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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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보고서 1
A comprehensive study of retail investors in the Korean ETF markets [24-02]
Senior Research Fellow Kim, Joon-Seok and others / Jan. 24, 2024
Participation of retail investors in the Korean ETF market has increased significantly throughout the COVID-19 pandemic. Before the outbreak, the cumulative net purchases of ETFs by retail investors amounted to only 6.2 trillion won. However, since then, the cumulative net purchases have risen dramatically to over 20 trillion won. The trading volume of retail investors has also increased substantially from around 15 trillion won per month before the outbreak to around 60 trillion won per month. ETFs have become a major investment vehicle for retail investors in Korea.

The most prominent feature of ETF trading by retail investors is the high proportion of trading in derivative ETFs. Since the introduction of leveraged and inverse ETFs, 60-70% of retail investors' ETF transactions have been generated from these ETFs. The problem is that leveraged and inverse ETFs are short-term, speculative products that are structurally complex and unsuitable as long-term investment vehicles. If the low cost and high accessibility of ETFs are utilized for speculative trading rather than contributing to the expansion of diversified investment opportunities, it is not desirable from the both perspective of retail investors’ investment performance and the development of the ETF market.

This paper comprehensively examines the characteristics of retail investors’ ETF holdings and transactions, and the impact of ETFs on investment performance by utilizing the securities holdings and transactions data of 136,000 Korean retail investors from January to October 2020. The characteristics of ETF investors in terms of ETF holdings and transactions can be summarized as follows. First, the number of investors who held or traded ETFs during the period analyzed is about 17% of the total investors, and they are mainly male investors with large investment sizes and experience. Second, ETF investors, compared to non-ETF investors, have a relatively high level of portfolio diversification, but they are also speculative with a high turnover rate and proportion of derivative ETFs held and traded.

The results of the analyses of the impact of ETFs on investment performance are summarized as follows. First, we find that ETFs harm retail investors' investment performance. Both the monthly portfolio return and the Sharpe ratio increase when ETF holdings and transactions are excluded from the total holdings and transactions of ETF investors. Second, we find that the negative impact of ETFs on investment performance is mainly driven by inverse ETFs. Regressions controlling for investor characteristics, risk factors, and portfolio characteristics show that both portfolio returns and Sharpe ratios decline as the percentage of holdings or turnover in inverse ETFs increases. For other ETF types, the Sharpe ratio increases with increasing holdings. Third, intraday trading in ETFs appears to improve portfolio performance. However, the magnitude of the improvement is very small. Fourth, for portfolio component replacement decisions, buying ETFs worsens portfolio returns, and selling ETFs improves portfolio returns. These results are particularly evident for inverse ETFs.

We find a positive effect of ETFs on reducing portfolio risk as a diversified investment tool, but this is overwhelmed by the negative effect of holding inverse ETFs on returns. However, it is not sufficient to interpret these results simply as a result of the upward trend of the stock market during the sample period. Retail investors' overconfidence that the market is overvalued, the lack of understanding of the structural features of inverse ETFs, and the disposition effect, whereby investors ignore accumulated losses, could all contribute to their holding of inverse ETFs during the sample period. We cannot rule out the possibility that the same negative effects could be seen with leveraged ETFs in a bear market.

To establish ETFs as a useful investment vehicle for retail investors, efforts to control the negative effects of derivative ETFs are necessary. A more rigorous review of whether derivative ETFs cause retail investors to over-trade, expose them to unexpected additional risks, provide regulatory arbitrage over other derivative products, and assess their suitability for retail investors is essential.
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