As the world struggles to stop the euro zone's sovereign debt crisis from igniting a replay of the 2008 global meltdown, some investors are pulling out of South Korea and other emerging markets — so far in a more orderly manner.
The death of North Korean dictator Kim Jong Il adds another risk factor, although investors seem to be taking that in their stride. The stock market and currency tumbled after Kim's death was announced, but have since stabilized.
Analysts said South Korea will certainly take another severe hit on its currency and exports should the world plunge back into a 2008-style collapse of credit and trade flows.
The impact, however, is likely to be shorter and milder.
"An investor panic over developments in the euro zone is probably the most likely trigger," said Tim Condon, chief Asia economist at ING in Singapore. "The panic would have real consequences, just like the (2008) global financial crisis."
Alarmed by a more than 30 percent drop in the won in just three months in late 2008, South Korea replaced its hard-line finance minister with a technocrat who cracked down on short-term foreign debt and tightened the grip on consumer lending.
The efforts have paid off this time — foreigners sold off $6.6 billion worth of stocks since August, but bought bonds and the current account remains firmly in surplus. The won has fallen 9 percent but is not collapsing.
Credit default swaps are below 200 basis points, versus more than 450 basis points in late 2008. The cost of swapping the won for dollars is now below minus-200 basis points, but was wider than minus-300 during the crisis.
"The authorities in Korea have largely fixed the financial instability problems in the economy after 2008, as reflected in the improvement of the country's external position and the decrease in banks' leverage," said Tieying Ma, economist at DBS Bank in Singapore.
The short-term foreign debt at the heart of the country's vulnerability has come down to below 50 percent of foreign reserves this year from nearly 80 percent in 2008, but is still more than double the level of some of its regional peers.
An absence of bids to match the heavy dollar/won forward sales by the world's top shipbuilders based in South Korea and the won's steep undervaluation have prompted banks to rely on overseas short-term borrowings to settle the forward deals.
The country also secured deals with neighboring giants China and Japan to get up to $126 billion in dollars, yuan and yen in exchange for the won. The amount can cover about 90 percent external debt due over the next one year.
However, the domestic debt picture looks darker.
Household debt has been piling up, bucking deleveraging attempts by other middle- to high-income countries, and was at 1.6 times the annual disposable income in 2010, compared with 1.3 times in 2008.
South Korea was already a hot topic among central bank and regulatory officials in Europe who gathered in London in November, with one warning of "a huge vulnerability" because of a massive pullout by European lenders.
"High household leverage makes the Korean economy vulnerable, particularly if funding stresses increase or growth weakens," said Erik Lueth, economist at Royal Bank of Scotland based in Hong Kong.
The country's failure to stop the household borrowing frenzy could prove fatal should the euro zone crisis spiral into a global crisis worse than 2008, leading to a series of consumer debt defaults and bank failures.
A worst-case 2008-kind crisis is not likely to happen, say the country's policymakers, but some warn that a simple misjudgment during times of stress could easily push the $1 trillion economy into a chaos.
"It's never too early to be on alert," said one former senior government official who was directly involved in financial policy during the 2008-2009 global crisis.
"Numbers simply don't do any help during crisis times because people would not trust any good number you show them," said the official, who requested anonymity because of the sensitivity of the issue.
But he said weakened political leadership ahead of next year's two national elections would make it all but impossible for the government to take drastic steps, such as accepting loans from the International Monetary Fund.
South Korea shut down hundreds of companies and laid off millions during the late 1990s under reforms mandated by the IMF in return for a bailout package, and the name of the lender has since been at the top of the taboo list.
South Korea's capital markets are also vulnerable to bouts of concern over increased tensions with North Korea, as was the case after the reclusive country belatedly announced the sudden death of its leader.
The markets quickly recovered from initial shocks during the week thanks in part to the absence of any internal conflicts after Kim's 17-year dictatorship ended and also on no immediate signs of rising tensions with the South.
But the latest case highlighted the underlying risk in investment in South Korea that has continued since its three-year war with the North ended only in a cease-fire nearly 60 years ago.
Analysts used to cite North Korea as the biggest of the elements behind a so-called "Korea Discount," a phrase used to explain the relatively undervalued South Korean assets and credit ratings compared to its economic potential.
Fitch Ratings, for example, ranks South Korea's sovereign debt on a par with less developed countries such as China and Estonia.
"It is too early to say how the situation will evolve after Kim Jong Il's death, but political developments demand close attention," Fitch said in a Dec. 19 statement.
"The extreme risks of an outbreak of hostilities or a collapse of the North Korean regime have long been 'high-impact-but-low-probability' events that have weighed on South Korea's rating."
