[Chatham House]② "Kepco is a bottomless pit black hole, electricity rates must rise"

Is a PF-Triggered Financial Crisis Really Coming?

Editor's NoteAsia Economy's economic and financial think tank, ‘Asia Economy Chatham House,’ has been launched. On the 1st, at Lotte Hotel in Sogong-dong, Jung-gu, Seoul, an in-depth discussion was held under the theme ‘Will a Crisis Emerge from Project Financing (PF)? ? An In-depth Diagnosis of Korean Finance’ with participants including Gwak 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 attendees 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 sharp debate between those advocating for proactive and aggressive policy responses and those warning 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,’ disclosing the list of participants but anonymizing each speaker’s remarks. The full discussion will be published in several parts.

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 on the 1st at Lotte Hotel, Sogong-dong, Jung-gu, Seoul, before the 1st Asia Economy Chatham House discussion. Photo by Kim Hyun-min kimhyun81@

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

(Reference)

PF-triggered Financial Crisis, Is It Really Coming? Continued

"Economic Downturn Phase, 'Upturn' Around Q2 2024"
"Capital Markets Will Remain Difficult Until First Half of Next Year"

<Discussant D> Recently, it is necessary to examine whether the PF crisis is a structural problem or merely a cyclical economic issue. Looking at the PF situation this year and next year, I tend to think it is cyclical. I see this as part of a contraction business cycle averaging 18 months since 1965. This would be the 12th such cycle, characterized by a very rapid rise in interest rates. Unlike before, policy rates have risen sharply. As a result, asset markets, especially real estate, have been affected, and the PF sectors invested in real estate are facing significant difficulties. Therefore, I view this as a cyclical phenomenon.

As C mentioned, our current capital market is such that the 26 trillion KRW worth of Korea Electric Power Corporation (KEPCO) bonds are drawing funds, causing companies to be unable to issue bonds and thus turning to banks. Banks need to lend, but due to liquidity ratio regulations, they must increase deposits, which leads to bank bond issuance. This, in turn, causes corporate bonds to be shunned in the market, creating a vicious cycle. There are even talks that if banks reduce bond issuance, those funds might flow into corporate bonds.

Given this situation, PF sectors lacking funds become risky. In fact, the PF market should be differentiated. PF loans consist of bridge loans and main PF loans. Main PF loans are backed by actual real estate, while bridge loans mostly cover down payments when purchasing land. The current problem lies not with main PF but with bridge loans. Bridge loans are smaller in scale and inherently riskier. Main PF loans are backed by land with collateral value, and apartments have already been marketed and even sold, so the government cannot ignore them. Leaving main PF loans unattended could ignite a crisis in the housing market. However, bridge loans are different. Bridge loans are loans for the 10% down payment at contract signing, and government support here is ambiguous. It is questionable whether public funds or banks should intervene to reduce risks in bridge loans. Financial companies should bear some risk themselves.

Moreover, as B mentioned, inflation will be a significant variable. Accepting inflation means that real purchasing power becomes more important than nominal value in the real estate market. For example, how much is the current bubble in the real estate market? How much is it overvalued? This is actually unknown, varying by person, region, and even building. However, suppose it is overvalued by 30% compared to fundamentals. When adjustment occurs, it is influenced more by real purchasing power than nominal value. Considering current inflation at about 3% and potential growth at 2%, about 5 percentage points of real value adjustment occurs annually. If 5% of the 30% overvaluation is adjusted yearly in real purchasing power and about 10% is absorbed by inflation, nominal value decline, etc., then within 4 to 5 years, a 30% overvaluation in real terms could be adjusted.

On the other hand, a nominal value drop exceeding that, for example, a 40% decline, would be a shock difficult for our financial sector to bear. But such a steep nominal drop is unlikely. Given the significant inflation, the real estate market might adjust faster.

The real interest lies in how the economy will perform next year. According to statistics, Korea is still in an expansion phase. The November 30th industrial activity survey by Statistics Korea shows exports have declined, but service sectors like restaurants, distribution, and entertainment are doing quite well.

However, the data is based on October, and leading indicators have already declined, so the expansion phase is expected to end by November or December, marking the start of a contraction phase. If this is the 12th business cycle, contraction phases have typically lasted 18 months since 1965. This suggests contraction until March or April of the year after next.

Will this contraction be longer or shorter than average? I believe it will be longer due to significantly increased household and corporate debt. Also, the biggest feature of this cycle is the rapid rise in interest rates, with uncertainty about when rates will fall. It is ambiguous whether policy rates will be lowered after next year. Usually, rates fall, demand revives, and the economy turns up, but now, with high debt and rates expected to remain high for some time, contraction will be longer than average. However, even if extended, it will likely be by only about one quarter. Thus, the economy should start an upturn around June or summer of the year after next.

A concern is when the bottom will be. The Bank of Korea began raising rates in November last year, mainly normalizing rates that had been sharply lowered during COVID-19. The inflation response began in earnest with the big step in July. The Bank of Korea states that monetary policy effects start from the second quarter after implementation and peak in the third quarter, meaning it takes about three quarters for full effect. Therefore, the peak effect of rate hikes will be around Q2 next year. This suggests a significant decline could occur in Q1 next year.

Looking at the coincident index cyclical component, which reflects the business cycle, it moves similarly to the stock market: a sharp initial drop, a prolonged bottoming phase, then a rise. So, a sudden sharp drop phase exists. This pattern is seen not only in stocks but also in the business cycle. The previous 12 cycles also had sharp initial drops. Considering this, a significant decline around Q1 next year is expected. Consequently, capital markets will be very difficult until the first half of next year. The non-investment grade corporate bond market may remain weak throughout next year and even into the year after next.

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

"No Profitable Projects, Non-Investment Grade Bonds Must Also Be Bought"

<Discussant E> The current capital market situation is seriously alarming. Many view it not just as a liquidity crunch but as a liquidity risk. The bond market below A rating and the short-term CP market are highly exposed to liquidity risk. Although the government has responded quickly with various measures, even investment-grade A1 construction company CPs are not trading in the short-term bond market. After the Legoland incident, the government bond market was also closed. KEPCO bonds with three-year maturities trading at over 6% is an absurd situation, indicating severe market tightening.

In fact, since around May, the PF-related short-term CP market volatility has gradually increased due to US rate hikes. The US’s giant step rate hikes have further tightened the short-term funding market rapidly. This situation has affected the medium- and long-term funding markets. Although the government’s 50 trillion KRW fund and follow-up measures have somewhat eased the long-term bond market, my biggest concern is the short-term bond market. The market is taking the risk in the short-term funding market very seriously. If A2 or single-A bonds or CPs are not trading and liquidity is blocked, this affects even higher-rated A1 or AA bonds. Investment-grade bonds are also blocked. Market stabilization is needed here. Recently, institutional investors like pension funds and the Korea Post have sharply reduced their participation in bond and short-term CP markets, worsening liquidity. Beyond government support measures, these institutions need to resume market participation. If selective investments are made not only in high-grade bonds but also in relatively sound A-grade and A2-rated construction company CPs, it would help capital market recovery.

Currently, financial companies’ funds are concentrated in banks and some top-tier securities firms. Specialized credit finance companies (SCFs), capital companies, small- and mid-sized securities firms, and insurance companies with high savings-type insurance proportions face relatively difficult funding conditions. The government is alleviating funding issues for insurers through expanded RP (repurchase agreement) facilities. Support funds are also being supplied to small- and mid-sized securities firms (short-term rating A2 or below) via Meritz, NH, and Korea Investment Securities, aiding market stabilization. However, additional market measures may be necessary.

This needs to be examined from a real estate perspective. Land is crucial in real estate, and land prices rose significantly under the previous administration. Prime commercial land in Gangnam, which used to be around 100 million KRW, now commands 400 to 500 million KRW in the past 3-4 years. Moreover, the Ukraine crisis caused raw material and labor costs to surge, raising construction costs by about 1.2 to 1.5 times. This means PF is truly in a difficult situation.

In fact, the loan interest rates for members of the most popular reconstruction complexes in Gangnam were 2-3% annually until recently but have now risen above 8%. This means that from the buyer’s perspective, investment attractiveness has significantly declined, and from the contractor’s perspective, there are no profitable projects. With increasing unsold units, contractors’ debt burdens have grown.

Contractors affiliated with groups should expand financial support for unsold projects through their groups, and those without groups should seek expanded financial support for unsold projects via HF (Korea Housing Finance Corporation) or HUG (Housing and Urban Guarantee Corporation). Eventually, the situation will resolve somehow, but if the short-term market problem is taken lightly, the painful period could be prolonged.

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

"PF Crisis Can Erupt as a Political Issue Anytime, Proactive Response Needed"
"KEPCO Bonds Ignite Financial Market Instability…The Only Solution Is Rate Hikes"

<Discussant B> I fully agree with Discussant E’s remarks and would like to add one point: political issues. Even if a securities firm goes bankrupt due to PF defaults, the market shock may not be severe because proprietary accounts exist. But what about insurers, credit unions, and Saemaul Geumgo that funded PF? Isn’t it the public’s money at risk? Political slogans like debt forgiveness for credit unions and Saemaul Geumgo will inevitably arise. How will that be managed? The newly inaugurated Yoon Seok-yeol administration might end up spending time cleaning up this mess.

As Discussant D said, if we are in a contraction phase and a sharp drop occurs in the first half of next year, the real estate market will be the first to be hit, which could quickly escalate into a political issue. Once politicized, structural reforms become impossible, and only short-term remedies like money printing can be used. After exhausting resources this way, long-term structural problems cannot be addressed. From this perspective, the government should have proactively and promptly eased real estate regulations from the start. Also, when revising the Depositor Protection Act enforcement decree, more financial stability funds should be allocated, and problematic parts of Saemaul Geumgo and credit unions should be weeded out. Thus, support should be selective and rational, not unconditional.

The KEPCO bond issue must also be resolved properly. KEPCO is expected to post a net loss of about 30 trillion KRW this year, indicating a serious problem. KEPCO’s deficit has led to massive bond issuance, which has significantly contributed to financial market instability and uncertainty. The only solution is electricity rate hikes. Raising electricity rates while providing energy vouchers to low-income households is necessary. This will remove uncertainty in financial markets. Additionally, the electricity rate hike should be an opportunity to reform the electricity tariff system. To preserve the capacity to address structural problems, short-term issues like this should not be delayed.

Discussant D mentioned that much of the current crisis is cyclical, so we can be somewhat relaxed. I strongly caution against this view. While the crisis has cyclical elements, these eventually turn into structural problems. We must not overlook this and assume time will solve it. I hope the government responds with a greater sense of urgency and crisis. (To be continued, see : "Next Year’s Economy More L-shaped than V-shaped... Preventing the Worst Is the Best")