[MSCI Advanced Index Agents]② Controversy Over Full Resumption of Short Selling... Side Effects on Inclusion Must Also Be Considered

Criticism of Insufficient Market Accessibility Improvements for Foreign Investors
Concerns Over Passive Capital Outflow from MSCI Emerging Markets ETF Upon Inclusion

The biggest obstacle to inclusion in the Morgan Stanley Capital International (MSCI) Developed Markets Index is short selling. Morgan Stanley considers factors such as ▲economic growth level ▲stock market size and liquidity ▲market accessibility for foreign investors as conditions for inclusion in the MSCI Developed Markets Index. Currently, the domestic capital market has no significant issues in terms of economic growth level or stock market size and liquidity. However, it is evaluated that market accessibility for foreign investors is lagging behind.

Market Accessibility Improvements Still Insufficient

The financial authorities are promoting three major initiatives to upgrade Korea to MSCI developed market status: improvements in the foreign exchange market, capital market system reforms, and dividend system improvements. To improve the foreign exchange market, the Ministry of Economy and Finance and the Bank of Korea plan to gradually introduce a 24-hour trading system. They are working on extending the closing time of the domestic foreign exchange market from 3:30 PM to 2 AM, which is the closing time of the London financial market in the UK. Depending on market conditions, they plan to expand it to 24 hours.

The financial authorities are preparing to enhance capital market accessibility by abolishing the foreign investor registration system, activating integrated accounts, providing convenience for over-the-counter trading, and implementing English disclosures.

The foreign investor registration system requires foreigners to register with the Financial Supervisory Service in advance to invest in the domestic capital market. To abolish this system, amendments to the Enforcement Decree of the Capital Markets Act, regulations on financial investment business, and enforcement rules are necessary. The Financial Services Commission aims to complete the amendment of the Enforcement Decree within the first half of this year.

Mandatory English disclosures are also being pursued. Currently, Korea relies on system-based automatic English translation and voluntary English disclosure submissions by companies, limiting foreign investors' access to information. The Financial Services Commission and the Korea Exchange revised related regulations in March and are promoting the introduction of mandatory English disclosures in two phases, scheduled to start in 2024. In phase 1 (2024?2025), English disclosures will be mandatory for KOSPI-listed companies with assets over 10 trillion won or those with foreign ownership of 30% or more (with assets between 2 trillion and 10 trillion won), focusing on market-critical information, excluding companies with foreign ownership below 5%. In phase 2 (from 2026), the scope will expand to companies with assets over 2 trillion won, including summaries of some statutory disclosures in English in addition to existing English disclosures.

However, MSCI demands that Korea's improvements reach a level that global investors can tangibly experience. A financial investment industry official pointed out, "Many initiatives are still underway, so there are no improvements that foreign investors can feel yet." Lee Kyung-min, a researcher at Daishin Securities, said, "While mandatory English disclosures are an improvement, they are insufficient to be evaluated at the developed market level. In 2022, over 60% of companies listed on the Tokyo Stock Exchange provided English disclosures, and even with phase 2 of mandatory English disclosures, Korea will still have a significant gap compared to Japan."

Full Resumption of Short Selling Remains Uncertain

The biggest hurdle to improving market accessibility is short selling. On March 16, 2020, the Financial Services Commission temporarily banned short selling on all KOSPI and KOSDAQ stocks to reduce stock price volatility caused by the COVID-19 pandemic. After volatility decreased, in May 2021, short selling was allowed only for 350 large-cap stocks included in the KOSPI 200 and KOSDAQ 150 indices.

More than two years have passed since the partial resumption, but a full resumption has yet to occur. There is strong criticism that the short selling system is biased in favor of institutions and foreigners, creating a "tilted playing field." Moreover, the public sentiment worsened due to the stock price crash triggered by SG Securities. Negative public opinion about Contracts for Difference (CFD), which caused the crash, is making the full resumption of short selling difficult.

With less than a year until next year's general election, the ruling party faces significant political burdens in bringing up the card of fully resuming short selling, which could cause a considerable drop in approval ratings. A financial investment industry official predicted, "Full resumption of short selling will likely only be discussed after next year's general election."

There is also conflict between the Korea Exchange and MSCI over index usage. MSCI has demanded three preconditions in addition to the full resumption of short selling for inclusion in the developed markets index: expanded offshore foreign exchange market openness, abolition of foreign investor registration requirements, and index usage rights. MSCI can develop financial products using indices such as the KOSPI 200 calculated by the Korea Exchange, but the original intellectual property rights of the indices belong to the exchange. MSCI requested the removal of prior approval for listing financial products using the indices, but the Korea Exchange reportedly rejected this. The Korea Exchange is concerned that if new financial products developed by MSCI are traded in overseas stock markets, trading of related products in the domestic market may shrink and profits may decrease.

Will 65 Trillion Won Flow into Domestic Stock Market upon Inclusion?

Although the government's inclusion in the MSCI Developed Markets Index is a long-cherished goal, there are also voices questioning how effective the actual impact of inclusion will be.

The Korea Economic Research Institute predicted a maximum inflow of 61 trillion won in funds upon MSCI developed market inclusion in 2021. The Korea Capital Market Institute stated in a report last year that the size of funds tracking the developed markets index is 5 to 6 times larger than those tracking emerging markets indices from an optimistic perspective. Accordingly, they forecast an inflow of $5 billion to $36 billion (approximately 6.5 trillion to 47 trillion won). According to a report published by Goldman Sachs this year, the expected fund inflow if Korea is included in the MSCI Developed Markets Index is estimated at $56 billion (approximately 73 trillion won).

Kiwoom Securities evaluated that inclusion in the MSCI Developed Markets Index would be positive for the domestic stock market in terms of expanding foreign investor demand. They judged that the passive fund (market index tracking investment funds) demand effect would be greater for the MSCI Korea Index than for the KOSPI 200. As of the second quarter of last year, funds tracking MSCI indices amounted to about $13.5 trillion (approximately 17,400 trillion won), with the developed markets index accounting for a significantly larger proportion. Also, the MSCI Korea Index has shown better long-term performance compared to the KOSPI 200, recording higher annual returns than the KOSPI 200 in 7 out of the last 10 years.

However, there are skeptical voices regarding the effect of MSCI developed market inclusion. Although new funds will flow in, outflows from funds already invested in emerging markets indices are inevitable. Park Eun-seok, a researcher at Hanwha Investment & Securities, said, "Upon inclusion in the MSCI Developed Markets Index, about $2.8 billion (approximately 3.37 trillion won) of passive funds are expected to flow out from the domestic stock market," adding, "Currently, about $13.44 billion of passive funds have flowed into the domestic stock market through MSCI Emerging Markets ETFs, but if Korea is included in the MSCI Developed Markets Index, all passive funds from MSCI Emerging Markets ETFs will exit."

Jung Eui-jung, president of the Korea Stock Investors Association, emphasized, "The effectiveness of MSCI developed market inclusion must be examined first," and added, "There is a possibility that entering the developed markets index could have adverse effects, so improving the domestic stock market should take priority over inclusion in the developed markets index."

The Korea Capital Market Institute also stated that preconditions must be resolved before inclusion in the developed markets index, and that natural inclusion would be ideal. Lee Seung-ho, senior researcher at the Korea Capital Market Institute, said, "Inclusion in the MSCI Developed Markets Index is a long-standing goal and could be a turning point for our financial market to take a step forward," but also pointed out, "It is difficult for positive effects to appear dramatically in the short term upon inclusion, and there are many preconditions that must be resolved regardless of index inclusion."

Meanwhile, some believe that even if Korea cannot enter the developed markets index for the time being, just preparing for it will help alleviate the undervaluation of the stock market to some extent. Kim Jin-young, a researcher at Kiwoom Securities, said, "Even if inclusion in the developed markets index fails, ongoing efforts to modernize the financial market are expected to help resolve chronic problems faced by the domestic stock market," emphasizing, "Inclusion in the MSCI Developed Markets Index should be viewed as a long-term task for improving the Korean stock market's structure, and once the government's institutional reforms begin to be fully implemented, the Korea discount problem will also be alleviated."