Despite Seoul’s continuous efforts to align its financial infrastructure with global developed market standards, persistent foreign exchange access issues remain a significant barrier.
South Korea has once again been overlooked for an upgrade to MSCI’s coveted developed market status, extending Seoul’s long-term ambition to transition from its current emerging market classification. This decision comes despite a comprehensive reform agenda specifically designed to enhance foreign investor accessibility.
MSCI, in its annual market classification review, announced early Wednesday Korea time that the country will remain in its emerging market category and was not added to the watchlist for potential developed market reclassification. This outcome pushes back South Korea’s upgrade timeline, as MSCI policy mandates a period on the watchlist before any formal reclassification can occur.
The global index provider acknowledged South Korea’s various reform initiatives but underscored that these measures have not yet sufficiently addressed the fundamental accessibility challenges.
“In Korea, authorities have continued implementing the reform agenda introduced in prior years, with additional measures announced across several areas,” MSCI stated in its global market accessibility review. “However, underlying accessibility issues remain unresolved.”
Key Hurdle: Foreign Exchange Market Access
MSCI’s most significant critique centered on the foreign exchange (FX) market. Specifically, the Korean won’s non-deliverable status offshore and the perceived insufficient liquidity within the onshore FX market during extended trading hours were highlighted as falling short of developed market benchmarks.
According to MSCI, the thin onshore liquidity during these extended FX trading periods hinders the tight execution standards global investors expect, similar to those in developed markets. This issue, it noted, “is constraining FX operational flexibility for index replicators and others.”
In a joint statement, the Korean government, through its Finance Ministry and financial authorities, responded that several reforms are still in progress, while others require more time to yield their intended impact. They reaffirmed their commitment to ongoing foreign exchange and capital market reforms, tailored to Korea’s own strategic timeline.
Reforms Await Market Validation
This setback illuminates a disparity between South Korea’s announced reform efforts and the level of operational convenience and fluidity MSCI expects from developed market environments. For MSCI, the crucial consideration wasn’t merely the number of policy measures introduced by Korea, but whether international investors could seamlessly trade, hedge, settle, and transfer Korean assets with the same ease experienced in developed markets.
To tackle the FX accessibility concerns, Seoul has implemented measures such as expanding access for registered foreign financial institutions, extending FX trading hours, and piloting third-party FX transactions with overseas investors.
The government also plans to launch a 24-hour onshore FX market in July. This will precede the introduction of a new offshore won settlement framework, designed to allow authorized foreign financial institutions to hold and transact in Korean won through accounts established within South Korea.
However, MSCI’s latest assessment suggests these significant steps are either still underway or require more comprehensive testing and validation. The index provider’s report emphasized that market participants need “ample time” to thoroughly evaluate the sustained effectiveness of these reforms before any reclassification consultations can commence.
Beyond FX, Korea has also enacted other significant reforms. These include abolishing the decades-old foreign investor registration requirement, adopting Legal Entity Identifiers (LEIs), expanding English-language disclosures, permitting broader use of omnibus accounts, and resuming short selling following an extended prohibition.
A seasoned capital markets researcher from the Korea Capital Market Institute suggested that South Korea might need to take further steps to fully address MSCI’s core concerns regarding offshore won accessibility.
“What foreign investors truly desire is the ability to exchange the won and the dollar in financial hubs like New York or London,” the researcher explained, speaking on condition of anonymity. “However, Korea’s current proposal is to keep the Seoul market open for 24 hours, requiring them to transact through Seoul. This is distinctly different from establishing an offshore spot won market.”
The planned offshore won settlement framework, while improving settlement access, does not equate to allowing offshore spot trading of the Korean won, the researcher further clarified.
While South Korea could still potentially be placed on the MSCI watchlist next year if its reform efforts are duly recognized, this wouldn’t signify an immediate resolution of the underlying issues, the researcher cautioned.
“Watchlist inclusion is a preliminary step, not the same as actual developed market inclusion,” the researcher noted, adding that such a process would still entail at least another year of review, followed by additional time for actual index rebalancing post-upgrade decision. “Even under the most optimistic scenario, this would likely take three to four years from now.”
Historically, Korea was placed on MSCI’s developed market watchlist in 2008 but was removed in 2014 due to insufficient progress on market accessibility – the very issue that continues to impede its upgrade bid today.
Even if South Korea eventually overcomes MSCI’s stringent requirements, some global investors maintain a cautious outlook on the potential implications of developed market status for the broader market.
Speaking at a Seoul forum on Tuesday, Alexander Redman, CLSA’s chief equity strategist, conceded that Korea presents a strong economic case for developed market status. However, he warned that such an upgrade might not necessarily guarantee widespread foreign investment demand across the entire market.
“From a merit-based approach, yes, Korea absolutely warrants developed market status,” Redman stated. “The more pressing question is whether this will actually be a beneficial development in the short term.”
He elaborated that an upgrade could trigger mandatory selling by emerging market funds, while global funds might primarily concentrate their investments on Korea’s dominant semiconductor companies, rather than diversifying across the broader market.
Should Korea be upgraded, it would transition from being “the archetype of a big fish in a little pond to a very small fish in a very large pond,” Redman illustrated, raising concerns about a potential investment vacuum in mid- and small-cap shares.
“Will these new funds buy the rest of the market? That remains a significant, unresolved question.”
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