into the real economy quickly enough. This is mainly due to the increase in counter-party risks and economic uncertainty led by the global financial turmoil and the downward trend of growth. In response, the government is pursuing restructuring of insolvent businesses, such as the construction and shipbuilding companies, in order to eliminate economic uncertainty. In addition, it will continue to provide liquidity to recoverable companies selectively through policy banks and national guarantors. The recently created Bond Market Stabilization Fund is also expected to play a role in resolving credit crunch in the bond market. The government also plans to establish a 20 trillion won "Bank Capital Expansion Fund" to expand bank's credit supply capacity.

¹²The government is increasing capital of policy banks (Korea Development Bank and Industrial Bank of Korea) by 2.4 trillion won, which will result in an expansion of corporate lending by 14 trillion won.

Moreover, the government is making additional investment into national guarantors (Korea Credit Guarantee Fund and Kibo Technology Fund) worth 1.1 trillion won to increase public guarantee by 11.7 trillion won.

< Reference > Details of the Bank Capital Expansion Fund

1. Background
The Fund is designed to strengthen banks' financial soundness and ability to absorb losses in the face of a prolonged economic slump and major restructuring, leading to a credit expansion in the real sector, including SMEs.

2. Fund Scale and Funding Method
A total of 20 trillion won will be raised by the BOK (about 10 trillion won in loans), institutional and individual investors (about 8 trillion won in investment) and KDB (about 2 trillion won in investment). ¹³

< Overview of the Capital Expansion Fund >

3. Targets and Methods
Banks have discretion to request funds, upon which the Fund will purchase preferred shares, hybrid securities, redeemable preferred shares, subordinated loans or others.

If the 20 trillion won Fund is used to raise Tier 1 capital, the BIS ratio of commercial banks can improve by as much as 2.59 percent.

¹³ When a bank applies for funds, the Capital Call method will be used to provide capital based on a pre-agreed ratio.

Although the Bond Market Stabilization Fund, worth 10 trillion won, is not large considering the volume of bond markets, we expect the fund contribute to easing liquidity problems by isolating the "temporary vicious cycle", in which contracted transaction leads to a rise in interest rate, a fall in bonds price and an increase in net selling of bonds.

In addition, the demand for investment grade bonds has recovered mainly thanks to the dramatic fall in the policy rate and the increased supply of liquidity, which drove down the money market rates.

We expect the fund to further contribute to easing of liquidity problems in the bond market, as the fund step in to buy up both non-investment grade corporate bonds and ABCP within the first quarter this year.

The fund was firstly raised to 5 trillion won and an additional 5 trillion won will be added once it is depleted.

Since the 1997 Asian financial crisis, the Korean government has strictly regulated foreign currency liquidity of domestic banks.

Thanks to such strict regulation, domestic banks have maintained sound repayment capacities even after the fall of Lehman Brothers. For example, their foreign currency liquidity ratios exceed the guidance ratio.

Note : numbers since end-Oct. are preliminary figures

Given the tightened external financing conditions stemming from the global financial turmoil, however, further action is necessary to minimize the related negative effects on the real economy.

The government has therefore continued to take a range of preemptive measures, such as providing foreign currency liquidity , arranging a package of foreign currency payment guarantees for domestic banks, and signing currency swap agreements with the U.S., Japan, and China (USD 30 billion, each)

Although domestic banks have faced difficulties in borrowing in foreign currency due to expansion of global credit crunch, their lending conditions have improved to some extent, as demonstrated by the fact that Korea became

¹¹As of the end of 2008, the government and the Bank of Korea had injected USD 48.1 billion of liquidity into banks through rediscounting export bills of exchange, lending, and swap transactions

the first Asian country to issue public bonds abroad since the Lehman Brothers bankruptcy.

In January, the Export-Import Bank of Korea and the Korea Development Bank successfully issued public bonds worth two billion dollars each, the largest amount since the government issuance of foreign exchange stabilization bond worth four billion dollars in 1998.

Korean banks will continue to maintain healthy foreign currency liquidity based on the government's continued efforts to closely monitor market conditions and thoroughly prepare for possible problems.

Korean banks' SME loans have continued increasing for the past few years driven by rising demand for finance in the real sector with booming SME businesses.

Note : Amount of increase (increase rate)

This illustrates partial recovery of domestic banks' industrial financing function, which was overly diminished after the Asian financial crisis.

The percentage of corporate loans by domestic banks reached 75 percent in 1996 before the Asian financial crisis.

However, the crisis led banks to engage in safe asset-oriented fund management, such as mortgage loans, driving the share of corporate loans down to 48.8 percent by the end of 2005. Then since 2006, increased SME loans has raised the percentage again to 55.6 percent as of today.

Note ( ): percentage

Despite the increase in SME loans, the SME loan delinquency ratio is mere 1.50 percent as of end of September 2008 and the coverage ratio remains high (197.1% for the entire banking sector).

Thanks to stringent regulations on DTI and LTV ratios, sensitivity to income or asset price shocks is thought to be relatively low.

Housing prices in Korea are not rising as fast as in other major countries and there has been no sign of significant fall in the prices, yet.

The average rate of housing price increase between 2001 and 2007 was 9.4 percent in the US and 12.6 percent in the UK while it was only 6.7 percent in Korea.

Between January and September 2008, housing prices in Korea rose by 4.1 percent while other countries saw 4~15 percent decline in housing prices.

The principle and interest payment burden is expected to be reduced for Korean households for the following three reasons;

- Korea's household debt has increased mainly among the high-income class

- the share of lump-sum repayment is low and c) the term to maturity is increasing.

⁹US: -15.9%, UK: -4.0%, Ireland: -9.3%
¹⁰Percentage of lump-sum repayment of bank mortgages: 86% (year-end 2003) → 40.8%

Source: Financial Supervisory Service

The government is also devising measures to alleviate the household debt repayment burden including the following;

- guarantee of supplementary collateral for the depreciated value in housing prices

- extension of maturity and grace period for mortgage loans (e.g. 3 years → 5 years)

- support for conversion of floating rate loan to fixed rate loan.

As of end-September 2008, financial institutions as a whole have provided a total of 81.6 trillion won in PF loans, but the delinquency ratio is at a moderate level of 4.6 percent.

Meanwhile, the coverage ratio stands at 104.5 percent and PF loans only account for 3.1 percent of the financial industry's total assets. Therefore, it is fair to judge that financial institutions hold little risk of losses.

In the case of savings bank PF loans, which have served as potential risk factors, the share of PF loans (23.4% in end-Sep. 2008 → 20.9% in end-Dec. 2008) and the delinquency ratio (16.9% in end-Sep. 2008 → 13.0% in end-Dec. 2008) have fallen dramatically thanks to the government's restructuring efforts.

⁶Coverage Ratio: Accumulated loan loss provision ÷ NPL

⁷The outstanding balance of PF loans have decreased as a result of sale of potentially non-performing PF loans to Korea Asset Management Corporation (KAMCO) (502.3 billion won) and exercise of security rights (101.1 billion won between Sep.~Dec. 2008).

The banking sector is also sustaining soundness with falling delinquency ratio from 1.27 percent at end-September 2008 to 1.07 percent at end-December 2008.⁸

In addition to reducing credit risk of PF loan-related construction companies through the main creditor-led corporate restructuring scheme, the government is preparing a comprehensive response based on the result of the fact finding on the real estate-related PF loans in the entire financial sector (Jan. 2008).

⁸The outstanding balance of loans has risen slightly in the process of undertaking previously-approved projects.

The Korean corporate sector is maintaining relatively healthy financial soundness and profitability, despite the recent downturn.

These measures have been devised through the IMF technical assistance program and the IMF has made positive assessment of them during the working-level consultation (Dec. 8~17, 2008)

But there is a possibility that further economic slowdown will add pressure on the Korean economy because some sectors, the construction industry and small and medium-sized shipbuilding companies in particular, are increasingly suffering from management problems.

Therefore, we see the need to promptly liquidate insolvent companies while providing liquidity support to viable companies to help them normalize.

Korea already has in place a creditor financial institution-led market-friendly restructuring scheme developed through the 1997 Asian financial crisis and the ensuing corporate restructuring.

Based on that scheme, the government is currently pursuing a company-based restructuring process that entails credit risk assessment led by main creditor banks. ⁵

⁵The credit risk assessment categorizes companies into four groups, "A" (Normal), "B" (Temporary liquidity shortage), "C" (Showing signs of distress) and "D" (Distressed), and different actions are taken to each category.

As planned, the Korean government is going to pursue privatization of Korea Development Bank (KDB) in consideration of the need to secure policy credibility and to meet the new demand for the investment bank function after the global financial crisis. However, the government will follow a flexible schedule to fully account for circumstantial changes, such as deterioration of sell-off condition triggered by the unstable global financial market. According to the Korea Development Bank Act Revision Bill submitted by the government, the government will guarantee payment of previously issued bonds at the time of the initial sell-off of the stake in the KDB holding company. And the government can provide guarantee on bonds to be newly issued by the KDB between the initial stake sell-off and the government stake sell-off.

These measures have been devised through the IMF technical assistance program and the IMF has made positive assessment of them during the working-level consultation (Dec. 8~17, 2008)

In the case of advanced countries, lax financial regulation and supervision gave rise to the current financial crisis. However, the problem in the Korean economy is attributable to excessive regulation that limited private sector self-regulation and innovation. In this regard, the Korean government's financial policy is directed at strengthening prudential regulation to reduce systemic risk while easing anti-competitive regulation to promote private sector self-regulation and innovation. To minimize potential side-effects of deregulation, such as financial market instability, in particular, the government has established a set of measures designed to strengthen monitoring of factors contributing to financial market instability as well as disclosure and supervision of derivatives trading, which is the main culprit of the current global crisis.(20.Dec.2008) The supervisory measures include 50 areas for improvement under four main pillars of a) stronger monitoring of the derivatives market, b) enhancement of investor protection mechanism, c) prevention of risks in financial institutions and the capital market and d) re-organization of roles between the supervisory authorities and self-regulatory institutions.

³While the US Securities and Exchange Commission abolished the net capital rule (Apr. 2004) and led to an increase in investment bank leverage by more than 30 times, Korea's Capital Market Consolidation Act will sustain the net capital rule to prevent the leverage from rising by more than 10 times.
⁴The investor protection mechanism, in particular, is to be supplemented greatly to provide protection customized to the concerned instrument's risk level and the investor's risk-taking capacity.

The Korean government has been maintaining fiscal surplus based on stable fiscal management. As a result, Korea's fiscal soundness is recognized as being much higher than other OECD member countries'.

In response to the current financial crisis, the Korean government has shifted is policy stance to expansionary fiscal management.

More specifically, the Korean government has earmarked 51.3 trillion won, 5.7 percent of GDP, for the economic stimulus package covering expansion of fiscal expenditure and tax reduction.

Some are concerned that such expansionary fiscal management can lead to deterioration of fiscal balance and national debt level. However, it is only an unfounded concern, as can be seen in the comparison of Korea's situation with other nations'.

First of all, the fiscal balance (IMF definition) is projected to record a surplus (0.6 percent of GDP) in 2009 despite the fiscal stimulus measures.
Meanwhile, other OECD members are expected to post fiscal deficit amounting to 3.8 percent of GDP on average.^1
1OECD average fiscal deficit (estimation for 2009, as a percentage of GDP): -3.8% (OECD
Although the fiscal stimulus is likely to cause the national debt level to shift from a downward trend that started in 2006 to an upward trend in 2009, it will still remain relatively small compared to other countries at 34.5 percent of GDP (OECD average: 82.8 percent).

It is true that the global economic recession has begun to wreck havoc on the Korean economy in earnest as illustrated by the minus 3.4 percent year-on-year growth recorded in the fourth quarter of last year.


As a result, institutions at home and abroad are generally forecasting the Korean economy to shrink this year, but their growth estimations vary a little.

However, they have the common view that the mid- to long-term prospect for the Korean economy is bright because Korea has strong economic fundamentals and the government is taking comprehensive and preemptive measures against the external shock, which will enable the economy to recover robust growth once the world economy recovers.


Although the IMF has also made an estimation of a negative growth for Korea in 2009, it is expecting the Korean economy to start recovery from the second half of the year and continue growing at the fastest rate in the world to record 4.2 percent growth in 2010 (+8.2 percentage points).


In particular, Korea has a very sound banking sector (BIS capital ratio: 10.86%, total delinquency ratio: 1.0%) and its corporate sector has healthy balance sheets. The government, too, sustains healthy finances.

With the government's continued large-scale pump-priming and liquidity provision efforts, the Korean economy is expected to get back on track from the second half of the year.

Some have raised their concern that Korea's current account balance can deteriorate this year as a dramatic fall in exports (-32.8%) caused Korea to record a current account deficit in January for two consecutive months.


Nevertheless, despite the slumping exports, the current account is generally forecast to record a surplus in 2009 thanks to the downward stabilization of raw material prices and the decreasing demand for imports triggered by the economic slowdown.


Among others, the drop in oil prices (from $100 in 2008 to $42 in 2009, in terms of WTI) is expected to play the biggest role in boosting the current account balance in 2009.


Even under the conservative assumption that Korea's oil import size remains at its average (890 million barrels a year), the import cost will fall by 17.8 billion dollars if oil prices decline by just 20 dollars.


In addition, the current global economic slowdown has only a limited impact on Korea's goods account because Korea's imports are falling in tandem with falling exports.


In particular, a large improvement in the service account is expected thanks to improving travel account driven by weaker won.


The service account deficit of the last two months of 2008 actually diminished dramatically to 1.65 billion dollars, a significant rise from the previous year (-3.18 billion dollars).


All things considered, it is reasonable to expect the current account balance to improve significantly this year.
Most institutions forecast the international oil prices at around 50 to 70 dollars per barrel in 2009 and their general outlook is that Korea will record a large current account surplus this year.

Causes of the Current Account Deficit in 2008

Korea's current account deficit in 2008 was mainly attributable to the soaring oil prices.


Korea recorded current account deficit of 6.4 billion dollars for 2008, about 12.3 billion dollar decline from the previous year (+5.9 billion dollars). This was largely driven by the oil price hike that the deteriorated net exports of crude and petroleum products by 11.9 billion dollars from the previous year (-36.1 billion dollars) to minus 48.0 billion dollars.


In fact, in Oct., Nov. and Dec. 2008 when global economic recession brought down the oil prices, Korea achieved current account surpluses of 4.75 billion dollars, 2.06 billion dollars, and 0.86 billion dollars respectively.