South Korea’s mid-sized construction companies are collapsing like houses of cards, intensifying fears of a looming liquidity crunch in Asia’s third-largest banking market.

Korea has remained largely immune to the sub-prime woes that have afflicted international markets. But a series of smaller construction companies have been defaulting on project financing loans as they struggle to sell apartments outside Seoul.

That has raised concern about a further deterioration in the quality of loans to construction companies and investors are beginning to worry about the impact on Korean banks.

“This is a critical moment,” said Chung Dong-joo of the Korea House Builders’ Association. “We call this a ‘bankruptcy surplus’, as companies have the ability to raise capital but are going bankrupt because of the high number of unsold apartment units. This hinders capital circulation and has plunged small and medium-sized companies into a crisis.”

Dongdo Construction, which has been building “Miso Dream” apartment complexes in the south-western province of Jeolla, last week went bankrupt after failing to pay back Won 5.1bn (about $5.5m) of debt. It joined other regional companies including Sejong, Samik, Shinil and Sechang among the defaulters.

Behind the bankruptcies is a sharp slowdown in Korea’s regional housing market following the government’s introduction of eight packages of real estate reforms in the last three years. That has been exacerbated by increases in interest rates to a six-year high point of 5 per cent.

Official data suggest numbers of unsold apartments in Korea rose by 11,000 from May to 89,924 in June (the most recent figures available).

That was the highest since the end of the 1998, after the Asian financial crisis. Mr Chung of the builders’ association said the real number could be higher.

Top-tier builders – such as Daewoo and Doosan– are riding high thanks to a frenzied apartment market in Seoul and lucrative contracts in the Middle East.

But potential disruption to the Korean economy caused by the bankruptcy of smaller builders is important. Construction accounts for about 6 per cent of Korea’s gross domestic product, compared to 3.7 per cent in the US.

“If small and medium-sized companies continue to collapse, the impact on the economy and the construction industry will be serious – it would be almost like having the middle class collapse,” said Kim Hyun-ah, an analyst at the Korea Construction and Economy Research Institute.

Project financing deals account for nearly a third of mutual savings banks’ outstanding loans, with 13 per cent of those loans now delinquent at the smaller saving banks compared to a 0.2 per cent at big banks.

Unlike the mortgage market turmoil in the US, the Korean situation appears to be contained.

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