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Our Research Series offers you a comprehensive and systematic overview with multi-faceted theoretical and empirical approaches to a focused theme for Korea’s financial industry and markets.

보고서 1
Entrepreneurial Capital Markets in Korea: Current Status and Future Directions [17-01]
Senior Research Fellow Park, Yong Rin and others / Mar. 09, 2017
Entrepreneurial capital in this report is defined as the investment capital in accordance to the corporate life cycle of growth stages (i.e., startup-expansion-maturity-restructuring) with a focus on innovative growth companies. It plays an indispensable role in the economic growth including the development of capital market and financial services industry. Various types of investments or investors such as crowdfunding, accelerators, angel investors, venture capital (VC) and private equity (PE) participate in the entrepreneurial capital market. In this respect, this report aims to diagnose current entrepreneurial capital markets in Korea, and suggest some policy implications for further market and regulatory improvements. 
In terms of the composition of global entrepreneurial capital market, PE accounts for about 71%, VC 12%, and the other types taking up the rest. Global Entrepreneurial capital markets can be largely classified into PE-oriented, VC/PE-oriented, or diversified markets depending on its composition. More importantly, it is becoming more diverse, with new investors or investment schemes such as accelerator, angel investors and crowdfunding. This phenomenon is seen not only in the countries with developed entrepreneurial markets but also in many European countries with developing entrepreneurial markets.
Changing landscape in the global entrepreneurial capital markets can be summarized into the evolutionary change in its participants, increasing dependance of unlisted firms on private capital markets, and the change in the private relationship between market participants. First, development of information technology such as internet and SNS has changed significantly the startup and investment environment. For example, it not only facilitates information creation and its dissemination but also reduce startup costs as seen in lean startup phenomenon. Accordingly, it has helped new types of seed and startup investment schemes such as crowdfunding emerge and shortened time for exit through M&As. Second, more unlisted companies have been able to finance within private capital market, reducing the demand for IPO. In addition, secondary market platforms for unlisted securities have been formed, reducing liquidity risk of entrepreneurial capital. Third, the pattern of capital contribution has changed in order to reduce the agency problem since the global financial crisis. For instance, co-investment or LP’s direct investment have increased in PE market, and the collaborative investment model where strategic investors contribute capital emerged in VC or angel investment market.  
Entrepreneurial capital market in Korea can be characterized as the state-led market. More specifically, public pension funds and government-sponsored financial institutions provide significant amount of capital, which might induce overly risk-averse investment environment stemming from public audit risk. On the manager side, domestic entrepreneurial capital market is VC/PE-oriented market in that VC and PE are dominant players although some accelerator, crowdfunding, and angel investors are active. Another significant problem in the Korean entrepreneurial capital market is its lack of exit markets. For example, domestic VCs depend excessively on IPOs as an exit route. In this sense, We need to diversify exit routes by facilitating M&A or developing alternative secondary markets and organized OTC markets.  
We also have implemented some empirical analysis based on domestic VC and PEF dataset. First, we performed tests to analyze the policy effects of government-sponsored venture capital (GVC) investments from 2004 to 2013. Results show that GVC has helped induce the private investment both in the intensive and extensive margin. That is, GVC has significantly contributed to the growth of VC in Korea. More importantly, this effects is most prominent in the co-investment of GVC and private VC (PVC). In addition, it turns out that co-investment is best while GVC pure investment is worst in its exit performance measured by IPO and M&A after VC investment. Second, we also have done tests to analyze the effects of PEF investment from 2005 to 2014 based on 302 investee companies. Results suggest that Korean PEFs generally invest in fast growing companies in economic boom. Also, investee companies grew significantly after PEFs’ investments in terms of assets, sales, and employment rather than its profitability. This implies that domestic PEFs tend to capitalize on the growth opportunities of investee companies, which is supported by higher exit probability of these investments.
In terms of regulatory and institutional aspects, we employs the concept of private capital market as opposed to public capital market that is a highly regulated market. Private capital market is a unregulated or minimally regulated market. The rationale for such non-regulation or minimal regulation roots on the facts that most investors in this market are sophisticated ones fending for themselves and it also includes small-amount markets having little benefit of regulatory intervention, such as crowdfunding and small-scale funding. From the viewpoint of economic theories, private capital market is a market for sophisticated investors who are able to resolve the problem of information asymmetry based on ‘private relationship.’ Korean capital market laws and regulations employ no such private capital market term, but the term could be understood as a capital market involved in private placement and OTC market from the Financial Services and Capital Market Act (FSCMA) perspective. Capital markets under the FSCMA can be broadly classified into public capital market, private capital market and semi-private capital market.
As one of the common features of overseas private capital market regulation, the US, EU and UK have a favorable regulatory environment in which private capital market may be well formed and developed. The US law provides for quite strict criteria for public and private placement. Capital formation through private placement, however, is active due to the various private placement rules. Likewise, the EU and UK law provide for relatively loose criteria for private placement offering regulatory soil on which private capital market may nourish. In addition, the US, EU and UK have a reasonal criteria for sophisticated investors through which various angel investments can be active. In the secondary market regulation aspects, the US, EU and UK have low entry barriers for investment firms, which enables intermediation of non-registered securities through such firms. In particular, minimal regulation for alternative trading systems (ATSs) provides for the regulatory basis on the emergence of various forms of ATS which intermediate non-registered securities. In the sector of semi-private capital market, the US has completed the legislative actions for securities-based crowdfunding and Regulation A plus, expanding the area of private capital market. The EU and UK have a regulatory room enough for crowdfunding and small-scale funding in the present regulation. As for the private fund regulation, first of all, the notable feature of overseas regulations therefor is the bifurcated regulatory system, specifying distinctive rules for private funds different from public funds. Further, overseas private fund regulation does not separately provide for rules for VC, hedge fund and PEF. but for unitary rules for those private funds with a lowest level of regulation for the managers for the private funds.
On the contrary, the Korean private capital market regulation is strictly bifurcated to public and private markets, and exchange and OTC markets, with the regulatory focus on the public and exchange markets in order to promote those markets taking into little account private and OTC markets. In such a circumstance, the Korean capital market has failed to build up a virtuous circle for the entrepreneurial capital ecosystem, requiring more flexible and private market oriented regulation.
Lastly, we present some policy tasks or future directions for the further development of domestic entrepreneurial capital ecosystem. First of all, more enhanced role of informed capital that identified and supports promising startups is highly desired.  In this sense, more policy efforts are needed to nurture players such as accelerator, angels, super-angels and micro VCs. We also need to diversify LPs and establish evaluation and compensation scheme on LP-side managers in order to strengthen the capital base or overcome overly conservative GP management. Needless to say, domestic GPs of VC an PEFs should make more efforts to enhance investment returns and cultivate their value creation capabilities. 
Exit markets need to be diversified. For instance, we may modify listing criteria to consider growth opportunities more objectively for IPOs. For M&A, we may consider some policy measures that help expand open innovation, improve corporate governance, enhance the role of intermediaries, and establish M&A transaction infrastructures. Establishing more secondary funds or introduction of PE fund of funds may help to diversify exit routes. Finally, private trading platform for unlisted securities need to be introduced after reviewing operational experience in overseas markets.
In order to enhance entrepreneurial capital ecosystem, sustainable private-led ecosystem needs to be established. To this end, it is desirable to utilize the expertise of private fund of funds managers in the management of policy funds. In addition, more incentives need to be provided to private sector LPs, which provides them with call options on fund units held by government or payoff scheme that gives upside potential or preferential distribution waterfall. 
From the regulatory and institutional perspective, it is desirable to establish a tiered regulation system bifurcating public and private capital market regulations, in order to develop the Korean private capital market. Especially, it is required to provide efficient regulation suitable for corporate growth stages and based on private relationship in private capital market. Toward that end, both passive and active approaches are necessary. Passive regulation is desirable for areas that require minimal regulatory intervention, i.e., angel investment, private placement, small-amount funding, crowdfunding, and private fund rules. However, active regulatory intervention is required for supporting the development private capital markets amid technological advances and consequent market changes.
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보고서 1
An Analysis on Korea’s IPO Market Structure [16-02]
Research Fellow Kim, Kab Lae and others / Apr. 05, 2016
Capital market globalization in the 1990s has repositioned the bookbuilding method developed in the US IPO market as a new standard and spread it to other countries. Many countries abandoned auctions or the fixed price method they had used and shifted towards bookbuilding. In 1999, the Korean IPO market followed the suit to adopt bookbuilding method for IPO valuation. 
The efficiency of the american bookbuilding method is known to be achieved by the reputable underwriters. That is, in the IPO market with information asymmetry, the reputable underwriters capitalize on their reliable investor networks for price discovery and allocation of IPO stocks. In short, the reputable underwriters play a “gatekeeper” role to achieve market efficiency. 
Unlike the US bookbuilding method that the underwriters have developed to achieve the intermediary function of the investment banking, Korea’s bookbuilding process was introduced and regulated by regulatory arrangements. This seems to leave Korean underwriters different from U.S. underwriters playing a significant role. The Korea’s different backgrounds take us to important questions about the efficiency of bookbuilding in Korea. Against the backdrop, our research question is as follows, “Has the Korea’s IPO market evolved into a gatekeeper market since the introduction of bookbuilding?” To answer it, we review regulatory changes since 1970’s and recent Korean IPO market features, and we examines the information efficiency of Korean bookbuilding method and the competition structure of the IPO market.
After the introduction of the bookbuilding, the Korean IPO market is observed to exhibit the following features. First, the IPO volume has decreased steadily. Second, Korean IPO firms show high ROA and low leverage, while IPO firms in advanced capital markets such as U.S. and U.K. show negative ROA and high leverage. Third, the magnitude of the Korea’s IPO underpricing is, albeit on a downward trend, high relative to advanced capital markets. Fourth, the market concentration index showing the degree of competition between underwriters has increased steadily and is internationally high. Fifth, Korean IPO spreads at one of the lowest levels in the world have recently been on a downward trend. These features cast doubt on whether the Korean IPO market structure has improved.
Our analysis on information efficiency reveals major changes as follows. Since 2007, a differentiation has been observed between the initial price range and institutional bids submitted in the bookbuilding process, which confirms bids’ higher information efficiency than that of the initial price range. It seems to suggest that information efficiency of Korea’s bookbuilding method has improved due to the shift towards a gatekeeper market. But, there is also evidence that rejects such shift. According to the descriptive statistics, most underwriters set the initial price range at a similar discount of the price-to-earnings and market-to-book multiples of comparable firms, and tend to set the offer price below the upper bound of the initial price range. In fact, it is difficult to find out where those results stem from: It could be either the formation of a gatekeeper market, or the regulatory reform and resultant changes in market participants’ behavior. If the latter is the case, then this should mean the appearance of the underwriters differentiating their services from the others to gain leadership in IPO market, which is directly examined through the analysis on the market’s competition structure. 
However, the results rejects our hypothesis that underwriters have evolved into a gatekeeper firm found in the U.S. IPO market. Although top underwriters in the Korean IPO market have secured their competitive edge, they have failed to differentiate their services enough to beat the low pricing strategy of competitors. Unlike the U.S. market, there is no evidence that top underwriters have competed with service quality, which seemed to have intensified the price competition in Korea’s IPO market: No improvements in service have been observed, for instances, voluntary market stabilization efforts, active analyst coverage after IPO, and long-term relationship building with some institutional investors. This leads us to the conclusion that Korea’s improved information efficiency stems from the regulatory overhaul rather than some improvements in underwriters’ service quality.
Given the characteristics of the Korea’s IPO market found in the analysis, it would be appropriate to define the Korean IPO market as an “infrastructure management market” rather than a “gatekeeper market”. The infrastructure here refers to authorities such as KRX and FSS. But such Korea’s IPO market structure should be changed due to two reasons. First, technology-based, innovative firms with high investment risk cannot go to public under the current IPO market structure where a significant part of underwriting is carried out by public infrastructure. Second, the market structure is losing its internal consistency under some competition. A demutualized exchange cannot prioritize its public functions. Hence, we propose to set Korea’s policy objectives as shifting the IPO market towards a “market discipline system”. 
More specifically, we suggest that,
1. Underwriter’s discretion in the bookbuilding operations in the IPO process be increased to the level on par with the American system;
2. Underwriters determine the offer price fully at their discretion without any intervention of regulatory authorities (KRX or FSS), and FSS improve the oversight so that the details  on determining the offer price may not be disclosed in the securities registration statement;
3. To ensure investor protection, regulatory authorities bolster oversight and supervision over unfair practices in exchange for granting wider discretion to underwriters; 
4. Regulatory authorities secure more effective sanction tools to ensure underwriters’ legal liabilities and accountability in relation to due diligence; 
5. The current regulation mandating bookbuilding be liberalized so that issuers can freely choose from bookbuilding, an auction, or a fixed-price method.
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보고서 1
The Internationalization of Asset Management Industry in Korea: Direction and Strategy [16-01]
Senior Research Fellow Kim, Jaechil and others / Mar. 02, 2016
In a broad sense, asset management industry includes investors, asset markets and asset management company as an intermediary between them. Thus, the internationalization of asset management industry can be defined as the status of investor’s capital flows   to asset markets taking place at different countries via asset     management company.
The internationalization of asset management industry has     various channels. This study focuses on the following three channels to set the directions for the internationalization. First, the role of Korean asset managers should be improved by invigorating the  overseas investment of domestic investors. Second, Korean asset management company should aggressively create the demand of  foreign investors. Third, we need to promote the financial center specialized in asset management. The primary goal of this study  is to provide the necessary tasks and strategies for achieving the above three directions.
Then, why is the internationalization of asset management industry important? Rapid population ageing leads to the conflicting results of a marked decline in the rate of return to investment and massive accumulation of retirement assets. Thus, domestic investors should come forward to invest overseas for efficient management of retirement assets with the help of special advisors. Considering that domestic customer base is not sufficient for the growth of Korean asset   managers, they should create foreign customer demand for the    long-term stability. The internationalization is also important for    Korean asset markets. The advancement of inbound internationalization means the internationally renowned asset managers and institutional investors becoming an active player in the Korean market. It may contribute to the improvement of Korean asset market by providing high quality information and creating the long-term asset demand.
The overseas investment by domestic investors has been growing, but there has been little change in the home bias. The investment pattern of individual investor is shifting from the indirect investment via asset managers to direct one. Especially overseas equity fund  investment of individual investors, once exploded in the middle of 2000s, has stagnated since the global financial crisis by the following factors. In terms of policy, as the tax exemption on overseas investment fund ended in 2010, the rich investors substantially exited from the overseas investment. For the problems pertaining to the asset     managers, their offered products were heavily inclined to specific regions and asset classes, which are rarely changed today. This   may result in the loss of investor’s confidence on the domestic   asset management company. Thus, the reformation of tax treatment on fund investment and capacity building of asset managers are  important factors to send the individual investors back to invest overseas. While the Korean government already acknowledged this  problem and decided to reintroduce the tax exemption on capital gain from overseas equity fund, this tax benefit should be settled down permanently. In addition, government should reduce the difference in tax treatment between overseas and domestic investment funds. At the same time, Korean asset managers should strive for developing new investment products and building management capacity by investing human capital and high quality management system. Importantly, the diversification of asset regions and classes is a must-do.
Recently, overseas investment by institutional investor has substantially increased. Most of pension funds including National Pension Service of Korea share the view that a fast-growing reserve should not be invested entirely on low-interest domestic assets. Still, the role of domestic asset managers in institutional investor’s overseas investment is very limited, which mainly results from the incompetence for overseas investment of domestic asset managers. Institutional investors including public pension funds consider management philosophy and system as well as management performance as a basis for stable investment, choosing consignment managers for overseas investment. Thus, Korean managers are in disadvantage due to the relatively short business history and the lack of capacity to meet the investor’s mandate for the multi country and multi asset class portfolio.
While the capacity building such as investment for human capital and management system is required for domestic asset managers to play a substantial role for overseas investment of institutional investors, we need to find a way to the partnership plan for mutual growth of institutional investors and Korean asset management company. The introduction of rookie managers for consignment management is a good example. At the same time, the obstacles for public pension funds to overseas investment such as the governance and short-term oriented performance evaluation should be removed.
For recent years, domestic managers have strived for overseas expansion, even though solid foreign customer base has not been made yet. Korean managers barely utilized UCITS fund as a vehicle for cross-border fund exports. Overseas expansion has been confined to the intermediary role for fund management to serve the domestic customer. The biggest obstacle for creating foreign customer lies at the lack of understanding. Major asset management companies which enjoy a considerable profit from domestic operation do not identify the need for overseas expansion. Thus, the management profits tend to be paid to shareholders as a dividend rather than retained them for future growth, which in turn makes asset managers with relatively long business history focus on domestic market due to the lack of capital for overseas expansion. Thus, various options for raising capital such as retained earnings, issuing new stocks and debts should be considered. Of course, upgrading corporate culture and organization for overseas investment should go side by side.
While there are few impediments to creating overseas demand in terms of regulation, the treatment of corporate type investment trust as a general corporate body is the one of biggest obstacles among the remainders. If a domestic manager set corporate type trust in U.S. or Europe, it should follow all the regulations related to financial holding companies act and foreign exchange trading act, because the fund is regarded as a foreign affiliates.
The asset managers also consider how they actually expand into overseas market; the green field investment of building new affiliates or branches and the brown field one of purchasing the existing firms to serve the target market. Literature study on the cases of global asset managers to extend their business abroad tells the following implications. First, the globally renowned managers were very cautious and conservative on overseas expansion even after being established in the domestic market. Second, they actually mixed the green field and brown field strategies properly. Third, the retail-oriented business model is not suitable for the green field strategies, because the penetration of foreign retail customers is very costly. These findings imply that the small scale green field strategy may not be a successful option for Korean asset managers with the lack of international awareness to pursue the retail-based model. Thus, domestic managers should consider the aggressive strategies, if they have an intention for overseas expansion. The possible business models may include 1) large scale green field investment with the reorganization of domestic operation, 2) fund exports via UCITS by purchasing boutique managers in Europe and 3) the acquisition of exiting medium scale managers in the target country.
Lastly, we turn to promoting the financial center specialized in asset management. There exist two kinds for this type of financial center; the hub type such as Luxemburg and Singapore to connect the investors and asset markets, and the asset management oriented one such as Australia for asset managers to enter the market serving a large customer base. Considering the economic fundamentals    and market ecosystem, we believe that the asset management type may be more appropriate for Korea. The success of the financial  center specialized in asset management mainly depends on attracting the global asset management companies and the long-term        investment from global institutional investors to Korea. A number of global asset managers have entered the Korean market, but    small market size and financial regulation in Korea induced the   local affiliates of global asset manage company play a peripheral  role in the Korean asset manage industry. To build the financial  center in Korea, asset management market expansion, promotion  of private equity fund market through deregulation, improvement  in corporate governance, and open-minded perception about foreign investors  to enter the domestic market are required. Considering that the raised issues are mostly related to the government policy, the government should have a strong drive and determination to handle the impediments to the financial center in northeastern Asia.
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보고서 1
Internationalization of Chinese yuan and its impact on international monetary and financial order [15-05]
Senior Research Fellow LEE, Seungho and others / Dec. 24, 2015
While major advanced countries including U.S. has conducted unconventional monetary easing since the global financial crisis, China has aggressively strived to internationalize its currency, yuan. The internationalization of Chinese yuan is based on reducing China’s dependence on U.S. dollar and enlarging its impact on international monetary and financial order as G-2.
Considering its early stages of financial account opening and less mature domestic financial markets, China pursued to develop offshore renminbi market and gradual opening of its domestic markets. For this purpose, China set the long-run goal of shifting Chinese yuan to the reserve currency in international financial markets, while focusing on the expansion of trade settlement by renminbi in the mean time.
As a starting point of renminbi internationalization, trade settlement has increased faster than expected. As of 2014, Chinese yuan accounts for 24% of total trade settlement in China. In addition, yuan is ranked No.5 in the global trade settlement, following U.S. dollar, euro, British pound and Japanese yen. Within the border, Chinese government allowed outward renminbi remittance and loan through financial special districts. 
At the same time, various policies such as designation of yuan clearing and settlement banks in the offshore markets, real time payment and settlement system and bilateral swap agreements have been introduced to promote the offshore markets. Now, yuan clearing and settlement banks have been designated in 15 countries and there are 33 countries who signed the bilateral swap contracts. As a result of the continued efforts, offshore financial markets have prospered. Offshore renminbi deposits reached 2 trillion dollars at the end of 2014. In addition, offshore yuan-denominated bond outstanding was 95.4 billion dollars. In addition, the inbound investment channels such as RQFII and Shanghai-Hong Kong stock connect have been implemented recently.
With this policy effort by Chinese government, many economies including Hong Kong, Singapore, Taiwan and the United Kingdom are trying to utilize the renminbi internationalization as their new opportunity by promoting the yuan-denominated financial trading in their domestic financial markets. Especially, Hong Kong is a leading economy to develop offshore renminbi markets, using its established status as international financial center and close ties with Chinese government. Korea also started to build yuan-trading infrastructure such as the designation of clearing and settlement bank and Korean won-yuan direct trading market opening since the Korea-China summit in 2014. 
61% of RQFII quota granted to Korea was already approved to the Korean financial institutions and the trading volume at the won-yuan foreign exchange market is high, even though yuan still accounts for very small share of trade settlement between the two countries.
It’s difficult to predict how fast yuan internalization will progress to be equal to the status of U.S. dollar and euro in the global financial market. Until now, Chinese financial account opening remains at the early stage and the prerequisites to become the reserve currency such as mature financial markets are not met. While its economic size is large enough for renminbi to become one of key currencies in international financial market, it is not as attractive as the other reserve currencies in terms of the small share in international bond markets and relatively closed domestic financial markets.
China has had strong trade linkage with regional Asian countries, and now it becomes increasingly connected to the global economy as a whole. In addition, Chinese efforts to make yuan exchange rate flexible may raise the possibility of making the regional economy ‘yuan bloc’. In this case, the impact of yuan exchange rates on regional currencies will be expected to grow. Empirical results based on several methodologies in this research also confirm the increased impact of yuan since its internationalization policy has been conducted. 
This implies that yuan is now replacing for the role as the reference currency once Japanese yen has taken in the region. If the Chinese financial markets become more open to the foreign investors, the impact of yuan on regional financial markets and economy will increase with the yuan bloc strengthened.  
Recent inclusion of renminbi into IMF SDR basket will contribute to raising its demand and status in international financial markets. In the long run, Chinese yuan is expected to rise as one of the key international currencies and to impact the current dollar-centered financial order. For the time being, the status of U.S. dollar supported by the largest economy and most developed financial markets in the world will be maintained, but it is likely that the global monetary system will shift to the multi-polar regime. 
The change of regional and international financial order in response to Chinese yuan’s emerging is expected to have significant impacts on the Korean economy. Its positive aspects include greater macroeconomic resilience by promoting the Korea-China trade and reducing Korea’s dependence on U.S. dollar. In addition, the portfolio investment to China as well as the inflows of Chinese capital to Korean financial markets will provide a new growth opportunity for the Korean financial service industry.
However, the increased capital inflows and outflows from China will affect the domestic financial instability. Moreover, Chinese economic downturn as it happened can be quickly spread to the domestic real economy and amplify the negative impact by deteriorating the risk for the portfolio invested in China. 
From the discussions above, we can drive the following policy implications. First, Considering that the renminbi internationalization is closely related to the financial market opening and greater trade and financial linkage with China, we should carefully monitor Chinese financial market and macro economy. 
Second, the regional monetary and exchange rate coordination should be strengthened further. Because the Chinese macroeconomic policy change will have a greater impact on the regional finance and economy through the construction of yuan bloc, the regular and effective discussions among the policy makers in Korea, China and Japan are needed. In addition, Korea should consider its own currency internationalization.
Third, we have to utilize the revitalization of investment to China. Because the yuan-denominated financial products provide higher yields, public pension and private financial institutions should considering greater weights to Chinese market with necessary risk management. In addition, increasing the share of Chinese yuan in the foreign exchange reserves should be worth consideration in the long run.
Lastly, the yuan trading in the Korean financial market should be expanded. For this purpose, the supply base for renminbi liquidity should be enlarged by inducing the yuan settlement for Korea-China trade. However, as it takes time to for exporting companies to change their invoicing currency, the effort from the financial sectors to raise the demand for yuan should be preceded.

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