A Hole Too Big for Korea to Ignore?

The investment-trust industry could undo Seoul's reforms

After the 1997-98 financial crisis, South Korea was faced with a long to-do list: Recapitalize the banks, let in more foreign investors, allow the currency to float freely. To Korea's credit, much of that has been done. But when it came to the country's $140 billion investment-trust industry, policymakers stopped before they finished the job.

Analysts now say that if more reforms aren't pushed through, its problems could explode with the next recession or sharp downturn in the market--and undo much of the progress made elsewhere in the financial sector. "An urgent surgery is necessary in the industry before the ailment gets more serious," warns Ko Kwang Soo, a research fellow at Korea Securities Research Institute.

The investment-trust industry holds a big part of the country's savings, yet it's riddled with absurd practices. The firms, which run mutual funds and money-market funds, continue to sit on billions of dollars' worth of nonperforming assets, such as the bonds of companies on life support that no longer pay interest. Some of the funds at the two oldest firms, Korea Investment Trust Co. and Daehan Investment Trust Co., promise fixed rates of return. Yet they invest in stocks and bonds, running the risk of disaster if their investments tank. No matter, says the government. "We had to let them sell products with attractive terms to help ease their liquidity squeeze, caused by [bad] debts," says one Finance Ministry official.

This mess was long in the making. In the 1970s, the government got the trust firms going to create a pool of money to fund the country's industrialization, and it regularly pressured them to buy securities when the market sagged. The big crisis came in mid-1999, when Daewoo Group, Korea's second-largest chaebol, went belly-up.

The funds were stuffed with Daewoo securities, and the savings of millions of Korean mom-and-pop investors were threatened.

The government injected $6.5 billion into Korea Investment and Daehan Investment. In addition, it had a state-run agency buy $15.2 billion worth of unsecured Daewoo bonds from the trust firms. And in 2000, it began requiring that most trust firms value their funds at current market prices and provide a daily disclosure showing what they're investing in.

But the trust industry remains the stepchild of Korean financial reform. Because of the plan, no firms folded, but it stopped short of solving their long-term problems. And although most funds must now honor new disclosure rules, money managers handling high-risk funds and fixed-rate accounts still aren't required to say what they're buying.

What's more, they're not required to follow mark-to-market principles. The result: "No outsider knows the health of the accounts," says one industry official. Analysts say the government should have injected twice as much into the most troubled trust firms. Accumulated losses at one, Hyundai Investment Trust & Securities Co., now exceed its capital by $1.6 billion. The government plans to bail it out and then arrange its sale.

Savers and investors, predictably, remain wary of the industry. The combined value of funds under management of the country's 30 trust firms peaked at $205 billion in 1999, and fell to as low as $109 billion in 2000. Assets are expected to climb back to $139 billion this year. But the fund companies are losing their battle with the banks to be the refuge of choice for savings. Trust-firm assets equaled only a third of bank deposits last year, compared with 80% in 1998.

The trust firms have other problems, too. They offer their customers too many fund choices, some critics say, so the average fund size is less than $20 million. Most of the funds are bond funds, and their small size makes it hard for money managers to spread their risks, so managers sometimes pool their funds when buying bonds. Some then distribute the profits to favored funds, which is not illegal in Korea. In this game of shuffle the money, institutional investors aren't shy about pressing their advantage. They often threaten to pull out of a fund unless they get a promise of high returns, which means the retail investor is likely to get cheated.

The trust firms' woes are festering at a time when South Korea is trying to leave the financial crisis behind. "Korea needs a stable and sound capital market if the country's resources are to be allocated efficiently," says Woo Jae Ryong, chief executive of Korea Fund Research, a fund-rating firm. "We must address the problems in the fund-management industry." But with little reform on the horizon, Korea won't be wrapping up its postcrisis to-do list anytime soon.

By Moon Ihlwan in Seoul

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