Financial Crisis and Transformation of Korean Business Groups: The Rise and Fall of Chaebols

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Financial Crisis and Transformation of Korean Business Groups This book argues that the Korean financial crisis of 1997 was due to the inertia of both the business groups known as chaebols and the Korean government, which prevented adaptation to changing external environments. After the Korean government stopped central economic planning and pursued economic liberalization in the 1980s, the transition created a void under which neither the government nor markets could monitor chaebols’ investment activities. Chaebols pursued ambitious expansions that often lacked a strong economic rationale. The intricate web of cross-shareholding, debt guarantees, and vertical integration resulted in extensive cross-subsidization and kept chaebols from shedding unprofitable businesses. The government’s continued interventions in banks’ lending practices created “moral hazards” for both chaebols and banks. This treatment demonstrates how the structure of chaebols, which was once optimal for their rapid growth, later inhibited other adaptations and for all practical purposes became nearly dysfunctional. The book argues that restructuring of chaebols should focus on improving corporate governance systems. After such restructuring, the author predicts, chaebols will reemerge as stronger, more focused global players. Sea-Jin Chang is Professor of Business Administration at Korea University. Previously, he was a faculty member at the Stern School of Business at New York University. He has also held visiting appointments at Stanford University and INSEAD, France. Prior to his doctoral study at the Wharton School of the University of Pennsylvania, he worked for large telecommunication companies in Korea and Japan. Professor Chang’s research focuses on understanding the process of creating operating synergies among diversified lines of business and building a strong local organization after foreign entry. His research has been published in journals such as Review of Economics and Statistics, Journal of Industrial Economics, Journal of Management Studies, and the Academy of Management Journal. He sits on the editorial boards of several leading journals in strategy and international business. He has also written several textbooks in strategy and international business.

To my teachers and colleagues

Financial Crisis and Transformation of Korean Business Groups The Rise and Fall of Chaebols

SEA-JIN CHANG Korea University

   Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo Cambridge University Press The Edinburgh Building, Cambridge  , United Kingdom Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9780521814355 © Sea-Jin Chang 2003 This book is in copyright. Subject to statutory exception and to the provision of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published in print format 2003 - isbn-13 978-0-511-06490-6 eBook (NetLibrary) -  eBook (NetLibrary) isbn-10 0-511-06490-X - isbn-13 978-0-521-81435-5 hardback - isbn-10 0-521-81435-9 hardback

Cambridge University Press has no responsibility for the persistence or accuracy of s for external or third-party internet websites referred to in this book, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate.

Contents

Preface

page ix

1 Introduction From Asian Miracle to Asian Crisis Chaebols: The Korean Business Groups The Theoretical Framework of this Book

1 3 9 24

2 The Evolution of Chaebols The Development of Chaebols in Korea Brief Histories of the Top Five Chaebols The Growth Strategy of Chaebols The Environmental Shift

43 45 62 70 75

3 Chaebols’ Diversified Business Structure The Extent of Chaebols’ Diversification Intragroup Resource Sharing Organizational Structure of Chaebols Diversification and Economic Performance

79 81 87 98 105

4 Vertical Integration of Chaebols The Scope of Chaebols’ Vertical Integration

111 113

v

vi

Contents Motives for Vertical Integration: Pros and Cons Performance Implications of Chaebols’ Vertical Integration

118 123

5 The Capital Structure of Chaebols Financial Market Environments in Korea Capital Structure of Chaebols Chaebols’ Internal Capital Markets and Cross-subsidization Collapse of Chaebols and Financial Institutions During the Crisis

131 133 141

6 Chaebols’ Ownership and Governance Structure Characteristics of the Ownership Structure of Chaebols The Corporate Governance System in Korea Agency Problems in Chaebols

161

7 The Restructuring of Chaebols The Restructuring Policy of the Korean Government Restructuring of the Financial Sector Restructuring of the Corporate Sector Enhancement of the Corporate Governance System Perspectives on the Restructuring of Chaebols 8 Conclusion The Crisis and the Fall of Chaebols: A Summary Business Groups in Other Countries The Taming of Chaebols The Future of Chaebols and the Developmental State

149 157

163 170 176 187 189 191 195 208 212 217 219 224 231 238

Contents

vii

Appendixes 1. Data Used in this Book 2. Comparing the Profitability of Group-affiliated Companies and Independent Companies 3. Profitability of Group-affiliated Firms 4. The Impact of Vertical Integration in Chaebols 5. Determinants of the Capital Structure of Chaebols 6. Profitability and Stock Ownership of Affiliates 7. Intragroup Business Transactions and Ownership Structures of the Top Five Chaebols 8. Key Economic Statistics

299 309

Notes References Index

311 327 345

245 249 264 275 284 291

Preface

The Asian Crisis in 1997 affected almost everyone in Korea. Thousands of companies went out of business, and many workers lost their jobs. Foreign investors fled the country, major banks became insolvent, and the government depleted its foreign reserves as the country went bankrupt. This crisis was financially and emotionally painful for me. I had returned to Korea in 1994. At that time, Korea’s prospects looked bright. Korean firms continued to grow at a phenomenal rate and had expanded aggressively overseas. Every Korean I met was proud of his country, and businessmen were confident that Korea would soon catch up to Japan, which had served as a role model for Korea. As one of the faithful, I sold my stock in U.S. companies and invested the proceeds in Korean firms. Right after the crisis, however, my net worth in dollars had shrunk to one eighth of what it had been. My wife once teased me, asking how a business school professor could be such a lousy investor. Like many Koreans, I was determined to find out who had ruined my country and stolen my pride. The widespread consensus was that chaebols were to blame for Korea’s downfall. Chaebols, which are powerful groups of ix

x

Preface

affiliated companies that helped catalyze Korea’s economic development, have long been admired and criticized. On one hand, people admired them. Korea’s top college graduates lined up to work for them. In downtown Seoul, where the insignias of Hyundai, Samsung, LG, Daewoo, and SK were displayed everywhere, the strength of Korea’s economy was palpable. The chaebol chairmen who managed these empires seemed glamorous. On the other hand, chaebols were the subject of fear, disdain, and resentment. They were blamed for devouring Korea’s resources and squeezing out smaller companies. Newspapers reported many incidents of chaebols making illegal contributions to politicians and receiving favors in return. Foreign governments often charged chaebols with dumping and other unfair business practices. Western businessmen believed chaebols were analogous to cancer cells that grew without purpose and thereby killed neighboring cells before consuming themselves. As I researched chaebols, I learned that they were neither crazy nor irrational. Rather, chaebols had been efficient given their environment. By sharing financial and intangible resources such as brands, technology, and human resources among affiliates, their internal markets had created enormous synergies. Such resource sharing had been the source of Korean firms’ competitive advantage and had enabled Korea’s economy to grow quickly. Yet the Asian Crisis revealed chaebols’ fatal weaknesses. The resource sharing among legally independent affiliates was possible only because chaebols were centralized, and their chairmen wielded immense power. There was no way to guard against the ill-conceived strategies of these chairmen, who pursued diversification that lacked any economic rationale, cross-subsidized unprofitable affiliates, and diverted profits to affiliates in which they and their families owned large equity stakes. All these activities wasted the synergies

Preface

xi

created through resource sharing. The intricate web of crossshareholding, debt guarantees, and vertical integration further inhibited chaebols’ efforts to restructure. During the transition from a state-controlled economy to a market-oriented economy in the years prior to the Asian Crisis, neither the Korean government nor the markets could monitor or guide chaebols’ investment activities. This book argues that wholesale criticisms of chaebols and radical prescriptions for chaebols, such as breaking them up, are wrong. It proposes instead that the Korean government needs to build institutional infrastructures, especially corporate governance systems, which will help markets function better. Other laws that protect minority shareholders’ rights and strictly enforce the Fair Trade Act will make practices such as expropriation and cross-subsidization more difficult and will ensure that chaebols’ investment decisions are sound. At the same time, increased international competition in their home markets will force chaebols to focus on their core businesses. By revamping its corporate governance system and trade policies, the Korean government can unleash the power of hardworking managers and workers, who were a key factor behind Korea’s dramatic economic growth. I have no doubt that when chaebols are reformed, they will once again become strong global players. As I researched and wrote about chaebols during the last five years, I realized how much I had learned – and continue to learn – from my teachers and colleagues. For this reason, I dedicate this book to them as a way of expressing my deep gratitude. Byung-Hyou Chong of the Seoul National University taught me industrial organization economics in college and encouraged me to pursue graduate work. Edward Bowman, Hubert Gatignon, Bruce Kogut, Dan Levinthal, and Harbir Singh of the Wharton School of the University of Pennsylvania were

xii

Preface

exemplary scholars who guided me through my doctoral studies. I am also indebted to my colleagues, who have been always a source of insight and encouragement. Tom Pugel and other colleagues at the Stern School of New York University created an intellectually stimulating environment. My colleagues at Korea University also provided me an environment in which I could concentrate on research. In particular, Linsu Kim helped me start this book project and Dean Jangro Lee of the Institute of Business Research provided me special funding for this research. While writing this book, I benefited from the detailed comments and helpful suggestions of Neil Fligstein, Mark Granovetter, Mauro Guillen, Tarun Khanna, Bruce Kogut, Tom Pugel, Seungdon Oh, Harbir Singh, three anonymous readers for Cambridge University Press, and seminar participants from Stanford University, University of Michigan, New York University, University of British Columbia, and Ewha University. Jaebum Hong of the Korea Information Service and Panseop Lee, Hyeonjung Park, Sekeun Park, and Kyungbae Son of Korea University helped me greatly in accessing and processing data for this work. John Lafkas copyedited the manuscript and provided helpful comments before I submitted it for review. Scott Parris, the editor at Cambridge University Press, and his fellow staff members encouraged and endured me as I prepared the manuscript. They did a wonderful job of turning my work into a book. Last but not least, I would like to thank my family, whose kindness, love, and understanding made this long journey possible.

1

Introduction

1

From Asian Miracle to Asian Crisis from asian miracle to asian crisis Korean citizens will never forget November 21, 1997. People were dismayed by what they heard from the media that day. There had been rumors of skyrocketing foreign exchange rates. Then the minister of finance and economy resigned. ChangRyol Lim, the succeeding minister, immediately announced that he would request funds from the International Monetary Fund (IMF). Korean media kindly added commentaries that their country was about to go bankrupt and was seeking a bailout by IMF. A few days later, Michel Camdessus, the IMF’s managing director, visited Korea to announce that the IMF would assist Korea, provided that the government would restructure Korea’s economy. Koreans were proud of their economic achievements and were shocked by this turn of events. The per capita income in Korea had increased from $82 in 1961 to $10,315 in 1997.1 The World Bank, a sister organization of the IMF, had published a book, Asian Miracle,2 that praised Korea as an exemplar of economic development. Yet something was wrong with the Korean economy. The Hanbo, Jinro, and Kia Groups, all members of Korea’s top thirty business groups, termed chaebols, went bankrupt earlier in 1997. Bankruptcies of large chaebols were unprecedented in Korea because the government had traditionally rescued large chaebols from bankruptcy; most Koreans believed that the bigger chaebols were, the less likely they were to fail. Yet informed citizens knew that these bankruptcies augured a situation that was not “business as usual.” In fact, the “Tiger Economies” of Asia were all on edge. The foreign exchange crisis in Asia, which started with the plummeting of Thai baht

3

Introduction in July 1997, spread quickly to Indonesia and Malaysia within two weeks, and other Asian countries were bracing for the worst. Unstable foreign exchange rates caused a dollar exodus from the region, resulting in sweeping instability throughout Southeast Asia. The Korean government had aggravated this instability by implementing the so-called antibankruptcy agreement after Hanbo, Jinro, and Kia went bankrupt. This agreement effectively blocked banks from demanding payments of overdue debts by already insolvent companies and forced these banks to provide insolvent firms with additional financing. Fearing further losses, commercial and merchant banks in Korea reacted to these policies by recalling loans to other companies that had financial problems. The resulting contraction in the financial market drove additional companies into bankruptcy. Observing these events, foreign investors began reexamining the fundamentals of the Korean economy. They then started withdrawing their funds from Korea en masse, liquidating their investments at a loss and converting them to dollars. Foreign financial institutions also sharply reduced advances to Korean companies and then began calling in their loans to financial institutions in Korea. These actions in turn created even larger contractions in the stock and foreign exchange markets and induced the bankruptcies of larger Korean firms. The Bank of Korea vainly intervened in the market to protect the won’s value, thereby reducing its foreign currency reserves to $5 billion at one point.3 Yet it continued supplying funds to financially troubled banks, which now owed large debts to foreign creditors. Foreign exchange rates soared from 864 won per dollar in January 1997 to 1,695 won per dollar by December 1997 (see Figure 1.1). The Korean stock exchange index tumbled from 669 to 390, and the number of Korean companies that went bankrupt increased from 1,000 per month to 3,500 per month. The Korean 4

From Asian Miracle to Asian Crisis Number of 4,000 bankruptcies

3,500 3,000 2,500 2,000 1,500 1,000 500

Exchange rate (won/$) Stock market index (point)

98 .9 98 .1 1

98 .7

98 .5

98 .3

98 .1

97 .9 97 .1 1

97 .7

97 .5

97 .3

97 .1

0

Interest rate (%)

1,800

20

1,600

18

1,400

16 14

1,200

12

1,000

10 800

8

600

6 4

200

2

0

0

97 .1 97 .3 97 .5 97 .7 97 . 97 9 .1 1 98 .1 98 .3 98 .5 98 .7 98 . 98 9 .1 1 99 .1 99 .3 99 .5 99 .7 99 .9

400

Exchange rate

Stock market index

Interest rate

Figure 1.1. Movements of exchange rates, interest rates, stock market index, and number of bankruptcies. Source: Bank of Korea, Economic Statistics Yearbook.

economy, which had created the miracle on the Han River from the ashes of the Korean War, returned to ashes. The IMF demanded that the Korean government adopt draconian measures in return for the relief fund. It wanted to restore confidence in the Korean economy and to fundamentally 5

Introduction restructure Korea’s financial and corporate sectors. To achieve the first goal, it raised short-term interest rates to 25% and ushered in a floating exchange rate regime. These initiatives resulted in soaring exchange rates, and their effectiveness was questionable. Notable economists, including Joseph Stiglitz, the vice president of the World Bank, and Jeffrey Sachs, publicly criticized the high interest rate policy because it triggered more bankruptcies and insolvencies.4 To achieve the second goal, the IMF pushed the Korean government to reorganize the chaebols. To do so, the Korean government first rescued virtually insolvent banks with an injection of public funds. It then sought to reorganize the chaebols financially by leveraging the banks to help chaebols lower their debt– equity ratio. Second, it forced the so-called Big Deal, which required the chaebols to swap and reorganize their businesses so that each chaebol would focus only on a select few lines of business. Various problems, however, beset this project. Chaebols initially objected to the plan by arguing that it was impractical for them to reduce their debts so quickly. They then tried to politicize the Big Deal to delay being restructured.5 Despite the government’s failure to restructure the chaebols promptly, the Korean economy gradually recovered from the shock of the foreign exchange crisis. The source of the relief was rather unexpected. The Asian economic malaise started to infect first Russia and the South American countries, and then finally even the advanced countries, including the United States. For example, one of the biggest hedge funds in America, Long-Term Capital Management, was saved from the verge of insolvency by the U.S. government in 1998. As the crisis in a few Asian countries began to snowball globally without control, the Federal Reserve Bank of the United States hurriedly lowered the interest rate to cool down the situation.6 Other countries 6

From Asian Miracle to Asian Crisis followed suit. As a result, the exchange rate of the Korean won stabilized at 1,100 won per dollar by the end of 1999, market interest rates decreased to less than 10%, and the stock exchange index surged past 1,000 by the middle of 1999. Further, the Korean government announced in November 1999 that it wished to repay the IMF relief fund ahead of schedule and that additional assistance would be unnecessary. Many have speculated about why Korea got caught in the Asian crisis.7 Some have speculated that the flood of “hot money” heightened the instability of the foreign exchange market and ultimately led to the crisis.8 There is room for debate about how deeply short-term speculative funds contributed to this crisis throughout Asia. Also, the IMF pointed out several mishaps by the Korean government that made Korean financial institutions vulnerable. Until the financial crisis in late 1997, Korea had experienced a long period of rapid growth, low inflation, and a sustained improvement in the standard of living. Prudent macroeconomic policies and high domestic savings and investment contributed to the rapid transformation of Korea into an advanced industrial economy in four decades. The government had begun an economic reform program – which gained momentum in 1993–96 – to gradually liberalize financial markets and the capital account. Capital account liberalization, however, was not well sequenced nor accompanied by the necessary reforms and strong prudential supervision of the financial system. The vulnerabilities of the economy to external events stemming from weaknesses in the corporate and financial sectors were not fully recognized. Controls on short-term external borrowing by 7

Introduction banks were eased, but controls on medium- and longterm capital remained in place.9 The Western popular press and financial community, however, blamed chaebols for being the main culprits of the crisis.10 They argued that chaebols are analogous to cancers that pursued purposeless growth and thereby killed neighboring cells before consuming themselves. The IMF’s assessment was worded more mildly, but it also identified the debt-ridden chaebols with an unholy alliance with financial institutions as the root cause of the crisis: In 1994–96, Korean conglomerates undertook an aggressive investment drive financed by large increases in borrowing from domestic banks, which, in turn, sharply increased short-term external borrowing. During 1997, an unprecedented number of highly leveraged conglomerates went into bankruptcy as the buildup in capacity proved unviable owing to the depreciation of the yen, a sharply adverse movement in Korea’s terms of trade, and the slowing of domestic demand in 1996. The bankruptcies resulted in a severe deterioration in the balance sheets of Korean financial institutions.11 Even now, after the apparent recovery, the crisis raises many questions about how robust Korean economic institutions are. Chief among these institutions is the chaebol, which is a major force in the Korean economy. Some have argued that chaebols drove Korea’s rapid economic growth.12 Could they have caused the foreign exchange crisis? How then, did they come to be the destroyer of their own creation? Several questions may also be raised about foreign financial institutions. Why did they 8

Chaebols: The Korean Business Groups continue providing loans to chaebols prior to the crisis, knowing that chaebols were heavily leveraged? How did chaebols and the Korean economy recover so quickly after the crisis even though they did not change much? Was the crisis an unforeseeable random event where investors and creditors showed a herd reaction? Were chaebols simply susceptible to external turbulence? If so, what is the real problem with the chaebol phenomenon? What are their strengths and weaknesses? Should they be dissolved as argued by the Western critique? Should the Korean government force them to restructure further? If so, what would this restructuring involve? Can chaebols once again continue to grow and prosper? Numerous books look at chaebols. Most focus on how they were formed and their relationship to the government. None, however, pursues chaebols in sufficient depth to show how they operate. This book thoroughly examines chaebols’ internal operations and evaluates their performance prior to the crisis and their subsequent restructuring. In doing so, it offers the broad, in-depth perspective necessary for answering the questions set out earlier. It also considers how chaebols might be restructured and whether they can once again become major players in the world market.

chaebols: the korean business groups The Role of the Chaebol in the Korean Economy As mentioned, a chaebol is a Korean business group. It encompasses many subsidiary firms under the same name. Chaebol originally meant money clique in Chinese and was used to refer to a group with a vast fortune. Some chaebols, such as Hyundai, Samsung, LG, Daewoo, and SK, are well known in the West. 9

Introduction There are many Korean companies with more than two subsidiaries that are controlled by one family, but the Korean government and media typically use “chaebols” to denote the thirty largest Korean business groups. The Korean government annually identifies the thirty largest business groups and publishes a listing of their affiliates under the “Monopoly Regulation and Fair Trade Act” (known as the Fair Trade Act) to block any anticompetitive behaviors. The act defines chaebols’ affiliates as those for which “either more than 30% of whose issued shares are owned by one person, his relatives, or a company controlled by him, or whose management such as appointing its officers is substantially affected.”13 This book uses that definition. Table 1.1 briefly describes their size, the trend of their intra-group business transactions, ownership of shares, and debt guarantees. The chaebols play a critical role in Korean markets. Figure 1.2 shows the portion of the Korean gross national product (GNP) attributable to the thirty largest chaebols from 1985 to 2000. To make these data comparable to GNP data, we calculated the value-added production of chaebols by adding up income before taxes, wages to workers, various financial expenses, and depreciation of all chaebol firms in our database except those in financial services and several small affiliates that were not “statutory audited firms.”14 In 1995, chaebols accounted for approximately 16% of the Korean GNP, and this portion would be much bigger if it included all the chaebols’ affiliates. Figure 1.2 also shows two important trends. First, it indicates that the chaebols’ share of the national GNP increased from 12% in 1985 to 16% in 1995, which proves that the national wealth had been increasingly concentrated into a few chaebols’ hands during the period. Second, it shows that almost all this increase during this time (an increase from about 6% to about 10%) accrued to the 10

Chaebols: The Korean Business Groups % 18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 1985

1987

1989

1991

1993

Top 5 %

1995

1997

1999

2000

Top 6-30 %

Figure 1.2. Shares of Korean GNP held by the top thirty chaebols, 1984–2000.

top five chaebols. There is a big difference between the sizes of the five biggest chaebols and those of the other twenty-five chaebols. In studying the chaebols, we shall thus focus on understanding the operations of the five biggest chaebols – Hyundai, Samsung, LG, Daewoo, and SK. The chaebols are also major global players (Ungson, Steers, and Park, 1997). As of 1997, ten affiliates of the top thirty chaebols made the Global Fortune 500 listing. The chaebols aggressively pursued globalization strategies during the 1990s: they engaged in various kinds of direct investments, mergers, and 11

Business groups

Hyundai Samsung LG Daewoo∗ SK Ssangyong Hanjin Kia∗ Hanwha∗ Lotte Kumho Halla∗ Dongah∗ Doosan Daelim Hansol Hyosung

1997 ranking

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

57 80 49 32 46 25 24 28 31 30 25 18 19 25 20 23 18

#. of affiliate firms

52,821 50,705 37,068 34,197 22,723 15,804 13,907 14,121 10,592 7,753 7,399 6,627 6,289 6,369 5,849 4,214 2,131

Assets (billion won) 67,990 60,113 46,674 38,243 26,640 19,445 8,708 12,001 9,657 7,192 4,443 5,293 3,885 4,042 4,832 2,513 5,477

Sales (billion won) 9,842 13,809 8,302 7,817 4,703 3,102 2,118 2,289 1,244 2,654 1,281 306 1,383 808 1,118 1,075 879

Equity (billion won) 436.7 267.2 346.5 337.5 383.2 409.5 556.6 516.9 751.4 192.1 477.6 2,065.7 354.7 688.2 423.2 292.0 142.4

Debt– equity ratio (%)

Table 1.1. The listing of the top thirty groups in 1997

31.6 28.2 23.7 35.6 21.4 35.4 8.3 33.8 20.2 11.6 7.1 31.0 2.6 15.8 26.4 26.8 14.5

Intragroup trade (%) 102.5 17.6 28.1 129.4 16.8 92.5 385.9 110.8 159.3 20.8 121.4 891.0 202.4 88.1 256.2 50.8 42.1

Debt guarantee/ equity (%) 13.8 3.5 5.4 6.1 14.1 3.6 18.7 20.8 5.9 3.4 2.0 18.8 12.0 13.4 8.8 3.7 13.5

Family ownership (%)

41.6 42.5 34.0 31.2 30.1 37.5 20.3 9.6 26.7 19.4 37.8 30.5 42.2 35.9 25.1 33.2 30.7

Affiliated ownership (%)

17 24 24 13 32 24 15 18 21 7 22 25 25 27

3,698 3,826 3,840 3,653 3,423 2,631 3,398 2,797 2,638 2,599 2,296 2,233 1,139 11,159 3,075 1,391 4,134 2,521 3,154 1,847 2,715 2,279 1,984 1,277 1,058 2,114 1,210 11,864 1,161 99 919 529 946 646 448 211 456 384 513 432 362 2,328

218.5 3,764.6 317.8 590.5 261.8 307.3 658.5 1,225.6 478.5 576.8 347.6 416.9 214.6 600.7 6.3 8.6 7.7 50.5 7.2 16.4 8.9 28.3 55.9 6.8 22.1 26.5 16.9 21.2 56.1 473.3 84.8 80.3 92.8 91.9 57.0 172.5 361.3 215.8 354.3 150.4 300.1 173.5 15.6 16.6 7.6 8.5 12.8 4.8 3.9 36.4 9.8 11.2 17.4 15.7 9.9 8.5 32.5 28.3 36.5 30.8 33.2 44.0 24.9 62.3 32.0 25.2 41.5 36.2 23.3 33.7

Notes: 1. * denotes firms either bankrupt or under the bank-sponsored workout program as of December 1999. 2. The group-level sales, asset, equity, debt–equity ratio, intragroup trade, and debt guarantees include nonfinancial services companies only. 3. The average family ownership and cross ownership figures are the weighted average of the top thirty chaebols with the equity capital of individual chaebols as the weighting factor, following the FTC convention. 4. Hanbo Group went bankrupt in early 1997 and was therefore excluded in the FTC listing of the top thirty groups. Source: Fair Trade Commission and Korea Information Service.

18 Dongkuk 19 Jinro∗ 20 Kolon 21 Kohap∗ 22 Dongbu 23 Dongyang 24 Haitai∗ 25 Newcore∗ 26 Anam 27 Hannil∗ 28 Keopyung∗ 29 Miwon 30 Shinho∗ Top 30 average

Introduction acquisitions throughout the world. For example, Samsung, LG, and Hyundai all enlarged their semiconductor production capacities and acquired such American companies as AST Research, Zenith, and Maxter, respectively. Daewoo Motors acquired FSO of Poland and constructed large auto manufacturing plants in India, Uzbekistan, and Romania. The Performance of Chaebols Prior to 1997 Although “hot money” and inappropriate government policies contributed to the crisis in Korea, the chaebols’ performance had greatly deteriorated before the financial crisis began. Chaebols were thus vulnerable to external events. Figure 1.3 shows that the profitability of the thirty largest chaebols, gauged by the return on invested capital (ROIC), had fallen steadily since the mid 1980s. The ROIC is defined as the sum of net income before tax plus interest payments, deflated by total assets, to provide a return metric that is comparable across firms. This measure of performance assesses operating efficiency without being biased by the relatively high debt–equity ratios common in Korean firms. The higher profitability of the chaebols during the late 1980s was due primarily to external factors such as low oil prices, low interest rates, and undervalued currency. In many cases, chaebol affiliates were not profitable enough to cover even their financing cost, which is calculated by dividing interest payments by interest-bearing liabilities. This statistic suggests that many affiliates were very inefficient. The figure also shows that the profitability of the top thirty chaebols was quite low relative to firms in other countries.15 The top thirty chaebols were sometimes less profitable than were smaller groups and independent companies, although the statistical analysis in Appendix 2 indicates that this difference 14

Chaebols: The Korean Business Groups 12.00 (%)

10.00

8.00

6.00

4.00

2.00

0.00 1985

1987

1989

1991

ROIC

1993

1995

1997

1999

Financial Expense

Figure 1.3. The profitability of chaebols, 1985–2000.

may be due largely to industry factors and various internal transactions. Many chaebols were in low-profit industries such as heavy equipment and chemical industries, which had chronic overcapacity. Because chaebols often used cross-subsidization through various forms of international transactions, it is hard to compare the profitability of chaebol and nonchaebol firms. Figure 1.3 also shows that the profitability of chaebols declined during the 1990s. 15

4,500

1,600

4,000

1,400

3,500

1,200

3,000

1,000

2,500 800 2,000 600 1,500 400

1,000

Real wage (thousands won)

Outgoing Foreign Direct Investment (million $)

Introduction

200

500

91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00

90

19

89

19

88

19

87

19

19

19

19

86

0 85

0

Year Outgoing foreign direct investment

Real wage

Figure 1.4. Real wages of Korean workers and outgoing foreign direct investment. Source: National Statistics Office.

There are three apparent reasons for this decline. First, Korean companies became uncompetitive in both low-end and high-end exports. After economic liberalization in the early 1980s, labor disputes intensified. As a result, Korean workers’ real wages doubled between 1985 and 1995 (see Figure 1.4), thus making Korean exports less competitive than were their equivalents from developing countries such as Indonesia and China. To make things worse, the Korean won was overvalued. Figure 1.5 displays the trends of the exchange rates for the won and the Japanese yen, as well as the surplus/deficit on capital and current accounts. Many Korean products directly or indirectly compete with Japanese counterparts in the world market. The sharp appreciation and eventual overvaluation of the Japanese yen against the U.S. dollar during the late 1980s generated huge 16

Chaebols: The Korean Business Groups Exchange rate

Balance of payments (U.S.$ million)

250

50,000 40,000

200 30,000 20,000

150

10,000 100

0 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 -10,000

50 -20,000 -30,000

0 Current Account

Capital Account

$/W(1985=100)

$/¥(1985=100)

Figure 1.5. Korean exchange rates and trade and capital accounts, 1985–2000. Source: Bank of Korea, Financial Statistics Yearbook.

trade surpluses for Korea and an economic bubble. In response, the Korean government liberalized foreign travel and foreign capital exports to reduce the amount of trade surpluses during the same period. This initiative induced extravagant foreign travel and conspicuous consumption, both of which decreased Korean trade surpluses during the first part of the 1990s. Korean companies, however, were forced into cutthroat price competition against Japanese companies during the mid 1990s. Such competition was exacerbated by the relative stability of the won and the sharp depreciation of the yen. Korea’s trade deficit therefore increased drastically during 1994–6. It was covered only by surpluses in Korea’s capital balance, which barely maintained the stability of the foreign 17

Introduction Labor productivity, Capital/Labor ratio

Capital productivity 0.7

250.00

0.6 200.00 0.5 150.00

0.4 0.3

100.00

0.2 50.00 0.1 0.00

0 1985

1987

1989

Capital/Labor ratio

1991

1993

1995

1997

Labor productivity

1999

Capital productivity

Figure 1.6. Chaebols’ capital investment.

exchange market. Capital balance surpluses, however, meant increased borrowing of foreign capital. The influx of short-term foreign capital into the Korean stock market was conspicuous during this period, and banks and other financial institutions in Korea were financed by the increasing funds from foreign financial institutions. The won’s value did not depreciate in this period only because of this influx of capital. Ultimately, though, the vicious cycle between the trade deficit and debt helped induce the exchange crisis. The exodus of foreign capital that occurred in late 1997 was the final blow to the won. Second, chaebols responded to the wage hike and the won’s overvaluation by increasing capital expenditures for both factory automation and factory construction overseas. Figure 1.6 illustrates the inflation-adjusted capital productivity, labor 18

Chaebols: The Korean Business Groups productivity, and the degree of capital intensity of chaebol companies as a whole for 1985–2000. The capital productivity was calculated by dividing the chaebols’ value-added production by their total amount of tangible fixed assets. The labor productivity index was calculated by dividing the value-added production by the number of total employees. The capital intensity is measured by the total amount of tangible fixed assets per employee.16 The relationship between these values is established by the following equation: Labor Productivity = Capital Productivity × Capital Intensity The indices of capital and labor productivity let us infer how much chaebols invested in fixed equipment such as factory and machinery and how much they benefited from these investments. Figure 1.6 shows that labor productivity, a concept similar to per capita GNP, increased continuously from 1985 to 2000. Capital productivity declined dramatically, however, because of the skyrocketing capital intensity of chaebol companies during the 1990s. Chaebols also aggressively built factories worldwide and increased their importation of technology and capital goods. Figure 1.4 shows the trends of wage rates and foreign direct investment. Korean firms stepped up foreign direct investment in 1990s. Chaebols’ short-run profitability and cash flow suffered because of these investments whose benefits could be reaped only in the long run. These trends are consistent with Krugman’s argument that the Asian miracle is the result of large inputs of capital and labor rather than productivity growth.17 Third, as we will discuss further in Chapter 3, chaebols engaged in unrelated diversification even when doing so was economically unviable. For example, the auto industry was plagued by overcapacity, especially after Hyundai and Kia increased 19

Introduction their capacity to deter Samsung from entering the industry. Hanbo Group, which ultimately went bankrupt, made economically unviable investments in minimill technology. Jinro went bankrupt after rapidly expanding its retailing businesses while relying on bank loans. Chaebols’ pursuit of unrelated diversification did not dwindle even during the economic downturn in the 1990s. The top thirty chaebols became more focused only after the crisis hit them in 1997.18 Such careless investments lend credence to criticisms that chaebols pursued growth relentlessly. Here, several questions arise. Why did chaebols expand in irrational ways? Why were there no control mechanisms in place that would have guarded against such risky investments? What happened to the Korean government, whose prudent guidance was considered crucial to Korea’s economic growth? What role did the banks play in evaluating investment projects? The next section reveals that there was no functioning governance system to guide chaebols’ investment activities. The Korean Economy in Transition Korea was experiencing a major transition to its economic system prior to the crisis. Among the elements that help define an economic system are the governance system, property rights, and rules of exchange it employs (Fligstein, 2001). In this book, we define the governance system broadly as institutionalized economic processes that organize and coordinate economic activity among organizations in the economy. Thus, markets, corporate hierarchies, networks, and the government itself are some specific forms of governance systems (Campbell and Lindberg, 1990). On the other hand, the corporate governance system, which is a central focus of Chapter 6, refers more specifically to firms’ internal organization and power structure, which 20

Chaebols: The Korean Business Groups encompass the functioning of the board of directors, the ownership structure, and the interrelationships among senior managers, shareholders, and other stakeholders such as the company’s workforce and creditors (Hopt et al., 1998). Governance systems and corporate governance systems differ by country. The U.S. governance system is largely market-based, and the government is not very involved in it. On the other hand, labor plays an important role in Germany’s governance system.19 In Korea, the government played a major role in the governance system as the economy developed. It tightly controlled capital allocation, as we will discuss in detail in Chapter 2, by designating several “strategic” industries and allocating capital to them at favorable rates. It also nationalized all banks and tightly controlled foreign sources of capital. Further, it assessed the performance of individual companies and rewarded successful ones by allocating more funds to them (Amsden, 1989). By doing so, it supplanted the market-based economy. By the early 1980s, however, it was uncertain whether the government could manage the economy as it had in the past. As the economy matured, the private sector had become more complex. Further, since the government had regarded the heavy equipment and chemical industries as “strategic,” its credibility was eroded after firms in these industries did poorly during the 1970s. At the same time, foreign pressure, especially from the IMF and World Bank, which in turn were heavily influenced by the U.S. government, to open up Korean markets intensified. The government finally stopped directly subsidizing businesses and pursued deregulation and economic liberalization. The transition from a state-based system to a market-based system, however, was neither well planned nor well executed. For example, while privatizing the financial services industry and easing foreign exchange controls, the government paid no 21

Introduction attention to providing institutional infrastructures that were necessary for the capital market to function properly. Here institutions denote formal constraints such as rules, laws and regulations, and informal constraints such as norms of behavior, conventions, self-imposed codes of conduct, and enforcement mechanisms, which structure human interaction to reduce uncertainty in exchange and provide incentives (North, 1991, 1994). Without institutions, markets neither develop nor function properly. For instance, during this transition, the government introduced no explicit mechanism to monitor the financial health of financial services institutions (Fields, 1995). Although chaebols either acquired or set up nonbanking financial firms and tapped their reserves as if they owned them, the government did not effectively guard against such abuse. During the 1990s, the government also deregulated access to the international capital markets. Banks and nonbank financial affiliates of chaebols were free to borrow from foreign banks and issue bonds. Yet the government continued to dictate banks’ lending practices and thereby prevented the private financial service sector from developing (Amdsen and Euh, 1993; Woo, 1991). Even after privatization, around 60% of bank credit in 1985 was lent for government-designated purposes.20 Often, the top management positions of commercial banks were filled by ex-Ministry of Finance officers. The ministries and the politicians could also influence the lending decisions, and thus created ample opportunities for crony capitalism. In short, Korea’s banks were heavily controlled even after they were privatized. By abrogating its role in developing institutional infrastructures, the Korean government helped undermine Korea’s economy. The chaebols’ investments during the 1990s clearly showed that no functioning governance system was in place. Such investment would not have been possible in the 1960s 22

Chaebols: The Korean Business Groups and 1970s when the government allocated capital to businesses and monitored their performance. Nor would it have occurred if capital markets, creditors, and shareholders could evaluate the soundness of these investments. In a sense, this crisis resembles those that swept Latin American countries such as Chile, Argentina, and Uruguay in the early 1980s. In each of these nations, under pressure from the IMF, the government ignited currency and debt crises by deregulating the economy without establishing an appropriate regulatory framework (Galvez and Tybout, 1985; Corbo, de Melo, and Tybout, 1986; Banuri, 1991; Khanna and Palepu, 2000). Mexico and Brazil, which also pursued economic liberalization, experienced currency crises in 1994 and 1999, respectively (Fernandez Jiberto and Mommem, 1996; Baer and Love, 2000). After years of import substitution development strategies that relied heavily on extensive government intervention, all these countries liberalized by both removing various controls on prices, trade barriers, and constraints on capital flows and privatizing state-owned firms, including financial service firms. Domestic firms tried to capitalize on the opportunities created by this rapid deregulation and privatization by borrowing from foreign creditors. Business groups in Chile, in particular, acquired banks and used their funds to acquire companies that were being privatized (Tybout, 1986). Debt and foreign exchange crises swept these nations when the firms that borrowed from foreign creditors could not pay their loans. The governments had to bail out failed banks by injecting massive public funds. The importance of institutional infrastructure is further demonstrated by the recent privatization experiences of Eastern European countries. Unlike the prescriptions by market liberalists, markets in these countries did not develop automatically when governments deregulated their nations’ economies. 23

Introduction Russia’s and the Czech Republic’s privatization efforts, which involved little effort to build institutions, failed. Managers and controlling shareholders of many privatized firms stripped these companies’ assets. They left poorly informed minority shareholders with worthless pieces of paper and firms teetering on the edge of bankruptcy (Stark and Bruzst, 1998: Dyck, 1999). In contrast, Poland allowed regulatory mechanisms that safeguarded the operations of financial markets to be developed at the same time it liberalized its economy. Its privatization efforts were relatively successful (Kogut and Spicer, 2002).

the theoretical framework of this book Chaebol as a Universal Phenomenon The chaebol may seem peculiar to Korea. Yet it is similar to organizational forms found throughout the world. These forms are different from country to country and reflect distinctions in economic, social, and cultural environments, but they share common features in the ways they enable business groups, such as conglomerates in the western hemisphere, Japanese zaibatsu and keiretsu, grupos economicos in Latin American countries, and business houses in India to pursue unrelated diversification under centralized administrative control. First, chaebols share many traits with the conglomerates of the United States and Europe. Both pursued unrelated diversification. They are different, however, in that affiliates of chaebols are bound with each other by cross-shareholding and mutual debt guarantee practices, even though they are legally independent, while business divisions within conglomerates are legally part of the same organization. Many underperforming U.S. conglomerates disappeared during the restructuring boom of the 24

The Theoretical Framework of this Book 1980s, although GE remains a conspicuous exception to this trend. Conglomerates also exist in Europe. Although many pre– World War II konzern in Germany were separated into many individual companies, groups such as Daimler-Benz and Siemens grew by diversifying their businesses. France has also a long tradition of conglomerates, many of which organized into holding companies. Many new conglomerates in France were created during the nationalization and reprivatization of Mitterand’s government.21 Unlike chaebols, however, the conglomerate is not usually subject to the influence of strong family owners and does not pursue vertical integration nearly as much as chaebols do.22 Chaebols are also distinct from conglomerates in their use of general trading companies to control and orchestrate other affiliates toward the export market. Figure 1.7 shows a schematic description of chaebols. Korean chaebols also are strikingly similar to the pre–World War II Japanese zaibatsu. Chaebol and zaibatsu literally share common Chinese characters in their nomenclature. Chaebols were heavily influenced by the zaibatsu and have operating characteristics similar to those of the zaibatsu. Families owned the holding companies of the four biggest zaibatsus – Mitsubishi, Mitsui, Sumitomo, and Yasuda. These holding companies practically controlled many other affiliated companies by equity ownership (Hadley, 1970). At one time, the production of these four zaibatsu amounted to 25% of Japanese GNP (Imai, 1987). In addition, trading companies within each group purchased raw materials and sold final products for their affiliated companies, and financial institutions within the group provided necessary funds to the companies. Almost every Japanese zaibatsu was formed during the Meiji Renovation Era, during which the Japanese government granted sizable benefits to a small class of capitalists to establish capitalism, and they 25

equity

equity

Figure 1.7. Schematic figure of chaebols.

parts supplier small affiliates

equity

Insurance/ Merchant Bank

equity equity

new ventures

direct family ownership

shipping company

indirect ownership through cross-shareholding

General Trading Companies

service providers

loan debt guarantee

equity

loans, debt guarantee

unrelated diversification

loans, debt guarantee

debt guarantee

parts supplier

loan

Major Industrial Companies

parts supplier

Vertical Integration

equity

Family

The Theoretical Framework of this Book accumulated great wealth under the government policy of supporting military-related industries. A few years after the defeat of Japan in World War II and the formal dissolution of the zaibatsu, ex-zaibatsu affiliates reorganized themselves to facilitate voluntary cooperation (Gerlach, 1992). These affiliates called themselves keiretsu and had a group membership structure similar to that of zaibatsu. Although no one family controls a keiretsu, affiliates within a keiretsu voluntarily swapped stock shares with each other and intensified internal transactions among themselves. The affiliated companies and the keiretsu concentrated their scarce resources into the industries designated by governmental industrial policy as strategic. Naturally, they formed strong bonds among themselves around a bank. The postwar Japanese government also assisted the growth and formation of keiretsu with various industrial policies. The keiretsu is different from the zaibatsu and the chaebol in that there is no formal control mechanism on individual affiliates. Chaebols do not have the network-type organization that keiretsu do, although recent restructuring efforts to promote independence of affiliate companies have tried to transform them into that direction.23 Rather, precrisis chaebols are most accurately described as multidivisional structures, in which individual affiliates function as business divisions despite their legal independence, while the intricate web of cross-ownership and debt guarantees among affiliates simply reflect the maximum utilization of external sources of capital with minimum injection of equity capital by chaebol families. We will discuss the financial structures of chaebols further in Chapters 5 and 6. Business groups similar to chaebols are more frequently observed among developing countries.24 The “Salim Group” of Indonesia and “CP Group” of Thailand are examples of similar organizations in Southeast Asian countries. Other examples 27

Introduction include grupos economicos in South American countries, which grew while their home governments pursued import substitution policies (Guillen, 2001). Business groups in Eastern Europe and China that emerged during the recent privatization process also bear similarities to chaebols. For instance, during the rapid privatization in the Czech Republic, various forms of crossownership among banks and investment trust funds were formed, and many of those investment trust companies turned themselves into holding companies (Coffee, 1999). Similarly, Stark (1996a) showed how previously state-owned firms in Hungary purchased small firms and formed groups on their own.

Theoretical Framework Conventional Theories on Business Groups There has been extensive research on business groups. This work can be roughly classified into three major categories. First, economists generally conceive the business group phenomenon as a result of market imperfections prevalent in developing countries. According to Leff (1978), in such countries, business groups perform several functions. First they provide access to capital and information, neither of which flows naturally in underdeveloped markets. Second, the unrelated diversification of business groups provides an alternative to portfolio diversification when markets for risk and uncertainty are absent. When the purchase of shares of stock in other companies is either impractical or impossible for chaebol families, they are forced to diversify the group itself to distribute risk and manage their portfolio more securely. Third, vertical integration provides a solution to the problems of bilateral monopolies and oligopolies that stem from imperfect intermediary goods markets. Recently, Khanna 28

The Theoretical Framework of this Book and Palepu (1997) echoed Leff by arguing that business groups such as chaebols replace poorly performing or nonexistent economic institutions (e.g., banks or external labor markets) that are taken for granted in developed countries. For example, creating an internal capital market is unnecessary and redundant if the banking system is well developed. There is also no need to utilize the internal labor market if the demand is met by a sufficient supply of high-quality personnel such as MBA graduates or technicians. The second line of research points out that active market interference by governments of developing countries has also greatly impacted the creation of business groups. Korea pursued an unbalanced growth strategy by focusing its resources on a few sectors that its government deemed “strategic” (Gerschenkron, 1962; Hirshman, 1958; Johnson, 1984). Amsden (1989) and Kim (1997) described how effectively the Korean government used chaebols as a way to “catch up” with more industrialized nations. Chaebols capitalized on government subsidies to grow, as is analyzed further in Chapter 2. The Japanese government’s support clearly was essential to the rise of both zaibatsu and keiretsu (Hadley, 1970; Johnson, 1982). Business groups in other developing countries have resulted from government interventions. For instance, import-substitution industrial policies pursued by Latin American countries induced the formation of business groups, which exploited their political contacts and access to the local markets by forming alliances with foreign multinationals (Evans, 1979; Guillen, 2001). Thus, some differences between business groups in different countries are merely a result of distinct patterns of government intervention, which further distort already imperfect markets in developing countries.25 Accordingly, the formation and growth of these business groups cannot be viewed in isolation from national 29

Introduction circumstances. Chapter 2 will deal with these issues in greater detail. The third line of research points out that business groups such as chaebols are socially and culturally embedded in the specific countries where they operate (Granovetter, 1995; Evans, 1995; Orru et al., 1997).26 According to this view, Korean firms enact a patrimonial logic, which is deeply rooted in the history and culture of Korea and expresses itself in the relationship between the state and businesses, between employers and employees, and within Korean families. Guillen (2001) extends this view that business groups should be conceived as a resource, not an obstacle, for a country’s modernization. He maintains that large, hierarchical organizations such as chaebols may be the most efficient organization form in mass production industries, such as those in which Korea holds competitive advantages. These three perspectives are useful in understanding why business groups such as chaebols are prevalent in developing countries. Indeed, chaebols are the creatures of market inefficiency, government intervention, and the sociocultural environment of Korea. Those three perspectives, however, do not help us understand how business groups evolve and why they persist over time. The economic approach would lead us to conclude that business groups would naturally disappear as an economy develops and market imperfections disappear. It fails to explain how markets develop over time. It is possible that the dominance of business groups deters the development of markets. For instance, chaebols’ dependence on internal capital and labor markets may obviate their need for external markets. The late development theory and the state intervention perspective do not help us understand how long state intervention should continue and whether it remains effective as the economy 30

The Theoretical Framework of this Book develops. Evans (1995) argued that it is possible that the developmental state could continue even after the economy matured. Kim (1997), however, discussed how the developmental state of Korea lost power to the private sector, especially to chaebols. Furthermore, the state interventionists do not discuss whether the transition from a state-controlled economy to a market-based economy is smooth. Several works that have examined the privatization of Latin American and Eastern European economies suggest that such transitions are often difficult and hazardous (Stark and Bruszt, 1998; Coffee, 1999; Kogut and Spicer, 2002). The perspective that emphasizes the sociocultural environment of each country, on the other hand, neglects the pressures of global convergence. These researchers tend to focus only on the national-level institutional environments that exercise coercive and imitative conformity pressures onto organizations. As globalization progresses, businesses and states alike are under greater conformity pressures to global standards (Meyer et al., 1997). For instance, domestic firms become increasingly more subject to global accounting standards (Jang, 2001). Similarly, shareholder activism, which originated in the United States, has become a global phenomenon as institutional investors diversified their portfolio internationally (Davis and Thompson, 1994; Useem, 1996). Evolutionary Perspective and Structural Inertia To understand why chaebols were instrumental in the early stage of Korea’s economic development and why many became insolvent in the recent crisis, we need a dynamic perspective that places the roles of the markets and the state in the context of changes in external economic and political environments at both 31

Introduction the national and global level. Figure 1.8 summarizes the framework employed in this book. Following the resource-based view (Penrose, 1959; Wernerfelt, 1984) and the evolutionary theory of Nelson and Winter (1982), business groups may be viewed as possessing productive resources and as being engaged in a continuous search and selection process to improve their performance, given their environments. Organizational search denotes firms’ review of current businesses, entrance into new business, and exit from existing businesses to improve performance. Firms’ selection environments, on the other hand, determine their performance and hence the extent to which they expand or contract. The Korean government and the general geopolitical environment in the 1960s and 1970s posed a favorable selection environment to chaebols and were critical in their formation. Amidst cold war politics, Korea could pursue exportoriented development without much conflict with trading partners. The government provided various subsidies to firms in strategic sectors and encouraged exports; at the same time, it protected its domestic markets. The internal capability of Korean firms was based on low wages while importing foreign technologies. To keep this low-cost advantage, the government severely suppressed any kind of labor movement. During the 1980s and 1990s, the political and economic environment turned unfavorable both to chaebols and the country as a whole. The cold war ended and Western countries including the United States, Korea’s closest ally, had trade disputes with Korea and pressured it to open up its domestic markets. External contingencies such as the IMF and the World Bank, heavily influenced by the U.S. government, pressured the Korean government to stop providing direct subsidies to businesses.27 There were also increasing challenges from competitors in emerging 32

Figure 1.8. State and chaebols in transition.

Chaebols

Korean government

Crisis

Global economic and political environment

inertia

inertia

• Competitive advantages based on cheap labor and exploitation of scale economies. • Have become powerful enough to turn regulations to their favor. • Centralized hierarchies. • Affiliates tightly coupled through debt guarantees, cross-ownership, and internal trade. • Cross-subsidization proliferated. • Ineffective corporate governance system created even stronger inertia .

• State bureaucrats became paralyzed during a transition from a state-controlled to a market-based economy. • Continued capital market intervention. • Kept bailing out bankrupt companies. • Created room for crony capitalism.

• Increasing pressures to open up domestic markets and stop government interventions. • Free flow of foreign capital. • Increasing challenges from emerging market competitors.

Introduction economies such as China and south Asian countries, which had lower wages than Korea did. These environmental changes demanded fundamental changes from both the government and chaebols, which were supposed to respond by shifting their focus from imitation to innovation (Kim, 1996). To remain competitive, they had to produce high-quality items with new designs and innovative ideas to compensate for their higher level of wages. The government was expected to transform itself from a developmental orientation in which it micromanaged the economy to a role in which it set the rules and provided a regulatory framework under which markets would develop. It is debatable, however, whether these transformations are easy. Within the field of organization theory, there are two distinct opinions about the ability of organizations and institutions to adapt to changes in their environments. On the one hand, adaptation theorists argue that effective organizations adapt to environmental threats and opportunities, although their abilities to sense and react to those environmental changes may be bounded (March and Simon, 1958; Katz and Kahn, 1966). According to Hamilton and Biggart (1988), enterprise structure represents a situational adaptation of preexisting organizational forms to specific political and economic conditions. On the other hand, organizational ecologists emphasize inertial forces that prevent organizations and institutions from adapting when change occurs in their environments (Hannan and Freeman, 1977). As a consequence of these two conflicting forces, organizational changes are often characterized by “punctuated equilibrium,” which denotes relatively long spans of only incremental changes and adaptations and relatively short periods of reorientation during which there is discontinuous change; strategy, power, structure, and controls are fundamentally 34

The Theoretical Framework of this Book realigned to match the changed environment (Tushman and Romanelli, 1985). Researchers note that sudden shifts in environments or serious deteriorations of performance such as financial crises are often the impetus for reorientation. The Korean financial crisis made it manifest that both chaebols and the government failed to respond to their changing constraints. The transitions of chaebols and the government did not entail the scrapping of the old system and starting from scratch. Rather, the routines and practices, organizational forms, and social ties persisted and functioned as sources of inertia. The inertia of the government can be attributed to the inherent limitations of the developmental state, which focuses primarily on economic development (Johnson, 1982). Evans (1995) argued that Korea was the most successful developmental state since its internally coherent group of elite bureaucrats brought about the autonomy of the state, and the embeddedness of its social networks enabled the government to carry out policies more effectively. These two building blocks, came under fire as the economy matured and globalization intensified. The state lost autonomy as the state elites mixed their interests with those capitalists (i.e., chaebol owners; Kim, 1997). Chaebols, which were the greatest beneficiaries of the developmental state, became the most vociferous protesters of the state’s power and became powerful enough to influence politicians and bureaucrats to turn regulations to their favor. Any reforms that could affect the chaebols’ status quo were blocked, and any rules that block chaebols’ interests were challenged in the name of deregulations and economic liberalizations. Under the name of deregulation, state-owned banks were privatized and chaebols were allowed to set up or acquire nonbank financial institutions. The state bureaucracy also lost its ability to manage the economy. The closed network of the state bureaucracy could not keep 35

Introduction up with the globalized capital markets and fast-paced changes in the private sector. As the economy developed and the private sector gained more resources and know-how, the provision of long-term goals, capital, technology, and indirect support by the government often hindered the vitality of private enterprise by miring firms in red tape. Furthermore, organized labor undermined the authoritarian government and further weakened the developmental state’s ability to implement any changes. Lacking both the internal coherence and the capability to handle the complex nature of global competition, the state bureaucrats became paralyzed and failed to adapt to changing circumstances. As Kim (1997) observed, such a transformation was challenging, as the authoritarian regime broke down and democratization occurred in the late 1980s. There was also no strong leadership at the state level to make the government respond more quickly to the changing global environment.28 The government failed to set up the rules and infrastructure upon which markets could develop. Instead, it kept on meddling in business affairs, particularly those involving banks’ lending practices. It thereby further impeded the development of markets (Woo, 1991). It also continued to rescue near-bankrupt companies. Although many observers wondered why so many chaebols went bankrupt simultaneously during the financial crisis, the more interesting question is why so few went bankrupt before that time. Implicit guarantees by the government toward large chaebols encouraged moral hazards by chaebols themselves, as well as the financial institutions that advanced loans to them. Chaebols recklessly pursued growth, and banks were there to finance their expansion blindly. The absence of functioning governance systems left chaebols completely unaccountable for their actions. Furthermore, 36

The Theoretical Framework of this Book the structural characteristics that chaebols developed during the economic planning period created enormous inertia that further impeded their ability to adapt to the changes they faced. The synergies that chaebols created by developing internal labor and capital markets and thereby overcoming market imperfections were possible only through a centralized control and command structure that concentrated strategic decisionmaking power in the hands of chaebol founders and their families. Without proper governance systems that would ensure the soundness of their investments, these individuals made important decisions that served their own personal interests at the expense of minority shareholders and that were sometimes not even beneficial to themselves. Without any effective corporate governance system in place, cross-subsidization proliferated without control, thus prolonging the lives of unsuccessful affiliates at the expense of more promising ones. The intricate web of cross-debt guarantees, cross-shareholding, and internal business trade made it difficult for chaebols to shed unprofitable affiliates and to focus on core competencies. In addition, the absence of effective corporate governance systems made chaebols resist change even more. Such inertia ultimately contributed to chaebols’ eventual collapse during the financial crisis. Thus, the crisis of 1997 was due to this mismatch between changing the external environments and internal capabilities of both chaebols and the government. This mismatch was caused by inertia of both institutions.29 More fundamentally, these inertias were exacerbated by the lack of functioning governance systems during the economic transition. Although several studies have addressed the limitations of the developmental state in Korea that lead to its inertia,30 little is understood about chaebols’ inertia. This book attempts to fill this research gap 37

Introduction by examining chaebols’ internal operation and evaluating the chaebols’ performance. The Structure of this Book This chapter has provided an overview of chaebols. It discussed their role in the Korean economy and reviewed their decline in performance since the late 1980s. It explained this decline as the result of capital inefficiency and the overvaluation of the won relative to the currencies of Japan and emerging competitors in developing countries. It also pointed out, however, that the most fundamental problem of chaebols lies in the void of effective governance mechanisms as Korea changes from a statecontrolled economy to a market-based economy. It also highlighted similarities between chaebols and organizational forms found in other countries. Although conglomerates in Western countries and the zaibatsu of Japan are somewhat similar to chaebols, companies that are most similar to the Korean chaebol are often found in developing countries. These descriptions form the basis for the accounts of the chaebols’ history and structural characteristics that will be developed in the rest of this book. Chapter 2 fleshes out the historical perspective by considering the growth strategies of chaebols. Consistent with the insights about business groups, it attributes the formation of Korean chaebols to two elements. First, after Japanese imperialism and the Korean War, Korean markets for capital and intermediate goods were imperfect. These inefficiencies compelled chaebols to internalize transactions. In addition, the Korean government intervened in Korean markets from 1961 onward to foster economic development, thus further distorting flawed market mechanisms and inducing more internal growth 38

The Theoretical Framework of this Book by chaebols. This chapter explains the major economic background of postliberation Korea and then briefly depicts the development of the Korean chaebol. It focuses primarily on the five biggest chaebols. In particular, this chapter emphasizes how much the Korean state’s influence has subdued and how powerful the chaebols became prior to the crisis. Chapter 3 details chaebols’ multifaceted business structure and economic performance. Following Chapter 2, it argues that given market imperfections, chaebols might have offered an efficient way to allocate scarce resources and generate synergies between affiliated companies. Korean chaebols shared human resources, brands, and technology among their affiliates and created enormous synergies and prioritized investments by creating a common pool of available funds for affiliates. Such sharing was possible because of the chaebols’ staff organization, which coordinated and fine-tuned the use of shared resources. Such a centralized structure, however, has its own weaknesses. This chapter addresses how such value creation was wasted in illconceived diversification moves prior to the crisis. The ineffective governance system exacerbated such weaknesses. Chapter 4 examines how chaebols used vertical integration and whether they did so efficiently. It argues that chaebols’ use of vertical integration is generally inefficient and proposes that chaebols could increase efficiency by rearranging the vertical relationships among their affiliates. Chaebols’ core manufacturing companies have multiple links to various affiliates that supply parts, and their general trading companies function as distributors to foreign markets. Although vertical integration can reduce transaction costs when the market for the intermediary goods is unstable, it can also create inflexible supply lines within a chaebol and decrease incentives to innovate that might contribute to long-run efficiency. The 39

Introduction costs of vertical integration became more acute in the 1990s when the economy slowed down. Chaebols could not shed inefficient part-supplying affiliates not only because of debt guarantees but also because of their own equity and governance structure. Chapter 5 sketches the capital structure of the chaebols, focusing especially on chaebols’ use of debt. It depicts how the chaebols’ internal capital markets evolved and concludes that the unstable system of chaebol financing, which emphasized the use of debt rather than equity, was a key factor behind the Korean economic crisis. Also, the use of mutual debt guarantees among affiliated companies enabled them to borrow more funds than they otherwise could. Korean banks, which were long deprived of the power and capability to evaluate investment projects, advanced funds only to companies that could secure debt guarantees. The result was a vicious cycle in which the bankruptcy of one chaebol affiliate triggered the bankruptcies of its affiliates until every member of the chaebol went bankrupt. This chapter highlights how much the group-affiliated financial institutions were abused as they supplied capital to their affiliates regardless of their own financial health. Chapter 6 describes the chaebols’ ownership and corporate governance structures. Family members of the thirty biggest chaebols virtually control all group affiliates even though they own only about 8.5% of these affiliates’ total shares. They can do so because of cross-shareholding among affiliates. This type of ownership structure, combined with the underdeveloped corporate governance system, was a second key factor behind the financial crisis in Korea. Family control of chaebols meant that there were few checks and balances to restrict inefficient investment activities. Furthermore, this ownership structure made it possible to transfer secretly the capital and 40

The Theoretical Framework of this Book wealth of one affiliate into another affiliate by artificially manipulating transfer-pricing schemes, for intragroup transactions. Therefore, this chapter suggests that any earnest restructuring effort of the chaebols must begin with the reform of chaebols’ corporate governance structure. Chapter 7 discusses the efforts to restructure Korean chaebols after the foreign exchange crisis and analyzes the effectiveness of these efforts. As discussed earlier, the Korean government supplied commercial banks with public funds, used these banks to restore the chaebols, and attempted to restructure the chaebols. Chaebols have, however, actively resisted more substantial restructuring. The restructuring efforts taken by the Korean government had only limited success because they did not address the fundamental problem of chaebols – the lack of effective corporate governance systems. This chapter concludes that the further corporate restructuring of chaebols should focus most on improving these systems. Chapter 8 attempts to decipher the formation and problems of the chaebols that drove both the rapid economic growth and collapse of Korea. It uses the analysis of the Korean experience, as well as accounts of break-ups of underperforming conglomerates in other countries. This book argues that chaebols are creatures of their environments, and they will not change unless the institutional environments facing themselves change in advance. After the crisis, however, chaebols are under tighter scrutiny from the international financial community. Chaebols have to respond more to foreign investors and creditors because they depend heavily upon foreign capital. These external parties have demanded that chaebols develop transparent accounting procedures, eliminate illegal and improper internal transactions, and enhance the rights of minority shareholders. Such increased pressure from financial markets will make it harder 41

Introduction to divert profits to poorly performing affiliates, and thus enables those firms that perform well to invest further in their core competence. At the end of such restructuring, chaebols will be transformed into loosely coupled networks of core affiliates, which are more focused on their core competencies and voluntarily cooperate with other affiliates on a few selected projects. This chapter concludes with implications for other developing countries, which stress astute governmental policies to cultivate markets and ensure that orderly shifts in power are important to guarantee a smoother transition from a developmental state to a market-based economy.

42

2

The Evolution of Chaebols

43

The Development of Chaebols in Korea This chapter will examine the evolution of chaebols. Chaebols are creatures of their political, economic, and cultural environments, all of which changed dramatically in the last half century. This chapter will focus, in particular, on chaebols’ relationship with the government, which shaped the environments that chaebols faced. From 1945 to 1980, the government helped chaebols grow by subsidizing them and protecting their domestic markets.1 After the government deregulated the economy in the 1980s, chaebols financed their growth internally. We will highlight how chaebols, especially the five largest ones, responded to changes in the government’s policies, and identify how chaebols altered their growth strategies.

the development of chaebols in korea Inception of Chaebols after World War II Korea was once called the country of the morning calm by Westerners. Despite being invaded incessantly by China, Mongolia, and Japan, Korea maintained its independence until the early twentieth century. At that time, Japan, which industrialized early, won its wars against China and Russia and annexed Korea in 1910. During the Japanese occupation, the Japanese government allowed Koreans to own only agricultural and mining concerns and small businesses, while Japanese trading companies controlled all other businesses in Korea. There were, however, some families who built businesses during this period. Sung-Soo Kim established Samyangsa, a spinning and a sugar-producing factory, and once owned a small bank. Heung-Sik Park established a paper manufacturing company, ran a department store, and traded with China and Southeast Asia. Those indigenous business activities, however, remained small.2 45

The Evolution of Chaebols Korean businesses could grow only after the liberation in 1945. After the Japanese left, however, there were institutional voids. All the legal systems, regulations, business rules, and practices that were established and developed by the Japanese no longer existed. The fledgling Korean government was not able to build political, social, and economic institutions swiftly. Moreover, between 1950 and 1953, the Korean War destroyed virtually the entire industrial base built by the Japanese and left Korea divided into two countries, North Korea and South Korea. While it occupied Korea, Japan had concentrated industrial development in northern Korea and used southern Korea to grow crops. Despite these impediments, chaebols did have opportunities to grow between 1945 and 1960. Without any institutions set up, many important government decisions were made by a handful of people. An event that greatly facilitated the development of chaebols was the sale of the assets owned by Japan’s government and firms. Those assets, including factories, production, equipment, and inventory, accounted for 30% of the Korean economy.3 They were initially taken by the government and then sold to individuals. Sales were based not on auctions but on the personal preference of high-ranking government officials. Friends and relatives of these officials thus had the best chance to buy such items (Kang, 1996) and reaped huge windfall profits by doing so since sales prices were based on the assets’ book values. Because inflation at this time was very high, buyers bought assets for only a fraction of their fair market value. Further, buyers had to pay only 10% upon purchase and then pay off the outstanding balance over 15 years without any interest. Chaebols such as Hanwha, Doosan, Samsung, SK, and Hyundai picked up those assets and used them as the foothold for further growth. 46

The Development of Chaebols in Korea Syngman Rhee, the first elected president, concentrated on securing a political foundation to win against the communist North and neglected economic development. The government relied heavily on foreign aid. The only other source of foreign currency was the sale of natural resources such as tungsten and gold. Rhee initiated an import substitution policy and allowed only raw materials to be imported. The Korean won was not convertible to other currency, and the government allocated foreign currency only to those who held import licenses. Such licenses were a key source of profits. In return for import licenses and allocation of foreign currency, established businessmen contributed to Rhee’s political fund. These close ties between the government and businesses enabled some businesses to grow quickly. Samsung, LG, and SK became chaebols during the Rhee regime. Widespread corruption, however, led to the collapse of the Rhee government in 1960, and the subsequent military coup. The Economic Development Plans of the 1960s After the collapse of the Rhee regime, there was a brief period of democratic government, which ended with the military coup by Chung-Hee Park. As a military junta, the Park government was fragile. To achieve legitimacy, the Park government made economic development its top priority. It initially indicted those who collaborated with the Rhee government, including ByungChul Lee, a founder of Samsung Group, but soon realized that it needed to get cooperation from these collaborators to show visible benefits to Korean citizens in a relatively short period of time.4 The government launched a series of five-year plans to achieve such results quickly. During the time of the first (1962–6) and the second (1967–71) plans, it focused on 47

The Evolution of Chaebols export-oriented industries such as textiles and clothing and some import substitute industries such as consumer goods.5 To facilitate development, it fostered a strong, centralized bureaucracy, which had enormous power over resource allocation.6 The choice of an export promotion strategy rather than the import substitution strategy that most Latin American countries used might be attributable to Korea’s lack of large domestic markets and natural resources. With a cheap and well-educated labor force, it was logical for Korea to import raw materials, manufacture goods domestically, and export them to foreign countries. In a sense, Korea closely followed the footsteps of its precursor, Japan. During this time, the geopolitical environment for Korea to emphasize an export-based strategy was favorable. Given the cold war, the United States provided significant aid to Korea and provided a market for Korean exports (Mason et al., 1980). Japan also loaned funds to Korea after the two countries reestablished a diplomatic relationship in 1965. The government thereby set out ambitious targets and allocated foreign loans for investment. It also effectively nationalized all banks by denying them the right to examine the validity of investment projects. Instead, the banks were to raise and allocate funds according to plans established by the Economic Planning Board. Most large-scale investments were allocated to only a few companies selected by the government. Through such means, the government virtually controlled Korean businesses and determined whether they succeeded or failed. It also influenced chaebols’ diversification strategy during this period, as it provided incentives to firms that it believed were able to carry out a project and punished poor performance by stripping firms of specific assets, and letting other companies acquire these properties. As a consequence, the gap between firms that the government selected and firms that it did 48

The Development of Chaebols in Korea not choose widened considerably. Amsden (1989) argued that this policy was efficient and suggested that by performing the resource allocation and governance functions normally done by the market,7 the government spurred Korea’s economic success. In contrast, such government monitoring and intervention did not occur in other countries. Amsden’s argument minimized how much incumbent firms used their political connections to entrench their positions; the rise of chaebols is attributable to more than their relative efficiency.8 The entrepreneurship of chaebol founders such as Ju-Yung Chung of Hyundai Group and Byung-Chul Lee of Samsung Group cannot be overlooked,9 although chaebols at this time enacted the grandiose plans of bureaucrats who selected industries to invest in and allocated funds to appropriate companies.10 To assimilate new technologies, Korean firms initially copied foreign firms’ designs and technology and later relied on licensing and OEM (original equipment manufacturing). The government sponsored research institutions that helped firms with such activities (Kim, 1996). Entrepreneurs became more important only as Korean firms shifted from imitation to innovation. The first two five-year plans are generally regarded as successful. The Korean economy grew at an annual average rate of 8.9 and 11.1%, respectively, during these two periods (Kim, 1997). The government-led economic planning generated several consequences. First, the winner and losers were determined by the government. Capital-intensive industries such as oil refining, fertilizers, synthetic textiles, and cement manufacturing benefited most from these plans. Table 2.1 highlights the rankings of the top ten chaebols, which vary dramatically from the preplanning period to the postplanning period. For example, six chaebols on the top ten list in 1960 were not on it in 1972. The 49

The Evolution of Chaebols Table 2.1. Top ten chaebols in 1960, 1972, 1984, and 1996 Ranking 1 2 3 4 5 6 7 8 9 10

1960

1972

1984

1996

Samsung Samho Kaepung Daehan LG Dongyang Kukdong Hanglass Dongrib Taechang

Samsung LG Hanjin Shinjin Ssangyong Hyundai Daehan Hanwha Kukdong Daenong

Hyundai LG Samsung SK Daewoo Ssangyong Kukje Hanyang Hanhwa Daelim

Hyundai Samsung LG Daewoo SK Ssangyong Kia Hanjin Hanwha Lotte

Source: Korea Fair Trade Commission.

ranking of chaebols stabilized only in the 1980s, when such economic planning officially ended. Second, the allocation of cheap loans substantially raised Korean firms’ debt–equity ratios and induced chaebols to prefer debt. The government used the banks to allocate and guarantee low-interest loans and foreign capital to selected companies in the strategic sectors. Figure 2.1 shows the interest rates and inflation rates during 1960 and 2000. Since interest rates in the so-called export industries were often lower than the actual inflation rates were, securing a loan was equivalent to receiving a subsidy. Firms that could not receive such loans had to rely on the curb market, in which interest rates were very high. Figure 2.2 also shows the trend of debt–equity ratios during the same period. In 1960, the debt–equity ratio was a little over 100%, but it increased to nearly 400% in 1970 and became even higher in later periods. It dropped only after the financial crisis. 50

The Development of Chaebols in Korea %

70

60

50

40

30

20

10

0 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990

inflation (consumer price index) curb market rate

interest rates in the export sector average loan interest rates

Figure 2.1. Trends of inflation and interest rates, 1964–91. Source: Bank of Korea, Financial Statistics Yearbook.

Third, not surprisingly, the government thwarted the development of capital markets by allocating resources. Banks were deprived of their capacity to evaluate investment projects. The government’s implicit guarantee to pay for bad loans encouraged moral hazards and set a precedent for support even after privatization and deregulations in the 1980s and 1990s.11 The government also favored chaebols by blocking foreigners and other domestic competitors from entering strategic sectors. Therefore, incumbent chaebols could gain monopolistic profits. 51

19

61

19

63

19

65 19

67 19

69 19

71 19

73 19

75 19

77

79

19

Year

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

Figure 2.2. Trends of debt–equity ratios, 1960–2000. Source: Bank of Korea, Financial Statistics Yearbook.

0. 0

100. 0

200. 0

300. 0

400. 0

500. 0

(%) 600.0

19

97

The Development of Chaebols in Korea In addition, the government provided various tax credits, preferential tariffs, and loans to firms in strategic sectors even as there was a capital shortage. Further, by privatizing state-owned companies, such as Korean Airlines, in the mid 1960s, it created several chaebols that had political connections. Chaebols’ Foray into the Heavy Equipment and Chemical Industries and the Formation of General Trading Companies in the 1970s The government’s original export-oriented policy encountered problems in the 1970s, however, as labor shortages occurred and real wages increased. The government responded by investing in the heavy equipment and chemical industries because it believed that developing these capital-intensive industries would be more appropriate given the labor shortages. In addition, President Park, who suspended the Constitution and became a dictator, wanted to show some grandiose plans to people and convince them that their country was a rising economic power. Furthermore, the government believed it needed to develop these defense-related industries at this time because the U.S. government indicated that it would no longer defend Korea from invasions by communist regimes.12 Yet Korea did not have capital, technology, or other supporting infrastructure to make firms in these industries economically viable. The big push for heavy and chemical industries were mainly politically motivated (Kim, 1997). During the third economic development plan (1972–6), the government designated steel, petrochemicals, nonferrous metals, machinery, shipbuilding, and electronics as “strategic” industries and subsidized industry participants. Between 1975 and 1979, it allocated 70% of its economic development funds to 53

The Evolution of Chaebols these industries (Kang, 1996). Figure 2.3 shows the total amount of various subsidies as a proportion of GNP. To achieve scale economies, the government allocated licenses to only a few companies. For example, it chose Hyundai and Daewoo to develop power plant facilities and Hyundai, Samsung, and Daewoo to build ships. As a result, from 1971 to 1979, the proportion of heavy equipment and chemical industries to total manufacturing shipment increased from 39 to 55%, while the proportion of exports to GNP increased from 16 to 36%. Although multinational corporations were not allowed to make direct investments in Korea during this period, some industries, including electronics, entered into joint ventures with firms like NEC, Sanyo, and Corning. These ventures facilitated technology transfers to the Korean partners (Woo, 1991; Kim, 1997; Guillen, 2001). The government’s actions during this period seriously distorted market mechanisms. First, firms receiving preferential treatment grew phenomenally, while those that didn’t suffered. In addition, government subsidies induced overcapacity in strategic industries. Second, in pushing chaebols into new industries, the government failed to consider the need for infrastructure from supporting industries. It evaluated comparative advantage only in terms of low wages. Since Korean firms built assembly plants but had no parts suppliers, they had to import core parts and could not create much value added. Later, they had to integrate vertically by establishing affiliates that supplied parts. Third, the oil shocks and the subsequent worldwide recession drove the companies close to bankruptcy. The government bailed them out by writing off loans, providing additional cheap loans, and swapping loans for stock (Woo, 1991). These rescues created a dangerous precedent, as chaebols assumed the government would be always there to pick up the check if they failed. 54

0

1

2

3

4

5

5.09

1.82

1.96

2.8

4.96

5.5

0

0

0

2.33

Deregulation (80-87)

2.93

Export finance Restructuring of bankrupt firms

3rd and 4th planning (72-79)

5.26

Preferential foreign loan Export-related tax subsidies

1st and 2nd planning (62-71)

Percent to GNP 6

Figure 2.3. Estimation of government subsidies during the economic plans. Source: So (1996).

The Evolution of Chaebols The government also set up general trading companies modeled after Japanese sogo shosha to spearhead Korean exports amidst the worldwide economic recession after the oil shock.13 For each dollar of exports, the government allowed trading companies to secure an equivalent amount in loans with an 8% interest rate. Since the average interest rate at that time was 20%, the government subsidized the difference. It also gave general trading companies the license to import various raw materials and exempted them from various taxes. All the largest chaebols set up general trading companies to tap such subsidies and used these ventures as the export windows for their group affiliates. Because the achievement of export targets was directly linked to the actual subsidies, there were enormous incentives to meet those targets, however high they might be. Chaebols thus took over many small companies to add these firms’ exports into their accounts. To increase their exports, the trading companies often sold goods at prices below cost. So long as the subsidies covered their losses, it was to their advantage. As a result, the general trading companies’ share of Korean exports jumped from 12.4% in 1975 to 31.5% in 1979. During this period, the government also began to allow chaebols to advance into nonbanking financial institutions such as insurance, securities, and merchant banking. The ten largest chaebols quickly developed or bought fourteen financial institutions between 1972 and 1978. They used these institutions to supply capital to their affiliates. To sum up, these strategic initiatives had their desired effect; Korea enjoyed rapid economic growth. By 1978, it achieved the government’s targets of $1,000 per capita GNP and $10 billion in exports. Kim (1997) summarized this period as one of a fruitful alliance between the state and businesses. Yet by offering incentives to pursue sales growth rather than profitability, these policies seriously distorted competition in key industries because 56

The Development of Chaebols in Korea they induced overcapacity and low margins. Further, the government’s repeated bailouts of failing companies increased the moral hazard associated with these firms’ investment strategies. Many bailed out firms remained unprofitable and survived only because of debt guarantees and cross-subsidization by affiliate companies. They became insolvent again during the crisis in 1997. Deregulation in the 1980s The Park regime ended abruptly when Park was assassinated in 1979. Another brief moment of democracy was interrupted by a military coup staged by Doo-Hwan Chun in 1980. His regime (1981–8) enacted economic policies that were very different from those of the Park regime. This transition was prompted by shifts in the external environment. First, the IMF and the World Bank pressured the government to reduce government expenditures, tighten the money supply, and pursue economic stability. Korea, at that time, was one of the largest foreign debtors, and the international financial community was concerned about its financial health (Woo, 1991). Furthermore, because of its economic success, Korea became a target of U.S. trade wars. Faced with pressure from the United States, the government had to open up its barriers to imports and foreign direct investment. Second, many companies in the heavy equipment and chemical industries became insolvent. The effectiveness of government intervention was questioned by many, including chaebols (Kim, 1997). Third, the labor movement, which had been suppressed during the Park regime, became more militant in the 1980s. It helped break the authoritarian state, and a direct presidential election was held in 1987. Yet its disputes eroded the lowwage advantage of Korean products and forced Korean firms to 57

The Evolution of Chaebols introduce more innovative products to create another source of competitive advantage. Thus, in 1980, the government came up with a new policy directive that emphasized liberalization and privatization. Although the government set out a fifth and sixth five-year economic plan, it decreased direct financing to business drastically, lowered the inflation rate, eradicated export subsidies, and shifted its attention to welfare issues. The cozy relationship between the government and business therefore soured. Chaebols had grown strong enough to raise voices against the government, which, on the other hand, had tried to tame chaebols. Upon his inauguration, Chun announced several measures to force chaebols to divest a number of their subsidiaries, sell speculative real estates holdings, and lower their debts, but these initiatives had only modest success because chaebols strongly resisted them (Fields, 1995). Later, chaebols fiercely opposed President Tae-Woo Roh’s executive order for them to dispose of their speculative real estates holdings and to focus on three core business areas, and Roh had to rescind this order.14 The only effective measure to curb the power of chaebols was the enactment of the Monopoly Regulation and Fair Trade Act (known as the Fair Trade Act) in 1980. The law designated the top thirty chaebols and put limits on their bank loans, cross-shareholding, and debt guarantees. It is worth emphasizing that executive orders by presidents to curb chaebols’ power never achieved their goals. The law made the real change. Despite these reforms, chaebols were able to grow on their own during the 1980s. In part, they could do so because the financial sector became less regulated. In 1983, the government started privatizing banks. Chaebols purchased large blocks of stock in these banks. Although the percentage of shares they could own was limited (see Table 2.2), their blocks were 58

Choheung Commercial Cheil Hanil Korea Foreign Exchange Kookmin Shinhan Koram Hana Boram Korea Peace Housing & Commercial Daeku Pusan Cheju Chunpuk Kangwon Kyungnam Chungbuk Long-term credit

Nationwide Commercial Bank

Note: As of December 1997, % of ownership. Source: Ministry of Finance and Economy.

Government-owned

Regional Banks

Chaebol

Bank

0.12

11.89

0.37

2.02 0.42

1.24 0.97 0.16 2.73

Hyundai

Table 2.2. Chaebols’ ownership of commercial banks

3.05 6.91 0.18 4.9 1.24 0.96 3.49 18.56 3.61 1.16 1.28 0.55 5.3 1.31 2.17 1.5 1.54 2.68 0.92 5.31

Samsung

0.21 0.82

18.56

0.42

Daewoo

1.82

0.63

7.57 0.73

0.4

0.19 2.48

LG

0.67

0.24 0.92

0.44 0.48

SK 4.29 7.88 0.53 10.11 1.68 4.28 3.91 37.12 3.61 9.18 4.12 0.55 5.3 1.31 2.17 1.5 14.06 2.68 0.92 7.92

Top 5 chaebols

The Evolution of Chaebols large enough to let them influence the banks’ lending decisions. During the Roh regime (1988–93), which followed the Chun regime, there was a de facto elimination of the limits on ownership of nonbank financial institutions such as insurance, investment trust, securities, and merchant banking firms. Such institutions became a key source of the chaebols’ capital, as chaebols purchased controlling shares of stock in them. Table 2.3 shows the extent of chaebols’ ownership in nonbank financial institutions. Through both direct and indirect means such as mutual debt guarantees, which will be discussed in Chapter 5, chaebols used their control over financial institutions to secure far larger loans from these institutions than was economically justifiable. With their in-house financial service arms, chaebols handled daily cash flow problems and bypassed the official banking system, which was still under government influence. By doing so, chaebols became independent from the government, although they were probably not strong enough to overpower it. With its control over commercial banks, the government still retained enough power to disband the Kukje Group in 1985, when this entire group of affiliates went bankrupt, and to sell these affiliates to other chaebols.15 Also, chaebols could prosper without governmental support in the 1980s because they had a favorable external environment. As the yen appreciated after the Plaza Accord in 1985, Korean exports became much more competitive. Low interest rates and low oil prices made the general economic environment even more favorable. Thus, chaebols were able to self-finance their growth during this period. Kim (1997) described how the relationship between the government and businesses shifted from a cozy symbiosis in the 1970s to an overt conflict over control of the economy by the 1990s.

60

2 – – 1 – 6 9

Note: As of December 1997.

Total

Top 5

Hyundai Samsung Daewoo LG SK Top 6–30

Merchant bank 2 1 1 1 1 5 11

Securities – 1 1 1 – 2 5

Investment trust – 1 1 – 1 5 8

Life insurance 1 1 – 1 – 3 6

Indemnity insurance

Table 2.3. Chaebols’ ownership of nonbank financial institutions

Total 7 7 6 7 3 46 76

Other financial services 2 3 3 3 1 25 37

The Evolution of Chaebols Liberalization and Globalization of the 1990s As the chaebols’ prominence in the economy increased, they became powerful enough to vie for political influence. This trend was epitomized when Ju-Yung Chung, the late chairman of the Hyundai Group, ran in Korea’s presidential election in 1992. Chaebols also tried to bribe politicians and government officials. In 1994, several chaebol chairmen publicly acknowledged illicit contributions of political funds to Chun and Rho. The state bureaucrats who Evans (1995) argued were critical to Korea’s early economic success were no longer a coherent force. Chaebols were no longer passive subjects of the government’s intervention, but instead actively participated in attempts to turn the regulations to their favor. In several cases, chaebols openly defied government policies and even derided them. In 1988, Chairman Kim of the Daewoo Group threatened to let Daewoo Shipbuilding, a formerly state-owned company, go bankrupt unless the government would provide additional funding. The government, which initially refused to accede to such a blatant demand, eventually provided these funds. In 1995, Chairman Lee of the Samsung Group infuriated Korean officials as well as President Young-Sam Kim by openly denouncing the Korean government as being third-rate. Although Chairman Lee later apologized, the fact that he felt free to make this comment revealed the decline of the government’s power. Under the Kim government (1993–8), privatization and deregulation further accelerated. The Kim government supported both deregulation and globalization. It did so in response to continued pressure from the international capital markets and from the chaebols themselves. Chaebols were free to issue bonds and stocks in overseas markets. Banks were also free to borrow short-term money from international capital markets. Thereby, 62

Brief Histories of the Top Five Chaebols foreign supplies of funds to Korean enterprises and financial institutions rapidly increased. In general, virtually all the currency flowing into Korea eventually went to chaebols, which were actively investing in capacity in both domestic and international markets. This mismatch between short-term liabilities and long-run investment contributed to the foreign exchange crisis of 1997, as we will discuss further in Chapter 5.

brief histories of the top five chaebols Hyundai Group Hyundai is the largest chaebol. In 1997, it had fifty-seven affiliates, assets of 52 trillion won, and sales of 67 trillion won.16 Hyundai Group is in many industries, including construction, automobiles, shipbuilding, heavy equipment, retailing, and financial services. Hyundai’s founder, Ju-Yung Chung, started his career as a clerk in a small store selling rice and worked for a motor repair shop. In 1950, he established Hyundai Construction Company. Hyundai Construction worked on construction projects for the U.S. Armed Forces during the Korean War and accumulated a large sum of capital. Hyundai continued growing as it participated in the country’s infrastructure projects, including dams, bridges, and highways. Eventually, it expanded into overseas markets. Hyundai’s growth peaked during the first two economic development plans. In 1967, it established Hyundai Motor and licensed auto-assembly technology from Ford. Hyundai Motor brought in parts from Ford and assembled cars in Korea. It developed its own car in 1976 and started exporting to Canada, the United States, and other countries. In 1973, Hyundai established Hyundai Heavy Industries and started shipbuilding. 63

The Evolution of Chaebols In the 1970s, Hyundai Group pursued vertical integration. The construction, automobile, and heavy equipment industries needed various parts and suppliers. During this time, Hyundai established many affiliates in upstream operations. For example, Hyundai Cement provided cement, Hyundai Pipe provided building chassis, Dongsuh Industries provided concrete and tiles, and Livart made furniture for Hyundai Construction. Hyundai Heavy Industries, which concentrated on shipbuilding, worked with Hyundai Engines, Hyundai Electric Machinery, and Hankuk Flange to provide various components for ships. Also, Hyundai Motor had other subsidiaries such as Hyundai Precision and Kepico that supplied a variety of components. During the 1980s, Hyundai pursued unrelated diversification. First, it established the Hyundai Department Store, which generated good cash flow for Hyundai Group. It also acquired several securities companies (Hyundai Securities, Hyundai Investment and Trust) and insurance (Hyundai Marine & Fire Insurance) to procure sources for funding. In addition, it diversified into memory semiconductors (Hyundai Electronics), the petrochemical industry (Hyundai Petrochemical), and shipping (Hyundai Merchant Marine). The Hyundai Group had a hard time securing bank loans during the Kim presidency because its chairman had run against Kim in 1992.17 Samsung Group Samsung Group is the oldest of the five big chaebols.18 In 1997, the Samsung Group had eighty affiliates, assets of 50 trillion won, and sales of 60 trillion won. It has engaged in diverse businesses such as trading, food processing, electronics, petrochemicals, machinery, shipbuilding, financial services, hotels, department stores, and the media. Its founder, Byung-Chul Lee, 64

Brief Histories of the Top Five Chaebols inherited land from his father during the Japanese occupation and ran small shipping businesses. When he established a trading company, now known as Samsung Corporation, in 1938, it originally focused on the export of Korean agricultural products. After Korea was liberated from the Japanese occupation in 1945, Samsung expanded into the importing of goods that were not available in Korea. It imported daily necessities like sugar, fertilizer, paper, wool, nylon, and medicine. With the profits earned from this business, Samsung expanded into manufacturing. It first established Cheil Jedang in 1953 and built a factory that produced sugar, which until then had been imported. Its chairman’s close relationship with Korea’s president helped it secure foreign currency. In 1954, it received a million dollars in aid from the United States and used this money to purchase the manufacturing facilities for its new subsidiary, Cheil Industries Inc., which produced woolen goods. At the same time, the government banned the import of woolen goods and sugar, which gave Samsung a monopoly on these goods within Korea. It soon took over Ankuk Fire Insurance Company, now known as Samsung Insurance, and also bought more than half the shares of three banks. Again, its chairman’s personal relationship with Korea’s president gave it the latitude to gain control of these businesses (Kim, 1997). Samsung initially faced many difficulties when Park took power in 1961. The Park regime charged Chairman Lee with corruption. After Park realized he had to compromise with chaebols to achieve his economic objectives, Lee actively accommodated the government’s goals. Lee assembled the businessmen of all other chaebols and organized the Federation of Korean Industries. Lee eventually handed over his banks to the government. Later, as a goodwill gesture, Lee established Hankuk 65

The Evolution of Chaebols Fertilizers and donated it to the government. In 1969, Samsung established Samsung Electronics, Dongyang Broadcasting Station, and Joongang Daily Newspaper. Like other major chaebols, Samsung invested heavily in government-designated strategic sectors during the 1970s, although it was not as enthusiastic about doing so as were other chaebols, such as Hyundai and Daewoo. It diversified into petrochemicals (Samsung Petrochemical), machinery (Samsung Heavy Industries), and shipbuilding (Samsung Shipbuilding). Samsung Corporation was the first chaebol subsidiary to be registered as a general trading company. At the same time, Samsung vertically integrated into parts-manufacturing businesses such as Samsung SDI, Samsung Corning, and Samsung Electro Mechanics. As the government scaled back its economic intervention during the 1980s and 1990s, Samsung continued to expand. It diversified into semiconductors (Samsung Semiconductor, later merged into Samsung Electronics), financial services (Samsung Securities, Samsung Credit Card, Samsung Merchant Banking), aeronautics (Samsung Aeronautics), and automobiles (Samsung Motors). This last market entry was a costly failure, however, and Samsung Motors had to file for bankruptcy in 1999. It was later sold to Renault. Also, Samsung Group spun off Shinsegae and Cheil Jedang in the late 1990s, which reflected the inheritance of the late chairman Lee’s holdings by his children. LG Group In 1997, LG had 37 trillion won in assets and 46 trillion won in sales, making it the third-largest chaebol. In-Hwoi Koo founded LG Group after Korea was liberated from Japan. The original 66

Brief Histories of the Top Five Chaebols firm was a trading company. Koo then established a consumer goods manufacturing company, now known as LG Chemical, in 1947 to manufacture cosmetics and soaps, which were very profitable businesses at that time. LG then entered the plastic industry to vertically integrate into cosmetics containers. It was soon equipped with modern facilities to produce soap containers and toothbrushes and acquired a monopoly in those businesses. During the 1960s, LG Group grew under the government’s economic development plan. It vastly expanded the operations of Goldstar, established in 1959 and now called LG Electronics. It began to produce consumer electronics and appliances such as radios, TVs, and washing machines. It entered the petroleum processing industry and established Honam Oil Company (now, LG Caltex Oil) in 1966. It eventually diversified into the insurance industry (LG Marine and Fire Insurance) to support its oil refinery business and save money on insurance premiums. Because LG Oil had to employ many ships for transporting crude oils, it paid insurance premiums that represented over half the total profit of Korea’s insurance industry. It also diversified into several related businesses in chemicals and electronics such as carbon black (LG Continental Carbon), communication equipment manufacturing (LG Information Communication), and electronic wiring (LG Cable). It continued to focus its related diversification and vertical integration around chemicals and electronics in the 1970s, when it established electronics-parts manufacturing affiliates such as Alps Electronics, LG Electric Machinery, and LG Instruments and vertically integrated in the chemical industry via LG Polychemical. During the 1970s, LG International was selected as one of the general trading companies sponsored by the government. 67

The Evolution of Chaebols Like other large chaebols, the LG Group was able to grow on its own during the 1980s. It expanded into financial services by establishing merchant banking (LG Merchant Bank), investment trust (LG Investment Trust), and securities companies (LG Securities) and also ventured into semiconductors when it established LG Semiconductor. During the 1990s, it focused on telecommunications, setting up LG Telecom, a wireless telecommunication company, and acquiring DACOM, the leading internet service provider and long distance service provider. Daewoo Group The Daewoo Group has been the fastest growing of the top five chaebols since being founded in 1967 by Woo-Choong Kim. Its affiliates faced bankruptcy in 1999, however, and Daewoo Group itself was being dismantled. The major reason it grew so rapidly was that it participated more actively in the Korean government’s economic policy than did any other large chaebol; its history closely parallels that of the government’s economic policies. In line with the government’s focus on export of items like textiles, apparel, and leather during the 1960s, Daewoo first grew by exporting those products and building a large clothing factory. When the United States imposed textile import quotas in 1972, Daewoo produced 40% of Korea’s textile exports. By achieving export targets set by the government, Daewoo could tap into export finances at low interest rates and obtain much tax exemption. Using the profits it made in textiles, Daewoo advanced into overseas construction projects, particularly in the Middle East, during the 1970s. The government officially designated Daewoo Corporation as a general trading company in 1975. 68

Brief Histories of the Top Five Chaebols Because it participated enthusiastically in the government’s policy to boost heavy equipment and the chemical industry, and took over many insolvent companies in those industries, Daewoo continued to be favored by the government. In 1976, it acquired Hankook Machinery, a troubled machinery manufacturer, and renamed it Daewoo Heavy Industries. In 1978, it acquired the financially troubled Okpo Shipyard and renamed it Daewoo Shipbuilding, and the bankrupt Saehan Motors, now known as Daewoo Motors. The government appreciated Daewoo’s taking over these insolvent enterprises and rewarded it handsomely for doing so by writing off loans and providing various subsidies, preferential loans, and tax breaks. Daewoo would not have enjoyed such treatment had it not been closely connected to the Park regime. Daewoo continued this growth strategy in the 1980s. In 1983, it took over the home electronics and telecommunication businesses of Daehan Group and renamed them Daewoo Electronics and Daewoo Telecom, respectively. It entered the financial services industry by taking over Sambo Securities Company in 1983 and renaming it Daewoo Securities, which became the biggest securities company in Korea. It also set up Koram Bank as a joint venture with Bank of America in 1983. Daewoo Motors integrated vertically into auto parts by establishing Daewoo Auto Parts, Daewoo HMS Industry, and Daewoo Carrier. In the 1990s, Daewoo actively pursued globalization. It set up overseas production plants for Daewoo Motors, Daewoo Electronics, and Daewoo Corporation and entered emerging markets such as Poland, Rumania, India, Vietnam, and Sudan. Its expansion plans were too ambitious, however, and the foreign exchange crisis of 1997 further weakened it. These factors led to its collapse in 1999. 69

The Evolution of Chaebols SK Group SK Group was the fifth largest chaebol in Korea as of 1997, with assets of 22 trillion won and sales of 26 trillion won. Like Daewoo, SK Group’s relationship with the government has been very close. An interesting aspect of SK Group is its repeated acquisition of previously state-owned companies. Jong-Kun Chey founded it in 1953 when he purchased from the government a textile manufacturing plant, which was previously owned by the Japanese. SK Group grew rapidly through continued exporting. In 1962, it established SK Construction. Under the government’s economic development plan, it established SK Chemical in 1969 to produce synthetic fibers out of imported petrochemical products. In addition, SK Global was selected as a general trading company in 1976. In 1980, SK Group stunned many when it acquired Yukong, a state-owned enterprise in oil refinery. At that time, the revenue of Yukong (now known as SK Corporation) was 5.5 times larger than that of SK Group. The government arranged a loan of $100 million to SK Group at a very low interest rate, and SK Group did not pay anything to acquire Yukong (Kang, 1996). The government also awarded SK Corporation with exclusive rights to import oil from Saudi Arabia. There was much speculation as to how SK Group could acquire Yukong on such favorable terms. It is likely that its close connection with the Chun government helped SK Group do so. After taking over Yukong, SK Group established SK Shipping to internalize shipping of crude oil and pursued vertical integration by establishing SK Gas and SK Oxychemical. SK Group also took over Korea Mobile Telecom, a stateowned monopoly of mobile telecommunication service, now known as SK Telecom, in 1994. Chaebols competed intensely 70

The Growth Strategy of Chaebols to get this enterprise, which generated hefty profits and had sound prospects of long-term growth. One factor that might have helped SK group secure this asset was the marriage of its chairman’s son to the daughter of President Rho. During the 1990s, SK Group expanded its financial services arms by establishing SK Securities and acquiring an insurance company (now SK Insurance).

the growth strategy of chaebols In this section, we will extract some common elements of chaebols’ growth strategies from the historical accounts set forth in the previous sections. These strategies have consisted of three elements: taking advantage of government policies, tapping internal and external capital markets, and pursuing unrelated diversification and vertical integration. Taking Advantage of Government Policies All the major chaebols grew by following the government’s economic policies and using political connections to win government contracts. The Korean government sold to only a few firms property that reverted to it after the Japanese left. Such preferential treatment provided chaebols a foundation to grow. The government also favored chaebols by allocating foreign currency, which let them grow rich by importing scarce products. Samsung and LG started as trading companies at the time and were able to accumulate funds that were essential for future investment. In addition, the government’s economic development plans provided huge subsidies for expansion into strategic industries 71

The Evolution of Chaebols such as heavy equipment and chemicals. The plans continued through the 1970s, when massive subsidies were given to general trading companies. Large chaebols such as Samsung, Hyundai, Daewoo, LG, and SK were all appointed as general trading companies and were given many privileges. Close connections with the government were also essential in winning government contracts and support. For example, SK Group’s takeover of Yukong and Korea Mobile Telecom would not have been possible without close connections to the incumbent government. Similarly, Daewoo’s takeover of insolvent companies, which gained it large subsidies, was attributable to its close government ties. Figure 2.4 summarizes the role of the government during the chaebols’ development. From this perspective, chaebols’ successful lobbying of the government was a core competence that was vital for growth, just as political connections were important resources that helped business groups form in Latin American countries (Guillen, 2001). It is, however, worth emphasizing that the relationship between the government and chaebols in general turned sour in the 1990s. Chaebols became powerful and self-sufficient with their own financial service arms. The government lost leverage against chaebols after it abolished various subsidies. Chaebols also became actively involved in politics to turn regulations to their favor. Exploitation of Internal and External Capital Markets Another critical element of chaebols’ growth was their ability to raise capital internally and externally. Although this competence

72

Export finance Trade finance

Foreign construction

Privatization of

public company

General trading company

Heavy & chemical industries

70-80

Assist exports

Assist major industries

60-70

international finance community

Allowing chaebols to borrow from

Establishment of financial affiliates

Foreign expansion

Allocation of license such as in telecommunication

Restructuring of heavy & chemical industries Acquisition of bankrupt companies

80-90

Figure 2.4. A schematic figure of the role of government in the development of chaebols.

Foreign aid

Financial Policy

Allocation of reverted asset

Industrial Policy

45-60

The Evolution of Chaebols might not be a source of competitive advantage in countries where capital markets were well developed, access to capital was critical for chaebols because Korea suffered from a chronic shortage of capital. Chaebols tapped into internal and external capital markets in several ways. First, they generated cash from their incumbent subsidiaries and invested it in new ventures. To facilitate investment, chaebols created the group-level staff organization, which controlled the free cash flows of affiliates. Because several companies participated in the equity investment of new venture, some degree of cross-shareholding resulted from these joint investments. In addition, by providing debt guarantees to new affiliates, existing affiliates helped their less established counterparts secure bank loans. This financing practice made it easier for chaebols to expand by creating new affiliates rather than by diversifying internally by adding business divisions. In addition, chaebols artificially increased their equity bases by exchanging shares among themselves, thereby securing more loans. From this perspective, chaebols’ capital structures, which were characterized by high debt–equity ratios, cross-shareholding, and mutual debt guarantees, were designed to maximize the loans they could secure from the banks. We will discuss chaebols’ capital structures more extensively in Chapters 5 and 6. Second, chaebols entered the financial services industry to secure more loans from financial institutions. Ultimately, they used these institutions’ reserves as their own private vaults. Although the government regulated the chaebols’ ownership of banks, chaebols ventured into less regulated financial services like merchant banking, insurance, securities, and investment trusts. Those financial service arms played the most significant role in chaebols’ expansion and downfall, as is illustrated in Chapter 5. 74

The Environmental Shift Pursuit of Diversification and Vertical Integration Chaebols’ growth strategy encompassed unrelated diversification, related diversification, and vertical integration. They entered unrelated business lines to capture government subsidies. As a consequence, several chaebols participate in industries such as shipbuilding, heavy equipment, automobiles, chemicals, and electronics and compete fiercely with each other. Without an infrastructure to supply these industries, chaebols then needed to integrate vertically to secure parts and raw materials. The general trading companies served as an export channel to overseas markets. Thus, chaebols show extensive vertical integration. In addition, chaebols also pursued related diversification, often within incumbent affiliates. In Chapters 3 and 4, we will examine the nature of chaebols’ diversification and vertical integration and assess the performance implications of these activities.

the environmental shift In this section, we will summarize some important changes in the external environments that chaebols have faced in the 1980s and 1990s. In the past, the chaebol was a successful organizational form. Yet the recent crisis demonstrated that chaebols could not continue reproducing this success because of the changes in their external environment. As creatures of market imperfection and state interventions that characterized the economic environment in Korea during the 1960s and 1970s, chaebols prospered under the favorable geopolitical environment during that time. As they expanded into foreign markets and Korea liberalized its own economy, however, they faced challenges that they were ill equipped to handle. 75

The Evolution of Chaebols Intensified Global Competition One of these challenges, which first became important in the 1980s, was intensified competition in both export and domestic markets. When Korea pursued export-oriented strategies in the 1960s and 1970s, it had few competitors from emerging markets. Since the 1980s, however, several other countries such as Indonesia and China have emulated Korea’s success. As a result of intensified labor disputes and shortages of labor, Korean workers’ wages rose, further eroding the conventional competitive advantages of Korean firms. The removal of various export subsidies further weakened the competitiveness of the Korean export sector. The global competition also intensified within Korea’s domestic markets. Since World War II, the General Agreement on Tariffs and Trade (GATT) helped remove tariff barriers and other nontariff barriers among its members. The World Trade Organization (WTO), which began operating in 1995, further strengthened the enforcement of GATT rules. Due to the GATT’s continued efforts and increasing pressures from trading partners, especially the United States, Korea had to open up its domestic markets. As a consequence, Korea increased its imports during the 1990s, sometimes more than it increased its exports. The resulting intensified competition in the domestic markets hurt chaebols because they were accustomed to compensating losses from export with profits from protected domestic markets.

Increasing Influence of Foreign Capital There have been some significant structural changes in the Korean capital market during the 1990s. In the past, the government tightly regulated foreign sources of capital and guaranteed 76

$ million

Incoming foreign direct investment

Incoming portfolio investment

Figure 2.5. Inflow of foreign capital, 1980–2000. Source: Bank of Korea, Financial Statistics Yearbook.

-4,000

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 -2,000

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

The Evolution of Chaebols that these funds would be repaid. The economic liberalization of the 1980s and 1990s removed such restraints. By the mid 1990s, banks, chaebols, and chaebol-owned financial institutions were free to borrow from foreign sources. Figure 2.5 shows three important trends. First, the inflow of foreign capital, as both foreign direct investment and portfolio investment, jumped in the 1990s. As it became more integrated into the global economy, Korea thus became more vulnerable to external turbulence, including exchange crises. Second, most of the inflow of foreign capital was in the form of portfolio investment as short-term speculative funds, rather than foreign direct investment, which often accompanied technology transfers and was long term in nature. Thus, Korea was especially subject to short-term fluctuations of foreign capital inflows/outflows. Third, because of these foreign capital flows, the composition of the capital market changed. By 1999, foreign ownership increased to 12.4% of the total number of stocks and 27% of the total market capitalization. As will be discussed in Chapter 7, the increased presence of foreign investors has led to greater shareholder activism, another significant structural change that has influenced the behavior of Korean listed companies. Foreign investors have both actively monitored performance and worked with domestic shareholder activists such as People’s Solidarity for Participatory Democracy to file lawsuits against chaebols. These two important environmental shifts required chaebols to narrow their business focus to a few core competencies and improve their technology, brands, and productivity to remain viable. Chaebols failed to make this transition. The following chapters will focus on the structural characteristics of chaebols that caused this inertia.

78

3

Chaebols’ Diversified Business Structure

79

The Extent of Chaebols’ Diversification As discussed in Chapter 2, chaebols have pursued both unrelated diversification and vertical integration. At the same time, their major affiliates engaged in related diversification. This chapter will focus on chaebols’ patterns of diversification and assess why they diversified as well as how they have implemented these efforts. In doing so, it will consider how chaebols have created synergy and value by diversifying. The success of this effort was not guaranteed, and chaebols could not have done so without centralized coordination and control systems. Finally, we examine the performance implications of chaebols’ diversification. In particular, we explore how chaebols became susceptible to the crisis. We argue that operating synergies, created by resource sharing among affiliates, were often offset by failures in strategic decision making.

the extent of chaebols' diversification Measuring Chaebols’ Diversification Most research on diversification has focused on two issues. Some of it, such as Chandler (1962), has emphasized firms’ use of diversification to capitalize on economies of scale and scope and utilize idle capacity. Other scholars (e.g., Rumelt, 1974) have distinguished between related and unrelated diversification and suggested that the former creates more value than the latter does because it enables firms to share resources and transfer skills among related business units (Porter, 1987; Prahalad and Hamel, 1990).1 Such research has concentrated primarily on firms in countries with well-developed markets, however, and it may not generalize to different contexts. For example, according to Rumelt’s

81

Chaebols’ Diversified Business Structure 1.80

1.60

1.40

1.20

1.00

0.80

0.60

0.40

0.20

0.00 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Total diversification

Unrelated diversification

82

Related diversification

The Extent of Chaebols’ Diversification classification scheme, which classified firms’ strategies as falling into one of four categories (i.e., single business, related diversification, unrelated diversification, and vertical integration), all the top thirty chaebols are unrelated diversifiers, providing no way to compare among themselves. Given this book’s focus, it is important to compare the extent to which individual chaebols diversified into related and unrelated areas. We thus adopted the entropy measure of diversification (Palepu, 1985), which decomposes total diversification into related and unrelated diversification, using the industry classification scheme. Related diversification captures distribution of sales by business segments defined by the four-digit Korean Standard Industry Classification (KSIC) within the same twodigit KSIC code and unrelated diversification by distribution of sales across different two-digit KSIC code. Figure 3.1 shows the trend of diversification of the top thirty chaebols with this index. The figure shows that chaebols’ diversification increased continuously from 1985 to 1997. Most ←−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−− Figure 3.1. Degree of related and unrelated diversification of the top thirty chaebols, 1985–2000. Note: The entropy measures of diversification are defined as follows. Consider a firm operating in N industry segments (defined by the four-digit KSIC industries). Those N industry segments aggregate into M industry groups (defined by the two-digit KSIC industries). Let Pi be the share of the ith segment in the total sales of the firm. Then, the total diversification (DT) is defined as DT=
N Pi ln(1/Pi ). The unrelated diversification (DU) is defined as DU =
M P j ln(1/P j ), and the related diversification (DR) is defined as DR = j j
M
i j Pi ln(1/Pi ). The entropy measure of diversification is decomposed into related and unrelated portions (DT = DU + DR). See Palepu (1985).

83

Chaebols’ Diversified Business Structure of those increases came from unrelated diversification, and chaebols kept diversifying into unrelated areas even during the economic decline of the 1990s. Chaebols became somewhat more focused only after the financial crisis. As shown in Figure 3.1, chaebols also pursued related diversification, often within existing affiliates. Figure 3.2 shows the business composition of the top five chaebols. Samsung and LG have a large presence in the electronics industry, while Hyundai and Daewoo emphasize automobiles and heavy equipment, and SK and LG derive a large proportion of their revenues from the chemical industry. All retain general trading companies; consequently, sales in retailing and wholesaling are important to all of them.2 The Motivations for Diversification Chaebols are often depicted as irrational economic organizations pursuing growth at the expense of profits. They are indeed ruthless competitors, undercutting their rivals in both domestic and overseas markets. In Korea, many have contended that chaebols drove out small and medium-sized firms and bought them when they went bankrupt (Lee, 1996; Kim, 1997). Yet it is not clear whether chaebols were irrational. To address this issue, we must consider why chaebols pursued unrelated diversification rather than focusing on a few core businesses. Modern management theories specify three main motives for diversification – pursuit of growth, risk aversion, and economies of scope. They are skeptical, however, about the first two motives, criticizing the first as a way to satisfy CEOs’ egos and the second as being more concerned with reducing firms’ own risks than maximizing shareholder value (Marris, 1964; Amihud and Lev, 1981) because shareholders can reduce risk by diversifying their own portfolio. Thus, these theories consider the pursuit of 84

The Extent of Chaebols’ Diversification 100%

0.51 1.65

machinery, iron, and steel 10.16

5.27

5.57

80%

0.33 1.75

1.01

3.38

6.18 0

1.71 0.06 0

12.39

0.16 0 0.83

0.35

electric 30.6 fiber,chemical 32.65

11.55

60%

telecommunication 9.91

finance 24.42

6.02

construction 10.03

2.61

26.35 motor vehicle transportation 22.87 3.66 21.07 4.98

3.47 0 0 40%

0

6.31 0.58 3.55 62.24

20%

0

wholesale and retail 44.69

39.5 34.7

32.33

0% Hyundai

Daewoo

Samsung

LG

SK

Wholesale and retail trade

Motor vehicle transportation

Construction

Transportation

Fiber, chemical

Electric

Machinery, iron and steel

Finance

Telecommunication

Figure 3.2. Business composition of top five chaebols, as of 1997.

85

Chaebols’ Diversified Business Structure synergies or economies of scope as the only legitimate reasons for diversification. Although chaebols have pursued growth rather than shortterm profits, they did not do so indiscriminately. In Korea, growth was directly related to long-term profit maximization. Figure 3.3 shows the composition of sales for Samsung Group in 1965, 1976, 1987, and 1998. It indicates that Samsung Group grew more by diversifying into new businesses than by expanding existing ones. In 1965, Samsung’s sales volume was 25.8 billion won and came mainly from textile, food, and insurance businesses. By 1976, its sales volume had increased to 640 billion won with consumer electronics contributing substantially to this growth. Samsung’s sales volume in 1987 was 16.7 trillion won; much of this growth stemmed from Samsung’s forays into machinery, shipbuilding, trade, and semiconductors. Still new sources of growth in automobiles, logistics, and telecommunications were seen in 1998. Those newly entered businesses contributed to both growth and profitability.3 For instance, in 1995, a boom year for semiconductors, the semiconductor division posted a profit of 2.5 trillion won, which was 84% of the profit of the entire Samsung Group. Since the Korean government had provided chaebols with many monetary incentives to expand into strategic business areas, as discussed in Chapter 2, unrelated diversification offered chaebols many kinds of opportunities to increase profits, such as subsidies, funds for investment, and protection from taxation and import barriers. Such expansion was therefore not motivated solely by growth. Chaebols also diversified to reduce the risk of their founding families, which invested all their assets into affiliates. These families wanted to earn stable profits from their investments. Of course, this goal did not serve the interests of minority 86

Intragroup Resource Sharing shareholders. This reason for risk reduction did not create much tension in the 1970s when only a few affiliates were listed on the stock exchange. Chaebols’ diversification is also motivated by their desire to create synergies by sharing intangible resources such as technology and brands, tangible resources, human resources, and capital. The next section analyzes how intragroup resource sharing created synergies and has been the factor underlying chaebols’ competitiveness.

intragroup resource sharing Sharing Technology, Brand, and Management Know-how A chaebol’s affiliates freely share technology with each other. To facilitate groupwide technical support for affiliates, chaebols established group-level R&D centers, organized along broadly defined business lines such as automobiles and electronics to meet these affiliates’ common needs (Kim, 1996). For example, Samsung Group established the Samsung Advanced Technology Institute to support a group-level effort for basic research. This institute offers sophisticated technological information to all affiliates. Several of these affiliates, including both final assemblers and parts suppliers, finance their joint R&D efforts and share any technological innovations from this research. Such sharing is more effective when several vertically integrated affiliates join forces. For instance, Samsung Electronics manufactures finished television products, Samsung SDI produces TV tubes, and Samsung Electro-Mechanics manufactures various TV electronic parts. Samsung Corning, a joint venture with Corning, delivers glass for TV tubes. In such cases, 87

Chaebols’ Diversified Business Structure

Other Services (0.1%) Semiconductor (0.8%) Telecommunications (0.1%)

Nonmetallic Minerals (1%) Machinery, Iron & Steel (0.1%)

Textiles

40%

Food

48%

Insurance

12%

1965 (25.8 billion won)

Construction

1%

Home Appliance

24%

Paper

3%

Textiles

28%

Food

25%

Insurance

18%

1976 (640 billion won)

Figure 3.3. Composition of sales in Samsung Group – 1965, 1976, 1987, and 1998. Source: Kim (1998) for 1965 and 1976 data. The data for 1987 and 1998 are from Korea Information Service.

88

Intragroup Resource Sharing Other Services (1.6%) Semiconductor

6% Telecommunications (1%)

Wholesale & Retail Trade 35% Wholesale& Retail Trade 35% Nonmetallic Minerals (1%)

Vehicles

3.3%

Construction

2.4%

Home Appliance

18.3%

Paper

0.5% 3.7%

Textile Food & Leisure

Finance (Insurance)

1987

Machinery, Iron & Steel (0.4%)

Vehicles (Automobile) 6.3%

Home Appliances 19.9%

Paper

Textiles

4.4%

0.3% 3.5% Food & Leisure (1.1%)

Finance 30.2%

(Insurance)

24.4%

1998

(16,767 billion won) (93,766 billion won)

89

Chaebols’ Diversified Business Structure technological innovation in one affiliate can directly contribute to cost savings and new product development in another affiliate. Another noteworthy characteristic of chaebols is that all affiliates in a group share its unique brand name. Group advertising, which emphasizes the image of a group rather than individual affiliates, generates considerable scale and scope economies.4 Figure 3.4 is a sample of Samsung’s group advertising that appeared in Business Week. It highlights Samsung’s brand name and mentions the names of individual affiliates in the fine print. In another example, Samsung’s sponsorship of Seri Park, the golfer who won the 1998 LPGA (Ladies Professional Golf Association) championship promotes awareness of Samsung’s brand name, which in turn helps every affiliate company in the Samsung Group. Similarly, Hyundai Group advertises that it manufactures “from chip to ship.” The empirical study in Appendix 3 provides strong evidence for the conjecture that the intragroup sharing of technology and brand improve the profitability of individual affiliates. Chaebols’ sharing of management know-how is also important, particularly when they enter a new business. When Samsung entered the specialty chemicals industry, many affiliates supplied the necessary investment funds as well as other managerial know-how (Chun and Han, 1994). Samsung Engineering designed the factory, and real estate experts from Samsung Life Insurance helped purchase the necessary land. Samsung Construction built the plant, and Samsung Heavy Industries supplied the materials for the plant’s construction. Also, Samsung SDS and Samsung Engineering designed the factory automation, Samsung Corporation helped expedite the supply of raw material and export of products, and Samsung Petrochemical and Cheil Industries helped secure necessary technology. Branch offices of Samsung Corporation took care of 90

Intragroup Resource Sharing the foreign correspondence, and the group-level training center trained newly hired and transferred employees. In short, when entering into new business areas, existing affiliates supplied various management resources and know-how for free so that the new businesses could enter at far lower costs than they could otherwise. This group-level sharing of resources may be the most critical factor that discriminates chaebols from business groups in other countries. Although grupos economicos in Latin American countries might also learn how to set up new ventures or take over privatized companies quickly and economically, their affiliates did not share brands, technology, and human resources as extensively as did chaebols. For instance, an Argentine business group, Perez Companc, grew by leveraging its political connections but did not attempt to share technology or brands among its group affiliates (Guillen, 2001). No group-level organizational structure was implemented to help member firms learn from each other’s organizational experience. This lack of attempts to create synergies among affiliates might be partly attributable to the fact that many affiliates in business groups in Latin American countries were created in joint ventures with multinational corporations (Evans, 1979). While pursuing import substitution policies, the governments handed out licenses to a few local companies that in turn borrowed technologies from multinational corporations. It would be hard to share resources among affiliates when each has its own joint venture partner. Sharing Human Resources Chaebols share human resources among affiliates through group-level recruiting and intragroup transfers. Unlike advanced countries with efficient labor markets and ample supplies of 91

Chaebols’ Diversified Business Structure

Figure 3.4. An example of group-level advertising.

92

Intragroup Resource Sharing

talented engineers and well-trained managers, Korea’s external market for human resources remains inefficient (Lee, 1996). Chaebols have therefore relied heavily on internal labor markets. Instead of having individual affiliates recruit and train 93

Chaebols’ Diversified Business Structure employees, they have set up groupwide training centers to do so. After training these new employees, they send them to affiliates after they calculate these affiliates’ need for personnel. These centers also provide ongoing management training to employees. They create economies of scale, instill group-level culture, and promote cooperative human resource sharing among affiliates. The intragroup labor market is also important for chaebols when they diversify into new businesses. It is very costly to hire and train the substantial personnel that such expansion requires. By transferring personnel into new affiliates, chaebols can save much time and money and further facilitate the sharing of technological resources and management know-how. For example, when Samsung Group established Samsung Electronics, it dispatched the existing employees of Cheil Industries and Cheil Jedang to a joint venture partner of Japanese NEC to obtain the required technology (Chun and Han, 1994). As recently as 1994, Samsung Group transferred a large number of employees to Samsung Motors. The extent of these transfers is manifested clearly when we examine the career path of executive officers in chaebols. Table 3.1 shows statistics on the job careers of incumbent presidents of the top five chaebols’ affiliates. It shows the companies they joined as new employees, the companies where they took executive positions for the first time, and their last appointments. Of the forty four presidents of Samsung Group affiliates, five started their career in Samsung Electronics, six in Joongang Daily News, four in Samsung Corporation, and twenty-two in other Samsung affiliates. Many presidents assumed their first executive positions at Samsung Electronics, Samsung Corporation, and Joongang Daily News. Furthermore, Table 3.1 indicates that eight incumbent presidents of affiliates in Samsung 94

Intragroup Resource Sharing Group had their latest appointment in Samsung Electronics, five in Samsung Corporation, and two in Joongang Daily News. Such career tracks are also common in the other large chaebols. Internal Pool of Capital There is a saying that “cash is king.” It certainly was in Korea, which experienced a shortage of capital throughout the development period. As elaborated in Chapter 2, the Korean capital market did not grow sufficiently during the turmoil after the liberation and the era of economic development, when almost all funds were distributed to the small business areas specified by the government. In this situation, it was necessary for chaebols to supply capital by channeling investment funds from existing affiliates to support new ventures. Chaebols collected funds from each affiliate and allocated them in the order of strategic importance. This use of free cash flow created an internal capital market. Unlike firms in developed countries with welldeveloped capital markets, an internal capital market can create enormous synergies and be a source of competitive advantages in firms in developing countries (Williamson, 1975; Leff, 1978). For instance, when entering new business areas, affiliates of chaebols provided their capital resources in the form of equity investment. When the venture capital found in developed countries was not available and a new business entity could not secure a loan from banks, group affiliates were the only source of capital. Figure 3.5 shows the equity investments Samsung affiliates made for Samsung Motors in 1994. Samsung Electronics purchased 30.6% of Samsung Motors’ equity; Samsung ElectroMechanics, 8.8%; Samsung SDI, 10.8%; Samsung Heavy Industries, 3.6%; and Samsung Everland, 1.8%. The remaining 44.3% of Samsung Motors’ equity was purchased by executive 95

First hired First executive position Latest appointment

First hired First executive position Latest appointment

First hired First executive position Latest appointment

11 6 6

LG Chemical

8 8 1

1 0 0

22 24 29

12 7 4

6 7 2

LG Caltex-Oil

LG Electronics

7 19 28

Other affiliates

0 0 0

Military

0 0 0

16 21 31

3 2 3

6 4 4 LG

Military

Hyundai

Military

Other affiliates

Other affiliates

Hyundai Motor

Hyundai Construction

6 4 2

Joongang Daily News

Hyundai Heavy Industries

4 4 5

Samsung Corp.

5 9 8

Samsung Electronics

Samsung

Table 3.1. Career paths of CEOs of major affiliates in top five chaebols

2 0 0

Civil servant

1 0 0

Civil servant

2 0 0

Civil servant

4 3 2

Others

9 8 4

Others

4 3 0

Others

42 42 42

Total

43 43 43

Total

44 44 44

Total

11 11 6

SKC

7 7 5

0 1 3

SK Gas

SK Chemical 2 4 1

0 3 2

Daewoo Heavy Industries

1 4 4

Daewoo Electronics

Source: Executive profile database, Korea Information Service, as of 1997.

First hired First executive position Latest appointment

First hired First executive position Latest appointment

Daewoo Corp.

2 5 12

Other affiliates

SK

2 10 14

Other affiliates

Daewoo

0 0 0

Military

0 0 0

Military

0 0 0

Civil servant

4 0 0

Civil servant

10 4 3

Others

13 3 2

Others

25 25 25

Total

27 27 27

Total

Chaebols’ Diversified Business Structure

Samsung Electronics (30.6%)

Samsung Electro-Mechanics (8.8%)

Samsung Motors

Samsung Everland (1.8%)

Employees (44.3%)

Samsung SDI (10.8%)

Samsung Heavy Industries (3.6%)

Figure 3.5. Equity infusion to the new venture: the case of Samsung Motor.

officers and employees of Samsung Group, making Samsung Group the sole owner of Samsung Motors. Affiliates also provide additional funding to new ventures by providing direct loans and debt guarantees. We will discuss these intragroup loans and debt guarantee practices in Chapter 5.

organizational structure of chaebols Although we have examined how chaebols’ affiliates share various resources, we have not considered why it is fairly easy for them to do so despite their independent legal status. Understanding chaebols’ organizational structures helps us answer this question. 98

Organizational Structure of Chaebols Multidivisional Structure In Western countries, firms with diversified businesses are organized as multidivisional structures. Under this system, only the CEO of a diversified company makes strategic decisions; the head of each business division determines only matters related to the business operations of his division (Williamson, 1975). Corporate staff personnel exist as a bridge linking the CEO to heads of business divisions. Similarly, the chairman of a chaebol acts as if he is CEO of a diversified company while presidents of affiliates play a function similar to heads of business divisions. As “CEO” of a chaebol, the chairman sets the direction for the chaebols’ corporate culture and personnel management and decides when the affiliates should make groupwide investments and divestitures. In fact, the term “chairman of the group” is a fictitious title since the group does not exist in a legal sense. As we will see in Chapter 6, extensive cross-shareholding ensures that each affiliate behaves just like an operating division in a diversified corporation even though it has its own shareholders and board of directors. As do multidivisional organizations, all chaebols have staff personnel that support and assist the chairman of the group. Samsung Group invented group-level staff organization by introducing the “Office of Secretaries” in 1959. At that time, Samsung Group was establishing a solid business base as a chaebol with Samsung Corporation, Cheil Jedang, and Cheil Industries as its core companies. As the group expanded into trade, manufacturing, and financial businesses, the late Chairman Byung-chul Lee could not control and coordinate all these businesses on his own. LG Group followed suit by creating the Office of Chairman in 1966. SK, Daewoo, and Hyundai made similar moves in 1974, 1976, and 1979, respectively. 99

Chaebols’ Diversified Business Structure In its early years, Samsung Group’s Office of Secretaries played a limited role in allocating funds and human resources in the process of financial control and personnel management. It initially had only about twenty employees.5 As Samsung Group advanced into a wide array of new businesses in line with the Korean government’s economic development policy, it increased in size to ten teams and 139 employees by 1980.6 Its role also expanded considerably, and eventually consisted of the planning team (new investment and management planning), the human resources team, the financial control team (managing groupwide funds), the financial team (external financing), the research team (new business opportunity and market information), the audit team (management evaluation and financial auditing of each affiliate), and the government policy team (information collection related to government policy and lobbying). In addition, it began to offer advice to and support for other affiliates by promoting public relations, internationalization, and groupwide investment in information technology. A key function of this group-level staff organization is to determine the transfer price of intragroup business transactions. Group-affiliated companies conduct extensive internal selling and purchasing of intermediate and final goods. Further, intragroup loans, debt guarantees, and equity investment are prevalent. Among multidivisional firms in the United States, there has been much conflict in determining transfer prices for internal transactions because they have a direct impact on performance evaluation and compensation of divisional managers (Eccles and White, 1988; Poppo, 1995). This group-level staff organization can determine internal transfer price so as to support underperforming affiliates or to minimize the tax liabilities by shifting profits from highly profitable affiliates to loss-making affiliates. 100

Organizational Structure of Chaebols It does so to maximize profit at the group level, not the affiliate level.7 It can exercise such control over internal transfer prices because it has the authority to evaluate the performance of individual affiliates and to recommend appointment/dismissal of affiliates’ presidents to the group chairman. At this point, someone may wonder how it is possible for individual affiliates, many of which are publicly owned companies with separate shareholders and boards of directors, to maximize profits at the group level but not their own profits. R&D and advertising expenses were often paid by an affiliate that was generating profits at that time. Other affiliates often used those resources without paying for them. Resources in the form of personnel transfer and loans were often transferred to newly established and unprofitable affiliates for no fee. Such activities could take place because the corporate governance system in Korea is ineffective, as we will discuss in detail in Chapter 6. Cross-ownership confered the control to chaebol families, while the rights of minority shareholders were severely restricted. Because managers and executives of individual companies were often transferred within the group, they maintained their identities with the group itself rather than with individual affiliates. The lack of external labor market opportunities, as well as seniority-based promotion, further ensured these employees’ strong loyalty to the group (Lee, 1996). Despite the existence of this office, Samsung’s group chairman found it difficult to deal with all the group’s affiliates because the number of these affiliates increased substantially in the 1990s. As a consequence, Samsung Group divided the group businesses into five major industries and built up subgroups. Under the subgroup scheme, the head of each subgroup deals with affiliates belonging to each subgroup, which is equivalent to adding another layer in the multidivisional structure. As of 101

Chaebols’ Diversified Business Structure

Group Chairman Secretarial Office Group Steering Committee

Electronics Sector

Financial Service Sector

Machinery Sector

Chemical Sector

Others

Samsung Electronics

Samsung Life Insurance

Samsung Heavy Ind.

Samsung Chemical

Samsung SDI

Samsung Securities

Samsung Precision

Samsung Fine Chem.

Samsung Corporation

Figure 3.6. Organization structure of Samsung Group, as of 1997.

1997, the organizational structure of Samsung Group consisted of the electronics, financial, machinery, chemical, and independent business subgroups, as shown in Figure 3.6. Under this new system, the group chairman delegated more authority to the heads of subgroups, who in turn created their own staff organizations to support their decision making. As a consequence, the Office of Secretaries reduced its headcount to around 100 employees by 1997 and delegated authority over decisions like strategic planning to the heads of subgroups. Substantial changes have occurred to chaebols’ organizational structure after the foreign exchange crisis. The Korean government prohibited this organizational structure because chaebols were believed to be one of the major culprits of the 102

Organizational Structure of Chaebols crisis. Despite the ban, these staff organizations were transferred to major affiliates. They are now called group restructuring committees or group coordination teams, but their functions are identical to their predecessors. Presidents’ Meetings In order for the group chairman to keep direct or indirect contact with and control over the presidents of affiliates, chaebols use the presidents’ meeting and the group steering committee. Both consist of presidents of major affiliates and play an important role in group-level decision making. As described in Table 3.2, presidents of all affiliates of a group participate in the presidents’ meeting on a weekly basis, at maximum, or on a half-yearly basis, at minimum. As chaebols increased their numbers of affiliates, it was difficult in practice to summon presidents of all affiliates for a meeting where they exchanged their opinions. Thus, many chaebols run smaller group steering committee meetings, which presidents of core affiliates attend. Important matters related to the group such as entry into new business, capital mobilization, and appointments/transfers of executive officers are considered at these meetings. Samsung Group’s Group Steering Committee comprises presidents of twenty-six major affiliates. LG Group and SK Group convene, respectively, for biweekly or monthly meetings of the steering committee. In practice, the timing and frequency of the presidents’ meetings are closely interlinked with a chaebol’s culture. For instance, in the Hyundai Group, where authority is more centralized, the presidents’ meeting is convened rather frequently because the group chairman often presents his opinions about the business operations of affiliates. In contrast, the group 103

1976

1974

Group Steering Committee Presidents’ meeting Office of the Chairman

Group Steering Committee Office of the Chairman

LG

Daewoo

SK 50

100

Four teams (strategic analysis, personnel development, financial management, and investment planning) CEOs of 6 major companies, meeting once a month Presidents of 40 affiliates, meeting three times a month Five teams (personnel management, financial management, management support, secretarial, and planning and public relations) Presidents of 26 major affiliates, meeting once a week Presidents of all affiliates, meeting twice a year Six teams (personnel management, financial management, public relations, international business, and management 1 and 2) and one department (management support) Presidents of 8 major affiliates, meeting twice a month Presidents of 20 major companies, meeting once a month Five teams (public relations, management, overseas business management, strategic planning, and monitoring) Presidents of 16 major companies, meeting once a week Four teams (personnel management, financial management, management development, and public relations) Presidents of 6 major companies, meeting once a month Presidents of all affiliates, meeting once a week

Description

Note: This information was collected from various sources such as articles that appeared in Seoul Business News and personal contacts, as of 1997.

Group Steering Committee Presidents’ Council

1966

Group Steering Committee Presidents’ meeting Office of the Chairman 80

100

Samsung

1959

Number of staff 60

Date of founding

1979

Name of group-level organization

Office of Corporate Planning and Coordination Group Steering Committee Presidents’ meeting Office of Secretaries

Hyundai

Groups

Table 3.2. Group-level staff organization and executive committees in top five chaebols

Diversification and Economic Performance chairman of Samsung Group refrains from contacting presidents of affiliates directly, and these presidents often discuss important matters among themselves. Although presidents of affiliates can determine matters that require small investment related to their existing business, they cannot make independent decisions on matters such as new business entry that require large investments or possibly overlap with the business lines of other affiliates. The group chairman decides such matters. Relative to the presidents of Japanese keiretsu affiliates, who also have presidents’ meetings to convene opinions amongst themselves, presidents of chaebol affiliates have very little power. The Japanese keiretsus maintain voluntary cooperation among affiliates (Gerlach, 1992) and do not exercise strong control over their affiliates. In effect, the Korean chaebols are similar to diversified corporations in the western hemisphere and presidents of chaebol affiliates are divisional managers.

diversification and economic performance Operating Efficiency This chapter has considered the various ways chaebols share resources. Such active sharing is expected to influence the economic performance of affiliates substantially. It is not easy, however, to analyze the performance of chaebols at the group level because all financial information appeared only on affiliate-level financial statements until 2000, when laws that require chaebols to release consolidated financial statements went into effect. This section, therefore, assesses whether intragroup resource sharing influences the profitability of individual affiliates. 105

Chaebols’ Diversified Business Structure The results of an empirical study, presented in Appendix 3, show that these shared resources are important determinants of the affiliates’ profitability. A company receives indirect benefits from the R&D investment and advertisement of other affiliates. In addition, when other affiliates have extra cash or are financially healthy, a company can easily borrow funds from these affiliates or obtain loans from financial institutions that are backed by debt repayment guarantees from other affiliates. To sum up, chaebols generate enormous synergies by sharing resources at the group level. After looking at the results of the empirical study, some may ask whether the chaebols maximized profitability or growth. Although the growth patterns of chaebols may indicate that they maximized growth, there should be no doubt that the chaebols pursued long-term profit maximization by pursuing unrelated diversification, which should be understood as an effort to find future sources of profits. To generate funds to finance these new ventures, on the other hand, individual affiliates sought to maximize their short-term profitability. In other words, chaebols could invest in new business opportunities to maximize growth and long-term profitability only when each affiliate maximized its profits and generated much-needed cash. The creation of synergies through sharing resources among group affiliates, however, became more difficult to achieve as more affiliates were listed on the stock exchange. Up until the 1970s, the Korean stock exchange had only about 200 listed companies. During the 1980s, however, the government pushed chaebols to list as many affiliates as possible. The number of public firms increased from 277 in 1986 to 641 in 1996; those public firms affiliated with the top thirty chaebols increased from 50 in 1986 to 122 in 1996. In this chapter, we described how chaebol affiliates shared technology, brands, 106

Diversification and Economic Performance human resources, and financial resources as if they were divisions of a diversified company. Within such a system, it was not clear who bore the costs and who benefited. A profitable affiliate usually picked up the tab and all other affiliates enjoyed a free ride, which did not create many problems when affiliates were privately owned. As more firms went public, however, minority shareholders objected to investing in and subsidizing other affiliates. For instance, minority shareholders of Samsung Electronics protested when this affiliate invested in Samsung Motors. Strategic Effectiveness Here another question arises, “If the Korean chaebols created such operating efficiencies by sharing resources, why did they face such difficulties amid the nation’s foreign exchange crisis?” To answer this question, we need to distinguish between individual affiliates’ performance and group performance. The value creation that occurred at the individual level through resource sharing was often totally wasted in some other part of the group due to ill-conceived strategies or to cross-subsidization of poorly performing affiliates. We believe that operating synergies created by resource sharing among affiliates were frequently offset by failures in strategic decision making. Samsung’s entry into the automobile industry during global industry consolidation is one prominent example of misguided diversification. Samsung failed not because its individual affiliates failed to create synergies but because its decision to enter the automobile industry was wrong. Several Samsung affiliates pledged equity capital and human resources to this new venture, which could not establish a niche in the auto industry as it experienced global consolidation. Other chaebols that went bankrupt in the financial 107

Chaebols’ Diversified Business Structure crisis all pursued diversification strategies that were grandiose but lacked any economic rationale. This weakness of chaebols (i.e., the ineffectiveness of grouplevel strategy) stems from their centralized structures, which were essential for creating synergies between affiliates at the operational level. By centralizing decision making, chaebols could quickly concentrate resources in a strategic area (e.g., a new business venture). Since the 1980s, however, several factors made this centralized apparatus more a liability than an asset. First, prior to the 1980s, chaebols diversified, largely framed under the government’s planning. The government not only designated which industry to enter and who would enter it but also picked up the check when something went wrong. In the 1980s, however, chaebols became responsible for their own actions. They followed their own strategies with their own funding. Although the government provided a governance system prior to 1980s, chaebols have had no functioning governance system to guard against wrong decisions since then. This problem became more acute when the chaebol chairmanship was passed down to the second and third generations of founding families. Frequently, these new chairmen, who had yet to demonstrate their management prowess, desired to prove their ability by embarking on ambitious, costly, economically unviable expansions that they financed with funds from their chaebols’ internal capital markets. There was no mechanism to stop them from doing so. These issues will be discussed further in Chapters 5 and 6. Second, by extensively sharing human resources among their affiliates, a chaebol created a homogenous group of managers. Managers were mostly internally promoted, and chaebol chairmanships were inherited within a family. In addition family members often assume presidentship in individual affiliates. For instance, Hyundai Group had five family members who took 108

Diversification and Economic Performance presidentship in eleven affiliates. Similarly, LG Group had six; SK Group had two; and Samsung Group and Daewoo Group had one each, acting as presidents. As a consequence, a chaebol chairman and presidents of affiliate companies alike possessed fairly homogenous management philosophy and practices, which can help transfers of existing knowledge more easily but can stifle creativity. Management literature stresses that the more homogenous the managers, the harder it is to change strategic orientation (Tushman and Romanelli, 1985). This inertial force may explain why chaebols continued unrelated diversification even when doing so was obviously unwise. In this chapter, we have examined how chaebols created operating synergies by sharing resources among group affiliates and highlighted how much value creation can be wasted by an ineffective group-level strategy. Without the presence of a functioning governance system, it is difficult to stop ill-conceived moves by group chairmen. Furthermore, internal promotions and a homogeneous group culture make it hard to change strategic orientation, which may help us understand why the chaebols relentlessly diversified. The further restructuring of chaebols should include stronger corporate governance systems, while preserving the chaebols’ capability to create synergies through resource sharing and coordination at the group level since this capability was the real source of chaebols’ competitive advantage prior to the crisis.

109

4

Vertical Integration of Chaebols

111

The Scope of Chaebols’ Vertical Integration In Chapter 3, we discussed how chaebols create synergies between different lines of business. Chaebols also use vertical integration extensively. This chapter will examine the scope of vertical integration in the chaebols and discuss the performance implications of their using it. It shows how vertical integration, which was necessitated by the absence of domestic supporting industries during the economic planning periods, turned inefficient and why chaebols ended up subsidizing unprofitable affiliates.

the scope of chaebols' vertical integration Vertical integration means an internal transfer of goods and services within a firm. In this book, we measure the extent of chaebols’ vertical integration by dividing their intragroup sales volume by their total revenue. By doing so, we measure the extent of vertical integration among group affiliates. This measure does not reflect the vertical integration within an affiliate. Table 1.1 manifests percentages of intragroup sales of the top thirty chaebols. Anam Group showed the highest level of vertical integration, chalking up 55.9% of intragroup transaction, while Dongah Group, which specialized in overseas construction, showed the lowest level of vertical integration. The top five chaebols were 20 to 30% integrated (Hyundai 31%, Samsung 28%, LG 23%, Daewoo 36%, SK 21%). Simple averages, however, can disguise the extent of vertical integration in affiliates. Individual affiliates, which supply parts to chaebols’ core manufacturing companies in distinct industries (e.g., chemical and electronics affiliates), usually have a higher volume of the intragroup transactions. Furthermore, because this measure does 113

Vertical Integration of Chaebols not reflect within-affiliate vertical integration, the actual level of vertical integration of chaebols is far more substantial than this number suggests.1 Figure 4.1 shows the Hyundai Group’s internal business transactions as of 1997. This group has two major construction companies, Hyundai Construction for overseas projects and Hyundai Industrial Development for domestic needs. In its chemical business, Hyundai Petrochemical and Hyundai Oil Refinery are the core firms. Hyundai Group’s other core companies include: Hyundai Heavy Industries in shipbuilding; Hyundai Electronics,2 the second largest manufacturer of memory semiconductor in the world; and Hyundai Motor in the automobile industry. These companies maintain backward (or upstream) integration with very extensive and intricate networks of smaller affiliates that supply intermediary goods and parts to them. For instance, Hyundai Pipe delivers construction pipes to Hyundai Construction and Hyundai Industrial Development. Hyundai Livart supplies furniture and interior decoration materials to Hyundai Construction and Hyundai Industrial Development. Hyundai Elevator distributes elevators to the core construction companies. Hyundai Pipe, Hyundai Livart, and Hyundai Elevator have a level of intragroup transactions as high as 38%. Inchon Steel derives about 27% of its total revenue from intragroup transactions. On the other hand, Hyundai Engineering designs and supplies major manufacturing facilities to Hyundai Oil Refinery, Hyundai Electronics, and Hyundai Heavy Industries. Korea Flange manufactures flanges and other automobile parts for the shipbuilding and automobile manufacturing companies. Firms such as KEPICO, Hyundai Precision, and Hyundai Aerospace supply Hyundai Motor. These suppliers

114

The Scope of Chaebols’ Vertical Integration may derive as much as 90% of their revenues from sales to affiliates. There are also instances of forward (or downstream) integration for manufacturing companies in Hyundai Group. Hyundai Corporation is a general trading company set up in accordance with the Korean government’s export drive during the mid 1970s.3 During this period, the government designated a number of general trading companies and supported them with low-interest loans as an export subsidy. Although these firms no longer receive this subsidy, they continue to be the intermediary of their affiliates’ exports and imports. Hyundai Corporation, for instance, imports raw materials and equipment on behalf of its affiliates, which presents 43% of its total revenue in 1997. It also purchases finished products from the affiliates and sells them in overseas market. Such transactions represent about 52% of the company’s total revenue.4 In addition, Hyundai Merchant Marine provides services to other affiliates that need to ship exports. Forward integration also takes place through domestic salesrelated affiliates. For instance, Hyundai Motor uses Hyundai Motor Service to distribute its products in Korea, Kumkang Development for its retail business, and Hyundai Logistics for domestic and overseas transportation services. Diamond Ad provides a variety of advertisements/commercials services to its affiliates so that most of its revenue comes from these affiliates. The chaebols’ various financial institutions also cater to the groups’ financial needs through internal financial transactions.5 Such vertical integration is not unique to Hyundai; similar patterns of activity are found in Samsung, SK, Daewoo, and LG (see Figures A.7.1–A.7.4) for the extent of vertical integration for each group). Such extensive vertical integration is unique

115

Vertical Integration of Chaebols

778

Hyundai Pipe

Hyundai Construction

499

38%

570 314

2%

718

1,306

Hyundai Livart

348

475

27%

Hyundai Industrial Development

305 793

Hyundai Elevator

311

20%

511

38%

Koryo Industry 1% 750 1,195

Inchon Steel

Hyundai Petrochem.

1,687

27%

26% 2,982

Hyundai Refinery

1,007

Hyundai Aerospace

1,700

52%

71%

669 456

797

484

Daehan Aluminum 26% 833

Hyundai Precision Mfg.

366

16%

539

483 355

Hyundai Heavy Industries

Hyundai Mipo Shipyard

50% 1,725

10% 980

Hyundai Engineering

405

Hyundai Info. System

1,881

2,494

378

709

Hyundai Electronics 20%

72% 2,134 587 335

Korea Flange 78%

1,939

324

3,127 690

1,074 1,562

Hyundai Motor

1,513

32%

Kepico 90%

Figure 4.1. Intragroup business transactions in Hyundai Group. Source: Korea Information Services.

116

The Scope of Chaebols’ Vertical Integration All data are as of December 1997. Unit is 100 million won 1. Large circles are for affiliates with over 5 trillion won in assets.

Kumkang Development

561

11%

2. We show internal sales that are over 30 billion won. 3. The percentage in a circle denotes the proportion of intragroup sales relative to the total sales of that affiliate.

Hyundai Oils 10,005

963

1,882 8

1,53

Hyundai Corp.

641

43%

2,769 2,554

450 381 971

Hyundai Merchant Marine 19%

Hyundai Merchant Bank

2,185 610

8,561

Hyundai Marine & Fire Insurance

Hyundai Motor Service 2% 36,967

Hyundai Capital

Hyundai Securities

Diamond Ad.

Hyundai Investment Trust

to chaebols with respect to business groups in other countries. In the following sections, we will examine in more detail why the chaebols adopted the vertical integration and its performance implications. 117

Vertical Integration of Chaebols motives for vertical integration: pros and cons The Advantages of Vertical Integration Differences in chaebols’ use of vertical integration stem from the distinct characteristics of the industries the chaebols are involved in. Hyundai Group, for example, uses much vertical integration because of its extensive engagement in construction, automobiles, heavy equipment, and chemicals. These industries involve complex assembly of numerous parts or multi-stage production processes. During the era of Five-Year Economic Development Plans, the Korean government forced chaebols into these industries without building any infrastructure of parts suppliers or supporting services. Since the chaebols found it difficult to purchase or otherwise secure necessary parts and the Korean government pushed domestic firms to industrialize, there were clear and seemingly inevitable reasons to integrate vertically. Table 4.1 shows the types of industries the top thirty chaebol groups are in, and the average internal sales and purchases of affiliates in each industry. Forward integration, measured by the intragroup sales ratio, is often found in industries such as foods, textile, pulp, oil refining, chemicals, plastics, metals, machinery, electronics, mining, and automobiles. Backward integration, measured by the intragroup purchasing ratio, is frequent among the textile, leather, oil refining, plastics, computing, medical equipment, and automobile industries. Vertical integration is conspicuous not only in machinery and construction industries like Hyundai but also in the electronics and chemical industries. For example, Samsung Electronics is closely interlinked with Samsung SDI, a manufacturer of television tubes, which in turn relies on Samsung Corning, which produces glass bulbs 118

Motives for Vertical Integration: Pros and Cons Table 4.1. The extent of vertical integration of chaebol affiliates by industry participation

Industry Food Textile Clothing Leather Pulp and paper Publishing Petroleum refining Chemicals Plastics Nonferrous metals Metals Fabrication metals Machinery Computing Electric machinery Electronics Medical equipment Auto & transportation equipment Other transportation equipment Furniture Mining Utilities Construction Automobile sales Wholesale Retail Hospitality industry Warehousing Transportation

No. of Average backward Average forward chaebol firms integration integration 22 5 1 1 8 3 3 43 8 10 15 4 9 1 6 30 3 26

8.0 20.6 2.7 20.0 7.1 0.7 23.0 18.8 26.4 16.9 11.7 12.9 2.2 27.1 12.7 11.4 37.8 13.4

28.1 27.5 1.4 14.8 45.0 5.8 51.7 22.2 32.9 37.8 18.1 16.8 31.5 17.3 23.2 40.6 13.5 53.3

6

5.9

16.5

1 1 7 33 5 33 14 13 8 7

22.7 8.7 18.8 2.2 80.4 28.6 3.9 4.4 8.0 9.1

1.0 100.0 7.2 22.4 8.5 21.4 3.6 4.7 18.4 21.0

119

Vertical Integration of Chaebols Table 4.1 (cont.)

Industry Air transportation Travel services Telecom services Information processing Others

No. of Average backward Average forward chaebol firms integration integration 1 11 3 17 27

0.0 2.9 3.9 7.9 0.9

0.0 55.0 33.3 51.3 44.0

Note: Forward integration is defined as the level of intragroup sales divided by the total sales of a firm. Backward integration is defined as the level of intragroup purchases divided by the total sales of a firm.

for the tubes, as indicated by the fact that 61% of its total revenue comes from Samsung SDI. Samsung SDI, in turn, supplies 52% of its products to Samsung Electronics. Samsung Electro-Mechanics, a producer of electronic parts, sells 69% of its products to Samsung Electronics. The chemical industry also has many examples of vertical integration such as those found in SK Group, which is devoted to energy and chemicals. SK Chemical, a leading producer of polyester fibers and other petrochemical products, secures raw materials from SK Corporation, a petroleum refinery. SKC, a producer of polyester film, in turn purchases raw materials from SK Chemical. Vertical integration in such industries tends to be efficient because it helps companies maintain better quality and punctuality than they could achieve through outsourcing. For example, if problems of defects or delay occur, the purchaser, who maintains large assembly lines under the economy of scale, will suffer greatly because it is forced to suspend the remaining assembly processes. They will then incur significant costs in finding, selling, negotiating, contracting, monitoring, and resolving 120

Motives for Vertical Integration: Pros and Cons disputes with suppliers in open market transactions (Coase, 1937; Williamson, 1975).6 Extensive vertical transactions may also allow efficient coordination, such as reduction of inventory and transportation costs and immediate adoption of efficient technology (Harrigan, 1983; D’Aveni and Ravenscraft, 1994). Furthermore, vertical integration means that the fruits of R&D in one stage of production are more likely to be shared with other stages, thereby increasing the overall competitiveness of both upstream and downstream operations. Therefore, chaebols’ core affiliates prefer vertical integration, which lets them control the quality of important parts and delivery schedules and carry lower inventories. In addition, when few companies manufacture a product, a buyer is subject to opportunistic behavior such as unstable prices. Conversely, suppliers are unwilling to make substantial asset-specific investments for customers with unique needs because buyers may also behave opportunistically. In such circumstances, vertical integration may be the most efficient alternative. In addition, increased information exchange between buyers and sellers can enhance technology development (Scherer and Ross, 1990). Finally, vertical integration reduces marketing and sales-related expenses. All those virtues suggest that chaebols can reap huge efficiency gains from vertical integration. Disadvantages of Vertical Integration Yet vertical integration is not always efficient. Since the corporate restructuring boom of the 1980s, firms in the United States have moved away from vertical integration and toward extensive outsourcing. Some of the largest U.S. firms have even spun off divisions because they believed these units would be more competitive if they were not constrained by a corporate parent. 121

Vertical Integration of Chaebols For example, AT&T spun off its hardware manufacturing unit and the Bell Laboratory into Lucent Technologies in 1996.7 Similarly, GM reversed a long-standing strategy of vertical integration by divesting automobile parts businesses, most notably with the spin-off of Delphi in 1999.8 One of the potential hazards of vertical integration is that vertically integrated suppliers lack the incentive to be more efficient or innovative because they have captive customers (Mahoney, 1992). This lack of incentives can be severe in the case of chaebols’ affiliates because large portions of their sales go to other affiliates. Efficiency can also be jeopardized when firms facing different market constraints are placed under one corporate umbrella. For example, small parts-supplying affiliates may want to use different payment and benefit structures than do large assembly affiliates. If grouped together, however, they are bound by the same payments and benefits, which may not fit any of them very well. To create a homogenous group culture and to facilitate the intragroup transfer of personnel, chaebols used the same level of payments and benefits for all affiliates; these levels were often too stringent for successful affiliates and too generous for poorly performing affiliates. Vertical integration is also not sufficiently flexible to adjust to different transaction volumes, which is especially important during periods of economic instability and fluctuations (Harrigan, 1985; D’Aveni and Ilinitch, 1992). In highly competitive and turbulent environments, firms are better off selecting the best external suppliers, switching suppliers when new technology appears, and avoiding idle capacity and inventory swings in its production. For example, Alcoa reduced its vertical integration from mining ores to rolling can sheets to avoid what was known as the “aluminum cycle.”9 Such risks could have been particularly detrimental to chaebols, which went through serious 122

Implications of Chaebols’ Vertical Integration economic downturns in the 1990s, as in Figure 1.3. Tied into cobwebs of debt guarantees and cross-shareholding, and constrained by external parties (i.e., the chairman of their group), chaebol affiliates might have found it extremely difficult to unravel themselves from vertically integrated relationships because doing so would affect the well-being of other vertically integrated affiliates. Eventually, financially troubled affiliates may survive only with support from their parent company, which is exactly what happened to chaebols. Chaebols supported unprofitable affiliates via various forms of internal transactions and could not shut down these affiliates until after the crisis.10

performance implications of chaebols' vertical integration This section will review the economic effects of chaebols’ vertical integration. It will analyze the cost structures of chaebols’ affiliates and the impact of vertical integration on each cost factor. This analysis helps us understand the balance of benefits and costs associated with vertical integration. It is based on an empirical study of the cost structure of vertical integration, which can be found in Appendix 4. Cost Structure and Performance Implication of Vertical Integration To estimate the magnitude of benefits and costs, we decomposed the cost factors of chaebols’ manufacturing affiliates into cost of goods sold and various expense items such as general and administrative, research and development, advertisement, and sales expenses for 1985–96. We use the return on invested capital (ROIC) measure that we used in Chapter 1 to assess 123

Vertical Integration of Chaebols performance. We then examined the impact of forward and backward integration on the cost structure. Again, forward integration is measured by the intragroup sales ratio, and backward integration, by its intragroup purchasing ratio. As summarized in Table 4.2, the empirical analysis shows that the cost of goods sold, which include payrolls, raw material, factory depreciation, and rental expenses, tends to increase according to the degree of forward or backward integration, suggesting that vertical integration is inefficient for chaebols. Some costs, such as sales, general, and administrative expenses, seem to decrease with vertical integration. Advertising expenses decrease for forward integration. R&D expenses increase with backward integration. All these effects of vertical integration collectively influence profitability, which increases for forward integration but decreases for backward integration. A more finegrained analysis by time period shows that vertical integration began to hurt chaebol firms’ profitability in the 1990s, when the economy contracted. Overall, the results imply that chaebol affiliates gain from forward integration and lose from backward integration. More specifically, suppliers gain from vertical integration, but only at the expense of their affiliate assemblers. Both buyers and sellers seem to suffer from operating inefficiency, however, as cost of goods sold increases with vertical integration. Chaebols would be more profitable if they divested their parts manufacturers and purchased goods in competitive markets. Cross-Subsidization This analysis poses some intriguing questions. Why did chaebols maintain vertical integration despite such inefficiency? In particular, why were downstream assemblers willing to pay the 124

− ns

+

+

− −

−

General and administrative expenses

−

Sales expense

+

ns

R&D expense

−

+

Profitability

Note: (+)/(−) denote the positive/negative impact on the cost item or profit. Ns denotes insignificant coefficients.

Forward integration Backward integration

Variable

Advertising expense

Cost of goods sold

Table 4.2. The impact of vertical integration on costs and profitability

Vertical Integration of Chaebols higher prices of their upstream affiliates? There are two possible answers to these questions. As we discuss in Chapter 5, one possible answer is the inertia toward changes, such as restructuring, which was created by mutual debt guarantee practices and cross-shareholding. Assemblers, which extended the debt payment guarantees to affiliated suppliers, could not let them go bankrupt because the assemblers themselves would then become liable for these debts. Also, if suppliers went bankrupt, assemblers would lose their equity investments in these affiliates. Bringing in third-party suppliers to increase competition might not be a viable option because it would hurt already weakened affiliates. Thus, assemblers might have to come and rescue the suppliers by extending subsidies in a variety of forms. Cross-subsidization, which is defined as “when a multiproduct firm prices one good below average cost and makes up for the losses through revenues collected from the sales of other goods that are priced above the average cost” (Viscusi, Vernon, and Harrington, 1992: 313), is, however, common in diversified business organizations. Firms often use artificial transfer pricing schemes to reallocate losses and profits among related business units. Such behavior is not consistent with profit maximization or welfare maximization for individual product lines but is consistent with maximizing the overall goal of a diversified corporation (Posner, 1971). Likewise, it does not make sense for individual affiliates to support poorly performing affiliates. Doing so does make sense, however, for the group headquarters, which wants to maximize the profits of the entire group. Several studies of the Japanese keiretsu found strong evidence of cross-subsidization.11 Cases of cross-subsidization were not very well documented in the past. The Fair Trade Commission of Korea, however, 126

Implications of Chaebols’ Vertical Integration started investigating these intragroup transactions in 1998.12 Two such investigations found evidence of subsidies in the top five chaebols: in 1998, the transaction volumes for these instances were 4 trillion won and 1.5 trillion won, respectively, and the subsidies affected summed to 209 billion won and 55 billion won, respectively. In 1999, there was evidence of 53 affiliates supporting 38 affiliates for 250 billion won on a transaction volume of 12 trillion won. The government found further evidence that chaebols continued to cross-subsidize affiliates in its fourth investigation in 2000. The government levied penalties on the chaebols for these transactions. They are summarized in Table 4.3 and are perhaps only a small fraction of the total amount of cross-subsidization. Chaebols apparently cross-subsidize many different types of transaction. For instance, Hyundai Merchant Marine assisted Hyundai Logistics by allowing it to operate its own logistics facilities and by neglecting for over a year to collect payments of 10.8 billion won Hyundai Logistics received from shipping companies. When Hyundai Logistics finally reimbursed Hyundai Merchant Marine, it did not pay any overdue interest rates.13 Another example includes Hyundai Securities, which launched a series of joint advertisements with Hyundai Investment Trust from March to April 1999 and paid the expenses by itself without requesting reimbursement from its joint advertiser.14 The government authorities also revealed other examples of intragroup support subsidies in Samsung Group, LG Group, and SK Group.15 What makes these actions more complicated and troubling is that they exploit chaebols’ ownership and corporate governance structures, which we discuss in Chapter 6. Most large downstream chaebol affiliates are listed in the stock exchange, and chaebol families hold but a small portion of their stock. 127

770 720 422 1,057 1,055 4,026

33 22 33 37 78 209 348 200 41 68 834 1,492

Estimated Volume of amount of unfair business subsidies transactions 29 7 8 7 4 55

4,093 399 5430 1,098 1,311 12,332

94 57 86 12 2 250

565 331 — 504 1,063 2,463

44 35 — 18 28 126

Estimated amount of subsidies

Fourth investigation (December 2000)

Estimated Volume of amount of unfair business subsidies transactions

Third investigation (October 1999)

Estimated Volume of amount of unfair business subsidies transactions

Second investigation (November 1998)

Note: Daewoo Group, which went bankrupt in 1999, was excluded in the fourth investigation. Source: Korea Fair Trade Commission.

Hyundai Samsung Daewoo LG SK Total

Volume of unfair business transactions

First investigation (July 1998)

Table 4.3. The total intragroup business transactions (in billion won) that were identified as cross-subsidization by the Korea Fair Trade Commission

Implications of Chaebols’ Vertical Integration However, because they have major shareholdings in the affiliates that supply these downstream manufacturers, it is possible that chaebols intentionally reduce the profitability of the listed companies by cross-subsidizing these suppliers. According to the investigation of intragroup business transaction by the Korea Fair Trade Commission, as summarized in Table 4.3, Hyundai Motor, Hyundai Heavy Industries, Hyundai Merchant Marine, and Hyundai Securities, all publicly traded companies, subsidized Hyundai Livart, Daehan Aluminum, Kumkang Development, and Hyundai Investment and Trust, which were privately owned and incurring heavy losses, via various forms of internal transactions such as providing interest-free loans or not collecting their accounts receivables. The SK Telecom case, which we will discuss in more detail in Chapter 6, provides further support for this conjecture. Vertical integration in Korean chaebols has been inefficient in recent years. Large assemblers have suffered from crosssubsidization. Further, they are stuck in inflexible supply relationships that reduce their ability to innovate in the long run. The analysis in this chapter shows that the ownership and corporate governance system created great inertia that prohibited faster restructuring of vertical integration. Chaebols should thus initiate business reforms that will reduce their scope of vertical integration. The reform in the corporate governance system will precipitate this restructuring process. In addition, the government should work harder to eradicate cross-subsidization within chaebols.

129

5

The Capital Structure of Chaebols

131

Financial Market Environments in Korea In this chapter, we will examine the financial market environment in which chaebols operate and then analyze chaebols’ capital structure. Specifically, we will focus on the correlation between Korean financial markets and chaebols’ heavy use of debt. We will also consider the practices that chaebols use in their internal capital market, including loans, debt guarantees, and cross-shareholding. This analysis will lead to a deeper understanding of how chaebols were vulnerable to the foreign exchange crisis in 1997.

financial market environments in korea The Korean Government’s Intervention Korean economic development was spurred on by active governmental intervention and Economic Development Plans, which aggressively channeled necessary capital into “strategic” industries, including export-oriented industries and heavy and chemical industries.1 After the 1961 coup d’etat, President Chung-Hee Park nationalized all private banks, which afterward ceased to function as credit examiners and instead functioned as a tool of Korean government’s industrial and resource allocation policies.2 He also placed the nation’s central bank, the Bank of Korea, under the supervision of the Ministry of Finance, which made major monetary decisions such as setting interest rates and discount rates and conducting open market operations. During this period, the Korean government also absorbed and mediated the risks faced by embryonic firms in the industries it supported. In many cases, it pledged payment guarantees to secure foreign loans for industrialization. When companies that enjoyed preferential credit from the government went 133

The Capital Structure of Chaebols bankrupt or faced financial difficulties, the government interfered by freezing the debts, arranging a relief fund at lower interest rates from banks, converting debt to equity, or forcing healthy companies to acquire these troubled firms.3 In the government’s eyes, private companies’ financial crises could lead to a national crisis, and thus merited governmental intervention. This assumption was particularly relevant for chaebols and created the belief that chaebols were “too big to fail.” As a result, chaebols were able to shift all risks accompanying their business enterprise to the government and ultimately the public, while hoarding all the benefits if they succeeded. Because the government would support them if they failed, chaebols had a huge incentive to disregard risk and to diversify into business areas favored by the government. Thus, “moral hazard” became prevalent in Korea.4 In fact, Krugman (1998) argued that existence of moral hazard was common to all Asian countries affected by the crisis. Banks, on the other hand, lacked the power, commitment, and capacity for strict credit analysis because they were but an extension of the government. Even after the privatization of commercial banks in 1981, the Ministry of Finance intervened extensively in their lending practices and in setting interest rates.5 Because of this continued intervention, bank managers had very little latitude in their asset management, and therefore had little accountability for their banks’ performance (Fields, 1995; Park, 1994). As partial compensation for this extensive governmental intervention, the regulations on bank’s lending practices were lax. For instance, all commercial banks maintained trust accounts, for which there were no specific exposure limits or provisioning rules on loans, and no reserve requirements, and yet they were just like deposits because the banks guaranteed both the principal and the yield. These 134

Financial Market Environments in Korea accounts exacerbated the crisis (Balino and Ubide, 1999). The government-owned specialized and development banks were not even subject to the minimal standards and supervision that commercial banks were.6 Because banks lacked the ability to function properly, they began to require high levels of collateral as well as debt guarantees to protect their assets. Chaebols responded by extending debt guarantees between affiliated companies. Ultimately, chaebols with more affiliates that could extend collateral and debt guarantees received better financial treatment and opportunities for further expansion than did other, smaller companies. These circumstances led to skyrocketing debt–equity ratios among chaebol affiliates that would have been impossible without governmental support; the government’s policies not only allowed such behavior but also encouraged it. Chaebols’ Financial Service Arms Chaebols’ appetite for capital did not end with the loans they secured from banks. They wanted to own banks so that they could tap banks’ reserves as if these reserves were their own. In fact, chaebols used to own banks. Upon the advice of American experts, the Korean government privatized banks in 1957 to prop up the financial service sector (Woo, 1991). Chaebols snatched up these banks, however, thereby nullifying the original intent of privatization. Banks were then nationalized immediately after President Park seized power in 1961. When banks were gradually privatized once again in the 1980s, chaebols immediately began aggressively purchasing stock in them.7 Before the Bank Act was revised in 1998, no one entity could own more than 4% of a national bank or 15% of a regional bank, except for foreign investors operating through a 135

The Capital Structure of Chaebols Table 5.1. Shares of top thirty chaebols in loans from bank and nonbank financial institutions in Korea as of 1997 Total loans to top 30 chaebols (in billion won)

Top 30 chaebols’ share (%)

73,827 55,949

20.3 32.9

133,776

24.5

Commercial banks Nonbank financial institutions All financial institutions Source: Financial Supervisory Board.

joint venture.8 As of 1997, Samsung Group owned more than 3% shares of Choheung Bank, 3.5% of Shinhan Bank, and 18.5% of Koram Bank in a three-party joint venture with Bank of America and Daewoo Group, and 3.6% of Hana Bank (see Table 2.2). For two other national commercial banks, Commercial Bank of Korea and Hanil Bank, Samsung owned more than the lawful limit (6.9 and 4.9%, respectively). It also had large stakes in several regional banks such as Taegu Bank. Hyundai Group owned more than 2% of Kookmin and Hanil Banks, as well as 11.9% of Kangwon Bank, a regional bank. Daewoo Group had a 18.5% interest in Koram Bank. Chaebols used this equity both to enhance their bargaining power during credit negotiations with banks and to prepare for acquiring banks if and when further deregulation of bank ownership occurred. In all, loans to top thirty chaebols by commercial banks amounted to 73 trillion won in 1997, representing 20.3% of these banks’ total loans (see Table 5.1). Chaebols also invested heavily in many nonbank financial institutions, including insurance companies, securities companies, 136

Financial Market Environments in Korea investment trusts, merchant banks, credit cards, and installment financing.9 Because nonbank financial institutions were not directly involved in the payment settlement system, the Korean government did not heavily regulate ownership of them. Many chaebols also invested in nonbank financial institutions after the regulation of such businesses became more lax in the early 1990s. For instance, the top five chaebols all own life insurance companies. Most large chaebols, including the top five, own securities companies, investment trust companies, and merchant banks. For example, Daewoo newly established Daewoo Installment Financing (1994), Daewoo Venture Capital (1996), and Daewoo Futures (1997), while it had owned Daewoo Securities since 1983. Hyundai, Samsung, SK, and LG also added many new nonbank financial companies. Table 2.3 depicts the top thirty chaebols’ ownership of these nonbank financial companies. Chaebols aggressively marched into the financial sector, partly because they believed it had high growth potential, which they could exploit for further expansion. More importantly, however, they wanted to use financial companies as the channel of capital procurement and portfolio management for all their affiliates. They were successful in doing so; Table 5.1 shows that their share of loans held by all nonbank financial institutions was 32.9%, which was much higher than their share of loans held by commercial banks was. For example, Samsung Life Insurance lent a total of 502.8 billion won to Samsung affiliates, which amounted to about 3.2% of its total lending. Hyundai Fire and Marine Insurance extended 6.7% of its total loans to Hyundai affiliates. These relatively low percentages resulted from the government limiting such firms’ lending to no more than 3% of their total assets to affiliates. These firms did, however, provide much more 137

The Capital Structure of Chaebols favorable terms for loans to affiliates than they did for loans to nonaffiliates. According to the report by Ministry of Finance and Economy, affiliated companies enjoyed preferential lending rates. For example, the average interest rates charged by Kyobo Life to other Daewoo affiliates were 10.7% while its average interest rates were as high as 11.8%.10 Security companies, which were subject to far less regulation than were banks or insurance companies, supported their affiliates more actively. In Table 5.2, for instance, Samsung Securities assumed rights to 1.07 trillion won of corporate bonds issued by Samsung affiliates from January to July 1997, which is 69.3% of all corporate bonds acquired by Samsung Securities during the same period. Daewoo Securities undertook 1.4 trillion won of corporate bonds issued by Daewoo affiliates, accounting for 51.1% of its corporate bond acquisitions. Such acquisitions allowed affiliates to sell various bonds through affiliated securities companies, securing funds directly from affiliated companies or external sources. It is difficult to gauge the lending structure of merchant banks because they were not subject to any restriction of intragroup lending. The Korean government allowed chaebols to own merchant banks in an effort to absorb curb markets. Their role, however, as the capital supplier for affiliated companies must be more extensive because one of their most prominent roles is to acquire and apply discounts on corporate promissory notes or commercial paper issued by affiliates. Chaebols’ financial companies play two additional important roles. First, they function as holding companies within their groups. For instance, Samsung Life Insurance owned 762.1 billion won worth of Samsung companies’ shares, about 9.4% of its stock portfolio. Similarly, Samsung Fire Insurance had 7.2% of its total stock interest in Samsung companies. Other insurance and securities companies as shown in Table 5.2 138

0 (0%)

79.8 (7.2%)

502.8 (3.2%)

762.1 (9.4%)

Samsung Fire Insurance

11.6

1,076 (69.3%)

Samsung Securities

19.5 (2.9%)

35 (6.7%)

Hyundai Fire and Marine

30.9

2,350 (76.6%)

Hyundai Securities

Hyundai

549.6 (5.0%)

Kyobo Life Insurance

103.4

1,436.4 (51.1.%)

Daewoo Securities

Daewoo

Note: SK Group acquired SK Life Insurance in December 1997. Thus, it is not shown in this table. Source: Ministry of Finance and Economy.

Loan to other group affiliates (% of total loans) Acquisitions of bonds issued by other affiliates (% of total bond acquisition) Stock holdings of other group affiliates (% of total stock holdings)

Samsung Life Insurance

Samsung

34.1 (6.3%)

0 (0%)

LG Fire Insurance

81.5

1,389 (62.6%)

LG Securities

LG

18.8

446 (60.4%)

SK Securities

SK

Table 5.2. Contributions as of July 1997 (in billion won) of top five chaebols’ nonbank financial institutions

The Capital Structure of Chaebols perform a similar function. Second, these financial institutions serve as portfolio managers for the chairmen and their families. Life insurance and securities companies can manipulate and control their own stock prices through this practice. For example, the chief executive officer of Hyundai Securities was convicted for his company’s price manipulation of Hyundai Semiconductor’s shares in 1999.11 By allowing chaebols to own financial companies, the government seriously distorted the flow of financial capital.12 Nonbank financial institutions gradually were turned into private vaults for the chaebol and did not direct capital flows to healthier businesses. Chaebol companies began investing money procured from their own financial institutions into inefficient businesses. There was no mechanism, such as credit analysis, in place to control these firms’ capital flows efficiently. In short, efficiency in capital allocation evaporated. Thus, when the financial crisis hit Korea, international liquidity problems quickly hit financial institutions and chaebols, resulting in chains of insolvencies. These events show that both inadequate financial supervision by the government and the resulting absence of a corporate governance system were the most fundamental causes for the financial crisis. There were some precedents to similar crises caused by inadequate financial supervision, most notably in Chile and Argentina in 1981 under their economic liberalization programs.13 In Chile, Pinochet, who took power through a coup d’etat, aggressively liberalized the economy. This liberalization plan balanced the budget, reduced inflation, and stabilized foreign exchange. It also raised the real interest rate to attract foreign investors and lowered tariffs to encourage imports. In addition, it privatized many companies nationalized by the Allende government. Despite its liberalization policies, Chile 140

Capital Structure of Chaebols experienced a foreign exchange crisis in 1981. The root cause for the crisis was that banks did not control their lending practices. Instead, banks owned by large business groups recklessly borrowed from foreign creditors and lent funds to their affiliates. When Mexico announced it was suspending its debt payments, foreign creditors withdrew their lending to all Latin American countries.14 Similarly, Argentina, which pursued economic liberalization from 1976 to 1981, had a foreign exchange crisis in 1981 for the same reasons that Chile did.

capital structure of chaebols High Debt–Equity Ratios The average debt–equity ratio of the top thirty chaebols is 600%. Some chaebols have ratios approaching 4,000% (see Table 1.1).15 These ratios are much higher than are those of firms in countries with well-developed equity capital markets such as the United States, United Kingdom, and Canada.16 Japanese companies, which rely mainly on bank financing, have ratios almost as high as their Korean counterparts. German, Austrian, and Spanish firms, which use both equity and debt financing, maintain average ratios between those of U.S. and Korean firms. Higher debt–equity ratios do not, however, necessarily mean that the firms with them are inefficient. Capital structures of companies are based on external factors, such as the macroeconomic or financial regulatory environments that companies must face. Numerous studies of the optimal corporate capital structure have hitherto failed to present any definitive conclusions.17 Rather, La Porta et al. (1998) showed that corporate capital structure is contingent on the legal environment in which the company operates. For example, the United States and United Kingdom 141

The Capital Structure of Chaebols stress the rights of minority shareholders, extend comprehensive support to hostile corporate takeovers, and prefer dissemination of corporate information and exercise of shareholders’ rights. These legal environments lower the costs of raising capital from equity markets and lead firms to prefer equity financing to debt financing. On the other hand, Germany and other countries that followed the German trajectory, such as Austria, Japan, and Korea, have weaker structures for minority shareholders’ rights protection, management monitoring, information dissemination, and accounting audits, resulting in a higher cost for equity financing because investors demand higher premiums to compensate for potential risks associated with incomplete information.18 In such countries, companies opted for indirect financing through banks to avoid the higher costs of equity financing. Chaebols’ high debt–equity ratios are also a result of recent Korean history. Under the Economic Development Plans during 1961–80, the government extended various special funds at low interest rates, inducing firms to increase their use of debt, and ultimately resulting in higher debt–equity ratios.19 Also, Korean companies that experienced rapid growth often had limited internal funds to meet their expansion needs. Unlike companies in mature economies with ample capital available, they had to rely on external sources of capital, which flowed into Korea as debt.20 Similarly, late economic developers such as Germany or Japan had to rely on the state or banks for capital because it was hard to secure capital from individuals.21 Thus, in Korea, it became inevitable that the government and the banks controlled by it would play a crucial role in allocating capital to businesses. Korea also used foreign capital to finance its long-term investment and to cover for the balance of payment deficit since the first economic planning period. Korea was the third largest 142

Capital Structure of Chaebols debtor, following only Mexico and Brazil in the mid 1970s, and creditors were concerned it would default (Woo, 1991). The ratio of foreign debt to GNP rose from 4% in 1963 to 32% in 1979 (Amsden, 1989). The IMF stepped in several times to slow down this increase. Thus, we need to consider not just how chaebols have become so indebted but also whether this debt is short term or long term, where it comes from, and how efficiently chaebols use it. Figure 5.1 shows changes in the debt–equity ratios of individual affiliates of the top thirty chaebols and the composition of their debts from 1985 to 2000. This ratio reached nearly 500% in the early 1980s, decreased somewhat during the economic boom in the late 1980s, and then increased during the 1990s. Figure 5.1 further classifies debts as short term, defined as having less than a year until maturity, or long term as well as by source – domestic versus foreign. Figure 5.1 also shows that from 1995 to 1997, affiliates’ use of every kind of debt instrument, especially short-term debt from domestic and foreign sources, rose dramatically. Because Korean financial institutions underwrote a large portion of short-term domestic debt, which they in turn borrowed from foreign financial institutions, chaebols depended even more on foreign currency than these data suggest. This dependence made them and Korean financial institutions vulnerable to contractions in supplies of foreign capital. Why did chaebols take on so much debt prior to the crisis? Table 5.3 analyzes cash flow statements to review the details of capital procurement and expenditure of the top thirty chaebols. From 1995 to 2000, internal funds from retained earnings, depreciation, and other sources at these chaebols decreased from 36.8% in 1995 to 22.4% in 1996 to 12.3% in 1997, and increased slightly to 12.6% in 1998. The Korean economy began contracting in 1995, thus reducing corporate profits and making 143

The Capital Structure of Chaebols % 600.00

500.00

400.00

bond foreign long-term debt

300.00

long-term domestic debt foreign short-term debt 200.00

domestic short-term debt

100.00

note 0.00 1985

1986

1987

1988 1989

1990

1991

1992

1993

1994

1995

1996 1997

1998

1999

2000

Year

Figure 5.1. The debt–equity ratio of chaebol-affiliated firms and the composition of debts expressed as a ratio to equity, 1985–2000. Source: Korea Information Service. Note: This figure is based on the financial data available in the KIS database. Thus, small affiliates with assets of less than 6 billion won were not included. As a consequence, the average debt–equity ratio, for instance in 1997, was lower than that in Table 1.1, which was based on all affiliates. See Appendix 1 for our sample composition

the acquisition of new capital from intracompany sources much more difficult. Capital raised through new equity issues also remained minuscule. Chaebols relied on new equity issues to meet the government’s demand to lower the debt–equity ratio to 200% only after 1999, as discussed in Chapter 7. In contrast, short-term credits rose exponentially from 49.6% in 1994 to a whopping 144

Capital Structure of Chaebols Table 5.3. Analysis of chaebols’ cash flow statements (a) Capital procurement External

1995 1996 1997 1998 1999 2000

Internal fund (%)

Equity issue (%)

Long-term loans (%)

Short-term loans (%)

Subtotal (%)

Total (%)

36.8 22.4 12.3 12.6 17.4 25.0

1.4 1.3 1.1 2.2 9.5 2.8

12.2 12.7 11.0 22.6 10.1 13.6

49.6 63.6 75.6 62.6 63.0 58.6

63.2 77.6 87.7 87.4 82.6 75.0

100 100 100 100 100 100

(b) Capital expenditure Investment Investment Short-term Short-term in production in securities financial operating Others Total (%) facilities (%) (%) investment (%) capital (%) (%) 1995 1996 1997 1998 1999 2000

8.1 9.2 7.1 4.9 4.5 8.8

1.4 1.3 1.6 4.5 5.8 4.3

1.4 1.6 1.5 1.6 0.5 0.9

83.7 87.7 84.8 76.5 78.4 76.3

5.4 0.2 5.0 12.5 10.7 9.7

100 100 100 100 100 100

Source: Choi (2001).

75% in 1997 and declined only after the crisis. Turning to the expenditure side, although internal sources of capital almost dried up, the proportion that chaebols spent for investment in production facilities did not change much during this period and finally came down after the crisis. The proportion of investment in production facilities to total expenditures in 1998 and 1999 145

The Capital Structure of Chaebols was only half of what it was prior to the crisis. This is consistent with the fact that the capital intensity ratio skyrocketed during the same time period, as can be seen in Figure 1.6. This means that chaebols continued to invest in long-term production facilities while relying heavily on short-term loans. The result of this mismatch was a series of bankruptcies, which started as soon as domestic and foreign financial institutions that had made short-term loans to Korean companies began demanding immediate repayment. Table 5.3 also shows that chaebols’ investment in production facilities rose back to the precrisis level in 2000 when chaebols recovered from the crisis. Chaebols’ investment in securities has increased since 1998, reflecting the increased cross-shareholding during the postcrisis restructuring process. Chaebols responded to the government’s pressures to reduce debt–equity ratios by buying new equity issues by other affiliates.22 Determinants of Capital Structure of Chaebols Why didn’t the chaebols raise equity when they made these huge capital investments? How did chaebol firms continue making such a huge investment amidst a capital shortage? Figure 5.2, which is based on a survey Kook, Park, and Lee (1997) sent to the CFOs (chief financial officers) of the top fifty chaebols, may provide answers to these questions. When asked about the most important consideration in finance-related decisions, 72% answered the maximization of group’s growth and 26%, the maximization of short-term profit. Only 2% responded the maximization of stock prices of individual affiliates. When asked if they considered group-level or individual company profitability, 52% pointed to group-level profit as their prime consideration. 146

Capital Structure of Chaebols 1.What is the most important consideration in corporate finance decisions? 2%

maximize stock price of individual affiliate maximize growth of group maximize profits

26%

72%

2. Do you care more about profitability at the group level or the profitability of individual firms when you make investment decisions?

Entire group 48%

52%

Individual firm

3. When you consider the cost of capital, do you do so for an individual firm or for the entire group? 40% 60%

Entire group Individual firm

4. Among various means of raising capital, other things being equal, which of the following do you prioritize? 48%

52%

maintaining the equity stake of large shareholder capital cost

Figure 5.2. Survey results of corporate financing practices. Source: Kook et al. (1997), p. 5.

Similarly, 40% of CFOs answered that they take into account a group-level cost of capital rather than the capital cost of an individual company. When asked about the prime consideration in determining the method for securing capital, all else equal, 52% responded that they tried to maintain the largest shareholders’ 147

The Capital Structure of Chaebols equity (i.e., avoiding dilution of chaebol chairmen’s equity stakes), and 48% pointed to the cost of raising capital. The results show that, on average, chaebols put far more emphasis on the group-level profit and cost of capital and avoided diluting key shareholders’ interests. Accordingly, even if the financial cost of equity capital is low, chaebols prefer debt to equity. Given this attitude, it is not surprising that chaebols depended more on external loans when their internal sources of capital dried up. This discussion leads us to conclude that the chaebols’ capital structure was biased toward debts as chaebol families attempted to maintain their controlling ownership stakes. It also points to the problems in the corporate governance systems of chaebols. Thus, the chaebols’ capital structure depended largely on their ability to secure debt. The more debt chaebols could secure, the better off they were since they could invest in far more projects than could other chaebols. Appendix 5 empirically examines the determinants of the capital structures of chaebol affiliates with data for 1985 to 1996. The results of this analysis indicate that debt-carrying capacity depends on the following factors: first, larger companies have higher debt–equity ratios. Because Korean financial institutions based their lending decisions mostly on the existence of collateral, companies that had greater access to it maintained higher debts. Second, companies that exploited more debt payment guarantees were liable for more debt. Third, affiliates in chaebols that owned financial institutions were more likely to borrow. The results also show that the type of financial company owned by a chaebol affects the type and source of debt that affiliates use: affiliations with merchant banks lead to more short-term debt, while affiliations with securities companies lead to more long-term debt and domestic debt. These results provide strong evidence that chaebols’ 148

Internal Capital Markets and Cross-subsidization financial affiliates have served as the private chests of chaebols. The results of this research are summarized in Appendix 5.

chaebols' internal capital market and cross-subsidization In this section, we look more closely at how chaebols’ internal capital markets operate. Chaebols adopted the business unit system to take full advantage of the internal capital market within a group.23 By controlling cash flow at the group level, chaebols can enhance financial efficiency. This capital market is composed of loans, debt guarantees, and cross-shareholding between affiliates. Figure 5.3 shows the size of major components of internal capital markets for the top thirty chaebols from 1993 to 2000. Interaffiliate Loans As discussed earlier, chaebols’ affiliates function as operating divisions in a diversified portfolio of businesses. The basic principle of portfolio management in a diversified corporation is gathering excess cash from the operational units and reallocating it to promising businesses or units that need financial support. Figure 5.3 suggests that interaffiliate short-term borrowing is not substantial. For example, in 1997, the size of interaffiliate loans amounted to only 1.5% of total equity capital. This figure is misleading, though, because it shows only the short-term credit balance among affiliates at the end of the fiscal year; the actual amount of short-term lending between affiliates during the year does not appear in the financial statements. Furthermore, chaebols do not always use direct loans to affiliates simply because such loans are too transparent. Affiliates 149

The Capital Structure of Chaebols 1. Intragroup loans over equity % 4. 0 3. 5 3. 0 2. 5 2. 0 1. 5 1. 0 0. 5 0. 0 93

94

95

96

97

98

99

2000

97

98

99

2000

99

2000

2. Debt guarantee to equity % 500. 0 450. 0 400. 0 350. 0 300. 0 250. 0 200. 0 150. 0 100. 0 50. 0 0. 0 93

94

95

96

3. Cross-shareholding % 50. 0 45. 0 40. 0 35. 0 30. 0 25. 0 20. 0 15. 0 10. 0 5. 0 0. 0 93

94

95

96

97

98

Figure 5.3. Internal capital markets of chaebols.

150

Internal Capital Markets and Cross-subsidization often adopt various creative methods of financially supporting each other, as demonstrated by the cross-subsidization discussed in Chapter 4.24 The volume of intragroup financial transactions that is classified as “supportive” by the FTC reached nearly 20 trillion won (see Table 4.3). The FTC estimates that the actual volume of subsidies emanating from these transactions may be as much as 640 billion won. In many cases, chaebols’ financial arms were heavily involved in such transactions, usually by purchasing promissory notes issued by another affiliate at a higher price. For example, Daewoo Capital and Diners Card acquired 3.8 trillion won worth of promissory notes from Daewoo Corporation, a flagship company in the Daewoo Group, at discount rates that were 2.5 to 8.9% lower than the normal rates (see Figure 5.4). In doing so, Daewoo Capital and Diners Card effectively transferred their financial resources to Daewoo Corporation in the form of discounted interest. Seoul Investment and Trust also acquired 200 billion won worth of promissory notes from Daewoo Corporation at rates from 3.9 to 7.5% lower than normal rates. Daewoo Securities even exceeded its credit limit to lend 194.3 billion won to Daewoo Corporation, which in turn has extended support to its affiliates. For example, it supported Daewoo Securities by acquiring 200 billion worth of nonguaranteed subordinated bonds from it in 1997. It also intentionally failed to collect construction expenses or sales income from Daewoo Precision and Daewoo Telecom, which constituted an interest subsidy to them until they paid it. Similarly, Daewoo Heavy Industries neglected to collect money from its sales of real estate to Daewoo Corporation. Other large chaebols typically engage in similar transactions. In general, these intragroup financial transactions have several characteristics. First, major affiliates support weaker 151

Daewoo Securities

bond of 200 billion)

(Acquire subordinate

(Acquire notes of 200 billion at high price)

the lawful limit)

(194 billion loan exceeding Daewoo Precision

423 billion)

(Delay in collecting

Daewoo Heavy Ind.

(Delay in collecting 17 billion)

Daewoo Telecom

for buying Daewoo cars)

Daewoo Corp.

subsidizing 39 billion)

(Subsidize employees

lower than the normal rate)

(Acquire notes of 200 billion won at 3.9–7.5%

Seoul Investment Trust

(Charge low exchange rate,

than normal rates)

2.5–8.9% point lower

Daewoo Capital

Figure 5.4. Unfair business practices in Daewoo Group, identified by the Korea Fair Trade Commission, 1997–99. Source: Korea Fair Trade Commission.

Hankook Chosa

Daewoo Electronics

Daewoo Motors

3.8 trillion

(at discount rates

Diners Club

Internal Capital Markets and Cross-subsidization affiliates. Affiliated financial institutions then acquire promissory notes from weak affiliates or extend credit over the legal limit to provide them with short-term capital. These weak affiliates are in very precarious shape; more than 75% of them were close to bankruptcy for at least one of the last three years. Thus, this assistance protected nonviable companies from having to file bankruptcy, while reducing the overall amount of investment funds for major affiliates. Second, this intragroup support mechanism strengthens the families’ position within the chaebol group. For example, a son of the main family in the Samsung Group was able to buy its warrant bonds at a discounted price, thereby effectively evading inheritance taxes and enjoying further profit from the transaction.25 We will discuss this type of internal trade in more detail in Chapter 6. Third, these transactions assume many forms and may be direct or indirect. For example, Samsung Life Insurance extended subordinated loans to four commercial banks, which in turn took over private placement bonds of another Samsung affiliates.26 Hyundai Heavy Industries created offshore funds, which in turn acquired overseas bonds issued by other sister companies at high prices to support these companies.27 In short, chaebol funds travel wildly among sister companies through many means. Debt Payment Guarantees As mentioned before, debt payment guarantees are prominent in chaebols. Although these guarantees nominally ensure that a firm’s affiliates will pay debts that the firm cannot, the widespread use of these agreements may result in situations in which nobody can really guarantee repayment. If one company

153

The Capital Structure of Chaebols involved in this practice becomes insolvent, its bankruptcy may have a domino effect on its affiliates. Consider a situation in which company A guarantees payment of company B, company B guarantees company C, and company C in turn guarantees A. So long as all these companies operate well, there is no problem. If company A files bankruptcy, however, company C may not be able to pay A’s debts, and B may not be able to pay C’s debts. Figure 5.5 shows the structure of the mutual guarantees in the Daewoo Group. Very often, the guarantor was either Daewoo Corporation, one of the major affiliates of Daewoo, or one of several other core companies, such as Daewoo Electronics, Daewoo Motors, or Daewoo Heavy Industries. The parent company, Daewoo Corporation, often extended payment guarantees to all other affiliates, but sometimes sister companies acted as guarantors of each other as well. Daewoo Corporation guaranteed payment of 1.4 trillion won by Daewoo Heavy Industries, and Daewoo Heavy Industries also guaranteed payment of 5.2 trillion won by Daewoo Corporation. Daewoo Corporation also guaranteed payment of 58.6 billion won by Daewoo Electronics, and vice versa. Thanks to the payment guarantee practice, affiliates were able to undertake new enterprises that required more financial resources than they could afford to spend. In fact, when Daewoo Group collapsed in 1999, all its affiliates went bankrupt simultaneously due to these debt guarantees. The Korea Fair Trade Commission knew of the problems presented by debt guarantees, and first revised the Fair Trade Act in 1993 to limit payment guarantees among affiliates in large business groups to 200% of an affiliates’ equity. It further curbed this practice in 1996, when it lowered the limit to 100% of an affiliate’s equity. As Figure 5.3 shows, chaebols have reduced this practice since 1993. The ratio once reached as high as 500%

154

136

88

2,286

1,943

Daewoo M otor

924

94

617

14

7

28

Daewoo Kijun

6,386

Daewoo Corporation

227

Koram Plastic

52,218

99

183

4,628

Daewoo Heavy Industries

1,401

3,481 191

85

Daewoo Development

Kyungnam Corp.

1,515

Daewoo Precision

Daewoo Securities

9,687

150

Kyungnam Metals

13,977

50

Figure 5.5. Debt guarantees among Daewoo affiliates. Source: Korea Information Service. People’s Solidarity for Participatory Democracy (1999). Notes: 1. As of December 1997; 2. All figures are in 100 million won; 3. Circles with thick lines represent firms with 3 trillion won in assets.

Orion Elec. Component

311

1,060

130

Daewoo Electric406 Component

Orion Electric

714

345

38

586

Daewoo Info. Systems

Daewoo Electronics

0.2

Daewoo Telecom

The Capital Structure of Chaebols of equity in 1985, and it hovered above 200% during the mid 1990s. In light of the failures of affiliates to make good on these guarantees, the Korean government revised the Fair Trade Act once again in 1998 and abolished the practice by 2000. It is encouraging that the government is trying to abolish the payment guarantee regime. Successfully eradicating the practice will, however, require financial institutions, especially banks, to change their lending practices. Banks should make loans when firms have promising investment opportunities or when firms can provide collateral. Otherwise, the payment guarantee system will persist, thereby defeating the government’s intent.

Cross-shareholding Figure 5.3 also shows a trend of cross-equity investment among affiliates, from about 33% in the mid 1990s to 43% by 1999. As demonstrated by the Samsung example discussed in Chapter 3, affiliates initially used cross-shareholding to secure necessary initial funds when they began a new enterprise. Under the group structure, decisions about how to use capital surpluses for largescale investment were made at the group level. Another function of cross-shareholding is, however, to maintain control over affiliates. Because expansion into new businesses via new affiliates meant that chaebol chairmen had to be able to influence the new affiliates, they ensured that existing businesses held substantial shares in these new ventures. Yet if A invests in B, B in C, and C in A, virtually no money had in fact been invested. By using such schemes, chaebol owners were able to control a whole group of companies and exert unlimited power over them as if they actually owned the group. We will examine such cross-equity ownership more closely in Chapter 6. 156

Collapse of Chaebols and Financial Institutions collapse of chaebols and financial institutions during the crisis The Bankruptcies of Chaebols The collapse of Hanbo and Kia Groups, two of the top thirty chaebols, in early 1997 shocked many. The chain reaction of affiliates’ insolvencies and bankruptcies became even more conspicuous during the financial crisis. Ten other top thirty chaebols – Hanhwa Group, Halla Group, Dongah Group, Jinro Group, Kohap Group, Haitai Group, Newcore Group, Hanil Group, Keopyung Group, and Shinho Group – either voluntarily filed for bankruptcy, were forced into bankruptcy proceedings, or narrowly escaped bankruptcy through government-sponsored “cooperative” emergency loans advanced by banks. These cooperative loans meant that the debtors were technically bankrupt and were subject to debt restructuring led by banks. Daewoo, the fourth largest chaebol, collapsed in July 1999. Many smaller business groups – such as Kapeul, Kukdong, Nasan, Taegu Department Store, Sungwon Construction, Cheonggu, Tongil, and Hwaseung – also faced a similar fate. Table 1.1 shows the difference in debt–equity ratios between bankrupt and surviving companies in the top thirty chaebols. Troubled companies share two traits: they were heavily leveraged, and they tried to manipulate their capital resources to heavily invest in facilities.28 For example, Halla Group was exposed to great risk by engaging in overseas construction projects, which put heavy stress on its flagship companies, such as Halla Heavy Industries, and which, in turn, weakened the group as a whole. Jinro and Newcore went bankrupt because of their reckless forays into the retail industry. Haitai also faced severe problems in its effort to participate in heavy equipment and consumer electronics industries. Daewoo set up automobile 157

The Capital Structure of Chaebols plants all over the world. In all these cases, widespread use of debt guarantees accelerated bankruptcy. Stress upon Financial Institutions The failure of chaebols has also weakened Korean financial institutions, which cannot be insulated from the effect of massive bankruptcies. As of June 1998, 40 trillion won out of 471.6 trillion won loaned by banks and 23.5 trillion won of 153.2 trillion won loaned by nonbanks was classified as insolvent. In total, 63.5 trillion won, which is 10.2% of the total credit extended in Korea, was insolvent. This calculation underestimates the situation, however, because a much more lenient standard is used in Korea for classifying bad loans. When we use the international standard to classify bad loans, total defaults amounted to 85.7 trillion won at banks and 32.2 trillion won at nonbank financial institutions, or about 18.9% of total loans. Loans earmarked “substandard, doubtful, and loss” reached 67 trillion won at banks and 12.8 trillion won at nonbanks. In sum, the accumulated bad credits amount to 197.7 trillion won, or about 31.6% of the total credit extended in Korea (see Table 5.4). During and after the financial crisis, most Korean banks in Korea had to face the risk of bankruptcy. The situation was even worse for many small nonbank financial institutions.29 To sum up, chaebols’ huge debts and the financial crisis were created by dysfunctional corporate governance systems and the distortions in financial markets. Chaebol families’ desire to maintain controlling equity stakes made them prefer debt to equity financing, and the government’s meddling in the financial service sector allowed these families to build up huge debts

158

40.0 23.5

63.5 10.2%

471.6 153.2

624.8

Bad Loans

72.5 11.6%

60.9 11.6

136.0 21.8%

100.9 35.1

Loans classified as substandard, Total doubtful, and nonperforming loans loss

21.8

21.4 22.9

%

117.9 18.9%

85.7 32.2

Bad loans

79.8 12.8%

67.0 12.8

197.7 31.6%

152.7 45.0

Loans classified as substandard, Total doubtful, and nonperforming loans loss

International standard

31.6

32.4 29.4

%

Note: 1. The conventional standard defined nonperforming loans as loans that had been in arrears for three months or more in Korea up until June 1998. Bad loans were defined as loans in arrears for more than six months. 2. The international standard defines nonperforming loans in a forward-looking way by considering the capabilities of debtors in paying back loans in the future. Source: Chee, D. 1998. Estimation of non-performing loans according to the international standard. Internal report, Korea Institute of Finance.

Banks Nonbank financial institutions Total %

Total amount of credits

Conventional standard

Table 5.4. Nonperforming loans of Korean financial institutions

The Capital Structure of Chaebols to finance their reckless expansion even during the economic downturn in 1990s, as we discussed in Chapter 3. Thus, the restructuring of chaebols should address these fundamental weaknesses. In addition, the government should guard against abuses of the internal capital market by continuously monitoring chaebols’ internal business transactions.

160

6

Chaebols’ Ownership and Governance Structure

161

Characteristics of the Ownership Structure of Chaebol Following upon the previous chapter, this chapter looks at the uses of equity in chaebols. It focuses particularly on how families wholly control chaebols despite owning only a small portion of their affiliates’ shares. In this context, this chapter will examine the ownership and governance structure of affiliates, which make such control possible. It also addresses the agency problems of chaebols, which stem from the lack of proper corporate governance systems in Korea.

characteristics of the ownership structure of chaebol Trends of Family Ownership and Cross-shareholding Figure 6.1 details the ownership structure of chaebols since 1983. It divides equity stakes into two components: those owned by chairmen and their families and those held by affiliates. Equity holdings by chairmen and their families have declined steadily since 1983 because these individuals cannot maintain large stakes in all affiliates as the number and volume of these affiliates grow. In contrast, the equity stakes held by other affiliates remains stable; ownership in chaebols has increasingly relied on cross-shareholding among affiliates. The aggregated sum of cross-shareholdings of chaebols decreased from 40% in 1987 to 32% in 1989 because the Fair Trade Act restricted the cross-shareholding of each individual affiliate to 40% of its net assets.1 Chaebols incurred penalties when they exceeded this limit. The Fair Trade Act was revised in 1994, further reducing the ceiling to 25% of the net assets of individual affiliates. The penalties imposed by the Fair Trade Commission were not high enough to encourage chaebols to comply with the law. On the contrary, cross-shareholding jumped sharply in 1998 and 163

Chaebols’ Ownership and Governance Structure %

50 45 40 35 30 25 20 15 10 5 0 83

87

89

90

91

92

Chaebol family

93

94

95

96

97

98

99

2000

Cross-shareholding

Figure 6.1. Trends of family ownership and cross-shareholding in the top thirty chaebols Source: Fair Trade Commission. Note: The family ownership and cross-shareholding data in this figure are the weighted average of the top thirty chaebols with the equity capital of individual chaebols as the weighing factor.

1999 due to the corporate restructuring efforts after the crisis. The government urged chaebols to reduce debt–equity ratios by bringing in foreign partners or by selling assets. Chaebol firms did issue equity, but their affiliates bought these issues with the proceeds from their own equity issues. As a consequence, such a reduction of debt–equity ratios did not involve net infusion of equity capital. The Mechanism of Cross-shareholdings The restriction on cross-shareholding was designed to limit chaebol families from wholly controlling all affiliates when they 164

Characteristics of the Ownership Structure of Chaebol held little equity in these firms. Figure 6.1 shows, on average, chaebol families held 5.4% of the shares of their affiliates in 1999. Their control, however, was based upon 44.1% of equity ownership by other affiliates. Figure 6.2 explains how a crossshareholding scheme works to help chaebol families control the whole group. In this example, a business group has core companies of A, B, and C, each with equity of 100 billion won, and smaller affiliates D, E, F, G, H, I, and J with equity of 10 billion won each. The chairman owns 10% each of A, B, and C. Company A then owns 20% of company B, company B owns 20% of company C, and company C owns 20% of company A. Therefore, the chairman effectively owns 30% each of A, B, and C; these stakes are sufficient to control each firm because the core companies are more likely to be listed on the Korea Stock Exchange. Furthermore, A owns 50% of D, 25% of E, and 25% of F, while B owns 25% of E, F, H, and I, and 50% of G. In sum, major affiliates effectively control smaller affiliates by owning them singly or jointly, and the chairman controls all these firms with a very small ownership stake. In this instance, the chairman controls all the chaebols’ affiliates with a total investment of 30 billion won, or only 8.1% of the group’s total equity. Further, the investments of A, B, and C in each other frequently involve no actual transfer of funds, thus creating fictitious capital. The Fair Trade Act prohibits obviously circular investments, such as those between A and B only, but it does not prohibit transitive investments such as the cross-shareholding between A, B, and C. Therefore, Korean chaebols have devised more complicated cross-shareholding schemes to increase equity stakes by affiliates far larger than actual capital infusion. High debt–equity ratios also help chaebols control large amounts of assets. For example, if affiliates have an average debt–equity ratio of 400%, the chaebol can borrow 1.4 trillion won with 165

Equity owned by chaebol family: 30 billion (8.1% of total equity) Cross-shareholding: 95 billion (25.6% of total equity) Total equity capital: 370 billion

Figure 6.2. An illustration of cross-shareholding in chaebols. Note: Numbers in parentheses are equity capital in billion won

Characteristics of the Ownership Structure of Chaebol total equity of 370 billion won. Therefore, the chaebol can use 1.8 trillion won in assets, and the chairman controls these assets with his equity investment of 30 billion won. Figure 6.3 shows a simplified version of the equity stakes held by SK Group’s chairman and the stakes held by the major affiliates in SK Group as of 1997. The chairman and his family own equity stakes of core affiliates (i.e., SK Global, SK Chemical, SKC, and SK Construction). These core affiliates were established early in the history of SK Group. SK Global was established in 1956, and its chairman and his family own 5.1% of it. The chairman of the SK Group and his family own 12.3% of SK Chemical. In addition, they own 31.8% of SKC and 22.9% in SK Construction. When SK Group acquired an oil refining business from the government in 1980, SK Global and SK Chemical took 13.8 and 2.7% equity stakes, respectively, in this venture, which was later renamed SK Corporation. At a later stage, SK Corporation owned large equity holdings in Daehan City Gas, SK Gas, SK Energy Sale, and SK Oxy-Chemical. SK Corporation also participated in the acquisition of SK Telecom from the government in 1994, by acquiring 18.5% equity stakes. For SK Securities, established in 1991, SKC, SK Construction, and SK Energy Sale took substantial equity stakes. The ownership structure of the SK Group indicates that timing of affiliate foundation and cash availability determine which affiliates hold equity stakes in other affiliates. There is also circular investment among SK Group’s affiliates. For instance, SK Global owns 13.8% of SK Corporation, while SK Corporation holds 18.5% in SK Telecom. SK Telecom in turn holds 4.1% of SK Global. In another case, SKC holds 7.1% in SK Chemical, SK Chemical has 2.7% in SK Corporation, and SK Corporation owns 2.3% of SKC. Another notable 167

Figure 6.3. The equity ownership structure of SK Group. Source: Korea Information Service and People’s Solidarity for Participatory Democracy (1999). Notes: 1. We show equity ownership of major affiliates that is more than 1% as of December 1997. 2. Dark circle for companies with more than 3 trillion won in assets. Dark arrow represents circular equity investment.

SK Capital

100.0

19.6

8.7

1.6

16.9

SK Securities

4.0

7.5

Sheraton Walker-Hill

49.4

25.1

Daehan Gas

9.9

SK Telecom

4.1

SK Global

5.1

SK Teletech

1.6

1.1

24.0

100.0

18.5

Kookil Gas

100.0

SK Gas

38.9

2.7

SK Chemical

12.3

2.4

SK Corporation

13.8

29.0

SK Shipping

25.8

Chairman & his family

43.4

100.0

100.0

70.8

100.0

3.3

SK Energy Sales

7.1

94.6

SK Oxy Chemical

Pohang Gas

Koomi Gas

SK C&C

2.3

SKC

31.8

SK Distribution

7.9

SK Construction

22.9

Characteristics of the Ownership Structure of Chaebol feature of the ownership structure of SK Group is that these affiliates hold equity stakes in other affiliates whose businesses are not related to each other, which is not common in Western companies. For example, SK Telecom invested in Daehan City Gas, SK Global, or SK Capital. Similarly, SK Securities was funded by several affiliates such as SKC, SK Construction, and SK Energy Sale. Again, availability of cash, not related diversification, influences which affiliates will invest in the chaebol’s new business ventures. Other groups have ownership structures very similar to that of SK Group. For instance, in Hyundai Group, four companies – Hyundai Heavy Industries, Hyundai Construction, Hyundai Motor, and Hyundai Merchant Marine – serve as holding companies of the group. In Samsung Group, Samsung Electronics, Samsung Life Insurance, and Samsung Corporation play similar roles. In Daewoo Group, Daewoo Corporation and Daewoo Electronics are the core companies. LG Group has LG Chemical and LG Electronics as its major holding companies (see Figures A.7.5–A.7.8). Note that many affiliates in chaebols are publicly traded companies. Chaebols resisted the government’s repeated request to list their affiliates on the stock exchange. The government had to pressure them to increase their sale of stock to the public. For instance, in 1984 the Hyundai Group agreed to sell shares of Hyundai Engineering and Construction publicly only after the Ministry of Finance had officially asked it to do so 28 times (Fields, 1995). Due to the government’s efforts, the number of affiliates of the top thirty chaebols listed on the stock exchange jumped from 50 in 1986 to 122 in 1996. Until the 1980s, there was less conflict between large shareholders and minority shareholders because there were only a few listed companies, and the chaebol families’ own shares in those companies were 169

Chaebols’ Ownership and Governance Structure substantial. By listing their affiliates involuntarily, chaebols had greater incentives to shift funds from public companies to private companies. We will discuss how SK Telecom shifted funds in this way later in this chapter.

the corporate governance system in korea This section will examine chaebols’ corporate ownership/ governance structures in more detail and assess whether they enable effective monitoring to take place. In Chapter 1, we defined the corporate governance system as the internal organizations and power structure of the firm, the functioning of the board of directors, ownership structure, and interrelationships among the management board, shareholders, and other stakeholders such as the company’s workforce and creditors (Hopt et al., 1998). Economists tend to focus on corporate governance as the ways both investors and creditors ensure that management will not appropriate their investments (Shleifer and Vishny, 1997). They also refer to managers’ (i.e., agents) pursuit of personal interests at the expense of the interests of shareholders (i.e., principals) as “agency problems.” Countries differ in the rules they have to protect investors’ and creditors’ interests. Although La Porta and co-worker’s (1998) study does not suggest what institutional safeguards are superior, it does indicate that effective corporate governance systems have two common elements. First, they legally protect investors’ rights, especially those of minority shareholders. Second, they offer direct exercise of control through concentrated ownership, which can occur through block ownership, hostile takeover, and the exercise of control by

170

The Corporate Governance System in Korea large creditors.2 We will examine various aspects of corporate governance systems in Korea later. Dual Role as Owner and Manager Unlike most large firms in the United States and Japan, Korean chaebols do not have a separation of ownership from control. As Berle and Means (1932) and many others have observed, this separation creates acute agency problems in many Western companies. In Japan, salaried professionals manage keiretsu affiliates. In contrast, the chairman of a chaebol acts as if he is the chief executive officer of the chaebol even though all the affiliates are legally independent entities with their own boards of directors and presidents. The term “chairman of the group” is a fictitious title since the group does not exist in a legal sense. The presidents of chaebols’ affiliates function like divisional managers do in a diversified corporation in Western society. The lack of separation of ownership from control is more apparent if we look at the succession of the chaebols’ chairmen. Cho (1997) found that twenty-one out of twenty-two chaebol chairmen inherited their positions from family members. Most commonly, second-generation “chairmen” joined their groups at the executive level (55%) or at the general manager level (45%). On average, it took them fifteen years to become chairmen after joining their groups, and many of their immediate family members also directly participated in corporate management, as discussed in Chapter 3. The fact that these positions passed on not only to the second generation of founders families but also to the third generation is possibly a result of Korea’s imperfect inheritance tax system. Otherwise, high tax rates would have reduced the equity stakes of the founders’ heirs. The fact

171

Chaebols’ Ownership and Governance Structure that these transitions happened seamlessly clearly indicates that founders used various loopholes in this tax system and passed on their equity to their successors without paying much inheritance tax. For instance, they used various tax-exempt cultural foundations, run by their chaebols, to avoid paying these taxes.3 Second, chaebol families have utilized initial public offerings as an avenue to pass on wealth and hence management control; we will examine how they did so later in this chapter. Therefore, principal–agent problems in chaebols do not assume the same form as they do in Western firms. Rather, large shareholders in chaebols, who are often top managers, pursue their own interests to the detriment of minority shareholders, as illustrated in Figure 6.4. The Board of Directors One of the important legal rights of shareholders is the right to elect boards of directors, which have certain rights and duties in regard to the incumbent management. In the United States, the boards of directors, which rely heavily on directors from outside a firm, have enormous power in appointing and dismissing top executives and in determining their compensation.4 In Japan, creditor financial institutions, which are often large shareholders as well, often dispatch directors to monitor managerial decision making. Korean Commercial Law also identifies the board of directors as the top-level decision-making body of a company. Under it, directors are appointed at general shareholders’ meetings. In practice, however, the authority and prestige of Korean boards are comparatively low relative to those in the United States because shareholders cannot appoint board members by mail but instead must show up at the shareholders’ meeting to vote. In practice, the chairman of a business group appoints the directors. 172

Pursuing large shareholders’ interests at the expense of minority shareholders’ interests

Figure 6.4. Agency problems in Korea.

Chaebols

Pursuing managers’ personal interests at the expense of shareholders’ interests

Western company

Principal

Large Shareholders

Delegation

Agent = Principal

Manager

Agent

Manager

Principal

Minority shareholders

Fragmented shareholders

Chaebols’ Ownership and Governance Structure At general shareholders’ meetings, the management of a company presents proposals concerning appointment of directors verbally, and any minority shareholders are completely ignored. Furthermore, the Korean boards comprise mainly executive officers so they do not monitor how effectively business operations are carried out. They merely offer ex post facto approval of major decisions. In addition, the few outside directors on these boards are generally chosen from lists of individuals who maintain close personal relations with chaebol families. Outside directors seldom represent the interests of minority shareholders. Therefore, chairmen of the groups essentially make decisions on their own, completely unchecked by anyone else. Rights of Minority Shareholders Some countries, including the United States, ensure that minority shareholders can aggressively exercise their rights via class action lawsuits or proxy fights. In contrast, minority shareholders in Korea have very limited rights. Under the Commercial Law prior to the crisis, minority shareholders were granted the right to file a lawsuit against a company or to review accounting books only if they owned at least 5% of the company; this standard can be prohibitively high for individual investors.5 Since minority shareholders did not know each other, they had only a slim chance to collaborate with other minority shareholders to access account books or file a lawsuit. Therefore, they tended to be short-term investors who sought quick capital gains. At the same time, the old Commercial Law also restricted institutional investors such as banks and investment trust companies from exercising their voting rights at shareholders’ meetings. Although the Korea Securities and Exchange Commission had

174

The Corporate Governance System in Korea the power to arrest suspected wrongdoers, regulation was carried out through persuasion rather than through legal means (Fields, 1995). Capital Market Control The discipline created by the active market for corporate control is one of the key elements of the corporate governance systems in the United States. In a typical hostile takeover, a bidder makes a tender offer to the shareholders of the target firms, often poorly performing firms, and if it solicits enough votes, it acquires the control of the target and replaces the incumbent management. Jensen and Ruback (1983) found evidence of performance improvement after takeovers. In Korea, hostile takeover has been all but impossible because of severe restraints. According to securities regulations, a potential acquirer who wanted to own at least 10% of a firm had to make this intention public. Further, this party had to purchase more than 50% of the firm’s equity, further limiting hostile takeovers.6 Unlike the United States, Japan has developed a corporate governance system via “main banks,” which are both shareholders and large creditors and steadily monitor corporate management.7 A “main bank” typically dispatches a director or an executive to a company. The firm’s board of directors supervises managerial decision making and replaces managers of poorly performing companies.8 Although Korea adopted a system very similar to Japan’s, Korean banks have not conducted aggressive audits of companies. As discussed in Chapter 5, Korean banks also have only limited ability to evaluate the credit capacity of their corporate customers. Put simply, Korea did not have any capital market controls on chaebols in practice.

175

Chaebols’ Ownership and Governance Structure agency problems in chaebols In this section, we will examine specific agency problems that this lack of corporate governance system might have caused. Lack of Accountability The chairmen of Korean chaebols clearly have almost total control over their groups. Yet CEOs of U.S. firms have strong control over their companies. For instance, Jack Welch of General Electric carried out large-scale corporate restructuring during the 1980s. He sold off affiliates that were not ranked first or second in their markets and slashed GE’s number of employees from more than 400,000 to almost half that. Yet it was assumed that he would be responsible for all the consequences of the restructuring, and he had to obtain consent from GE’s board of directors, which had many outside members, when he made any significant decisions that affected GE as a whole. If his efforts had failed, he would have lost his job. Chaebol chairmen, however, have no accountability when they make bad decisions. They also do not have to seek consent from a board of directors. After all, the group does not exist in a legal sense. Sometimes these chairmen have used this power to make successful decisions that they would have been unable to implement under U.S. forms of governance. The late chairman Lee of the Samsung Group ventured into the semiconductor business, despite opposition from both the government and his own lieutenants.9 The late chairman Chung of the Hyundai Group gambled in diversifying into shipbuilding without any prior experience by building a shipyard and the ship concurrently.10 Such decision often invited large-scale failure, however, as demonstrated by Samsung Group’s venture into the automobile 176

Agency Problems in Chaebols industry in 1994. It appeared to do so less for sound strategic reasons than because of the personal desires of Samsung Group’s chairman,11 who was a serious auto collector with a strong desire to be in the automobile business himself.12 At that time, the industry was undergoing substantial consolidation. Larger auto firms were acquiring smaller auto firms in an attempt to reap economies of scale for many related activities. When Samsung Group announced this venture, many in Korea raised objections. Despite these concerns, it introduced technology and production facilities from Nissan and started its automobile business. Both Samsung Motors’ affiliates and many employees and executives of Samsung Electronics, Samsung SDI, Samsung Heavy Industries and Samsung Electro-Mechanics purchased stock in this new venture. Ironically, the chairman did not himself invest in this risky business because he was apparently reluctant to invest in a company that was certain to lose large sums for several years. Ultimately, Samsung Motors applied for court receivership in 1999, and all its investors lost money. The chairman himself was not held responsible. If Samsung had been run according to a U.S. model of corporate governance, it would likely have never embarked on such an ill-advised venture. Although the absolute power of chaebols’ chairmen may have been an asset when the government developed economic plans, provided funds for new businesses, and saved failing ventures, it can be now a liability since the government stopped these activities in the early 1980s and chaebols became responsible for their own strategic decisions. The liability of such power is even more apparent now that second- and third-generation chaebol chairmen are now in control. Such individuals controlled most of the business groups that went bankrupt after the crisis in 1997. Since they inherited their empires, these chairmen feel more pressure to show their 177

Chaebols’ Ownership and Governance Structure managerial aptitude. Often, they attempt to do so by diversifying aggressively, as part of a “second founding” of their groups. For example, Jinro Group expanded its Korean traditional liquor business and tried to be a leader in wholesaling/retailing. The rapid buildup in distribution facilities, however, induced Jinro’s collapse. Haitai Group faced default after the group diversified into electronics and heavy machinery. Unlike wealth, the management prowess of chaebols’ founders does not seem to be inherited. Thus, familial succession seems to create a serious agency problem because a successor’s job competence is not known and his power is unchecked. Expropriation Through Inside Trading Not surprisingly, chaebols’ chairmen have insider information about the operations of affiliates. Such information is obviously advantageous to chairmen and their families and detrimental to the interests of minority shareholders. Quite often, chaebol families purchase stock of companies at low prices before announcements that these firms will be listed and earn large capital gains after such announcements. A conspicuous example is the case of Samsung Group chairman Kun-Hee Lee and his son Jae-Young Lee.13 As of 1999, chairman Kun-Hee Lee’s wealth was estimated to be two trillion won, and his son’s wealth was estimated to be several hundred billion won. Jae-Young Lee was still a student and had never run a business. When he inherited assets worth several hundred billion won, he paid an inheritance tax of only 1.6 billion won. His increase in wealth is attributable to the large capital gains of Initial Public Offering (IPO) stocks. Figure 6.5 shows that Kun-Hee Lee donated 6 billion won to Jae-Young Lee in December 1995. This is the only instance of Kun-Hee Lee officially donating cash to his son. After paying the 178

SDS

1.9 billion

2.3 billion

15.3 billion

IPO in 1998

Converted to 29.7% equity

Cheil Communication

Convertible bond 1.8 billion

Jae-yong Lee

4.4 billion

Inheritance of 6 billion won (1995)

IPO in 1996

IPO in 1996

Samsung Everland

IPO planned

Samsung Life Insurance

Purchase 20% equity

Convertible bond (converted to 31.9% of equity)

Samsung Engineering

S-one

Figure 6.5. Transfer of wealth through insider information.

IPO planned

Convertible bond 23 billion

Inheritance tax of 1.6 billion

Kun-Hee Lee

Converted to equity

Samsung Electronics

Convertible bond 45 billion

23 billion

35.7 billion

Chaebols’ Ownership and Governance Structure inheritance tax, Jae-Young Lee used the remaining 4.4 billion won to purchase stocks of unlisted affiliates of Samsung Group. He bought 124,800 shares of S-one, a home security company, with 2.3 billion won and 470,000 shares of Samsung Engineering with 1.9 billion won. When S-one and Samsung Engineering became listed on stock market several months later, the value of his stock in S-one and Samsung Engineering was 35.7 billion won and 23 billion won, respectively. He sold these shares for 58.7 billion won, or twelve times his original investment. Using these proceeds, he bought convertible bonds of Cheil Communication, then unlisted, worth 1.8 billion won. These bonds were subsequently converted into stock that gave him 29.7% ownership of the company. When Cheil Communication was listed on the stock market in March 1998, his investment of 1.8 billion won soared to 15.3 billion won. He also purchased convertible bonds in Samsung Everland for far less than their market price. These bonds were then converted to a 31.9% equity stake in this firm, which then used the proceeds of this convertible bond issue to purchase 20% ownership in Samsung Life, which is one of the core holding companies in the Samsung Group. He also bought 23 billion won of convertible bonds issued by Samsung SDS at the issue price of 7,150 won, which was far below then-market price of 54,000 won.14 As Samsung SDS is soon to be listed, the value of this investment is anticipated to increase by twenty times the acquisition price. Furthermore, he invested 45 billion won to buy convertible bonds of Samsung Electronics. The convertible bonds were issued at a below-market price and provided high interest rates. He then converted these bonds to stock, thus securing 0.78% of Samsung Electronics. Such activities capitalize on loopholes in the Korean tax system that let family members inherit wealth and managerial 180

Agency Problems in Chaebols control without a heavy tax burden. At the same time, such activities take away the assets of minority shareholders of listed firms. Furthermore, buying shares of unlisted companies at low prices and reaping large capital gains after these firms are listed is a clear abuse of insider information and represents another facet of the agency problems in chaebols’ governance structure. Expropriation Through Internal Transfer Pricing Scheme As discussed in Chapter 4, chaebol firms frequently crosssubsidize their affiliates through artificially derived transfer prices. Chaebol chairmen can also use this device to transfer profits into affiliates in which they have large equity stakes. One such example of this behavior is provided by internal transactions between SK Telecom and its affiliates – Daehan Telecom (now called SK C&C) and SK Distribution. As shown in Figure 6.6, SK Group acquired Korea Mobile Telecommunication in 1994 from the government. It renamed this firm SK Telecom and made it an affiliate of SK Group. As of 1994, SK Telecom posted 782.8 billion won in revenue with a 36.7% operating margin. After it became an affiliate, it engaged in many intragroup transactions, particularly with Daehan Telecom (now SK C&C) and SK Distribution, which were both small businesses. The chairman of SK Group and his family owned 100% of Daehan Telecom and 95% of SK Distribution. SK Telecom subcontracted purchasing of some equipment to Daehan Telecom, which charged hefty margins of 200%. It also signed service contracts with Daehan Telecom for services it could handle itself. The service contracts with SK Telecom helped Daehan Telecom earn large profits. In 1994, Daehan Telecom posted minuscule operating income 181

Service contract

2.3 32.2 19.3 21.3

0.64 146 137 182 Operating Income (% )

Sales

36.7 21.1

17.3

16.6

2,871 2,789 4,620 5,842

Operating Income (% )

Sales

Sales agency contract

1994 1995 1996 1997 7,828 13,225 26,760 35,120

(SK affiliates: 22% , general public 78% )

SK Telecom

-2.3

-41

-0.4

-16

1.1

66

0.9

88

1994 1995 1996 1997 1,747 3,618 5,951 10,188

SK Distribution

(family, 95% ; SK affiliates, 1% , others 4%)

Figure 6.6. The changes in profitability of SK Telecom as a result of intragroup trade with SK C&C (formerly Daehan Telecom) and SK Distribution. Source: Korea Fair Trade Commission and Korea Information Service.

Operating Income (% )

In 100 million won 1994 1995 1996 1997 Sales 28 453 709 853

(Daehan Telecom) (family, 100%)

SK C&C

Agency Problems in Chaebols of 64 million won and net losses after deducting payments for interest and other nonoperating expenses. By 1997, its revenue had multiplied thirty times, and its operating income increased to 18.2 billion won. SK Distribution similarly benefited from its transactions with SK Telecom, charging high fees with large margins,15 and became profitable. Conversely, SK Telecom’s operating margins dropped from 36.7% in 1994 to 16.6% in 1997. One other notable feature of this set of transactions is that SK Telecom was listed on the Korean Stock Exchange but Daehan Telecom and SK Distribution were not. Further, equity stake by the chairman and his family in SK Telecom was low, while his family was the majority owner of the two other companies. This phenomenon poses some intriguing issues about the conventional wisdom regarding the relationship between ownership and performance. After the study by Berle and Means, it was believed that concentrated ownership generates higher performance due to tighter monitoring by owners.16 In Korean chaebols, ownership concentration leads to higher performance not because of tighter monitoring and control but because of manipulation of internal transfer prices. Furthermore, the causal relationship can be reversed so that high performance leads to ownership concentration. Chaebol families frequently increase their direct shareholdings in highly profitable companies. Chaebol chairmen then induce affiliate firms to increase their equity stakes in less profitable firms so that they can exert managerial control without having direct ownership. Cho’s (1998) study of the behavior of U.S. companies, which showed that profitability exerts a strong influence on the ownership structure of a company, provides additional support for this conjecture. Appendix 6 examines the possibility of reverse causality with a sample of chaebol firms. According to this study, chaebols’ 183

Chaebols’ Ownership and Governance Structure families tend to own larger stakes in more profitable companies and smaller stakes in less profitable ones. They tend to control less profitable companies through cross-shareholding. These findings suggest that chaebol families use insider information to decide how much of an affiliate they will own directly. This trend is further evidence for the problems in corporate governance in Korea. Such explicit cases of expropriation by large shareholders are commonly found in many other countries. As La Porta et al. (1999, 2000) noted, large shareholders in most countries have control rights in excess of their cash flow rights because they use pyramid and cross-shareholding mechanisms and directly participate in management.17 With such control, these owners have the power to expropriate value from minority shareholders (Shleifer and Vishny, 1997; Wolfenzen, 1999).18 Evidence indicates controlling shareholders exercise such power through such means as not paying dividends, transferring profits to other companies they control, providing high or low interest loans, selling or purchasing intermediate products at nonmarket prices, and offering debt guarantees to other affiliates. Such instances occur even in well-developed countries: Barclay and Holderness (1989), Bergstrom and Rydqvist (1990), and Zingales (1994) found evidence of small shareholder expropriation in the United States, Sweden, and Italy, respectively, while Weinstein and Yafeh (1998) found that Japanese firms belonging to bank-controlled keiretsus pay higher interest rates on their liabilities than do unaffiliated companies. Explicit cases of minority shareholder expropriation by large shareholders, however, occur in firms in emerging economies because these firms are largely owned and controlled by families and there are few rules and procedures to protect minority shareholders. With a sample of Indian firms, Bertrand, Mehta, 184

Agency Problems in Chaebols and Mullainathan (2000) found strong evidence of “tunneling,” which they defined as transferring resources from companies in which a controlling family has few cash flow rights to ones in which it has substantial cash flow rights. Coffee (1999) reported that some Czech investment funds sold significant ownership packages to related companies at a fraction of their real value. Dharwadkar, George, and Brandes (2000) also discussed the expropriation that occurs when state-owned enterprises in emerging economies are privatized. Another study by Claessens, Djankov, and Lang (2000) and Claessens et al. (1999) showed that many of the firms affected by the Asian crisis used pyramid structure and cross-shareholding, which was negatively associated with a firm’s market value. Johnson et al. (2000) found that the stock market decline in individual countries during the crisis was negatively correlated with protections for minority shareholders. This chapter has documented several substantial problems with chaebols’ ownership and governance structures. In particular, there exist no systematic controls to avert chairmen’s ill-conceived strategies. These problems greatly diminish the potential for synergies that chaebols can create. Therefore, the restructuring of chaebols must start with the restructuring of their corporate governance systems. As discussed in Chapter 4, the Fair Trade Commission has effectively begun one such change by launching aggressive in-depth investigations into internal transactions. By ferreting out such abuses, it will prevent one form of wealth transfer that hurts the interests of minority shareholders. Clearly, the Korean government needs to take additional steps in this area.

185

7

The Restructuring of Chaebols

187

The Restructuring Policy of the Korean Government In the preceding chapters, we discussed how various structural aspects of chaebols made chaebols resist the shifts to their environment and become dysfunctional. Our results suggest that chaebols’ creation of operational synergies was wasted in illconceived diversification strategies. Vertical integration resulted in inefficiency and massive subsidization. Chaebols’ in-house financial services and mutual debt guarantee practices contributed to high debt levels. We pointed out, however, that the fundamental problems of chaebols are instead attributable to chaebols’ weak corporate governance systems and the distortions in Korean financial markets. We thus concluded that the restructuring of chaebols should address these fundamental weaknesses. In this chapter, we will examine the restructuring efforts by the Korean government and chaebols after the foreign exchange crisis in 1997. This chapter will also discuss the further restructuring of chaebols.

the restructuring policy of the korean government When Korea applied for emergency funds from the IMF, Korea was nearly bankrupt. The Bank of Korea’s foreign reserves were almost depleted. Foreign creditors demanded the redemption of loans from both local banks and companies. Under such circumstances, the Korean government had no leverage against the IMF and the World Bank, also known as the International Bank for Reconstruction and Development (IBRD), in bargaining conditions of loans. The guidelines imposed by the IMF and the World Bank greatly influenced the Korean government’s subsequent restructuring policies.

189

The Restructuring of Chaebols Under articles 32 and 37 of the agreement, the IMF demanded that the Korean government implement the following measures:1 1. Liberalization of foreign investment in the Korean equity market by increasing the ceiling on aggregate ownership from 26 to 50% by the end of 1997, and to 55% by the end of 1998. The ceiling on individual foreign ownership will be lifted from 7 to 50% by the end of 1997. 2. Improvement of corporate governance structures. In particular, the IMF demanded that the government adopt international accounting principles to enhance the transparency of the Korean accounting system. As part of such efforts, the IMF requested that the Korean chaebols disclose information and make public their combined financial statements. 3. No government interference with banks’ business operations and lending decisions. 4. Improvement of bankruptcy procedures and elimination of any subsidies to bail out individual companies. 5. Reduction of debt levels of Korean companies and changes to the system of mutual guarantees within conglomerates to reduce the risk these guarantees entail. The World Bank demanded similar restructuring efforts in its agreement with the Korean government, further requiring reinforcement of the Fair Trade Act to promote competition and the removal of any regulations against entry and exit. The Korean government followed these guidelines rather closely. President-elect Dae-Jung Kim realized that the restructuring of chaebols was necessary to regain confidence from foreign investors. The government announced the following five 190

Restructuring of the Financial Sector principles for corporate restructuring on January 13, 1998. First, the government would require chaebols to introduce combined financial statements and adopt Western accounting practices to improve transparency.2 Second, it would force chaebols to abolish debt guarantee practices to avoid serial bankruptcies. Third, chaebols would reduce their debts substantially and sell unprofitable assets. Fourth, chaebols would improve international competitiveness by focusing on core businesses. Fifth, the government would improve the governance system of companies and would enforce the responsibilities of family owners to minority shareholders. In a sense, these principles simply reiterated what the IMF and World Bank demanded in return for a bailout. In the next section, we will examine the restructuring of the financial sector. The subsequent section will detail changes to debt practices, diversification activities, and corporate governance.

restructuring of the financial sector The analyses in prior chapters indicated the tight relationship between chaebols and Korean financial institutions. Chaebols’ overall problems contributed heavily to the financial problems these institutions faced. As of June 1998, 40 trillion won in loans were officially classified as bad (see Table 5.4). This statistic excludes loans classified as substandard, doubtful, and loss. Using a 55% loan recovery rate, the total amount of required write-offs was estimated to be 47.1 trillion won, which was about 2.6 times the equity capitals of all banks at the end of 1998.3 This estimate is based on the lenient definition of bad loan used by the Korean government. Using the international standard for bad loans increases this figure to 85.7 trillion won. In other words, most banks were technically bankrupt. 191

The Restructuring of Chaebols Furthermore, there was an impending financial crisis as people withdrew their deposits from banks and firms continued to go bankrupt as banks restricted additional loans. Hence, the Korean government had no other option than to delay restructuring in the corporate sector and fix the financial sector first. In early 1998, the government infused 3 trillion won into two large national commercial banks that were insolvent – Chiel Bank (also known as the Korea First Bank) and Seoul Bank – and shut down five smaller regional commercial banks. In a parallel move, four financially weak banks were merged with healthier ones – the Commercial Bank of Korea and Hanil Bank were merged into Hanvit Bank; Boram Bank, into Hana Bank; the Long-term Credit Bank of Korea, into Kookmin Bank; and Kangwon Bank, into Choheung Bank. This consolidation reduced the total number of commercial banks from thirty three at the end of 1997 to twenty four by June 1999. The government also injected an additional 13.5 trillion won of public funds to prop up the equity capital of other weak banks and 9.6 trillion won to pay for the deposits of liquidated banks. In addition, the government chipped in public money to buy back bad loans held by the surviving financial institutions. The government-owned Korea Asset Management Corporation (KAMCO) bought 17.3 trillion won of default assets from banks at a discounted price.4 By 1999, the government infused a total of 45.2 trillion won to restructure commercial banks. In doing so, it helped financially sound commercial banks exceed Bank for International Settlement (BIS) ratios of 10%, which is the international standard. International accrediting organizations such as S&P and Pitch IBCA upgraded the sovereign rating of Korea in February 1999 to investment grade, and the spread on 5-yearmaturity foreign currency stabilization bonds steadily declined. 192

Restructuring of the Financial Sector Table 7.1. Infusion of public funds to the financial sector Public funds raised in 1998 and used by December 1999 (trillion won)

Infusion of equity capital Paying deposits on behalf of the bankrupt financial institutions Purchase of assets Purchase of bad loans by KAMCO Others Subtotal Total

Additional public funds raised in December 2000 and planned usage (trillion won)

Bank

Nonbank financial institutions

Bank

Nonbank financial institutions

16.5

4.0

10.7

9.8

9.6

11.4

—

16.9

1.8 17.3

— 3.2

— 5.9

— —

— 45.2

0.2 18.8

— 16.6

6.7 33.4

64.0

50.0

Source: Ministry of Finance and Economy, A White Paper on Public Funds: Interim Report for the Completion of Financial Restructuring, September 2000.

Similarly, nonbanking financial institutions experienced major shakeouts. Eighteen out of thirty merchant banks were shut down or merged. Additionally, six securities firms, five insurance firms, and three investment trust firms were shut down. Forty savings and loans and 131 cooperatives were shut down as well. The government infused 4.0 trillion won of equity capital into troubled life insurance companies and paid 11.4 trillion won for the deposits of the closed nonbank financial institutions. KAMCO purchased 3.2 trillion won of bad loans. (Refer to 193

The Restructuring of Chaebols Table 7.1 for details.) In all, the infusion of public funds to all financial institutions reached 64 trillion won by December 1999.5 This massive bailout of commercial banks resembles the 1981 foreign exchange crises that hit Chile and Argentina, which were caused by group-affiliated banks lending recklessly to other affiliates. Commercial banks in those countries were practically nationalized when the government rescued them. Similarly, the Hungarian government’s effort to save banks after privatization by purchasing their bad loans in 1992 was nullified only after one year when the same banks became again insolvent (Stark, 1996a). After recapitalizing banks, the government became the dominant shareholder of large commercial banks. Yet these efforts were not sufficient to salvage the financial industry. Although a massive injection of public funds to the failed financial institutions was necessary, the Korean government depleted its financial resources as a consequence; the total government budget and the gross national product of Korea for 1999 were only 80 trillion won and 483 trillion won, respectively. Furthermore, this infusion set another bad precedent of bailing out failed financial institutions with tax money and created a moral hazard for domestic financial institutions. In December 2000, the government reported that six commercial banks that received government funds in 1998, including Seoul Bank and Hanvit Bank, once again needed additional funds to remain solvent. The government announced that 50 trillion won of additional public funds were needed to clean up the balance sheets of commercial banks and to close out bankrupt financial institutions. In short, injecting public funds into finance companies without changing these institutions’ management and lending practices was an inadequate solution. Furthermore, government interventions, such as forcing banks to extend additional loans to near-bankrupt companies 194

Restructuring of the Corporate Sector and to acquire bonds issued by them, did not stop after the crisis. In the meantime, foreign ownership of financial institutions, which had been strictly restricted, was substantially increased. Newbridge Capital acquired majority ownership in Cheil Bank. Kommertzbank became the largest shareholder of Korea Exchange Bank. Goldman Sachs became the largest shareholder of Kookmin Bank. The ING Bank and International Finance Corporation (IFC) participated as the second largest shareholders for the Housing and Commercial Bank and Hana Bank, respectively. Foreign securities firms such as Regent Pacific, Quantum Emerging, H&Q, and Prudential bought shares of Korean firms. MetLife, Allianz, and New York Life took equity positions in Korean insurance firms. The increase in foreign ownership of financial institutions is expected to result in tighter monitoring of these institutions’ lending practices and restrict the government’s meddling in the financial sector. For instance, in December 2000, the government forced banks to acquire bonds issued by financially weak companies. Only the Cheil Bank, under the management of Newbridge Capital, could refuse this request.6

restructuring of the corporate sector Financial Restructuring of Chaebols Financial restructuring of Korean chaebols has focused on three main reforms. The first focused on chaebols reducing their debt– equity ratios to less than 200%. The second involves chaebols completely eliminating cross-debt guarantees among their affiliates by the end of 2000. The third requires smaller chaebols to improve their financial structures through corporate workout 195

The Restructuring of Chaebols programs. To implement these measures, chaebols were placed under the close supervision of banks that were practically nationalized through the massive capital infusions described earlier. Again, it should be noted that the government initiated the restructuring of chaebols. Under the government-led corporate restructuring plan, substantial progress was made in cutting bloated corporate debts. The government used the technically nationalized banks to force chaebols to reduce their debt–equity ratios to 200% by the end of 1999. The top thirty chaebols’ average debt–equity ratio fell from 516.4% at the end of 1997 to 344.6% at the end of 1998, to 189.6% by the end of 1999 (see Figure 5.1). During the same period, the top five chaebols reduced their average debt–equity ratios from 477.9% in 1997 to 329.5% in 1998 and 144.9% in 1999.7 These statistics show dramatic reductions of debt–equity ratios in a short period of time. A detailed analysis, however, suggests a more complicated picture than these statistics indicate. The top five chaebols actually saw an increase in total debts from 221.2 trillion won in 1997 to 234.6 trillion won in 1998 (see Table 7.2). Their debt–equity ratios dropped because their shareholders’ equity rose from 46.9 trillion won in 1997 to 69.9 trillion won in 1998. Of this amount, 12.2 trillion won came from new equity issues, most of which went to affiliates. Thus, the cross-shareholding discussed in Chapter 6 actually increased and artificially decreased debt–equity ratios as a side effect. The remaining portion of this equity increase is attributable to massive asset revaluation. Chaebols revalued their real estate and securities holdings. In contrast, the rest of the top thirty chaebols, which generally had lower credit ratings than the top five chaebols did, had actually slashed their total debts from 136 trillion won at the end of 1997 to 132 trillion won at the end of 1998, while 196

Restructuring of the Corporate Sector Table 7.2. Changes in the debts and equities of the top five chaebols, 1997–1999 1997 aggregated financial statements Hyundai Samsung Debt Equity Debt–equity ratio Number of affiliates

LG

Daewoo

SK

Sum/Average 221.2 46.9 477.9

61.7 10.7 576.6

50.0 13.5 370.4

42.9 8.5 504.7

42.7 9.1 469.2

23.9 5.1 468.6

62

61

52

37

45

1998 aggregated financial statements Hyundai Samsung Debt Equity Debt–equity ratio Number of affiliates

LG

Daewoo

72.6 15.0 484.0

43.2 17.1 252.6

36.4 11.5 316.5

59.8 16.9 353.8

57

62

48

36

SK

Sum/Average

22.6 234.6 (174.6) 9.4 69.9 (53.1) 240.4 329.5 41

244

1999 aggregated financial statements Hyundai Samsung Debt Equity Debt–equity ratio Number of affiliates

LG

Daewoo

SK

Sum/Average

— — —

22.6 16.9 133.7

141.1 96.4 144.9

39

162

52.6 34.6 152.0

38.4 26.3 146.0

27.5 18.6 147.8

35

45

43

197

The Restructuring of Chaebols Table 7.2 (cont.) 1999 combined financial statements Hyundai Samsung

LG

Debt 60.2 41.5 30.6 Equity 26.2 21.4 11.2 Debt–equity 229.8 193.9 273.2 ratio Number of 103 (30) 159 (39) 118 (35) affiliates

Daewoo

SK

Sum/Average

— — —

23.1 10.2 226.5

155.4 69.0 230.8

57 (33)

437 (137)

Notes: 1. The aggregated financial statements simply add the accounting items from the financial statements of individual affiliates without any consolidation. The combined financial statements consolidate all the affiliates that are effectively controlled by the chaebol chairmen. 2. Both aggregated and consolidated statements here exclude financial services affiliates. 3. “Sum/Average” denotes sum of debts, equities, and number of affiliates of five (four excluding Daewoo) and average for debt–equity ratios. 4. The 1999 combined financial statements include both domestic and foreign affiliates. Number of affiliates in parentheses denotes domestic affiliates. 5. Daewoo Group went bankrupt. Figures in parentheses in 1998 statements are sum of those excluding Daewoo. Source: The aggregated financial statements are from the Korea Fair Trade Commission, and the combined financial statements are from the Korea Financial Supervisory Board.

only slightly increasing their equity base. It was only after the Daewoo Group went bankrupt in 1999 that the other top chaebols engaged in substantive restructuring. The four remaining biggest chaebols further reduced their debt–equity ratios. They increased their equities from 53.1 trillion won in 1998 to 96.4 trillion won in 1999 and reduced their debts from 174.6 trillion won in 1998 to 141.1 trillion won in 1999 by raising capital 198

Restructuring of the Corporate Sector from new equity issues and paying down their debts. The booming stock market contributed to their ability to make these debt– equity swaps. As a consequence, their average debt–equity ratio went down to 144.9% in 1999. Table 7.3 uses LG Group as one example of this restructuring. LG issued 2.4 trillion won in equity in both 1998 and 1999. Between these issues, asset revaluations (0.9 trillion won in 1998 and 1.4 trillion won in 1999), and profits (almost none in 1998 and 3.6 trillion won in 1999), LG Group increased its total equity from 8.5 trillion won in 1997 to 11.5 trillion won in 1998 and 18.6 trillion won in 1999. Most of the new equity issued in 1998 was assumed by other affiliates, thus increasing cross-shareholding from 36.3% in 1997 to 48% in 1998. In contrast, outside investors bought most of LG Group’s new equity issues in 1999, and affiliates sold 953 billion won of their equity holdings in their affiliates to outside investors to pay back their debts. As a consequence, cross-shareholding in LG Group dropped from 48% in 1998 to 36.2% in 1999. In addition, LG sold its semiconductor business to Hyundai Semiconductor in 1999 as a part of the Big Deal, which we will discuss in the next section. Several LG affiliates converted their businesses into joint ventures with foreign partners such as Rohm & Hass, Dow Chemical, PowerGen, Philips, British Telecom, Nippon Mining, and OTIS, and sold their own joint venture partnership shares off to foreign partners such as LG Allied Signal and LG Honeywell. LG raised $1.7 billion in 1998 and $2.7 billion in 1999 by selling assets to foreigners. The true degree of chaebols’ indebtedness was revealed only when chaebols’ combined financial statements became available for the 1999 financial year. The government required that chaebols present the combined statements of all domestic and foreign affiliates after subtracting all internal sales transactions. 199

1,460 973 2,434

1999

Amount

U.S. $30 million

Company

LG Chemical

U.S. $1.52 million

2,499 423 207 3,130

1998

Rohm & Haas Allied Signal

Partner

Established LG-Shipley Co., Ltd., a joint venture photoresist manufacturer. Sold LG Allied Signal to Allied Signal.

Contents

Foreign capital attraction

1,553 953 1,211 3,719

1999

Asset sales (in billion won)

1,878 528 2,407

Real estate/facilities Financial asset Others Total

Domestic Foreign capital inflow Total

1998

Equity issue (in billion won)

Table 7.3. Restructuring of LG Group

Sept. 98

Jan. 98

Date

Royal Philips Electronics LG Honeywell British Telecom Nippon Mining

Carrier OTIS

U.S. $170 million U.S. $210 million

U.S. $1.6 billion

15 billion won (U.S. $ figure n/a) U.S. $400 million

U.S. $830 million

U.S. $66 million U.S. $500 million

LG LCD

LG Honeywell LG Telecom

LG Industrial Systems

Dow Chemical Degussa PowerGen

LG Energy

U.S. $320 million

Established a joint venture firm with equal shares and LG IS’s copper smelting and refining business unit was sold to the joint venture Sold a vending machine business unit. Established a joint venture, LG OTIS Elevator, and the joint venture took over LG IS’s building facilities business.

Established a polycarbonate joint venture firm. Sold carbon black business to Degussa. Sold 49.9% stake (U.S. $60 million) to PowerGen. PowerGen arranged loans for LG Energy(U.S. $150 million). Established a joint venture, LG Phillips LCD and sold 50% stake to the joint venture Sold all LG shares in LG Honeywell to Honeywell. Sold 23.49% stake in LG Telecom to BT.

June 99 Nov. 99

July 99

Oct. 98

April 99

May 99

Nov. 98 Feb. 99

Oct. 98

The Restructuring of Chaebols Table 7.2 shows the equities and debts of the four largest chaebols as listed in the combined financial statements of 1999 and highlights the substantial differences between chaebols’ debt and equity levels for the aggregated and combined accounting data. In the combined statements, debts incurred by foreign subsidiaries were added, and cross-shareholdings were crossed out. As a consequence, the average debt–equity ratio was 230.8%, which was much higher than was the average from the aggregated statements. The second important element of chaebols’ financial restructuring was the elimination of mutual debt guarantee practices. As we saw in Chapter 6, such practices created ripple effects of bankruptcies among chaebol affiliates.8 After the financial crisis, the Korean government attempted to rapidly eliminate all such guarantees by 2000. In 1997, the top thirty chaebols’ total cross-debt guarantees, excluding payment guarantees related to industry rationalization, overseas construction, and technology development, which were qualified for exemption, amounted to 63.5 trillion won. These chaebols reduced this amount to approximately 22.4 trillion won in 1998 and to only 1.3 trillion won by 2000. Most notably, the top four chaebols eliminated all such guarantees by the end of 2000 (see Figure 5.3). This restructuring program is also attempting to facilitate the smooth exit of nonviable companies and to transform financially weak, yet promising companies into financially sound ones. To accomplish this, creditor financial institutions have been implementing corporate workout programs centered on smaller chaebols. Corporate workouts, by definition, mean financially weak firms negotiate with their creditors to restore their financial health by restructuring their debt profiles before they have to file for bankruptcy and be liquidated.9 In doing so, these firms can reduce their debts and begin the recovery process. They 202

Restructuring of the Corporate Sector continue to operate and serve their customers, thus increasing their cash flows, and thereby improving creditors’ prospects for eventually recouping the loans they made to these firms. In June 1998, 210 Korean financial institutions signed the Creditor Banks Agreement on Accelerating Corporate Restructuring with the government. This agreement specified that approval from a majority or 75% of financial creditors is needed to place a company under a corporate workout program. In addition, using the Technical Assistance Loans from the World Bank, the Korean government appointed six external advisory groups to the commercial banks to provide them with much needed professional expertise and skills for implementing corporate workout programs. The advisory groups were composed of experts in various fields, including accountants, lawyers, and investment bankers from leading firms. These experts evaluated the progress of the corporate workout programs and provided advice on restructuring and financing. The major tools utilized in these corporate workout programs included interest rate reductions, interest expense write-offs, and debt–equity swaps. New credit extension was minimal. Companies were required to sell or merge assets and business units that were either outside their core business lines or had little chance of recovering. Creditor banks required equity write-offs before they made debt–equity swaps. Both creditors and existing shareholders lost money on these swaps, thus limiting moral hazard by both parties. Before initiating the corporate workout program, the Financial Supervisory Board announced the liquidation of fifty-five bankrupt companies in June 1998. By 1999, fifty-four companies belonging to seventeen business groups and thirty-nine medium-sized and large independent companies operated under the workout program. Many of these companies were not performing well, however, and twenty-nine of them 203

The Restructuring of Chaebols were liquidated in November 2000.10 The Korea Development Institute, a government-sponsored research agency, contended that the workout program merely extended financially troubled companies’ lives rather than helping turn them around.11 In sum, the financial restructuring program was only moderately successful. By selling assets and issuing equity, chaebols strengthened their finances. They also made themselves less vulnerable to the ripple effects of bankruptcy by eliminating mutual debt guarantee practices. Yet this program also needlessly delayed the lives of many technically bankrupt companies. Business Restructuring By implementing the Big Deal plan, the Korean government also attempted to consolidate industries and induce chaebols to focus only on their core competencies. This plan involved eight industries: semiconductors, petrochemicals, aerospace, railroad vehicles, power generation machinery, ship engines, oil refining, automobiles, and electronics. Highly capital intensive with huge fixed assets, these industries faced serious overcapacity and inefficiency as a result of the Korean government’s economic development policies in the late 1970s, which induced chaebols to enter these businesses. In a sense, this Big Deal policy resembles past methods of dealing with prior economic crises and bankruptcies. After the second oil crisis, many Korean firms, particularly those in the heavy equipment and chemical industries, were in deep financial trouble. The total external debts to GNP rose from 32% in 1979 to 48% in 1981. The government then lowered the interest rates and depreciated its currency. The government also bailed out many failed firms by letting healthier firms take them over or merge with each other. For instance, Saehan Motors, a 204

Restructuring of the Corporate Sector passenger car manufacturer, was acquired by Daewoo Group, and Kia Motors was forced to concentrate on the commercial vehicle while exiting the passenger car business. Large ship engine firms were consolidated into Hyundai and Korea Heavy Industries, and small ship engines, into Ssangyong. Heavy equipment machinery businesses of Ssangyong and Kolon were merged to Hyosung. Samsung, Hyundai, and Daewoo were ordered to give up the power generation business to Korea Heavy Industries, but they managed to have this order rescinded. Large subsidies were provided to firms involved in restructuring (Amsden, 1989; Woo, 1991). In the semiconductor industry, Hyundai Electronics acquired LG Semiconductor, while in the oil refinery industry, Hyundai took over Hanwha. In railroad vehicles, Hyundai, Daewoo, and Hanjin jointly established a new business entity. Similarly, Hyundai, Daewoo, and Samsung formed a joint business entity for the aerospace industry. In power generation machinery, Korea Heavy Industries was to take over Samsung and Hyundai’s power generation machinery units; however, Samsung and Korea Heavy Industries were pursuing the establishment of a separate entity with independent management for ship engines. In petrochemicals, Hyundai and Samsung were negotiating with potential foreign investors to form an integrated entity within the Daesan petrochemical complex and become joint majority shareholders. In the automobile and electronics industries, however, Samsung Electronics failed to take over Daewoo Electronics while Daewoo Motors could not acquire Samsung Motors. It is worth noting that the same industries that were subject to the 1981 restructuring were again reorganized after the 1997 crisis. It suggests the negative consequences that the government’s drive to develop the heavy equipment and chemical industries had on the future development of Korean 205

The Restructuring of Chaebols industries and demonstrates that the previous governmentdriven restructuring was ineffective. This program had several embedded problems, however. The biggest problem was that the rationale for the program was based on political rather than economic motives. During the 1970s and 1980s, the government initiated several industrial policies to rescue unviable companies by extending loans, employing debt–equity swaps, and merging with others. In that sense, the Big Deal represented another attempt by the government to manage the economy, despite the fact that its past efforts to do so had proved unsuccessful. The government wanted to show visible results to its citizens and the international financial community very quickly and failed to evaluate the economic benefits of swapping assets. Many argued that this idea was more window dressing than a real restructuring.12 For instance, studies suggested that a merger between LG Semiconductor and Hyundai Electronics was not feasible and would create few synergies because of these firms’ technological and production incompatibilities. Nonetheless, the Korean government pushed the two companies to merge. Similarly, many also raised questions over the long-term business prospects of the joint venture in aerospace. Some even suggested that all Korean firms should exit the aerospace industry. For power generation machinery, ship engines, and oil refineries, industry experts argued that the consolidation of businesses would create economically inefficient monopolies rather than provide economies of scale and cost efficiencies. As of December 2000, the Big Deal plan is generally regarded as a big failure (see Table 7.4).13 Hyundai Electronics, after acquiring LG Semiconductor, suffered from huge debts and a plunge in the price of DRAMs. Hyundai Electronics (now Hynix) is surviving only because the government pressured 206

LG Semiconductor and Hyundai Electronics merge into one company.

Affiliates of Hyundai, Daewoo, Samsung merge into one company.

Hyundai, Daewoo, Hanjin merge their operations.

Samsung and Hyundai sell their businesses to Korea Heavy Industries. Samsung sells its business to Korea Heavy Industries. Hyundai acquires Hanwha Refinery. Daewoo acquires Samsung Motors. Samsung acquires Daewoo Electronics.

Semiconductors

Petrochemicals, aerospace

Railroad vehicle

Power generation machinery

Automobile Electronics

Petroleum refinery

Ship engines

Government’s plan

Industry

Table 7.4. Big Deals among chaebols

Hyundai acquired Hanwha Refinery in June 1999. Deal did not go through. Deal did not go through.

Korea Heavy Industries acquired Samsung and Hyundai’s business. Merged as planned.

Hyundai, Daewoo, Hanjin merged their operations in October 1999.

Aerospace businesses were combined into one in October 1999.

Acquisition of LG Semiconductor by Hyundai Electronics was completed in July 1999.

Implemented as of December 1999

Making a profit. Doosan acquired Korea Heavy Industries Postacquisition integration has yet to take place.

Due to the lost synergies and the plunge of price of DRAMs, Hyundai Electronics is technically bankrupt. The government asked banks to buy bonds issued by Hyundai Electronics. The merged company kept making losses. The government provided 530 billion won aids in 2000. Petrochemical deal did not go through. Labor unions of three companies oppose the postmerger integration process. Overcapacity problem did not ease. The government is seeking a buyer. Doosan, the 12th largest chaebol, acquired Korea Heavy Industries.

Results as of December 2000

The Restructuring of Chaebols banks to buy its bond issues. The combined aerospace business has never made money, and the government provided it with 530 billion won to help it avoid bankruptcy. The railroad vehicle concern has suffered from labor disputes, as three separate labor unions from the previous companies have opposed any integration and rationalization efforts. The government is seeking a buyer for this combined unit. The petroleum refinery business suffered from similar problems. Only the ship engine business made a modest profit. Doosan, the twelfth largest chaebol, eventually acquired it in 2000. Overall, it appears that politically driven intervention has not created economically successful outcomes.

enhancement of the corporate governance system As reviewed in the previous chapters, corporate governance in chaebols is weak. Chaebols’ founders, along with their families, have pursued their own interests at the expense of minority shareholders. They have engaged in ill-conceived diversified expansion, subsidized unprofitable affiliates, and expropriated funds by using inside information and other forms of subsidies. Ultimately, these practices helped precipitate the financial crisis in 1997. Consequently, the IMF and World Bank required a reform in the corporate governance structure of Korean corporations in the agreement with the Korean government. The Korean government initially seemed determined to reform the corporate governance structure of the chaebols and enhance corporate management transparency and accountability. As a first step to improve transparency and accountability, it required the top thirty chaebols to prepare combined financial 208

Enhancement of the Corporate Governance System statements that are in line with international standards as of the 1999 financial year.14 The roles of outside directors and independent auditors were strengthened. Independent auditors would be punished if they failed to produce accurate information about the companies they audited. An electronic reporting system was adopted and regulations on inadequate reporting for contingent liabilities, including cross debt guarantees among affiliates, were strengthened. Second, the commercial laws were amended to simplify merger and acquisitions (M&A) procedures for both friendly and hostile M&As. In early 1998, the ceiling on foreign equity ownership in a Korean firm was 55%. This ceiling was completely eliminated to allow 100% foreign ownership in late 1998. Also, the ownership limit by a single foreign national, which requires approval from the board of directors, was increased from 10 to 33%. The rule on tender offers, which previously required that when acquiring more than a 25% stake, one must place a tender offer publicly for more than 50% plus one share, was deleted. Moreover, the government streamlined regulations on corporate spin-offs and small-scale mergers. These steps to ease regulations on foreign ownership facilitated a rapid growth in foreign investment in Korean companies. Despite these changes, hostile mergers and acquisitions in Korea are unlikely due to high cross-ownership among affiliates of the chaebols. Third, the Korean government also required chaebols to abolish their group-level staff organizations. Chaebols, however, resisted this demand and simply shifted this function to their flagship companies. Because chaebols continued to need to coordinate activities of group affiliates, the government’s demand was na¨ıve. Along with these measures, in an attempt to increase accountability, the government persuaded the chaebol “chairmen” to assume the chief executive officer (CEO) 209

The Restructuring of Chaebols positions in individual affiliates and thus made them liable for all wrongdoing. Furthermore, to improve monitoring of top management, listed companies were first required to appoint at lease one outside director. Starting in 1999, these firms had to ensure that outside investors represented at least 25% of their boards of directors.15 As a result, for the 554 companies listed on the Korea Stock Exchange (KSE) at the end of 1997, 667 outside directors were selected. Since the majority of these directors were simply appointed by the dominant shareholders, however, most of them had close relationships with the dominant shareholders.16 A survey by the KSE in 2000 indicated that these outside directors attend fewer than 66% of board meetings and approve over 99% of the business items presented during these meetings.17 Thus, this measure has brought limited change. It will likely be some time before Korea has a sophisticated outside director system that helps institutional investors exert significant influence. In tandem with these measures, the rights of minority shareholders stipulated by the Securities and Exchange Act have been slightly improved. In the past, shareholders with an equity stake of 1% or larger for at least six months could file class action lawsuits. The representation requirement for filing class action lawsuits against the “listed” firms was drastically reduced from 1 to 0.01% in May 1998. The equity threshold for being able to examine a firm’s accounting data was reduced from 3 to 1%, again with the six-month holding requirement. Yet the government remained reluctant to further ease the requirement for filing class action lawsuits.18 In addition, it has not yet acceded to minority shareholders’ demand to be allowed to elect directors by accumulating votes among themselves.19 The chaebols and their trade association, 210

Enhancement of the Corporate Governance System the Federation of Korean Industries, have fiercely opposed these measures. According to a survey conducted in 2000 on the effectiveness of the Korea corporate governance systems, 98.5% of foreign fund managers and 77% of domestic fund managers believe that Korean companies still suffer from transparency problems, and 93.9% of foreign fund managers and 77% of domestic fund managers contended that Korean companies fail to serve the interests of shareholders.20 Ninety-seven percent of foreign fund managers and 77% of domestic fund managers demanded the immediate introduction of class action lawsuit reforms, as well as the right to accumulate votes. These results suggest that the corporate government systems are not yet effective. The fourth investigation by the Korea Fair Trade Commission on internal business trade in the four largest chaebols, which was conducted in December 2000, shows that chaebols had not reduced their unfair internal business trade practices such as subsidizing other affiliates or transferring wealth to chaebol family members, even after they paid huge fines ensuing from the first three investigations (see Table 4.3).21 The total amount of unfair business trade and estimated amount of subsidies amounted to 2,463 billion won and 126 billion won, respectively. Chaebols have become much more sophisticated in how they subsidize affiliates than they were during the first three investigations. Rather than using their own financial services affiliates, chaebols deposited funds into unaffiliated financial institutions and let them lend money to the financially weak affiliates at favorable terms while using these deposits as collateral. Also, in several cases, listed companies transferred wealth to chaebol families. For instance, LG Chemical and LG Telecom, both of which are listed firms, sold shares of unlisted affiliates at low prices to several chaebol family members. The Fair Trade Commission 211

The Restructuring of Chaebols estimates that these sales thereby expropriated 146 billion won from minority shareholders.22 Overall, the corporate governance systems in Korea need to be improved considerably. In the face of fierce resistance from chaebols, the government has been lax in initiating legislation on class action lawsuits and accumulating votes. Quicker action is required to protect the interests of minority shareholders.

perspectives on the restructuring of chaebols This chapter evaluated the restructuring efforts of chaebols. It should be noted that these efforts were engineered and forced by the government. After the crisis, the government rescued the financial services industry and used it as a vehicle to restructure chaebols. In other countries, market forces have driven similar restructuring efforts. For instance, the extensive corporate restructuring activities of U.S. companies in the 1980s were driven by increased competition from overseas and hostile takeover activities by corporate raiders (Bowman et al., 1999). Many corporations, including most conglomerates, divested their unrelated businesses and focused on their core competencies (Chang, 1996). We will examine such market-driven efforts in other countries in Chapter 8. In a sense, the restructuring of chaebols shows some interesting parallels to the dissolution of zaibatsu after World War II.23 To avoid resurrection of Japanese imperialism, General McArthur formally dissolved the zaibatsu into many independent firms (Hadley, 1970). After the occupation ended, however, the firms rebuilt their network linkages, though in a less centralized fashion, into keiretsu. Although the zaibatsu reform 212

Perspectives on the Restructuring of Chaebols resulted in removing the founding family entirely, the exzaibatsu firms simply regrouped voluntarily by exchanging shares and pooling resources. As a consequence, the internal operations of keiretsu remain a closed system, although direct control over individual affiliates has been weakened in comparison with the pre-war zaibatsu. The chaebol reforms in Korea were triggered by the collapse of the Korean economy and forced by the IMF and World Bank. The Korean government followed their guidelines rather closely to escape the default risk. The Japanese experience, however, illustrates the limitation of corporate restructuring initiated by external forces. The chaebol restructuring program consisted of three components: (1) restructuring business to produce visible results over the short term, (2) revising financial structures to improve results in the next few years, and (3) strengthening corporate governance mechanisms to induce long-run stability. Business restructuring was a complete failure in that it created no efficiency gains. It was driven by politicians’ desire to show immediate results rather than by sound economic rationales. On the other hand, the government’s effort to reduce debts and remove debt guarantee practices showed some visible results: as of 2000, chaebols reduced their debt–equity ratios substantially and eliminated almost all the mutual debt guarantees. In part, however, they did so by revaluing their assets and increasing cross-shareholding. Furthermore, the government’s efforts to restructure companies through bank-sponsored workout programs resulted in miserable failures. The banks merely extended the lives of already bankrupt companies. Although the government worked very hard to achieve results through business restructuring and financial restructuring, it did not put much effort into improving corporate governance systems, which are less visible but can be potentially more 213

The Restructuring of Chaebols important in the long run. Although there was some improvement in the underlying legal framework, the current system still favors large shareholders in many respects, and the government is reluctant to introduce rules for broader protection of minority shareholders such as class action lawsuits and agglomeration of votes. It is likely that many problems arising from the Korean chaebols can be addressed over the long run only after the government strengthens these mechanisms further. Rather, the real force behind the further restructuring of chaebols is the shareholder activist. Since 1998, the People’s Solidarity for Participatory Democracy, a nongovernment organization, has coordinated minority shareholders and foreign institutional investors. It filed a lawsuit against explicit cases of expropriation such as those in Samsung Electronics and SK Telecom (see Chapter 6) and exercised rights of minority shareholders at annual general shareholders’ meetings.24 Such efforts pressure the government to make changes in the legal framework that hold chaebols for their behavior. In the case of SK Telecom, foreign investors such as the Tiger Fund collaborated with domestic minority shareholders to wage a proxy fight in the general shareholders’ meeting. They obtained the right to appoint two outside directors. SK’s founding family agreed to give these directors the authority to approve internal transactions above a certain amount. The People’s Solidarity for Participatory Democracy also caused a stir at the general shareholders’ meeting of Samsung Electronics over the company’s unfair internal transactions. Backed by the nongovernmental organizations’ (NGOs’) movement to reinforce the rights of minority shareholders, the further strengthening of the legal framework will improve corporate governance and further prompt restructuring of the chaebols. 214

Perspectives on the Restructuring of Chaebols After being bailed out by the IMF, the Korean government carried out various programs to restructure Korea’s financial institutions. It also aggressively intervened to restructure chaebols, which is ironic because previous governmental regimes had originally initiated and subsidized chaebols’ development and growth. In this chapter, we can conclude that the success of these efforts was limited for two related reasons. First, the government, rather than market forces, initiated these efforts. Second, these efforts did not fully address the fundamental problems in chaebols’ corporate governance. The analysis of this chapter leads us to conclude that the earnest restructuring of chaebols should begin with improvements in the corporate governance system.

215

8

Conclusion

217

The Crisis and the Fall of Chaebols: A Summary the crisis and the fall of chaebols: a summary The Financial Crisis as a System Failure This book began by posing several questions about the financial crisis that hit Korea in 1997. Twelve of the top thirty chaebols and Korea as a whole went technically bankrupt at this time. Foreign and domestic observers were amazed by such a spectacular collapse, as the Korean economy had been praised as the exemplar of economic development. Several plausible causes for the crisis have been raised: currency speculation, inadequate government policies, and heavily indebted chaebols. Are chaebols the main culprit of the crisis? In a capitalist society, there are always some companies that go bankrupt. Schumpeter (1937) called this process, by which inefficient firms are replaced by new innovative firms, “creative destruction.” Although chaebols’ performance had deteriorated throughout the 1990s, it is astonishing not only that none went bankrupt prior to the crisis but also that all went bankrupt during and after the crisis. The analysis in this book showed that technically bankrupt chaebols stayed solvent only through crosssubsidization and government intervention. To the extent the government propped up failing chaebols, is it to blame for impeding the orderly exit of already failed companies? Further, why did the international financial community advance loans to chaebols, knowing that they were heavily indebted? Why did foreign investors suddenly recall the loans? By highlighting the interrelationships between chaebols, the Korean government, and foreign investors, this book has shown that the financial crisis was a systematic problem for which all these parties were to blame. Although the government proclaimed a policy of economic liberalization, it continued to push 219

Conclusion banks to make guaranteed loans to chaebols. As a consequence, it created moral hazards for chaebols and banks. Moreover, there were no governance mechanisms for monitoring chaebols’ investment activities. Chaebols’ ownership of nonbank financial services institutions further jeopardized the capital market discipline of firms’ investment decisions. Chaebols collapsed only when foreign investors and creditors suddenly realized that the Korean government could neither credibly guarantee loans any longer nor manage the economy as it had in the past. Nonetheless, chaebols were financially vulnerable. If not for the crisis in 1997, their performance would have declined continuously and the Korean economy might have had an extended depression. Although the financial crisis dramatically exposed the weaknesses of chaebols and the Korean economy, some sort of crisis was probably inevitable. Structural Inertia of Chaebols The system failure denotes that the developmental state and the chaebols, two main pillars of the Korean economy, became no longer viable to the environments they faced in the 1990s. Both the government and chaebols showed enormous inertia to the changes brought about by economic success, deregulation, global competition, and the influx of foreign capital. As the economy developed, the private sector became too complicated for government bureaucrats to control. Global competition intensified, and other countries and international institutions pressured Korea to reduce its trade barriers. Foreign capital could swiftly move in and out of countries. State bureaucrats became paralyzed. The structures of chaebols, which were optimal for Korea’s economic environment during the period

220

The Crisis and the Fall of Chaebols: A Summary of economic development and were the sources of competitive advantages, inhibited adaptation, and became dysfunctional when the environment changed. The absence of effective governance mechanisms during the transition period further exacerbated this inertia. Chaebols’ diversified business structure was geared to generate operating synergies by sharing financial and intangible resources such as brands, technology, and know-how embedded in human resources among affiliates. Such sharing was possible only because of chaebols’ centralized organizational structure. Yet this strength was also a weakness because there was no way to guard against the ill-considered strategies of chaebol chairmen, who had the final say in resource allocation and diversification decisions. Further, these chairmen cross-subsidized unprofitable affiliates and diverted profits to affiliates in which they and their families owned large equity stakes. All these activities wasted the synergies created through resource sharing. Moreover, because the chaebols’ chairmanship was inherited within families, there was no opportunity to change the course of action (i.e., strategic reorientation). These problems might explain chaebols’ continued pursuit of unrelated diversification even during the economic declines of the 1990s. Chaebols also used vertical integration extensively. Within chaebols, many small affiliates supplied parts and intermediate goods to the affiliates that assembled final products. Chaebols had to integrate vertically when the government pushed them into the heavy equipment and chemical industries when other supporting industries were underdeveloped. Although vertical integration might have eliminated transactions costs in acquiring necessary parts and services from imperfect markets, especially during periods of rapid economic growth, it also made chaebols

221

Conclusion increasingly inefficient and inflexible because it did not give enough incentives to firms in upstream operations to be innovative and cost-effective and prohibited assemblers from switching suppliers. Furthermore, intricate webs of cross-ownership and debt guarantees made buying goods from external suppliers difficult. Assemblers had to support unprofitable affiliates by cross-subsidizing them. The overall capital structure of chaebols shows another aspect of inertia. Chaebols favored debt to equity financing because it enabled chaebol families to maintain their controlling stakes even as their empires grew too large for them to infuse additional equity. We observed that two mechanisms served to maximize the amount of debts they could carry. One was to have their own in-house financial affiliates and the other was to use mutual debt guarantees. The former became a major source of capital after the government deregulated the financial service industry in the 1980s. The mutual debt guarantees increased affiliates’ debt levels to unsustainable levels. As a consequence of debt guarantees, chaebol affiliates became tightly coupled with each other so that a bankruptcy of one affiliate would lead to the collapse of the entire group. These guarantees impeded the exit of unprofitable affiliates because their guarantors became liable for their debts. They thus also stifled investment in more promising affiliates. Chaebols’ ownership and governance structure was a further source of inertia. Cross-ownership was devised to ensure the controlling ownership stake of chaebol families. It artificially inflated ownership stakes controlled by affiliates’ companies and insulated them from capital market control. Further, no corporate governance systems functioned to prevent illconceived strategies or even explicit cases of expropriation.

222

The Crisis and the Fall of Chaebols: A Summary Limitations of the Crisis-Driven Transformation This book also examined the various restructuring programs imposed on chaebols after the crisis. The government tried to narrow the chaebols’ business focus by ordering them to swap businesses, reduce their debt–equity ratios, and eliminate their debt guarantee practices. Such reforms had only limited success: the so-called Big Deal failed when chaebols resisted it. Even though several mergers were completed, the combined entities remained uncompetitive because there was no sincere effort to reduce overcapacity. The government’s effort to force chaebols to reduce debt–equity ratios was hindered after chaebols merely revalued their assets and bought new equity issues by other affiliates. The government was successful only in eliminating the debt guarantee practices. The restructuring of chaebols indicates the limitations of such reforms when there are no changes in underlying institutional arrangements. Such forced changes are analogous to the orders that dissolved the zaibatsu after World War II. Although the Supreme Command of the Occupation Force succeeded in taking ownership away from zaibatsu families, former zaibatsu affiliates voluntarily formed keiretsu after U.S. forces left Japan. In contrast, the restructuring of conglomerates in the United States was initiated from within these organizations. Conglomerates’ managers and boards accepted the financial conception of control, which ultimately led to changes in their strategy (Fligstein, 1990). The Korean experience demonstrates that further restructuring of chaebols entails changes in the institutional environments facing them, especially changes that improve corporate governance systems. The fact that the most effective means of controlling chaebols’ power to date was enacting the Fair Trade Act provides additional support for this argument. 223

Conclusion business groups in other countries As we pointed out earlier, chaebols are not unique to Korea. Business groups like chaebols are found worldwide. They include conglomerates in Western countries, keiretsu in Japan, and grupos economicos in Latin American countries. Although many of these business groups are currently doing poorly, business groups are not likely to disappear in the near future. This section will examine this trend and the reasons behind it. Conglomerates in the United States and Europe During the 1980s, many U.S. firms dramatically changed their corporate strategies. In the 1960s, many large U.S. firms had aggressively pursued growth through unrelated diversification, mainly through mergers and acquisitions. In the 1980s, corporate raiders took over many of these conglomerates and divested most of their holdings. Still other firms reversed their diversification strategy by selling off unrelated business units and focusing on their core businesses (Markides, 1990; Chang, 1996).1 Fligstein (1990) described the U.S. corporate restructuring in the 1980s as a crisis in the market for corporate control, just as the financial crisis in Korea was a crisis in the governance system. He argued that this period of restructuring reflected investors’ more aggressive use of capital markets to wrest control from the managers of poorly performing firms. According to him, high inflation during the 1970s pushed up interest rates and depressed returns on investments. Furthermore, foreign competitors penetrated U.S. firms’ market and challenged their home base. U.S. companies had to focus their resources on core businesses to improve profitability.2 Managers, however, failed to comply with investors’ demands. 224

Business Groups in Other Countries Investors wanted to gain control in two ways. First, some investors, termed corporate raiders, engaged in hostile takeovers, in which they fired managers of firms that were doing poorly. New financial instruments such as junk bonds, which carry high risk and high returns, contributed to the increased number of hostile takeovers.3 Second, the influence of institutional investors such as pension funds and mutual funds, which became the dominant owners of listed companies, on top management became stronger. CEOs of firms such as K-Mart, GM, Philip Morris, and W. R. Grace did not pay attention to institutional investors’ demands and were replaced. Other managers, paying heed to this trend, worked hard to restructure their firms, enhance efficiency, and improve profitability to keep their jobs. Overall, increased international competition and an active market for corporate control have effectively limited careless diversification by U.S. firms. European conglomerates also refocused on their core businesses and divested unrelated concerns in the 1990s. For instance, when Schrempf became CEO of Daimler Benz in 1995, he liquidated many poorly performing unrelated businesses and restructured the remaining business divisions under the banner of “transportation-related konzern.”4 A French conglomerate, CGE, sold nonrelated businesses and decided to focus on water management and telecommunications. It altered the company name in 1998 to Vivendi to reflect its new strategic focus and to make it easy for foreign investors to pronounce its name. Again, these conglomerates in Europe were in crisis. The factors that led to these firms shifting their strategies are the same as those that influenced U.S. conglomerates. First, competition from both firms inside Europe and American and Japanese companies increased.5 As once-heterogeneous European markets, which used different distribution channels 225

Conclusion and pricing schemes, were integrated, firms throughout Europe had to improve their competitiveness by merging with other companies and thereby tapping economies of scale. The introduction of the Euro hastened integration and increased competition. Firms had to divest unrelated businesses to generate capital and free managers to focus on their core businesses. Second, increased pressure from capital markets facilitated this trend (Useem, 1998). In the past, European corporations felt little pressure from investors. In Germany, banks have possessed large stakes in big conglomerates and exercised voting rights on behalf of other shareholders. As a consequence, hostile takeovers have been almost impossible. In France, crossshareholding among conglomerates eliminated the possibility of a hostile takeover. Cross-shareholding among European companies, however, has been declining. Institutional investors, especially U.S. institutional investors, have filled the gap generated by weakened cross-shareholding. For example, foreign investment in the French stock market in 1997 accounted for approximately 35% of this market’s total capital, and U.S. institutional investors such as CalPERS and Fidelity had purchased substantial portions of French companies. These investors have initiated higher standards for performance, thereby increasing the pressure on European managers to focus only on core businesses. In addition, European firms are now more willing to attempt hostile takeovers of other firms. The much-publicized case of Vodafone’s takeover of Mannesmann is but one prominent example of this trend.6 Top managers in European firms clearly have strong incentives to enhance their firms’ performance. Another new development in European capital markets in the 1990s, somewhat different from events in the United States during the 1980s, is the creation of new capital markets dominated by high-tech companies. New capital markets modeled 226

Business Groups in Other Countries after the NASDAQ (National Association of Securities Dealers Automated Quotation), such as Neuer Markt of Germany and Neuveau March´e in France, were opened in Europe. They have attracted large sums of capital and thereby created shortages of capital for incumbent listed companies on conventional exchanges. Overall, the factors that have forced U.S. and European conglomerates to restructure are very similar to each other. Yet GE, Daimler Benz, and Vivendi are still vastly diversified, and it is premature to announce the demise of conglomerates in the United States and Europe.7 Furthermore, significant legal and social barriers inhibit European firms’ latitude to sell off or close down divisions.8 Nevertheless, unsuccessful conglomerates that have no clear reason for combining unrelated businesses under one corporate umbrella clearly are no longer in vogue in either the United States or Europe. Keiretsu Network in Japan As briefly discussed in Chapter 1, the keiretsu is a voluntary association of corporations that was established to replace the prewar zaibatsu.9 Affiliates maintain their membership by crossshareholding, exchanges of executive officers, internal trade, and joint investment. Thus, the keiretsu remains a closed system with favorable business relationships among insiders. In 1992, intra-keiretsu trade was as high as 38.7%, meaning that some keiretsu engaged as extensively in intragroup trade as did chaebols.10 In the late 1990s, however, there were signs that the keiretsu system was in crisis. Japanese banks, the core of this system, began having financial problems because of the Japanese recession and the collapse of real estate markets in Japan and elsewhere. As the major sources of capital to affiliates, keiretsu 227

Conclusion banks had made many loans to affiliates that the affiliates could no longer repay. Banks began to merge with other banks associated with other keiretsu to survive. For example, Mitsubishi Bank, hit by its own investments in the real estate market and by the cost of rescuing its affiliates such as Mitsubishi Real Estates and Nippon Trust, including the bankruptcy of Rockerfeller Center, tried to overcome its financial crisis by merging with the Bank of Tokyo.11 Similarly, the Industrial Bank of Japan, Fuji Bank, and Daiichi Kangyo Bank, the three pillars of three separate keiretsu, merged in 1999 in a restructuring attempt. In addition, Sumitomo Bank and Sakura Bank of Mitsui Group, which resulted from a merger of Mitsui, Taiyo, and Kobe Bank in 1989, announced their merger in 2000. Because of these mergers, the keiretsu system is losing its most important building block. In addition, nonbank affiliates in a keiretsu are now forming alliances or merging with affiliates of other keiretsu to increase their competitiveness and reduce overcapacity, thus further weakening the keiretsu system. Another source of the crisis was foreign, in particular the U.S. pressure to break open the procurement arrangements of keiretsu, to open up financial markets, and to allow the market for corporate control to operate. In 1998, Nikko Securities of Mitsubishi Group sold one-fourth of its shares to CitiCorp without consulting its affiliates. In 2000, Nissan and Mitsubishi Motors transferred their controlling shares to Renault and Chrysler, respectively. Furthermore, crosskeiretsu mergers, as exemplified by the mergers of Sumitomo Chemical and Mitsui Chemical, and Mitsubishi Oil and Nippon Oil, are also becoming more common. As in the United States and Europe, intensified global competition and a crisis in the financial service sector is driving these changes. In the past, keiretsu affiliates were profitable because they received favorable exchange terms from their affiliates. 228

Business Groups in Other Countries This inward-looking attitude and closed system, however, could not deal with either the changing demands of customers or active competition. Globalization exposed the vulnerability of this system when some affiliates in a keiretsu were not doing well and needed help.12 It is nonetheless premature to announce the death of the keiretsu system.13 Although the level of crossshareholding by affiliates has decreased significantly since the early 1990s, it still averaged 38% in 1999.14 Yet given the developments discussed here, the keiretsu system will likely never be as closed as it used to be. Business Groups in the Developing Countries As mentioned in Chapter 1, business groups similar to chaebols are often found in developing countries, where market imperfections provide ample opportunity for business groups to create value by internalizing resource allocation (Leff, 1978). Various government interventions such as export-promotion and importsubstitution, which further distort these imperfect markets, provide additional ground for business groups to grow (Amsden, 1989; Kim, 1997; Guillen, 2000). There is little evidence that business groups are dismantling in other developing countries, whatever the effects of the recent economic and financial crises. Business groups will thrive so long as they can capitalize on market imperfection and government intervention. In this regard, events in Spain and Chile, where some business groups were disbanded, provide insight into how business groups will be changed as markets develop and government interventions diminish. Although Spain is a developed country, it experienced the decline of business groups when economic liberalization occurred there during the 1970s. Under Franco, the government 229

Conclusion implemented various foreign exchange controls and protectionist measures. This economic environment provided a basis for business groups to grow because it prohibited natural flows of foreign capital and technology and favored those who already had contacts in government, local businesses, and banks. As a consequence, several business groups were formed around banks and large industrial companies. Spain was hit hard, however, by the oil crises and the subsequent downturns in the 1970s, and many Spanish business groups became financially weak. When Spain joined the European Union and removed its restrictions on trade and foreign investment, these groups faced intense competition. Under these pressures, some groups collapsed. Others succeeded in refocusing their core businesses or were acquired by foreign multinationals. By the mid 1990s, only a few business groups, which had focused around banks such as BCH and BBV or large retailers (El Corte Ingles), had survived (Guillen, 2001). Postcrisis Chile provides another example of groups voluntarily disbanding. After experiencing a financial crisis in 1981, the Chilean government privatized banks by selling them to foreign investors. As a consequence, Chile built the most sophisticated capital market among Latin American countries. This well-developed capital market affected the operations of Chilean business groups. As financial markets develop, however, business groups have less opportunity to create value by using internal capital markets to share resources among affiliates.15 Further, after the 1981 foreign currency crisis, Chile’s government has prevented the pension funds from subsidizing their affiliates. In addition, several Chilean companies successfully raised capital from the global capital market by issuing ADR (American depository receipts). As a result, some groups such as Compa˜n´ıa Acero del Pacifico (CAP) voluntarily dismantled themselves.16 230

The Taming of Chaebols Other business groups in Chile that shared managerial talent and technology as well as financial capital still survive. This difference in approaches suggests that efficient sharing of management resources is the sine qua non of business groups. When business groups no longer create value by sharing resources among affiliates, they have no reason to exist. The CAP case may be an isolated instance, however, of voluntary disbanding.

the taming of chaebols Our examination of business groups throughout the world shows some important trends; First, business groups can create value by internalizing transactions only to the extent that markets, especially capital markets, are not well developed. The markets for some intangible resources such as technology, brands, and management know-how are inherently imperfect, thus providing opportunities for business groups to prosper even in developed countries. Second, as a government loosens restrictions on international trade and investment, business groups are subject to intense international competition and become less viable. As globalization has increased international competition and ensured free flows of capital across borders, it has been a key underlying cause for these trends. Korea has become subject to these forces, and the power of its government has declined accordingly. We will examine various external and internal factors that force chaebols to restructure further. Foreign Investors and Creditors Foreign investors and creditors will be an important force that will force chaebols to restructure further. Fligstein (2001) pointed out that exogenous forces often cause economic crises 231

Conclusion and transformations of markets. Sociologists view markets as social constructions that reflect the unique political–cultural arrangements of their firms and nations (White, 1981; Fligstein, 1990; Granovetter, 1995).17 According to Fligstein, a market becomes unsettled and creates the possibility for a crisis when foreign trade arrives with a new concept of control. Incumbent local firms will resist the new concept of control that threatens their own interests. When they can no longer resist it, the national market becomes absorbed into the international market as firms adopt this new concept of control. This adoption can be voluntary or involuntary (Meyer et al., 1997). The concepts of financial control, shareholder value, and a market for corporate control are becoming diffused worldwide as foreign investment increases (Useem, 1996). The United States at the beginning of the twentieth century is one example of how foreign capital led to a voluntary change in the governance system.18 At that time, the United States was a debtor nation with an enormous demand for capital to develop capital-intensive industries such as railroads. A large portion of this capital came from foreign investors. At that time, the expropriation of minority shareholders and manipulation of stock prices were prevalent. Robber barons such as Jay Gould and Commodore Vanderbilt even bribed judges for favorable injunctions regarding control over the Erie Railroad.19 Given these legally primitive conditions and the need to attract foreign capital, investment bankers placed one or more representatives on the stock issuers’ boards. Such self-regulation assured foreign investors that their investments were safe, and showed that demand for foreign capital could itself initiate a new governance system. Foreign investors can also institute coercive changes in governance systems. Institutional investors, who ushered in the 232

The Taming of Chaebols decline of U.S. and European conglomerates, have expanded their portfolio of foreign stock. For instance, in Korea, foreign ownership increased to 27% of the total market capitalization in 1999. As discussed in Chapter 7, this increase has led to greater shareholder activism. Foreign investors have both actively monitored performance and worked with domestic shareholder activists such as People’s Solidarity for Participatory Democracy to file lawsuits against chaebols, as we discussed in Chapter 7. We expect that the global integration of financial markets will continue and that countries will become more subject to the influence of foreign capital. Table 8.1 shows that the inflow of foreign capital increased sharply during the 1990s. We also expect that the increasing influence of foreign capital will entail measures to ensure that such investments are safe and that those who wish to attract foreign capital will come up with ways to meet those demands. Even in developed countries, there is movement toward cross-national stock exchanges, increased activity by securities analysts, convergence of international accounting standards, and international waves of mergers and acquisitions. If the globalization of financial markets continues, local firms will have to adopt international accounting standards, which will ensure more transparency (Jang, 2001). Strengthened Banks and Local Capital Markets Although the previous section argued that foreign investors and creditors will drive the further restructuring of chaebols, it does not imply that Korea’s banking system, which was modeled after those of Germany and Japan, will not vanish overnight. Most Koreans still deposit their savings in banks, and Korean corporations rely mainly on bank loans to conduct businesses. These 233

51.1

43.2

111.4

1.0

2.1 10.5

219.1

19.4

7.6

12.6

0.4

2.2 1.4

43.6

1999

24.3

0.5 0.9

2.5

8.2

1.1

11.1

1990

185.4

3.1 7.9

1.5

90.4

26.5

56.0

1999

Foreign direct investment ($ billion)

Source: World Bank, World Development Indicators, 2001.

East Asia & Pacific Europe & Central Asia Latin America & Caribbean Middle East & North Africa South Asia Sub-Saharan Africa Total

1990

Net private capital flow ($ billion)

19.1 0.2 −1.2 0.2

1.9 0.1 −0.1 0.1

25.4

6.2

−0.8

1.2

1.1

1999

1.2

1990

Bond portfolio investment flow ($ billion)

Table 8.1. Financial flow to low and medium income countries

3.7

0.1 0.0

0

1.1

0.2

2.3

1990

34.5

1.3 3.9

0.7

3.9

3.6

21.1

1999

Equity portfolio investment flow ($ billion)

14.5

−26.2

−1.1 −1.6

−1.3 −2.0 1.5 0.5

−2.0

6.9

−27.2

1999

3.2

4.5

6.8

1990

Bank and trade-related lending ($ billion)

The Taming of Chaebols relationships will last for a while. Further, Rajan and Zingales (1998b) argued that the arm’s length, market-based financial system is not necessarily superior to the relation-based financial system, especially when there is a shortage of capital. As we examined in Chapter 7, most Korean banks went technically bankrupt during the crisis. The government infused massive public funds to revive them. As a result, it became the largest shareholder in many commercial banks. By the end of 2001, it had used this leverage to force banks to merge with each other. For instance, it was able to compel Kookmin Bank, a leading bank with a relatively sound balance sheet, to merge with the Long-term Credit Bank in 1999 and with Housing and Commercial Bank, another bank with a sound balance sheet, in 2001 because of its large shareholdings in all three banks. The rationale for this merger was to create a strong, large bank that could effect operational economies of scale and improve the quality of its credit analysis. The government expected this merger to provoke voluntary mergers by the remaining commercial banks. If such consolidation continues to takes place, there will be only a few large banks left in Korea. These remaining banks can potentially have a stronger position when bargaining with the chaebols and thereby better monitor chaebols’ investment activity. Furthermore, foreign banks operating in Korea will diffuse advanced banking practices to the banking industry in Korea. Cheil Bank, which was sold to Newbridge Capital, remains independent from the government’s pressure to provide extra loans to Hynix Semiconductor, as mentioned in Chapter 7. Citibank and Hong Kong Shanghai Bank are expanding their retail bank practices in Korea. The intensified competition between foreign banks and large local banks will further develop the local capital markets. 235

Conclusion Another important structural change in the Korean capital market has been the relative decline in importance of the Korean Stock Exchange, a conventional exchange for “brick and mortar” firms that is similar to the New York Stock Exchange (NYSE), and the emergence of KOSDAQ (Korea Securities Dealers Automated Quotation), a Korean version of NASDAQ founded in 1996 that is designed for small start-ups and technology firms. The rise of KOSDAQ induced many talented engineers and managers to leave established companies, mostly chaebols, to set up their own ventures. This exodus would have been unthinkable in the past.20 Venture capital firms and wealthy individuals were eager to fund ex-chaebol employees. These infrastructures will facilitate start-ups and spur innovations (Kim, 1996). Koreans joke that start-ups, not the government, restructured chaebols. If this phenomenon continues, Korean chaebols will no longer enjoy a monopoly position in securing funds or talent. Under this scenario, especially in light of the other developments we have discussed, the chaebol’s economic significance will decrease further. Globalization can also create internal sources of change. For instance, shareholder activism has become a global phenomenon, as shareholders from all countries, including Korea, demand transparency and higher returns (Davis and Thompson, 1994; Useem, 1996).21 The People’s Solidarity for Participatory Democracy is but one example of home-grown activists who will spur changes in governance mechanisms. Increased International Competition in Local Markets Chaebols are also facing tougher competition both domestically and internationally. In the past, chaebols had practical 236

The Taming of Chaebols monopoly in many markets in Korea. The government aggressively blocked imports and protected the domestic market. Recently, however, the Fair Trade Commission in Korea has actively policed chaebols’ predatory behavior against domestic competitors and, as discussed in Chapter 4, has investigated chaebols’ cross-subsidization practices. At the same time, Korea is removing trade and investment barriers to comply with the IMF’s conditions for relief. For instance, Japanese auto and electronics manufacturers are now able to sell their products in Korea. The U.S. government has asked the Korean government to reform its tax scheme to be more favorable to U.S. cars. Furthermore, chaebols’ aggressive price cutting in international markets, often dubbed “dumping,” is increasingly difficult to practice due to the World Trade Organization’s rules. At the same time, many financially troubled companies were sold to foreign multinationals during the crisis. Philips acquired LG Group’s LCD business, and Volvo acquired Samsung’s heavy equipment business. Renault and GM acquired Samsung Motors and Daewoo Motors, respectively. Such acquisitions will spur intensified competition in Korea. As a consequence, Hyundai, which acquired Kia, has to focus on its car business and refrain from diversifying into unrelated businesses. The overall impact of intensified international competition will force chaebols to reduce unrelated diversification and to focus on a few competencies. The Government After the crisis, there have been several attempts to remove barriers to international competition. There have also been some improvements in financial transparency and corporate governance. The Korean government announced that it would allow class 237

Conclusion action lawsuits from 2002 onward. Initially, firms with more than 2 trillion won in assets are subject to this law. The government plans to allow shareholders to file class action lawsuits against all public firms in the near future. In addition, the government suspended the licenses of several accounting firms that helped chaebols manipulate accounting; this action sent clear signals to other auditors. The Korea Fair Trade Commission has played a key role in restraining chaebols’ expansion. Its continued investigation of unfair business practices of chaebols helped restrain chaebols’ cross-subsidization practices. Its regulation of cross-shareholding has also blocked chaebols from controlling affiliates without real infusion of capital. Continued enforcement of such regulations will help reduce explicit expropriation of minority shareholders and subsidies to poorly performing affiliates.

the future of chaebols and the developmental state Next, we will draw implications for business groups and the economic model of the developing state in the light of globalization. The Future of Chaebols Because we believe chaebols are creatures of market imperfections and government intervention, we argue that, as these forces diminish, chaebols will decline in the long run. The Korean financial market has undergone big changes. Institutional investors, especially foreign ones, have assumed bigger roles in the Korean capital market. Korean companies increasingly list their shares in the foreign stock market. Both trends

238

The Future of Chaebols and the Developmental State have increased outsiders’ influence on chaebols. Shareholder activism and stricter enforcement of the Fair Trade Act will also make practices such as cross-subsidization more difficult. At the same time, increased market competition will force chaebols to focus upon their core businesses. Chaebols and business groups in other countries will not, however, disband overnight. It takes time to build institutions and for the effects of competition to be felt. As institutional and market forces diffuse, business groups can survive or even prosper by focusing on sharing resources for which markets are still imperfect, such as human resources, brands, and technology. If business groups evolve in that direction, chaebols in the medium term may be more or less like Japanese keiretsu, loosely coupled and voluntarily cooperating on a few investment projects when there is mutual strategic advantage in doing so. In the meantime, the revamping of the corporate governance systems in Korea will unleash the power of professional managers. The dramatic economic growth of Korea was based on more than the few entrepreneurs who founded chaebols and the elite group of government bureaucrats. It was also attributable to hardworking Korean workers and managers. The recent crisis showed that much of their effort has been wasted due to chaebol chairmen’s ill-conceived strategies. Although there were many competent managers in chaebol affiliates, they could not fully utilize their managerial expertise because they were given only operational responsibilities in business divisions. The improved corporate governance system will limit the power of chaebol chairmen and enable these professional managers to use their strategic acumen. For instance, professional managers can introduce market discipline into the groups’ internal markets. Although business

239

Conclusion groups in other countries actively share resources and trade among their divisions, their interdivisional transfer prices reflect market prices. Professional managers whose performance incentives are tied to their divisional performance cannot favor their affiliates against their outside customers. The introduction of market-based internal transfer-pricing will instill discipline into the internal markets, thereby ending the perennial crosssubsidization within the chaebols. The key challenge to avoiding another crisis and ensuring chaebols’ further success will be how to maintain discipline in tapping internal markets while creating synergies from them. The resource sharing within chaebols has been the reason for their existence. It was, however, easy to lose discipline and let cross-subsidization proliferate without control. In addition, allowing greater freedom to professional managers will further encourage the creativity of Korean workers. Some chaebol families have already initiated changes. Doosan Group, the fourteenth largest group as of 1996, undertook serious restructuring before the Asian crisis hit the country and other chaebols. It hired a foreign consulting company and turned the group around by selling underperforming businesses to foreign investors. Had it not been proactive, Doosan Group could have been the first casualty of the crisis. Another mechanism for proactive change may stem from the chaebols’ efforts to access capital from foreign markets. Several Korean companies, including Korea Telecom, Hyundai Motors, and Samsung Electronics, have listed their stocks in foreign markets, especially by issuing ADRs.22 This voluntary listing means that these firms have adopted governance and contractual reforms that require them to make more transparent accounting information available to the general public.

240

The Future of Chaebols and the Developmental State Implications for the Developmental State The previous discussion leads us to conclude that globalization will continue and financial markets will be increasingly subject to international scrutiny. These trends give rise to several questions. What is the government’s role under these circumstances? Should the government just leave everything to the markets? How can other emerging countries have a smoother transition to a market-based economy while avoiding a similar crisis? La Porta et al. (1998) argue that deep and liquid securities markets and dispersed ownership arose only in common law countries where the legal system provided adequate protection for minority shareholders. This news is not good for countries that have a tradition of civil law, as well as countries that are undergoing the transition to market-based economies. Several scholars praised the developmental state, which focused mainly on promoting economic development (Johnson, 1982; Evans, 1995). By definition, in the developmental state, the government replaces the role of capital market and allocates resources to strategically important areas. Although Korea has been praised as the most successful development state, its success resulted in underdeveloped capital markets. Coffee (2001) argued that the lack of direct governmental interference, not a tradition of common law, was the important factor for the development of financial markets. He suggested that some common law countries, such as the United States and the United Kingdom, protect minority shareholders because they are decentralized. Decentralization made it possible for private entities to develop laws and for self-regulatory bodies to develop. In turn, this development facilitated the rise of market-based institutions such as the stock exchange. Without governmental intervention, the NYSE regulated itself by 241

Conclusion listing only large, high-quality issuers, and therefore imposed high listing standards and higher disclosure requirements. In contrast, French financial markets were strictly regulated by the government. Neither the securities markets nor dispersed ownership developed as much as they did in the United States and the United Kingdom. The French government often misused listings of foreign stock as a cheap alternative for foreign policy. The government provided no adequate supervision over the stock exchange. The Bourse, a heavily regulated state monopoly, did not have any incentives to innovate to improve its business, unlike its counterparts in the United Kingdom or the United States. In Germany, the government stunted the stock market’s potential growth. On the other hand, some believe that the state should play an important role in the transition to a market-based economy. They argue that the government can do a better job by setting up institutional infrastructures upon which markets can develop further. The massive privatization process in former communist countries, such as the Czech Republic and Russia, showed that markets would not automatically develop by privatization alone. Without adequate regulatory infrastructures, mass privatization resulted in poorly informed shareholders and created systematic expropriation through various forms of tunneling (Stark, 1996b; Kogut and Spicer, 2002). In contrast, Poland imposed high disclosure standards from the outset of privatization, created an SEC-like law-enforcement agency, provided for ownership transparency, and regulated takeovers. Due to its setup of this institutional infrastructure, Poland’s privatization was more successful, albeit slower. Experiences in Korea and Latin American countries provide further evidence that markets do not develop automatically and that the state should be astute in building up institutions upon which markets will develop. 242

The Future of Chaebols and the Developmental State These institutions, which involve property rights, governance structures, conception of control, and rules of exchange, enable actors in markets to organize, compete and cooperate, and exchange. By doing so, the state ensures the formation and ongoing stability of markets (Kogut and Spicer, 2002; Fligstein, 2001). The experiences of Korea this book describes stress that astute governmental policies to cultivate markets and ensure orderly shifts in power are important to ensure a smoother transition from a developmental state to a market-based economy, which is an important lesson for other developing countries. For instance, developing countries may want to enact laws and create law enforcement agencies. Drawing evidence from the experience of privatization in the Czech Republic and Russia, Coffee (1999) argued that the failure to enforce laws, not the absence of law, makes expropriation possible. During the 1920s, U.S. holding companies and investment trusts formed a pyramid structure under which control rights and cash flow right were widely separated. After the 1929 crash, the U.S. Congress demolished some of these pyramids, and most of the rest collapsed on their own. Between the 1960s and 1980s, major European countries followed the United States in creating a strong regulatory agency modeled after the American Securities and Exchange Commission (SEC). The governments in developing countries may wish to benchmark institutions in the developed market economies and put some regulatory emphasis into their own legal codes. For instance, in countries with weak legal protections for minority shareholders, they suggest that firms should bond themselves, install credible monitoring controls, and meet higher standards of disclosure to sell stock to dispersed shareholders. Similarly, in the United Kingdom, a series of stock market scandals resulted in stronger regulations for the London Stock Exchange (LSE). Note that the enactment 243

Conclusion of the Fair Trade Act has been the only effective way to control the power of chaebols. This study has some other interesting implications for countries that industrialized only recently. Amsden (1989, 1994) depicted the Korean experience as one in which the state played a critical role and criticized those who endorse basic liberal market discipline. She argued why it is right to make prices “wrong” or, in other words, to introduce market distortions. State intervention helped Korea gain momentum in its early stage of development. The recent crisis in Korea, however, showed that the potential costs of distorting the markets could be severe. Furthermore, it demonstrated that a transition from a state-controlled economy to a market-based economy was neither automatic nor easy. The crisis, for which Korea is still paying the huge price of past market distortions, reminds us of a simple dictum: there is no free lunch.

244

Appendix 1. Data Used in This Book This book relies largely on the database built by the Korea Information Service (KIS). The Korea Information Service is a leading credit rating agency in Korea, equivalent to Standard & Poors or Moody’s, both of which collect, analyze, and evaluate corporate financial data. It collaborates with Moody’s to supply information on Korean companies for an international audience. The Korea Information Service’s corporate information database includes financial information not only for companies listed in the stock exchanges and registered for securing promissory notes but also for every company with assets of more than 6 billion won from 1985 onward. All Korean firms meeting this condition have to be audited by third-party accounting firms and are thus called statutory audited companies. For instance, the database includes financial information for 641 listed companies and 3,411 statutory audited companies in nonfinancial sectors as of 1996. Financial services firms were not used in the statistical analyses in this book because their accounting data were not compatible with those of firms in other industries. This book also identifies the business group membership of our sample firms. The Korean Fair Trade Commission (KFTC) 245

Appendix 1. Data Used in This Book legally defines a business group as “a group of companies, more than 30% of whose shares are owned by some individuals or by companies controlled by those individuals, and whose management such as appointing officers is substantially affected.” Because ownership is widely dispersed, chaebol families can control some public firms even when the combined family and affiliate ownership is below 30%. In such cases, the KFTC identifies a firm as a chaebol affiliate even though the criteria of 30% ownership is not met. Using this definition, the Fair Trade Commission annually announces the thirty biggest chaebols in order to block the concentration of economic power. In addition, the Bank Supervisory Board (now, Financial Supervisory Board) used the same definition to decide group membership of small business groups for the purpose of credit management. A total of 461 business groups were identified as of 1996. The statistical analyses in the appendixes use several subsets of this original database. Because many firms went bankrupt or underwent restructuring after Korea entered a recession as a result of the Asian Crisis in 1997, the analysis was restricted to 1985–96. Appendix 2 uses this full data set of both listed companies and statutory audited companies (hereafter, Sample A) during 1985–96 to compare the profitability of group-affiliated companies and independent companies. Appendix 3 examines the determinants of profitability of group-affiliated companies and therefore uses only firms that are associated with business groups. Because financial information was available only for listed or statutory audited companies, 144 out of the 461 business groups identified by the KFTC and Bank Supervisory Board have only one company or no company that appears in our database. Because the groupwide resource variables needed to be computed, the definition of business groups was restricted to the ones that have at least two listed or statutory audited 246

Appendix 1. Data Used in This Book companies in the database. Thus, the final sample in Sample B consists of a total of 1,248 companies associated with 317 business groups as of 1996. Appendixes 4 and 5, which examine the performance implications of vertical integration and the determinants of debt structure of group-affiliated companies respectively, use Sample B. Appendix 6 examines the simultaneous relationship between ownership structure and firm profitability. For this study, our sample was restricted to the public companies that are also affiliated with business groups. Information about ownership is available from the KIS database from 1986 onward and only for public companies. Ownership information on private companies is not available in this database until the mid 1990s. Thus, for Appendix 6, Sample B
, which samples only publicly traded group affiliates and is a subset of Sample B, was used. In each analysis, observations for firms that were either bankrupt or showed negative equity were eliminated because such firms are technically bankrupt. These firms survive in Korea because of the cumbersome bankruptcy procedures and debt guarantees provided by other companies. Further, several observations from the sample were excluded as a result of missing information or unrealistic values for some variables. Table A.1.1 shows the number of samples in each year.

247

Independent companies

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Total

1,652 1,856 2,199 2,475 2,739 2,955 3,302 3,410 3,527 3,827 4,090 4,052 36,084

263 277 308 387 477 510 544 546 552 600 603 641 5,707

1,041 1,180 1,436 1,624 1,795 1,954 2,195 2,267 2,349 2,593 2,827 2,804 24,065 35 35 37 49 54 61 73 75 75 77 78 84 733 74 77 82 91 103 103 109 109 114 122 124 123 1,231

113 122 130 134 146 153 165 156 177 182 192 194 1,864 424 477 551 626 695 745 833 878 887 930 947 931 8,924

611 676 763 851 944 1,001 1,107 1,143 1,178 1,234 1,263 1,248 12,019

228 242 271 338 423 449 471 471 477 523 525 557 4,975

n/a 104 153 198 270 258 324 317 342 358 370 392 3,086

Groupaffiliated public Groupcompanies with affiliated ownership public information companies (Sample B
)

Group-affiliated companies

Total Total cases of Total publicly groupcases Publicly traded affiliated of traded Total companies independent independent Top 5 Top 6–30 Small companies groups (Sample B) Year (Sample A) (Sample A
) companies companies groups groups

Whole sample of firms

Table A.1.1. Sample composition

Appendix 2. Comparing the Profitability of Group-affiliated Companies and Independent Companies This appendix compares the profitability of group-affiliated companies vis-`a-vis independent companies. As a precedent, previous work (Chang and Choi, 1988) used the data of publicly traded Korean companies during 1975–84 to show that group-affiliated Korean firms, especially those affiliated with the top four groups, which clearly showed characteristics similar to those of multidivisional structure, performed better than independent firms did. These results were interpreted as evidence for the efficiency of business groups, which are able to minimize transactions costs prevalent in developing countries such as Korea (Williamson, 1975; Leff, 1978). This appendix extends Chang and Choi (1988) to a more recent time frame (i.e., 1985–96) and compares the profitability of group-affiliated companies vis-`a-vis independent companies with dummy variables that note group membership. Table A.2.1 shows the results based on all the firms in the sample (i.e., 249

250

12.19 (2.19)∗∗∗

Constant

0.07 (0.02)∗∗∗ −0.11 R&D (0.04)∗∗ Liquidity 0.59 (0.04)∗∗∗ −0.14 Leverage (0.01)∗∗∗ −0.32 Firm size (0.03)∗∗∗ Business group membership −0.78 Top 5 group (0.21)∗∗∗ −0.73 Top 6–30 group (0.16)∗∗∗ −0.16 Small group (0.08)∗

Firm-level resources Advertising

(1)

Variable

0.15 (0.03)∗∗∗ 0.12 (0.06)∗ 0.40 (0.06)∗∗∗ −0.11 (0.01)∗∗∗ −0.30 (0.05)∗∗∗ 0.15 (0.31) −0.32 (0.25) 0.11 (0.12)

−0.63 (0.35)† −0.53 (0.28)† 0.07 (0.14) −0.81 (0.35)∗ −0.73 (0.28)∗∗ −0.04 (0.14) −1.39 (0.43)∗∗ −1.05 (0.33)∗∗ −0.63 (0.18)∗∗∗ −1.90 (0.42)∗∗∗ −1.39 (0.33)∗∗∗ −0.83 (0.18)∗∗∗

−0.53 (0.21)∗∗ −0.50 (0.16)∗∗ −0.02 (0.08)

11.86 (1.55)∗∗∗

(7)

0.12 (0.04)∗∗ −0.38 (0.07)∗∗∗ 0.65 (0.08)∗∗∗ −0.15 (0.01)∗∗∗ −0.39 (0.06)∗∗∗

12.62 (2.12)∗∗∗

(6)

0.12 (0.04)∗∗ −0.40 (0.08)∗∗∗ 0.66 (0.08)∗∗∗ −0.16 (0.01)∗∗∗ −0.42 (0.05)∗∗∗

11.87 (2.12)∗∗∗

(5)

0.39 (0.31) −0.05 (0.25) 0.28 (0.12)∗

0.14 (0.03)∗∗∗ 0.16 (0.06)∗∗ 0.35 (0.06)∗∗∗ −0.08 (0.01)∗∗∗ −0.35 (0.05)∗∗∗

13.07 (1.54)∗∗∗

(8)

Period 3 (1993–96)

−0.16 (0.05)∗∗∗ −0.52 (0.15)∗∗∗ 0.90 (0.10)∗∗∗ −0.16 (0.01)∗∗∗ −0.19 (0.07)∗∗

11.48 (2.51)∗∗∗

(4)

Period 2 (1989–92)

−0.15 (0.05)∗∗∗ −0.50 (0.15)∗∗∗ 0.88 (0.10)∗∗∗ −0.17 (0.01)∗∗∗ −0.25 (0.07)∗∗∗

12.28 (2.51)∗∗∗

(3)

Period 1 (1985–88)

0.06 (0.02)∗∗ −0.11 (0.04)∗ 0.58 (0.04)∗∗∗ −0.12 (0.01)∗∗∗ −0.28 (0.03)∗∗∗

11.54 (2.21)∗∗∗

(2)

Whole sample

Table A.2.1. Profitability of Korean companies from 1985 to 1996

251

0.13

−0.15 (0.03)∗∗∗ 0.02 (0.01)† −0.14 (0.08) −7.81 (0.58)∗∗∗ −0.09 (0.18) −1.17 (0.29)∗∗∗ 0.14 0.16

−0.15 (0.06)∗∗ −0.01 (0.03) −0.20 (0.25) 0.65 (1.34) −1.64 (0.42)∗∗∗ −2.22 (0.66)∗∗∗ 0.16 0.12

−0.12 (0.04)∗∗ −0.00 (0.02) 0.05 (0.16) −10.34 (1.40)∗∗∗ 0.50 (0.31) −1.84 (0.49)∗∗∗ 0.12 0.08

−0.15 (0.04)∗∗∗ 0.04 (0.02)∗ −0.33 (0.12)∗∗ −12.01 (0.74)∗∗∗ 0.19 (0.26) 0.08 (0.41) 0.10

Notes: 1. 11 year dummies, 45 industry dummies, and 451 industry–year interaction terms to reflect the fixed effects model are not shown. 2. Numbers in the parentheses are standard deviations. 3. ∗∗∗ p < .001, ∗∗ p < .01, ∗ p < .05, † p < .10. 4. N = 36,084.

Purchase from affiliate Adjusted R 2

Internal business transactions Supply of debt guarantee Reception of debt guarantee Equity invest to affiliate Equity invest from affiliate Sales to affiliates

252

5.28 (4.49)

Constant

0.19 (0.03)∗∗∗ R&D 0.21 (0.08)∗ Liquidity 0.46 (0.11)∗∗∗ −0.13 Leverage (0.02)∗∗∗ −0.25 Firm Size (0.07)∗∗ Business group membership Top 5 group 0.05 (0.33) −1.03 Top 6–30 group (0.25)∗∗∗ −0.29 Small group (0.15)†

Firm-level resources Advertising

(1)

Variable

0.05 (0.07) −0.39 (0.27) 1.22 (0.27)∗∗∗ −0.20 (0.04)∗∗∗ −0.64 (0.16)∗∗∗ 0.41 (0.71) −1.11 (0.52)∗ −0.13 (0.35)

0.31 (0.34) −0.84 (0.25)∗∗ −0.18 (0.15)

11.00 (4.91)∗

(3)

1.11 (0.76) −1.09 (0.54)∗ −0.18 (0.36)

0.06 (0.07) −0.39 (0.28) 1.21 (0.27)∗∗∗ −0.26 (0.04)∗∗∗ −0.53 (0.16)∗∗∗

9.37 (4.88)†

(4)

Period 1 (1985–88)

0.19 (0.03)∗∗∗ 0.21 (0.08)∗ 0.45 (0.11)∗∗∗ −0.12 (0.02)∗∗∗ −0.23 (0.07)∗∗∗

5.02 (4.49)

(2)

Whole sample

0.27 (0.05)∗∗∗ −0.01 (0.14) 0.30 (0.18)† −0.10 (0.04)∗ −0.20 (0.11)† 0.29 (0.58) −1.17 (0.42)∗∗ 0.00 (0.26)

−0.09 (0.56) −1.41 (0.41)∗∗∗ −0.14 (0.25)

4.59 (4.68)

(6)

0.27 (0.05)∗∗∗ −0.01 (0.14) 0.32 (0.18)† −0.14 (0.04)∗∗∗ −0.16 (0.11)

3.70 (4.68)

(5)

Period 2 (1989–92)

Table A.2.2. Profitability of Korean public companies from 1985 to 1996

−0.20 (0.50) −0.67 (0.38)† −0.42 (0.22)†

0.19 (0.05)∗∗∗ 0.38 (0.11)∗∗∗ 0.38 (0.15)∗ −0.11 (0.02)∗∗∗ −0.24 (0.09)∗

−1.29 (4.67)

(7)

0.39 (0.51) −0.52 (0.39) −0.33 (0.22)

0.18 (0.05)∗∗∗ 0.39 (0.11)∗∗∗ 0.32 (0.15)∗ −0.06 (0.03)∗∗ −0.26 (0.10)∗∗

−0.56 (4.69)

(8)

Period 3 (1993–96)

253

−0.03 (0.04) −0.01 (0.03) −0.23 (0.26) −2.48 (1.52) −0.70 (0.42)† −1.51 (0.67)∗ 0.22 0.30

−0.17 (0.09)† 0.11 (0.04)∗ 1.30 (0.52) 0.35 (1.68) −2.66 (0.97)∗∗ −2.66 (1.97) 0.31 0.16

0.10 (0.07) −0.10 (0.05)∗ −0.66 (0.43) −20.01 (6.13)∗∗ −1.15 (0.74) −0.61 (1.23) 0.16 0.10

−0.02 (0.06) 0.00 (0.04) −0.91 (0.41)∗ −13.09 (3.84)∗∗∗ 0.17 (0.59) −1.52 (0.87)† 0.11

Notes: 1. 11 year dummies, 45 industry dummies, and 451 industry–year interaction terms to reflect the fixed effects model are not shown. 2. Numbers in the parentheses are standard deviations. 3. ∗∗∗ p < .001, ∗∗ p < .01, ∗ p < .05, † p < .10. 4. N = 5,707

Internal business transactions Supply of debt guarantee Reception of debt guarantee Equity invest to affiliate Equity invest from affiliate Sales to affiliates Purchase from affiliates Adjusted R 2 0.21

Appendix 2. Comparing the Profitability Sample A), and Table A.2.2 shows the results for Sample A , which is based only on public firms. Sample A is comparable to Chang and Choi (1988), which was also based only on public firms. The prime interest in this appendix is to examine the signs of business group dummies after controlling all other independent variables that affect profitability. If the business group dummy variables are positive and significant, this result will suggest that firms associated with business groups are more profitable than are comparable independent firms.1 Although it is difficult to identify a single indicator for a firm’s performance, this study used profitability to measure this variable. Some argue that Korean firms pursued growth rather than profitability. To some extent, this study agreed with this view. This study, however, proposed that Korean firms pursued growth at the business group level but pursued profitability at the individual affiliate level. Even though Korean firms pursued growth at the business group level, such growth was directly related to long-term profitability as discussed in Chapter 3.2 Under the multidivisional structure, Korean business groups typically pursued growth by venturing into new businesses. Such expansions took place through the creation of new affiliate companies in which several existing group affiliates assumed equity positions. Individual affiliates were expected to maximize profits so that the group headquarters could invest them in new ventures or investment opportunities in other affiliates. For nongroup-affiliated firms, it is even more imperative to maximize profits. Although it is also true that some Korean companies emphasized market share (and sales growth), particularly when first entering a business, they pursued profitability in the long term. Because the data set of this study spans a 12-year interval, it was reasonable to expect that the economic performance of an 254

Appendix 2. Comparing the Profitability individual affiliate could be measured by its profitability. Firmlevel economic performance was measured by the return on invested capital (ROIC), which is defined as the sum of net income before tax plus interest payments, deflated by total assets, to provide a return metric that is comparable across firms. This measure of performance was supposed to measure operating efficiency without being biased by the relatively high debt–equity ratios common in Korean firms. PROFITA BILITY :

ROIC, measured at time t.

To explain firm profitability, this study included two types of productive resources commonly used in strategy research. The strategy field has conventionally emphasized the important role that firm-specific resources play in influencing superior financial performance (Penrose, 1959). Intangible resources such as technology or brand loyalty are particularly important sources of sustainable competitive advantage (Prahalad and Hamel, 1990; Kogut and Zander, 1992; Teece, Pisano, and Shuen, 1997). Teece et al. defined capabilities as “a set of differentiated skills, complementary assets, and routines that provide the basis for a firm’s competitive capacities and sustainable advantage in a particular business.” Thus, a firm possessing more intangible resources was expected to exhibit higher performance. Intangible knowledge-based resources were identified through research and development (R&D) and advertising intensities. Previous strategy research has used these measures as proxies for intangible knowledge-based resources (Caves, 1982; Chatterjee and Wernerfelt, 1991; Montgomery and Hariharan, 1991; Sharma and Kesner, 1996).3 Physical resources are also important determinants of firm performance. As in all economies that have experienced rapid 255

Appendix 2. Comparing the Profitability growth, the demand for capital in Korea far exceeded its supply. Because Korea’s external capital market was inefficient, easy access to financial capital played a key role in determining firm performance. This study therefore used indicators of liquidity and the level of debt carried by the firm to reflect the availability of capital raised (Myers, 1977; Myers and Majluf, 1984). A high debt–equity ratio will increase the likelihood of bankruptcy and financial distress and thereby limit the firm’s ability to finance its investment by borrowing (Froot, Scharfstein, and Stein, 1994). Thus, this study expected that firms with more cash and debtcarrying capacity can better finance their investments and expect to show higher performance. In addition, firm size was included to control for any size-related factors. R &D: The

R&D expenditure divided by total sales, measured at time t. A DVERTISING: The advertising expenditure divided by total sales, measured at time t. LIQUIDITY : Current assets divided by current liabilities, measured at time t. LEVERA GE: Long-term debt to equity, measured at time t. FIRM SIZE: Log of total assets in thousands won, measured at time t. Comparing individual firm-level performance between independent companies and group-affiliated companies can be misleading because of extensive intragroup business transactions that may used to cross-subsidize affiliates that are either poorly performing or strategically important (Nakatani, 1984; Fudenberg and Tirole, 1986; Lincoln, et al., 1996). This study, therefore, introduced various internal financial and business transactions variables. Although such data are difficult to obtain 256

Appendix 2. Comparing the Profitability in countries where business divisions do not report their internal transactions, intragroup internal transactions are explicitly reported in Korea as footnote items in the financial statements of group-affiliated companies. The extent of intragroup financial transactions was measured by capital outflows and inflows in the form of debt guarantees, as well as equity participation. This study could not measure the extent of direct loans between affiliates because they are carried out only for short-term financing and rarely show up in the financial statements. It was expected that the outflow of capital in the form of debt guarantees and equity would be negatively associated with the profitability of the contributors, and that the inflow of such capital will be positively associated with the profitability of the recipients. Internal business trade is also measured by sales to and purchases from affiliated companies to the total sales for each company. This study did not have any a priori expectation for the sign of internal purchases and sales. The discussions in Chapter 4, however, suggest that cross-subsidization often takes place from downstream operations to upstream operations. SUPPLY OF DEBT GUA RA NTEE:

The debt guarantee supplied to group members divided by the equity base of the providing firm, measured at time t. RECEPTION OF DEBT GUA RA NTEE: The debt guarantee received from group members divided by the equity base of the recipient, measured at time t. EQUITY INVESTMENT TO A FFILIA TES : The equity participation of group members divided by the equity base of the provider, measured at time t. EQUITY INVESTMENT FROM A FFILIA TE: The equity participation by group members divided by the equity base of the recipient, measured at time t. 257

Appendix 2. Comparing the Profitability SA LES TO A FFLIA TES :

The amount of sales to affiliated companies divided by the total sales of a firm, measured at time t. PURCHA SE FROM A FFLIA TES : The amount of purchases from affiliated companies divided by the total sales of a firm, measured at time t. To compare the profitability of group-affiliated companies and that of independent companies, this study employed three dichotomous variables to denote group membership for the top five chaebols, the top six through thirty chaebols, and smaller business groups. The number of companies in each category can be found in Table A.1.1. Because a sample of companies over a 12-year period was used, an appropriate methodology was needed to analyze the panel data (Hsiao, 1986). If Yit is defined as the profitability of firm i at time t and X kit is defined as the kth independent variable of firm i at time t, the model can be described as Yit = α + k=1,K βk X kit + εit ,

i = 1, 2, . . . , N ,

t = 1, 2, . . . , T

(1)

To fully exploit the panel data, it was necessary to test whether parameters, α and β, stay constant across all i and t. As a first step, it was tested whether the intercept term, α, stays constant for all firms at all times. If the intercept term, α, shifts over time and over individual firms, the intercept may be described as αit = µ + νi + γt + δit

(2)

where µ represents the constant intercept term, νi is the firm-specific effect, γt is the time-specific effect, and δit is the 258

Appendix 2. Comparing the Profitability interaction effects between firm- and time-specific factors. A way to estimate these various factors affecting the intercept term is to use the fixed effects model, which includes dummy variables for each firm, year, and firm–year interaction terms.4 Because this study had panel data for more than 4,000 companies over 12 years, it was difficult to include firm dummies and their interaction terms into the regression. Further, the inclusion of firm-specific dummies probably would not have suited the purpose of this study, which tried to explain firm profitability with a set of firm-specific independent variables. It was, therefore, decided to include industry-specific dummy variables instead of firm-specific dummy variables, which assume that firm-specific fixed effects can be approximated with industry-specific fixed effects. Chow’s F-test confirmed the conjecture that the intercept term varies over time and across industries. As a second step, it was checked whether the slopes, βk , are homogeneous across firms and over time. Because the data set has only a 12-year time span, the slopes could not be allowed to vary across firms; however, whether the slopes are constant over time could be considered. Again, the fixed effects model, where the slope coefficients shift from year to year, was assumed. Chow’s F-test for the homogeneity of the slope coefficients over a 12-year time period suggested that the slope coefficients vary along the time dimension. This study then sequentially added the yearly data, performed a series of F-tests for the pooled years, and finally concluded that the slope coefficients were homogeneous for the periods of 1985–8, 1989–92, and 1993–6. This study, therefore, performed the analysis by separating the observations into three time periods. As shown in Figure 1.3, Korean firms enjoyed stable growth and strong performance from 1985 to 1988. From 1989 onward, however, Korean firms faced much tougher global competition and experienced 259

Appendix 2. Comparing the Profitability stagnant growth and low profitability, particularly from 1993 to 1996. Thus, the model was formulated with the following equation: Yit = µ + ν j + γt + δ jt + k=1,K β pk X kit + εit , i = 1, 2, . . . , N ,

t = 1, 2, . . . , T,

j = 1, . . . , J,

p = 1, 2, 3

(3)

where i represents the firm, t represents the year, j is the industry, and p is three time periods. A total of 45 dummy variables for each two-digit KSIC industry dummy variables, 11 year dummy variables, and 451 year–industry interaction dummy variables were introduced. Table A.2.1 shows regression results based on all the sample firms in the data set (Sample A), and Table A.2.2 shows the results based on the subsample of public firms (Sample A ). The equations in the tables incorporate firm-level resources, business group membership, and control variables for industry and year. In Table A.2.1, the firm-level resource variables show a somewhat interesting pattern. The liquidity ratio is positively signed and significant, and the leverage ratio is negatively signed and significant in all equations. The financial resource variables, reflected in the liquidity and leverage ratios, lead to higher performance. The marketing-related resources contribute positively to firm performance but the technical resources have a negative impact on firm performance with the whole sample, as in models (1) and (2). The subsample analysis according to the time period in models (3)–(8), however, showed that both advertising and R&D were negative and significant during the late 1980s but turned positive and significant in the 1990s. In a sample consisting only of public firms, both advertising and R&D were positively related to firm performance in the whole

260

Appendix 2. Comparing the Profitability sample as in models (1) and (2) of Table A.2.2. In a subsample analysis, both variables were insignificant in late 1980s but turned positively significant in the 1990s. The results indicated that firm size is negatively related to firm performance. A possible explanation for the negative sign for the advertising and R&D variables in the late 1980s is that the payoff for such investments takes some time. Korean firms based their competitive advantage on low wages until the early 1980s. They began to invest in brands and technology only in the late 1980s. Faced with increasing challenges from low-wage countries such as China and Indonesia, Korean firms had to increase their investment in technology and brands. Subsample analysis for different time periods provided support for this conjecture. This result may reflect the shift in sources of competitive advantage noted previously. Tables A.2.1 and A.2.2 examine the profitability of groupaffiliated companies vis-`a-vis independent companies with a set of dummy variables. There are two important trends. First, model (1) in Table A.2.1 shows that the group-affiliated firms are on average less profitable than independent companies are. Subsample analyses in models (3)–(8) showed that such negative group affiliation effects were most severe in the late 1980s but diminished in the 1990s. From 1993 to 1996, there were no significant differences between group-affiliated companies and independent companies. Second, the negative impact of group membership on firm performance diminished appreciably when various internal transactions variables were introduced. The even-numbered models in Table A.2.1 introduced various internal transactions variables. Compared to the odd-numbered equations in the same table, the size and the significance level of each business group

261

Appendix 2. Comparing the Profitability dummy variable are much smaller than are those in the evennumbered equations. Similar patterns are found in a sample of public firms: as shown in Table A.2.2, group-affiliated firms performed worse than independent firms did at least during the late 1980s. Most of this difference vanished in the mid 1990s, and those differences almost disappeared when various internal trade variables were introduced. In general, debt guarantee provisions are found to depress the profitability of the guarantor significantly, while they improve the profitability of the borrower. The results also showed that internal purchasing significantly decreases firm profitability; these findings suggested that it is likely chaebols cross-subsidize affiliates via internal trade. Although the business group as a whole may benefit from vertical integration, affiliate buyers appear, on average, to support unprofitable affiliate suppliers by paying higher than market prices. Appendix 4 examines this issue more fully. Furthermore, affiliate buyers in chaebols are often large, publicly listed firms, while affiliate sellers are usually smaller companies that are often privately held by the major family shareholders. Chaebols likely use internal pricing schemes to transfer profits to these privately held companies. The recent example of SK Telecom, as discussed in Chapter 6, provides some support for this conjecture. The outflow of equity investment, however, had a negative impact on firm profitability during the economic slump in the mid 1990s. The inflow of equity investment was negatively significant for firm performance, again during the economic slowdown since the early 1990s. These results suggested that business groups may use debt guarantees to subsidize weak affiliates. Furthermore, investing in other affiliates may hurt the investor when it is very short of capital. One possible reason why the sign of the equity inflow variable was negative is that the primary recipients of equity capital 262

Appendix 2. Comparing the Profitability might be new firms in industries that business groups have entered only recently. These equity inflows might also be related to large investment projects that firms have undertaken because such projects are often not very profitable in their initial periods. These conjectures are, however, highly speculative. The fact that group-affiliated firms performed poorly in the late 1980s countered the results of earlier work (Chang and Choi, 1988), which found that group-affiliated public firms performed better than independent companies did.5 The period of 1985–8 was extremely favorable to Korean firms. Koreans often referred to it as the “three low” economic boom: low oil prices, low interest rates, and low exchange rates (yen appreciation). It is puzzling not only that chaebol-affiliated firms performed poorly compared to independent firms during this period but also that this gap narrowed during the economic slump. Chaebols might have diverted profits through various forms of internal transactions during the economic boom of the 1980s in ways that were not fully captured by internal transactions variables. Caves and Uekusa (1976) and Nakatani (1984) found that group-affiliated Japanese firms not only had poorer performance on average than independent firms did but also had less variance in profitability. They explained that these affiliates might have been crosssubsidizing their less successful affiliates. The results presented here could be demonstrating a similar phenomenon. Lower profitability of group-affiliated firms in the late 1980s might have been caused by this cross-subsidization and by internal transactions other than those captured by various internal transactions variables used in this study.

263

Appendix 3. Profitability of Group-affiliated Firms Appendix 2 showed that group-affiliated firms performed worse than independent firms did, especially during the late 1980s. This result may indicate that group affiliates diverted their profits by either subsidizing poorly performing affiliates or investing in group-level projects. This appendix focuses on how group affiliation may positively affect firm performance by enabling affiliates to share resources with each other.6 The resourcebased theory emphasizes the role of corporatewide resource sharing in building competitive advantage. Corporate strategy, according to Andrews (1980), “defines the business in which a company will compete, preferably in a way that focuses resources to convert distinctive competence into corporate advantage” (pp. 18–19). Prahalad and Hamel (1990) argued that corporate strategy and structure significantly and positively influence firm performance. This view is consistent with Porter (1987), who argued that corporate strategists can create value by transferring skills and sharing rent-generating activities among individual business units. In Korea, chaebol affiliates freely share intangible resources with their affiliates, as discussed in Chapter 3. Kim (1996) 264

Appendix 3. Profitability of Group-affiliated Firms illustrated how group-level R&D activities were the sources of competitive advantage in several leading industries such as automobiles, electronics, and semiconductors. Chaebols typically set up group-level R&D centers organized along broadly defined business areas such as electronics or automobiles. Several affiliates, including both final assemblers and parts suppliers, finance their joint R&D efforts. They share any technological innovations from these efforts to an extent that is not necessarily proportional to their contributions. They also transfer key personnel to facilitate further the sharing of technological resources. Groupwide advertising, which emphasizes the image of a business group rather than individual affiliates, also generates considerable scale and scope economies. Affiliates also share a reputation simply by being associated with a particular business group. A firm can obtain loans from banks more easily and at lower rates if it is associated with a business group of strong credit and good reputation. On the other hand, a firm affiliated with a group that has poor credit and a bad reputation suffers from this association, no matter how profitable it is. Therefore, the firms that have affiliates with more cash and less debt can more easily finance their own investments and thereby be more profitable. This study treated an affiliated company as an operating division just like a strategic business unit (SBU) in a diversified corporation. To measure group-level productive resources, this study developed measures using the weighted averages of financial indicators of other firms associated with the same business group. For instance, if a member firm heavily invests in advertising, it will benefit other firms in the same business group since all its affiliates share a common group name. Likewise, active research work by a member firm will benefit other firms in the same group who develop intermediate goods or related 265

Appendix 3. Profitability of Group-affiliated Firms products. In a similar fashion, the availability of financial resources of other member firms, reflected in their liquidity and leverage ratios, will affect the performance of a firm in the same business group. Firm profitability was, therefore, expected to be positively associated with group-level R&D, advertising, and liquidity and negatively associated with group-level leverage. To calculate the group-level resource variables, this study used Sample B, which consists only of group-affiliated companies. If resources owned by other affiliates in the same business group influence the economic performance of an individual firm, this finding will suggest that firms in business groups benefit from synergies. GROUP R &D:

The weighted average of R&D intensity of all other firms (excluding itself) in the same business group, where the weighing factor is sales. More specifically, the GROUP R &D variable for a firm i can be measured by
l
=i (R&Dl )w l , where i = 1, 2, . . . , I and l = 1, 2, . . . , I, w l is the proportion of sales of a firm l to the aggregated total sales of all other firms associated with the same business group, measured at time t. GROUP A DVERTISING: The weighted average of advertising intensity of all other firms (excluding itself) in the same business group, where the weighing factor is sales, measured at time t, analogous to the GROUP R &D variable. GROUP LIQUIDITY : The weighted average of liquidity ratios of all other firms (excluding itself) in the same business group, where the weighing factor is each firm’s current liability. More specifically, the group liquidity variable for a firm i can be measured by
l
=i (liquidityl ) w l , where i = 1, 2, . . . , I and l = 1, 2, . . . , I, w l is the proportion of current liability of a firm l to the aggregated total current 266

Appendix 3. Profitability of Group-affiliated Firms liabilities of all other firms associated with the same business group, measured at time t. GROUP LEVERA GE: The weighted average of leverage ratios of other firms (excluding itself) in the same business group, where the weighing factor is each firm’s equity base. More specifically, the group leverage ratio variable for a firm i can be measured by
l
=i (leveragel ) w l , where i = 1, 2, . . . , I and l = 1, 2, . . . , I, w l is the proportion of equity of a firm l to the aggregated total equity bases of all other firms associated with the same business group, measured at time t. This study also adopted the entropy measure of group-level diversification as a control variable. This measure is widely used in strategy research (Jacquemin and Berry, 1979; Palepu 1985; Amit and Livnat 1988; Hill, Hitt, and Hoskisson, 1992), although some criticize it because it depends on the SIC (Standard Industry Classification) scheme (Robins and Wiersema, 1995). This measure is useful, however, because the degree of total diversification (DT) can be decomposed into related (DR) and unrelated diversification (DU) portions. Related diversification arises out of operating segments within an industry group, and unrelated diversification picks up the portion of diversification between industry groups. The two-digit Korean Standard Industry Classification (KSIC) was used as the definition of industry group. To calculate the diversification indices, this study broke down the sales of all group-affiliated firms using the two-digit SIC code. GROUP UNRELA TED DIVERSIFICA TION :

The entropy measure of unrelated diversification at the group level between two-digit KSIC industry groups, measured at time t. 267

Appendix 3. Profitability of Group-affiliated Firms GROUP RELA TED DIVERSIFICA TION :

The entropy measure of related diversification at the group level within two-digit KSIC industry groups, measured at time t.

The size of business groups was also controlled for: BUSINESS GROUP SIZE: The sum of total assets in thousands won,

measured at time t, of all firms associated with the business group, in a log transformation. This analysis also performed the pooling test to check whether the intercept terms and the slopes were homogeneous across firms and over time, as we specified in Appendix 2, and found that the slope coefficients are homogeneous for the periods of 1985–8, 1989–92, and 1993–6. This study, therefore, performed the analysis by separating the observations into three time periods and also used the fixed effects model by including industry, year, and year–industry interaction dummy variables. Additionally, the residuals from the ordinary least squared (OLS) regressions were analyzed to detect any heteroscedasticity problems. If the error terms, εit , were not independent across observations, the estimated coefficients might not be the most efficient ones. The Durbin-Watson statistics showed no evidence for autocorrelation. The residuals from the OLS method, however, increased monotonically with the size of the business groups (Bgsize). Several standard tests for heteroscedasticity – including the Goldfelt-Quandt test, the Glesjer test, and the Breusch-Pagan test – confirmed that the error terms are proportional to the size of the business group. Var(εi ) = σ 2 ∗ Bgsize 268

(4)

Appendix 3. Profitability of Group-affiliated Firms This study, therefore, estimated models in Table A.3.1 with 1/Bgsize as a weight. The weighted least squared (WLS) regression is a type of generalized least squared method that significantly improves R 2 relative to OLS regressions, while the estimated coefficients of the two regressions are consistent with each other. Table A.3.1 shows the results. In models (1)–(3), the sets of independent variables were sequentially added in order to detect any possible multicollinearity and to observe changes in the explanatory power. In particular, this study attempted to avoid any multicollinearity between the firm-level and group-level resource variables. Various diagnostic tests for multicollinearity, including Belsley, Kuh, and Welsch, detected no evidence of multicollinearity (Johnston, 1984). None of the signs for firmlevel variables changed as the group-level resource variables were added in model (2). In general, firm-level resource variables show a similar pattern with the results in Table A.2.1. The marketing-related resources and financial resources, reflected in liquidity and leverage ratios, are positively related to firm performance, while the technical resources have no significant impact on firm performance. Model (2) showed that group-level intangible resources and financial resources turn out to be important factors of an individual firm’s profitability. The weighted averages of R&D and advertising intensities of other firms in the same business group had a positive and significant impact on the profitability of an affiliate. R&D expenditures, which had no significant impact on firm-level profitability, had a positive impact at the group level, suggesting that a firm’s R&D expenditures may generate positive spillover effects to other firms in the same business group. For instance, a TV picture tube innovation will help cut costs or improve quality for an affiliate TV assembler. Also, advertising 269

270

Firm size

Leverage

Liquidity

R&D

0.28 (0.04)∗∗∗ 0.10 (0.10) 1.21 (0.08)∗∗∗ −0.14 (0.01)∗∗∗ −0.28 (0.06)∗∗∗

12.16 (3.36)∗∗∗

Constant

Firm-level resources Advertising

(1)

Variable

0.21 (0.04)∗∗∗ 0.04 (0.10) 1.18 (0.08)∗∗∗ −0.14 (0.01)∗∗∗ 0.03 (0.07)

15.48 (3.41)∗∗∗

(2)

Full sample (1985–96)

Table A.3.1. Profitability of group-affiliated companies

0.22 (0.10)∗∗∗ 0.06 (0.10) 1.15 (0.08)∗∗∗ −0.14 (0.01)∗∗∗ 0.10 (0.10)

14.54 (3.41)∗∗∗

(3)

0.06 (0.07) 0.40 (0.32) 1.10 (0.17)∗∗∗ −0.18 (0.02)∗∗∗ 0.30 (0.12)∗

0.20 (0.06)∗∗ −0.37 (0.13)∗∗ 1.07 (0.13)∗∗∗ −0.12 (0.02)∗∗∗ −0.22 (0.10)∗

20.69 (3.47)∗∗∗

0.20 (0.05)∗∗∗ 0.22 (0.10)∗ 0.48 (0.12)∗∗∗ −0.09 (0.01)∗∗∗ −0.29 (0.09)∗∗

13.97 (3.34)∗∗∗

(6) (5)

(4) 13.38 (4.11)∗∗

Period 3 (1993–96)

Period 2 (1989–92)

Period 1 (1985–88)

271

Reception of debt guarantee

Internal business transactions Supply of debt guarantee

Group size

Related diversification

Unrelated diversification

Group leverage

Group liquidity

Group R&D

Group-level resources Group advertising 0.17 (0.03)∗∗∗ 0.50 (0.11)∗∗∗ 0.50 (0.10)∗∗∗ −0.03 (0.01)∗∗ 0.39 (0.19)∗ 1.80 (0.22)∗∗∗ −0.53 (0.22)∗∗∗ −0.22 (0.04)∗∗∗ 0.08 (0.02)∗∗∗

0.16 (0.03)∗∗∗ 0.52 (0.12)∗∗∗ 0.51 (0.10)∗∗∗ −0.03 (0.01)∗∗ 0.38 (0.19)∗ 1.80 (0.22)∗∗∗ −0.55 (0.78)∗∗∗ −0.16 (0.08)∗ 0.00 (0.04)

0.21 (0.07)∗∗ 0.83 (0.41)∗ 1.09 (0.24)∗∗∗ −0.06 (0.03)∗ 0.52 (0.35) 1.84 (0.45)∗∗∗ −0.73 (0.13)∗∗∗ −0.14 (0.07)∗ 0.07 (0.04)∗

0.24 (0.05)∗∗∗ 0.59 (0.18)∗∗ 0.14 (0.18) 0.02 (0.02) 0.71 (0.29)∗ 2.82 (0.35)∗∗∗ −0.58 (0.11)∗∗∗

−0.18 (0.05)∗∗ 0.09 (0.02)∗∗∗

0.18 (0.05)∗∗∗ 0.35 (0.13)∗∗ −0.21 (0.18) −0.09 (0.02)∗∗∗ −0.15 (0.25) 0.37 (0.29) −0.07 (0.09)

272

0.22

(1)

0.23

(2)

Full sample (1985–96)

−0.11 (0.13) −4.89 (1.00)∗∗∗ 0.93 (0.26)∗∗∗ −0.98 (0.43)∗ 0.24

(3)

0.03 (0.21) −13.99 (2.35)∗∗∗ 1.35 (0.44)∗∗ −2.00 (0.72)∗∗ 0.17

−0.31 (0.18)† −9.68 (1.13)∗∗∗ 1.10 (0.35)∗∗ −0.77 (0.60) 0.13

(6) (5)

(4) −0.27 (0.32) 0.03 (2.02) 0.66 (0.54) −0.90 (0.85) 0.20

Period 3 (1993–96)

Period 2 (1989–92)

Period 1 (1985–88)

Notes: 1. 11 year dummies, 45 industry dummies, and 451 industry–year interaction terms to reflect the fixed effects model are not shown. 2. Numbers in the parentheses are standard deviations. 3. ∗∗∗ p < .001, ∗∗ p < .01, ∗ p < .05, † p < .10. 4. N = 12, 019 5. This table is adapted from Chang and Hong (2000).

Adjusted R 2

Purchase from affiliates

Sales to affiliates

Equity invest from affiliate

Equity invest to affiliate

Variable

Table A.3.1. (coont.)

Appendix 3. Profitability of Group-affiliated Firms that emphasizes the name of the business group allows affiliates to enjoy the free benefits of brand equity. The group-level financial resource variables were also consistent with expectations. The results showed that when a firm’s affiliates had higher levels of debt, the firm itself was less profitable. This result may reflect the fact that the financial risks of affiliates are tied to those of other affiliates through extensive debt guarantees. A failure of one firm will result in the serial bankruptcies of other member firms that provided debt guarantees to it. A higher level of liquid capital at the group level also leads to higher firm performance. Model (3) introduced the internal transaction variables. The results were consistent with those in Tables A.2.1 and A.2.2. Debt guarantee provisions significantly depressed the profitability of the guarantor but improved the profitability of the borrower. The results also showed that internal selling had a positive and significant impact on firm profitability. The internal purchase variable, however, had a negative and significant impact on firm profitability, suggesting the possibility of crosssubsidization via internal trade. The outflow of equity investment had no significant impact on firm profitability. The inflow of equity investment was negatively significant for firm performance. As for controls, both unrelated and related diversification led to higher performance. The group size is negatively correlated with individual firm performance. The subsample analysis for each of the three time periods showed a similar pattern to information presented in Tables A.2.1 and A.2.2. The most striking difference across time was the impact of internal transactions on firm performance. Most internal business transaction variables, with the exception of the supply of debt guarantees, were not significant in period 1 but became significant in the later time periods. Even the 273

Appendix 3. Profitability of Group-affiliated Firms outflows of capital through equity investment variable, which was not significant in periods 1 and 2, was negatively significant, albeit weakly, in period 3. Period 1 was a time of economic expansion when Korean firms enjoyed high profitability. Various forms of cross-subsidization did not appear to affect firm profitability during such periods. These forms may hurt providers, even chaebol affiliates, when the economy slumps and everyone is short of capital. The subsample analyses provided additional support for the conjecture that business groups extensively used various forms of internal transaction for cross-subsidization. The overall results suggested that business groups are in fact generating real economies of scale and scope. This study found that both firm-level and group-level resources are important determinants of firm performance. Further, internal transactions reveal the complex patterns of cross-subsidization via debt guarantees, equity investments, and vertical integration.

274

Appendix 4. The Impact of Vertical Integration in Chaebols This appendix examines the impact of forward and backward integration on costs and profitability. Vertical integration can reduce the transaction costs involved in finding, selling, negotiating, contracting, monitoring, and resolving disputes with other firms in market transactions (Coase, 1937; Williamson, 1975). Through internalization, corporate managers can harmonize incentives in the vertical value chain and therefore achieve joint profit maximization. Vertical integration can also improve information exchange between vertical chains of production and contribute to collaborative R&D efforts. Such information exchange can reduce inventory carrying costs and transportation costs (Harrigan, 1983). In addition, vertical integration can reduce advertising and sales expenses of upstream operations, as well as ensure stable supplies of parts and intermediate goods. On the other hand, vertical integration results in increases in organizational size and complexity, and thus increases bureaucratic control. It may be costly to manage both upstream and downstream operations that require totally different core competences (Prahalad and Hamel, 1990). For example, small parts-suppliers may want to use different payment and benefit 275

Appendix 4. The Impact of Vertical Integration structures than do large assemblers. If these firms are grouped together, however, they are bound by the same payment and benefit schemes, which may not fit either of them very well. The efficiency loss from vertical integration can be sizable because vertically integrated suppliers lack the incentive to be more efficient or innovative for their captive customers (Mahoney, 1992). Vertical integration is also not sufficiently flexible to adjust to different transaction volumes, which is especially important during periods of economic instability and fluctuations (D’Aveni and Ilinitch, 1992; Harrigan, 1985). In highly competitive and turbulent environments, firms are better off selecting the best external suppliers, switching suppliers when new technology appears, and avoiding idle capacity and inventory swings in its production. This empirical study attempted to identify the relative benefits and harms of vertical integration analogous to D’Aveni and Ravenscraft (1994). Forward integration was calculated as the proportion of a company’s intragroup sales to its total sales, previously measured as SA LES TO A FFILIA TES in Appendixes 2 and 3, and backward integration as the company’s intragroup purchase deflated by its total sales, measured as PURCHA SE FROM A FFILA TES . The cost factors of chaebols’ manufacturing affiliates were decomposed into costs of goods sold, general and administration expenses, research and development expenses, and advertising and sales expenses. Thus, each dependent variable is a percentage of the cost item relative to total sales. A DVERTISING and R &D EX PENSES are the same measures used in Appendixes 2 and 3. These cost items were expected to be lower with a higher level of vertical integration if vertical integration was efficiency-enhancing. If they are higher with a higher level of vertical integration, the result would indicate that vertical integration is value-destroying. 276

Appendix 4. The Impact of Vertical Integration COSTS OF GOODS SOLD:

The cost of goods sold item in the income statement of a firm divided by its total sales, measured at time t. SA LES EX PENSES : The sales expense item in the income statement excluding advertising expense divided by its total sales, measured at time t. GENERA L A ND A DMINISTRA TIVE EX PENSES : The general and administrative expense item divided by its total sales, measured at time t. In addition to vertical integration indixes, several control variables were added to control for economies of scale and scope. First, market share, as measured by the firm’s sales in the respective industry, was included to control for economies of scale. It was expected that the higher the market share was the lower the individual cost items would be. RELA TED and UNRELA TED DIVERSIFICA TION , which were previously used in Appendix 3, were included to examine any scope-related factors. The existence of common inputs was expected to lead to lower costs in a diversified firm, and these costs were expected to be much lower for related diversification than they would be for unrelated diversification. FIRM SIZE and BUSINESS GROUP SIZE variables, previously used in Appendixes 2 and 3, were included to control for size-related factors. MA RKET SHA RE: A

firm’s total sales divided by the aggregated sales of all firms in the same two-digit industry, measured at time t.

Sample B was used for this study (i.e., group-affiliated firms in our database). Production costs, R&D expenses, advertising expenses, sales expenses, and general administrative expenses 277

278

62.35 (21.16)∗∗∗ 6.34 (0.58)∗∗∗ 6.68 (0.99)∗∗∗ −0.00 (0.03) 0.20 (0.13) 0.59 (0.12)∗∗∗ −1.04 (0.49)∗ −0.99 (0.35)∗∗ 0.31

Constant

Sales expense 2.32 (3.49)∗∗∗ −1.28 (0.13)∗∗∗ −0.48 (0.22)∗ −0.01 (0.01) 0.18 (0.03)∗∗∗ −0.19 (0.03)∗∗∗ 0.72 (0.11)∗∗∗ 0.41 (0.08)∗∗∗ 0.16

−0.60 (0.31)∗ −0.48 (0.06)∗∗∗ 0.14 (0.11) −0.01 (0.00)∗∗∗ 0.18 (0.01)∗∗∗ −0.06 (0.01)∗∗∗ 0.05 (0.05) 0.03 (0.04) 0.20

(3)

Advertising expense

(2) General administrative expense 20.69 (2.44)∗∗∗ −2.56 (0.48)∗∗∗ −1.62 (0.82)∗ −0.05 (0.02)∗ −0.49 (0.11)∗∗∗ 0.04 (0.10) 0.97 (0.41)∗ 0.15 (0.29) 0.16

(4)

−0.57 (0.17)∗∗∗ −0.03 (0.03) 0.13 (0.06)∗ 0.00 (0.00) 0.04 (0.01)∗∗∗ 0.06 (0.01)∗∗∗ −0.16 (0.03)∗∗∗ −0.04 (0.02)† 0.15

R&D expense

(5)

(6)

14.87 (1.19)∗∗∗ 0.96 (0.23)∗∗∗ −1.81 (0.40)∗∗∗ 0.04 (0.01)∗∗∗ −0.20 (0.05)∗∗∗ −0.38 (0.05)∗∗∗ 1.42 (0.19)∗∗∗ 0.42 (0.14)∗∗ 0.09

Profitability

Notes: 1. 11 year dummies, 45 industry dummies, and 451 industry–year interaction terms to reflect the fixed effects model are not shown. 2. Numbers in the parentheses are standard deviations. 3. ∗∗∗ p < .001, ∗∗ p < .01, ∗ p < .05, † p < .10. 4. N = 12, 019

Related diversification Unrelated diversification Adjusted R 2

Group size

Firm size

Market share

Backward integration

Forward integration

Cost of goods sold

(1)

Variable

Whole time periods

Table A.4.1. Cost and profit impact of vertical integration

279

64.43 (5.94)∗∗∗ 5.15 (1.33)∗∗∗ 8.37 (2.25)∗∗∗ −0.04 (0.05) −0.17 (0.28) 0.70 (0.27)∗∗ 1.72 (1.13)∗ −0.35 (0.77) 0.31

Constant

0.34 (0.59) −0.47 (0.13)∗∗∗ 0.15 (0.22) −0.00 (0.01) 0.14 (0.03)∗∗∗ −0.05 (0.03)∗ 0.20 (0.11)† 0.16 (0.08)∗ 0.18

Advertising expense

(8)

2.89 (1.17)∗ −1.21 (0.26)∗∗∗ −1.17 (0.44)∗∗ −0.03 (0.01)∗ 0.15 (0.06)∗∗ −0.15 (0.05)∗∗ 0.46 (0.23)∗ 0.37 (0.15)∗ 0.16

Sales expense

(9) General administrative expense 2.90 (6.48) −1.65 (1.44) −2.17 (2.45) −0.11 (0.06)† −0.86 (0.31)∗∗ 1.05 (0.29)∗∗∗ 1.00 (1.24) −2.76 (0.84) 0.21

(10)

0.15 (0.20) −0.03 (0.04) −0.02 (0.08) 0.01 (0.01) 0.01 (0.01) 0.05 (0.01)∗∗∗ −0.14 (0.04)∗∗∗ −0.03 (0.03) 0.15

R&D expense

(11)

(12)

16.93 (2.30)∗∗∗ 0.52 (0.51) −1.36 (0.87) 0.06 (0.02)∗∗ −0.08 (0.11) −0.59 (0.10)∗∗∗ 1.22 (0.44)∗∗ 0.40 (0.30) 0.13

Profitability

Notes: 1. 11 year dummies, 45 industry dummies, and 451 industry–year interaction terms to reflect the fixed effects model are not shown. 2. Numbers in the parentheses are standard deviations. 3. ∗∗∗ p < .001, ∗∗ p < .01, ∗ p < .05, † p < .10. 4. N = 2,901

Related diversification Unrelated diversification Adjusted R 2

Group size

Firm size

Market share

Backward integration

Forward integration

Cost of goods sold

(7)

Variable

Time period I (1985–88)

280

57.90 (5.09)∗∗∗ 5.99 (0.99)∗∗∗ 6.28 (1.64)∗∗∗ −0.09 (0.05)† 0.66 (0.21)∗∗ 0.42 (0.21)∗ −2.65 (0.81)∗∗ −0.86 (0.59) 0.29

Constant

Sales expense 3.43 (1.16)∗∗ −1.12 (0.22)∗∗∗ −0.07 (0.37) −0.00 (0.01) 0.16 (0.05)∗∗ −0.22 (0.05)∗∗∗ 0.77 (0.19)∗∗∗ 0.44 (0.14)∗∗ 0.15

−0.97 (0.56) −0.48 (0.11)∗∗∗ 0.21 (0.18) −0.00 (0.01) 0.17 (0.02)∗∗∗ −0.05 (0.03)∗ −0.02 (0.09) −0.02 (0.06) 0.20

(15)

Advertising expense

(14) General administrative expense 38.77 (3.88)∗∗∗ −3.15 (0.75)∗∗∗ −1.42 (1.25) −0.00 (0.04) −0.75 (0.16)∗∗∗ −0.06 (0.16) 0.79 (0.62) 1.05 (0.45) 0.12

(16)

−0.18 (0.30) −0.13 (0.06)∗ 0.32 (0.10)∗∗ 0.01 (0.00)∗∗ 0.01 (0.01) 0.06 (0.01)∗∗∗ −0.16 (0.05)∗∗ −0.03 (0.03) 0.14

R&D expense

(17)

(18)

18.72 (2.09)∗∗∗ 1.69 (0.42)∗∗∗ −2.72 (0.67)∗∗∗ 0.08 (0.02)∗∗∗ −0.28 (0.09)∗∗ −0.56 (0.09)∗∗∗ 2.49 (0.33)∗∗∗ 0.72 (0.24)∗∗ 0.10

Profitability

Notes: 1. 11 year dummies, 45 industry dummies, and 451 industry–year interaction terms to reflect the fixed effects model are not shown. 2. Numbers in the parentheses are standard deviations. 3. ∗∗∗ p < .001, ∗∗ p < .01, ∗ p < .05, † p < .10. 4. N = 4,195

Related diversification Unrelated diversification Adjusted R 2

Group size

Firm size

Market share

Backward integration

Forward integration

Cost of goods sold

(13)

Variable

Time period 2 (1989–92)

281

64.72 (4.73)∗∗∗ 7.26 (0.84)∗∗∗ 6.74 (1.47)∗∗∗ 0.03 (0.05) 0.18 (0.19) 0.67 (0.18)∗∗ −1.49 (0.71)∗ −1.71 (0.53)∗∗ 0.31

Constant

Sales expense 0.93 (1.14) −1.42 (0.20)∗∗∗ −0.68 (0.36)† −0.00 (0.01) 0.21 (0.05)∗∗∗ −0.18 (0.04)∗∗∗ 0.80 (0.17)∗∗∗ 0.35 (0.13)∗∗ 0.19

−1.26 (0.53)∗ −0.48 (0.09)∗∗∗ 0.07 (0.16) −0.02 (0.00)∗∗∗ 0.21 (0.02)∗∗∗ −0.07 (0.02)∗∗∗ 0.03 (0.07) 0.02 (0.06) 0.22

(21)

Advertising expense

(20) General administrative expense 20.19 (2.74)∗∗∗ −2.42 (0.49)∗∗∗ −1.82 (0.85)∗ −0.02 (0.03) −0.15 (0.11) −0.45 (0.11)∗∗∗ 1.09 (0.41)∗∗ 1.18 (0.31)∗∗∗ 0.19

(22)

−0.89 (0.32)∗∗ 0.05 (0.06) −0.05 (0.10) 0.01 (0.00)∗ 0.06 (0.01)∗∗∗ 0.05 (0.01)∗∗∗ −0.20 (0.04)∗∗∗ −0.06 (0.04)† 0.17

R&D expense

(23)

(24)

8.40 (1.92)∗∗∗ 0.82 (0.34)∗ −1.18 (0.60)∗ 0.02 (0.02) −0.24 (0.08)∗∗ −0.15 (0.08)∗ 0.92 (0.29)∗∗ 0.36 (0.21)† 0.06

Profitability

Notes: 1. 11 year dummies, 45 industry dummies, and 451 industry–year interaction terms to reflect the fixed effects model are not shown. 2. Numbers in the parentheses are standard deviations. 3. ∗∗∗ p < .001, ∗∗ p < .01, ∗ p < .05, † p < .10. 4. N = 4,923

Related diversification Unrelated diversification Adjusted R 2

Group size

Firm size

Market share

Backward integration

Forward integration

Cost of goods sold

(19)

Variable

Time period 3 (1993–96)

Appendix 4. The Impact of Vertical Integration were used as dependent variables in regressions. Industryspecific dummy variables, year dummy variables, and their interaction terms were included to handle the panel data, as in previous appendixes. Chow’s F-test confirmed the conjecture that the intercept term varies over time and across industries. Table A.4.1 shows the regression results with each cost item as a dependent variable. Here the samples were further divided into three time periods, consistent with the analyses in Appendixes 2 and 3. Models (1)–(6) showed the results based on the entire time period. The empirical analysis showed that the cost of goods sold, which included payrolls, raw material, factory depreciation, and rental expenses, was positively and significantly correlated with both forward and backward integration, implying that greater integration into upstream and downstream operations leads to higher costs. This result supported the argument that the costs of vertical integration exceeded the benefits. However, some cost items seemed to decrease with vertical integration. For instance, both forward and backward integration seemed to lower sales expenses and overhead expenses. Advertisement costs were lower only for companies integrating forward. R&D expenses were actually higher for firms in the downstream operation. Profitability, reflected in ROIC in model (6) of Table A.4.1, is essentially the same as in model (3) of Table A.3.1. It is positively related to forward integration but negatively related to backward integration. Models (7)–(24) showed the regression analyses according to each time period. The cost of goods sold variable was positive and significant in all regressions, suggesting that the inefficiency in production costs associated with vertical integration persisted during the entire time period of study. The profitability equation in each time period showed that forward and backward integration did not hurt firms’ performance in period 1 when 282

Appendix 4. The Impact of Vertical Integration the economy was strong but that it began to hurt their performance during the economic slump. Backward integration had a particularly strong negative effect during this period, consistent with the results in Appendix 3. General administrative expenses, which did not show any cost saving associated with vertical integration in period 1, became negatively associated with vertical integration in period 3. Vertical integration apparently did not help downstream operators improve their profitability during the economic downturn. As for controls, market share was associated with a decrease in advertising and general administrative expenses and increased profitability. Firm size was associated with increased advertising, sales, and R&D expenses. Group size was positively associated with cost of goods sold and R&D expenses but negatively associated with advertising and sales expenses. Both related and unrelated diversification reduced costs of goods sold and R&D expenses but were associated with higher sales expenses and general administrative costs. Overall, the results implied that forward integration helped chaebol companies reap higher profits, but that backward integration reduced their profitability. More specifically, the suppliers of parts gain from vertical integration, but only at the expense of assemblers. This asymmetric impact was stronger when the economy was weaker.

283

Appendix 5. Determinants of the Capital Structure of Chaebols This appendix examines the determinants of chaebol affiliates’ capital structure. A firm’s capital structure comprises its debts and equity capital. Modigliani and Miller (1958) argued that capital structure (i.e., whether a firm uses equity or debt) does not affect a firm’s value when taxes are not an issue. More recent theory emphasized, however, that that cross-country variations in capital structure depend largely upon institutional factors.7 Here, this study attempted to identify the factors that lead chaebol affiliates to increase their debts by focusing on the debt– equity ratio as the dependent variable. This study further distinguished debts into two categories according to their maturity and their sources, and examined whether there are any differences in the factors that determine the type of debt used. In particular, this study tried to assess what role group-affiliated financial institutions play in determining the capital structures of their affiliates. For this study, only interest-bearing corporate debts were considered, excluding liabilities such as accounts payable. The 284

Appendix 5. Determinants of the Capital Structure debt–equity ratio was calculated by dividing interest-bearing debts by equity capital. This study further classified debts as short-term or long-term debts according to whether they matured in less than a year (SHORT -TERM DEBTS ) or more than a year (LONG-TERM DEBTS ). It also classified the debts as DOMESTIC or FOREIGN according to their sources of origin. This study used several explanatory variables, including several that were employed in Appendix 3 such as the PROFITA BILITY , measured by the return on invested capital. It was expected that when the profit rate was high, more internal capital would be accumulated and lower debt ratios would be achieved (Myers and Majluf, 1984).8 This study also included the firm growth rate, as fast-growing firms would likely have a greater demand for capital and thus have higher debt levels.9 The fixed asset ratio is the ratio of tangible fixed assets to total assets, which is the basis of collateral. The existence of collateral makes it much easier to obtain debt and tends to increase the dependency on debt (Harris and Raviv, 1991; Berger and Udell, 1994). Debt payment guarantees from other affiliates, reflected in the RECEPTION OF DEBT GUA RA NTEE variable, also makes these companies more attractive to investors. This study expected that firms that can secure debt payment guarantees from other affiliates can secure more debts than those firms that cannot. A dichotomous variable, PUBLIC FIRM , which notes firms listed on the stock exchange, was also included. Listed firms can raise equity capital by issuing equity and are likely to have a lower debt–equity ratio than unlisted firms have. In addition, the FIRM SIZE and BUSINESS GROUP SIZE variables were added to control for size-related factors. Larger firms and chaebols have a greater access to collateral and lower likelihood of default, which were expected to lead to a higher debt–equity ratio. Large firms are also more capable of issuing information sensitive securities. 285

Appendix 5. Determinants of the Capital Structure SA LES GROW TH:

The annual percentage growth of sales of a firm from time t − 1 to time t. FIXED A SSETS : A ratio of tangible fixed assets to total assets of a firm, at time t. PUBLIC FIRM : The dichotomous variable assigning a value of one for a listed firm and zero for a private firm. One of the interesting features of this study was that it employed several dichotomous variables noting the existence of financial service institutions within the same group. When there was a merchant bank, an investment trust company, a securities company, a life insurance company, or a fire insurance company in the group with which a firm is associated, the variable for this type of institution was assigned a value of one. This study was interested in examining whether the existence of a financial service institution in a group increases the debts of the firm and, if so, which type of debts will be higher. This study used Sample B, which consists only of groupaffiliated companies from 1985 to 1996. Industry-specific dummy variables, year dummy variables, and their interaction terms were included to handle the panel data. Chow’s F-test confirmed the conjecture that the intercept term would vary over time and across industries. Table A.5.1 shows the regression results. The results showed that when the profit rate was high, more internal capital would be accumulated, and lower debt ratios would result, consistent with the expectation. Sales growth tended to be associated with a higher debt–equity ratio. In Korea, fast-growing firms tended to rely more on debts than equity capital. Firms with large fixed assets, which reflect the availability of collateral, tended to have lower debt–equity ratios, contrary to the expectation. Publicly traded chaebol affiliates had lower 286

Appendix 5. Determinants of the Capital Structure debts than did unlisted chaebol affiliates because they could raise equity capital from the stock market. Debt payment guarantees from other affiliates contributed to higher debt–equity ratios. The size of individual firms, measured as the logarithm values of affiliated firms’ assets, was positively significant, suggesting that large firms tend to be more leveraged. The larger the group was, the lower its affiliates’ debt–equity ratios were. This study tried to see if chaebols’ ownership of financial institutions actually made higher debts possible. In the formula, chaebols’ ownership of financial institutions such as securities firms, merchant banks, life insurance and fire insurance companies, and/or investment trust companies was added as an explanatory variable. Model (1) showed that a chaebol that owns at least one financial company depended more on debt than did chaebols that owned no financial concerns. In model (2), several binary variables noting different kinds of sister financial institutions were included. The result showed that ownership of merchant banks, securities companies, and life insurance companies increased debt dependency. Models (3) and (4) separated debts into short-term and longterm categories. Several differences emerged: high values of fixed assets led to more long-term debt but less short-term debt, which was consistent with the conventional wisdom that fixed assets should be financed by long-term debt. The ownership of merchant banks, whose main function was to purchase firms’ promissory notes, increased short-term debt, whereas the ownership of securities companies meant more long-term debt, including corporate bonds. Table 5.2 shows that group-affiliated securities firms purchased a large portion of corporate bonds issued by other affiliates. For instance, Samsung Securities assumed rights to 1.07 trillion won of corporate bonds issued by Samsung affiliates from January to July 1997, which was 69.3% 287

288

Reception of debt guarantee Firm size

Public/private

Fixed assets

Sales growth

Profitability

Constant

4.16 (1.09)∗ −0.14 (0.01)∗∗∗ 0.001 (0.00)∗∗∗ −1.05 (0.28)∗∗∗ −2.45 (0.14)∗∗∗ 0.49 (0.01)∗∗∗ 0.35 (0.05)∗∗∗

(1)

4.30 (1.11)∗ −0.14 (0.01)∗∗∗ 0.001 (0.00)∗∗∗ −1.08 (0.29)∗∗∗ −2.44 (0.14)∗∗∗ 0.49 (0.01)∗∗∗ 0.36 (0.05)∗∗∗

(2)

Total debt to equity

Table A.5.1. Determinants of debt–equity ratio

5.21 (0.90)∗∗∗ −0.10 (0.01)∗∗∗ 0.001 (0.00)∗∗∗ −2.70 (0.23)∗∗∗ −1.89 (0.11)∗∗∗ 0.37 (0.01)∗∗∗ 0.18 (0.04)∗∗∗

(3)

Short-term debt to equity (5) 5.28 (1.08)∗ −0.14 (0.01)∗∗∗ 0.001 (0.00)∗∗∗ −1.49 (0.28)∗∗∗ −2.26 (0.13)∗∗∗ 0.47 (0.01)∗∗∗ 0.28 (0.05)∗∗∗

−0.90 (0.40)∗ −0.04 (0.00)∗∗∗ 0.001 (0.00)∗∗∗ 1.62 (0.10)∗∗∗ −0.54 (0.05)∗∗∗ 0.12 (0.00)∗∗∗ 0.17 (0.02)∗∗∗

Domestic debt to equity

(4)

Long-term debt to equity

−0.97 (0.15)∗ −0.00 (0.01)∗∗∗ 0.001 (0.00)∗∗∗ 0.41 (0.04)∗∗∗ −0.18 (0.02)∗∗∗ 0.03 (0.00)∗∗∗ 0.07 (0.01)∗∗∗

(6)

Foreign debt to equity

289

0.20

−0.35 (0.04)∗∗∗ 0.56 (0.17)∗∗

0.41 (0.20)∗ 0.60 (0.24)∗∗ 0.03 (0.31) 0.48 (0.23)∗ −0.40 (0.29) 0.20

−0.36 (0.05)∗∗∗

0.43 (0.16)∗∗ 0.20 (0.20) 0.18 (0.25) 0.40 (0.19)∗ −0.20 (0.24) 0.20

−0.26 (0.04)∗∗∗

−0.02 (0.07) 0.39 (0.08)∗∗∗ −0.15 (0.11) 0.08 (0.08) −0.19 (0.10)† 0.14

−0.10 (0.02)∗∗∗

0.36 (0.19)† 0.62 (0.23)∗∗ −0.00 (0.30) 0.41 (0.22)† −0.38 (0.28) 0.20

−0.35 (0.04)∗∗∗

0.05 (0.03)† −0.02 (0.03)∗∗ 0.04 (0.04) 0.07 (0.03)∗ −0.02 (0.04) 0.16

−0.02 (0.01)∗

Notes: 1. 11 year dummies, 45 industry dummies, and 451 industry–year interaction terms to reflect the fixed effects model are not shown. 2. Numbers in parentheses are standard deviations. 3. ∗∗∗ p < .001, ∗∗ p < .01, ∗ p < .05, † p < .10. 4. N = 12,019.

Investment and trust company Life insurance company Fire insurance company Adjusted R 2

Securities company

Group’s ownership of financial service affiliates Merchant bank

Business group size

Appendix 5. Determinants of the Capital Structure of all corporate bonds acquired by Samsung Securities during this period. The ownership of a life insurance company increased short-term debts, whereas ownership of fire indemnity insurance companies reduced long-term debts, albeit weakly. These results demonstrated very clearly that ownership of financial service institutions increased the actual debts a business group carried and that the type of financial company owned influenced what type of debt affiliates used, suggesting that group-affiliated financial service firms functioned as sources of capital for their groups. Models (5) and (6) distinguished domestic debt from foreign debt. Again, fixed assets, reflecting collateral, increased foreign debts but decreased domestic debts. Firms in groups that owned a merchant bank or a life insurance company were more likely to have higher levels of both domestic and foreign debt. On the other hand, firms in groups that owned securities companies were more likely to have a higher portion of domestic debt and a lower portion of foreign debt. Again, the type of financial company owned influenced the type of debt used. It is evident that chaebol affiliates have served as the private vaults of chaebols.

290

Appendix 6. Profitability and Stock Ownership of Affiliates This empirical study examined the simultaneous relationship between profitability and the stock ownership of affiliates. Ever since Berle and Means’ (1932) seminal work, researchers argued that professional managers with little equity in the firms they run seek their own interests at the expense of shareholder value and asserted that concentrated ownership helps reduce this agency problem (Jensen and Meckling, 1976; Shleifer and Vishny, 1986). This conventional line of research is currently being challenged on two theoretical grounds. Some have argued that strategy scholars need to consider non-Western contexts, in which key owners often not only manage their own firms but may also control other affiliated firms through cross-shareholding (La Porta et al., 1999). According to their view, the greatest source of agency problems in most countries is not professional managers but instead controlling shareholders, who expropriate value from minority shareholders. A second, distinct line of research suggests that it is wrong to accept ownership structure as exogenously given (Demsetz, 1983; Demsetz and Lehn, 1985). Others, building on this insight, have instead posited that 291

Appendix 6. Profitability and Stock Ownership performance may influence ownership structure but not vice versa, as previous studies argued. Kole (1996) provided related evidence for this conjecture by showing that managers prefer equity compensation only when they expect their firms to perform well, suggesting that managerial ownership represents an endogenous outcome of compensation contracting practices. Cho (1998) used the simultaneous equations estimation technique to show that corporate value affects ownership structure, while the reverse relationship does not hold. When controlling shareholders directly or indirectly manage a firm, the possibility of reverse causality can be much greater because these individuals can use insider information about their firms for their personal gain, much in the same way that managers prefer stock options when they think their firms will perform well. For instance, they may use insider information to increase their own shares of an affiliate that is likely to develop a breakthrough technology or to win a large contract and decrease their own shares in affiliates that have only lackluster prospects. By doing so, large shareholders expropriate value from minority shareholders who do not have access to such information. Just as chaebol families may increase their shares of profitable affiliates, they may wish to decrease ownership of an affiliate that has potential liabilities. This study used a simultaneous equation model to identify how equity stakes held by the chairman and other affiliates determine a company’s profits, as well as how equity ownership itself gets determined. This study restricted the sample firms to the public companies affiliated with business groups (i.e., Sample B
). The ownership information for public firms was available from 1986 onward; however, the same information for private firms was not available until the mid 1990s. The KIS carefully established information on the family membership of 292

Appendix 6. Profitability and Stock Ownership controlling shareholders, who are often founders and their descendants, and calculated the family ownership. Identifying affiliate ownership is straightforward and follows the definition of business groups by KFTC. FA MILY OW NERSHIP: the

percentage of equity shares owned by the family members who are identified as the controlling shareholders of a business group at time t. A FFILIA TE OW NERSHIP: the percentage of equity shares owned by other affiliates in the same business group at time t. It is necessary to control for both firm and business group size, as each may affect the ownership decision and firm performance. This study incorporated both FIRM EQUITY and GROUP EQUITY in thousands of won. It was expected that the larger the firm’s equity was, the smaller the portions of inside ownership would be, given wealth constraints. The same logic held for the total level of equity at the group level because it would be hard for a family or an affiliate to maintain a higher level of ownership for every affiliate. There was no a priori expectation of firm size variable in the profitability model. Y EA RS OF LISTING is defined as the number of calendar years since a firm was listed. Both family and affiliate ownership were expected to be dispersed over time. This study also incorporated a measure of uncertainty faced by the firm. Demsetz and Lehn (1985) argued that the more uncertain the firm’s environment was, the greater was the firm’s need to maintain tight ownership control. This study measured VOLA TILITY by the standard deviation of profitability during the past 5 years (Cho, 1998). SA LES GROW TH, as used in Appendix 5, was included as a determinant for firm performance. FIRM EQUITY : Equity

of a firm in thousands won, measured at

time t. 293

Appendix 6. Profitability and Stock Ownership GROUP EQUITY : Sum of equities of all firms associated with the

business group, in thousands won, measured at time t. Y EA R OF LISTING: Years since establishment, measured at time t. VOLA TILITY : The standard deviation of the profitability measured by ROIC during the time t and time t-4. This study used the panel data analysis technique and the twostage least squared (2SLS) regression methods to estimate the profitability and ownership structure with panel data for public group affiliates for 1986–96. Initially, this study estimated individual equations with the OLS method while incorporating only the year and industry effects variables, based on the two-digit KSIC level. Himmelberg, Hubbard, and Palia (1999) observed, however, that there could be spurious causal relationships between ownership and firm performance because of unobserved firm heterogeneity. This study adopted the panel data technique of Himmelberg et al. by including a set of firm and year dummy variables (Hsiao, 1986). Nonetheless, the panel analysis technique did not resolve the endogeneity problems between dependent and independent variables. This study thus used the simultaneous equation technique to explore this endogeneity as Cho (1998) did in studying ownership concentration and performance for U.S. firms. The 2SLS method first estimates individual endogenous variables with instruments that are independent of these variables. It then replaces the endogenous variables with the estimates from the first-stage regressions. It is not easy to find suitable instruments that are both conceptually and empirically exogenous to the system. This study used firm characteristics such as sales growth, firm equity, group equity, volatility, and years of listing because there was no a priori reason why they were endogenous to ownership or firm performance. 294

Appendix 6. Profitability and Stock Ownership Models (1)–(3) of Table A.6.1 show the results accounting for firm heterogeneity. Two-stage models (4)–(6) handle both firm heterogeneity and endogeneity. In model (1), family ownership is associated with higher profitability, which supports the agency theory hypothesis that concentrated family ownership ensures more effective monitoring of managers. In model (2), profitability was also associated with family ownership, which in turn suggested that family ownership was higher in more profitable firms. Affiliate ownership and profitability were not significantly related to one another in models (1) and (3). The study then reestimated equations with two-stage regression models. In order to avoid over-identification, we selected only a partial set of potential instruments (Johnston, 1984).10 Sales growth was a significant indicator of profitability and was selected as an instrument for a profitability model. As for the ownership models, group equity and volatility became the primary candidates. Years of listing and firm equity were included as controls in all models. Variables for firm investment (R&D, advertising, liquidity, and leverage) and intra-group transaction variables might be endogenous to firm performance and ownership (Cho, 1998; Himmelberg et al. 1997; Chang and Hong, 2000) and were not used as instruments. After controlling for endogeneity, the effects of family ownership to performance vanished, as in model (4). In contrast, the relationship between performance and family ownership was positively significant in model (5), albeit weakly. The results suggest that firm profitability affected the ownership structure but not vice versa, and demonstrates that endogeneity problems indeed affect the results in models (1)–(3). Family ownership and affiliate ownership had significant and negative coefficients in models (5) and (6), suggesting that they are really substitutes, even after controlling for endogeneity. In order to maintain a 295

0.02 (0.01)∗ 0.43

−0.16 (0.65)∗

0.05 (0.02)∗ 0.01 (0.01) 1.72∗ 10−9 (8.29∗ 10−10 )∗

9.18 (1.31)∗∗∗

0.87

−0.22 (0.03)∗∗∗ 2.08∗ 10−9 (7.37∗ 10−10 )∗∗ −3.98∗ 10−10 (1.66∗ 10−10 )∗ 0.34 (0.16)∗ 0.07 (0.06)

22.99 (2.12)∗∗∗ 0.11 (0.05)∗

(2) Family ownership

0.88

1.99∗ 10−9 (1.27∗ 10−9 ) −7.10∗ 10−10 (2.52∗ 10−10 )∗∗ −0.90 (0.16)∗∗∗ 0.11 (0.05)∗

17.97 (1.96)∗∗∗ 0.01 (0.02) −0.16 (0.02)∗∗∗

(3) Affiliate ownership

0.02 (0.01)∗ 0.25

−0.42 (0.34)

0.41 (0.28) −0.04 (0.12) 1.23∗ 10−9 (9.35∗ 10−10 )

2.44 (7.99)

(4) Profitability

0.84

−0.65 (0.38)† 2.03∗ 10−9 (1.46∗ 10−9 ) −6.78∗ 10−10 (3.84∗ 10−10 )† 1.69 (0.89)† 0.08 (0.08)

5.68 (10.64) 0.56 (0.34)†

(5) Family ownership

0.54

3.13∗ 10−9 (2.58∗ 10−9 ) −1.05∗ 10−9 (3.79∗ 10−10 )∗∗ 0.16 (1.01) 0.13 (0.12)

35.67 (12.36)∗∗ 0.87 (0.56) −1.54 (0.90)†

(6) Affiliate ownership

2SLS with firm effects

Notes: 1. Numbers in parentheses are the White’s heteroscedasticity-consistent robust standard errors. 2. ∗∗∗ p < 0.001, ∗∗ p < 0.01, ∗ p < 0.05, † p < 0.10, N = 3,086.

Sales growth R2

Family ownership Affiliate ownership Firm equity Group equity Years of listing Volatility

Profitability

Intercept

(1) Profitability

With firm effects

Table A.6.1. OLS and 2SLS models of profitability and family and affiliate ownership

Appendix 6. Profitability and Stock Ownership controlling stake, a family should have either a higher direct ownership stake or a lower affiliate ownership stake, or vice versa. Chaebol families are not likely to hold more equity than they need to ensure control since they would rather invest in new ventures. In general, the instrument variables were consistent with expectations. Sales growth was an important predictor of firm performance. The group equity variable was negative for both family and affiliate ownership, reflecting wealth constraints. Volatility was insignificant, however. These results indicated that chaebol families increased their ownership stakes of more profitable firms and decreased their stakes in less profitable firms. There was no evidence for the conventional argument linking ownership concentration to better firm performance. The overall results from this empirical study confirm that chaebols posed severe agency problems because chaebol families maximized their own profits at the expense of minority shareholders.

297

Appendix 7. Intragroup Business Transactions and Ownership Structures of the Top Five Chaebols Chapter 4 examined the Hyundai Groups’ internal transactions. The core manufacturing companies maintained backward (or upstream) integration with smaller affiliates that supply intermediate goods and parts to them. On the other hand, there are instances of forward (or downstream) integration through a general trading company and domestic sales-related affiliates. Figures A.7.1–A.7.4 show similar patterns of vertical integration in Samsung, LG, Daewoo, and SK Group, respectively. Chapter 6 examined the ownership structure of the SK Group. Figures A.7.5–A.7.8 show a simplified version of equity stakes held by group chairmen and the stakes held by the major affiliates in Samsung, Hyundai, LG, and Daewoo Group, respectively. They demonstrate how major affiliates in each group effectively control small affiliates by owning them singly and jointly, and the chaebol chairmen control all these firms with very small ownership stakes.

299

300

Samsung SDS

Samsung Kwang Ju Electronics Co., Ltd.

Samsung Corning Co., Ltd.

Samsung ElectroMechanics Co., Ltd.

1,724

Samsung SDI

594

345

2,041

302

346

338

455

387 1,858

5,059

8,993

3,149

471

476

1,085

Samsung Life Insurance

Samsung Electronics

1,670

Samsung Heavy Industries

Samsung Petrochemical

Samsung Fine Chemicals

811

782

1,256

27,499

333

931

Samsung General 799 Chemical

710

Cheil Industries

1,832

2,467

435

64,595

457

3,310

Figure A.7.1. Intragroup business transactions of Samsung Group. Source: Korea Information Service. Note: All data are as of December 1997. Unit is 100 million won: 1. Large circles are for affiliates with over 5 trillion won in assets; 2. We show internal sales that are over 30 billion won.

355

3,275

2,237

Samsung Aerospace Industries, Ltd.

Samsung Engineering Co., Ltd.

485

426

Samsung Corporation

1,286

611

425

Shinsegae Food System

318

Shinsegae Department Store

Cheil Communications

Mujin Development Co., Ltd.

Samsung Everland

576

456

573

1,256

Shinsegae Merchant Bank

Samsung Securities

Samsung Capital

Samsung Card

Samsung Fire & Marine Insurance

301

Siltron, Inc.

LG Owens Cornng

LG EDS

LG Component

LG Micron Ltd.

LG Cable Ltd.

2,686

LG Ceramic

723

LG Engineering

LG Precision

LG MMA

LG Industrial Systems.

521

396

1,127

731

300

684

1,125

2,245

303

4,752

LG Chemical

780

LG Construction

715

468 903

LG Semicon

350

456

LG Electronics

486

LG Information & Communication

LG Petrochemical

974

647

LG Caltex Oil Refinery

5,652

453

2,030

463

359

4,883

856 5,595

799

6,016

3,612

LG AD

LG Telecoam

1,070

LG International

1,298

Hoyu Tanker

LG Mart

LG Gas Sale

305 1,372

6,460

778

2,018

LG-Caltex Gas 27,006

1,785

1,562 870

Bumin Mutual Saving's & Finance

LG Insurance

LG Mortgage Finance

LG Securities

LG Merchant Banking Corporation

LG Capital

Figure A.7.2. Intragroup business transactions of LG Group. Source: Korea Information Service. Note: All data are as of December 1997. Unit is 100 million won: 1. Large circles are for affiliates with over 5 trillion won in assets; 2. We show internal sales that are over 30 billion won.

Appendix 7. Intragroup business transactions 178

Kyungnam Metal

2,511

Kyungnam Enterprises,

156

Koram Plastics

Daewoo Heavy Industries

150

Daewoo Precision Industries

722 2,476

294

551

619

5,578

4,190 202

Daewoo Automotive Components

5,946 678

Daewoo Motor

Korea Automotive Fuel System

Daewoo Telecom 404

Daewoo Information Systems

1,771 157 197

Daewoo Electronics

566

Daewoo Electronic Components

2,412 285

Orion Electric Components

747

796

302

Orion Electric

295

Appendix 7. Intragroup business transactions

16,821

155

533

Daewoo Corporation

36,080

Figure A.7.3. Intragroup business transactions of Daewoo Group. Source: Korea Information Services. Note: All data are as of December 1997. Unit is 100 million won: 1. Large circles are for affiliates with over 5 trillion won in assets; 2. We show internal sales that are over 30 billion won.

1,465 223 9,603

4,906

Daewoo Development Daewoo Capital Diners Club of Korea Daewoo Securities

303

304

331

168

100

161

Daehan Telecom

Pohang City Gas

Kuk Il Energy

Kumi City Gas

424

932

793

233

SK Oxi Chemical

SK Gas

3,783

854

1,030

1,615

SK Engineering & Construction

1,913

SK Telecom

SKC

504

SK Chemical

SK

622

8,696

2,790

213

190

280

2,131

1,696

151

25,062

SK Distribution

321

SK Global

18,688

Kyong Jin Shipping

159

SK Shipping

SK Energy Sale

116

1,451

SK Securities

Figure A.7.4. Intragroup business transactions of SK Group. Source: Korea Information Services. Note: All data are as of December 1997. Unit is 100 million won: 1. Large circles are for affiliates with over 5 trillion won in assets; 2. We show internal sales that are over 30 billion won.

305

100.0

8.1

5.0

Samsung Heavy Industries

18.92

7.8

Samsung Card

54.4

10.1

Samsung Aerospace Industries

29.8

5.4

16.1

21.5

14.4

37.8

Samsung SDI

10.9

10.4

8.2

7.0

2.3 6.2

9.3

6.2

25.3

5.0

29.9

11.4

11.7

9.9

14.7

10.6 5.5

Pohang Kangje Industry

16.0

11.5

Chiel Industries

Samsung Fire & Marine Insurance

Samsung Engineering

6.2

Samsung Securities

16.4

10.0

6.2

8.5

5.0

Samsung Everland

Joongang Daily

67.3

Cheil Jedang

38.0

41.8

Samsung Petrochemical

10.0

5.6

Samsung ElectroMechanics

11.5

Samsung SDS

14.8

S1 Corporation

10.0

Samsung Life Insurance

15.0

Samsung Fine Chemicals

12.7

13.2

Samsung Corporation

5.7

Hotel Shilla Co., Ltd..

Chairman & his family

Samsung Kwang Ju Electronics

95.0

10.3

5.4

Samsung Electronics

Bokwang

70.1

Figure A.7.5. The equity ownership of Samsung Group. Source: Korea Information Service. Samsung General Notes: 1. We show more than 5% Chemical of equity ownership as of December 1997; 2. Dark circle for company of more than 3 trillion in assets. Dark arrow represent circular equity investment.

Samsung Commercial Vehicles

Samsung Corning

48.4

Cheil Communication

Bokwang Family Mart

306

10.9

Figure A.7.6. The equity ownership of Hyundai Group. Source: Korea Information Service. Notes: 1. We show more than 5% of equity ownership as of December 1997; 2. Dark circle for company of more than 3 trillion in assets. Dark arrow represents circular equity investment.

19.3

43.0

5.4

Korea Industrial Development

21.9

Diamond Ad.

83.3

6.1

18.0

Hyundai Motor

Hyundai Engineering

42.8

Hyundai Industrial Development & Construction

13.7

14.0

15.0

1.4

6.2

Hyundai Finance

12.18

5.5

7.8

80.0

7.5

8.5

21.8

Hyundai Oil

45.1

18.0

Hyundai Elevator

39.0 5.3

22.0

Hyundai Information Technology

5.3

5.0

6.5

Hyundai Securities

5.5

Inchon Iron & Steel

Hyundai Petrochemical

11.9

7.8

5.1

Chairman & his Family

Hyundai Corporation

6.60

5.7

19.8

12.7

6.9

9.6

6.3

Hyundai Merchant Bank

29.9

100

Hyundai Electronics

8.0

20.9

Hyundai Engineering & Construction

8.7

Kumkang Development

7.1

22.5

37.9

10.4

9.5

6.9

9.5

1.2

10.4

12.6

6.0

Hyundai Space & Aircraft

40.0

Hyundai Motor Service

9.6

Hyundai Mipo Dockyard

Hyundai Oil Sale

Hyundai Pipe

8.7

45.4

62.2

Hyundai Precision & Ind.

11.4

Hyundai Heavy Industries Co., Ltd.

31.4

Hyundai Merchant Marine

Hyundai Merchant Marine

16.8

Korea Flange

307

8.0

5.1

8.6

3.6

LG International

1.9

7.3 15.0

35.0

3.3

22.1 10.0 38.9

LG Construction

5.0

25.8

9.7

19.0

LG Ceramic

7.8

4.1

7.1

9.0

46.3

5.5

17.4 85.0

23.6

5.0

LG Precision

48.9

5.9

LG AD

10.0

50.0

50.0

40.0

5.0

LG Honeywell

25.0

LG Mortgage Finance

10.0

LG Micron

LG Electronics Component

LG Telecom

LG Hitachi

100.0

LG Electronics

LG Information & Communication

13.2

LG Semiconductor

6.9

LG Industrial Systems

12.1

Chairman & his family

4.3

LG Mart

LG Capital

32.7

LG Chemical

LG Department Store

5.0

13.1

Hanmoo Development

18.2

LG Caltex Gas

LG Insurnace

7.2

20.0

6.0

2.7

LG-EDS System

10.0

LG Engineering

20.0

LG Cable

Figure A.7.7. The equity ownership of LG Group. Source: Korea Information Service. Notes: 1. We show more than 5% of equity ownership as of December 1997; 2. Dark circle for company of more than 3 trillion in assets. Dark arrow represents circular equity investment.

Bumin Mutual Saving's & Finance

49.5

LG Merchant Banking Corporation

LG Securities

6.2

50.0

100.0

LG Petrochemical

LG MMA

28.8

10.0

51.5

Siltron

Hoyu Tanker

48.5

LG Gas Sale

308

51.0

21.0

Koram Plastics

Kyungnam Metal

45.0

11.8

4.5

30.0

Daewoo Corporation

21.9

37.0

Daewoo Motor

29.1

7.1

7.6

23.0

6.1

5.3

Daewoo Automotive Components

24.7

8.5

Daewoo Heavy Industries, Ltd.

2.9

Daewoo Cultural Foundation

11.1

Daewoo Securities

47.6

5.7

7.9

Daewoo Telecom

1.4

Daewoo Electronics

3.1

1.7

Daewoo Information Systems

44.4

6.9

1.2

3.1

1.00

8.5

19.2

39.9

6.9

80.0

39.9

Orion Electric Component

Daewoo Electronics Component

Diners Club of Korea

20.0

Orion Electric

Figure A.7.8. The equity ownership of Daewoo Group. Source: Korea Information Service. Notes: 1. We show more than 5% of equity ownership as of December 1997; 2. Dark circle for company of more than 3 trillion in assets. Dark arrow represents circular equity investment.

Korea Automotive Fuel System

Daewoo Precision Industries

39.0

Daewoo Development

Chairman & his family

Appendix 8. Key Economic Statistics, 1960–2000

Gross Current domestic Exchange account product Per capita rate Export balance Year (billion $) income ($) (won/$) Inflation (%) (billion $) (billion $) 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976

2.0 2.1 2.3 2.7 2.9 3.0 3.7 4.3 5.2 6.6 8.0 9.4 10.6 13.5 18.8 21.1 28.9

79 82 87 100 103 105 125 142 169 210 249 286 316 394 540 592 799

65.0 130.0 130.0 130.0 256.0 272.1 271.5 274.6 281.5 304.5 316.6 373.2 398.9 397.5 484.0 484.0 484.0

309

11.3 10.9 10.8 12.4 16.0 13.5 11.7 3.2 24.3 25.2 15.3

0.03 0.04 0.05 0.09 0.1 0.2 0.3 0.3 0.5 0.6 0.8 1.1 1.6 3.2 4.5 5.1 7.7

0.01 0.03 −0.06 −0.1 −0.03 0.01 −0.1 −0.2 −0.4 −0.5 −0.6 −0.8 −0.4 −0.3 −2.0 −1.9 −0.3

Appendix 8. Key Economic Statistics, 1960–2000 Appendix 8. (cont. ) Gross Current domestic Exchange account product Per capita rate Export balance Year (billion $) income ($) (won/$) Inflation (%) (billion $) (billion $) 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

37.1 52.0 61.9 62.2 69.6 74.4 82.3 90.6 93.4 107.6 135.2 180.8 220.7 252.5 295.1 314.7 345.7 402.4 489.4 520.0 476.6 317.7 405.8 461.7

1,009 1,399 1,636 1,598 1,749 1,847 2,020 2,190 2,229 2,550 3,201 4,268 5,185 5,886 6,810 7,183 7,811 8,998 10,823 11,385 10,315 6,744 8,595 9,770

484.0 484.0 484.0 659.9 700.5 748.8 795.5 827.4 890.2 861.4 792.3 684.1 679.6 716.4 760.8 788.4 808.1 788.7 774.7 844.2 1,415.2 1,207.8 1,145.4 1,259.7

10.1 14.5 18.3 28.7 21.4 7.2 3.4 2.3 2.5 2.8 3.1 7.1 5.7 8.6 9.3 6.2 4.8 6.3 4.5 4.9 4.4 7.5 0.8 2.3

10.0 12.7 15.5 17.2 20.7 20.9 23.2 26.4 26.6 34.1 46.5 59.9 61.8 63.6 70.5 76.1 82.0 94.9 124.6 129.9 138.6 132.1 145.1 175.9

0.0 −1.1 −4.2 −5.3 −4.6 −2.5 −1.5 −1.2 −0.7 4.7 10.0 14.5 5.3 −2.0 −8.3 −3.9 0.9 −3.8 −8.5 −23.0 −8.1 40.3 24.4 12.2

Note: 1. Gross domestic product (GDP), per capita income, export and current account balance are in nominal U.S. dollars. 2. Inflation is defined as the annual change in the consumer price index, which became available since 1965. Source: Bank of Korea and Korea National Statistical Office

310

Notes

chapter 1 1 Figures are in nominal U.S. dollars from the Economic Statistics Yearbook, Bank of Korea. 2 World Bank, 1993. 3 At the end of 1996, the foreign currency reserve of Korea was $32 billion. At the end of 2000, it increased to $96 billion, according to the Financial Statistics Yearbook, Bank of Korea. 4 Jeffrey Sachs, “The Wrong Medicine for Asia,” The New York Times, November 3, 1997; Jeffery Sachs, “IMF Is a Power onto Itself,” Financial Times, December 11, 1997; Joseph Stiglitz, “Must Financial Crises Be This Frequent and This Painful?,” manuscript, 1998; “World Bank, IMF at Odds Over Asian Austerity – Some Economists Contend That Harsh Measures Could Worsen the Crisis,” Wall Street Journal; January 8, 1998. 5 “The Chaebol That Ate Korea,” Economist, November 12, 1998. 6 See Frenkel and Roubini (2000) for more in-depth discussion on this topic. 7 See Corsetti, Pesenti, and Roubini (1998) for a survey on this topic. 8 Prime Minister Mahatir of Malaysia was the strongest proponent of this hypothesis. Between 1996 and 1997, there was a $109 billion reversal of net private capital flows (more than 10% of GDP) overall in East Asian region (Institute of International Finance, 1998, quoted in Joseph Stiglitz, “Must Financial Crises Be This Frequent and This Painful?,” manuscript, 1998). See Figure 2.5 for inflow of foreign capital to Korea.

311

Notes to pages 8–25 9 IMF, Press Information Notice, 98/39, “IMF Concludes Article IV Consultation with Korea.” 10 “The Apologist,” Economist, August 27, 1998; “Chaebols That Ate Korea,” Economist, November 12, 1998; “Korean Inc. Balks,” Business Week, January 19, 1998. 11 IMF, Press Information Notice, 98/39, “IMF Concludes Article IV Consultation with Korea.” 12 For a representative proponent, see Amsden (1989). 13 See Appendix 1 for more details. 14 See the data appendix for more information on sample composition. According to the Korea Development Institute, the top thirty chaebols accounted for 40% of Korea’s output in the mining and manufacturing sectors in 1996. 15 The average ROIC of U.S. public firms during 1981 and 1991 was 14.5%. 16 The preceding productivity indices calculate the average productivity by dividing the total value added by one unit of capital or labor without decomposing their respective contribution to the total value added. The marginal level of labor and capital productivity or total factor productivity is calculated by estimating the production function with time series data. See Kim and Lau (1994, 1996), and Young (1995) for examples of this approach. 17 Krugman (1994). Krugman’s argument was based on the empirical findings of Kim and Lau (1994, 1996), which decomposed the sources of the post-war period of economic growth into factors attributable to capital, labor, and technical progress. They estimated the contributions of capital, labor, and technical progress in the growth of Korea as 86.3, 12.7, and 1.0%, respectively. 18 See Figure 3.1. 19 See Blair and Roe (1999, chapters 5–7) for a detailed description of Germany’s governance system. 20 Fields (1995, p. 96). 21 His administration encouraged private French companies to buy shares in reprivatizing companies. For example, CGE (Compagnie G´en´erale des Eaux), a water and waste treatment service company until the mid1970s that had already diversified into real estate, telecommunications,

312

Notes to pages 25–36

22

23

24

25

26

27

28

construction, and hospital management, purchased 11 billion Frf. worth of shares in other French companies such as St. Gobain, Alcatel Alsthom, Accor, Paribas, and Soci´et´e G´en´erale by mid 1990. At the same time, other companies such as Soci´et´e G´en´erale, AXA, and Banque Nationale de Paris purchased shares of CGE. Some conglomerates, particularly French ones, are subject to family control. Unlike chaebols, members of the controlling families did not manage these firms’ affiliates. For example, Orru, Biggart, and Hamilton (1997) and Powell and SmithDoer (1994) describe chaebols as networks. Characteristics such as extensive debt guarantee, cross-ownership, and internal transactions may give the impression of a network. Considering that individual affiliates are tightly controlled and coordinated by group-level headquarters, chaebols are more accurately described as a hierarchical structure. Shin and Kwon (1999) also warned against the view that considers chaebol as a type of a network. See Granovetter (1995) for a review. Ghemawat and Khanna (1998) provide a table that summarizes the evidence of business groups prevalent in developing countries. See McVey (1992) and Orru et al. (1997) for examples of business groups in Southeast Asia, Strachan (1976) for Nicaragua, Ghemawat and Khanna (1998) for India, and Khanna and Wu (1998) for Chile. Similarly, North (1981) argues that the state tends to create inefficient property rights for political reasons, which generate high transactions costs. According to him, economic organizations such as business groups can be viewed as natural evolution that reduce transactions cost and improve performance. This view can be generally referred to as the institutional approach or comparative institutional approach. See Orru et al. (1997) and Evans (1995) for more theoretical discussion of this topic. See chapter 7 of Woo (1991) and chapter 6 of Kim (1997) for more detailed descriptions of the changes in geopolitical environments during the 1980s. Furthermore, its prior success was an important source for inertia because it is difficult to change a course of action that was successful in the past. March (1994) refers to this difficulty as a competency trap.

313

Notes to pages 37–49 29 Johnson et al. (2000) argue that the weakness of legal institutions for corporate governance had adverse effects on asset prices and exchange rates in all countries affected by the Asian crisis. 30 See Kim (1997) and Woo-Cumings (1999).

chapter 2 1 There are several books that examine the historical development of chaebols. See Amsden (1989), Kang (1996), and Kim (1996). 2 See McNamara (1990) for more information on the economic activities of Korean companies during the Japanese occupation. Eckert (1991) also provides a history of Sung-Soo Kim and his family during the Japanese occupation. 3 Kang, 1996, p. 45. See also chapter 2 of Kim (1998) for detailed information on the formation of chaebols during this period. 4 There have been numerous studies of the early development of chaebols, including Amsden (1989) and Kim (1997). 5 See Jones and Sakong (1980) and Kim (1997) for more details on economic planning during this era. 6 Evans (1995) argued that such an elite group of state bureaucrats is a critical element of the developmental state. 7 It was possible since the government owned all commercial banks and controlled the loans. 8 Under this system, incumbent firms had an advantage, which was furthered through their political connections. Amsden (1989), however, justified the government’s repeated patronage of a few chaebols on the basis of efficiency rather than political connections. 9 Several scholars, including Kim (1997), argued that chaebols were not merely puppets for the intervention-oriented government, and that chaebols chose somewhat different paths from each other. For instance, Samsung and LG were not as enthusiastic about the government’s drive into heavy and chemical industries in the 1970s as were Hyundai and Daewoo. Although chaebols had some degree of freedom in their actions, their strategies were largely based on what the government wanted. 10 Hirshman (1958) argued that a dearth of entrepreneurs was a critical missing element in late entrants. Amsden (1989) also pointed out that in the late

314

Notes to pages 49–86

11

12

13 14 15

16 17

18

industrialization, the state and the salaried engineers were two key figures but private entrepreneurs were squeezed between them because the state was the overall allocator of resources and the latter were the gatekeepers of foreign technology transfer. Woo (1991), Fields (1995), and Cho and Kim (1997) provided detailed analysis of the government’s intervention in the financial service sector and its consequences. The Nixon doctrine in 1969 declared to leave the defense of the Pacific Rim to the countries of that region. President Carter also vowed to withdraw troops from Korea. See Cho (1987) for more information on the Korean general trading companies. Those presidents might have done so to appeal to populism and gain legitimacy for their own regime. The dissolution of Kukje Group is widely believed to be a political punishment for its refusal to contribute political funds to President Chun. See Fields (1995) and Kim (1997) for more details of the fall of the Kukje Group. See Steers (1999) for more information on Hyundai. In 2002, Hyundai Group was broken into several minigroups focusing on, among other things, automobiles and heavy industries. This split reflects the inheritance of Chairman Chung’s holdings by his sons rather than earnest restructuring effects. See Kim (1998) for a history of Samsung. Chun and Han (1994) also provided an overview of Samsung’s history. chapter 3

1 See Christensen and Montgomery (1981) and Rumelt (1982) for empirical studies on this topic. 2 The sales information in this figure is based upon aggregation of sales of individual affiliates, not upon consolidated income statements, which become available in 2000. Thus, intragroup sales are double-counted. 3 Of course, not all of these efforts were successful. Many governmentinduced efforts in the chemical and heavy equipment industries during the economic development era resulted in heavy losses as a result of overcapacity.

315

Notes to pages 90–126 4 Profitable affiliates often bear group-level image advertisement expenses, while unprofitable affiliates share intangible resources free of charge. See Chapter 4 for more discussion of such cross-subsidization. 5 Samsung Group, 50 Year History of Samsung. 6 Chun and Han, 1994. 7 Sometimes, the goal is the maximization of the wealth of the group chairman and his family. Chapter 6 will discuss this topic further.

chapter 4 1 Many subcontractors supply parts and services to chaebol affiliates. Because we define chaebol membership according to the 30% ownership criterion specified by the Korea Fair Trade Commission (see Chapter 1), the extent of vertical integration in chaebols is more substantial if we add those subcontractors with less than 30% of chaebol ownership. 2 Hyundai Electronics was renamed Hynix in 2001. 3 See Chapter 2 for more details. 4 The export portion has gradually declined since its manufacturing affiliates are increasingly engaged in developing overseas markets themselves. 5 Chapter 5 analyzes how chaebols’ internal capital markets operate. In-house financial service firms play a critical role in these markets. 6 Coase (1937) and Williamson (1975) pointed out that vertical integration enhances efficiency by reducing transactions costs caused by imperfect intermediate goods markets. 7 “Bell Labs Faces Mundane Future under Breakup Plan,” Wall Street Journal, September 22, 1995. 8 “Major Overhaul,” Wall Street Journal, October 23, 1992; “GM Is Expected to Distribute the Remainder of Delphi to Shareholders, Next Month,” Wall Street Journal, April 12, 1999. 9 “Reynolds Metals, Alcoa Split on Strategy – But Both Remain Captive to the Aluminum Cycle,” Wall Street Journal, November 7, 1990. 10 See Chapter 7 for more discussion on restructuring the chaebols. 11 Lincoln, Gerlach, and Ahmadjian (1996) argue that keiretsu grouping enhances the viability of the group as a whole by realigning its members’ prospects and resources. These adjustments amount to subsidization by prosperous members to guarantee the survival and hasten the recovery of financially troubled companies. They found strong evidence that the

316

Notes to pages 126–34

12

13 14 15

current profitability of a firm is negatively correlated with the interaction terms between its lagged profitability and the various keiretsu ties that it has. This result suggests that unprofitable firms benefited while profitable firms suffered from cross-subsidization. They argued that, in the long run, the successful rescue and turnaround of a business partner might pay for itself through loans and contracts otherwise lost to failure. In the short run, however, the burden on the firms providing the subsidies may be severe. Other research on Japanese business groups found that the group membership was often associated with negative performance (Caves and Uekusa, 1976; Nakatani, 1984). The Korea Fair Trade Commission conducted four rounds of investigation on the unfair business practices during 1998–2000. The details of findings from those investigations are available from press releases, dated July 30, 1998, November 13, 1998, October 1, 1999, and December 14, 2000. Korea Fair Trade Commission, press release of July 30, 1998. Op. cit. Many instances of such support involve an affiliated financial institution. Financial institutions affiliated with a chaebol serve as a coffer for their groups. The financial institution purchases corporate bills issued by its affiliate at a low discount rate or disburses cheap loans to an affiliate. In addition, the issue of bonds with warrants at low prices involves intensive support to financially unhealthy affiliates. Chapter 5 examines this role of in-house financial institutions in more detail.

chapter 5 1 See Chapter 2 for more details. 2 See Woo (1991), Nam (1994), Park (1994), and Fields (1995) for more discussion of the government interventions in the financial service industry in Korea. 3 The most notable case was the massive government bailouts of the troubled firms in the heavy equipment and chemical industries in 1980 (Woo, 1991). 4 Moral hazard refers to the tendency to take more risks if one knows it will be rescued in cases of failure. 5 Borensztein and Lee (1999) argued empirically that the capital allocation of the Korean financial sector was largely inefficient, both before and after the financial reforms.

317

Notes to pages 135–42 6 See Balino and Ubide (1999) for details about the lack of financial supervisions in Korea prior to the crisis. 7 See Chapter 2 for a more in-depth discussion of this point. 8 Under the revised Bank Act, legal entities or persons who meet certain conditions may own up to 10% of national commercial banks and 15% of regional banks. One of these conditions was an obligation to report to the Financial Supervisory Commission. 9 See Fields (1995), Chapter 4 for a history of the deregulation and privatization of the Korean financial service sector. 10 Report by Ministry of Finance and Economy to the Finance and Banking Committee, National Assembly, 1998. 11 “South Korean Finance: Murkier and Murkier,” Economist, September 11, 1999. 12 Balino and Ubide, 1999. 13 Cho (1986) pointed out that financial liberalization in the absence of wellfunctioning equity markets could generate a much worse outcome than could occur under financial repression. 14 Khanna and Wu, 1998. 15 Chaebols’ debt structures show debts of only the mother companies in Korea. They do not reflect debts of their overseas subsidiaries. Local financing for chaebols had increased from $187.6 billion in 1993 to $514.6 billion in 1997 – a 170% increase. The top five chaebols had consumed about $359.4 billion as of 1997, about 69% of total local financing. In short, overseas debts during this period were mainly held by these top five chaebols. 16 Bank of Korea, Business Statistics, 1998. 17 See the survey by Harris and Raviv (1991) and Rajan and Zingales (1995). 18 Coffee (2001) argued that relative decentralization, which enabled private entrepreneurs to devise their own techniques to attract foreign capital and to develop their own financial institutions, is a better way to develop the means to protect minority shareholders than is the legal tradition (civil law versus common law) itself. 19 See Chapter 2 for an in-depth historical review of this issue. 20 Nevertheless, not all Korean companies are saddled with high debt–equity ratios. In fact, financial structures vary according to company size: the smaller the company is, the lower the debt–equity ratio. Small firms did not benefit from the government’s industrial policy, nor did they have the

318

Notes to pages 142–75

21 22 23 24

25 26 27 28

29

luxury of debt guarantees or support from their own financial affiliates, as did chaebols. Gerschenkron (1962) pointed out that an equity-based financing system is an artifact of early industrialization. See Chapter 7 for details. See Chapter 3 for details. The Korea Fair Trade Commission conducted three rounds of investigations of these practices during 1998–9. The details of its findings are available from press releases from July 29, 1998, November 13, 1998, and October 1, 1999. Korea Fair Trade Commission, press release of October 1, 1999. Korea Fair Trade Commission, press release of July 30, 1998. Korea Fair Trade Commission, press release of October 1, 1999. Nam and Hong (1999) provided empirical support for this conjecture. They found that the main reasons for distress were high debts and a high level of fixed investment. Chapter 7 deals with the restructuring of financial institutions in detail. chapter 6

1 The Korea Fair Trade Commission defines net assets as paid-in capital minus equity investment by other affiliates. 2 Please refer to the extensive survey by Shleifer and Vishny (1997). 3 Refer to Kang, Choi, and Chang (1991, p. 55). 4 The effectiveness of the board is not without dispute. There is evidence that board intervention had always been too late (Warner, Watts, and Wruck, 1988) and that corporate boards, even in the United States, were controlled by management (Jensen, 1993). 5 Under the Commercial Law, amended in 1998, minority shareholders with more than 1% ownership can bring a lawsuit and those with more than 3% can demand the opening of accounting books. For public companies, the newly enacted Securities Transaction Law allows minority shareholders with a stake greater than 0.01% to file a lawsuit. 6 Such restraints were officially lifted in 1998. 7 Several scholars argue for the effectiveness of corporate governance system in Japan. For instance, Hoshi, Kashiyap, and Scharfstein (1991) showed that firms with main banking relationships recover quickly from

319

Notes to pages 175–91

8 9 10 11 12 13 14 15 16

17

18

financial distress. Porter (1992) argued that the Japanese system ensures long-term investment. See Kang and Shivdasani (1995) for empirical evidence. See Chun and Han (1994) for a history of Samsung’s semiconductor venture. See Steers (1999) for the background history of Hyundai’s shipbuilding business. “The Crises in Samsung,” Business Week, March 23, 1998; “Samsung: Not Just Chips Are Down,” Business Week, July 29, 1996. Lee, 1997. Fair Trade Commission, press release, October 1, 1999. Op. cit. Fair Trade Commission, case number 9712. For example, see Franks and Mayer (1994) for Germany, Kang and Shivdasani (1995) for Japan, and Morck, Shleifer, and Vishny (1998) for the United States. La Porta et al. (1999) defines a pyramid as “an ownership structure in which a firm has an ultimate owner and at least one publicly traded company between it and the ultimate owner in the chain of voting rights.” They define cross-shareholding as “any instance when a firm owns any shares in its controlling shareholder or in the companies along that chain of control.” According to their classification scheme, chaebols use both pyramids and cross-shareholding. In this study, we do not distinguish between pyramids and cross-shareholding, and use the term crossshareholding to denote the percentage of ownership by other public or private affiliates. See Wolfenzon (1999) for a formal model of this feature. chapter 7

1 International Monetary Fund, “Republic of Korea – IMF Standby Agreement: Summary of Economic Program,” press release, December 5, 1997. 2 The combined financial statements consolidate financial statements of all subsidiaries that are effectively controlled by one individual (see Accounting Research Bulletin, No. 51, by the American Institute of Certified Public Accounts for more details). They differ from the conventional consolidated

320

Notes to pages 191–210

3 4 5 6

7

8 9 10 11 12 13 14

15 16 17 18

statements whose consolidation criteria are based on direct equity holdings. As a consequence, several affiliates in a chaebol had reported their consolidated financial statements reflecting their own equity holdings. The combined statements require chaebols to consolidate all the affiliates that are effectively controlled by the chaebol chairmen. Kim (1999). See Balino and Ubide (1999) for more information on the operations of KAMCO and financial sector reform in Korea. See the Ministry of Finance and Economy (2000) for more information on the source of public funds and the details of its expenditures. “Financial Supervisory Board will punish Cheil Bank for resisting the acquisition of bonds of troubled companies,” Chosun Ilbo, January 5, 2001. Because many chaebols were bankrupt as of 1999, the averages for the top thirty chaebols in 1999 are for only twenty-three surviving chaebols, and the average for the top five chaebols excludes Daewoo’s ratio. Lieberman and Mako (1998), p. 63. See Solomon and Saret (1992) for more information on the corporate workout procedure. “29 Companies Were Liquidated,” Chosun Ilbo, November 4, 2000. “KDI Severely Criticizes the Government’s Restructuring Policies,” Donga Ilbo, December 9, 2000. “Big Deal Became Empty Deal after Two Years,” Chosun Ilbo, December 20, 2000. Op. cit. In December 1998, the Corporate Accounting Standards were amended to conform to international standards and a new rule for accounting of financial institutions has been enacted. In September 1999, the Korea Accounting Research Institute was founded to propose accounting standards that are in line with international practices. The proportion of outside directors on the boards of U.S. firms was 78% in 2000 (“Outside Directors,” Economist, February 10, 2001). “The Chaebols Spurn Change,” Economist, July 22, 2000. Korea Stock Exchange, press release, November 30, 2000. Giving in to the demands of the People’s Solidarity for Participatory Democracy, a nongovernmental organization, the government planned to allow anyone with one share in a listed firm with more than 2 trillion

321

Notes to pages 210–25

19 20

21

22 23

24

won in assets to initiate a class action lawsuit from the year 2002 onward. No director has been appointed through such procedures as of 2000. This survey was conducted by the Hangil Research Center at the request of the People’s Solidarity for Participatory Democracy. The survey was conducted by eighty-seven domestic fund managers and sixty-six foreign fund managers during the month of December 2000. The detailed survey results are available at http:\peoplepower21.org. The Korea Fair Trade Commission, “The Report on the 4th Unfair Internal Business Trade of the Four Largest Groups,” press release, December 15, 2000. Op. cit. The main elements of the zaibatsu dissolution program included (1) the dissolution of zaibatsu holding companies, (2) barring of old zaibatsu family members from resuming positions as company officers in the exzaibatsu enterprises, as well as (3) prohibition of the use of the traditional zaibatsu trade names and insignia. “Scourge of the Chaebol,” Economist, March 27, 2000; “This Time Around, Goliath May Strike Back,” Business Week, March 29, 1999. chapter 8

1 See Davis, Diekmann, and Tinsley (1994) for more information on the institutional factors behind the decline of conglomerates in the 1980s. 2 Bowman et al. (1999) showed that among financial, business, and organizational restructuring, only financial restructuring has been valueenhancing. Business restructuring induced mild improvements, while organizational restructuring negatively impacted performance. This pattern is similar to the Korean case, where financial restructuring had a moderate but positive impact, while business restructuring failed. An important difference is that U.S. firms used new financial instruments such as leveraged buyouts (LBOs) and management buyouts (MBOs) to swap equity for debt, which disciplined managers to run firms efficiently, whereas the financial restructuring of chaebols involved debt for equity swaps. 3 For instance, corporate raiders issued junk bonds to do LBOs of listed firms. They then took these firms private and divested most of their

322

Notes to pages 225–32

4

5 6 7 8

9

10 11 12 13 14 15

16 17

noncore assets. Sometimes the top managers of a firm took over their company in MBOs. “Daimler Taking Over Mercedes Subsidiary in Restructuring Bid,” Wall Street Journal, January 24, 1997; “Daimler-Benz’s DASA to Cut 9000 Jobs,” Wall Street Journal, October 24, 1995. “Survey: European Business,” Economist, April 27, 2000. In 1999, $393 billion of $1,500 billion worth of M&A deals were hostile takeovers. “Bidding for the Future,” Economist, February 10, 2000. “Neat but Not Yet Tidy,” Economist, September 23, 1999. For instance, Hoechst’s attempts to divest unprofitable basic chemical businesses and focus on life science were blocked by the opposition of labor unions. “Survey: European Business,” Economist, April 27, 2000. According to Dodwell Marketing (1992), 713 of 1,687 listed Japanese firms are associated with eight bank-centered horizontal keiretsu – Mitsubishi, Mitsui, Sumitomo, Daiichi Kangyo, Sanwa, Fuyo, Tokai, and Industrial Bank of Japan – or thirty-one vertical keiretsu linked with major manufacturing companies. This definition is conservative, however, because there are different definitions of group affiliation. Japanese Fair Trade Commission, 1992. “Fall of a Keiretsu,” Business Week, March 15, 1999. “Japan’s Keiretsu: Mindset,” Economist, October 23, 1999. Gerlach and Lincoln (2001) argued that keiretsu were still very much intact. “Japan’s Keiretsu: Regrouping,” Economist, November 23, 2000. Khanna and Palepu (2000) provided additional support for this conjecture. According to their study, Chilean business groups showed higher performance than independent companies from 1988 to 1992. Such performance differentials, however, disappeared after early 1990. See Khanna and Wu (1998). Critical to such markets are property rights, governance structures, and rules of exchange. Markets require stable and reliable conditions for firms in them to organize, compete, cooperate, and exchange without difficulty. In the past, national culture has produced unique social relationships within and between firms. Each country therefore had very different ownership structures, business firms, forms of competition and capital markets, and relations between workers and managers. Because of such differences,

323

Notes to pages 232–59

18

19 20 21 22

some scholars argue that global convergence is unlikely to take place (Hamilton and Biggart, 1988; Fligstein, 1997; Guillen, 2001). Rajan and Zingales’ (1998a) study showed that financial development facilitates faster economic growth and provides additional support to this argument. See Coffee (2001), p. 25. “Career Path,” Economist, April 1, 2000. “Europe’s Revolting Shareholders,” Economist, May 12, 2001. As of June 2000, there were twenty-nine Korean companies issuing ADRs.

appendixes 1 See Caves and Uekusa (1976), Nakatani (1984), and Lincoln et al. (1996) for similar approaches as applied to Japanese keiretsu. 2 An additional analysis with sales growth as a dependent variable generated weaker results than those with profitability as a dependent variable, further suggesting that profitability is a better measure of performance at the affiliate company level. The results from the same analysis using the ROA (Return on Asset) as a dependent variable are similar to those using the ROIC measure. 3 In Korea, the government provides tax credits for firms’ R&D expenses. R&D expenditures are also an important factor for securing loans from banks. Further, Korean accounting regulations allow firms to report R&D expenditures as expense items either in the income statement, in the cost of goods manufactured statement, or as a deferred asset on the balance sheet. Korean firms, therefore, have no incentives not to report their R&D expenditures in their financial statements, unless they are “immaterial.” About 22% of this study’s observations, however did not report R&Drelated expenses. The KIS database treats such cases as zero spending on R&D. See Son (1997) for more information on R&D-related tax incentives, and Choi and Choi (1998) for Korean accounting practices regarding R&D expenditures. 4 Alternatively, a random effects model, which assumes that the levels of the effects are randomly selected from an infinite population, could be used (Searle, 1971, p. 383). This model assumes, however, that individual effects are uncorrelated with other effects or other independent variables. Hausman’s specification test, which tests the equality of the coefficients

324

Notes to pages 259–95

5

6 7 8

9 10

estimated by the fixed and random effects estimators, assesses whether this critical independence assumption is satisfied (Hausman, 1978). The results suggested that this assumption is violated. Choi and Cowing (1999), using the data of Korean public firms, found that group-affiliated firms were less profitable than independent firms were during 1986–91, but the difference in profitability became insignificant during 1992–3, which is consistent with the findings presented here. This appendix is based on the published article by Chang and Hong (2000). See Rajan and Zingales (1995) for a review. Jensen (1986), on the other hand, suggested a positive relationship between profitability and leverage if the market for corporate control is efficient and forces firms to pay out cash by increasing their debt burdens. Myers (1977) argued that firms expecting high future growth should use a greater amount of equity capital. To demonstrate the robustness of our results, we reestimated the system of equations including other potential instruments such as firm sales and market share. Results from these over-identified models were generally consistent with those from just-identified models.

325

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343

Index

accountability, of chaebols, 41, 176–78, 208 Act for Monopoly Regulation and Fair Trade Promotion. See Fair Trade Act, 10 adaptation, by organizations, 34 ADR (American depository receipts), 230, 240 advertising by chaebols, 90, 92, 101, 127, 256, 265, 266, 269 expenses of, 125 aeronautics, Samsung in, 66 aerospace industry, chaebols in, 208 affiliates sales to and from, 258, 276 stock ownership of, 291, 296 agency problems, in chaebols, 170, 173, 176–85 agricultural products, Samsung export of, 65 Alcoa, 122 Allende, Salvador, 140

Allianz, 195 Allied Signal, 200 Alps Electronics, 67 aluminum cycle, 122 American depository receipts. See ADR (American depository receipts) Amsden, Alice, 49, 244, 310 (n10) Anam Group, structure and assets of, 12, 113 Ankuk Fire Insurance Company (now known as Samsung Life Insurance), 65 antibankruptcy agreement, 4 Argentina currency and debt crises in, 140, 141, 194 privatization in, 91 Asian Crisis, 3–9, 185, 246 Asian miracle, 3–9, 19 AST Research, chaebol acquisition of, 14 AT&T, 122 Austria, 141

345

Index automobiles chaebol manufacture of, 63, 64, 66, 75, 84, 86, 114, 118, 176–77, 204–5, 207, 237 chaebol overproduction of, 19–20 backward integration, 118, 124, 125, 278, 279, 280, 281, 283 bailouts, of chaebols, 57 Bank Act [rev. 1998], 314 (n8) Bank for International Settlement (BIS), 192 bank mergers, 228 Bank of America, 69, 136 Bank of Korea, 133, 189 role in financial crisis, 4 Bank of Tokyo, 228 bankruptcies of chaebols, 126, 154 in Korean crisis, 3–9, 54, 107–8 ripple effects of, 202, 204 banks chaebol ownership of, 59, 63, 74, 135–41 deregulation of, 35 financing by, 48 in Japan, 228, 233, 319 (n9) in Korea, 233–34 privatization of, 58–60, 134, 135 Bank Supervisory Board, 246 BBV, 230 BCH, 239 Bell Laboratory, 122, 312 (n7) Big Deal plan, 6, 199, 204, 206, 207, 223 block ownership, 170 board of directors, 21, 170, 172–74, 209 Boram Bank, 59, 192

brand name, chaebol sharing of, 90 Brazil, 143 Breusch-Pagan test, 268 British Telecom, 199, 201 bureaucratic control, of Korean business, 35, 48 business composition, of chaebols, 85 business groups chaebols compared to, 91, 224 conventional theories on, 28–31 definition of, 246 in developing countries, 27, 28–31, 38, 229–31 diversification of, 28, 268 formation of, 27–28 in Latin America, 91 size control of, 268 business houses (India), chaebols compared to, 24 business restructuring, 204–8 business structure, diversification of, 79–109 cable manufacturing, by chaebols, 67 CalPERS, 226 Camdessus, Michel, 3 Canada, 63, 141 capital account liberalization, in Korea, 7 capital allocation, 313 (n5) capital balance, Korean surpluses of, 17–18 capital expenditures, of chaebols, 145 capital inefficiency, Korean crisis from, 38 capital-intensive industries, chaebols as, 19, 49, 95–98

346

Index capitalism, in Meiji Japan, 25–26 capital market control, 173, 226 capital productivity, of chaebols, 18 capital structure, of chaebols, 40, 72–74, 131–60, 284–90 carbon black, LG manufacture of, 67 Carrier, 201 cash flows, in chaebols, 95–98, 145 cement, chaebol manufacture of, 49, 64 centralized control, of chaebols, 221 CGE, 225 chaebols bank holdings of, 59 bankruptcies of, 3–9, 36, 40, 157–60, 277, 317 (n7) bureaucratic control by, 35 capital structures of, 40, 72–74, 131–60 chairmanship of, 103–5, 108 corporate governance of, 40 diversification of, 19–20, 39, 48, 75 evolution of, 43–78 family control of, 158–59, 163–64, 171, 178, 183, 191, 221, 262, 295 future of, 238–44 governance structure of, 161 government relationship to, 71–72, 73 government subsidy of, 55 growth of, 38, 71–74 management of, 103–5 as networks, 309 (n23) nonbank holdings of, 61 organizational structure of, 98–105 ownership of, 40, 161–85

prior to 1997, 14–19 profitability of, 14–15 ranking of, 50 restructuring of, 41, 42, 160, 185–215, 236, 312 (n10) role in Korean economy, 9–14 schematic of, 26 structural inertia of, 31–38, 220–22 structure and assets of, 12–13, 14, 39 study of, 9–19 taming of, 231–36 in transition, 33 as universal phenomenon, 24–28 vertical integration of, 39–40, 64, 66, 75, 221 chairman of the group. See chairmen of chaebols, 171, 312 (n7) chairmen, of chaebols, 99, 163, 167, 171, 185, 209–210, 221 Cheil Bank. See Korea First Bank, 59, 192, 195, 235 Cheil Communication, 180 Cheil Industries, Inc., 65, 66 Cheil Jedang, 65, 66, 94, 99 Cheil Textile, 90, 94, 99 Cheju Bank, chaebol ownership in, 59 chemicals, chaebol manufacture of, 15, 53–57, 67, 69, 72, 75, 90–91, 102, 113, 114, 118, 120, 205–6, 221 Cheonggu, bankruptcy of, 157 Chey, Jong-Kun, 70 chief executive officers (CEOs) of chaebols, 96–97, 99, 104, 176, 209–10 diversification and, 84 of U.S. firms, 225

347

Index chief financial officers (CFOs), of chaebols, 146–47 Chile business groups in, 319 (n15) financial crisis in, 23, 140–41, 229, 230–31 China, 45, 261 business groups of, 28 as Korean competitor, 16, 76 wages in, 34 Choheung Bank, chaebol ownership in, 59, 136, 192 Chow’s F-test, 259, 282, 286 Chrysler, 228 Chun, Doo-Hwan, 57, 58, 60, 62, 70, 311 (n15) Chung, Ju-Yung, 49, 62, 63, 176, 311 (n17) Chungbuk Bank, chaebol ownership in, 59 Chung-Hee Park. See Park, Chung-Hee Chunpuk Bank, chaebol ownership in, 59 circular investment, 167–169 CitiCorp, 228 clothing, chaebol manufacture of, 68 cold war, 32, 48 Commercial Bank of Korea, 59, 136, 192 commercial banks, 194 role in chaebol restructuring, 41, 60, 192 Commercial Law (Korea), 172, 174, 315 (n5) commercial paper, 138 common law, 241 Compagnie G´en´erale des Eaux, 308 (n21)

Compa˜nia Acero del Pacifico (CAP), 230–31 competitive advantage, chaebol source of, 109 conglomerates chaebols compared to, 24–25, 38, 223, 224–27 decline of, 318 (n1) underperformance of, 41 construction, by chaebols, 63, 64, 68, 90, 113, 114, 118 consumer goods, chaebol manufacture of, 67 cooperative loans, 157 Corning, 54, 87 Corporate Accounting Standards, 317 (n14) corporate governance of chaebols, 20–21, 40, 41, 127, 147, 184 enhancement of, 208–12 corporate governance system, in Korea, 170–85 corporate sector, restructuring of, 195–208 corporate strategy, 264 corporate workout program, 203 cost of goods sold, 123, 277, 282 cost structures, vertical integration and, 123–24 CP Group, chaebol compared to, 27 creative destruction, bankruptcy as, 219 Credit Bank, 235 Creditor Banks Agreement on Accelerating Corporate Restructuring, 203 cross-debt guarantees, in chaebols, 37

348

Index cross-ownership of business groups, 28 in chaebols, 27, 101, 222 cross-shareholding in chaebols, 24, 37, 40, 58, 74, 99, 123, 126, 156, 163–64, 184, 291 in Europe, 226 mechanism of, 164–170 cross-subsidization, in chaebols, 37, 57, 107, 124–29, 149–156, 181, 238, 239, 240, 256, 274 cultural foundations, tax-exempt, 172 curb market, interest rates in, 50 currency, foreign, 71 Czech Republic, 185, 242, 243 privatization in, 24, 28 DACOM, 68 Daehan Aluminum, 129 Daehan City Gas, 167, 169 Daehan Group, rank of, 50 Daehan Telecom. See SK C&C, 181–83 Daeku Bank, chaebol ownership in, 59 Daelim Group, structure and assets of, 12 rank of, 50 Daenong Group, rank of, 50 Daesan petrochemical complex, 205, 207 Daewoo Auto Parts, 69 Daewoo Capital, 151 Daewoo Carrier, 69 Daewoo Corporation, 69, 97, 151, 154, 169 Daewoo Electronics, 69, 97, 154, 169, 207

Daewoo Futures, 137 Daewoo Group, 9, 11, 66, 69, 70, 151 bank holdings of, 59, 136 bankruptcy of, 157 debt guarantees of, 154–56 equity ownership of, 306 family members in, 109 as general trading company, 72 growth of, 310 (n9) history of, 68–69, 72 intragroup transactions in, 300–1 labor practices of, 97 management of, 104 nonbank holdings of, 61, 138, 139 power plants of, 54 rank of, 50 restructuring of, 195–96, 205, 207 shipbuilding by, 54 structure and assets of, 12, 14, 99 unfair business practices in, 152 vertical integration in, 113, 115, 127, 297 Daewoo Heavy Industries, 69, 84, 97, 151, 154 Daewoo HMS Industry, 69 Daewoo Installment Financing, 137 Daewoo Machinery, 69 Daewoo Motors, 69, 154, 205, 237 Daewoo Precision, 151 Daewoo Securities, 69, 137, 138, 139, 151 Daewoo Shipbulding, 62 Daewoo Telecom, 69, 151 Daiichi Kangyo Bank, 228 Daimler-Benz, 25, 225, 227, 319 (n4) debt, chaebol use of, 133

349

Index debt-equity ratios, of chaebols, 14, 50, 52, 74, 135, 141–46, 157, 165, 195–96, 213, 222, 223, 255, 285, 287, 314 (n20) debt guarantees, 100, 123, 153–56, 222, 257, 273, 274 Korean banks and, 40, 57, 58, 135 debt structures, of chaebols, 314 (n15) decentralization, 241 Degussa, 201 Delphi, 122, 312 (n8) democratization, 236 department stores, Samsung ownership of, 64 deregulation, by Korean banks, 35, 51, 57–61 developing countries business groups in, 27, 28–31, 38, 229–31, 309 (n24) as Korean competitors, 16 market imperfections in, 28 developmental state, of chaebols, 31, 241–44 Diamond Ad, 115 Diners Card, 151 diversification of chaebols, 19–20, 39, 48, 64, 70–109, 75, 221, 277 economic performance and, 105–9 entropy measure of, 83 group-unrelated, 267–68 measurement of, 81–84 motivations for, 84–87 unrelated, 81, 83–84 Dongah Group bankruptcy of, 157 structure and assets of, 12 vertical integration of, 113

Dongbu Group, structure and assets of, 12 Dongkuk Group, structure and assets of, 12 Dongrib Group, rank of, 50 Dongsuh Industries, 64 Dongyang Broadcasting Company, 66 Dongyang Group rank of, 50 structure and assets of, 12 Doosan Group, 46, 207, 208, 240 structure and assets of, 12 Dow Chemical, 199, 201 downstream integration, 115, 121, 129, 207 DRAMs, 206, 207 dumping, 237 Durbin-Watson statistics, 268 Eastern European countries, privatization in, 23, 28, 31 economic liberalization, 219 economic performance, diversification and, 105–9 Economic Development Plans (Korea), 53–54, 133, 142 Economic Planning Board (Korea), 48 economic reform, in Korea, 7 El Corte Ingles, 230 electronics, chaebol manufacture of, 53, 54, 64, 69, 75, 84, 86, 102, 113, 207 emerging economies, 241 entrepreneurs, chaebol founders as, 49, 310 (n10) entropy measure of diversification, 83–84, 267

350

Index environmental shift, effect on chaebols, 75–78 equity investments, of chaebols, 95, 100, 164, 257, 262, 272, 274 equity ownership of chaebols, 303, 304 of zaibatsu, 25 Erie Railroad, 232 Euro [currency], 226 Europe, conglomerates in, 224–27 European Union, 230 Evans, Peter, 62 evolutionary perspective, of chaebols, 31 export industries, 48, 50, 53, 56, 76 export subsidies, Korean eradication of, 58, 76 expropriation of minority shareholders, 238, 292 through inside trading, 178–81 through internal transfer pricing, 181–85 external labor market, chaebol use of, 72–74 Fair Trade Act, 10, 57, 58, 165, 223, 239 Fair Trade Act (1993), 154 Fair Trade Act (1994), 163 Fair Trade Act (1998), 156 Fair Trade Commission (Korea), 126–27, 128, 129, 151, 152, 154, 163, 185, 190, 211–12, 237, 238, 244, 245–46, 293, 312 (n1), 313 (n12), 315 (n1; n24) familial succession, in chaebols, 221

family ownership of chaebols, 12, 25, 26, 40–41, 108, 158–59, 163–64, 171, 178, 183, 191, 262, 295 of conglomerates, 25 Federal Reserve Bank, effects on Korean bankruptcy, 6 Federation of Korean Industries, 65, 211 Fidelity, 226 financial crisis (Korea), 3–9, 35, 37, 69, 133, 140 chaebol bankruptcies in, 157–58 as system failure, 219–20 transformation from, 223–24 financial distress, 256 financial institutions chaebol failure effects on, 158–60 chaebol ownership of, 63, 69, 102, 115, 313 (n15) nonperforming loans of, 159 financial markets, in Korea, 133–41 financial restructuring, of chaebols, 195–204 financial sector, restructuring of, 191–95 financial services, as chaebol business, 64, 66, 68, 71, 74–75, 135–41, 220, 311 (n11) Financial Supervisory Board, 203, 246, 314 (n8) fire insurance companies, chaebol holdings in, 286, 290 Five-Year Economic Development Plans, 118 Fligstein, Neil, 231–232 floating exchange rate, 6 foods, chaebol manufacture of, 64, 86

351

Index Ford Motor Company, as Hyundai supplier, 63 foreign aid, to Korea, 47 foreign capital effect on chaebols, 41, 50, 63, 76–78, 142–43, 220 effect on early U.S., 232 foreign capital attraction, to Korean stock market, 18 foreign currency reserve, in Korea, 307 (n3) foreign debts, 285 foreign direct investment, in Korea, 19 foreign exchange crises, in Latin America, 141, 194 foreign exchange crisis, in Korea, 41, 102, 107, 133, 189 foreign exchange rates, escalation of, 3, 4, 5, 7 foreign investment, in Korea, 4, 54, 133, 135–36, 190, 209, 219, 231–32 forward integration, 115, 119–20, 124, 125, 278, 279, 280, 281, 283, 297 France, 25, 225, 242 conglomerates in, 309 (n22) Franco, Francisco, 229–30 FSO (Poland), chaebol acquisition of, 14 Fuji Bank, 228

General Agreement on Tariffs and Trade (GATT), 76 general and administrative expenses, 277 General Electric (GE), structure of, 25, 176, 227

general trading companies, chaebols as, 53–57, 66, 67, 68, 70, 72, 84, 115, 311 (n13) Germany, 141, 142, 225, 226 governance system of, 21, 308 (n19) Glesjer test, 268 global competition, effect on chaebols, 36, 76, 220 global convergence, of businesses, 31, 319 (n17) Global Fortune 500 List, chaebols in, 11 globalization effect on keiretsu, 229 in Korea, 62, 69, 231, 236 GM (General Motors), 122, 225, 237 Goldfelt-Quandt test, 268 Goldman Sachs, 195 Goldstar, 67 Gould, Jay, 232 governance structures. (See also corporate governance) of chaebols, 109, 127, 161–85 governance systems. (See also corporate governance) of chaebols, 36–37, 39, 170–85, 190 definition of, 20–21 foreign investors and, 232–33 government chaebol relationship to, 71–72, 73 intervention by, in Korea, 133–35 in Korea, 237–38 restructuring policy of, 189–91, 208 Granovetter, Mark, 309 (n24) gross national product (GNP) chaebol contribution to, 10–11, 54, 56, 194, 204

352

Index zaibatsu contribution to, 25 group-affiliated companies, profitability of, 249–74 group-level advertising, 90, 92 group-level staff organization, of chaebols, 100, 104, 209 group-level strategies, 108, 109 Group Steering Committees, of chaebols, 103, 104 growth, of chaebols, 84, 86, 106 grupos economicos (Latin America), chaebols compared to, 24, 28, 91, 224 Haitai Group, 12, 157, 178 Halla Group, 12, 157 Halla Heavy Industries, 157 Hana Bank, 59, 136, 192, 195 Hanbo Group, bankruptcy of, 3, 4, 13, 20, 157 Hangil Research Center, 318 (n20) Hanglass Group, rank of, 50 Hanhwa Group, bankruptcy of, 157 Hanil Bank, 59, 136, 192 Hanjin Group, 206, 207 rank of, 50 structure and assets of, 12 Hankook Machinery, 69 Hankuk Fertilizers, 65–66 Hankuk Flange, 64 Hanil Group, structure and assets of, 13 bankruptcy of, 157 Hansol Group, structure and assets of, 12 Hanvit Bank, 192, 194 Hanwha Group, 46, 206, 207 rank of, 50 structure and assets of, 12 Hanyang Group, rank of, 50

Hausman’s specification test, 320 (n4) heavy equipment, chaebol manufacture of, 15, 53–57, 63, 64, 69, 72, 75, 84, 118, 221, 237 hedge funds, Asian bankruptcy effects on, 6 heteroscedasticity tests, 268 H&Q, 195 Hoechst, 319 (n8) Honam Oil Company, 67 Hong Kong Shanghai Bank, 235 hostile takeovers, 170, 175, 225 hotels, Samsung ownership of, 64 hot money effect on foreign exchange, 7 role in Korean crisis, 14 Housing & Commercial Bank, 59, 195, 235 human resources, sharing of, 91–95, 108 Hungary, 28, 194 Hwaseung, bankruptcy of, 157 Hynix. See Hyundai Electronics, 206, 235, 312 (n2) Hyosung Group, 12, 205 Hyundai Aluminum, 114 Hyundai Construction, 63, 64, 96, 114, 169 Hyundai Corporation, 115 Hyundai Department Store, 64 Hyundai Electric Machinery, 64 Hyundai Electronics, 64, 114, 140, 199, 205, 206, 207, 312 (n2) Hyundai Elevator, 114 Hyundai Engineering, 114, 169 Hyundai Engines, 64 Hyundai Fire and Marine Insurance, 137, 139

353

Index Hyundai Group, 9, 11, 46, 62, 66, 237 advertising by, 90 bank holdings of, 59, 136 diversification of, 64 equity ownership of, 304 family members in, 108–9 financial companies of, 137, 139 founding of, 49, 63 as general trading company, 72 growth of, 310 (n9) history of, 63–64, 311 (n16) internal transactions in, 103, 104, 297 labor practices of, 96, 108 management of, 103, 104 nonbank holdings of, 61 overcapacity of, 19–20 ownership structure of, 169 power plants of, 54 rank of, 50 restructuring of, 195–96, 205, 207, 311 (n17) shipbuilding by, 54, 64 structure and assets of, 12, 14, 99 vertical integration of, 64, 113, 114, 116–17, 118, 128 Hyundai Heavy Industries, 63, 64, 96, 114, 129, 153, 169, 205 Hyundai Industrial Development, 114 Hyundai Investment Trust, 64, 127, 129 Hyundai Livart, 64, 114, 129 Hyundai Logistics, 115, 127 Hyundai Marine & Fire Insurance, 64 Hyundai Merchant Marine, 64, 115, 121, 129, 169

Hyundai Motor, 63, 64, 96, 114, 115, 129, 169, 240 Hyundai Motor Service, 115 Hyundai Oil Refinery, 114 Hyundai Petrochemical, 64, 114 Hyundai Pipe, 64, 114 Hyundai Precision, 64, 114 Hyundai Securities, 64, 127, 129, 139, 140

imitation, by chaebols, 49 import substitute industry, in Latin America, 23, 28, 48 import substitution policy in Korea, 47 in Latin America, 29 Inchon Steel, 114 indemnity insurance companies, chaebol holdings in, 61 India business houses in, 24 chaebol plants in, 14, 69 “tunneling” in, 185 Indonesia business groups of, 27 as Korean competitor, 16, 76, 261 money crisis in, 4 Industrial Bank of Japan, 2228 inertia force, 222 inflation rate, in Korean crisis, 51 infrastructure, regulatory, 242 ING Bank, 195 inheritance tax, 171–72, 178 In-Hwoi Koo, 66 Initial Public Offering (IPO) stocks, 178 innovation, by chaebols, 49 inside trading, expropriation through, 178–81

354

Index installation financing, by chaebols, 137 insurance companies, 60 chaebol holdings in, 64, 67, 71, 74, 86, 136, 195 interaffilate loans, 149–53 interest rates of chaebol affiliates, 138 in Korean bankruptcy, 5, 6, 50, 133 internal business trade, by chaebols, 37, 38 internal capital market chaebol dependence on, 30, 40, 72, 149–56 creation of, 29 internalization, in chaebols, 38, 275 internal labor markets business groups and, 29 chaebol dependence on, 30 internal pricing schemes, 262 internal transfer pricing, 181–85 International Bank for Reconstruction and Development (IBRD), 6, 189, 191, 203, 208 international competition, 236–37 International Finance Corporation, 195 International Monetary Fund (IMF), aid to Korea by, 3, 5–6, 7, 8, 21, 32, 57, 143, 189, 190, 191, 208, 215, 237 intragroup loans, 100 intragroup sales, of chaebols, 113 intragroup transactions, among chaebols, 41, 100, 127, 297–306

investment trusts, chaebol holdings in, 60, 68, 74, 137, 286 irrationality, chaebols perceived as, 84 Italy, 184 Japan, 142, 225. See also keiretsu; zaibatsu corporate governance systems in, 171, 172, 175, 315 (n7) debt-equity ratios in, 141 as Korean competitor, 16 Korean occupation by, 48, 65, 66, 71 zaibatsu dissolution in, 212 Japanese yen. See yen [Japanese currency] Jinro Group bankruptcy of, 4, 20, 157 structure and assets of, 12 Joonang Daily News, 66, 94, 95, 96 junk bonds, 318 (n3) Kaepung Group, rank of, 50 Kangwon Bank, 59, 136, 192 Kapeul, bankruptcy of, 157 keiretsu chaebols compared to, 24, 27, 105, 171, 184, 224, 239 formation and structure of, 27, 29, 212, 223, 227–29, 310 (n1), 312 (n11), 319 (n9; n11; n12; n13; n14) Keopyung Group bankruptcy of, 157 structure and assets of, 13 KEPICO, 64, 114 Khanna, Tarun, 28–29

355

Index Kia Group, 237 bankruptcy of, 3, 4, 157 overcapacity of, 19–20 rank of, 50 structure and assets of, 12 Kia Motors, 205 Kim, Dae-Jung, 190 Kim, Eun-Mee, 36 Kim, Sung-Soo, 45 Kim, Woo-Choong, 68 Kim, Young-Sam, 62, 64 K-Mart, 225 Kobe Bank, 228 Kohap Group, 12 Kolon Group, 12, 205 Kommertzbank, 195 konzern (Germany), 25, 225 Kookmin Bank, 59, 136, 192, 195, 235 Koram Bank, 59, 69, 136 Korea, 142, 242 economic transition of, 20–24, 47–53 Japanese occupation of, 45, 46, 310 (n2) postliberation period in, 39 restructuring policy of, 189 U.S. aid to, 48 Korea Accounting Research Institute, 317 (n14) Korea Asset Management Corporation (KAMCO), 192, 193, 317 (n4) Korea Development Institute, 204, 308 (n14) Korea Exchange Bank, 195 Korea First Bank. See Cheil Bank Korea Flange, 114 Korea Foreign Exchange Bank, chaebol ownership in, 59

Korea Heavy Industries, 205, 207 Korea Investor’s Service (KIS), 245, 247, 293 Korea Mobile Telecom, 70, 72, 181 Korean Airlines, 53 Korean Fair Trade Commission (KFTC). See Fair Trade Commission. Korean Standard Industry Classification (KSIC), 83, 260, 267 Korean War, 5, 38, 46, 63 Korea Peace Bank, chaebol ownership in, 59 Korea Stock Exchange (KSE), 165, 183, 210, 236 index fall of, 4–5 Korea Telecom, 240 KOSDAQ, 236 Krugman, Paul, 19, 134, 308 (n17) Kukdong Group, 50, 157 Kukje Group disbanding of, 60, 311 (n15) rank of, 50 Kumho Group, 12 Kumkang Development, 115, 129 Kyobo Life Insurance, 138, 139 Kyungnam Bank, chaebol ownership in, 59 labor, shortages of, 53, 76 labor force, in Korea, 48, 91–95, 170 labor movement, Korean suppression of, 32, 36, 57 labor productivity, of chaebols, 18–19 labor productivity index, 19 Ladies Professional Golf Association (LPGA), 90

356

Index La Porta, Rafael, 141, 170, 184, 316 (n17) late development theory, of chaebols, 30–31 Latin America, 48, 91, 242. See also grupos economicos business groups in, 29, 72 currency and debt crises in, 23, 141 foreign exchange crises in, 141, 194 privatization in, 31 LCD, 237 Lee, Byung-Chul, 47, 49, 62, 64–66, 99, 176 Lee, Jae-Yong, 178, 180 Lee, Kun-Hee, 178 Leff, Daniel, 29 leverage, of chaebols, 256, 267 leveraged buyouts (LBOs), 318 (n2; n3) LG Allied Signal, 199 LG Cable, 67 LG Caltex-Oil, 67, 96 LG Chemical, 67, 84, 96, 169, 200, 211 LG Electronics, 67, 84, 96, 169 LG Energy, 201 LG Fire Insurance, 139 LG Group, 9, 47, 71, 237 bank holdings of, 59 equity ownership of, 305 family members in, 109, 211–12 financial companies of, 137 as general trading company, 72, 84 growth of, 310 (n9) history of, 66–68 intragroup transactions in, 299 labor practices of, 96, 97

management of, 103, 104 nonbank holdings of, 61, 139 ownership structures of, 169 rank of, 50 restructuring of, 195–196, 199, 200–1 structure and assets of, 12, 14, 99 vertical integration in, 113, 115, 127, 297 LG Honeywell, 199, 201 LG Industrial Systems, 201 LG Information Communication, 67 LG Instruments, 67 LG International, 67 LG Investment Trust, 68 LG LCD, 201 LG Marine and Fire Insurance, 67 LG Merchant Bank, 68 LG Polychemical, 67 LG Securities, 68, 139 LG Semiconductors. See Hynix, 68, 205, 206, 207 LG-Shipley Co., 200 LG Telecom, 68, 201, 211 liberalization of foreign investment, 78 by Korean government, 58, 62, 75 life insurance companies, chaebol holdings in, 61, 137, 139, 140, 286, 290 liquidity, of chaebols, 256, 266–67 liquor business, chaebols in, 178 Livart. See Hyundai Livart loan(s), to chaebols, 129, 136, 149–53, 158 logistics, of chaebols, 86 London Stock Exchange, 243–44 Long-term Capital Management, Asian bankruptcy effects on, 6

357

Index Long-term Credit Bank of Korea, 192 long-term debts, 285 Lotte Group, 12, 50 Lucent Technologies, 122 machinery, chaebol manufacture of, 86, 102 Mahathir bin Mohamad, 307 (n8) main banks system (Japan), 175 management buyouts (MBOs), 318 (n2; n3) Mannesmann, 226 market imperfections, effects on chaebols, 37 market share, 277, 278, 279, 280, 281 Maxter, chaebol acquisition of, 14 McArthur, Douglas A., 212 media holdings, of Samsung, 64 Meiji Renovation Era, zaibatsu formation in, 25 merchant banks, chaebol holdings in, 60, 74, 137, 138, 286 mergers and acquisitions of chaebols, 209 in U.S., 224 Metlife, 195 Mexico, 141, 143 Middle East, chaebol construction in, 68 minimill technology, 20 Ministry of Finance, in Korea. See Ministry of Finance and Economy, 22, 133, 134, 183, 169, 314 (n10) minority shareholders in chaebols, 37, 41, 86–87, 101, 107, 142, 170, 181, 184–85, 208, 210, 241, 314 (n18)

expropriation of, 238, 292 rights of, 174–175, 214 Mitsubishi Bank, 228 Mitsubishi Group, family ownership of, 25 Mitsubishi Motors, 228 Mitsubishi Oil, 228 Mitsubishi Real Estates, 228 Mitsui Bank, 228 Mitsui Chemical, 228 Mitsui Group, 25, 228 Mitterand, François, 25 Miwon Group, structure and assets of, 12 Mongolia, 45 monopolistic profits, of chaebols, 51 Moody’s, 245 moral hazard, of chaebol bailouts, 57, 134, 313 (n4) multicollinearity tests, 269 multidivisional structure, of chaebols, 99–103 multinational corporations business group alliances with, 29, 91 chaebols and, 29 in U.S., 100 mutual debt guarantees, of chaebols, 74 mutual funds, 225 Nasan, bankruptcy of, 157 NASDAQ, 227, 236 NEC, chaebol venture of, 54, 94 networks, chaebols as, 309 (n23) Neuer Markt, 227 Neuveau March´e, 227 Newbridge Capital, 195, 235 Newcore Group, 12, 157 New York Life, 195

358

Index New York Stock Exchange (NYSE), 241–42 Nikko Securities, 228 Nippon Mining, 199, 201 Nippon Oil, 228 Nippon Trust, 228 Nissan, 177, 228 nonferrous metals, manufacture by chaebols, 53 nongovernment organizaitons (NGOs), 214 OEM (original equipment manufacturing), of chaebols, 49 Office of Chairman, 99 Office of Secretaries, 99, 100, 102 oil refining, as chaebol industry, 49, 205 oil shocks, effects on Korean industries, 54, 56 Okpo Shipyard, 69 operating efficiency, of chaebols, 105–7 ordinary least squared (OLS) regressions, 268, 294, 295 organizational structures, of chaebols, 98–105 organizational ecologist, on adaptation, 34 OTIS, 199, 201 outsourcing, 121 overcapacity, of chaebols, 57 ownership structure, of chaebols, 161–85, 297–306 Palepu, Krishna, 29 Park, Chung-Hee, 47, 53, 57, 68, 133, 135 Park, Heung-Sik, 45 Park, Seri, 90

patrimonial logic, of chaebols, 30 pension funds, 225 People’s Solidarity for Participatory Democracy, 78, 214, 233, 236, 317 (n18), 318 (n20) per capita income, of Korea, 3 Perez Companc, 91 performance, vertical integration and, 123–124 personnel, intragroup transfer of, 122 petrochemicals, chaebol manufacture of, 53, 64, 66, 205, 206 petroleum industry, chaebols in, 67, 207 Philip Morris, 225 Philips, 199, 201, 237 Pinochet, Augusto, 140 Pitch IBCA, 192 plastic goods, chaebol manufacture of, 67 Plaza Accord (1985), 60 Poland, 24, 69, 242 portfolio diversification, in business groups, 28 portfolio investment, in chaebols, 78 PowerGen, 199, 201 power generation machinery, 207 power plants, chaebol development of, 54 precision machinery, chaebol manufacture of, 66 presidents’ meetings, 103–105 principal-agent problems, 172 privatization, 242 in Korea, 21–22, 51, 53, 58 in Latin America, 91 productivity indices, 308 (n16) professional managers, 239–40, 291

359

Index

Quantum Emerging, 195

return on invested capital (ROIC) of chaebols, 14, 123, 255, 282, 288 of U.S. firms, 308 (n15) reverse causality, 183–84 Rhee, Syngman, 47 Rho, Tae-Woo, 58, 60, 62, 71 risk aversion, by chaebols, 84, 134 Rockerfeller Center, 228 Rohm & Haas, 199 Romania, 14, 69 Royal Philips Electronics. See Philips Rumelt, Richard, 81, 83 Russia, 45, 242 Asian economy effects on, 6 privatization in, 24

railroad vehicles, 205, 207 random effects model, 320 (n4) R&D. See research and development (R&D) real estate, chaebol holdings of, 58 reception of debt guarantee, 285 Regent Pacific, 195 regression analyses, 282 related diversification, 278 relief funds, 134 Renault, 66, 228 research and development (R&D), by chaebols, 87, 101, 106, 121, 124, 125, 255, 260–61, 265, 269, 275, 283, 320 (n3) resource-based theory, 264 resources, allocation of, 51 resource sharing, 87–98, 107 restructuring, of chaebols, 41, 42, 109, 187–215, 223 retailing, chaebols in, 63, 84 Return on Asset (ROA), 320 (n2)

Sachs, Jeffrey, 6, 307 (n4) Saehan Motors, 69, 204–5 Sakura Bank, 228 sales growth, 286, 293 Salim Group, chaebols compared to, 27 Sambo Securities Company, 69 Samsung Advanced Technology Institute, 87 Samsung Aeronautics, 66 Samsung Construction, 90 Samsung Corning, 66, 87, 118–119 Samsung Corporation, 65, 90, 94, 95, 96, 169, 177 Samsung Credit Card, 66 Samsung Display Devices. See Samsung SDI. Samsung Electro-Mechanics, 66, 87, 95, 120 Samsung Electronics, 66, 84, 86, 87, 94, 95, 96, 107, 120, 177, 180, 214, 240

profitability of chaebols, 14–15, 86, 106, 247, 255–56, 291–96 leverage and, 321 (n9) promissory notes, 138, 287 Prudential, 195 public companies (Korea), 106, 260, 286 profitability of, 252–53 punctuated equilibrium, in organizational change, 34 Pusan Bank, chaebol ownership in, 59 pyramid structure, of shareholding, 184, 316 (n17)

360

Index Samsung Engineering, 90, 180 Samsung Everland, 95, 180 Samsung Fire Insurance, 138, 139 Samsung Group, 9, 11, 20, 46, 47, 62, 205, 237 advertising by, 90, 92–93 bank holdings of, 59, 136 cross-shareholding in, 156 diversification of, 176–77 equity ownership of, 303 family members in, 109, 153, 178 financial companies of, 137, 139 founding of, 47, 49 as general trading company, 72 growth of, 86, 100, 310 (n9) history of, 64–66, 71, 311 (n18), 312 (n5) intragroup transactions in, 178–80, 298 labor practices of, 94–98, 100, 101 management of, 103, 104, 105, 176 multidivisional structure of, 99, 100, 101–2 nonbank holdings of, 61 organizational structure of, 102 ownership structures of, 169 rank of, 50 restructuring of, 195–96, 205, 207 sales composition of, 86, 87, 88–89 shipbuilding by, 54 structure and assets of, 12, 14 vertical integration in, 113, 115, 118, 127, 128, 297 Samsung Heavy Industries, 66, 90, 95, 177 Samsung Life Insurance, 65, 90, 137, 138, 139, 153, 169, 180

Samsung Merchant Banking, 66 Samsung Motors, 66, 94, 95, 96, 98, 107, 176–77, 205, 207, 237 Samsung Petrochemical, 66, 90 Samsung SDI, 66, 87, 95, 118, 120, 177 Samsung SDS, 90, 180 Samsung Securities, 66, 138, 139, 287 Samsung Semiconductor. See Samsung Electronics, 66 Samsung Shipbuilding, 66 Samyangsa, 45 Samho Group, rank of, 50 Sanyo, chaebol venture of, 54 Saudi Arabia, 70 Schrempf, Jurgen, 225 Schumpeter, Joseph, 219 scope, economics of, 84 Securities and Exchange Act, 210 Securities and Exchange Commission, in Korea, 174–75, 242 securities and exchange commissions, in Europe, 243 securities companies, chaebol holdings in, 60, 61, 64, 68, 74, 136, 138, 286 Securities Transaction Law, 315 (n5) semiconductors, chaebol manufacture of, 54, 66, 68, 86, 114, 176, 199, 205, 207 seniority-based promotion, 101 Seoul Bank, 192, 194 Seoul Investment and Trust, 151 shareholder activities, effect on chaebols, 78 shareholders expropriation by, 184–85 legal rights of, 172

361

Index shareholder value, maximization of, 84 Shinhan Bank, chaebol ownership in, 59, 136 Shinho Group, structure and assets of, 12, 157 Shinjin Group, 50 Shinsegae, 66 shipbuilding, by chaebols, 53, 63, 64, 66, 75, 86, 114, 176, 207 shipping, chaebols in, 64 short-term debt, 62, 146, 149 short-term speculative funds, 78 Siemens, diversification of, 25 single business, diversification of, 83 SKC, 97, 120, 167 SK Capital, 169 SK C&C. See Daehan Telecom, 181, 182 SK Chemical, 70, 84, 97, 120, 167 SK Construction, 70, 167, 169 SK Corporation, 70, 120, 167 SK Distribution, 181, 182, 183 SK Energy Sale, 167, 169 SK Gas, 70, 97, 167 SK Global, 70, 167, 169 SK Group, 9, 11, 46, 47 bank holdings of, 59 family members in, 109, 167 financial companies of, 137 as general trading company, 72 history of, 70–71 intragroup transactions in, 302 labor practices of, 97 management of, 103, 104 nonbank holdings of, 61 rank of, 50 restructuring of, 195–96

structure of, 99 vertical integration in, 113, 127, 128, 297 SK Insurance, 71 SK Oxychemical, 70, 167 SK Securities, 139, 167, 169 SK Shipping, 70 SK Telecom, 70–71, 167, 169, 170, 181, 183, 214, 262 cross-subsidization of, 129 sociocultural environment, of Korea, 30, 31 sogo shosha, Korean companies modeled after, 56 S-one, 180 South America. See also grupos economicos Asian bankruptcy effects on, 6 South Asia, wages in, 34 Southeast Asia, business groups in S&P. See Standard & Poors (S&P) Spain, 141, 229–30 spin-offs, 209 Ssangyong Group, 12, 50, 205 standard of living, Korean improvement of, 7 Standard & Poors (S&P), 195, 245 state bureaucracy, role in Korean economy, 35–36 steel manufacture, by chaebols, 53 stock exchanges chaebols listed on, 106, 127, 183 cross-national, 233 stock market, in Korean crisis, 7, 17, 78, 185 strategic business unit (SBU), 29, 265 strategic effectiveness, of chaebols, 107, 109

362

Index strategic industries, in Korea, 133 structural inertia, of chaebols, 31–38, 220–22 subsidization. See also cross-subsidization of chaebols, 127, 189 Sudan, 69 sugar, chaebol production of, 65 Sumitomo Bank, 228 Sumitomo Chemical, 228 Sumitomo Group, family ownership of, 25 Sungwon Construction, bankruptcy of, 157 Sunkyung Group. See also SK Group structure and assets of, 12 Sweden, 184 synergies, of chaebols, 37, 39, 87, 95, 106, 185, 189 synthetic textiles, chaebol manufacture of, 49 Taechang Group, rank of, 50 Taegu Bank, 136 Taegu Department Store, bankruptcy of, 157 Taiyo Bank, 228 tariffs, removal of, 76 tax credits, for chaebols, 86 Technical Assistance Loans, 203 technology, chaebol transfer of, 310 (n10) telecommunications, chaebols in, 68, 70–71, 86 television products, chaebol manufacture of, 87 tender offers, 209 textiles, chaebol manufacture of, 86

Thailand business groups of, 27 money crisis in, 3–4 “three low” economic boom, 263 Tiger Economies, 3 Tiger Fund, 214 Tongil, bankruptcy of, 157 trade wars, Korea as target of, 57 trading companies, chaebol use of, 25 transfer-pricing schemes, of chaebols, 41, 126 tunneling, 185 underdeveloped markets, business group role in, 28 unfair business practices, of chaebols, 211–12, 313 (n12) United Kingdom, 241, 242 debt-equity ratios in, 141 United States, 242 aid to Korea by, 65 Asian bankruptcy effects on, 6 conglomerates in, 24–25, 224–27 corporate restructuring in, 212 debt-equity ratios in, 141 governance systems in, 21, 171, 174, 184 Hyundai exports to, 63 unrelated diversification, 278 upstream integration, 121 Uruguay, currency and debt crises in, 23 Uzbekistan, chaebol plants in, 14 value creation, in chaebols, 39 Vanderbilt, Cornelius, 232 venture capital firms, chaebols as, 95

363

Index vertical integration advantages of, 118–21 of business groups, 28 of chaebols, 39–40, 64, 66, 75, 81, 83, 111–29, 189, 221, 274, 275–83 definition of, 113 disadvantages of, 39, 121–23 performance implication of, 123–29 Vietnam, 69 Vivendi, 225, 227 Vodafone, 226 Volvo, 237 W. R. Grace, 225 wages, of Korean workers, 16, 34, 57–58, 261 Welch, Jack, 176 welfare issues, in Korea, 58 wholesaling, chaebols in, 84 windfall profits, 46

won [Korean currency], 47, 63 overvaluation of, 4, 7, 16, 17, 18 woolen goods, Samsung production of, 65 World Bank, 3, 32, 57 World Trade Organization (WTO), 76, 237 World War II, 25, 27, 76, 223 Yasuda, family ownership of, 25 yen [Japanese currency] depreciation of, 16, 17, 38 Plaza Accord and, 60 Yukong. See SK Corporation, 70, 72 zaibatsu chaebols compared to, 24, 25, 38 dissolution of, 27, 212–13, 223, 318 (n23) growth of, 27 Zenith, chaebol acquisition of, 14

364