To get people to sell won for dollars, pushing down the won’s value
If you recall, a fund is a firm where an expert, the fund manager, pools money from different individuals, invests the pooled money in stocks or bonds, and returns gains or losses to the investors. If you invest in a foreign equity fund, it literally means that you invest not in Korean stocks but in overseas stocks.
Currently, there are no taxes on income from investments in Korean funds, but a tax of 15.4 percent is levied on profits from a foreign fund investment. This tax exemption means the return on investment in overseas funds will increase.
For instance, let’s assume you have invested in both a domestic fund and an overseas fund, and have received a 10 percent return on each of them. If you put 10 million won ($10,589.40) in each, you would have earned 1 million won on the Korean fund. However, because of the tax obligation, you would have received only 846,000 won from the foreign fund with the same investment. Should the government proposal be approved by the National Assembly, the foreign fund investment in this scenario will yield the same return as the Korean equivalent.
With the added incentive, it is little wonder that people have flocked to foreign funds of late. In fact, after the government announced the proposal in mid-January, Korea’s securities brokerages and banks have been bombarded with calls from customers asking for recommendations on overseas funds where they could invest.
But not all funds that invest in overseas assets would receive the tax break. The so-called “offshore funds” will not be eligible for the tax exemption, should the measure come into effect. Offshore funds also place their investment in foreign stocks. But whereas foreign funds are formed in Korea, offshore funds are created overseas before they are sold here.
“Funds of funds”― an offshore fund that invests in other offshore funds ― also will not receive the tax exemption. This means there will be a 15.4 percent tax on both offshore funds and funds of funds.
Currently, there are about 35 trillion won invested in overseas equity markets; excluding offshore funds and funds of funds, about 21 trillion won are eligible for the government tax break.
Why did the government come up with this idea in the first place? It wanted to encourage investors to make their investments in U.S. dollars, so that the value of the dollar would rise. Korea’s exporting companies have struggled of late because the dollar has been weak compared to the Korean won.
To explain: If the won-dollar exchange rate is 1,000 won to the dollar, that means one U.S. dollar would buy 1,000 Korean won in the foreign currency market.
How is the rate determined? Let’s use apples as an example. In a good year, there will be plenty of apples on the market. The larger the number of apples up for grabs, the lower the price of each one will be. The same logic applies to won: if there are a lot of won available in the currency exchange market, then the price of the Korean won will naturally fall. In other words, the more won a U.S. dollar can purchase, the higher the dollar exchange rate. In this equation, a decrease of the won’s worth equals a rise in the dollar’s value, which translates to a higher exchange rate.
In contrast, in a bad harvest there will be fewer apples, making each one more valuable. The fewer won in the market, the pricier they will be. In this case, the increase of the won’s value means lower value for the dollar, leading to a lower exchange rate.
If the exchange rate falls, Korea’s exporters will suffer, because that would make Korean products more expensive in overseas markets. For example, if the won-dollar exchange rate is 1,000 won, you could buy a 1,000-won Korean product at $1. But should the rate fall to 900 won, you would need $1.11 to buy that same 1,000-won item. Pricier goods would naturally be less popular among consumers. Since Korea lacks natural resources and is heavily dependent on exports for its economy, the government feels a lower exchange rate would deal a blow not only to exports but eventually to the economy as a whole.
To go back to overseas funds: In order to invest in those products, you would have to exchange your won for dollars. As foreign funds grow popular, there will be more people hoping to exchange their won, which would place a growing amount of won on the market. That would drag down the value of the won, leading to a higher won-dollar exchange rate.
This is why the government is pushing for the tax break on overseas funds: It would naturally spur individual investors to exchange their won, causing the exchange rate to rise and eventually helping exporters to maintain their price competitiveness. The government is hoping its new measure would generate up to $15 billion in overseas investment per year, which would have a fairly significant impact on stabilizing the exchange rate.
The amount of investment in foreign funds has steadily increased. The reason for the popularity is that foreign stock markets have performed well of late, whereas the Korean stock market has been struggling. Korean equity funds averaged only 1 percent in returns on investments last year, but thanks to red-hot stock markets in China and India, some funds that invested in assets in those countries returned as much as 40 percent on investments.
Despite the lofty figure, foreign funds do not always offer higher returns. In 2005, the average return from Korean funds reached 62 percent on average, easily beating out overseas funds.
The difference is due to performance in stock markets here and overseas. In the case of foreign funds, the return rate depends largely on just where the assets are invested. In 2005, equity funds investing in Japanese assets provided return rates in the 30-percent range, but investors in those funds actually lost ground last year. Chinese equity funds performed very well last year, but they struggled in the previous two years.
This is why you should not just look at previous return rates when investing in funds. Many experts say emerging market indexes, such as those in China and India, might not be as strong this year. Funds investing in Indonesian assets, which turned in a 49-percent return in 2006, have not lived up to that standard so far this year.
Fund experts advise that you must diversify your portfolio ― in other words, it is always safer to spread out your investments. The difference in return rates is so great among different equity markets that it would be easy to lose money if you placed all your investments in just one market. And before you make an overseas investment, make sure you have enough understanding of economic situations in countries of your interest.
By Sohn Hae-yong JoongAng Ilbo [jeeho@joongang.co.kr]
with the Korea JoongAng Daily
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