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South Korea’s government is facing piling political pressure after a credit default by a theme park developer snowballed into a nationwide credit market crunch. South Korean bonds backed by the local government, generally considered on par with national debt, have lost their appeal among investors who are now causing a liquidity crunch in the corporate debt market.
The country has now joined other economies in the global credit market rout, and all eyes are now on Korean policymakers who are facing accusations of ineptitude to contain the financial market turmoil. The South Korean economy is already facing difficulties due to rising inflation, a weakening won and monetary policy tightening.
Behavioural finance and South Korean bond market
In September, Jin-Tae Kim, the governor of South Korea’s Gangwon province said that a special purpose entity called Gangwon Jungdo Development Corp (GJC) will not be paying back the 205 bn won (~$150 m) to its creditors. The amount relates to the construction of Legoland in the province which was funded by the local government by issuing bonds through GJC. The bonds were then said to be backed by GJC-owned real estate and the Gangwon provincial government.
Kim’s declaration to the public that the local government will not honour its commitment to its creditors, and that GJC would enter bankruptcy, caused investors to flee credit markets. BNK Securities, the underwriter for the bonds, declared a default on the GJC bonds, which instantly led to their downgrade to junk status.
The decision to declare the Legoland default might have been a hasty one, as Gangwon has an annual budget of over 17.7 tn (~$13 bn) and the 205 bn won could have been restructured. But the damage was already done as investors grew concerned of the creditworthiness of corporate bonds, dumping the credit securities and raising yields sharply.
As per the data from Korea Financial Investment Association, the average yield for three-year corporate bonds with an AA-credit rating has reached 5.69%, a sharp uptick from 4.537% just two months ago. Credit spreads between three-year Korean treasury bonds and AA-credit have widened to 147 as of November 4.
What’s driving market sentiment further into the negative is the Bank of Korea’s first-of-its-kind aggressive monetary tightening policy to contain rising inflation. The central bank last month raised the terminal interest rate by 50 basis points to 3%, with a target to hit 3.5% in upcoming meetings.
The Gangwon governor was quick to rescind his statement, and the provincial government has promised to repay the 205 bn won in December, but the damage has already been done.
Korean credit market is shaken
Several South Korean bonds are due to mature in 2022, and issuers are scrambling to refinance their debts by issuing more bonds, but there are few buyers left. Korea Electric Power Corp, South Korea’s biggest power company which has a credit rating of AAA, was able to raise only half the money of its target from a bond sale in October. The company was able to raise only 590 bn won (~$445 m) from the market against its target of 1.2 tn won.
Incheon Housing and City Development Corp abandoned its plan to issue bonds for affordable housing construction as it expected no buyers. Gwacheon Urban Corp, which issued bonds worth 60 bn won for public housing construction in Seoul, could not find buyers for 40 bn won of its debt, the first time in the company’s history.
In late October the Korean government, sensing the uneasiness in the credit market, pledged 50 tn won (~$37.6 bn) to support corporate debt issuances. South Korea’s finance minister Kyung-Ho Choo in a statement said that the country will operate a “liquidity supply program” to prevent a credit squeeze.
The government said it will start buying corporate debt by using 1.6 tn won (~$1.2 bn) from its bond stabilization fund of 20 tn won that had been set up in response to the pandemic.
“We believe the current policy measures will provide only limited near-term help and are unlikely to address the potential risks of a system-wide credit crunch,” said Jeong-Woo Park, an economist at Nomura, in a note.
Earlier this month, Heungkuk Life Insurance Co said it will postpone a call option for its dollar perpetual note citing unfavourable market conditions, the first time a company had declined to exercise a call option since the global financial crisis. Already on their toes, bond investors took this move to the heart. The insurance company has since retracted its statement and said it would go ahead with the call option on the scheduled date.
Apart from the one developer of Legoland, there have not been any extensive defaults in South Korea’s corporate debt market, but yields are hovering at a high. An analysis by Bloomberg found that yields on Korean commercial paper had risen to levels last seen during the global financial crisis, with local currency bond issuances falling to the lowest since 1999.
“We don’t think the credit crunch will pose a systemic risk to the financial system because corporate’s debt condition has improved on average compared to 2015 and most of them are already in risk management mode. But, this will hurt near-term growth and drag the economy into recession next year,” writes Min Joo Kang, Senior Economist, South Korea & Japan, at ING.
The domestic credit issue is a stark one for South Korea, which would want to continue having ample liquidity in the market but is facing rising inflation and must resort to policy tightening. For the country’s real estate sector, the concern is even higher as rising borrowing costs, lack of liquidity and rising costs of raw materials has pushed developers into a corner.
To avoid a contraction of the real estate sector, South Korea has unveiled a package of 10 tn won (~$7.51 bn) to aid property developers. “Even if we foresee some defaults in construction, the estimated damage should be smaller than in the past,” says ING’s Kang.
