KoreaÆs financial recovery is facing its toughest test yet. On 1 July 2000, the country's investment trust companies (ITCs) will have to mark their assets-to-market. Fears are growing that this could expose a gaping hole between their assets and liabilities, and unleash a wave of panic that will unhinge the rest of the financial system.

KoreaÆs ITCs are very similar to those in the UK, in that they are incorporated like a company; an investor receives shares rather than units. Whereas the number of shares in unit trusts expands and contracts on demand for units, ITCs have a fixed number of shares in issue at any one time.

In return for becoming a shareholder in an ITC, investors received a high return. The ITC fund manager did not have to buy or sell shares because of the closed-end structure, and could instead strategically invest with a longer-term view. High returns were assured, particularly with a soaring stockmarket in early 1999, and low interest rates at banks. Or so the argument went.

The ITCs' troubles began with the collapse of the Daewoo group last year. Most reported big losses on their Daewoo bonds. Retail investors panicked and mass redemptions ensued. The en masse liquidation of their portfolios led to the collapse of the equity and bond markets last April and May, which in turn paralysed ITCs, rendering them unable to meet redemptions effectively. What started as a liquidity problem snowballed into a solvency crisis, which Korea is now addressing.

Was it a question of being in the wrong place at the wrong time? Quite simply, no. Back in 1999, when the faltering Daewoo group issued piles of corporate paper, KoreaÆs ITCs were persuaded to prop them up. And they did. By the end, they owned W18 trillion ($16.16 billion) in Daewoo paper. ITCs could afford to be generous; 1999 was a go-go year. ITCs saw their funds surge to W250 trillion in July 1999, up 182% from January 1998. They extended their largesse to other chaebol, bankrolling their massive capital-raising exercises; all of which coincided with a flood of new funds to ITCs.

Downhill from there

By August 1999, Daewoo had flooded banks with so much debt that KoreaÆs banks baulked, refusing to accept its credit was good. Unfortunately, Daewoo exposure made up 10% of ITCs' assets at W25 trillion. It was only a matter of time before panic set in.

ôBasically when [the regulators] decided to put Daewoo in workout, thatÆs when they realized how much Daewoo paper ITCs were caught up with. Investors figured the problem must be big and started redeeming,ö says Brian Hunsaker, head of research at Dresdner Kleinworth Benson in Seoul.

By April 2000, ITCsÆ asset base shrank 36% to W160 trillion, from its July 1999 peak of W250 trillion. Some of this was due to bond losses, the rest due to redemptions. Banks saw a flood of new deposits coming their way as Koreans stuck their money back into banks deposits.

ITCs had the government to thank that their predicament wasnÆt worse. In August, the government came up with a plan for staunching the flow of redemptions. First, it said that ITCs should figure out the percentage of assets invested in Daewoo papers. Second, it set up a system to penalize investors who withdrew their funds too early.

For example, if an ITC had invested 10% of its assets in Daewoo, investors were allowed to withdraw 90% of their invested amounts. But, if they took their investment out within the three months following 13 August, they had to forgo 50% of their net funds. If they took the investment out between 13 November and 13 February, they received 80% of their remaining funds back. And if they held on until after 13 February, they got back 95% of their funds.

ôAt best, investors are left with non-liquid assets, and to enjoy liquidity they must take a huge cut in principal value. In other words, they must bear the brunt of terrible investment misjudgements on the part of investment trust companies,ö said Kim Yu-kyung, director of international relations at KoreaÆs stock exchange, in a newspaper article last August.

Without these steps, KoreaÆs financial system would have faced an immediate meltdown. ITCs, KoreaÆs de facto fund managers, are KoreaÆs biggest buyers of bonds and equities. At their peak last year, ITCs rivalled the banking system in funds. But of the W65 trillion of assets that the ITCs sold to meet redemptions, two- thirds took place this year, driving KoreaÆs benchmark Kospi index from the 850 to 655 level. That W65 trillion makes up a third of ITCs' assets in April, or 25% of their peak assets. That leaves another W160 trillion, or 66% of current assets. This raises the question: what will investors do come 1 July, when ITCs finally have to show their hands?

Has enough been done to avert crisis?

Some analysts like Dresdner's Hunsaker are betting no meltdown will occur. Hunsaker points out that most of the money has now been withdrawn and the government has already put in place sensible policies to avert a disaster. That's despite the government's recent estimate that only 17.5% of assets at ITCs are currently market valued.

One thing's for sure: ITCs are definitely counting on some trouble. According to Simon Maughan, head of Asia-Pacific Banking Research at Lehman Brothers, ITC funds are operating on a bond-cash-equity ratio of 60:30:10, compared with an earlier bond-equity ratio of 60:40. That means, with bond funds remaining at W100 trillion, ITCs had to liquidate roughly 88% of their equity funds to meet redemptions.

These ratios also suggest that if redemptions are higher than the cash ITCs have at hand, ITCs will be selling their bonds into a very illiquid market. But, there will be some support, analysts say. Korea's banks, which are awash with funds, are investing between 25% and 33% of their assets. Any less commitment and they would risk incurring losses on their own assets. ITCs won't be able to avoid taking a haircut of some kind, however, as there is little appetite for corporate bonds.

But whatever happens, the average Mr and Mrs Kim can feel secure. With ordinary Koreans owning up to 48% of ITCs at their height, the government was compelled to help out so investors didn't lose their entire savings.

The government has already picked up the bill for ITCs that have no majority shareholder like a bank or chaebol behind them. It has cleaned up two of Korea's biggest and most troublesome ITCs. And it has given Korea's chaebol and banks an ultimatum to either put up more cash or shut down the ITCs. The only exception to this hard line has been Hyundai ITC, into which the government is injecting new funds.

But is this enough? Clearly, the government will be bracing itself on 1 July.