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On the MSCI EM Index through the first eight months of the year, the only three markets in positive territory in dollar terms are in Asia: China, South Korea, and Taiwan. Their “first in, first out” of the Covid-19 crisis pandemic amid unprecedented low interest rates and expansionary fiscal policies have attracted local and foreign investor interest in both stocks and bonds. Inflows have also been driven by majority weighting on the MSCI EM Index, 65% of the total, and China is half the local bond markets universe, USD 14 trillion, with Korea another size leader. On the equity index, eight of the ten largest companies are from these three markets, accounting for 27.5%, dominated by Alibaba Group, Tencent Holding, and Taiwan Semiconductor.
All three economies show signs of recovery, spurred by export rebound. The IMF is projecting that China will be one of the few countries to grow this year and Taiwan’s government is similarly expecting expansion, both around 1%. The wealthy nation OECD expects that Korea will outperform its peers and contract only 0.8%. China and Taiwan have benefited from relatively stable currencies, while South Korea’s won has recovered 8% from its March low and is only down over 2% against the USD this year.
However, not classic sovereign but company/personal debt levels could derail continued early recovery progress. In all three loan repayment standstills due to expire at end-September are likely to be extended, only to “kick the can” down the road. As of mid-August, loan repayments worth USD 33 billion were on hold in South Korea, with Fitch Ratings estimating banks had made an additional USD 150 billion in corporate relief loans. Pre-pandemic debt levels in all three markets were worrisome. Traditionally EM investors assess government debt/GDP as a key factor in investment decision-making, with a 60% level the danger zone. China, Taiwan, and South Korea all have official, on-balance sheet debt at less than 50% of GDP.
Corporate and/or household debt levels are already elevated, threatening the bank and non-bank financial sectors. According to the Bank for International Settlements most recent data, credit to the non-financial sector as a percentage of GDP is 258% in China and 237% in South Korea. In Taiwan, household debt/GDP has topped 90% and in South Korea the level is at a record high of over 97%, according to the Institute for International Finance. While in China it is just below 60% of GDP, lending for consumer debt and mortgages has surged in recent year from only 18% in 2008, while outstanding credit card debt doubled the past five years.
In South Korea, corporate debt was 104.6% of GDP in Q1, up from 97.2% a year earlier. With record low interest rates, it has surged since them. In July, corporate bond issuance totaled USD 17.5 billion, up 74% from a month earlier and dominated by low grade issuers more likely to be unable to meet obligations. In China, corporate debt/GDP surged 13%-points in the first half to reach 164.4% according to the National Institution for Finance and Development. In contrast, Taiwan’s local corporate debt remains manageable for now with a large life insurer buying base. As in China and South Korea, issuance has surged, doubling from the same period a year ago, with risk expected to rise as lower rated, pandemic-hit companies come to market.
Bond default risk and bank and consumer lender stress are growing. Already this year the banking regulator in China estimated bad loans will reach near USD 500 billion, while it reported that the official level – which does not include debt repayments on hold – stood at a 10-year high of 1.94% in June. While onshore local bond delinquencies fell 17% in the first half of the year, the drop came as the government encouraged bond holders to accept payment delays and issuers to find solutions such as extending maturities. Some USD 500 billion in local bonds are due to mature by year-end, and defaults will be a double-hit to domestic banks, the largest holders of corporate bonds. They will also derail the massive foreign inflows which have topped USD 66 billion so far this year chasing positive real yields. Last year local corporate bond defaults reached a record high at more than USD 20 billion.
A Special Purpose Vehicle was established in South Korea by the government, central bank, and Korea Development Bank to purchase select corporate bonds and commercial paper to prevent defaults and stabilize the market. The program is largely focused on A-rated debt but can also buy fallen angels that were downgraded to junk due to the pandemic. The USD 8 billion SPV, which can be expanded, was established in May and is due to expire in November, although like bank loan standstills, this too will likely to be extended. While default prospects in Taiwan remain less likely, there is growing worry about pressure on banks from small- and medium-enterprise loans which have grown rapidly in recent years, with loan growth averaging over 6% the past two years against 5.2% for other corporate loans.
While China, South Korea, and Taiwan have attracted interest in recent months on signs of recovery, a second wave of Covid-19 could easily derail investor appetite. Behind the rosier macro-economic data on exports, PMI, low rates, and contained inflation, the already high pre-pandemic debt levels are still rising. Loan repayment standstills will eventually end. Access to the bond markets for junk-rated, highly leveraged corporates will halt as inability to pay becomes clearer. The potential debt crisis in the three East Asian economies will be vastly different than the traditional EM sovereign debt crises of recent decades, with a departure from blanket fiscal support during pandemic peak. Household and corporate debt levels of near or over 100% of GDP restrict another wholesale bailout round, as they are first in to attempt cleanup of a long-ignored mess.
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