Distress spreads in South Korea; Template that relies less on leverage needed

April 23, 2013 5:44 pm

Distress spreads in South Korea

By Henny Sender

Template that relies less on leverage needed

For many years, Japanese business people believed their economic malaise lay in a cheap South Korean won, rather than anything intrinsic to their country. Once the yen depreciated, all would be well.

The Japanese definition of well meant that consumers around the globe would cease to buy Samsung goods and turn to Japanese products instead. Now their thesis is about to be tested.

Thanks to Abenomics, massive liquidity in Japan means corporate distress there is diminishing. International hedge funds that bet not long ago on the cost of credit insurance going up for the weakest sectors, such as shipbuilding and steel, have seen the cost come down instead – at least for the moment.

By contrast, signs of distress in South Korean companies are starting to intensify. The country successfully weathered the 2008 global financial crisis but five years later, it isn’t faring as well.In most places in the world, companies and households have been reducing their debt burden. But in South Korea, leverage still remains too high. The top 30 conglomerates have 1,000tn won ($893bn) in debt according to one recent study. In the second half of last year, four of the top 12 groups were unable to cover their interest payments from operating profit.

That burden falls unequally on a group’s constituent parts. At one big South Korean conglomerate, for example, cash flows from stronger activities, such as car parts, are supporting weaker activities, such as construction, according to a board member.

Things may not be as bad as the Asian financial crisis of 1997-1998 when housewives sold their gold to help the country’s finances, but it is worrying nevertheless. The distress is particularly intense in shipping, shipbuilding, construction and real estate, all of which are facing a severe credit crunch according to the Korea Development Institute.

Weaker conglomerates are already feeling the pain. In 2011, the number of companies filing for receivership was five times that of five years earlier, and things have worsened since.

The first big shock this time was the failure of the Woongjin group, which went into receivership in September. Woongjin, among the top 35 conglomerates in the country, was in every struggling sector, from construction and shipbuilding to a savings bank and solar energy.

The Woongjin shock in turn contributed to the capital markets freezing up, increasing the stress on other cash-strapped groups. Capital markets have been especially spooked by the fact that many ailing companies raised debt in the market only weeks before going bust. That has led to a crisis of confidence regarding local credit agencies as well.

Now worries are growing about the health of the banking system. Many savings banks have already gone bust and in recent months, regulators have forced more than two dozen to suspend operations. But today the major banks are also seeing signs of pressure. Net interest margins have dropped while non-performing loans have been inching up, hitting earnings which are expected to decline at double-digit rates in coming quarters. Officially defaults on loans to companies last year rose to 2 per cent for the first time since 2003.

But seven major banks established a sort of bad bank several years ago, which they capitalised with their own equity, allowing it to buy up some of their bad loans. One hedge fund analyst in Hong Kong says it borrowed money extensively in the corporate bond market, paying for the loans with a mix of the capital from its shareholder banks and the money it raised, potentially disguising the scale of bad debts in the system. That sort of uncertainty and lack of transparency is never a good thing.

In the past, South Korea has confounded the naysayers several times. But today, as economic growth slows everywhere, competitive pressures and a zero-sum mentality about currencies is becoming more intense. For both South Korea and Japan, exports have been the principal driver of growth and both seem dedicated to that model despite the headwinds.

To be sure, there are opportunities amid the distress in South Korea. MBK, the Asian private equity fund last year bought Coway, a water company from Woongjin, acquiring a lucrative asset from a distressed seller. But the real opportunity for South Korea lies in developing a new template that relies less on leverage, especially hidden leverage.