The Peninsula

South Korea and the Next Financial Crisis

By Kyle Ferrier

Bearish investor perspectives on a number of economic indicators have translated into volatile swings in global markets this month, including South Korea’s key stock market index, the KOSPI. A fall in U.S. markets on October 11 led the KOSPI to drop by 4.4 percent, the biggest single day loss in nearly 7 years. Analysts view the tumble and swings in stock markets since as a market correction rather than the beginning of something more ominous. However, ongoing developments should serve as a reminder of how quickly things can take a turn for the worst and that another financial crisis is inevitable.

As a country that has been particularly impacted by financial crises in the past two decades, South Korea has made a lot of headway in protecting itself from the next one, but significant risks still remain.

Risks

Internal

Burgeoning household debt represents the most significant internal risk to the South Korean financial market.

By April this year, South Korean household debt had reached 95.2 percent of GDP, up 2.3 percent from what is was last year. This jump makes Korea the country with the third fastest debt growth, after China and Hong Kong. Data from April through June shows this debt continues to reach new heights.

While household debt is not inherently bad as it can help jumpstart growth, too much of it can act as a drag on the economy and can greatly exacerbate or even cause a financial crisis – best demonstrated by the 2008 global financial crisis. Koreans are spending more across a number of categories, setting records in areas such as private education, but the biggest source of debt growth are mortgages.

South Korea’s housing market has been rapidly expanding. The value of the housing market in 2017 was $3.6 trillion, a jump of 7.6 percent from 2016. This is the largest annual increase since 2007 and outpaced the 5.1 percent rise in disposable income over the same period – representing increased risk of insolvency.

External

The urgency of South Korea’s household debt problem is intensified by the Federal Reserve’s interest rate hikes. As Fed Chairman Jerome Powell continues his predecessor’s efforts to normalize interest rates, there is increased pressure on private South Korean banks and the Bank of Korea (BOK) to raise lending rates to prevent investor money from leaving the country in pursuit of higher yields. However, higher domestic interest rates increases the cost of servicing the large pool of existing debt and potentially risks a wave of defaults.

The federal funds rate is currently 2.0-2.25 percent and is projected to be raised four more times by the end of next year. The BOK’s base rate on the other hand has been fixed at 1.5 percent since November last year and was held once again after the latest monetary policy board meeting on October 17. However, rate divergence with the Fed cannot be sustained indefinitely for a small open economy like South Korea. Even without BOK activity, pressure from the Fed has been spilling into mortgage lending – Korean banks just raised rates for new and outstanding loans for the 13^th straight month. These rates will not only continue to go up at, but likely pick up speed as the BOK tries to at least somewhat keep pace with the Fed.

South Korea’s reliance on the global economy also makes it susceptible to external shocks. As a share of GDP, 41 percent of South Korean household, corporate, and government debt is denominated in foreign currency. This debt to be paid in foreign currencies represents relatively high exposure to currency risk, the extreme of which is a currency crisis. Additionally, the Korean economy’s dependence on exports could present challenges. The IMF downgraded South Korea’s growth outlook this year from 2.9 to 2.6 percent, citing tensions in global trade and tighter financial conditions. The country is also among the most to lose from a U.S.-China trade war.

While the risks to the Korean economy are substantial, so too are the government’s tools to prevent and manage the next financial crisis.

Tools

Fiscal, regulatory, and monetary policy

President Moon’s economic policies known as “J-nomics” center on government spending-led growth. Though this has resulted in record government budgets, Moon’s predecessors have given him a lot of fiscal space to work with. In 2016, the last year of the Park Geun-hye presidency, South Korean government spending was 32.3 percent of GDP, among the lowest in the OECD at the time. The latest IMF Article IV country report for South Korea is supportive of Moon’s expansionary fiscal policy to strengthen the social safety net and reduce inequality. The BOK has so far accommodated this fiscal stimulus through its low rates.

The administration has also been actively trying cut down on household debt. Moon’s policies have mainly focused on restricting mortgage rules, cutting down on speculation, offering incentives to new homeowners, building more affordable housing, and helping marginalized borrowers. His party is looking to further limit real estate prices in the Seoul area by encouraging people to move to newly built cities around the country.

Other areas of particular regulatory interest include cryptocurrencies and chaebols.

The current government has taken great interest in blockchain technology, but the Financial Services Commission (FSC) – the top financial regulator – has been cautious about the application of this technology in digital currency transactions. Heightening the regulator’s wariness, the Korean public has enthusiastically embraced cryptocurrencies, with some estimates showing that they represent 30 percent of all cryptocurrency trading despite being less than 1 percent of the global population. Such widespread acceptance of cryptocurrencies over a relatively short time has prompted heavy-handed FSC interventions. The latest public debate is over whether initial coin offerings should be allowed, which the FSC will make a decision on in November.

Moon has also been doing more to regulate the chaebol – South Korea’s large multinational conglomerates. A longstanding complaint against chaebols has been that they serve the interests of the controlling families rather than the shareholders. Investors argue this leads to inefficiencies and mismanagement, which, given their massive size, could potentially be disastrous for the economy. To address this, the Fair Trade Commission plans to roll out new rules to dilute the power of the families controlling chaebols and the National Pension Service – the country’s largest domestic investor – will play a larger role in influencing corporate governance in the interest of the Korean people.

The administration’s efforts to grow the economy and reduce the risks of the next crisis, however, has been an uphill battle which will likely only get tougher with time. While government spending is ballooning, the initial results for the economy have been underwhelming. Ongoing measures to curb household debt are more extensive than previous administrations, but still have not been able to rein in rising home prices and debt. Moreover, the Fed’s rate hikes not only pose a challenge to existing debt, but to the effectiveness of fiscal policy as well. This would be particularly troubling during a financial crisis as counter-cyclical fiscal policy would be less potent.

Currency reserves and access

Perhaps the most significant lesson South Korea learned from the Asian and global financial crises has been the importance of access to emergency liquidity, which is clearly reflected in government policy.

After the 1997-98 crisis, Korea’s foreign exchange accumulation took off and, with the exception of the 2008 crisis, has continued to rise since. The country’s over $400 billion in foreign currency reserves ranks 9^th in the world, just barely behind India.

Korea has also been actively supplementing its access to other sources of foreign exchange.

South Korea added global financial safety nets to the G20 agenda in 2010, leading to the enhancement of the IMF’s Flexible Credit Line and the establishment of the Precautionary Credit Line, which was upgraded a year later. The Lee Myung-bak administration additionally proposed the creation of a global swap regime at the same summit in Seoul – inspired by how the Fed’s emergency bilateral currency swaps with key central banks helped stem the spread of the 2008 crisis. However, this idea was ultimately shot down by the United States.

After opting not to access the Chiang Mai Initiative (CMI) during the 2008 crisis, South Korea played a key role in its upgrade to the CMI Multilateralization (CMIM) in 2010. The CMIM is a regional financial arrangement among ASEAN+3 countries which allows members to swap local currencies for U.S. dollars to fend off a crisis. Its size today is $240 billion, of which South Korea can draw on $38 billion, but only $11.52 billion without triggering IMF involvement.

Recent administrations have also been making efforts to negotiate bilateral swap agreements in currencies other than the U.S. dollar. Both swaps in reserve and local currencies offer access to emergency liquidity. However, while the main advantage of swaps in a reserve currency like the dollar is access to a more stable currency in a crisis, the key benefit of local currency swaps is boosting bilateral trade in these currencies, thereby cutting down on dollar dependency. The BOK has local currency swaps with Canada, Switzerland, Malaysia, Australia, Indonesia, and China. Similar agreements with the UAE and Japan have elapsed.

Between its own reserves and other means, Seoul clearly has access to a large amount of foreign exchange, but the proverbial question is if it is enough?

When Seoul took a $58.4 billion IMF loan in 1997 the country had $63.8 billion in short-term external debt against its $9.1 billion of usable foreign reserves. By the 2008 crisis, however, South Korea was in a much better position to cover its debt. In March that year the BOK had nearly $265 billion in foreign reserves, but by the beginning of November it had drained over $63 billion to support the won. What turned the tide was the Fed’s $30 billion swap deal with the BOK in late October even though this amount was dwarfed by Korea’s reserves. This highlights that not only are a country’s resources important to allay market concerns during a crisis, but so too is international cooperation.

An arrangement with the IMF or the Fed proved to be the clearest way to restore market confidence during a crisis, but both institution’s capacity going forward could be more limited than it was during the global financial crisis.

While not uniquely a Korea problem, much-needed leadership from Washington to upgrade an underdeveloped global financial safety net and to help manage the next crisis seems to be less assured than in the past. Because the U.S. quota share effectively grants it veto power in the IMF, the U.S. Treasury Department and Congress play a critical role in determining IMF resources. The 2010 IMF Quota reform – doubling the institution’s lending capacity – was held up by Congress until December 2015 for political reasons and was only approved because of added conditions granting further Congressional influence over the IMF.

The Trump administration will be developing its recommendations for the next quota review, scheduled to be completed by the IMF in the fall of next year at the latest. While there is no official position yet, Congressional testimony from U.S. Treasury Undersecretary for International Affairs David Malpass in November 2017, that “the IMF currently has ample resources to fulfill its mission,” suggests the U.S. may not support expanding the lending capacity of the institution. How the administration approaches the next IMF quota reform also has major consequences for the renewal or replacement of the supplementary $450 billion contributions to the New Arrangements to Borrow, set to expire in 2020.

These challenges to cooperation could all be moot if the independent Fed once again decides to extend bilateral credit lines to central banks in countries experiencing a financial crisis. However, the Fed only seems inclined to do this for a crisis with the potential to destabilize the global economy like what occurred in 2008. Even then, these swaps would be difficult to implement if strongly opposed by the White House.

Bottom line

Integration with global markets has transformed South Korea into an advanced economy, but the flip side is that it is more susceptible to financial shocks. The strength of South Korean institutions has enabled successive administrations to identify major external risks and pursue policies to fend off and prepare for the next crisis. However, as a small open economy, there is only so much that can be done to influence outside economic factors, though Seoul should continue to push for greater international cooperation across the multiple levels of the global financial safety net.

The Moon administration has rightly focused its attention on resolving the most pressing domestic issues, but will likely find the macroeconomic environment increasingly less accommodating as time goes on. While the government’s fiscal space buys Moon some time, external pressures such as the Fed’s planned rate hikes also should provide his agenda a sense of urgency to find successes that have not yet materialized.

Kyle Ferrier is the Director of Academic Affairs and Research at the Korea Economic Institute of America. The views expressed here are the author’s alone.

Photo from the Republic of Korea’s photostream on flickr Creative Commons.