Commentary: South Korea: A Boom Or A "Ticking Bomb"?

South Korea is widely regarded as the star performer in pulling out of Asia's 1997 financial collapse. A cursory glance at the latest data suggests that its reputation may be well deserved. The economy grew at a fiery 10.2% in 1999 after slumping 5.8% in 1998; inflation is below 1% after reaching 7.5% in 1998. Meanwhile, the trade surplus has soared to $24.5 billion, and foreign-currency reserves have reached $74 billion.

Yet, say economists, the country remains vulnerable to another bust. Beneath the reassuring surface, Korea Inc. is still a financial wreck. Companies are highly leveraged and laden with debts. Banks are taking on dubious loans. And the administration of President Kim Dae Jung is pegging interest rates around 10%--about half their level during the first half of 1999--to pump growth just as analysts increasingly worry that the economy is overheating. "This is a ticking bomb," says Jun Sung In, economics professor at Seoul's Hong Ik University. "The only hope is that the government will get its act together before the bomb explodes."

STRONG-ARMED BANKS. That hope may be overblown. Facing parliamentary elections in April, 2000, the government is in no mood to risk its narrow majority by inflicting economic pain on voters. A year ago, Economy & Finance Minister Kang Bong Kyun promised that Seoul would focus on overhauling the financial system. Instead, the government has shied away from any measure that could hurt the nation's 24 investment trust companies. That's because together they hold a massive $175 billion owned by 10 million Koreans--or nearly a quarter of all savings. The trusts invest in high-yield corporate debt. They hold, for example, $23 billion worth of bonds sold by the failed Daewoo Group.

In turn, the trusts' exposure to corporate debt has made Seoul most reluctant to force companies to clean up their balance sheets. In 1998, South Korea's corporations had to spend 125% of their operating profits to service debt, according to the state-backed Korea Development Institute. As a result, companies had to borrow yet more. The situation improved in the first half of 1999, but debt service still amounted to 60% of operating profits. Foreign banks regard a 50% figure as a warning sign. Even Hyundai Electronics Industries Co., now the world's largest computer memory chipmaker, couldn't earn enough to service its debt last year.

The government had reason to be spooked. A wave of corporate collapses or debt write-downs could have sparked a bond market bust. Even if the financial system survived, rates would again have soared, probably halting growth.

But in attempting to avoid such a fate, the government often ties itself in knots. In late September, for example, it strong-armed banks to underwrite a $20 billion bond stabilization fund to prop up the investment trusts. Now, it won't allow institutional investors to redeem any funds used to buy nearly worthless Daewoo bonds until July. Retail investors can withdraw up to 80% of such holdings. Few have, because come February, trust companies will have to guarantee to repay them 95% of the original value. Next, the government plans to use taxpayer dollars to keep the investment trusts afloat if they face huge withdrawals.

Meanwhile, Seoul has delayed, beyond the elections, a requirement for the trusts to mark their bond holdings to market values. For now, the bonds are listed at inflated purchase prices. Even when the new rules go into effect in July, they will apply only to new purchases.

The same air of unreality surrounds local credit practices. After insolvent companies are bolstered by bailouts, local ratings agencies often score them as investment-grade, according to KDI. The agencies aren't alone in wearing rosy spectacles. Creditor banks of Ssangyong Motor, a money-loser in each of the past five years, declared it was suffering a "temporary liquidity shortage"--to avoid taking write-downs on their own balance sheets.

Neither creative accounting nor the economic numbers blind shrewd local observers to the underlying reality. For one thing, booming exports depend largely on the surging yen and high prices for lines such as DRAM computer chips, currently in short supply. "The remarkable economic recovery has not been the result of successful reform, but because reform was delayed," says Chung Un Chan, economics professor at Seoul National University.

For now, though, too many people in South Korea and abroad still hold on to the illusion. That's the most worrisome sign of all.

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