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South Korea’s industrial conglomerates, the chaebol, were once seen as a driving force behind that country’s high rates of economic growth. At the beginning of the 1997 economic crisis, optimists saw them as the engine that would pull South Korea out of its doldrums. Indeed, about 40 chaebol still account for about 80 percent of GDP and 50 percent of exports, even though most of them face difficult financial straits.

It is ironic that leaders in Beijing once considered the “Korean model” to resolve China’s restructuring problems. However, the chaebol are the product of institutional arrangements that led to South Korea’s economic crisis. As such, they are the problem, not the solution. They are part of the past, not the future.

Government involvement in directing economic development encouraged the concentration of industrial production. Favored treatment from the government caused the chaebol to overexpand, including into areas where they had no experience or comparative advantage. In particular, encouraging the establishment of and support for the chaebol led to increased inefficiency through the cartelization of the domestic economy. In turn, these conglomerates began destroying shareholder value with impunity as they focused on market share and expansion instead of profits.

South Korea’s economic crisis arose from problems for which there are no simple economic solutions. Decades of interventionist policy have thoroughly corrupted the political system and stimulated a high degree of cynicism and contempt for political processes. Political order and economic recovery require that the chaebol be stripped of all their privileges.

South Korea, the world’s ninth-largest economy, recorded 13 percent growth the fourth quarter of 1999, but its economy is not out of the woods — not by a long shot. Exports are booming, but there are continuing concerns about the domestic sector, which is the largest component of the economy.

After an impressive and encouraging runup, share markets are now down by about 30 percent for the current year, including a recent drop of precipitous proportions. And once again, blame is laid at the feet of the chaebol. This time, the Hyundai Group is the culprit, but it is not the only mischief-maker.

It all goes back to the Byzantine business arrangements of South Korea’s financial and corporate interests. When domestic banks were brought to their knees by the chaebol’s bad debts, depositors moved their assets to investment-trust companies. These were then tapped by the capital-destroying chaebol, doubtless because of their extensive cross-shareholdings with the ITCs. Once again the entire financial system has been put at risk because the commercial banks hold much of the debt of the investment trusts.

There has already been an infusion of 100 trillion won from public-sector funds to local banks; at least another 30 trillion is expected to go to the ailing ITCs. The trusts have been hemorrhaging money over the year as a result of a collapse in confidence.

Daewoo’s collapse was a significant factor in the 5 trillion won in losses recorded by South Korea’s banks in 1999. Daewoo had been the second-largest chaebol and collapsed under the weight of its $78 billion debt, $20 billion more than the bailout provided by the International Monetary Fund in 1998 for the entire country.

An asset management fund, the Korea Asset Management Corporation has purchased bad debts with a face value of about 75 trillion won ($66 billion). It has recouped about 14 trillion won by re-selling them.

There are signs that government intervention in the banking system to prop up failing companies will stop: That is the message in the announcement that deposit insurance will be limited to 20 million won starting next year. It remains to be seen whether the political will can be mustered for the debt writeoffs and liquidation of insolvent firms that will lead to rising unemployment. But all are necessary before there can be the net inflow of capital that is needed for the recapitalization of the banking system.

A domestic-currency bond market must emerge so that local companies will not be as dependent on foreign-currency bond markets. Many of the problems associated with the 1997 crisis arose from companies being unable to meet debt payments after the won was devalued.

Increased transparency and accountability will arise through limiting subsidized lending within chaebol groups and by ending the reliance upon bank lending. When corporate lenders are forced to turn to domestic capital markets, they will encounter lenders that are constantly reassessing the credit worthiness of each borrower.

Recent steps have boosted South Korea’s underdeveloped domestic bond market. Securities companies will be allowed to specialize in bond trading while bond-sale procedures will be simplified and standardized so that more companies can raise funds in the bond market. South Korean securities might become more attractive when local companies improve their disclosure process. With the opening of a third stock exchange, more companies will be able to trade their stocks instead of turning to the Korea Stock Exchange or the over-the-counter Kosdaq exchange.

There should not be too much emphasis on the restoration of South Korea’s vaunted export engine because the entire economy will continue to lag until the domestic sector develops a basis for sustained growth. This will require more investment funds for small and medium-size enterprises. That will occur only when the chaebol have cut excess capacity and have stopped absorbing the lion’s share of lending.

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