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2 RISKY
BUSINESS Economic
crisis closing in on South Korea By Jephraim P Gundzik
South Korea's short-term external debt
stock nearly doubled in 2006 on the back of
prolific yen-borrowing by commercial banks.
This injection of foreign capital did
little to stabilize South Korea's
deflation-gripped economy. While savvy Korean
investors sent record sums of money abroad in
2006, foreign investors, apparently unaware of the
country's weak and deteriorating political, social
and economic fundamentals, continued to load up
on
Korean assets.
Yen appreciation against
most currencies in 2007 will provoke widespread
defaults in South Korea, reversing short-term
foreign-capital flows. This could prompt the
devaluation of the won and a correction in the
stock market of 50% or more.
Asian
crisis redux The 1997 Asian financial
crisis, with its epicenter in Thailand, erupted
suddenly and viciously after the revelation that
many countries in the region had built
unsustainably large piles of short-term external
debt. International banks played a key role in
this debt buildup by recklessly lending huge sums
of money to domestic banks in Thailand, South
Korea, Malaysia, the Philippines and Indonesia.
This reckless lending was supported by the world's
largest central banks, which compressed investment
risk with overly loose monetary policies.
The factors that created the last Asian
crisis reappeared in earnest last year. Despite
inflation considerably eclipsing its target range,
the US Federal Reserve shifted monetary policy to
neutral in mid-2006. More significant, the Bank of
Japan followed suit, leaving short-term interest
rates just above zero and encouraging Japanese
banks to become intermediaries between the
money-printing central bank and investors
worldwide. This intermediation has become
popularly known as the "yen carry trade".
Despite generally rising investment risk
worldwide triggered by increasing global inflation
and extreme global geopolitical instability, the
central Bank of Japan suppressed this risk,
allowing the yen carry trade to shower hundreds of
billions of dollars on emerging market countries.
This made assets in many countries extremely
expensive relative to risk in 2006. Nowhere was
this more apparent than in South Korea.
In
2005, South Korea's stock of short-term external
debt was US$66 billion, equivalent to 35% of total
external debt. According to the central Bank of
Korea, by the second quarter of 2006, the stock of
short-term external debt leaped to $94 billion,
equivalent to 41% of total external debt. By the
end of the year, Korea's short-term external debt
is estimated to have reached nearly $120 billion,
representing 46% of total external debt
outstanding. By comparison, the ratio of
short-term external debt to total external debt in
Thailand in 1997 was 43%.
Though South
Korea's ratio of short-term external debt to total
external debt exceeded 60% in 1997, its
composition was entirely different. During the
mid-1990s, South Korea's mega-corporations
(chaebol) were responsible for the rapid
buildup of short-term external debt. Supported by
relatively strong cash flow, the chaebol
disguised their over-leveraged position until
Thailand was rocked by financial crisis and
investors began to take a harder look at leverage
regionwide.
Last year, the surge of
short-term external debt was engineered by South
Korea's commercial banks, which were anxious to
increase profits by borrowing yen to expand
domestic household credit. In many instances,
Koreans used very low-interest yen credit offered
by South Korea's commercial banks to finance
speculative mortgages in the country's real-estate
market. This has left Korean households with large
unhedged exposure to the Japanese yen and South
Korean banks facing the prospect of widespread
mortgage default in the event of the yen's
reversal. South Korea's commercial banks also have
enormous unhedged exposure to the yen through
massive carry trades on their own balance sheets.
The news gets worse Despite the
apparent acceleration of real gross domestic
product (GDP) growth to 5% last year, domestic
demand in South Korea remains very weak. This is
obviated by the acceleration of domestic
deflation. In 2005, South Korea's GDP deflator
slipped into negative territory, falling by 0.4%.
In 2006, deflation accelerated, with the GDP
deflator estimated to have contracted by nearly
1%. The negative GDP deflator artificially boosted
real GDP growth in both 2005 and 2006.
Real GDP growth is calculated by
subtracting the GDP deflator from nominal GDP
growth. However, when the GDP deflator turns
negative, it is added to nominal GDP growth. Under
such unusual circumstances, nominal GDP growth is
a better indicator of overall
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