South Korea's debt crisis brewing? The Bank of Korea is in a dilemma

The world's long history of low interest rates over the past few years has made money unusually cheap and has led to a surge in debt. Now, as central banks raise interest rates and borrowing costs rise, from global corporate defaults to the U.S. banking crisis, all kinds of debts accumulated over a long period of time have been "settled". In South Korea, the "account" falls on community credit unions.

After losing 60 billion won (1 yuan about 181.6 won) on real estate loans, MG Community Credit Union (MGCCC), South Korea's largest community credit union, suffered a run and closed a branch. While South Korea's financial regulator quickly and aggressively backed struggling lenders, the market fears that the credit crisis is not over.

The MGCCC triggered a credit crunch

MGCCC is a special non-bank financial institution that began in 1963 as a credit mutual aid group of the Shinchon Movement in Korea. Subsequently, policymakers enacted laws giving them the functions of absorbing savings and providing loans. According to the South Korean Ministry of the Interior, it has more than 1,200 branches and more than 40% of South Koreans use its services every year. Thanks to tax incentives and higher interest rates than bank deposits, total assets have increased nearly threefold in the past 10 years, reaching 284 trillion won last year. The Bank of Korea's data also showed that MGCCC deposits were on par with some of South Korea's largest banks: 260 trillion won as of June, and Kookmin Bank, South Korea's largest commercial bank, had 380 trillion won. In addition, due to its particularity, some loans that cannot be mortgaged by banks can be issued quickly by MGCCC and is a large full-rental housing loan in South Korea.

But as the Bank of Korea follows the Fed in raising interest rates, benchmark interest rates continue to rise, and South Korea's real estate sector is weak, making it difficult for more borrowers to service their debts. At the end of June, MGCCC's loan delinquency rate climbed to 6.18% from 3.59% at the end of last year, and the spread between bonds and government bonds of some cooperatives widened to a four-month high, according to data from South Korea's Ministry of the Interior. After Korean media reported that the loan delinquency rate of some branches of MGCC exceeded 20%, a run occurred, and MGCCC eventually had to close one of its branches.

After the crisis, South Korea's Financial Services Commission (FSC) quickly intervened, issuing a statement saying that "MGCCC's capital adequacy ratio and liquidity ratio are much higher than regulatory ratios, and it has sufficient cash equivalent assets", and ordered South Korea's five major commercial banks to sign repurchase agreements with it, allowing MGCCC to exchange collateral such as bonds for cash, providing it with a total of 5 trillion won in potential financing.

While these actions helped stabilize investor sentiment, bond yields at some credit unions continued to widen, suggesting lingering fears of a credit crisis.

Park Sunyoung, an associate professor of economics at Dongguk University in Seoul, said liquidity runs at some credit unions showed a complete failure by the government and financial regulators in monitoring credit risk. "MGCCC is at highest risk of failure in project financing due to a rapid increase in lending during the height of the housing boom in 2020." According to the Bank of Korea, of MGCCC's total loans of 201 trillion won as of January this year, 56.4 trillion were real estate loans and 15.8 trillion yuan were real estate project financing debts.

Harald Finger, head of the International Monetary Fund's delegation to South Korea, warned this week: "As interest rates rise in South Korea and many other countries around the world, financial stability risks in South Korea increase, and vulnerabilities are emerging in some sectors, particularly non-bank lenders with exposure to property-related financing." He also suggested that South Korean banks should also strengthen their resilience to financial stress by improving liquidity buffers and bad debt absorption capabilities.

A pivotal moment for the Bank of Korea

In addition to the credit crisis itself, the market is also worried about the impact of the crisis on South Korean households. South Korea's household debt is one of the highest in the world, accounting for annual rents of about $800 billion, and the ratio of household debt to gross domestic product (GDP) is 157%, the highest among developed countries.

Data from the Korea Financial Investment Association also shows that most of the assets of South Korean households are non-financial products such as real estate, accounting for 64.4%, higher than 28.5% in the United States and 37% in Japan (as of 2021). Moreover, most South Korean households' property loans are variable-rate loans, which means that if interest rates continue to rise, the default rate will rise. There is also a leasing practice called "jeonse" in South Korea, in which tenants pay a one-time deposit to the landlord, which is often reinvested in real estate, which is also feared to be lost if house prices fall sharply.

This creates a dilemma for the Bank of Korea: on the one hand, fears of a credit crisis make it impossible for the Bank of Korea to easily raise interest rates; On the other hand, the widening interest rate differential between the United States and South Korea has continued the depreciation pressure of the Korean won, and it is necessary to raise interest rates moderately to stabilize the exchange rate. The won is now near a nine-month low against the dollar, making it the worst performing currency in Asia this month.

"The pivotal moment for the Bank of Korea has arrived." Yoon Yeo-sam, an analyst at Seoul-based Meritz Securities, said: "They should play the role of monitoring the government and warning about the increase in household debt lest their efforts to curb risk lead to more moral hazard and project-financed loans." ”

Today (24th), the Bank of Korea kept interest rates unchanged at 3.5%, pausing interest rate hikes for the fifth consecutive time. Ahn Yea-ha, an analyst at Kiwoom Securities, said: "South Korea's inflation rate fell to its lowest level in more than two years in July, giving the Bank of Korea breathing room to deal with rising economic risks. In particular, a branch of MGCCC was forced to close, and non-performing loans related to real estate projects have caused growing concern in the Korean credit market. The Bank of Korea stepped up emergency measures to support troubled lenders, but concerns remain. ”

Kwon Hyosung, a Bloomberg economist, said the Bank of Korea is concerned about the acceleration of lending to South Korean households by non-bank financial institutions because it is a financial stability risk. With South Korea's weakening growth outlook, the fragile non-bank financial sector is at risk of loan defaults, making it unlikely that interest rates will rise. But at the same time, the record interest rate differential between South Korea and the United States has put huge downward pressure on the won and complicated the Bank of Korea's efforts to control inflation, as South Korea relies heavily on food and energy imports.