Seoul's High Stakes Shell Game

How long can it prop up troubled investment trusts?

South Korea appears to be on the verge of financial stability. The government has worked out an agreement with the foreign creditors of Daewoo Group, the failed chaebol. Banks are lending money again. The currency is holding steady. Foreign exchange reserves are rising. But behind the scenes, the government is still playing a shell game, moving public money from its coffers to prop up troubled investment trust companies and doing whatever is necessary to shield them from market forces.

That's why on Feb. 8 it will have to make good on a promise to repay retail investors 95% of the original value of Daewoo bonds they hold. The 24 trusts bought some $24 billion worth of the paper in 1997 and 1998, figuring that Seoul wouldn't let a company as big as Daewoo go under. Of course, they figured wrong. Daewoo all but declared bankruptcy in July, 1999; the bonds became practically worthless. The government feared a run on the trusts that together manage about $170 billion--more than a fifth of all South Korean savings--and so offered the guarantee.

Seoul isn't taking any chances. The government estimates that redemptions could reach as much as $27 billion, including $21 billion worth of bonds that will have matured by Feb. 8. In preparation, officials secured $32 billion and a promise from the central bank to buy bonds directly from the trusts if necessary. "There won't be any financial calamity in February," declares Lee Yong Keun, chairman of the state-run Financial Supervisory Commission.

CRASH CONTROL. The government has every reason to be cautious. Since July, Koreans have withdrawn some $54 billion from the trusts. If 10 million spooked investors pulled out the rest of their money, the trusts would have to dump stocks and bonds to cover the redemptions. That would bring down the equity market and send interest rates soaring; the economy would reel back into recession

Seoul's policy isn't motivated only by economics, though. Parliamentary elections are due in April. With more than a third of all voters holding trust accounts, President Kim Dae Jung wants to avoid inflicting financial pain on them. Nor does he want other taxpayers to think they will have to foot the bill for trust companies' losses. Many people seem unaware that they have already begun to. And there's no getting around the fact that one day Seoul will have to bail out the entire investment trust system. "Eventually, the government will have to use taxpayers' money to clean up the trusts," says Shin In Seok, a research fellow at Korea Development Institute, a government think tank. There's no saying now just how much that could cost.

For now, though, a cleanup isn't on the government's agenda. It just wants to keep the trust companies up and running. Korea Asset Management Corp., the state agency charged with sorting out the financial sector, has agreed to buy $16.6 billion of unsecured Daewoo debt from the trusts at a 65% discount. And the government will directly inject $2.6 billion into the two oldest and most troubled trusts--Korea Investment Trust and Daehan Investment Trust Co. Their combined losses exceed their net worth by $1.6 billion (table).

Adding to the problems of the trusts in general is an absurd settlement system. When customers redeem their shares in bond funds, they are paid out immediately--based on the previous day's prices. "The trusts were set up in the 1970s to create a new source of funds for the country's industrialization, not because of market needs," explains Shin Hwa Seob, a planning manager at Daehan Investment.

LIMITED REFORM. Policymakers have tried to make the trusts competitive. But often their initiatives fail for want of political will. Last year, for example, the government mandated that the trusts must sell part of their portfolio to meet redemption claims, instead of borrowing cash and handing it out right away. Yet the new system won't apply to most bond funds until July. That's also when the trusts will have to begin adhering to the most basic accounting principle: calculate the value of bonds based on market prices, not on inflated purchase prices. Even then, the rules will apply only to new bond funds.

If they're applied at all. Seoul could easily back down. But as long as the government continues to prop up the investment trusts with public money and protect them from market forces, Korea's financial system is in jeopardy. The shell game is more dangerous than it looks. In the end, the losers come up empty-handed.