Back on form: South Korea's economy was on the brink of disaster in January 2009, but is now one of the fastest recovering markets in Asia

Despite falling into a major economic trough in the first quarter of 2009, the majority of South Korea's banks are poised for a stable recovery in 2010. But the unwinding of stimulus packages worldwide and the risk of a possible double-dip global recession in the West continue to threaten the Korean banking sector. Writer Mee Hyoe Koo

South Korean banks experienced the same challenges posed by the foreign currency liquidity crunch and asset quality deterioration, brought on by the global financial crisis, as the majority of their Asian peers. However, a relatively strong Korean economy, robust capital positions, little exposure to US subprime toxic debt and deep, expansive and swift measures undertaken by the South Korean government to support its economy and financial system have seen the country's banks largely outperform their peers in other Organisation for Economic Co-operation and Development (OECD) countries.

Despite confronting what in January of last year looked like economic disaster, the South Korean economy is expected to grow a solid 3.6% to 5% in 2010, positioning it as one of the fastest recovering markets in Asia. South Korean banks even posted a net profit in the final quarter of 2009, with charges set aside against bad loans nearly halving, according to Reuters. Now, despite the bleak picture found in South Korea in the first quarter 2009, the region's banks have rebounded and are poised for a stable recovery in 2010. However, the unwinding of stimulus packages and the threat of a possible double-dip recession in the West continue to pose risks to the sector.

Determined measures

The South Korean government's determined measures in the face of the 2009 global economic slump owe much to the lessons learned during the 1997-98 Asian financial crisis and the country's less well-known 2003-04 credit card liquidity crisis, says Youngil Choi, vice-president and senior analyst at Moody's in Hong Kong. "The Korean authorities were much more thoroughly prepared to take necessary actions to cope with possible risks [and] have successfully implemented policies to reduce the risks in the banking system."

Currency stability is one area, in particular, where the government's efforts have proved both robust and highly effective.

The South Korean banking sector is highly dependent on the interbank lending market, which, during the course of the past year, has been exposed to major foreign funding pressures. Furthermore, the country has proved particularly vulnerable to the global slump in trade due to its reliance on the US dollar for external payment settlements.

The situation improved following the negotiation of a number of crucial currency swap agreements, starting with the US in October 2008 and followed by further agreements with Japan and China. The swap lines allowed the South Korean central bank to guarantee the foreign debt of commercial banks, bringing stability to the country's foreign exchange market. "With tight foreign currency liquidity, banks tended to reduce foreign currency loans in favour of Korean won-denominated instruments," says Yung-Ku Ha, the CEO of Citibank Korea. The appreciation of won and valuations of securities investments during the past year, however, have revived local banks' balance sheets.

In November 2009, the government also moved to introduce six new measures to improve standards for liquidity management in foreign currencies, including tightening the formula calculating regulatory foreign currency liquidity ratios and the requirement to have a minimum level of high quality foreign currency assets.

The growing strength of the banking sector is borne out in a number of financial indicators. Following the South Korean government strengthening its guidance for banks' regulatory capital adequacy far above the minimum requirement of 8% BIS capital ratio, the country's banks had improved their BIS II capital ratio to 14.1% by September 2009, while their Tier 1 ratio had risen to 10.7%, according to Moody's. Major South Korean banks also posted a net profit in the final quarter of 2009, with charges set aside against bad loans nearly halving, says Reuters. Of the country's top lenders, only Shinhan Financial Group posted a drop in quarterly profit.

As funds have trickled back into the system, many banks have been able in turn to manage down their loan-to-deposit ratio. "We recorded a higher performance in 2009 compared with 2008," says Citibank's Mr Ha. "Of note was the growth in customer deposits in 2009, with 54% growth year on year - which is a trend we expect to continue in 2010." Despite the lingering risks, the general health of the banks' balance sheets remains better than initially expected, says Jason Rogers, senior analyst at Barclays Capital in Tokyo. "Declining loan-to-deposit ratios combined with increased regulatory capital levels have resulted in a far more resilient banking sector," he adds.

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Youngil Choi, vice-president and senior analyst at Moody's in Hong Kong

SME woes linger on

Despite an upward trend, many local banks are unwilling to comment. This may reflect ongoing concerns. Lending growth, for example, is expected to be somewhat moderated in 2010. "I expect the credit growth could be around high single-digit or low teens, depending on individual banks' strategies," says Moody's Mr Choi. "I do not expect that the banks could grow their loan book as fast as 2005-07 due to the regulatory restrictions, as well as remaining risks in the operating environments."

Unlike the very large corporate sector, which underwent restructuring and deleveraging following the Asian financial crisis, South Korea's small and medium-sized enterprise (SME) sector was badly hit by the global slump and remains one of the more troubled lending segments. Many SMEs have suffered foreign exchange losses following the drastic depreciation of the won in 2009. According to Hung-Joo Lee, head of retail and the commercial banking group at Citibank Korea, local banks in particular have borne the brunt of SME woes. "Many local banks continued to grow SME lending, which resulted in asset deterioration on real estate project financing, SME construction and SME shipbuilding, whereas foreign banks focused on consumer lending activity," he says.

The commercial banks have generally proved cautious toward SME lending, according to Moody's, meaning government-funded policy banks have been forced to up their market share in SME loans. In early 2009, the government pressured local and foreign banks to continue lending to troubled SMEs to suppress the unemployment rate - but lending to SMEs continued to fall dramatically.

The government was forced to introduce extended credit guarantees on all SME loans through the public Korea Credit Guarantee Fund. Additionally, the government introduced a Won20,000bn ($15bn) bank recapitalisation fund, combined with a separate Won40,000bn fund to purchase distressed corporate bonds and non-performing loans (NPLs) from financial institutions. The government's extraordinary support for the SMEs through the financial guarantee will be withdrawn gradually. But this presents new risks. "As the government credit guarantee facility decreases, [SMEs] may experience more difficulties," says Heakyu Chang, director at Fitch Ratings Korea. With the recent appreciation of the won, foreign exchange losses will be more manageable this year, although this may be offset by lower export profitability, say some market analysts.

On the other hand, South Korea's large corporate sector has fared well in the past year, led by a resurgence in the IT, telecommunications and auto industries. What remains a relatively weak won exchange rate also helped exporters gain global market share. However, shipping and ship-building industries, a major source of export revenues for South Korea, the world's leading ship-builder, are still grappling with oversupply and diminished demand. "If the number of new ship orders does not pick up significantly in a few years, even big ship-builders may face difficulties," says Mr Chang. The construction sector, meanwhile, has stabilised after the Korean government's swift measures to boost domestic demand through infrastructure investment. Exporters in key industries are expected to continue to perform well as the global economy recovers.

Mixed consumer outlook

The outlook for the consumer segment in South Korea for 2010 is mixed, however. Consumer sentiment has improved and the Korean economy is expected to grow between 3.6% and 5% in 2010. "As unemployment rates stabilise and start to decrease, we should observe stability in credit performance, helping to bring default rates down to pre-financial crisis levels," says Sergio Zanatti, head of the cards group at Citibank Korea.

Since the Financial Supervisory Service's (FSS) introduction of tighter debt-to-income ratios in mid-2009, designed to cool the housing market, South Korean banks' new mortgage lending has shown notable slowdown - a trend set to continue this year. Mortgage asset quality also remains a concern for some onlookers. Fitch Rating's Mr Chang says that while the consumer sector's delinquency rate is low, relative to previous years, ongoing unemployment will put pressure on consumer sector loan quality. "Mortgages have been the best quality assets to the banks, but as interest rates rise, household borrowers may face difficulty making timely payments as the debt-serving capability of the consumer sector has been decreasing," he says.

According to the FSS, the total delinquent ratio for local currency loans was 0.76% in December 2009, the lowest since December 2007. "The NPL ratios have been on a downward trajectory for the [later] quarters in 2009 following the peaking out of delinquencies in the first half of 2009. Even though some problems will linger in 2010, especially as the government rolls back its support for many companies, a renewed surge in asset quality problems is unlikely," says Wai Ho Leong, senior economist at Barclays Capital in Singapore.

As write-offs in the corporate sector are slowly returning to pre-crisis levels after peaking in the second and third quarter of 2009, the banking system looks to be returning to health. But as the Bank of Korea has been at pains to point out, considerable uncertainties remain.


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