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Posted by on Sep 16, 2016 in Korea Investment Management, Market Insight

South Korea Gets Upgrade Despite Shipping Turmoil

South Korea Gets Upgrade Despite Shipping Turmoil

Editor’s Note: The following insight comes from Korea Investment Management – a leading asset manager in South Korea – and continues a series of posts intended to introduce South Korea as an investment destination.

 
On August 8, S&P upgraded its sovereign credit rating for South Korea from AA- to AA with a stable outlook, the first upward revision in 11 months. Of note, this is a record-high sovereign rating for the country. Currently, Korea’s rating is the highest among emerging markets and even higher than neighboring China (AA-) and Japan (A+).

S&P attributed the upgrade to 1) more stable economic growth relative to developed economies, 2) a well-diversified trade structure that is not dependent on a specific sector or export market, 3) sturdy external soundness and 4) sufficient fiscal and monetary policy flexibility.

We believe the upgrade is particularly notable given the ongoing rating downgrades for other emerging economies and advanced markets (third upgrade for Korea over the past year by credit rating agencies). As Korea has a better credit rating than other emerging economies and neighboring countries, it will work to cement Korea’s presence as a safe emerging market asset.

As capital continues to enter emerging markets on a trickle-down effect from reflation policy measures, we forecast a sustained inflow of foreign capital into the Korean bond and stock markets. In fact, Korean government bond yields are higher than that of the UK, France, Belgium and other countries with the same credit rating. Furthermore, stock market valuations are the lowest among economies with the same credit rating.
 
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As oil prices began plunging from 2H14, demand for both commercial vessels and offshore plants deteriorated, leading to a sharp decline in order backlogs for Korean shipbuilders. In fact, backlog years to sales at the three major shipbuilders fell to 1.4 years. Furthermore, the ratio has only 0.4 years left, to the critical point of 1.0x annual sales (after reaching a high of 3 years in 2008). As such, 2H16 appears to be the last opportunity for restructuring.

During this period, government-run banks have continued to provide loans to shipyards as shipbuilders are major employers and as commercial banks would face substantial refund guarantee (RG) problems if the shipbuilders faced significant financial difficulties. However, 1) it looks like small- and mid-sized yards have a very slender chance for revival, while 2) financial stability at major shipbuilders has deteriorated due to major losses on offshore plants.

Accordingly, creditors are no longer offering unfettered aid, and forced the Big 3 shipyards to fulfil a combined W10.3tn self-rescue plan. Meanwhile, the government enacted the “One-Shot Rule” (effective August 13), which eases regulations and tax laws if the group restructures around the core affiliate. Following asset disposals and labor restructuring in 1H16, corporate restructuring should ramp up backed by the “One-Shot Rule.”

Earnings at Hyundai Heavy Industries (HHI), the largest shipbuilder, turned around in 1H16 as management slashed costs by W800bn, including laying off 3,000 workers. Chinese shipyards are also trimming workforces following the White List announcement in 2014. Going forward, we believe HHI will be the best positioned player once the commercial vessel cycle rebounds. Furthermore, feasibility studies have been conducted again on offshore plants at the lower crude prices, and projects should proceed based on profitability.
 
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1. Reasons that Korean container shipping companies have collapsed

–    Korean shipping companies placed a large number of shipbuilding orders from 2007 to 2011, which eroded margins (Hanjin Shipping (HJS)’s fleet expanded from 85 vessels in 2007 to 114 in 2011).

–  European competitors adopted a strategy of utilizing ultra large vessels, which increased competitive pressure and pushed down freight rates (Shanghai Container Freight Index (SCFI) fell 60% from its 2010 peak).

–  Shipment volume declined structurally as Asian economies, especially China, slowed after the financial crisis.

–  Financial stability at Korean shipping companies deteriorated as the worsening conditions eroded margins and led to larger debt loads.

–  HJS and Hyundai Merchant Marine (HMM) were already close to bankruptcy by end-2015   (yearend debt ratios of 848% at HJS and 2,007% at HMM).

2. Outlook for restructuring and future direction

– HMM reached a self-rescue agreement with creditors while HJS has entered court receivership.

– HJS has been ejected from the CKYHE shipping alliance, and a recovery appears unlikely as clients have abandoned the company.

– Given HJS’ substantial debt load, an M&A appears unlikely and liquidation appears probable.

– HMM will likely emerge as the only major Korean shipping company after acquiring Hanjin’s healthy assets.

3. Container shipping operating environment and share price outlook

– After HJS filed for court receivership, the SCFI surged 30%.

– However, we believe the strength will be only temporary as it was fueled by typical start-of-the-month freight rate hikes and the HJS court receivership.

– The oversupply in global shipping capacity will likely continue despite the HJS bankruptcy.

– Shipping rates should continue to fall due to the supply glut. Accordingly, shipping share prices are unlikely to rebound.

 
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