Photo source: the Japan Times
Debt Deflation. In the credit cycle, this is the phase in which the financial system stops generating new credit, and since new credit is needed to service debts incurred when credit was expanding, a great deal of existing debt goes bad. Here's Bridgewater Associates' diagram of the typical debt deflation credit cycle.
Source: Principles for Navigating Big Debt Crises, Ray Dalio
Industrial Production was down 12.7 percent on a year over year basis in South Korea as of January 2023, this was the fourth consecutive year over year decline. I also believe this "real economy" indicator is reflective of the powder keg sitting in the Korean financial system.
Like many countries around the world, Korea has seen an outsized increase in real estate prices since 2020. With real estate price gains has come investment in property development and the wealth effect that asset appreciation can have on stocks and bonds. Existing residential real estate prices increased about 17 percent from the end of 2019 to July 2022, and have corrected by 6 percent as of January 2023.
Source: OECD
Rapid appreciation in real estate is typical in the expansion phase of a credit cycle, and is often accompanied by the real economic activity of a building boom. Some notable examples are the run up to the Great Depression, as well as that of the Asia Financial Crisis. Another feature of the expansion phase is that new modes of financing real estate purchases and construction are invented by banks and nonbank lenders. In other words, financial markets find new ways of helping investors take on debts to invest: leverage. Leverage multiplies the upside in the expansion phase, but also multiplies the downside in the contraction phase.
In a typical residential real estate project, there are two "layers" of leverage. At step one, the developer often borrows money in order to fund the buildup of vacant land or improvement of an existing structure. That's the first layer. Developers use some combination of equity and debt to build the structure.
Layer two comes from the purchaser. In the case of multi-family housing (apartments) in the US, the buyer of a complex gets funding from a bank or mortgage lender. The lender will ultimately sell the loan to a securitizing financial institution (Fannie Mae or Freddie Mac, for example) and it will become part of a multifamily mortgage backed security.
To the development company, they are using income from the sale of the building to pay off the debt they incurred to build it. But to the system as a whole, new debt is being used to pay off old debt.
In Korea, there is yet a third layer of leverage. As rents have become increasingly unaffordable, lenders not only lend to property buyers but to apartment renters. These arrangements are called "jeonse" ("Chon-say") loans. Imagine the following scenario:
The property developer takes on debt (by issuing bonds perhaps) to finance a 10 story apartment building
A multifamily real estate investment company takes on debt to buy the property once it's completed and up for sale
The real estate company buys the finished building and begins to rent it out
"Renters" go to a lender and get a loan in the amount of around 70 percent of the apartment's total market value (if it were bought outright), at a set interest rate, for a two year term
The renter uses this loan as their rent, paid ahead for two years. The loan is posted to the landlord (real estate investment company)
The landlord uses the inflows of these jeonse loans to pay off the debts used to buy the property in the first place, or to invest in new properties
The landlord must pay back the deposit to the renter at the end of the two year term, so that the renter can repay the lender
If lenders shrink their issuance of new jeonse loans, landlords are unable to fill vacant units and thus, unable to pay back the renters who are using existing loans
This is likely to compound the decline in real estate values as well, since real estate investment firms are losing the income stream necessary to pay off the loans incurred on their properties
This market for "Jeonse" ("chon-say") loans has increased to $828 billion, which is about 46 percent of Korea's Gross Domestic Product (GDP). As of May 2022, Jeonse loans made up more of rental arrangements than traditional leases. Apartment renters have found it advantageous to get Jeonse loans because the interest they pay until the term expires is cheaper than rent. As long as the landlord is able to repay, the two year loan can be rolled over at the end of the term. If the landlord does not repay, the renter is on the hook for the shortfall. With the property market slowing down over the second half of 2022, landlords' ability to rollover their debts has been hit hard, and defaults on jeonse deposits are becoming more common.
About the situation, Economist Moon Hong-Cheol told Reuters, "The jeonse crisis poses limited macroeconomic risks, yet it is still another part of the whole property market fallout." While it often seems that way when one sector is troubled (see American economists from 2006-2008), South Korea's total debt load paints a different picture.
An economy's total debt burden tends to rise over time. The world is on an inflationary money system and so credit expansion is the norm. Several different bodies of research have pointed to the pattern of a rapid increase in debt burdens preceding every financial crisis. Several observers of different generations have pointed this out, including Ludwig Von Mises in the early 20th century, Ray Dalio of Bridgewater Investments, and Claudio Borio of the BIS.
When a country's credit growth outpaces GDP growth by a large margin, conditions are ripe for a debt driven crisis, and South Korea currently fits the bill. Total debt incurred by the non-financial sector has reached 220 percent of GDP, about 15 percent higher than trend. For comparison, US non-financial sector debt was 168 percent of GDP at the start of the economy's debt deflation in August 2007, which was 12 percent higher than trend.
Source: Bank for International Settlements
In assessing whether one sector of the economy, be it Korean Apartment loans or American Subprime mortgages, poses risk to the larger whole, economists incorrectly focus on the size of that sector. In doing so, they focus on the size of the pin, instead of the balloon it threatens to pop. In reality, the pin doesn't have to be especially large to completely destroy an inflated balloon. Korea has all of the necessary ingredients for a full blown financial crisis that will impact the returns of East Asian assets for the next decade. The Lake Street Review will continue to track this saga as it develops.