08 September 2015

Korea, the "chaebol republic"

Korea’s chaebol. the family conglomerates that dominate the economy, are now holding back the country from realising its full potential, argues John West.

Heather Cho, Vice-President of Korea Air, provoked a storm when she delayed the takeoff of a Korean Air flight in December 2014, over her dissatisfaction with the service of macadamia nuts. This ridiculous incident reminded the whole world that Korea is not a people's republic. It is still a "chaebol republic".

Today, the dominant role of Korea's chaebol (large and sprawling, family-controlled conglomerates) in the nation's politics, economy and society is seriously questioned by many -- and not just because of the "nutgate" incident. But it is still without question that the chaebol played a crucial role in Korea's rags-to-riches development miracle.

Miracle on the Han River

The "miracle on the Han River" was perhaps the most unlikely of all the Asian economic miracles. The three-year Korean War, which ended in 1953, killed 2 1/2 million of the combined population of North and South Korea of 30 million. The peninsula's infrastructure of roads, buildings, bridges and so on was almost completely destroyed. And one-third of the population were left homeless.

At the end of the 1950s, Korea's situation still remained bleak, under the corrupt and authoritarian leadership of President Rhee. GDP per capita was well below $100 a year, worse than many Sub-Saharan African countries, and even worse than North Africa, while life expectancy was a mere 54 years.

Then, in the space of the two decades, the 1960s and 70s, President Park Chung-hee, the father of the current Korean president, laid the foundations for the comprehensive transformation of the Korean economy, society and politics through his “guided capitalism”.

President Park was no believer in free markets or democracy. On the contrary, he was a ruthless dictator who came to power in 1961 following a military coup. He corralled the nation's leading businessmen into his economic development project. They were offered access to cheap finance and foreign technology, protection from imports and foreign investment, export subsidies, tax breaks, cheap labour and other favours, if they would develop industries like fertilisers, cement, chemicals, oil refining and textiles.

Anti-competitive behaviour like cartels, collusion and price-fixing were also tolerated. And corruption was widespread, as it still is today. Today, Korea ranks 43rd on Transparency International's Corruption Perceptions Index, way below Japan's 15th place.

These companies, the chaebol (meaning group or party of wealth or fortune), were also pressured to succeed on export markets, the ultimate test of their efficiency. The chaebol drove Korea’s export-oriented development, and played a crucial role in transforming Korea into a “Asian miracle” economy.

The government also supported development in other ways. Massive investments were made in education, and infrastructure (usually subcontracted to chaebol). In 2012, Korea ranked 5th of the 64 countries in the OECD's PISA program (Programme for International Student Assessment), which measures performance of 15-year old students in mathematics, reading and science. And today Korea has the world's 14th best infrastructure, according to the World Economic Forum.

Korea matures

Those who live by the sword, all too often die by the sword, and President Park was assassinated in 1979. But his ruthless economic nationalism put the country on an irreversible path to prosperity. It also paved the way for democracy.

Korea's political space was always contested, notably by two individuals who would become president in the 1990s, Kim Young-sam, and Kim Dae-jung. And protests by Korea's well-educated students were a recurrent feature. In 1987, in the midst of widespread student and trade union protests, designated presidential successor Roh Tae-woo made the historic decision to hold elections, which he won.

Ever since, Korea has held free and fair elections, with peaceful transfers of power. Today, Korea is ranked a "full democracy" by the Economist Intelligence Unit, and is placed 21st in its Democracy Index, only two places behind the US, and two places ahead of France.

Korea's dramatic transformation would earn it OECD membership in 1996. Coincidentally, within a year, Korea would be a victim of the "Asian financial crisis". The chaebol had gone an international borrowing spree, ignoring the risks of short-term, dollar-denominated debt. When international lenders then lost confidence in the Asian-miracle hype of the time, and withdrew their capital, Korea was left in financial crisis.

Due to the harsh bailout conditions, most Koreans still today refer to it as the "IMF-crisis". Blaming outsiders for domestic problems is typical of highly nationalistic countries. But Korea recovered very quickly from the financial crisis. And the imposed reforms, notably for corporate governance, opening to foreign direct investment (FDI), and deregulation laid the foundation for a return to strong economic growth.

One of the great advantages of any crisis is the opportunity for reform. Crises can enable strong leadership to break the back of vested interests, and mobilise public opinion to support change. But the risk is, especially as in the case of Korea, that when the crisis passes, the chaebol vested interests can regroup and reassert the influence over national policy making.

Korea's chaebol have since continued to power the economy forward. Electronics giant Samsung has been the star, and is now ranked the world's 7th most valuable brand by Forbes magazine, on a list headed by its nemesis, Apple. But Samsung is not the only one. Automobile companies, Hyundai and KIA Motors are ranked 64th and 97th respectively.

The chaebol completely dominate the Korean economy, with Samsung accounting for one-fifth of Korea’s exports, and the 30 biggest chaebol for over four-fifths of exports. The chaebol’s penchant for empire-building is symbolised by Samsung’s 70 subsidiaries, which cover a vast array of unrelated industries like electronics, insurance, shipbuilding and petrochemicals. But they have been successful in upgrading the Korean economy from a producer of low-end manufactures to high-tech electronics and automobiles.

Overall, in the three decades from the early 1960s, the Korean economy achieved average annual growth rates of 8%. Korea was able to defy both history and geography (it is a resource-poor mountainous country) to become the world’s 15th largest economy and 7th biggest exporter. But this strategy has led to a lopsided economy, where service sector productivity is less than half that of the manufacturing sector. And while the government used the chaebol to create an economic miracle, the government created a monster more almost powerful than itself.

Korea’s challenges

Despite Korea’s stunning success, the country has caught some of the "diseases" afflicting other advanced countries in Asia and elsewhere, even while its very impressive GDP per capita in purchasing power parity terms of $33,000 is still only 60% of that of the US. Indeed, Korea’s GDP per capita remains well below those of Hong Kong, Singapore and Taiwan, its fellow Asian tigers, none of which are as dominated by big conglomerates as Korea is.

Korea has been a "copycat nation", like catchup economies the world over. And despite its great success, Samsung has certainly been a copycat company. While absorbing technology and knowledge from the rest of the world is important during the catchup phase of development, it is necessary to become an innovation nation to reach the levels of world leaders. The limitations of Korea’s continuing copycat approach is evident in that, today, Samsung’s success in the mobile phone sector is being challenged by another copycat company in the form of China’s Xiaomi, while the more innovative Apple is holding on to the high end of the market, even in China.

Korea has great potential to become an innovation nation. It has invested greatly in information technology, and is now ranked second in the world, after Denmark, in the ICT Development Index of the International Telecommunications Union. Koreans also have a great passion for studying English, the language of the global economy. And the birth of “Korean Cool” is evidence of a very creative culture. The “Korean wave” of K-pop, television drama and cinema has conquered East Asia, and is now spreading its wings further afield.

Overall, Korea has much to do to foster a creative and innovative economy. The OECD identifies particular weaknesses in the areas of international collaboration, the role of universities, venture capital, and openness to domestic and international competition.

Korea's national obsession with education and credentialism needs reorientation to foster a more innovative culture. School and university students are too focused on rote-learning, memorisation and passing exams, rather than critical thinking, creativity and analytical skills. Korea's education elitism also places too much emphasis on university qualifications. Parents and their children need to get over their social stigma associated with vocational education and training, as it can provide critical skills for the market economy and undoubtedly suits the aptitude of many of Korea’s youth.

Another challenge is that Korea’s fertility rate has fallen to 1.4 children per woman, well below the “replacement rate” of 2.1, Korea’s fertility rate is even lower than China’s, despite the latter’s one-child policy. Many families can only “afford” to have one child, in part due to the very high cost of the country's education obsession. The upshot is that Korea is facing massive costs of a very rapidly ageing population (it has the fastest ageing population among the advanced OECD countries). Korea’s workforce will start declining from 2017, and overall population decline could set in from the year 2035.

In contrast to Japan, Korea has at least had the wisdom to open up significantly to immigration, with the share of foreigners in the total population increasing from 0.1% to 2.0% from 1990 to 2013. Regrettably, however, in today's Korea where many still believe in the purity and superiority of the Korean race, foreigners still suffer from great discrimination (as they also do in Japan). Even refugees from North Korea, visible by the stunted size, are also subject to discrimination.

One area where Korea performs even worse than Japan is in its treatment of women. Women still face immense discrimination in all walks of life, be it business, government or the family. Korea ranks an appalling 117th in the world in the World Economic Forum's Global Gender Gap Index.

As Korea has opened up more to foreign investment, multinational companies have been hiring Korea’s very talented women. One can only hope that Korean companies will follow suit. One part of the solution to Korea's demographic challenges is to offer more opportunity to the country's women. Anyone who doubts the ability of Korean women need only look at the Ladies Professional Golf Association rankings which are completely dominated by Korean lady golfers.

Korea has experienced a marked rise in income inequality and relative poverty since the 1997 financial crisis. Income inequality is the tenth highest of the 35 OECD member countries, while Korea’s relative poverty rate of 15% is the 8th highest of the OECD. This is a complete turnaround from Korea’s “growth with equity” in the decades leading up to 1997, as the effects of globalization, technological progress, population aging and low public spending take their toll. Social cohesion has quickly become a major challenge for Korea’s seemingly homogeneous society.

Another prospective challenge Korea faces is the possibility of reunification with North Korea which could be dramatic, unpredictable (especially regarding China’s posture) and very costly. After 60 years of separation, the majority of South Koreans are not so keen on the prospect of a costly reunification. But if and when the time comes, they may not have much of a choice.

The chaebol and Korea’s future

The ability of Korea to complete its catchup to the levels of North America or Northern Europe will depend on its ability to tackle these many challenges, and in particular to substantially lift its productivity. This will be a daunting challenge as Korea’s economic miracle has been driven much more by increasing inputs of capital and labor, rather than productivity.

Following their undoubted contribution to the liftoff of the Korean economy, would the continuing dominance of the chaebol be an asset or liability looking ahead?

Overall, the evidence suggests that the chaebol’s dominant position, and continued favoured treatment are stifling Korea’s quest to become a creative and innovative nation, and to catchup to the world’s leading economies. For example, there have been no new leading chaebol since the 1970s, a period during which the US has seen the creation of Apple, Google, Amazon, Facebook and a host of other successful companies. Even conservative old Japan has seen the rise of new global companies like Softbank, Uniqlo and Muji since that time.

Also, while Korea is much more open to international trade and investment than it used to be, there is still much to be done to eliminate such barriers and expose the chaebol to more healthy international and domestic competition. Korea’s restrictions on inward FDI are higher than the OECD average, according to the OECD's FDI Restrictiveness Index. Korea also has one of the worst scores on the OECD's Product Market Restrictiveness Index, which measures state controls on the economy, barriers to entrepreneurship, and barriers to trade and investment.

According to the US State Department, FDI into Korea “is still at times hindered by insufficient regulatory transparency, including inconsistent and sudden changes in interpretation of regulations, as well as underdeveloped corporate governance, high labor costs, an inflexible labor system, and significant economic domination by large conglomerates, or chaebol”.

In addition, it notes that “the practical impact of Korea's laws and policies regulating monopolistic practices and unfair competition, however, has been limited by the long-standing economic strength of the chaebol … Chaebol-government relations can also sometimes influence the business-government dialogue, to the detriment of foreign and small and medium-sized enterprises (SMEs).”

Despite the reforms following the Asian financial crisis, Korea’s corporate governance is still among the weakest in Asia, with complex webs of cross-shareholdings and pyramidal chaebol shareholdings, which enable owner families to exert control, but inhibits its economic efficiency and innovation performance. The Asian Corporate Governance Association (ACGA) ranks Korea only equal 8th with China on its list of 11 Asian countries, behind Hong Kong, Singapore, Thailand, Japan, Malaysia, Taiwan and India, and ahead of only the Philippines and Indonesia.

"Korea is held back by a lack leadership on corporate governance policy by the Park administration, a failure to progress with legislative amendments, weak corporate governance culture among the chaebol, and constant rotation of officials responsible for financial regulation,” according to Jamie Allen, ACGA Secretary General.

Lax enforcement of corporate governance policies has been identified as a major problem. The takeover of Samsung C&T by holding company Cheil Industries, another part of the Samsung Group, is one such example. The move was seen as a crucial step for the consolidation by Samsung’s founding family of its control of the chaebol, at a time when a new generation leader is taking over the chaebol’s leadership.

Over the years, there have been a series of chaebol scandals related to various financial crimes. Seven of the leaders of Korea’s ten largest chaebol, including chairmen of Samsung, Hyundai Motors and SK have been convicted of crimes such as breach of trust, corruption, embezzlement and large-scale accounting fraud. While prosecutions and court cases follow, they invariably lead to official pardons, thanks to the corrupt and cosy ties between the chaebol and government. But as was evident in the 2014 tragic sinking of the Sewol ferry, collusion between government regulators and regulated industries can contribute to great tragedies.

Chaebol leadership succession is still very much a family affair, rather than based on meritocracy, and some of the new (third) generation of leaders are of the petulant variety, like Korea Air’s Heather Cho, whose father is the company’s Chairman. In sharp contrast to Korea, successful new generation Japanese companies like Softbank and Uniqlo are deliberately grooming outsiders for the leadership succession, in recognition of the fact that family nepotism usually doesn’t work.

Another factor concerning the chaebol is their internal management style, which is reportedly “top-down, authoritarian and paternalistic”. Top-down decision-making means that there is little transparency inside the chaebol, and there are low levels of institutionalised trust and delegation, as Michael Witt argues. Seniority-based pay remains the norm, rather than a performance-related system.

The chaebol have been a major source of “structural inertia” in the Korean economy, argues Michael Witt. Enterprise creation remains low in Korea. The continued dominance of the chaebol stifles on entrepreneurship, as they can use their market power to make it difficult for new entrants to gain a foothold, as business consulting firm EY has argued. Even when new entrants do succeed, they are often acquired in takeovers by chaebol. Against that, recent market reports suggest that a burgeoning startup scene may be bubbling up.

The Korean public is also a part of the “chaebol problem”. They may find the arrogant, high-handed behaviour of the “chaebol aristocracy” like Heather Cho unacceptable. Yet most parents will dedicate their lives to trying to prepare their children for a job in a chaebol, especially through academic success. The most prestigious job in Korean society is still one in a chaebol or in government, rather than starting your own business. Today’s youth generation and their parents are risk averse and fearful of failure. And Korea’s fascination with the chaebol sees some of their leaders treated like celebrities, subject to scandalous gossip, and portrayed in television soap operas.

A second miracle on the Han River?

It is widely acknowledged that the Korean economy needs a more level playing field, and that the chaebol should be brought to heel. Various governments have made some efforts to do so under the banner of economic democratisation, but to little effect. Given their economic dominance, it is easy for the chaebol to scaremonger about the possible adverse effects of any reforms.

When President Park Geun-hye took office in February 2013, she called for a “second miracle on the Han River”. One year later, she announced details of a Three-year Plan for Economic Innovation, with a view to fostering a creative economy, promoting social cohesion and boosting the employment rate.

But as the OECD noted rather diplomatically, “The Plan addresses many longstanding problems in the Korean economy that have not been resolved due to strong resistance from interest groups”. Like the OECD, we can only hope that the personal commitment of the President will lead to greater success in the future. Otherwise the "hermit kingdom" will become another Asian country that achieves moderate success, but is unable to realise its full potential by catching up to world leaders.
Tags: asia, korea, corporate governance

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