Korea sparks extremes of sentiment. Until recently the country was viewed as a paragon of reform and liberalization. One dive in the local stockmarket and doom-mongering has surfaced. There are fears the country has been upgraded too fast, has been sluggish on reform and is on the cusp of a renewed financial crisis. As ever, the truth lies somewhere in the middle. We believe the current travails in the local asset markets are tractable, albeit at the expense of a weaker won over the coming weeks.
Of course, while the market has started to draw more parallels with the financial crisis of 1997-1998, current problems do not have the same external dimension. In 1997, an excessive reliance on short-term foreign borrowing exposed Korea to an external credit crunch when the market reassessed the countryÆs growth prospects (usable FX reserves fell to just $8 billion in December 1997).
This time around Korea enjoys $86 billion FX reserves and has positive net foreign assets. In this regard, current concerns surround the risk of a domestic debt crisis driven by problems in the Chaebol sector and within the financial system.
Problem #1 - the ITCs and the KOSPI
Two problems have recently surfaced in Korea to prompt these fears. Firstly, local asset markets have corrected sharply lower, with corporate bond yields rising and with the KOSPI falling from around 1100 at the start of the year to below 650 at one stage this week. Weak local asset markets have hurt the Chaebol sector which relied so heavily on a long rally in the stock market to achieve the governmentÆs 200% debt/equity target last year from over 400% in 1997. (The fall in debt/equity ratios owed more to capital raising, often through equity issuance, than to a reduction in the pool of outstanding debt.)
Moreover, the heavy exposure of Investment Trust Companies (ITCs) to local asset markets has raised concerns over the liquidity of these firms given that they were already undercapitalized prior to the latest bout of asset market weakness. (We assume the ITCs, along with insurance companies, require $26 billion in fresh government funds.)
In fact, the problems in the ITC sector have themselves fed upon the asset market weakness, since a wave of redemptions from these institutions (W120 trillion or around $105 billon since July 1999!) has raised concerns of accelerated forced selling of assets. As a result, the non-bank financial sector is in the midst of a credit crunch, given that ITC buying of corporate bonds has dried up which is feeding onto the corporate sector and since Chaebol cannot rely on equity issuance to raise funds in the current climate.
This has meant liquidity concerns for Korean corporates, especially small and medium-scale enterprises. One fear is that a downward spiral of ITC weakness, declining asset markets and rising liquidity problems in corporate Korea, will start to significantly affect NPLs in a banking system which until now has been supporting growth after a restoration of the intermediation process in mid-1999.
Problem #2 - Hyundai
A second problem that has emerged is Hyundai, whereby some affiliates are facing acute liquidity problems and have required a line of credit from the main creditor, Korea Exchange Bank. As with all Chaebol, HyundaiÆs high degree of leverage means that it would fail if its creditors refused to rollover its debt, which raises fears of the current problems in the financial sector quickly feeding through to the real economy. Ultimately, Hyundai refocuses attention on how the problem of excessive corporate leverage and thus weakened resilience to external shocks remains an issue in Korea.
However, Hyundai is not another Daewoo...
Hyundai is indeed vulnerable to the problems at the ITCs since they will request repayment of debt when local bonds and CPs fall due, which will force the group to rely on continued bank financing to meet these liabilities. However, we expect this financing line to be made available. Unlike Daewoo, HyundaiÆs core businesses are solid; many are industry leaders in domestic and international markets and enjoy modest profitability (Chaebols have yet to fully prioritize profits over growth).
Further reforms of HyundaiÆs efficiency and business practices are of course needed and must be seen over the coming months and years, but the Group does have core value. Banks will in our view be willing to support this Chaebol from a liquidity crunch for this reason (unlike Daewoo, which had little prospects of repaying its debt over the medium- to longer-term), especially since the ripples of a Hyundai failure would vibrate throughout the economy, and would thus be vehemently opposed by the government, which is a majority shareholder in the banking system.
... financial sector credit crunch outside the banking system
Moreover, the banking system has been restored to an acceptable degree of health, with an aggressive reform program by the government restoring the sectorÆs capitalization ratios above the 8% BIS level while the system is extremely liquid. (A lot of redemptions from ITCs have been recycled into the banking system via increased deposits at banks.)
Indeed, one of key factors behind the recovery of KoreaÆs economy has been the rapid restoration of the intermediation process in the banking system, almost 12 months before another crisis hit economies, with bank lending growing 31.6% y/y in April for instance, and having recorded positive growth since last May.
As such, we do not see the banks being compelled to withdraw funding to corporate Korea during the current non-bank credit crunch. Hyundai therefore will be an example of the continued weakness of the Chaebol sector and the need for a significant amount of further reforms, rather than being an event shock akin to Daewoo.
This reality has long been accepted by us, and has influenced our view that interest rate settings in Korea will remain expansionary into 2001 in order to support local financial markets, the non-bank financial sector, and the over-leveraged corporate sector.
For instance, O/N call rates are currently at 5% in nominal terms and 3.9% in real terms. Given that a broad proxy for neutral interest rate settings is a nominal yield equal to nominal GDP growth and rate yields equal to real growth (admittedly, an even more imperfect measure of neutrality in emerging markets), current rate settings would suggest highly expansionary rate settings given Q1 real GDP growth of 12.6% y/y in real terms and an estimated 13.5% in nominal terms!
In terms of the problems in the non-bank financial sector and the local asset markets, we believe the authorities have the policy tools at their disposal to stabilize the market.
1) The government has the fiscal strength needed to recapitalize the non-bank financial sector and to prevent the sudden failure of an institution in a manner that would further destabilize the KOSPI and local bond market.
We are assuming another 20% of GDP worth of fiscal funds will be provided by the government over the coming years to fully restructure the financial sector and facilitate Chaebol reform, which would push public sector indebtedness to a manageable 62% of GDP. The credibility of government pledges to support ITCs are therefore strong, and will ultimately help reduce the degree to which ITCs demand full repayment.
2) The government has an ability to pump liquidity into the system to support asset markets. The government is aware that weak asset markets will substantially complicate future efforts at structural reform given that they inflate debt-equity ratios and raise market concerns over ITCs.
Policy priorities have changed
Crucially, the current non-bank credit crunch has meant a change in the governmentÆs immediate policy priorities. Until recently, the focus of policy was in deepening the process of Chaebol and financial sector reform, and in slowing down economic growth to a level more consistent with the BOKÆs estimate of around 6% trend rates of economic growth.
However, these goals have been displaced by the current need to ease the non-banking sector credit crunch and to support asset valuations and thus limit the follow-through to the real economy. This will lead to policies which are negative for the won over the short-term: we expect the authorities to pump liquidity into the system by inflating the monetary base, while some of the more painful economic reforms may be put on hold, and indeed already the government has repealed previous regulations limiting financial sector exposure to individual Chaebol bonds.
The ability to pump liquidity into the system is helped by a benign inflation backdrop given the lagged effect of won strength and due to excess capacity. May CPI, for instance, grew by just 1.1% y/y and fell 0.1% m/m. The ability to use fiscal and monetary policy levers to stabilize asset markets and the ITC sector therefore support our view that the downward spiral mentioned earlier can be avoided, that local asset markets will stabilize and that the banking sector (currently providing loan growth of over 27% y/y) will not be engulfed in the ITCÆs current credit crunch.
Until government eases credit crunch and stabilizes asset markets, USD/KRW to rise
Equally important is the fact that we do not expect pronounced net outflows of the more than $70 billion stock of foreign investment in the KOSPI. Of course, our view that the current market dynamics are tractable would argue against a large net withdrawal of foreign funds over the near-term.
Moreover, foreign investors are focused on the stronger corporates in Korea, those likely to be relatively more immune from the current problems in the non-bank financial sector and thus better able to regain market value.
Hyundai, for instance, currently represents only around 3.9% of the market capitalization of the KOSPI while Samsung Electronics, SK Telecom, Korea Telecom, and KEPCO amount to over 55% of the market.
Of course, the won is vulnerable until such time as the government has restored confidence to ITCs and the local asset markets since the policies aimed at achieving these goals are negative for the currency. Despite the pronounced Nasdaq-inspired rise in the KOSPI on Tuesday, a stabilization of sentiment is likely to be some weeks off.
For that reason, until we see signs of redemptions from ITCs slowing and a sustained recovery in the KOSPI, USD/KRW is a buy on dips in what will be a temporary correction to a downtrend. Immediate resistance is at 1148 with 1161.50 forming the 50% retracement of the post-Daewoo rally in the KRW.
Policies return to reform, growth deceleration over coming months
However, we have not altered our positive, medium-term view on the won. We expect the current travails in the non-bank financial sector to be overcome, and that the authorities will therefore be able to ease the current nervousness that has driven local asset markets lower.
After that, we would expect the policy priority to swing back to the task of accelerating Chaebol and financial sector reform and in slowing growth towards trend rates. Indeed, the problems that have surfaced at some of HyundaiÆs units will accelerate the pace of restructuring in the Chaebol sector as we see accelerated moves towards asset disposal, capacity shutdowns, and deleveraging that is more reliant of debt reductions rather than capital increases. (The very process of corporate reform will be deflationary and help maintain the current benign trend on the CPI, thus allowing BOK more latitude to keep rates low.)
Of course, the current problems in Korea highlight how the financial system as a whole and the Chaebol sector have not yet completed the path or reforms and hence remains vulnerable to sharply higher interest rates.
We therefore continue to feel that interest rates will remain expansionary going forward with the onus of policy tightening instead falling on fiscal policy (large primary budget surpluses should be seen in the coming years) and on a stronger currency.
We still look for USD/KRW to trade lower towards 1050 over the next 12 months, especially since if the government is able to achieve a slowdown towards 6%-7% GDP we believe the attendant decline in investment will see Korea become a structural capital exporting country, even at such stronger levels of the won.
Our belief that Korean economic fundamentals will endure the current period of market instability therefore highlights why we also remain fundamentally bullish on the medium-term outlook for the benchmark credits, and view the current sell-off to provide an attractive buying opportunity.
Moreover, the exaggerated concerns surrounding systemic financial sector risk suggest that the Korean sub-debt market has been significantly oversold given that upper level currently provides absolute yields of around 14.0-14.5%. This sector would be expected to rally in tandem with the won when the governmentÆs policies to ease current market volatility begin to bear fruit.
Desmond Supple is Head of Research, Asia at Barclays Capital