COVID-19, Yeongkkeul, Debt Investment... Bank of Korea "Financial Potential Risks Increased" (Comprehensive Report 2)

Bank of Korea Financial Stability Report
Financial Stability Index at 'Caution' Level... Highest Since Financial Crisis

1 in 5 Companies This Year Are Marginal
Increasing Number of Companies Unable to Pay Interest Despite Earnings

Household Debt-to-Disposable Income Ratio Hits Record High
Rising Risk in Mutual Finance Corporate Loans Too

[Asia Economy Reporters Eunbyeol Kim, Sehee Jang] The ongoing COVID-19 pandemic has revealed that the latent vulnerabilities of South Korea's financial system have grown to levels comparable to the 2008 financial crisis. This is due to increased borrowing to overcome the real economy crisis caused by COVID-19, coupled with asset market concentration, which has led to a surge in debt-financed investments. By the end of this year, one in five domestic companies is highly likely to become a marginal company, and the debt-to-disposable income ratio has reached an all-time high, indicating a deterioration in debt quality and an increase in latent risks within the financial system.

On the 24th, the Bank of Korea announced in its 'Financial Stability Report' that the new Financial Stability Index (FSI-Q) rose to 70.1 in the second quarter. This is the highest level since the third quarter of 2008 (72.3). At the end of last year, the FSI-Q was at 64.1, rising to 68.2 in the first quarter and surpassing 70 in the second quarter. The Bank of Korea considers an FSI-Q above 66 as the 'caution' stage and above 81 as the 'crisis' stage. A Bank of Korea official explained, "The sharp increase in loans and the strengthening of risk appetite have continuously increased vulnerabilities," adding, "The heightened risk appetite in the real estate market and the increase in household and corporate debt are the main factors."

Reflecting financial conditions in the second quarter, the Bank of Korea's forecast for the next year’s GaR (Growth-at-risk) is -4.5% (annualized), a drop of more than 1 percentage point compared to -3.0% a year ago. GaR represents the 5th percentile of possible future GDP growth rates under current financial conditions.

More than 1 in 5 companies to become marginal this year... 5,033 companies

The report estimated that considering the sales shock caused by COVID-19, the proportion of marginal companies this year will rise to 21.4%, up 6.6 percentage points from last year. The debt held by marginal companies is expected to increase to 175.6 trillion KRW. This is an increase of 60.1 trillion KRW compared to the end of last year (115.5 trillion KRW). This amount accounts for 22.9% of all loans to externally audited companies. The expected default probability of marginal companies was 4.1% on average in June, 2.4 times higher than the 1.7% expected default probability of non-marginal companies.

Min Jwahong, Director of the Financial Stability Department at the Bank of Korea, said at a press briefing, "Assuming a severe stress scenario from the COVID-19 sales shock this year, the number of marginal companies is estimated to reach 5,033." This means that 21.4% of all externally audited companies will be unable to cover interest payments with operating profits over three years. Regarding the trend in expected default rates of marginal companies, he said, "The expected default probability has significantly increased this year," noting it rose from 3.1% in December 2018 to 4.1% as of June this year. The expected default rate of marginal companies is estimated based on stock price trends.

While debt has increased significantly, the ability to repay it is deteriorating. At the end of the first quarter this year, the interest coverage ratio of companies fell sharply to 3.1 times from 4.7 times in the first quarter of last year. The debt-to-equity ratio rose from 78.5% at the end of last year to 82.2% as corporate loans increased. The number of companies falling into marginal status due to inability to pay interest with operating profits is rapidly increasing. Although 838 companies exited marginal status last year, up from 768 in 2018, the number of companies newly entering marginal status rose faster, from 892 to 1,077 during the same period.

Professor Donghyun Ahn of Seoul National University’s Department of Economics said, "Marginal companies that should be exited from the market are surviving due to low interest rates," adding, "It is necessary to identify the good and bad companies by analyzing indicators such as sales, net income, operating profit, and capital erosion." He also noted, "The increase in marginal companies, which had been rising even before COVID-19, has accelerated," and "Even large corporations are entering marginal status, accelerating the entry of marginal companies." This indicates a vicious cycle where marginal companies accumulate layer upon layer as the number of newly entering marginal companies increases alongside existing ones.

Debt-to-disposable income ratio hits all-time high... Potential mutual finance insolvency amid regional economic downturn

With the low interest and low growth environment, money flowing into asset markets has caused household debt to surge. The craze for 'Yeongkkeul' (borrowing to the limit) and 'Bittou' (debt-financed investment) has led many to take loans to invest in real estate or stocks. The household debt-to-disposable income ratio reached an estimated 166.5% in the second quarter, the highest since the Bank of Korea began compiling statistics in the first quarter of 2007. This is an increase of 7.0 percentage points compared to the second quarter of last year.

In particular, the Bank of Korea noted that as housing transaction volumes increased, the growth in housing-related loans expanded again, and the risk of other loans (such as credit loans) also rose. From June to August this year, the increase in housing-related loans and other loans amounted to 15.4 trillion KRW and 17.8 trillion KRW respectively, expanding by 81.2% and 93.3% compared to the same period last year.

Among financial institutions, mutual finance institutions (including Nonghyup, Suhyup, Forestry Cooperatives, Credit Unions, and Saemaeul Geumgo) were identified as problematic. Mutual finance institutions located in regional areas (non-metropolitan) have increased corporate loans to real estate-related sectors, but the deterioration of regional economies has sharply reduced the soundness of loans in these sectors.

As of the end of June, the ratio of non-performing loans classified as fixed or below (non-performing loans) in mutual finance corporate loans was 3.24%, rapidly rising from 1.60% at the end of 2017. In particular, the growth rate of fixed or below non-performing loans expanded significantly from an annual average of 20.3% during 2016-2017 to 75.6% during 2018-2019, and 59.0% as of the end of June 2020 (year-on-year). By industry, the delinquency rate in construction rose from 1.30% at the end of 2017 to 4.11% at the end of June this year, and in real estate from 0.91% to 2.91%. The increase in delinquency rates in real estate-related sectors exceeded those in other sectors such as accommodation and food services (+1.08 percentage points) and wholesale and retail trade (+1.04 percentage points) by more than double.

Despite this, the loan growth rate in real estate-related sectors by mutual finance institutions continues to rise. The annual average loan growth rate for real estate-related sectors from 2016 to 2019 was 50.6%, significantly exceeding the overall corporate loan growth rate of 38.3% during the same period. The loan balance for real estate-related sectors (excluding Saemaeul Geumgo) was 72.4 trillion KRW at the end of June, accounting for 55.6% of total corporate loans. The Bank of Korea is particularly monitoring delinquency rates of mutual finance institutions in regional areas. The delinquency rate in regional mutual finance institutions rose from 1.17% at the end of 2017 to 2.27% at the end of June (+1.10 percentage points), significantly outpacing the increase in metropolitan mutual finance institutions (1.20% to 1.54%, +0.34 percentage points). The delinquency rate in the southeastern region (Busan, Ulsan, Gyeongnam), where regional key industries such as shipbuilding and shipping are in downturn, showed the largest increase (1.38% to 3.04%, +1.66 percentage points).

This content was produced with the assistance of AI translation services.