Risks of an economic downturn looms in South Korea as China stumbles and the Fed’s rate hike nears.

The China Factor

China’s stock market lost more than $1 trillion in value from equities when its main stock indices plummeted 22% starting on August 21st. The sudden drop led to a historical stock market sell-off, and was hence dubbed as “Black Monday”.

This soon revealed to have only limited impact on the economy, and investors’ confidence rose again. The market bounced back when China’s central bank simultaneously lowered its interest rate and requirement-reserve ratio (RRR) to ease lending, and expectations of a Fed rate hike in September subsided.

However, these measures by China’s central bank caught investors by surprise, and rather exacerbated the irrational fear that a collapse of the economy is near.

For example, the Chinese government eased restrictions in the housing market by making it easier for foreigners to buy properties, which is uncommon for a country known for heavily regulating foreign capital. Some analysts claimed that China could be heading towards deflation.

This fear has been exaggerated. China is still rapidly growing, and, as the world’s second-largest economy, is ready to intervene in the market where it seems fit.

In May 26th 2015, IMF reported that China’s yuan is no longer undervalued due to appreciation in the past year. It has given the government leeway to set the exchange rate policy, leading to currency devaluation.

For emerging economies and neighboring countries, competitive currency devaluation means trouble. In South Korea, Hyundai Economic Research Institute reported that South Korea loses 3% of total export when the value of the yuan falls 5%.

Implications for the South Korean economy and the government’s lack of response

The downward pressure in the consumption in China and the devaluation of the yuan has already affected South Korea’s economy, as a quarter of its total export is to China and China is its largest trading partner. The data released in August showed that South Korean exports fell 15% and exports to China dropped 8.8%.

So far, the South Korean government has proven unable to read the market by constantly changing stances in its economic outlook, exposing its inefficacy in acting decisively against the market volatility. Investors should be wary of the government’s lack of confidence.

When China devalued the yuan for the first time on August 11th, the Minister of Strategy and Finance and Economic Deputy Prime Minister Choi Kyung Hwan said that devaluation would strengthen China’s exports and thus increase demand in China’s import of South Korea’s products. His stance changed on August 20th, when he said the devaluation of the yuan is instigating currency war and anxiety in emerging markets.

When the China’s stock market crashed on August 20th, he said it would have limited impact in the South Korean economy. In contrast, with the release of weak August export data and a lower growth forecast for 2016, Choi warned of China’s “extremely huge impact.”

The housing crisis and the household debt

South Korea has bigger underlying problems than its dwindling export, however. A housing crisis looms, coupled with a bubble in housing prices and record-high household debt.

The engine of record growth in the wealth of 1st and 2nd generation South Korean households relied on its unique rental system, named “chonsei.” Chonsei is a Korean lease contract in which the tenant pays an up-front deposit of 40-70% of the housing price with no requirement for periodic rent payments. This provided a way to save tenant’s rent money and freed up the circulation of investment for landlords.

Currently, the chonsei system is becoming obsolete, as landlords cannot make any profitable return on investment with a low-interest rate. What does this mean? In a period of market volatility and uncertainty, there is excess demand for chonsei, but no supply.

As a result, households are borrowing more to own properties in the already expensive housing market. By the end of last year, the household debt to disposable income ratio had jumped to 164%.

Due to stagnant growth in the housing market, Deputy Prime Minister Choi eased mortgage restrictions, such as relaxing DTI & LTV loan requirements, and pressured Bank of Korea Chairman Lee Joo Yeol to cut the interest rate to 2%, making it easier for households to borrow capital. Household debt rose 6.6% in 2014.

Because of the MERS outbreak last June in South Korea, the Bank of Korea has cut its base rate to a record-low 1.5% to prop up the economy. The next day, Chairman Lee said the risk of household debt leading to repercussion in the financial system is low. Conversely, on August 20th, Lee said “low interest rate policy has led to growth in the household debt and the weakening consumption and macroeconomic conditions.”

The government has been sending mixed signals by making statements that heavily indebted households are from upper-middle class families who have the capability to pay back their loans. Nonetheless, in the worst-case scenario, a recession in China will slash overall income in South Korea, and the forthcoming Feds rate hike will put more burden on the nation’s debt.

The consistent low-interest rate policy and the soaring household debt have placed South Korea in a difficult position, and investors are losing confidence.