Growing Corporate Leverage Posing Increasing Risk

BMI View: With elevated levels of household debt already weighing on the Korean economy, leverage within the corporate sector now appears also to be becoming a problem. Debt ratios of an increasing number of chaebols have risen to alarming levels and the recent failure of a number of conglomerates has sparked fear of further meltdowns. To us, a key risk stems from the cross-shareholding strategy that many chaebols employ in order to insulate themselves against market pressures and consequently guard against hostile takeover bids. The intricate relationships expose the balance sheet of healthy companies to a possible deterioration in financial health of numerous other companies to which they are linked.

South Korea appears to be unable to escape its addiction with debt. With elevated levels of household debt already constricting consumption and weighing on the country's economic growth, leverage within the corporate sector appears to progressively be becoming a problem for South Korea.

In late September, five affiliates of the Tongyang Group, a mid-tier chaebol, filed for court receivership after succumbing to years of mounting financial losses. The final blow came when the group failed to secure sufficient funding to repay maturing debts at the end of last month. Earlier in June, STX Pan Ocean, the shipping arm of the STX Group, was forced into receivership after its aggressive debt-fuelled expansion back-fired amid a prolonged downturn in the global shipping industry.

Corporate Borrowings Increasingly Worrisome
South Korea - Top 10 Chaebol Debt Profile

BMI View: With elevated levels of household debt already weighing on the Korean economy, leverage within the corporate sector now appears also to be becoming a problem. Debt ratios of an increasing number of chaebols have risen to alarming levels and the recent failure of a number of conglomerates has sparked fear of further meltdowns. To us, a key risk stems from the cross-shareholding strategy that many chaebols employ in order to insulate themselves against market pressures and consequently guard against hostile takeover bids. The intricate relationships expose the balance sheet of healthy companies to a possible deterioration in financial health of numerous other companies to which they are linked.

South Korea appears to be unable to escape its addiction with debt. With elevated levels of household debt already constricting consumption and weighing on the country's economic growth, leverage within the corporate sector appears to progressively be becoming a problem for South Korea.

In late September, five affiliates of the Tongyang Group, a mid-tier chaebol, filed for court receivership after succumbing to years of mounting financial losses. The final blow came when the group failed to secure sufficient funding to repay maturing debts at the end of last month. Earlier in June, STX Pan Ocean, the shipping arm of the STX Group, was forced into receivership after its aggressive debt-fuelled expansion back-fired amid a prolonged downturn in the global shipping industry.

According to chaebul.com, over the past five years, the country's top 30 chaebols saw their debt almost double to KRW574.9trn at the end of 2012. Debt of the nation's top 30 conglomerates has now surpassed the country's national debt level, estimated to total KRW445trn this year.

Corporate Borrowings Increasingly Worrisome
South Korea - Top 10 Chaebol Debt Profile

Debt Ratios On The Rise

Corporate Korea trimmed their borrowings in the aftermath of the global financial crisis but corporate sector leverage appears to have been on the rise in recent years. Indeed, the corporate borrowings-to-GDP ratio fell from its peak of 165.1% of GDP in 2010 but has rebounded and appears to be embarking on an upward trajectory As the accompanying chart shows, the debt held by the country's top 10 chaebols has witnessed considerable growth between 2007 and 2012. A rise in debt may not necessarily entail higher financial risk and of course different industries are deemed to have differing acceptable levels of debt.

That said, what remains of concern to us is that an increasing number of the country's conglomerates have seen an alarming surge in their debt ratios. Hanjin Group, with its struggling air transport (Korean Air) and shipping affiliate (Hanjin Shipping), has seen its debt ratio shoot past 400%, as has Hyundai Group. Doosan Group, which counts the country's leading power equipment maker as well as the largest construction equipment manufacturer among its affiliates, is starting to see signs of erosion of its capital buffer as interest costs mount and losses rise following years of aggressive expansion via a leverage buyout strategy (LBO).

Cross-Shareholdings May Prove To Be Chaebols' Undoing

To us, a key risk stems from the circular shareholding strategy that most chaebols employ in order to help the founding families cement their ownership of the company. Indeed, while cross-shareholdings can help the conglomerates insulate themselves, to a certain extent, against market pressures and consequently guard against hostile takeover bids, such a strategy can also work greatly to their disadvantage.

Cross-shareholding essentially leads to an intricately linked web of companies and exposes the balance sheet of one company to the financial health of another. Consequently, even though a particular arm of a business may be doing relatively well, it will be exposed to any financial deterioration of the numerous other companies to which it is tied to. The effects of circular ownership among companies was keenly felt during the global financial crisis by Japanese conglomerates such as Mitsubishi UFJ, NEC and JFE Holdings and we believe that Korea's chaebols stand to face a greater risk from their circular shareholdings given that the practice is more pervasive within the country.

Moreover, apart from a handful of conglomerates such as Samsung and SK Group, which have managed to carve out a large global presence, many of Korea's conglomerates are still inward looking and are thus exposed to the country's floundering economic fortunes. Indeed, with a number of the country's core pillars of growth such as shipbuilding, steelmaking and construction sector likely to see continued weakness in the quarters ahead, coupled with significant chaebol exposure to these sectors, failure to curtail the rise in corporate leverage may consequently augur increasing financial stress within the private sector going forward.

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This article is tagged to:
Sector: Country Risk
Geography: South Korea
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