Korea Fails to Join Global Sovereign Bond Index... Market Expects "September Hope"

FTSE Russell "Need to Observe Market Reaction More on South Korean Government Measures"
Focus on Inclusion in September This Year... Expecting 90 Trillion Won Inflow and Long-Term Bond Benefits

South Korea's early inclusion in the World Government Bond Index (WGBI) has failed. FTSE Russell, the Financial Times Stock Exchange Russell that manages the WGBI, announced on the 30th (local time) that South Korea will maintain its status as a watchlist country for the government bond index. FTSE Russell explained the background by stating that it will continuously monitor the implementation of various measures announced by the South Korean government and the market's response to them. In its report, FTSE Russell stated, "Although Korean authorities are pursuing several initiatives to improve the structure and accessibility of the capital market, these measures require amendments to regulations to be smoothly implemented, which will take until 2024." This means that the various measures by Korean authorities to improve the capital market structure have not yet produced substantial results. FTSE Russell also said, "We plan to continue monitoring market opinions on South Korea's efforts to improve market structure, such as tax clearance issues and efficient foreign investor registration."

As one of the world's top three bond indices, the inclusion of government bonds from 23 major countries including the United States and the United Kingdom in the WGBI is announced twice a year in March and September. The assets tracking the index are estimated to be around $2.5 trillion. If South Korea is included in the WGBI, it is expected to enhance the credibility of Korean government bonds and attract foreign investment funds that track the WGBI.

FTSE included South Korea in the watchlist in September last year. Because of this, there had been speculation about the possibility of index inclusion as early as March this year. However, this was only the earliest possible inclusion date, and the market largely believed that the actual inclusion would likely occur after September.

Jaekyun Lim, a researcher at KB Securities, attributed the reason why Korean government bonds were not included this time and why inclusion is expected as early as September to South Korea receiving market accessibility Level 1. Yoonmin Baek, a research fellow at Kyobo Securities, also said, "Realistically, the possibility of WGBI inclusion seems higher in September," adding, "Since South Korea's current market accessibility is at Level 1, it needs to be raised to at least Level 2 for WGBI inclusion." Although the government announced market accessibility improvement measures, most have not yet been implemented.

Quantitative Criteria Met but Market Accessibility Factors Insufficient

The most important factors determining final inclusion in the WGBI are the 'quantitative factors' such as the size of the domestic government bond market, and the 'market accessibility factors,' which comprehensively assess the target country's macroeconomy, foreign exchange market and bond market structure, and connectivity with global custodians and depositories. As of last month, South Korea met the quantitative criteria with a treasury bond issuance balance of 965.1 trillion won, exceeding the $50 billion (approximately 64 trillion won, credit rating S&P A-) threshold.

However, challenges remain in the market accessibility factors. Although revisions related to tax exemption on interest and capital gains for foreigners' government bond purchases were completed earlier this year, issues such as ▲extension of trading hours and participation of overseas financial firms in the onshore foreign exchange market (to be implemented from July next year) ▲opening of a euroclear-KSD integrated government bond account (targeted for the first half of the year) ▲abolition of the foreign investor registration system (targeted for the third quarter) remain. Completing these tasks is necessary to achieve market accessibility Level 2.

Researcher Lim explained, "While tax exemption is applied to foreigners' investments in government and monetary stabilization bonds, and efforts are underway to modernize the foreign exchange market and extend trading hours, the decisive factor for index inclusion is the introduction of euroclear." Euroclear is an international central securities depository account that allows trading of government bonds. The WGBI, which includes government bonds from 23 major countries such as the United States, United Kingdom, Japan, and China, is one of the world's top three bond indices. Last year, the government signed a memorandum of understanding (MOU) with Euroclear, and in January at the World Economic Forum (WEF) held in Davos, Switzerland, Deputy Prime Minister Choo Kyung-ho met with the Euroclear CEO and stated preparations are underway for Euroclear implementation within the year.

WGBI's Assets Under Management Estimated at $2.5 Trillion

The assets tracking the WGBI are estimated at approximately $2.5 trillion. Among the world's top 10 countries by nominal GDP, only South Korea and India are not included in the WGBI. If South Korean government bonds are included, foreign funds tracking the index will flow into the government bond market, enhancing the credibility of the bonds.

Due to the relatively low status of government bonds, a discount (undervaluation) occurred on won-denominated bonds, causing interest rates to rise further. However, joining the bond index is expected to lower bond issuance rates and attract additional foreign currency funds. KB Securities estimated that if Korean government bonds are included in the bond index, new funds flowing into the Korean bond market would amount to $66.93 billion, approximately 89.5 trillion won. KB Securities also estimated that the interest rate reduction effect would be about 90 basis points (1bp = 0.01 percentage points). Research fellow Baek also said, "South Korea's inclusion in the WGBI is clearly a positive factor for supply and demand as it can expect additional foreign buying funds, and if WGBI inclusion becomes visible, foreign bond investment funds are likely to flow in proactively." Considering the size of funds tracking the WGBI and South Korea's expected WGBI inclusion weight (2.0~2.5%), he forecasted that the amount of foreign funds that could flow into the domestic market upon index inclusion would be between 70 trillion and 90 trillion won.

A government official said, "We will do our best to accelerate the implementation of institutional reforms and strengthen communication with the market to enable inclusion by September."

Meanwhile, if Korean government bonds are included in the WGBI, they will be included in the index according to the outstanding issuance amount. In theory, since the inclusion scale is determined by the outstanding amount, there is no difference by maturity. However, all bonds with a holding ratio exceeding 50% by funds and insurance companies have a remaining maturity of over 10 years. Insurance companies have high demand for ultra-long-term bonds due to asset and liability duration matching. Also, some bonds with large holdings by insurance companies and funds are also held by foreigners. Unlike short-term bonds with arbitrage trading demand, foreign investors holding long-term bonds are likely to be long-term investors such as central banks or central governments. Therefore, experts expect that the benefit from WGBI index inclusion will mainly go to long-term bonds due to the limited amount of bonds circulating in the market.