South Korean exports surged 45.6% year-on-year in May, amid a global trade recovery as the impact of the Covid-19 pandemic lessens in many countries. The rebound was led by semiconductors — South Korea’s biggest export — followed by automobiles and petrochemicals.

The exports jump is expected to bolster South Korea’s economic recovery, which is already among the fastest in the world. Gross domestic product (GDP) is forecast to grow 4.5% in 2021, up from 3.3% previously, according to Oxford Economics.

As the economy recovers, some analysts expect the Bank of Korea (BOK) to begin raising interest rates to contain financial risks, as low rates fuel the fastest rise in house prices since 2007.

“We expect the central bank to raise rates at its meeting in November,” says Alex Holmes, Asia economist at Capital Economics. Such a move would make the BOK the second Asian central bank to start tightening policy, after the People’s Bank of China.

“Rising interest rates are generally good for the profitability of the banking sector, because the spread between the rates at which they borrow and the long rates at which they lend get bigger and their profit margins increase,” Mr Holmes says.

“The fact that interest rate hikes are being driven by an upswing in the economy is positive for people wanting to borrow more, creating more demand for lending. The main risk from a rate hike could be the risks it creates to the quality of banks’ existing loans.”

Household debt risks

Household debt in South Korea — at 170% of disposable income — was already among the highest levels in the world before the pandemic. Moreover, household debt growth has accelerated over the past few quarters and is now growing at almost 10% year-on-year.

According to Capital Economics, about 70% of household debt is accounted for by mortgages and rental lease deposits.

Among South Korea’s leading banks, NongHyup Financial Group had largest proportion of mortgages on its loan books, as of end December 2020, equalling 43% of gross total loans, according to The Banker Database. At the two largest banks by Tier 1 capital, KB Financial and Shinhan Financial, mortgages made up 22% and 14% of gross total loans, respectively.

According to Mr Holmes: “Household debt is very high, which means households are very sensitive to any rise in rates. [A rise in interest rates] risks pushing household balance sheets into the red. And then banks would see a rise in non-performing loans, which could mean they would have to write off loans, which would then push their risk premiums up.”

The average loan-to-value ratio — the share of mortgage loans of the property sales price — in South Korea between 2004 and 2020 was 56.4%, according to Statista.

“Loan-to-value ratios are really quite low. It wouldn’t take a lot for households to go into negative equity, if rate hikes weighed on the housing market too much. On top of that, rising interest rates would also push up borrowing costs for firms,” Mr Holmes adds.

Uneven recovery

In common with many countries, the economic recovery in South Korea has been uneven. Many export-led large corporates have grown strongly. But many domestically-focused small and medium-sized enterprises (SMEs) have been hit hard.  

“Non-financial corporate debt is a risk category. Most of that is owed by SMEs. That’s probably a risky spot for banks. But, overall, there’s not really a massive systemic risk to the banking sector, which is well capitalised,” Mr Holmes adds.

Many South Korean corporates have had liquidity issues during the pandemic, says Lloyd Chan, senior economist at Oxford Economics, adding that net interest margins — a comparison of the net interest income a bank generates from credit products with the outgoing interest it pays to holders of savings accounts — remains an area of weakness in banks’ profitability.

“But as we see growth momentum improving, we could see some stabilisation in the credit costs for banks which could help to offset weakness in net interest margins,” he says.

Despite the improved growth forecasts, Mr Chan said a downside risk to the South Korean economy remains ongoing trade tensions between the US and China.

China is South Korea’s biggest trading partner. The escalation in tensions between the US and China in 2019 had a significant impact on Korean exports, and relations between the two countries remain strained despite the change in US administration. “Another escalation in trade tensions could upset South Korea’s recovery,” Mr Chan adds.