When the Bank of Korea released the latest data on Korea’s external debt last week, it had both good news and bad news. First the bad news. The nation’s foreign debt continued to increase in the second quarter, with the outstanding balance reaching $398 billion as of the end of June, a new record high.
The figure represented an increase of $38 billion from the end of 2010, a sharp jump compared with the $14.6 billion gain for the whole of 2010. Given the pace of growth, the balance has probably already passed the psychologically important $400 billion line.
The bank’s debt data unnerved many, reminding them of the 1997-98 and 2008 financial crises Korea experienced. In both cases, the trigger was the nation’s external debt, especially short-term debt, which was perceived to be unsustainable.
Furthermore, the bank could not release its data at a worse time. Recently, global financial instability has escalated due to the twin debt crises in the eurozone and the United States. This has taken a toll on the Korean economy as it is highly vulnerable to external shocks. The debt data were a fresh reminder of Korea’s external vulnerability.
Now the good news. While the total foreign debt increased, the share of short-term debt declined, albeit by a small margin. Short-term debt reached $149.7 billion as of end-June, accounting for 37.6 percent of the balance, 1.2 percentage points lower than in March.
The short-term debt ratio is an important indicator of the sustainability of a nation’s foreign debt. In September 2008 when Korea was swept into the global financial maelstrom, the ratio stood at 51.9 percent. Korea’s ratio of short-term debt to foreign exchange reserves has also improved, falling from 79.1 percent three years ago to 49.2 percent in June 2011.
What these figures suggest, according to officials of the bank and the Ministry of Strategy and Finance, is that while Korea’s foreign debt has risen to an important psychological line, it does not mean that the nation has entered the danger zone. The low short-term debt ratio, they claim, indicates its debt is kept within sustainable limits.
Furthermore, they say, Korea’s foreign debt growth is a testament to its economic strength rather than weakness. A large proportion of the nation’s debt, they note, is related with trade financing and forward exchange transactions with exporters. As long as the nation’s export volume grows, its external debt is bound to expand. Korea’s strong economic performance also attracts foreign investment in local stocks and bonds, boosting its debt.
We share the view that Korea’s foreign debt is nowhere near large enough to cause problems, in light of its $300 billion foreign exchange reserves, annual exports topping $500 billion and yearly current account surplus of $30 billion.
But this does not spare policymakers the need to keep close tabs on debt and global financial markets. They need to keep an eye on European financial markets because many banks in eurozone countries are in trouble due to their heavy exposure to bonds issued by fiscally troubled countries.
If liquidity dries up amid a credit crunch, these banks will be forced to relentlessly unwind their overseas investment. To them, it matters little whether Korea’s economic fundamentals are strong. Due to its fluid capital markets, Korea will rather be one of the first countries to suffer sudden capital outflows.
This was exactly what happened in 2008. At the time, policymakers kept saying Korea’s economic fundamentals were strong. But strong fundamentals were useless when a credit crunch hit global financial markets. This is why Korea should take care to curb the growth of external debt. Until global financial markets stabilize, policymakers should bring debt growth under control.
