CHICAGO – South Korea is emerging as a closely watched weak link in the US$63 trillion (S$85.8 trillion) world of shadow banking.
Delinquency rates at one key group of South Korean lenders nearly doubled to 6.55 per cent in 2023, while economists at Citigroup estimate 111 trillion won (S$109.7 billion) of project finance debt is “troubled”. South Korean shadow bank financing to the real estate sector rose to a record 926 trillion won in 2023, over four times a decade ago, data from the Korea Capital Market Institute shows.
Policymakers stemmed contagion risks by expanding certain loan guarantees, but a shock restructuring announcement in late 2023 by builder Taeyoung Engineering and Construction underscored the threat of flare-ups. The firm will need a debt-to-equity swap of about one trillion won to erase capital impairments, its largest creditor said last week.
Such restructurings stand to worsen strains among shadow banks – as non-bank lenders are often called. The part of that sector with activities that may pose stability risks is large compared with other advanced economies, and is second only to the United States in relative size, according to data from the international Financial Stability Board.
“What is happening in South Korea is probably a microcosm of what could be happening elsewhere,” said Mr Quentin Fitzsimmons, a global fixed-income portfolio manager at T. Rowe Price Group. “It has made me concerned.”
South Korean policymakers can ill afford a steep drop in property prices that might exacerbate bad loans and hurt the economy, as happened in Japan in the 1990s.
The country’s non-bank lenders have made large investments in overseas commercial real estate in the past decade, lured by favourable exchange rates and the perception – common until the pandemic – that offices, with their long-term leases, provide safe returns.
Many of those assets suffered in the post-Covid-19 slump. Hana Alternative Asset Management’s investment in London retail-and-office property No. 1 Poultry is an example.
Threats are most acute for smaller lenders of the type that, at least in Asia, are often considered part of the private credit market.
“Given the government’s intention to restructure some of the weak-performing development sites, we think some of the smaller and non-bank financial institutions are more vulnerable,” said Mr Matt Choi, director of Asia-Pacific financial institutions at Fitch Ratings.
Shadow-bank lending grew quickly in the aftermath of the 2008-2009 financial crisis as banks pulled back from risky loans, prompting smaller and less profitable businesses to turn to alternative sources.
The challenges of refinancing such borrowings rose to the fore after the Bank of Korea became one of the first major central banks to raise interest rates in 2021. Of course, South Korea is now far from the only economy dealing with the unintended consequences of higher financing costs. The default rate on US leveraged loans topped 6 per cent for the first three months of 2024 and spreads on the riskiest European junk bonds recently widened to the most since early in the pandemic.
But in South Korea, the extent of the concern can be seen in the rapidity of the policy response. An official at South Korea’s financial watchdog, the Financial Supervisory Service, said earlier in April that the organisation may conduct on-site inspections of savings banks after evaluating loan delinquencies for the first quarter.
Still, overall credit risks have not sparked broader economic damage, in contrast to China. An unprecedented real estate slump there has fuelled more than US$130 billion of bond defaults and persistent deflation. It also led shadow lender Zhongzhi Enterprise Group to file for bankruptcy in 2024.
Many private lenders spooked by such risks in China have considered channelling money elsewhere in Asia, including South Korea. KKR & Co, for example, signed a deal to lend US$40 million to property firm Innovalue earlier in 2024.
But the worst from South Korea’s property malaise is likely yet to come. Citigroup economist Kim Jin-wook reiterated the bank’s view in April that restructuring of project finance debt will slow economic growth in the second half to 0.2 per cent in its base-case scenario.
Project finance loans – a kind of short-maturity debt – became popular with developers after the Asian financial crisis in 1997, when South Korea requested an International Monetary Fund (IMF) bailout.
The practice of using such funding gained momentum during the years of low rates and rising property values. Brokerages got in on the action by securitising such loans and selling them on to money market investors.
But they have become a common thread through the recent scares.
The first signs of trouble in South Korean credit markets emerged about 19 months ago, when the developer of a Legoland amusement park to the north-east of Seoul missed payment on project finance loans, triggering the biggest local run-up in short-term debt yields since the global financial crisis. Then, in July 2023, fears about ill-timed real estate bets forced a branch of a non-bank lender, one of South Korea’s biggest credit unions, to shut.
The South Korean authorities have so far managed to limit the pain. After Taeyoung, they promised to expand a US$66 billion stabilisation package if needed to limit the spillover. In March, the government backed up those pledges with billions of US dollars of additional support.
“They are managing the risks, but it has to be monitored closely,” Dr Krishna Srinivasan, director of the IMF’s Asia and Pacific Department, told Bloomberg. “Some of the smaller institutions could be at risk.” BLOOMBERG
