NATION BUILDERS

The Economist, July 10th 1999

As you tour the car plant in Asan, an hour's drive from Seoul, you feel almost sorry for the nice man from Kia Motors. Visitors used to be impressed by the sheer size of the place; it seemed to reflect the company's strength and self-confidence. Now they see the plant's scale as just the kind of extravagance that brought corporate Korea low and led Kia into bankruptcy. There is no doubt that South Korea constructed some world-class businesses in an astonishingly short space of time. The trouble is that their failings were world-class too. Top among them was a spate of maniacal diversification. Hyundai, Daewoo, Samsung, LG and SK, the five biggest of the chaebol, as South Korea's family-controlled conglomerates are known, at one point had hundreds of subsidiaries between them. In seeking to marry construction with underwear, and hotels with confectionery, the chaebol were defying business logicthough not the political logic that encouraged them to exploit their connections with the bureaucracy. Their protesta

tions that America's General Electric is a conglomerate too only go to show how undiscerning their expansion was. That diversification went hand in hand with huge borrowing. Big groups were able to put pressure on the banks to lend them money cheaply, if only because the largest were presumed to carry a guarantee of government support. At the same time, the chaebol's owners were eager to avoid issuing equity to outsiders, because that would have threatened their control. instead, they stretched their borrowing further by getting their successful subsidiaries to guarantee the debts of start-ups. For as long as this system held together, it permitted assets to grow fast, which was particularly valuable in capital-intensive industries, such as making memory chips and building ships, where a large market share pays dividends. But there were two dangers. First, the entire edifice was vulnerable

to a loss of competitiviness, which would reduce profits and might leave the firm unable to meet its interest payments. And second, the failings of South Korean firms made such a loss of competitiveness almost unavoidable. Wages were particularly troublesome. With the arrival of democracy in 1987, pay started to go up. Rises were long overdue after years of repression, but workers enjoyed total job security, and had no notion that wages should bear some relation to productivity. For a whole decade increases averaged 15% a year. As a result, by the time the Asian economic crisis struck, labour productivity in South Korea was only half of that in America. Managers and owners were culpable too. Diversification was a costly distraction. in most chaebol, one or two subsidiaries continued to earn almost all the profit. Because these subsidiaries typically produced goods that were subject to large swings in price, the quality of the chaebol's earnings was low. The large firms ploughed capital and talent into heavy

industry and technology, while South Korea's service sector remained stunted. The performance of South Korean firms had been deteriorating even before the Asian crisis. The collapse in semiconductor prices, which fell by more than 70% in 1996, coincided with a poor market for other South Korean exports, such as steel and chemicals. The effect was to cut total corporate profits in half, according to Dungchul Cho of the Korea Development Institute, a government think-tank. Once the crisis struck, the cross-guarantees caused thetrouble to spread rapidly across the economy. That was what hurt Kia. its car business, which was in fair shape, was hit by the failure of its steel subsidiary. Hanbo, also a steel maker, fell victim in January 1997, well before the Asian crisis, to a financial scandal involving the son of the then president, Kim Young Sam. Ssangyong, another chaebol, did not seek help until its debt was 86 times bigger than its equity. In 1997 and 1998 more than a dozen of the total of 64 chaebol went b

ankrupt.

Chaebol for the chop

The arrogant chaebol had long been unpopular in South Korea, and became doubly so after the crisis. The government resolved to tackle them. At the end of last year President Kim Dae Jung felt confident enough to declare: "The chaebol system, which puts the emphasis on outward expansion that burdens the people, has come to an end."

on the face of it, that seemed a reasonable claim. in the largest of the chaebol subsidiaries, the businesses on which everything else rests, professional managers have begun to shake things Up. LG Chemical, the heart of the fourth-biggest chaebol, has embarked on a high-profile round of cutting costs and improving quality. It plans to increase its output of specially chemicals to 6o% of its total production, from a quarter now. At its Yochon plant at Korea's southern tip, the firm has introduced a new system of performance-related pay, with a bonus that can be worth as much as three months'wages. The government has encouraged the chaebol to

sell subsidiaries to foreigners, a bold step for such an inwardlooking nation. Foreigners complain that Koreans are asking too much for their assets, but a number of deals have gone through all the same. Samsung sold its construction-equipment division to Volvo of Sweden, and Samsung Electronics sold its power integratedcircuit division to America's Fairchild. British Telecom spent $373m on becoming LG Telecom's second-biggest shareholder. Other firms, such as BASF and Hewlett-Packard, have bought out their Korean joint-venture partners. The government has also taken steps that should help to prevent corporate Korea getting in a mess again. it has imposed stricter reporting standards for company accounts, banned cross-guarantees, which must be eliminated by March 2ooo, and stipulated that the ratio of debt to equity must fall below 2oo% by the end of this year. The idea is both to make bankruptcy less likely and to isolate subsidiaries should they fail. Yet some people deride the restructuring of the chaebol

as a sham. The scepticism is easy to understand. The government first attempted to cut the chaebot down to size as early as 1980. It got nowhere then, and it has got nowhere in many subsequent efforts. Will it get somewhere this time? There are doubts.The new rules against cross-guarantees and cross-shareholdings will be hard to enforce. The chaebol can exploit loopholes using foreign subsidiaries and complex corporate structures. The government has tried to get the five largest chaebol to restructure by choreographing a series of "big deals". The idea is that each chaebol should concentrate on a few core businesses, but the chaebol have resisted. LG only reluctantly threw in its chip business with Hyundai. Samsung has been unable to agree on the sale of its carbusiness to Daewoo, even though that meant the subsidiary went into receivership. Samsung and Hyundai are supposed to be merging their petrochemical subsidiaries. But the scheme is flawed-and not only because it does nothing to reduce the overcapacit

y that has plagued South Korean firms. Its main defect is that it makes the government responsible for corporate restructuring just when it should be withdrawing. It uses up political goodwill that will be needed later to push through more important reforms in the capital markets. And in some cases it creates domestic duopolies. If they end up controlling almost all of the market, South Korea's two remaining car makers, Hyundai and Daewoo, will naturally want to exploit their market dominance. Whatever they may say in public, the chaebol owners seem keen to carry on as usual. Their consolidated results as calculated by the Korea Stock Exchange are dreadful (see chart 2)-and disturbingly different from their own figures. Samsung persisted with a wrong-headed $3 billion scheme to become a car maker, launching its first model in February 1998 just as Asian car demand slumped. Hyundai announced a restructuring in May under which its 79 subsidiaries will be cut to 26, concentrating on only five businesses. But on

closer inspection the news is not as dramatic as it seems. Hyundai is closing only four subsidiaries and selling eight (which it had bought when it took over Kia). There is a vague promise to sell a further unidentified 13. The rest are being merged into the group or run at arm's length. Far from slimming down, the company has expanded since the crisis. Hyundai has bought not only Kia, but also an oil refinery, two fund managers and a chip business. It is also planning to create a life insurer. in addition, it may expand its steel business and buy back a heavy-industry firm that was nationalised in 1980.

Rule to work

Employment in the chaebol has not changed much either, despite the number of people out of work. Although President Kim has changed the labour laws to allow redundancies, neither the government nor the conglomerates seem keen to put the new legislation to use. South Korea continues to suffer from a "Confucian" labour market in which paternalistic managers bully and protect workers in equal measure. Rather than sack its workers, one Samsung subsidiary asked some of them-both men and women-to take unpaid "paternity leave". Jinro, which makes soju, a Korean liquor, might have gone bankrupt months ago. But it is still around, because Seoul District Court wants to protect jobs and refuses to close it.

Hyundai did establish the principle of lay-offs at its car plant in Ulsan last August, but in a much watered-down form. Having originally planned 5,ooo lay-offs, it cut the number to some 1,5oo in response to a strike, and later agreed to sack only 277 (167 Of them from the staff canteen); the rest will return to work after 18 months' unpaid leave. Kia, for its part, is proud of its nostrikes, no-lay-offs agreement with the unions. To generate work for all its staff, however, the firm will have to push up its output to 8oo,ooo cars-which will mean exporting more.

This sort of thinking cannot persist. Although the economic crisis is past its worst, some of the large firms-and Hyundai and Daewooin particularremain weak. if they are to tackle their high costs, jobs will have to go. The unions pulled back from a public-sector strike earlier this year, but say that "the environment is set for confrontation." The conservatism of both workers and owners makes the politics of chaebol reform highly complicated-which is why the economics matter so much. Left to pursue their own economic interests, lenders and investors will, in time, cut the chaebol down to size. Intimately, the best master for the overweening chaebol is not President Kim with his bureaucrats, but the South Korean capital market.