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A casual observer would be forgiven for thinking that, when not hosting the Winter Olympics, South Korea is preoccupied solely with its bellicose northern neighbour and its relationship with the U.S.

The Korean peninsula is regularly listed as a top geopolitical risk to the global economy, especially after months of North Korean rocket tests and insults between leader Kim Jong-un and U.S. President Donald Trump.

“Everything that we see in the news is all about the U.S. and […] the military exercises,” says Christine Tan, AVP of portfolio management at Sun Life Global Investments in Toronto. While that relationship is important, she says, there are some strains with Trump’s desire to renegotiate the U.S.-Korea Trade Agreement. There’s also been a recent détente with China.

South Korea’s emerging market depends largely on trade, with products such as machinery, distilled petrochemicals and semiconductors for smartphones all linked to global economic activity. “It’s one of the economies that definitely benefits when the global economic picture improves,” says Tan.

About 16% of Korea’s exports are currently with the U.S., compared to 25% with China, says Nishant Upadhyay, head of global emerging markets debt at HSBC Global Asset Management in New York.

Global growth, particularly within the U.S. and China, “clearly augurs well for South Korea,” he says. But Korea is “exposed” to any changes in global economic fortunes—not to mention geopolitical flare-ups.

Comparing December 2016 and December 2017, South Korea’s exports to China increased roughly 17% to almost $14 billion, Tan says, citing Korea Investment Management Co. (KIMCO) figures. The shipment of goods to ASEAN countries (which include Indonesia, Thailand and the Philippines) rose by roughly 33% to US$8 billion. Trade with the U.S., on the other hand, declined by roughly 17% to just over US$5 billion.

Under President Moon Jae-in, there is the potential for a change in how the country will engage with North Korea. “This new administration wants to be more balanced,” Tan says. That was on display at the Olympics’ opening ceremonies last month, when U.S. Vice-President Mike Pence awkwardly shared a box with Kim Yo-jong, Kim Jong-un’s sister, as well as Japanese Prime Minister Shinzo Abe and Moon himself.

Moon was elected in May 2017 after a corruption scandal brought down former president Park Geun-hye and implicated top executives in the business community, including Samsung Electronics vice-chairman Lee Jae-yong. Moon has promised to rein in the chaebol: family-owned conglomerates that often have strong ties to the political community. He’s also raised taxes on some high-income earners and corporations in order to pay for 174,000 new government jobs, Tan says, and hiked the minimum wage by 16%.

“His policies are kind of focused on redistribution because there’s a fair amount of wealth disparity in Korea,” she says. “That’s positive for consumption, especially more of the mass consumption names.”

For markets, Moon’s election brought stability after the uncertainty that resulted from the impeachment drama, says Upadhyay.

The basics

Official name: Republic of Korea

Capital: Seoul

Head of state: Moon Jae-in

Government type: presidential republic

Population: 51.18 million (2017)

Citizenship: at least one parent must be a citizen; no dual citizenship

Currency: The Korean won (KRW) was “on a tear” in 2017, making it “undeniably expensive” when placed against a weakened U.S. dollar, says Upadhyay of HSBC Global Asset Management. But so far the country has avoided the downsides of an expensive currency on exports. “Part of the reason for that is that Korea has done a really good job of moving up the value of the things it manufactures and sells,” he says.

Semiconductors were the country’s fastest-growing export segment in 2017, says Tan of Sun Life Global Investments, increasing from US$6 trillion to $9.5 trillion. Those products are going predominantly to smartphone makers in China, she says.

As of Feb. 27, the U.S. dollar had risen 1.31% against the won this year.

Economy:

GDP (purchasing power parity): US$2.027 trillion

GDP growth: 3%

Inflation rate: 1.9%

GDP per capita: US$39,400

Unemployment rate: 3.8%

GDP by sector

 South Korea: GDP per sector
Agriculture: 2.2%

Industry: 38.8%

Services: 59.1%

Investing

With the MSCI Korea Index up 47% in U.S. dollar terms last year, “Korea was clearly one of the best-performing countries,” says Tan. “What investors might not realize is the earnings growth was 53%. In other words, we actually came out of the year with a slightly lower PE multiple than we entered the year [with], despite the strong performance. That’s why we still like that region.”

Moon’s consumer-friendly policies have boosted consumer confidence and consumption, Tan says, so she holds LG Household and Health Care, which manufactures consumer goods as diverse as appliances and cosmetics.

A warming relationship with China is also driving consumer growth, she says, with the cosmetics and tourism industries benefiting from Chinese consumers.

Korean banks have recovered from corporate loans to sectors that “were extremely cash-crunched” during the financial crisis and left bank earnings “quite depressed for a number of years,” Tan says. Loan activities resumed last year and the sector stands to benefit from interest rate hikes. She likes Shin Han Financial, which she calls “the TD Bank of Korea.”

“It’s a traditional bank. They have lower exposure to investment banking or exotic derivative products,” she says. “It’s just a pure, old-school retail bank.”

The Chinese government’s push for electric vehicles has created other export opportunities. Hyundai Mobis, the car parts company, makes a lot of components for electric vehicles, Tan says, but that side of the business is still a small element of the overall company.

“We would love to find a pure-play component maker that services [electric] vehicles or provides components for [electric] vehicles, but it’s still relatively early,” she says.

In the semiconductor memory chip market, she holds SK Hynix as a pure play.

For investors looking at Korean ETFs, Tan cautions that Samsung’s weighting is large, leaving investors exposed to its fortunes. “Last year it was a good thing, because it did very well,” she says.

The KOSPI Index (Korea Composite Stock Price Index) tracks the common stocks traded on the Korea Exchange.

On the fixed income side, Korea is pleasantly unexciting, Upadhyay says. He views it as a developed economy, with inflation around 2% and an expected fiscal surplus. Korea, which enjoys a double-A debt rating from Standard & Poor’s, has also not been burdened by “the distorting effects” of quantitative easing like many developed economies.

“It’s a nice, boring, fixed income market, which is a good thing,” he says.

The yields on Korean dollar-denominated bonds are somewhere between 40 and 70 basis points above U.S. 10-year Treasurys, which isn’t a lot compared to other emerging market economies, he says.

“It’s not the most exciting thing, but it’s stable. At this point, holding a bond issued in dollars by a Korean sovereign-owned entity is really more like holding duration with a little bit of extra spread. They will move with duration; they will not move so much with credit spread,” he says.

Taxation

Corporate

Income and branch tax: progressive from 10% to 22%

Capital gains tax: progressive from 10% to 22% for resident companies; for non-resident companies, it’s the lesser of 11% of proceeds or 22% of gain realized

Minimum tax: progressive from 10% to 17% (7% for SMEs)

Individual

Income tax: progressive from 6% to 40%

Inheritance tax: progressive rates up to 50%

Capital gains tax: gains are exempt unless the person owns more than 1%, or more than 2.5 billion won, of the company’s shares.

The government has postponed its plan to widen the capital gains tax on foreign buyers of Korean stocks. The government had signaled last August that it wanted to include more foreign investors in its tax base.

The scrapped draft law had proposed lowering the foreign ownership threshold for capital gains from the current 25% to 5% of outstanding shares in the issuer, Reuters reported.

Source: Deloitte’s “Taxation and Investment in Korea 2017” report

Crypto crackdown

South Korea, a hub for cryptocurrency trade, introduced new rules on Jan. 30 to prevent digital currency from being used for money laundering. Now, cryptocurrency trading can only be done through proper bank accounts.

The country’s banking laws say that anyone who moves more than US$3,000 out of the country must explain the reasons to tax authorities. Annual transfers of more than US$50,000 must also be reported.

Korean customs had found that foreign investors were using digital coins to illegally trade currency—roughly 472 billion won in foreign exchange crimes related to cryptocurrency, Reuters reported.

The government backed away from a proposal late last year to close digital currency exchanges altogether.

Central bank

Governor Lee Ju-yeol hiked interest rates in November for the first time since 2011, from 1.25% to 1.50%. Tan is forecasting growth around 3% (the central bank also forecast 3% at its January meeting) and inflation around 2% (the bank’s forecast was 1.7%). She sees interest rates rising to 2% this year, which would be “relatively benign.”

At Lee’s last meeting as chair on Feb. 27, he held the rate at 1.50%.

Originally published in Advisor's Edge

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