SEOUL, July 30,2010—South Korea’s prime minister resigned Thursday over a controversial government-office development plan, as mounting troubles in the housing and construction industries threaten the country’s rapid recovery from the global economic crisis.
The country is enjoying a heady rate of growth. The Bank of Korea on Monday reported a 7.2% year-to-year jump in second-quarter gross domestic product, driven by exports and facility investment.That figure followed marginal performance over the past two years.

But amid that vibrant turnaround, government officials for months have been wrestling with a stagnating housing market, a politically difficult challenge in a country where most people have their wealth tied up in real estate. Last week, government finance and land agencies clashed over ways to boost sagging home values and put off a final decision.

On Tuesday, Korea Land & Housing, the state-run funder of home and government construction, canceled or delayed dozens of planned projects, citing mounting debt and its limited ability to tap the bond market.

The resignation of Prime Minister Chung Un-chan also is tied to a real-estate controversy. Mr. Chung, an economist and former university president, argued when he took office last September that a plan to build a taxpayer-funded, $20 billion city as a second center for national government offices was expensive and inefficient.

But last month, the National Assembly rejected a new plan devised by Mr. Chung and supported by President Lee Myung-bak to broaden the city, dubbed Sejong, into a center for business and science. In Korean politics, such a high-profile failure often leads to an official’s resignation.

Prime ministers, appointed by the president to mainly handle policy and ceremonial duties, are especially vulnerable and typically serve for just six months to two years.

Mr. Chung cited the Sejong development issue in his farewell speech Thursday afternoon. “More than anything, I prepared a revised plan for Sejong city for the country for the coming hundred years,” he said. “But the fact that I failed to make it through makes me feel guilty that I couldn’t prevent national waste and confusion that are certain to come in the future.”

Despite such developments, South Korea doesn’t appear on the verge of a Japan-style real-estate crisis. For one thing, its ability to spend on wasteful projects is constrained. Lacking the large savings base that Japanese officials were able to tap in bond sales, South Korea has to turn to the less-forgiving international bond market to raise construction funds.

Even so, the current trouble in real estate and construction holds the potential to become a turning point in a decadeslong practice by the Korean government of driving economic growth with massive capital spending, though both government officials and economists say it is too early to say that with certainty.

Demand for real estate has been sagging, in part due to high levels of household debt. That same problem has been a constraint on officials at the Bank of Korea who want to raise interest rates—which had been at a record low 2% for 18 months until a 25-basis point increase this month—but worry about burdening consumers with higher mortgage payments.

Adding to the pressure, about 95% of South Korean home borrowers use flexible-rate mortgages and are facing the likelihood of significant jumps in payments when interest rates go up.

“There’s too much risk in households,” says Douglas Kim, a former hedge fund manager and author of two recent books on South Korean real estate and finance. “They need to lower that as soon as possible, but changing to fixed-rate loans will create demand that cause the rates for them to go up.”

Of all the action in the past two weeks, the most surprising was the LH decision to halt dozens of projects. LH is the country’s third-largest financial institution by asset size and the chief funder of government projects from low-income housing to municipal buildings. Chief Executive Officer Lee Ji-song said earlier this week the firm would need 420 trillion won ($354.14 billion) to proceed with its more than 400 existing and planned projects.

Its debt stood at 118 trillion won on June 30, up from 108 trillion won at the end of 2009 and 86 trillion won at the end of 2008. As a result, in addition to scrapping most of the projects on the drawing board, Mr. Lee said LH is likely by the end of August to stop some construction already started.

The company’s decision to halt projects angered politicians and residents throughout the country. In the southern part of Daejeon, a city of 1.5 million in central South Korea, a neighborhood redevelopment that began in 2006 has stalled because of LH’s debt problem. The company stopped paying land compensation to residents in the affected neighborhood last year and, according to some media accounts, this week’s announcement put reconstruction on hold.

“Local residents are all really upset, and we are going to protest in August,” Choi Ju-young, an activist in the Daejeon neighborhood said in an interview Thursday. “We won’t just sit and wait. Enough is enough.”

LH is also the chief funder for the Sejong project, but it is unclear at present how the company’s problems will affect the planned government city.