Eastern exposure

In Seoul's vibrant central district, the lustre of rising affluence fills the atmosphere. Among the busy streets and underground, shopping arcades proliferate, the fruit of a rapid period of industrialisation that has transformed South Korea into a top-ten export-driven powerhouse boasting a slew of world-class manufacturing brands.

Samsung Group, well-known in the West for its mobile phones and flat-screen televisions, is among the world's largest conglomerates: by annual revenues, the company would rank among the world's top 50 economies. Besides high-end electronics, South Korea has developed a thriving trade in car production, steel, petrochemicals, robotics, and is the world's largest ship-builder. Enjoying a gross domestic product (GDP) growth rate of 5% in recent years, South Korea now ranks as the world's 13th largest economy. Not bad for a country which, only 40 years ago, subsisted on a per capita income equal to that of present-day Sudan.

Miraculous though Korea's economic explosion has been, the very engine of its industrialisation has rendered the country uniquely vulnerable to the global economic downturn. As a producer of boom-time big-ticket items, some 25% of its annual exports are highly sensitive to a reduction in global credit. But the extent to which South Korea has been exposed to Western woes was not fully clear until the fourth quarter of last year, when it was revealed exports collapsed by an eye-watering 17.4% and 33% in December 2008 and January 2009, respectively. As a result, the country's GDP growth rate plummeted by a disastrous 5.6% on a quarterly basis. Based on the most recent data, the IMF forecasts a growth rate of minus 4% this year, a figure regarded as "inconceivable" only six months ago, says one economist.

Beyond the inconceivable

To the extent its exports have been ravaged, South Korea is not exceptional among its Asian peers. Japan, Taiwan, Singapore and even China all confront a similar challenge. South Korea's predicted economic contraction is also reassuringly slight compared to the 6.6% decline suffered in 1998 at the height of the Asian financial crisis, when the country was bailed out by the IMF in what Koreans now refer to as "the IMF Crisis". But as Suktae Oh, director economist at Citibank Korea, points out, South Korea is not an ordinary export-driven economy: it is also a hugely leveraged economy. "In Korea, external debt is about 40% of GDP. Compared to the West this is very low, but compared to Asia it is quite high," he says. Korea's household leverage is among the highest of Asian economies, meaning that, unlike other Asian countries such as China, it will struggle to compensate for a collapse in exports by stimulating domestic demand.

In a scenario that owes more to its Western customers than Asian counterparts, much of South Korea's domestic debt has been extended by over-leveraged local lenders. Unlike other Asian banking sectors, South Korean banks are highly dependent on the inter-bank lending market, which has exposed them to major foreign funding pressures: in the fourth quarter of 2008, the Bank of Korea was forced to provide some $55bn of dollar liquidity in order to allow local banks to repay their short-term foreign debt. The situation has accelerated the depreciation of the Korean won against the dollar, which entered into a downward spiral in December 2007 after the country's current account posted a deficit.

In a further blow, South Korea's highly liquid stock market has been hardest hit by the flight of foreign investors, suffering massive net equity outflows in 2008 of more than $30bn. As a result, the value of the won, which has depreciated by some 30% over the past six months, plummeted to an 11-year low in March 2009.

If the economic environment is fraught, the political atmosphere has been borderline chaotic. Although Lee Myung-bak, South Korea's conservative president, is "hyperactive" in his efforts to address the crisis, South Korea's politics "have been weak", says Kihwan Kim, an independent advisor to President Lee. Since late December, South Korea's parliamentary opposition, the Democratic Party, has stubbornly blocked a raft of reform bills which President Lee claims are critical to tackling South Korea's precipitous slump. In its most unedifying moments, the political stand-off has deteriorated into astounding physical brawls more befitting of a boxing match than a national assembly.

None of which is to suggest, however, that the South Korean government has been anything other than vigorous in its response to the crisis. Theatrics aside, the government is acting as fast as it can to roll out an expansive programme designed to mitigate the short-term slump and, for the most part, many experts agree with Mr Byung-Hwa Kim, deputy governor of Bank of Korea, when he claims to be "doing everything we can". Given how powerless South Korea has been to control the external trade environment, experts believe that the recovery action plan must focus on three broad long and short-term areas: the immediate stimulation of domestic demand; improving the competitiveness and capital structure of the country's troubled small and medium-sized enterprise (SME) sector; and the long-term development of South Korea's shallow capital markets.

Domestic demand

Experts are agreed that South Korea must expand the base of its domestic demand. "In order to develop the Korean economy in the short term, the government needs to focus on the domestic market in order to increase the capacity," says Mr Kyeseong Kim, executive vice-president of the finance and management planning unit at Woori Bank. "It is necessary to increase consumer expenditure," he adds. The government is making strenuous efforts in this regard. As of early March, its fiscal stimulus measures totalled some Won51300bn ($49.28billion), according to Reuters, comprising additional government spending, tax cuts, public works programmes and long-term, environmentally focused investments designed to create nearly 1 million jobs.

A supplementary budget bill anticipated to be in the region of Won30,000bn is also in the pipeline. In total, these efforts represent more than 5.7% of GDP, far exceeding stimulous plans being rolled out in the majority of Western countries.

But since marginal consumption has largely been debt-assisted in recent years, many economists predict domestic demand will decline as South Korean households move to reduce their debt. To this extent, the government is restricted in its capacity to encourage domestic consumption, save for the lever of interest rates. The Bank of Korea has moved aggressively in this regard, slashing the base rate from 5.25% to the 2% since October 2008. In March, the bank unexpectedly held rates as it moved to assess the impact of previous cuts. "We are very conscious that we have lowered the base rate dramatically," says Mr Byung-Hwa Kim. "So we have to be very careful about the future: if there are any signs that the financial market will be stabilised we have to normalise the magnitude of monetary supply," he adds. Many economists believe another cut will be necessary as the Korean economy deteriorates.

The extent to which domestic demand can be stimulated, or even sustained, will be largely determined by the rate of unemployment. Local Koreans are quick to note that the number of jobless, at 3.5%, is still low when compared with the IMF crisis, although Mr Kihwan Kim, also chairman of the Seoul Financial Forum, a financial think-tank, believes the official statistics do not reflect the real figure.

Even so, the situation would be a lot worse had the government not quickly focused its efforts on supporting the SME community which employs the majority of the Korean workforce. Unlike the very large corporate sector, which underwent both restructuring and de-leveraging following the IMF crisis, the SME community – the majority of which supports the global supply chain – are being pummeled by the crisis. "If you look at the SME companies their structure is not as good as the large corporates," says Mr Byung-Hwa Kim. "The SMEs are crying out for money," he adds.

Restructure imperative

This makes the SME sector a problem not only for the government but for local lenders too, says Jin-Hei Park, managing director, head of institutional clients group at Citibank Korea. In the past five years, South Korean SME sector credit has grown significantly: in 2007, lending to the segment shot up by 25%, with some banks growing their SME lending by up to 40%, notes Mr Park.

While this sector has been bruised by the downturn in exports, the data suggests that nearly one-third has never been financially viable, with some 30% unable to service their debt with earnings. Due to the benign credit cycle, many companies have been able to borrow at extremely competitive rates against the rising collateral value of their operations in order to repay their existing debt. But declining property prices combined with slashed revenues has tipped this model on its side. "This segment has over-borrowed: faced with this recession it is obvious that quite a few of them will have a problem," says Mr Park.

In order to keep the troubled SME sector afloat, the government is leaning on the banks to increase their net lending to the sector. But as Mr Byung-Hwa Kim notes, local banks remain "very reluctant" to lend to this segment despite the flattened base rate. Not without good reason, however. The non-performing loan (NPL) ratio on SME loans is rising and many banks are now worried about delinquency rates, which are reaching 2%, says David Mann, head of research at Standard Chartered First Bank Korea. In a debate that will be all too familiar to UK policy-makers, some Korean bankers suggest it would be more effective and indeed preferable for the government to engage directly with the SME community by creating a lending window. Instead, the central bank has created a number of what Mr Byung-Hwa Kim describes as "unorthodox" liquidity channels. These include offering a 100% guarantee to loans extended to a 15% to 20% tranche of the SME sector in order to allow them to rollover loans, and a Won20000bn recapitalisation fund to absorb losses on delinquencies.

But there is a limit on how long the government will be able to sustain this liquidity support. In response to the fundamental challenges facing the SME community, the Korean government has asked lenders to lead a large-scale restructuring of the sector. The speed and success of this process will be critical to South Korea's immediate recovery, says Mr Yong Hwan Kim, senior deputy governor at Financial Supervisory Service, the enforcement arm of South Korea's financial regulator. "The present focus is on the restructuring and reform. The most important thing is how corporate restructuring will go: we are trying to promptly go through this and those that recover will use it as an opportunity to grow."

But many bankers feel the government's message is ambiguous. Although the government does not expect banks to support companies verging on bankruptcy, it continues to exert pressure on lenders to offer a 100% roll-over rate to companies that many banks regard as long-term unviable. For over-leveraged local lenders, this is a very unattractive proposition that conflicts with the government's stated goals.

"If a bank wants to keep its balance sheet strong and capital sound we shouldn't lend our money to these bad companies. If we withdraw from the bad companies then in aggregate restructuring would be done," says Mr Park. "But although the government keeps signalling that a restructuring is necessary, it keeps asking us to lend, meaning they are delaying the restructuring process."

There is no sincere governmental desire to restructure, adds one economist, who notes that the number of corporate bankruptcies so far remains negligible. This dilatory approach may protect jobs in the short-term, but it will only serve to undermine the competitiveness of the South Korean SME sector in the future, say some. Many bankers believe it is vital to bury the zombie SMEs as soon as possible. "We need to let good companies go on and bad companies file for bankruptcy. Through the restructuring process, companies need to survive on their own," says Mr Kyeseong Kim.

Beyond the frying pan

The restructuring of South Korea's industry will be limited by Korea's under-developed capital markets, warns Mr Kihwan Kim. Until this is resolved, Korea will remain vulnerable to future global currency crises, he adds. The recent dollar liquidity shortage continues to exert considerable pressure on the lending community – to say nothing of the won itself and the wider economy – causing some banks to be downgraded. As one senior banker at a major local lender complains, the situation is "unfair", beyond the banks' control and does not reflect the true credit-worthiness of the Korean banking sector. The government claims its formidable $200bn in currency reserves, combined with some $90bn in currency swap lines secured with the US, Japan and China, is more than adequate to cover the $160bn in short-term debt due this year.

But the Bank of Korea is aware that this is not a long-term solution. "Even though we have a huge amount of foreign reserves it is not enough to defend our country when we have this kind of international turmoil," says Mr Byung-Hwa Kim. South Korea must reduce its dependence on short-term foreign debt and increase its "credibility" in the eyes of foreign investors, he adds. It is often said that the country aspires to build its own Goldman Sachs and the government has determined to transform Seoul into an international financial centre.

In February, the much anticipated Capital Markets Consolidation Act came into being, which, in a similar way to London's so-called 'Big Bang', will liberalise the financial sector: banks and securities firms will be free to develop more diverse and sophisticated financial products, pursue acquisitions, and transform themselves into full-service investment banks. Though many commentators believe that the global crisis will delay the process, government officials are adamant that it is the only way South Korea can reduce its vulnerability to future downturns. "At the moment, Korea is like a large shallow frying pan: it heats quickly, and it cools quickly," says Mr Kihwan Kim.

Following the IMF crisis, South Korea bounced back within 11 months. Few economists are so hopeful this time round. Citi's Mr Oh believes the pace of recovery will be more gradual, with many forecasts predicting a return to strong growth of 4.2% in 2010. But in Seoul, the mood among local bankers remains palpably optimistic. "The Korean economy has been built by overcoming problems," as one banker observes. "We have optimism in our DNA."