[Frozen Corporate Loans]②Accumulating SME and Self-Employed Loan Defaults "Second Half Is the Crucial Period"

Will Accumulated Insolvencies Erupt if Economic Slowdown Becomes Visible in the Second Half?

[Asia Economy Reporters Yu Je-hoon and Bu Ae-ri] Park Ki-wang (51), who runs a small factory in Gyeonggi Province, turned away after knocking on the doors of banks to borrow about 200 million won needed for business expansion at the end of last year. This was because the loan interest rates applied soared to 5-6% due to the rapid interest rate hikes that took place last year, making the interest burden heavy. Park said, "I am thinking of inquiring with policy financial institutions because their interest rates are relatively low and the limits are generous."

Kim Ki-sung (44), a self-employed restaurant owner in the metropolitan area, has been unable to sleep recently after receiving a text message warning about the principal repayment of a policy fund loan he took out at the beginning of the COVID-19 pandemic. Adding the existing loan repayments, he is in a situation where it is difficult even to cover living expenses. He said, "If the grace period is not extended, default is inevitable," and added, "I am worried whether I can endure as repayments for other loans will come one after another."

The cause of the freeze in corporate loans following household loans is attributed to the uncertain business environment expected in the future. Although indicators show that soundness is maintained, the possibility of defaults among marginal companies and borrowers such as small and medium-sized enterprises (SMEs) and self-employed individuals is increasing as the economic slowdown in the second half of the year becomes a reality and government financial support measures related to COVID-19 come to an end. Experts advise that a soft-landing plan is necessary to prevent rapid deterioration.

Signs of Distress in Companies Soar 16% in One Year

According to the Bank of Korea on the 10th, as of the end of the third quarter last year, financial institutions' loans to SMEs reached 1,480.4 trillion won, an increase of 15.0%. Along with COVID-19-related financial support policies, working capital dried up, causing SME corporate loans to expand by 15.7% to 819.4 trillion won, and individual business loans to increase by 14.1% to 661.1 trillion won. Large corporate loans also rose by 14.8% to 239.2 trillion won.

Of course, indicators still show that the soundness of domestic corporate loans is relatively good. According to the Financial Supervisory Service, as of the end of October last year, the delinquency rate on domestic corporate loans (in Korean won) was 0.26%, which is 0.34 percentage points lower than 0.60% in October 2019 before COVID-19. However, the financial sector and authorities evaluate these indicators as an 'optical illusion.' This is due to the base effect caused by an increase in loan balances and the reflection of government measures such as maturity extensions and repayment deferrals related to COVID-19.

The financial strength of companies is also weakening, especially among SMEs. The sales growth rate of SMEs slowed slightly from 13.6% in 2021 to 12.4% in the first half of last year, and the proportion of interest coverage ratio vulnerable companies increased slightly from 48.4% at the end of 2021 to 49.7%. The interest coverage ratio is an indicator showing how much of a company's operating profit is used to pay interest expenses. If this ratio is below 1, it means the company cannot even cover interest expenses with operating profit.

According to the '2022 Regular Credit Risk Assessment' announced by the Financial Supervisory Service, a total of 185 companies were selected as distressed companies in 2022, of which 183 were SMEs and 2 were large corporations. The number of large corporations decreased by one compared to the previous year, but SMEs increased by 26, showing a significant rise. The number of SMEs selected as distressed companies has been increasing annually, with 153 in 2020 and 157 in 2021.

A financial sector official said, "SME loans have large margins but also high risks, so how banks manage this this year is crucial," adding, "If the economic slowdown in the second half of the year becomes more pronounced, the lending threshold for SMEs may rise."

Maximum 19 Trillion Won Risk of Default Among Vulnerable Self-Employed

Loans to self-employed individuals also increased by 14.3% year-on-year to 1,014.2 trillion won as of the end of the third quarter last year. Of course, the delinquency rate among self-employed borrowers remained very low at 0.19% as of the third quarter last year, due to the COVID-19 maturity extension and interest deferral programs.

However, the latent scale of defaults is considerable. The Bank of Korea estimated the default risk rate of self-employed borrowers under assumptions including a 0.5 percentage point interest rate increase this year, a slowdown in the service industry economy, and the expiration of government financial support measures. It analyzed that the default risk rate for vulnerable borrowers could rise to as high as 19.1% this year. The corresponding scale of default risk is expected to reach between 15 trillion and 19.5 trillion won.

The basic financial strength of self-employed borrowers responding to this is also weak. Looking at the collateral for self-employed loans, the proportion of real estate is 69.6%, which is more than 10 percentage points higher than that of non-self-employed borrowers (55.3%). Even so, the proportion of real estate collateral loans excluding residential properties, which have low liquidity, is 29.2%, nearly three times that of non-self-employed borrowers (9.9%). Considering the recent downturn in the real estate market, it can be inferred that the basic financial strength of self-employed individuals has significantly decreased.

The Bank of Korea stated, "If the upward trend in loan interest rates continues, sales recovery slows, and the effects of financial support policies gradually disappear, defaults could rapidly increase, especially among vulnerable borrowers," and added, "To prevent self-employed loan defaults from undermining financial system stability, it is necessary to promote debt restructuring for vulnerable borrowers with high default risk."

Specifically, this includes ▲ the phased termination of financial support measures and conversion of bullet repayment loans to installment repayment loans ▲ excessive credit supply restraint for real estate rental businesses ▲ micro-level policy implementation to prepare for funding difficulties of self-employed individuals with good business prospects ▲ expansion of loan loss provisions by financial institutions and proactive capital augmentation.

Experts advise that measures should be prepared to support the soft landing of SMEs and self-employed individuals. Professor Seo Ji-yong of Sangmyung University said, "There is a possibility of further base rate hikes in the first half of the year, and accordingly, the economic slowdown is likely to become more pronounced in the second half. This year, the risk of defaults related to SME loans is particularly high," adding, "It would be advisable to extend the rollover period for SME loans to ease interest burdens during the rate hike period and consider providing incentives to banks that lower interest rates."

Professor Seo also commented on the COVID-19 maturity extension and interest deferral programs scheduled to end within the year, saying, "For zombie companies, extensions are meaningless, so alternative exits should be prepared," but added, "Selective additional extensions may be necessary only for sound companies temporarily facing liquidity problems."