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

The long-term low interest rates around the world over the years have made funds exceptionally cheap, leading to a surge in debt. Nowadays, as central banks around the world raise interest rates and borrowing costs rise, from global corporate bond defaults to the US banking crisis, various debts accumulated over the long term have all been subject to "post autumn accounting". In South Korea, this "account" falls on community credit cooperatives.

Due to a loss of 60 billion Korean won on real estate loans, the largest community credit cooperative in South Korea, MG Community Credit Cooperative, was previously run on and closed a branch. Although South Korean financial regulatory authorities have quickly and strongly supported struggling lending institutions, the market is concerned that the credit crisis is not yet over.

MGCCC triggers a credit crisis

MGCCC is a special non bank financial institution that began as a credit mutual aid group in the 1963 New Village Movement in South Korea. Subsequently, policy makers enacted laws granting them the functions of attracting deposits and providing loans. According to data from the South Korean Ministry of the Interior, its branches have exceeded 1200, and over 40% of Koreans use its services every year. Due to tax incentives and higher interest rates than bank deposits, total assets have increased nearly threefold in the past decade, reaching 284 trillion Korean won last year. The data from the Bank of Korea also shows that MGCCC's deposit size is comparable to some of the largest banks in South Korea: as of June, its deposit size was 260 trillion won, while the deposit size of the largest commercial bank in South Korea, the National Bank of Korea, was 380 trillion won. In addition, due to its particularity, some loans that cannot be mortgaged by banks can be quickly disbursed by MGCCC, making it a major player in full rental housing loans in South Korea.

But as the Bank of Korea follows the Federal Reserve in raising interest rates, the benchmark interest rate continues to rise, coupled with the weakness of the South Korean real estate industry, more and more borrowers are struggling to repay their debts. According to the data of the Ministry of the Interior of South Korea, at the end of June, the loan default rate of MGCCC climbed to 6.18% from 3.59% at the end of last year, and the spread between bonds of some cooperatives and treasury bond widened to a four month high. After South Korean media reported that the loan default rate of some branches of MGCCC exceeded 20%, a run occurred and MGCCC had to shut down one of the branches.

After the crisis, the South Korean Financial Services Commission quickly took action, stating that "MGCCC's capital adequacy ratio and liquidity are much higher than regulatory ratios, and it has sufficient cash equivalent assets." It also ordered the five major commercial banks in South Korea to sign repurchase agreements with them, allowing MGCCC to exchange bonds and other collateral for cash, providing a total potential financing of KRW 5 trillion.

Although these actions have helped stabilize investor sentiment, the bond yields of some credit cooperatives continue to widen, indicating that market concerns about the credit crisis are lingering.

Park Sunyoung, Associate Professor of Economics at Seoul East University, stated that the liquidity runs on some credit cooperatives indicate a complete failure of the government and financial regulatory agencies in monitoring credit risk. Due to the rapid increase in loans during the peak of the real estate boom in 2020, MGCCC has the highest risk of failure in project financing. According to data from the Bank of Korea, as of January this year, out of MGCCC's total loans of 201 trillion won, 56.4 trillion yuan were for real estate loans and 15.8 trillion yuan were for real estate project financing debt.

Harald Finger, head of the International Monetary Fund's delegation to South Korea, warned this week that "as interest rates rise in South Korea and many other countries around the world, the risk of financial stability in South Korea is increasing, and some parts are showing fragility, especially non bank lending institutions with risk exposure to real estate related financing." He also suggested that South Korean banks should strengthen their resilience to financial pressure by improving their liquidity buffer and bad debt absorption capacity.

Key Moments for the Bank of Korea

In addition to the credit crisis itself, the market is also concerned about the impact of the crisis on Korean households. South Korea's household debt is among the highest in the world, with an annual rent of approximately $800 billion. The ratio of household debt to GDP in South Korea is 157%, the highest among developed countries.

According to data from the Korea Financial Investment Association, the majority of assets in 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. Moreover, most Korean households have floating rate loans for their property, which means that if interest rates continue to rise, the default rate will continue to rise. There is also a leasing practice in South Korea called "Jeonse", where tenants pay a one-time deposit to the landlord, which is usually reinvested in real estate. If housing prices drop sharply, these deposits may also be wasted.

This puts the Bank of Korea in a dilemma: on the one hand, concerns about the credit crisis make it difficult for the Bank of Korea to easily raise interest rates again; On the other hand, the widening interest rate spread between the United States and South Korea has continued to put pressure on the depreciation of the Korean won, and moderate interest rate hikes are needed to stabilize the exchange rate. The Korean won is currently close to a nine month low against the US dollar, making it the worst performing currency in Asia this month.

"The critical moment for the Bank of Korea has arrived," said Yoon Yeo sam, an analyst at Meritz Securities in Seoul. "They should play a supervisory role in the government and issue warnings about the increase in household debt to prevent their efforts to contain risks from leading to more moral hazard and project financing loans."

Today, the Bank of Korea kept interest rates unchanged at 3.5%, suspending interest rate hikes for the fifth consecutive time. "South Korea's inflation rate fell to its lowest level in over two years in July, providing the Bank of Korea with breathing space to cope with rising economic risks. In particular, a branch of MGCCC was forced to close, and non-performing loans related to real estate projects have raised concerns in the South Korean credit market. The Bank of Korea has strengthened emergency measures to support struggling lending institutions, but related concerns still persist."

Bloomberg economist Kwon Hyosung stated that the Bank of Korea is concerned about the acceleration of non bank financial institutions lending to Korean households, as this is a financial stability risk. With the weak growth prospects in South Korea, the fragile non bank financial sector faces the risk of loan defaults, making it unlikely to raise interest rates. However, at the same time, the interest rate spread between South Korea and the United States has reached a historic high, putting enormous downward pressure on the Korean won and complicating the efforts of the South Korean central bank to control inflation, as South Korea heavily relies on food and energy imports.