There have been growing worries about a credit crunch in South Korea recently. Gangwon Jungdo Development Corp., the developer of the new Legoland Korea theme park, defaulted on an asset-backed commercial paper worth KRW205bn in October. The payment of this commercial paper was guaranteed by the Gangwon provincial government. 

The rare default of a state-backed real estate developer undermined investor confidence. The credit spread between the 3Y AA- corporate bonds and 3Y treasury bonds widened sharply to 119bps in October; the spread between the 3M CP rate and the benchmark repo rate also widened to 92bps. Both were close to the peak levels during the Covid outbreak in 2020. Meanwhile, the net issuance of corporate bonds on the Korea Exchange contracted sharply in October by KRW10.7tn.

Sector-specific debt problems

Against the macro backdrop of monetary policy tightening and general economic slowdown this year, financing costs increase, and corporate profitability weakens, unsurprisingly creating pressure in the credit market. Our assessment suggests that corporate debt default risks are concentrated in some specific sectors with high leverage and high vulnerability. Large-scale defaults and a systematic credit crisis should remain unlikely.

On average, the leverage ratio of South Korean companies increased only slightly in recent years. The debt-to-equity ratio of all companies in all industries stood at 120% in 2021, higher than the trough of 111% in 2018, but still notably lower than the peak of 159% seen after the global financial crisis in 2009.

The rise in debt ratio was concentrated in the electricity & gas and accommodation & food services sectors. The debt ratio in the electricity & gas sector increased to 184% in 2021, sharply higher than 144% in 2018. This sector’s operating income-to-sales ratio and interest coverage ratios also turned negative in 2021. The situation worsened further this year. During the oil price surge caused by the Russia-Ukraine war, the South Korean government required the state-owned Korea Electric Power Corporation (KEPCO) to subsidize public utilities prices. KEPCO incurred large profit losses, and financed these losses through greater bond issuance on the back of government guarantees.

In the accommodation & food services sector, the debt ratio increased sharply to 253% in 2021 from 192% in 2018. The operating income-to-sales and interest coverage ratios registered two consecutive negative readings in 2020 and 2021. Companies in this sector suffered massive losses from consumer spending and foreign visitor declines during the Covid pandemic. Many of these companies are SMEs. To cover the losses during the pandemic, they increased loan borrowings from domestic financial institutions under the Covid-related financing support programs.

In terms of exposure to corporate credit, pay attention to non-bank financial institutions (NBFIs). Corporate loans extended by NBFIs accelerated sharply in recent years, to 31% YoY in 2Q22 from 15.5% in 1Q18. In contrast, banks’ corporate loans picked up moderately to 10.5% from 4.8% during the same period. The total amount of outstanding corporate bonds increased by 7.5% in 2021, a slower pace than 9.3% in 2018.

The NBFIs, including insurance and securities firms, heavily participated in project finance (PF) loans in recent years, such as developing warehouses, logistics centers and other commercial/industrial projects. According to the Bank of Korea (BOK), the PF loans extended by insurers amounted to KRW43.3tn as of 2Q22, a nearly tenfold increase compared to a decade ago. Due to the rise in interest rates and construction costs, some PF projects now have problems. The PF loan delinquency rate among insurers remained low at 0.3% as of March. But the corresponding rate among securities firms already reached 4.7%, according to the data disclosed by the Financial Supervisory Service.

Swift and targeted policy response

To ease the stress in the credit market and restore investor confidence, the government and the BOK have rolled out a series of policy measures in recent weeks. These measures are timely and well-targeted. They include: 1) the government will reactivate the KRW20tn bond market stabilization fund to purchase corporate bonds and commercial papers, first injecting KRW1.6tn; 2) Korea Development Bank, Industrial Bank of Korea and Korea Credit Guarantee Fund will double the ceiling of their corporate bond and commercial paper purchases to KRW16tn; 3) Korea Securities Finance Corporation will provide KRW3tn liquidity support for securities firms, through repos and stock-secured loans; 4) BOK will loosen the collateral policies for financial institutions applying loans from the central bank, accepting collaterals including bank debentures and debt issued by state-owned companies for three months; and 5) BOK will launch a temporary repo facility worth KRW6tn.

Implications for GDP and monetary policy forecasts

The recent credit market stress is likely to act as a modest drag on GDP growth by weighing on corporate financing conditions, business sentiment and private investment growth. As a systematic credit crisis risk remains low, we think an outright recession will be avoided. The latest 3Q GDP roughly matched our expectations, reporting a modest growth of 1.1% QoQ saar (3.0% in 2Q). We are revising our annual GDP growth forecasts by a small margin. Our GDP growth forecast for 2022 is trimmed to 2.7% from 2.8%, while the forecast for 2023 is lowered to 1.8% from 2.0%.

The recent liquidity support measures adopted by the BOK are micro and temporary. They do not represent an easing of the broad monetary policy. The latest data showed that CPI inflation remained sticky at 5.7% YoY in October (5.6% in Sep), and core CPI continued to creep higher to 4.8% (4.5% in Sep). The BOK forecasts CPI inflation to average 3.7% in 2023, lower than 5.2% this year but still above its current policy rate of 3.00%. As such, we are leaving our interest rate forecast unchanged. We expect the BOK to slow the rate hikes to 25bps at the November meeting but maintain the tightening stance for a few more months, taking the benchmark repo rate to 3.75% by 1Q23.

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