“Contagion” is never a happy word but in Asia right now it has particularly scary connotations, particularly for South Korea, which is exhorting its banks to flog off foreign assets and bring home dollars.
South Korea was once known as the “hedge fund of the global economy”, although it now might be more appropriately called “Asia’s weakest link”.
On Monday, the country saw its already battered currency plunge a further 5 per cent to its lowest level in six years as the costs of borrowing on the money-market surged and analysts predicted a steeper slide in the won amid growing difficulties in refinancing short-term debt.
The won’s fall came as Seoul – clearly shaken by the global financial turmoil – took the extreme step of advising banks to sell off and liquidate their foreign assets to raise funds to boost lending to companies struggling with higher foreign-currency borrowing costs. Seoul also promised to use its currency reserves to shield lenders from the financial crisis engulfing the US and Europe.
But, as Reuters observed, the promise “did little to reassure markets in a country that analysts say faces greater risks than most in Asia from the upheaval that destroyed Wall Street investment banks last month and now threatens lenders from Iceland to Italy”.
Korea’s particular problem is one of excessive leverage: its banks have an extraordinarly high loan-to-deposit ratio, which climbed to 139 per cent after a lending spree between 2002 and 2007. And according to Moody’s, which last week downgraded its outlook to negative for four Korean banks, that ratio rose further in the second quarter to a staggering 150-180 per cent.
Most Asian countries by comparison have loans-to-deposit ratios below 100 with Malaysia at around 74 per cent, Japan slightly higher and the Philippines at 57 per cent.
The loans-to-deposit ratio of the big four Korean banks – Kookmin Bank, Woori Finance Holdings, Shinhan Financial Group and Hana Financial Group – ranged between 135-177 per cent in the first quarter of 2008, Moody’s noted.
Korean household debt meanwhile has hit 82 per cent of GDP and 148 per cent of disposable income, according to Reuters.
System-wide, Korea’s financial liabilities are estimated at 2.7 times GDP – ranking it at the top for Asia. But as Korean banks have been amongst the most aggressive lenders, this problem could well become a regional problem – and quickly.
Korea’s other main vulnerability, as Lex observed last week, is the preponderance of loans to the small and medium-sized enterprises likely to feel the pinch when growth slows.
Sure, the Korean government, with large stakes in the country’s banks, is more likely than their western counterparts to respond rapidly in crises. But the real risks mean bank shares – now mostly at or below book value – will continue to tank.
For Korea’s embattled banks, it is hardly an idea time to sell off foreign assets, given the turmoil elsewhere. Even as the won tumbled and borrowing costs surged, the Seoul stock market, tracking a regional selloff, plunged nearly 5 per cent to a 20-month low. Overall, the Korean bank index has fallen 25 per cent this year, against a 28 per cent loss in the broader market.
South Korean Finance Minister Kang Man-so put the problem thus: “Recently our financial institutions have begun experiencing troubles in securing foreign-exchange liquidity,” he told a meeting of executives from local commercial banks, according to Reuters.
“The government judges that we need to deal with the situation pre-emptively, while assuming the worst-case scenario.” While he did not elaborate on what “pre-emptive action” might include, Kang said banks should take measures themselves such as selling foreign-currency securities and other assets to secure foreign exchange liquidity.
However, his reiteration of a government pledge to give banks access to Korean forex reserves, the world’s sixth largest at nearly $240bn, was hardly comforting for the big banks now under pressure to liquidate overseas assets and bring in the dollars (the Korean government owns a good chunk of the banks).
Many analysts say the fears of a 1997-style Asian financial crisis are overblown:
“This rush for foreign currency has been heightened not only due to the global credit squeeze but also because Korea has seen its current account falling sharply in recent months, even as investment outflow continues,” said UBS analysts in a note. “Although we are not expecting a banking crisis in Korea, the credit crunch is likely to be most severely felt in Korea among Asian economies given the highly leveraged Korean corporate and households.”
Meanwhile, Lim Ji-won, economist at JPMorgan Chase told Reuters: “It’s different from the previous crisis because foreign reserves are now more than enough to cover short-term foreign debt.”
But others disagree. As Lex asked in an August note on Korea: “If Sleeping Beauty, the heroine of European folklore, were to wake up in Seoul today, would she know she had been asleep for 11 years?”
And Bloomberg reports Monday that Korea’s debt-financing problems are likely to deepen from now, with the won likely to lose a further 10 per cent against the dollar in the next six months as the credit crisis reduces exports and investors repatriate capital, according to CFC Seymour in Hong Kong.
The won, which is already the world’s worst-performing major currency this year with a loss of 26 per cent, will weaken to 1,400 to the dollar as Korea struggles to refinance its short- term debt, CFC’s chief investment strategist Dariusz Kowalczyk wrote in a report Monday. The last time the currency breached that level was amid the Asian financial crisis, in 1998, when the won lost half of its value.
To add to the cheer, Reuters reminds us that Korea is also on track to post its first annual current account deficit since that crisis and foreign investors notched up net stock sales of 30 trillion won ($24.57bn) this year, already the highest on record.
South Korean debt maturing in less than a year is worth about $210bn. The cost of protection against a default on South Korea’s five-year sovereign debt, meanwhile, has surged six-fold this year to 240bp. Although little changed in recent weeks, an investor would need to pay $240,000 a year to insure $10m of South Korean bonds against default.
As Lex noted: “Although a massive collapse is not immediately on the cards, some of the fault-lines do look eerily familiar.”