How a liquidity crunch in South Korea began at Legoland

South Korean companies are struggling to refinance maturing debts after a sell-off was triggered by the default of a Legoland theme park developer and the announcement by a midsized insurer that it would not exercise a call option on its perpetual notes.

Yields on top-rated five-year Korean corporate debt have surged 157 basis points in the three months through October — the worst spike on record — with widening credit spreads accounting for about one-third of the move.

The country’s offshore bonds, seen as a relatively safe bet in the region, are seeing spreads widen, while the cost to insure five-year sovereign debt against default has almost doubled since mid-September.

Policymakers have introduced a series of measures to shore up the Korean credit market, but experts warn that an increasing number of corporate defaults next year will be a further drag on the country’s economic slowdown. With central banks raising rates worldwide, global growth is expected to slow sharply in 2023, risking a “devastating” impact on people in emerging markets and developing economies, according to the World Bank.

Lee Sang-ho, a director at the Federation of Korean Industries, a lobby group for big conglomerates, said “market liquidity is drying up, making it difficult for many companies to sell bonds and pay back maturing debt”.

“Companies are struggling to secure more liquidity as this credit squeeze is bound to lead to less investment and hiring, weighing on the overall economy,” he added.

A missed Won205bn ($150mn) bond payment in September by the developer of the Legoland Korea theme park outside Seoul set off the initial turmoil.

But that turned into a market panic when Gangwon province, the local municipality, suggested it would renege on a guarantee over the debt. That prompted credit rating agencies to downgrade the bond from an A1 to a D rating almost overnight, casting doubt on dozens of similar, highly rated obligations. Gangwon has since said it would repay the developer’s debt.

“The credit squeeze came earlier than expected as the Legoland default shook the entire bond market,” said Hwang Se-woon, an analyst at Korea Capital Market Institute.

“Companies will be able to weather the storm until the end of this year or early next year, but we are likely to see an extensive wave of corporate defaults in the second half of next year after interest rates peak in the first quarter,” he added.

The Korean government announced a Won50tn package to shore up credit markets last month, under which it will buy a wide range of bonds and commercial paper to stabilise the market.

The Bank of Korea has launched a temporary bond-buying program worth Won6tn, while local banks have also pledged to contribute billions of dollars to buy corporate debt.

Heungkuk Life, a midsized insurer, also paid back a $500mn perpetual bond due on Wednesday. It had sent tremors through the market when it first called the bond, but then tried to cancel the call after it struggled to raise replacement capital.

Heungkuk finally repaid the bond after support from its parent company and other financial institutions allowed it to meet minimum solvency requirements.

Absolute yield levels in South Korea remain lower than in many other countries. But spreads on commercial paper are at elevated levels and nearly Won45tn of corporate bonds will mature between now and mid-2023, according to the Korea Financial Investment Association.

Min Ji-hee, a credit analyst at Mirae Asset, cautioned that the credit squeeze could worsen if the BoK opted for another outsized rate increase later this month.

“The current liquidity crunch is not as serious as that seen in past crises, but we are likely to see more liquidity problems going forward,” she said.

Policymakers also face a tough balancing act as they try to curb inflation through monetary tightening and shore up the credit market by pumping more liquidity.

“The government will find it more difficult to respond to the credit squeeze as actively as it did during the pandemic,” said Park Chong-hoon, head of Korea and Japan research at Standard Chartered.

Dutch bank ING said the recent liquidity crunch was a “major concern” for Asia’s fourth-largest economy, but was unlikely to pose a systemic risk to the financial system. It added that the overall debt ratio of Korean companies had fallen from 105.6 per cent in the first quarter of 2015 to 91.2 per cent in the second quarter of 2022.

“It is unlikely this will lead to large-scale insolvency of the corporate bond market,” Kang Min-joo, senior economist for Korea and Japan at ING, wrote in a report this week. “But this will hurt near-term growth and drag the economy into recession next year.”