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As Chairman and CEO of the Korea Stock Exchange, Hong In-Kie was committed to
leading the development of the Korean capital markets to a truly world-class level. He
believed that the long-term prosperity of Korea depended critically on the success of this
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Traditionally, the stock market played a relatively small role in the Korean ¬nancial
system. The ¬rst signi¬cant boost to the Korean stock market came in 1976 when the
Securities and Exchange Law underwent extensive revision. The main objective of the
amendment was to ensure more effective supervision of the securities industry and to re-
inforce investor protection.
Throughout the latter half of the 1970s, the Korean securities market experienced an
Korea Stock Exchange 1998

unprecedented rush of public offerings. The number of listed corporations, which stood
at only 66 in 1972, jumped to 356 by the end of 1978. At the end of 1997, the number
of listed companies was 776. During the period from 1972 to 1997, the traded value of
listed stocks jumped more than two thousandfold from 71 billion won to 162.3 trillion
won and the total market capitalization increased from 246 billion won to 71 trillion won
(see Exhibit 6 and Exhibit 7).
Even though the absolute amount of both the traded value of stocks and market cap-
italization has increased over time, the relative magnitude of market capitalization to
GDP declined in recent years. In 1994 and 1995, the market value to GDP ratio was
greater than 40 percent, but it declined to 30 percent in 1996 and to 17 percent in 1997
(see Exhibit 8). The signi¬cance of equity as a source of ¬nancing also decreased over
the last decade: The proportion of ¬nancing from the stock market relative to all sources
of external ¬nancing declined from 23 percent in 1989 to 7.87 percent in 1997 (see Ex-
hibit 9 and Exhibit 10).
The KOSPI composite index (100 as of January 4, 1980) rose from 532 on January 1,
1988, to 1007 on April 1, 1989. Many small investors were counting capital gains in ex-
cess of 100 percent in a little over a year. However, this 1988“89 upturn in the Korea
Stock Exchange was not sustainable. The composite index has since dived and climbed
like a roller coaster. On August 21, 1992, the composite index bottomed out at 460.
Many small investors became seriously disillusioned with the stock market in 1992,
blaming the government for their losses. Indeed, for political reasons the government
had repeatedly intervened to prop up share prices by infusing large in¬‚ows of cash from
various stabilization funds. Hardly anyone approached the market from a long-term per-
spective of focusing on the fundamental ¬nancial soundness of the company, managerial
acumen, or on dividend performance.11

Recent Developments
After Mr. Hong became the CEO of the stock exchange in 1993, he initiated several ef-
forts to modernize it. In 1996 the stock exchange moved to a new skyscraper with a fully
computerized trading ¬‚oor and a strict computerized surveillance system to monitor
trading activity. Under Mr. Hong™s leadership, the Korea Stock Exchange introduced de-
rivative products for the ¬rst time”KOSPI 200 stock index futures contracts in May
1996, and KOSPI 200 stock index option contracts in July 1997. While Mr. Hong was
proud of these innovations, and the investments in improving the physical infrastructure

11. James M. West, “Korea Stock Exchange,” Korea Herald, August 30, 1998.
22 A Framework for Business Analysis and Valuation Using Financial Statements

A Framework for Business Valuation Using Financial Statements

of the exchange, he was aware that the exchange would not become truly world-class
without signi¬cantly more support of institutional infrastructure. Mr. Hong noted with
satisfaction some recent developments in this direction.
Recognizing the fact that lack of transparency was one of the weaknesses that con-
tributed to the current crisis, the Korean government proposed major changes in ac-
counting rules. New regulations required the 30 largest conglomerates to prepare

Korea Stock Exchange 1998
certi¬ed ¬nancial statements which would cover all the af¬liated companies on a com-
bined basis beginning in the 1999 ¬scal year. The objective of this requirement was to
improve the transparency of large conglomerates. There was also a move to make a fun-
damental change in Korean Generally Accepted Accounting Principles by adopting the
more stringent International Accounting Standards.
There was also a change in the process through which accounting standards were set.
Earlier, the Korea Securities and Exchange Commissions (KSEC) used to set accounting
standards. When a new accounting standard was proposed, the KSEC would form a tem-
porary board to review that standard. Board members included auditors, accounting pro-
fessors, and government of¬cials. Starting in April 1998, the KSEC became a part of the
Financial Supervisory Board, and the FSC took over the supervision of accounting stan-
dard setting.
To improve shareholder rights, the Korean government took a number of steps. For
example, in April 1998, to improve minority shareholders™ rights, the current require-
ment of 1 percent ownership to bring suits against management was eased to 0.05 per-
cent; the requirement of 1 percent ownership to request the dismissal of a director or an
auditor for an illegal act was relaxed to 0.5 percent; the minimum share-ownership re-
quired to examine corporate books was reduced from 3 percent to 1 percent.
New regulations also attempted to ease restrictions that had previously made hostile
takeovers of Korean companies very dif¬cult. Earlier, a company or an individual could
not acquire more than 25 percent of the outstanding shares of another company unless
an open tender offer to purchase more than 50 percent of the outstanding shares was
made. However, in February 1998, this provision was abolished. Also, restrictions on in-
stitutional investors™ voting rights were eliminated.
Public shareholders were also becoming more vocal in demanding management ac-
countability. In May 1998, for the ¬rst time, foreign shareholders were beginning to have
a voice in the management of Korean companies. The New York-based hedge fund Tiger
Management, with the coalition of other foreign funds, staged a successful revolt at SK
Telecom, the country™s leading cellular phone operator. These outsider shareholders
forced the phone company to stop subsidizing its sister companies in the SK Group. SK
Telecom, for instance, backed a $50 million loan to its sibling SK Securities, which re-
cently suffered heavy losses in derivatives trading. To guard against such maneuvers in
the future, minority shareholders demanded”and got”three outside directors on the
board of SK Telecom and an independent auditor.12, 13
12. Louis Kraar, “Korea™s comeback . . . Don™t expect a miracle,” Forbes , May 25, 1998, p.120.

13. Starting in 1999, all Korea Stock Exchange listed ¬rms are required to have at least 25 percent of their board mem-
bers be outside directors.
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Management accountability was also being championed by nongovernmental organi-
zations such as The People™s Solidarity for Participatory Democracy (PSPD). The orga-
nization was founded in September, 1994, and headed by Professor Chang Ha-sung at
Korea University. In July 1998 PSPD successfully won a legal judgment against the man-
agement of the Korea First Bank for failure to exercise due diligence in its lending to a
failed company, Hanbo Steel. The court order required four former top managers of Ko-
Korea Stock Exchange 1998

rea First Bank to pay about U.S.$30 million with their personal wealth to the bank (not
to the plaintiffs) to make up for the losses caused by their negligence. The Korean press
hailed it as the ¬rst case where plaintiffs won in a suit against management based on the
failure to perform due diligence.

Future Challenges
Mr. Hong was convinced that a lot of progress had been made in the past few months.
There was evidence that foreign investors were beginning to come back. Korea was also
winning praise from the IMF for following closely its prescriptions. However, he was
also aware that much more needed to be done.
Although the new accounting regulations were aimed at improving the quality of in-
formation available to investors to monitor corporate managers, there was much skepti-
cism about the rules that had been mandated. The editor of a major Korean newspaper
commented, “It™s ¬ne for the government and the international investors to demand
transparency. However, it™s important to realize that the different facets of Korean soci-
ety are closely tied together”the government, business, and the banks. The entire sys-
tem will have to be made transparent, not just a part of it.”
Mr. Hong also noted that without effective auditing, ¬nancial reports were unlikely
to be viewed by investors as reliable. One of the senior partners at a Big Five accounting
¬rm in the United States echoed this sentiment: “Foreign investors know that the quality
of audits in Korea is suspect; they will not be satis¬ed unless the ¬nancial statements of
their Korean companies are signed by reputable international accounting ¬rms.”
The recent victory of minority shareholders represented the coming of major changes
in Korean ¬nancial markets. However, this development was viewed with mixed feel-
ings by several observers. Given the average Korean citizen™s lack of sophistication
about ¬nancial markets, there was a concern that minority shareholder rights would be
pushed forward without adequate attention paid to minority shareholder responsibilities.
Would the prospect of shareholder lawsuits and second-guessing management decisions
by courts hamper the restructuring process?
There was also a debate in Korea and other emerging markets on the appropriate
speed of opening capital markets to foreign investors, given the experience of the past
few months. One of the major concerns was the instability of the stock market due to
speculative hot money. There was a concern that rapid out¬‚ow would signi¬cantly dam-
age not only the stock market but also the foreign exchange rate. In order to prevent this,
many emerging countries imposed regulations on foreign investment and intervened in
their stock markets.
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A Framework for Business Valuation Using Financial Statements

Mr. Hong believed that full liberalization of the stock market was the fundamental so-
lution. He stated, “Government regulations, as in the case of Malaysia, or government
interventions in the stock market, as in the case of Hong Kong, do not guarantee the
long-term development of a stock market. While in the rest of the world the acronym
PKO may stand for Peace Keeping Operation, the same term in Asian securities markets
is known as Price Keeping Operation, a derogatory term for intervention by the govern-

Korea Stock Exchange 1998
ment. As the underlying philosophy of the government is based on democracy and a
market economy, stock market participants must not rely on government to implement
arti¬cial market-boosting measures. In the short term, the stock market may have dif¬-
culty in breaking out of the doldrums, but as the market ¬nds itself free from any sort of
intervention, it will grow into a more independent, transparent, predictable, accountable,
and self-sustaining market. Korea is following closely the IMF prescription toward a
fully open market. The earlier we can get to the open market, the better.” However, he
wondered whether Korea had the institutional infrastructure necessary to support an
open stock market.
As he pondered over these issues, Mr. Hong knew that the stakes were high. A senior
editor of one of Korea™s leading newspapers summed up the situation: “The newly
elected President asked for a year to resolve matters. It has been six months already. If
things don™t improve, Korean people may not remain patient much longer.” Due to the
efforts made by government and business, there was a sign of increase in the foreign in-
vestment in Korean stocks (see Exhibit 11). However, the level has not met Mr. Hong™s
expectation. Mr. Hong wondered which of several possible directions the Korean stock
market should pursue to attract foreign investment.

1. What are the merits and demerits of a stock versus a bank system of financing?
2. To prevent another bad loan problem in the future, what changes should be made in
South Korean banks?
3. Is it a good idea for South Korea to rely more on the stock market as a source of cor-
porate finance? Is it a good idea from the perspective of the chaebols?
4. How long do you think it will take South Korea to develop a vibrant stock market?
What are the impediments? Are the changes contemplated adequate for the develop-
ment of a vibrant stock market? What other steps would you recommend?
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Selected Economic Indicators for South Korea

1995 1996 1997 1998 (estimate)
Korea Composite Stock Price
Korea Stock Exchange 1998

Index (year-end) 882.94 651.22 376.31
Real GDP growth (percent change) 8.8 5.5 “0.4 “4.0 to “5.5
Consumer prices (percent change) 7.4 4.8 7.7 10.0
Central government balance
(% of GDP) 3.0 2.4 “0.9 “2.4
External debt (billion US$) 82.6 90.5 91.8 89.7

Source: International Monetary Fund.
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