[Chatham House] ① Is the PF-triggered Financial Crisis Really Coming?

"Japernization or Japanification, Next Year Is the Turning Point"

Imjin, President of the Korea Chamber of Commerce and Industry SGI (from left), Cho Won-dong, former Chief Presidential Secretary for Economic Affairs, Lee Jung-jae, Director and Editorial Advisor of Asia Economy Economic Media School, Kim Dong-won, former Visiting Professor at Korea University, Park Jae-ha, former Vice President of Korea Institute of Finance, and Kwak Young-kwon, Executive Director of Meritz Securities, are posing for a commemorative photo before the 1st Asia Economy Chatham House discussion held on the 1st at Lotte Hotel, Sogong-dong, Jung-gu, Seoul. Photo by Kim Hyun-min kimhyun81@

Editor's NoteOur economic and financial think tank, 'Asia Economy Chatham House,' has been launched. On the 1st of this month, at Lotte Hotel in Sogong-dong, Jung-gu, Seoul, an in-depth discussion was held under the theme 'Is a Crisis Triggered by Project Financing (PF) Coming? - An In-depth Diagnosis of Korean Finance,' featuring Kwak Young-kwon, Executive Director of Meritz Securities; Kim Dong-won, former invited professor at Korea University; Park Jae-ha, former Deputy Director of Korea Institute of Finance; Lim Jin, Director of the Korea Chamber of Commerce and Industry's Sustainable Growth Initiative (SGI); and Cho Won-dong, former Chief Presidential Secretary for Economic Affairs (in alphabetical order). The participants forecasted that "the current economic recession will not reach the level of the past International Monetary Fund (IMF) foreign exchange crisis." However, opinions diverged on the extent of the government's role in overcoming the crisis. There was a strong debate between those advocating proactive and aggressive policy responses and those arguing that government intervention might hinder the market's natural structural adjustment. Many also pointed out that preparing for the deepening polarization and super-aged society after 2023 is more urgent than immediate market instability. Asia Economy Chatham House follows the 'Chatham House Rule,' where the list of participants is disclosed, but the remarks of each speaker are anonymized. The full discussion will be published in several parts.

◆ Moderator = Lee Jung-jae, Director and Editorial Advisor of Asia Economy Economic Media School

There are many economic issues we need to address, but sometimes we cannot speak frankly due to concerns about market shocks or relationships with policymakers and government authorities. This Chatham House discussion was created with the intention of setting those aside and speaking honestly and straightforwardly. The Chatham House method means that while the names and faces of participants are disclosed, their specific remarks are not; only the content of their statements will be conveyed.

The first topic is the 'PF-triggered financial crisis.' There is extreme market anxiety and stress about whether this crisis will actually occur. The government is taking a somewhat conservative stance to stabilize the market, often saying things like "It's okay" or "There is no problem," but we want to have an open discussion about whether this is truly appropriate or if we need to prepare more actively.

"The Era of 2% Inflation Is Over"

This year will mark the end of a historic period. We have experienced inflation for the first time in 42 years, along with the COVID-19 pandemic and the Ukraine war. The war seems likely to end by next spring, and COVID has almost become like a common cold. Inflation has peaked and will come down. However, the aftermath of all these events will not be trivial.

I believe 2023 will be a very special year, both globally and geopolitically, as well as in terms of U.S. policy. Moreover, Korea's aging population is expected to accelerate sharply in the coming years. The baby boom generation born between 1958 and 1963 is entering old age in earnest. The Yoon administration period will be the steepest in our history, with the aging rate rising by 3.5%. If this leads to a long-term recession, the result will be severe polarization. Polarization began in earnest from the COVID crisis, and aging will accelerate growth stagnation and polarization. Especially for young people, very difficult times are approaching.

I see 2023 as a race against time. If we spend 2023 just putting out fires like a financial crisis and miss the opportunity, we will lose the chance to address bigger issues. There will be a general election in April 2024 and a presidential election in March 2027. After next year, politics will dominate, leaving no room to tackle major economic problems. Therefore, I believe the government must take bold action next year. That is the main point I want to make today.

Today's topic is PF, but looking back, I think PF will not be a major problem. Of course, PF issues are not trivial, especially foreign debt problems will be very challenging. However, when we look back around this time next year, the PF crisis will likely not be such a big issue. We should focus more on bigger matters such as restoring the economic system, preparing for aging and polarization, and securing growth potential.

I completely agree with you, but it is difficult to cover all these topics in a short time. First, please freely share how the current events in Korean finance relate to what you mentioned, what changes might occur, and how we might find more reasonable improvements or solutions.

I mostly agree with Discussant A. However, I find it difficult to agree with the idea of not wasting too much energy trying to prevent the current PF crisis. If we just leave the PF crisis unchecked and it festers and bursts, we will have no capacity left to handle important issues like preparing for aging. We cannot ignore the current short-term market situation. We need to pay close attention and devote a significant portion of our capacity to dealing with the PF crisis.

Also, one of Discussant A's points that we must address macroeconomically is that 'the era of 2% inflation stability is over.' Going forward, interest rates and inflation will remain above 2% for a considerable period. There are various reasons for this. Countries worldwide have increased debt significantly to respond to COVID. How to resolve this enormous debt is not easy by simply raising taxes. Ultimately, we may have no choice but to tolerate some inflation to reduce real debt. This approach is not new; after World War II, inflation was used to reduce massive war debts. The key question is how much and how long inflation will be tolerated. This is where the government’s dilemma lies.

Historically, rising prices reduced real debt but also caused workers to feel betrayed due to real wage declines. This strengthened labor unions and intensified social conflicts. We need to consider such macro variables when addressing future issues like aging. Of course, I do not expect to find answers here immediately. Therefore, I hope we focus first on short-term issues like the PF crisis and Korean finance.

On the 1st, participants are sharing their opinions at the 1st Asia Economy Chatham House event titled 'Is a PF Crisis Coming?

"Taiwan Issue Is the Biggest Geopolitical Risk ? Is Korea Safe?"

I fully agree with Discussant A’s view that next year will be a major turning point and a time to prepare for the future. Before that, let me address today’s topic of the 'PF-triggered financial crisis.' Recently, following the Legoland incident, Heungkuk Life Insurance postponed exercising its perpetual bond call option, shaking the financial market. Governor Kim Jin-tae of Gangwon Province was heavily criticized for refusing to guarantee ABCP (Asset-Backed Commercial Paper) payments, but looking closely, that is not entirely accurate. The Kim incident was a trigger, but the underlying causes are more structural and fundamental.

Looking broadly, the global cause is inflation-driven interest rate hikes. As policy rates rise, market rates also increase, causing supply-demand imbalances in bond and short-term funding markets. Insolvency should never occur in financial markets, but a local government declaring a guarantee default violates the most important market principle. Thus, this was not a simple issue but a hasty and thoughtless act that triggered financial market instability.

Not only Governor Kim but also financial authorities sometimes make imprudent remarks. For example, Governor Lee Chang-yong is internationally savvy and an excellent scholar, but as the Bank of Korea Governor, he may be speaking too much. For instance, his statement that "the Bank of Korea can be independent from the government but not from the Fed" is acceptable, but adding that "our interest rates should be about 100 basis points different from the Fed’s" goes too far. Such remarks immediately influence market players. If our policymakers have target rates, market rates will just rise to meet them. In stock market terms, if the U.S. raises rates, the market just sells off at the open. Therefore, policymakers need to be especially cautious with their statements during market instability.

Moreover, Korea Electric Power Corporation (KEPCO), trapped in deficits, issued a large amount of KEPCO bonds, and banks increased their bond issuance significantly, leaving corporate bonds unsold. From investors’ perspective, there is no reason to buy corporate bonds when safer assets like KEPCO and bank bonds are available. Excessive issuance of safe assets has caused market funds to be rapidly absorbed by these, creating supply-demand instability and increasing financial market anxiety.

Additionally, concerns about a real estate market bubble bursting, which rose excessively over the past five years, have sharply increased. These factors combined have led to scenarios of PF-triggered financial collapse. To conclude, I agree with Discussant A that the PF crisis will not escalate into a full financial market crisis.

By early next year, much of the current financial market instability will likely stabilize. We have accumulated know-how from various financial and economic crises since the foreign exchange crisis 25 years ago. Policymakers know the solutions well, so if they respond timely, there should be no major problems.

In fact, the government quickly recognized the seriousness of the PF crisis and handled it well. The government released 50 trillion won plus alpha, summoned the heads of the five major financial groups to supply 95 trillion won in liquidity, expanded Bank of Korea RP purchases, and the securities industry formed a second bond stabilization fund?all in one shot. Through these complex policies, the government appropriately responded to prevent the crisis from escalating. I believe that with such detailed policy responses, a financial crisis will be avoided. Especially by early next year, the policies implemented will take effect, improving market liquidity conditions significantly.

However, this refers to a won currency crisis. The foreign exchange situation may differ. When I talk about a financial crisis, I want to distinguish between a won crisis and a foreign exchange crisis. The won liquidity crisis, which we can control, is not really a crisis. We can respond by printing money. The problem is the foreign exchange crisis. We must be very cautious here. International interest rates will continue to rise at least until next year, followed by a full-scale liquidity tightening. We must avoid becoming scapegoats in this process. Remember in 2015, when the U.S. Federal Reserve’s tapering announcement caused turmoil in international financial markets? The countries hit hardest were those with weak fundamentals like Turkey, South Africa, Malaysia, and Indonesia. But Korea passed through unshaken thanks to strong fundamentals and good responses. We must do the same this time.

Korea is a small open economy, so fundamentals are especially important. The key is how robustly we maintain our fundamentals. The future hinges on aging and fiscal health. Japan serves as an example. I have had many private discussions with Japanese bank and finance ministry officials. Previously, the term 'Japanization' (the spread of Japanese culture) was popular, but nowadays, 'Japanification' (long-term stagnation with aging like Japan) is more commonly used. Our economy is following Japan’s path, which is worrisome. The most important issues are aging and low birth rates, which are very bleak. Despite decades of spending tens to hundreds of trillions of won, we have seen no effect.

Next is fiscal soundness. Japan calls its aging, low-growth economy an 'alligator mouth.' Revenues grow sideways while expenditures increase exponentially, resembling an alligator’s wide-open mouth. We wonder if we can escape this 'alligator mouth.' Since the previous administration, there has been a tendency to spend first and worry later?populism. This applies to fiscal policy and the national pension system. What scares me most is the national pension. Is it really good to give out basic pensions indiscriminately? We must pay special attention to this issue, learning from Japan’s experience.

More serious is the geopolitical risk. You mentioned the Ukraine war, but I am more concerned about the Taiwan issue amid U.S.-China tensions. Many foreign investors believe war is inevitable, at least a localized conflict. They often ask, "If that happens, will the Korean Peninsula be safe?" However, we seem to underestimate the importance of the Taiwan issue, both politically and in the market. It is time to deeply examine whether Korea can be safe from such geopolitical risks. (To be continued in the next installment, reference: "PF Crisis is a business cycle process... The real bottom will be in Q1 next year")