The two Koreas’ doomsday debt dodges are powder kegs

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The latest nuclear scare on the Korean Peninsula, despite vows of “watertight risk management” by South Korean Finance Minister Kim Dong-yeon against currency and securities shocks, underscored recent economic signals that the 25% post-presidential-election stock-market rally through July may be exhausted.

The escalation also cast light on exotic debt instruments for both North and South, reflecting separate and interrelated troubles. A few hedge funds reportedly turned overnight 10% profits on the possible confrontation toll as spreads widened on South Korea’s five-year sovereign credit default swaps (CDS), which had barely budged from the 55-basis-point range over US Treasuries with their “AA” investment-grade rating and “stable” outlook.

However, expanded United Nations sanctions had the effect of indefinitely banning trading of North Korea’s defaulted loans dating back decades, with US$1 billion in face value and interest arrears several times that sum.

Prices jumped almost 5 cents toward 20 cents on the dollar when Kim Jong-un first took power five years ago on hopes of North Korea’s commercial opening, but activity has been stuck since the imposition of the UN’s 2013 curbs, although specialist houses in London and elsewhere can theoretically act as brokers.

French bank Paribas packaged the debt into a standalone instrument in the late 1990s, and major frontier-market investors hold it in their portfolios with a 2020 maturity.

At the same time, Sweden’s export agency is owed an estimated $350 million for a thousand Volvo cars never paid for and may be looking for its own securitization structure to entice distressed buyers, especially across the 38th parallel, but such offerings are now shelved amid the geopolitical standoff and the South’s own household and corporate debt dilemmas.

Chinese bank CDS rates also came in for additional tracking in the aftermath of sweeping commodity-import restrictions on North Korea agreed by Beijing beyond coal to include iron ore and seafood. One small North Korean border lender, Bank of Dandong, was punished in June after US Justice and Treasury department investigations for previous boycott violations, and China’s main state commercial banks with global operations could risk multibillion-dollar fines and exclusion from dollar clearing under Washington’s future regulatory and diplomatic response taking shape along Iran’s precedent.

Textiles falsely labeled “made in China” as Pyongyang’s No 2 export, estimated at $750 million last year, could soon be subject to credit warnings if not outright crackdowns as well and raise default-swap pressure at the margin.

South Korea’s gross domestic product grew by 2.7% in the second quarter, matching the full-year official forecast as the government and central bank decided to consider near-term fiscal and monetary stimulus. Semiconductor, computer-panel and petrochemical exports increased at a double-digit monthly pace through June, but shipping slipped along with domestic construction and housing.

The Purchasing Managers’ Index for the manufacturing sector was scarcely positive at 50.1 in June, and services suffered from China’s tourist ban in retaliation for installation of the THAAD (Terminal High Altitude Area Defense) anti-missile system in South Korea.

Unemployment in South Korea is under 4% and inflation tame at less than 2%, as the central bank kept the benchmark rate unchanged but earmarked $20 billion for small business on-lending under President Moon Jae-in’s five-year program to diversify from chaebol reliance.

A supplemental budget in the range of 5 trillion to 10 trillion won is under preparation as the first step in a medium-term policy agenda of “inclusive” growth focused on public-sector hiring and a revamp of conglomerates corporate governance. Youth training and product research for high-tech industries are major components, and the final cost is calculated at close to 200 trillion won ($176 billion).

President Moon’s other core platform is to cool the runaway property market and household leverage, which recently drew alarm from the World Economic Forum for a ratio well above the 90%-of-GDP danger zone. A separate Bank for International Settlements report noted that a 2.5% interest-rate hike over time would raise the private-sector debt burden by almost 4%.

A second round of curbs targeting Seoul residents will cap bank lending at 40% of property value and mortgage payments at 40% of annual income. Morgan Stanley called the moves “strong medicine” as they cut projected housing-credit growth to 5% this year and recommended bank-stock caution after buoyant performance through August.

Non-bank savings institutions and insurers, with record outstanding mortgage portfolios at $675 billion, will also soon be in the net according to experts, as debt powder kegs on both sides of the conflict on the peninsula remain far from demilitarization.

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