CAPITAL FLAWS

The Economist, July 10th, 1999

DONGSUNG CHEMICAL is a medium-sized Dcompany in the city of Pusan, on South Korea's south coast. Its speciality is making glue for sticking soles on shoes, a legacy of the days when footwear was the region's main export. Dongsung coped with the economic crisis reasonably well. Although its domestic business tumbled, its exports, which account for more than 6o% of sales, gained from the won's collapse. Even so, the firm fell victim to South Korea's financial system. Lenders who, for political reasons, were unable to call in their loans to the big firms turned to smaller ones instead. With its creditors at the door, Dongsung became desperate to raise capital. Although it avoided lay-offs, the firm had to sell a start-up to Germany'S BASF and a controlling share of its main footwear business to Britain's ICI. The firm is putting a brave face on it, but the past couple of years have been awful. Dongsung is not the only company to have been badly served by South Korea's capital markets. The country's small-busine

ss association says 23,000 Of its members went bankrupt last year, double the usual number, whereas large companies have been able to go on borrowing more or less at will. Yet it is the small businesses that should be the innovators and new employers in South Korea. Unless the country can straighten out its capital markets, those businesses will remain hamstrung.

To be fair, small firms' difficulties cannot all be blamed on the lenders; the government played a prominent part too. From the beginning of the 1960s it used the banks to funnel capital to favoured businesses on attractive terms. Later these policies became less explicit, but the political influence remained. Banks knew that the government would bail out their biggest clients and their depositors, so they never developed adequate credit-risk analysis. Because financial products were heavily regulated and the labour laws made it difficult to close branches, the easiest way for banks to increase their profits (though not their profitability) was to increase the volume of their lending, rather than to innovate or cut costs. But nobody seemed to mind. Thanks to legislation designed to keep the chaebol in check, no shareholder could own more than 4% of a bank. Paradoxically, the absence of strong owners made the banks easier for chaebol and bureaucrats to dominate. when the stockmarket began to fall at the end o

f 1996, for example, bureaucrats issued "window guidance", requiring the banks to support share prices by holding on to their equity investments, even though this would aggravate their losses. The banks duly complied. The partial liberalisation of the economy in the years leading up to 1996-97 made the banks even more vulnerable. The government withdrew its guarantee to support the banks, but introduced no corresponding improvement in supervision. No wonder international investors at first refused to believe that the government would let businesses and banks fail. The financial crisis struck partly because those investors eventually concluded that perhaps it would, after all. At one point in late 1997 South Korea's foreign-exchange reserves dipped to a microscopic $3.9 billion. The banks lacked the skillsto estimate their bad loans, and to gauge how those loans might be affected by a deteriorating economy. Worse, the banks and other lenders were heavily exposed to the fall in the won, because they had large

short-term borrowings in foreign currencies backed by longer-term loans inside South Korea.

Won for all

At the end Of 1997 the government launched an emergency rescue. The idea was to prevent panic, and also thoroughly overhaul bank supervision to rebuild confidence. The bail-out funds had a total of 64 trillion won, raised through a government bond issue, with which to buy bad loans and inject new capital into the banking system in the form of equity. The government nationalised the worst-affected banks, Korea First Bank, Seoul Bank and Hanvit (created out of Hanil Bank and the Commercial Bank of Korea). The first two are now being sold to America's Newbridge and Britain'S HSBC (Hongkong & Shanghai Banking Corporation) respectively-though both sales have been plagued by difficult negotiations. Stronger South Korean financial institutions bought five other banks. others agreed to different remedies, such as detailed restructuring plans or equity investments by foreign banks. Germany's Commerzbank, for example, bought a 17.7% stake in Korea Exchange Bank. Duties formerly spread among several regulators, includi

ng the finance ministry, have now been concentrated in a single body, the Financial Supervisory Commission (FSC). The FSC will also oversee a, set of new prudential regulations conservative enough to elicit praise from the OECD. In addition, it must ensure that South Korean banks at last begin to develop the techniques they need to assess their loans and track their positions. To this end, it has been given strong powers, as well as the president's personal backing. In a poll, South Koreans named Lee Hun Jai, the FSC'S mild-mannered, cardiganwearing chief, as the country's most powerful economic manager after the president. The banks are not out of trouble yet. Later this year they will have to begin making provisions for loans they expect to turn bad, as well as those already in default. According to Lee Duk Hoon, an academic at the Korea Development Institute, a government think-tank, this will wipe out a large proportion of their equity, leaving their capital-to-loans ratio well below the 8% norm recommen

ded by the Bank for international Settlements. in other words, without further government support the banks will remain vulnerable.

The FSC wants banks to be equipped for creditrisk analysis by the end of this year. Yet Korea Exchange Bank, which has been able to draw on Commerzbank's expertise, has found that the process takes two years. Even if the information systems can be installed quickly enough, there is a shortage of South Koreans with the right skills. Recruiting foreigners instead is not an attractive option, because they would be expensive to employ and, given the politics of the Korean workplace, might find it difficult to assert themselves. If there is to be any change, it will have to be imposed by the FSC. But that will take a superhuman effort. Mr Lee readily admits of South Korea's reforms: "We have the rules, but not the spirit." The regulator has already tried the patience of bankers and businessmen. At one stage he moved into a hotel for his own safety. The FSC will thus have its work cut out to reform the behaviour of the banks, to say nothing of the mess at other lenders and asset managers. The insurers, whichcarry

a large share of loans on their books, are a particular worry. The talk in Seoul is that the bureaucrats may be leaving the banks alone, but they are still asking the insurers to lend money to their business friends.

The growing presence of the chaebol in South Korean finance is also worrying. It is no help if banks discover financial prudence only for big business groups to exploit the non-banks as tame buyers of their paper and sources of cheap loans. Yet most chaebol now own stakes in life insurers, asset managers, "merchant banks" (which specialise in shortterm corporate loans) and so on.

Three grounds for hope

That is why the equity market is so important. Minority shareholders are likely to be the best watchdogs against abuses. There are three encouraging trends. The first is that President Kim Dae Jung's government has lowered the stake required to bring a motion at a company's annual meeting to only 0.01% of total equity, and has brought in a rule requiring public companies to appoint a quarter of their directors from outside. The second is that a growing number of investors in all manner of Korean companies and banks are foreigners, who will not suffer in silence if they think they are being exploited. And the third is that venture capital, from both South Korea and abroad, is becoming increasingly available. When a small biotech firm called Bioneer lists its shares later this year, five or six South Korean thirtysomethings stand to become dollar millionaires. Han Duk Soo, the country's trade minister, puts it this way: "The hardware was prepared last year, this year the software must be put in place." Yet, al

though the legislation and the regulatory powers now exist, creating a, genuinely independent financial system will be a long, hard slog. When South Korean banks drew up a list of their worst clients last year, they failed to include a single significant chaebol subsidiary, because the banks are trained to do the chaebol's bidding. Rewriting South Korea's ,,software" thus means altering the way power is wielded. And that is a job for the politicians.