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JEON Hyo-Chan

How to Tackle Growing Bad Corporate Loans

JEON Hyo-Chan

July 6, 2009

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Distressed bank loans are piling up at a rapid pace. At the end of May, the delinquency rate on corporate loans was 2.3%, up 0.9 percentage points from a year earlier and the highest level since May 2005. Furthermore, outstanding non-performing loans have increased by as much as 31% during the first three months of 2009, and the ratio of such loans in total bank loans rose to 1.5% as of the end of March, the highest since the end of June 2005.

Companies are expected to face more bad loans and late payments in the second half of this year. In past economic crises, the bad loan ratio of financial institutions lingered for a considerable time even after the downturns bottomed out.

A prime reason for the pessimistic outlook is beleaguered debt-servicing capability of companies. When the speed of the economic swoon accelerated early this year, operating profit plunged and financing costs rose. First-quarter operating profit of listed companies stood at 7.7 trillion won, down 50.8% from the same period in 2008. Their debt-to-equity ratio rose as companies struggled to secure liquidity, which in turn ramped up financing costs. The interest coverage ratio ? operating profit/interest payment ? fell to 2.3 in the first quarter, down from 6.7 a year ago. A low interest coverage ratio means worsening of debt-servicing capability.

In particular, the number of companies with the ratio of less than 1 has increased significantly, indicating an increase in failures to cover interest expenses with operating profit. With the pace of any economic rebound expected to be slow in the second half of 2009, there is high possibility that companies will face more bad debt.

Another reason for the bleak outlook is the precarious situation surrounding a wave of loans extended when the economy was in good shape. Corporate loans grew by 20% in 2007 and 2008. The economy was robust up to the first half of 2008 and the number of bad loans was not large until then. However, the steep economic descent thereafter has raised the potential of the existing loans going bad. Given that corporate lending remained high in the first quarter of 2009 when the economy was in negative territory (on year-on-year basis), it is likely that bad loans will rise in the second half.

A third obstacle is a credit crunch facing companies. The global financial crisis has sparked a flight to safe haven assets since the second half of 2008, making it difficult to raise capital. Although investments in riskier assets have resumed recently, capital still is concentrated in certain financial instruments such as highly rated corporate bonds. As a result, the credit spread - the yield gap between BBB- corporate bonds and government bonds - surpassed 7 percentage points in June. This was higher than the 5 percentage point level seen when the credit card crisis in 2003 swelled the credit spread. This indicates that the funding of companies with a low credit rating has worsened. Such a high concentration will not disappear quickly, meaning companies will continue to face tight lending and subsequent rise in bad debt.

A fourth risk is lower corporate profitability due to rising values of the won and oil prices. The won/dollar exchange is forecast to drop to the 1,100-plus level in the second half. According to an analysis by Samsung Securities, a 100-won drop in the won/dollar exchange rate in the second quarter is estimated to have reduced the operating profit of 92 listed companies by around 12%. As for the recent spike in oil prices, a 10% increase raises the cost of manufactured goods by 0.98%, according to Samsung Economic Research Institute's estimates.

It is thus crucial for companies to focus on upgrading their financial health to cope with the risk of rising bad loans. In particular, they should seek to enhance competitiveness by improving cost structure, reducing debt ratio, and disposing of unprofitable businesses. Companies also should prepare for possible volatility in the won and oil prices and devise appropriate strategies for potential price levels.

The financial authorities, meanwhile, needs to address supportive measures to help companies upgrade competitiveness. It will be necessary to utilize the corporate restructuring fund to efficiently solve bad loan problems. At the same time the soundness of financial institutions can be strengthened through the bank recapitalization and financial market stabilization funds, which help shore up banks' capital base and prevent corporate debt lead to more delinquent loans. It is also crucial to allow sources of corporate restructuring funds such as private equity funds to play a bigger role in restructuring financially distressed companies.

Meanwhile, since it will take some time for domestic demand and exports to rebound, an aggressive fiscal policy and economic boosting stance need to be retained. If a liquidity problem arises, more microscopic measures will have to be adopted. But if liquidity triggers inflation, tightening measures such more monetary stabilization bonds, will be needed along with stricter bank lending to cope any volatility in property prices.

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