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보고서 1
Impact of carbon risk in the Korean economy and the importance of portfolio carbon neutrality [24-06]
Research Fellow Kim, Minki and others / Feb. 26, 2024
In recent years, the international community has been demanding for more extensive and intensified greenhouse gas reduction efforts and actions to promote climate change response, which has become a major challenge and issue for companies and capital market participants. The Korean government has declared carbon neutrality by 2050, revised 2030 NDC upward and proposed detailed implementation plans. Also, the EU has announced a proposal to introduce a carbon border adjustment mechanism, which might accelerate internal and external efforts for climate change. In this regard, the carbon price is expected to increase gradually, and there is a global consensus that the carbon price must increase further than the current level to achieve the goal of carbon neutrality in 2050.

Based on this background, this study aims to estimate the impact of rising carbon prices on Korean companies and industries through a simple model, and this study is purposed to to highlight the importance of carbon risk and the need to proactively manage the carbon risk for domestic companies and capital market participants. In addition, by investigating and introducing various decarbonization investment methodologies that have been discussed and utilized overseas, we hope to help domestic financial investment companies and institutional investors effectively manage their portfolios’ carbon risk.

The results of our analysis of the impact of carbon price increases on domestic companies are as follows. First, the increase in carbon price, which is generally following the carbon neutrality pathway, leads to an increase in financial losses for companies in almost all industries. Second, this increase in financial losses leads to a worsening of credit risk, such as default. This trend is more pronounced in industries with high GHG emissions. Finally, we examine the impact of carbon risk in a model that takes into account the interaction among industries and find that the cost shock of carbon emissions is estimated to have significant spillover effects not only on high-carbon industries, but also on their associated low-carbon industries. The results of this empirical analysis suggest the importance of carbon risk for domestic companies and capital market participants and the need to prepare for it in the future.

Next, we investigate portfolio construction methodologies that investors can use to effectively manage carbon risk. Regarding this subject, our findings can be summarized as follows. First, internationally, there has been an ongoing discussion about how to reduce the carbon risk of a portfolio while still having similar risk-return characteristics to benchmark indices. Second, the key to these low-carbon investment methodology is to minimize the uncertainty of capital returns and the potential for greenwashing while maintaining the carbon neutrality of the portfolio. It is the most important to provide decarbonization incentives for companies in the portfolio by managing portfolios in such a way that investors could continue to invest and take engagement to the firms as a shareholder. Third, by applying the decarbonizing portfolio construction methodology used abroad and using GHG emission data of listed companies in the Korean stock market, the simple empirical results show that by setting appropriate parameters, an optimal portfolio can be constructed that achieves carbon neutrality of the portfolio while minimizing the opportunity cost for investors. Based on the contents of this paper, we expect that the Korean capital market will be able to utilize those decarbonizing investments methodologies in various ways in the future.

The impact of carbon risk on domestic companies and the implications of decarbonization methods and practices that have been consistently utilized overseas are quite clear. However, the Korean capital market still has not yet been able to vitalize decarbonizing investments for the most of domestic investors. Carbon risk is likely to materialize in the near future, and Korea economy will not be an exception. As we move toward carbon neutrality, the impact on invested companies and portfolios will be clear if the carbon price reaches the adequate level. Therefore, investors need to consider carbon risk as a material risk to their investment portfolios and promote efforts and actions to response the risk. Voluntary efforts by domestic companies and industries will be also important, but it is very critical that investors, as shareholders of companies, set carbon neutrality targets and promote sustainable investing for the future.
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보고서 1
Assessing the likelihood of a structural shift in interest rates (II): Economic structural change and inflation [24-05]
Senior Research Fellow Kang, Hyunju and others / Feb. 19, 2024
This study analyses the impact of economic structural variables, with a focus on globalisation and demographics, on the low inflation rate in Korea and the United States, and assesses whether changes in the inflation rate may occur in the future. This article examines the low inflationary conditions that have persisted since the 1980s from two perspectives: the flattening of the Phillips curve and the downward stabilisation of trend inflation. The flattening of the Phillips curve refers to the dampening of the sensitivity of inflation to the domestic economy, while the downward stabilization of trend inflation refers to the lowering of the underlying inflation rate, i.e. the long-term trend of inflation. From the 1980s to before the coronavirus pandemic, U.S.-Korean inflation was characterized by a downward stabilisation of trend inflation, while the flattening of the Phillips curve weakened the pro-cyclical nature of inflation, resulting in a stable low inflation rate.

This study empirically examines whether this low inflationary trend can be attributed to structural changes in the economy, such as globalisation and demographic change, along with the stability of long-term inflation expectations due to successful inflation management by central banks.

Before presenting the results of the analysis, we summarise the trends of globalisation and demographic changes in Korea and the United States from 1980 to 2020, the period of analysis. First, the world economy, including the Korean economy, entered the hyper-globalisation era in the 1990s, with significant progress of globalization. The U.S.-Korea globalisation entered the slowbalization phase around 2008 (U.S.) and 2013 (Korea), respectively. Next, this paper examines the demographic structure, focusing on the proportion of the working-age population (15~64 years old) and the elderly population (65+ years old) to the total population. The working-age population ratio in both countries has generally been on the rise since 1980, but it began to decline in the United States in 2008-2009 and in Korea in 2012-2013. In particular, the decline in the working-age population in Korea has been sharper than in the United States. As a result, the proportion of elderly people is increasing in both countries, but the proportion of elderly people in Korea is rising steeper than the United States.

The impact of these globalisation and demographic changes on the low inflation rate in Korea and the United States is as follows. First, our analysis shows that globalisation has played an important role in the flattening of the US-Korea Phillips curve. This result is observed for both headline and core inflation. In the case of the United States, where we were able to examine the role of long-term inflation expectations, the stabilization of inflation expectations also contributed to the decline in the cyclical sensitivity of inflation.

In our empirical analysis, globalisation is also found to have played a key role in the downward stabilisation of US and Korean trend inflation. After a large decline during the hyperglobalisation period, trend inflation in the two countries remained stable until the pandemic, suggesting that the decline in trend inflation during the hyperglobalisation period was largely driven by globalisation. This can be understood as a result of cost-efficiency improvements and increased competition among firms due to globalisation, as discussed in the existing literature. The impact of globalisation on trend inflation has been significantly lower in the US and Korea since around 2008 (US) and 2013 (Korea), respectively, reflecting the fact that globalisation in each country entered a plateau around the same time. In the United States, the stabilization of central bank-managed inflation expectations also contributed to the decline in trend inflation, with the impact mainly concentrated in the early to mid-1980s.

Second, differences were observed in the impact of demographic change on trend inflation between the two countries. First, in both countries, trend inflation rose as the share of the working-age population declined. This can be understood as a decrease in labour supply in the economy leading to higher inflation. On the other hand, for the elderly population share, trend inflation increased as the share increased in the US, but decreased in Korea. In the US, the elderly population can be attributed to their role as net consumers, consuming more than they produce. The elderly in Korea have been steadily increasing their participation in productive activities, and their spending power is much lower, so they have not been able to act as an inflationary force, unlike in the US.

The impact of demographics on trend inflation changed significantly when the baby boomers began to retire in each country (around 2008 in the US and 2013 in Korea). In both countries, the impact of demographic change on trend inflation was statistically significant, but economically limited compared to globalisation. In both countries, the impact of globalisation on trend inflation has largely outweighed the demographic effect.

However, in both countries, the impact of demographics on trend inflation has increased significantly as the baby boomers have begun to enter the elderly population. In the U.S., the share of the elderly population has been rising since before 2008, which has contributed to higher inflation, while the share of the working-age population has been declining since 2008, which has added upward pressure on inflation. As a result, after 2008, the impact of demographics on trend inflation exceeded the effect of globalisation and became a significant inflationary factor.

In Korea, the proportion of the elderly population has steadily increased since 1980, which has acted as a downward pressure on inflation. In addition, the share of the working-age population ended its upward trend around 2013 and entered a downward trend, turning it from a depressant to an inflationary factor. Until 2020, the period of empirical analysis in this study, the downward pressure on inflation due to the increase in the share of the elderly population was higher than the upward pressure on inflation due to the decrease in the share of the working-age population. However, using Statistics Korea's future population projections, it is estimated that from 2025 onwards, the upward pressure on trend inflation from the declining share of the working-age population will outweigh the downward pressure on trend inflation from the increasing share of the elderly population. This suggests that Korea's demographics are likely to be a structural driver of inflation in the future.

Along with a possible retreat from globalisation in the future, both Korea and the US are expected to experience a demographic transition in which the share of the working-age population declines and the share of the elderly increases for a considerable period of time. Applying the results of this study's empirical analysis to these economic structural changes, it is assessed that the low inflation rate that has remained stable in both Korea and the U.S. is likely to end and inflation volatility is likely to increase structurally. The steepening of the Phillips curve as a result of globalisation is likely to restore the cyclical sensitivity of inflation, which could lead to a structural increase in inflation volatility. We also expect trend inflation to rise as globalisation recedes.
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보고서 1
Assessing the likelihood of a structural shift in interest rates (I): Economic structural change and the real neutral interest rate [24-04]
Senior Research Fellow Kang, Hyunju and others / Feb. 19, 2024
Following the spread of COVID-19 and the steep rise in inflation, along with central banks in major countries raising interest rates, there is uncertainty about the future interest rate trend. There are contrasting views on whether we will return to the low-interest rates seen after the global financial crisis or if the long-standing trend of declining interest rates since the 1980s will be halted, resulting in a prolonged period of high interest rates. In this context, this report aims to provide the directional outlook for trend nominal interest rate fluctuations based on anticipated structural changes, such as demographic shifts, deglobalization, and productivity improvements.

Firstly, it has been statistically demonstrated that long-term government bond yields in South Korea and the United States maintain a stable relationship with the real neutral rate and trend inflation. Consequently, the factors influencing interest rates have been analyzed by distinguishing between the real neutral rate and trend inflation, leading to the creation of two research reports. This report, as the first part, primarily analyzes the impact of economic structural changes on the real neutral rate, summarizes and incorporates the outlook for trend inflation to be addressed in the second part, presenting the directional changes in trend interest rates and deriving policy implications.

To analyze the impact of economic structural variables such as demographic changes, productivity shifts, and national debt on the real neutral rate, forecasts for long-term real neutral rates in South Korea and the United States were estimated using UN population estimates, OECD productivity forecasts, and the National Assembly Budget Office's fiscal outlook. The analysis results suggest that the United States is expected to experience a rebound in the real neutral rate due to productivity improvements, while South Korea is forecasted to have a sustained plateau in the real neutral rate due to rapid population aging. Moreover, considering the results of the second part, which indicates a significant possibility of the end of the low inflation trend in South Korea and the U.S. due to future deglobalization and aging trends, it is concluded that global interest rates are likely to be stuck in a high-interest rate environment, and domestic interest rates are expected to find it challenging to return to the previous low-interest levels.

The directional trend of these interest rates poses challenges for fiscal policy in terms of the potential burden of interest costs due to expanding national debt and the possibility of fiscal expansion amid a household debt crisis. Regarding monetary policy, it raises challenges such as the central bank's dilemma in responding to supply shocks and the structural reversal of domestic and foreign interest rate differentials. Additionally, for the financial investment industry and pension funds, it suggests the need to consider changes in the relationship between asset yields and formulate new asset allocation strategies in response to market changes.
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보고서 1
Effect of Mandatory Auditing of Internal Control over Financial Reporting on Preventing Fraud in the Korean Capital Market [24-03]
Research Fellow Lee, Sang Ho and others / Feb. 05, 2024
Since 2019, Korea has strengthened the external verification of the effectiveness of internal control systems following the amendments to the External Audit Act. To be more exact, the verification level of the internal control over financial reporting(hereafter, ICFR) was raised from 'review' to 'audit' for listed companies with total assets of more than 2 trillion KRW. Despite the effort, there have been several large-scale embezzlement cases where the internal control system has been overrode at firms and government agencies, such as Osstem Implants and Woori Bank. Based on these events, it seems necessary to examine the effect of mandating an audit of ICFR. Furthermore, we intend to gain a comprehensive understanding of the regulation and how it should be pursued.

This study aims to investigate the effect of the mandatory audit of ICFR, introduced in 2019, in deterring the likelihood of corporate fraud, especially regarding embezzlement and breach of trust. In addition, this report intends to identify improvement measures for the effective operation of the advanced internal control system. We thereby evaluate the effectiveness of the current system and provide policy implications supported by empirical evidence.

First, we compare Korea's intensified internal control system with those of the United States and Japan and find that Korea's internal control system is the most stringent in terms of procedural rigor. However, among the significant weaknesses of the internal accounting control system, a high proportion of cases fell under the category of "insufficient funds," indicating the need for improvement of the effectiveness of ICFR.

Next, we examine the trend of embezzlement and breach of trust before and after the mandatory audit of ICFR using the staggered difference-in-differences model. We find that the incidence of embezzlement and breach of trust in the overall capital market has been declining since 2019, and the decline has been more pronounced among companies with total assets of more than 2 trillion KRW, which were initially subject to the mandatory audit of ICFR. This suggests that the regulatory reformation that reinforced the assurance level of the ICFR from 'review' to 'audit' may have the impact of enhancing the effectiveness of the internal control system and deterring the occurrence of fraud.

Based on the empirical results, this study suggests several policy implications for a more effective internal control system. First, it is necessary to further refine and quantify the sentencing guidelines for large-scale embezzlement cases to deter employees' motivation to commit violations. Next, it is necessary to grant tax benefits to ease the cost burden of designing and implementing the ICFR for a limited period. Furthermore, the incentives for executives and employees to actively contribute to the effective operation of the ICFR and to whistle-blowing need to be expanded.
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