South Korea's Stock-Market Miracle Was Built on Leverage. The Bill Has Come Due.

WHEN SOUTH KOREA'S president set out to lift the KOSPI to 5,000 points, he was promising to close a long-standing gap between the country's economic might and its market valuation. Investors called it the "Korea discount" - the gap between Korean firms' earnings power and the price global investors would pay for it. By late June this year, the index had reached nearly 9,000. Mr Lee's target was not merely met; it was blown past with reckless speed.

A month later, the KOSPI has fallen about 25% from its peak, slipping back into the 6,000s. The broader lesson is familiar: when a market's ascent is powered by leverage rather than earnings, the descent is mechanical. What is more instructive is how a well-intentioned governance campaign became entangled with a speculative frenzy, and what that reveals about the limits of stock-market engineering.

Seoul traders

The real question is not whether Korean equities are overvalued. It is how the market's plumbing was rewired to invite the kind of volatility that no amount of corporate reform can prevent. Two structural facts explain what happened. The first is concentration. Samsung Electronics and SK Hynix together account for more than half of the KOSPI by market capitalisation. Nvidia, the dominant chip stock in America, makes up only about 7% of the S&P 500. When two stocks dominate an index, any swing in sentiment becomes an index-level event.

The second fact is leverage. On May 27 the Korea Exchange launched single-stock leveraged exchange-traded funds - products that promise to deliver twice the daily return of the underlying share. They were intended to keep domestic retail money at home rather than letting it flow to similar products listed in Hong Kong. The idea was pragmatic. The result was catastrophic. In May and June alone, retail investors piled roughly 78 trillion won ($54 billion) into the KOSPI, much of it through margin loans. When chip sentiment soured in July, the same mechanisms that amplified gains amplified losses. Citi estimated that Korean retail investors lost about $38.7 billion on single-stock leveraged ETFs in a single month.

The mechanics are worth spelling out. Leveraged ETFs must rebalance daily to maintain their promised return ratio. In a market where two stocks dominate trading - together accounting for more than 70% of value traded - those rebalancing flows become self-reinforcing. A fall in SK Hynix triggers selling in its leveraged ETF, which forces the fund to sell more of the underlying share, pushing the price lower still. Goldman Sachs estimated that a 5% swing in the KOSPI can generate about $4.7 billion in ETF rebalancing flows, roughly one-eighth of a normal day's trading. The tail, as an ETF analyst put it, began to wag the dog.

The politics of a target

Mr Lee's governance reforms are real. He took office in June 2025 and moved swiftly to strengthen shareholder rights, improve board accountability, and crack down on stock-price manipulation. Those changes deserved the market's reward. But a president who publicly champions a specific index level sends a signal that goes beyond corporate governance. It tells retail investors that the state is betting on higher prices. When leveraged products then arrive on the scene, the message is unmistakable, even if regulators did not intend it.

The opposition seized on the disconnect. The People Power Party accused the administration of encouraging excessive risk-taking while overlooking growing leverage. A public petition calling for intervention attracted more than 35,000 signatures. Presidential chief of staff for policy Kim Yong-beom, an early advocate of the leveraged ETFs, made matters worse by suggesting that retail investors themselves bore some responsibility for the volatility. "Does the government take credit when the market soars and do the people take responsibility when it crashes?" asked an opposition lawmaker. The question was harder to answer than it sounded.

Regulators have since responded. On July 16 the Financial Services Commission halted new listings of single-stock leveraged ETFs and raised the minimum deposit from 10 million won to 30 million won. The government is considering individual investment caps and a variable-leverage system modelled on Hong Kong's approach, which would allow regulators to reduce leverage ratios daily in response to market conditions. The measures are sensible. But they are also late. Morgan Stanley analysts noted that the higher deposit requirement would take weeks to take effect, and that any immediate stabilising impact is limited.

The deeper problem

To be sure, the underlying investment thesis has not collapsed. Samsung and SK Hynix continue to benefit from a strong memory-chip cycle driven by hyperscaler demand for AI infrastructure. Forward price-to-earnings ratios for the KOSPI have actually fallen this year despite share prices more than doubling, as Reuters reported. The market remains up roughly 60% in 2026, far ahead of the global average. The problem is not the direction of earnings; it is the market structure through which retail investors are expressing the view.

The real risk is institutional. When a market's day-to-day functioning is distorted by the mechanical flows of leveraged products, price discovery breaks down. Forced selling in a downturn can be mistaken for a fundamental deterioration, scaring off foreign capital at precisely the moment it could provide ballast. Foreign investors have already pulled a record $110 billion from Korean equities this year, largely to rebalance portfolios after the surge. That leaves domestic retail investors - the most leveraged, least diversified cohort - as the market's primary counterparty. That is not a stable equilibrium.

There is also the question of capital flight. Some investors warn that the crackdown could simply push retail money offshore, where similar leveraged Korean ETFs already trade beyond the reach of Seoul's regulators. A ban is a speed bump, not a wall.

A steadier hand

The better answer is not to ban leverage altogether but to build a market structure that can absorb it without breaking. The variable-leverage system under consideration, if implemented properly, would allow regulators to dial down gearing in turbulent periods rather than facing a binary choice between unlimited leverage and a total ban. Investment caps on individual exposure would help, but only if enforced across domestic and cross-border products. More fundamentally, a market where two stocks command more than half the index is inherently fragile. Diversification cannot be legislated, but listing fees, disclosure rules, and investor education can nudge capital toward the rest of the economy.

For investors, the relevant takeaway is structural, not tactical. The AI-driven earnings case for Korea's chipmakers remains compelling. But a market that trades with meme-stock volatility, where 5% index moves become routine and circuit breakers are triggered nearly half as many times this year as in the entire previous two decades combined, is not one in which fundamentals can be assessed with any confidence. The valuation only looks attractive if you can hold through the swings without being forced out.

Mr Lee's governance reforms were a sound bet. The leveraged ETFs were not. The state should not engineer rallies. Its job is to ensure that the market, when it rallies on genuine strength, does not tear itself apart on the way back.

A market that can only function as a casino will eventually frighten away everyone but the gamblers.