Flood in the basement

South Korea has assumed battle stations. Investors’ retreat from emerging markets has exposed the country’s reliance on short-term foreign credit, sending its markets spinning and prompting Prime Minister Lee Myung Bak to call the first economic crisis meeting in almost a year. Banks and government balance sheets look sturdy, but an economic slump centred on indebted households is a real risk.

Korean consumers have been able to borrow cheaply for years, thanks to massive inflows of cash and credit. Like other Asian economies, the country has suppressed its currency to keep exports competitive, while keeping markets open to foreign investment - creating a big draw for foreign investors. Policymakers stuck to their course despite damaging capital outflows in 1997 and 2008, instead using macroprudential measures to moderate capital inflows.

With Europe in crisis, the flows are again reversing, but on many measures, Korea is in good shape. External debt is a third of GDP. Roughly 40 per cent, or $150 billion, of that matures within two years or less. But Korea has $300 billion in foreign-exchange reserves and a generous current account surplus, so it should avoid a balance of payments crisis. Banks also appear unlikely to face solvency problems. They owe some three-quarters of Korea’s short-term external debt pile, and slightly more than a third of that came from European banks. The good news is that most borrowers are themselves foreign banks: Korean institutions only represent 45 per cent of short-term external borrowing; just six per cent of overall loans. A funding crisis also looks unlikely. Lee may be right to worry, though. Though European banks hadn’t lent directly to households, if they pull out funds, it could put a roughly $75 billion hole in Korea’s credit landscape. That could push up borrowing costs on consumers’ roughly $700 billion in debt, and leave some borrowers in distress.

Korean households’ debt is more than double their yearly disposable income, almost the level US household debt reached before the subprime mortgage crisis erupted in 2007. Only 1.3 per cent of bank loans are non-performing at present, but if households should start to default, that number will go up fast. Korea’s finances look strong, but they may need to be.