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1. Introduction
South Korea has been one of the world's fastest growing economiessince the early 1960s, which is referred as the Miracle on theHan River. Having almost no natural resources and alwayssuffering from overpopulation in its small territory, South Koreaadapted an export-oriented economic strategy to fuel its economywhich ranked the sixth largest exporter and tenth largestimporter in the world in 2010. The Korea business groups,chaebols, dominated most key industries in Korea and played animportant role in the miracle economic growth of the country forthe last several decades. They are defined as large businessgroups that consist of formally independent firms, operating indiverse industries and controlled by the family members of thefounder (Choe and Pattnaik, 2007). Each year, the government ofKorea identifies 30 largest chaebol based on their total assets,these groups are subject to the Fair Trade Commission’s policieswhich include strict regulations on their intra-firm debt andcredit performances (Kim, 2000). The paper aims to provide acomprehensive description and analysis of business groups inSouth Korea. Within the scope of this research paper, the authorswill present the evolution of chaebols in Korea including theirformation and development, corporate governance and performance,as well as future prospect.
The chaebols are family owned and managedconglomerates, which have dominated Korean economy fromthe 1960s. Each year, the government of Koreaidentifies 30 business groups (chaebol) based on their
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total assets. These groups are subject to the FairTrade Commission’s policies which include strictregulations on their intra-firm debt and creditperformances (Kim, 2000, p103).
According to Choe and Pattnaik (2007), a Korean chaebolis defined as a large business group that consists offormally independent firms, operating in diverseindustries and controlled by the family members of thefounder.
Contribution to the economic development...
2. Evolution of chaebolsSouth Korea has a marketeconomy which ranks 15th in the world by nominal GDPand 12th by purchasing power parity (PPP), identifyingit as one of the G-20 major economies. It is a high-income developed country, with an emerging economy,[4]and is a member of OECD. South Korea is one of theAsian Tigers, and is the only developed country so farto have been included in the group of Next Elevencountries. South Korea had one of the world's fastestgrowing economies from the early 1960s to the late1990s, and South Korea is still one of the fastestgrowing developed countries in the 2000s, along withHong Kong, Singapore, and Taiwan, the other three
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members of Asian Tigers.[5] South Koreans refer to thisgrowth as the Miracle on the Han River.[6] Havingalmost no natural resources and always suffering fromoverpopulation in its small territory, which deterredcontinued population growth and the formation of alarge internal consumer market, South Korea adapted anexport-oriented economic strategy to fuel its economy,and in 2010, South Korea was the sixth largest exporterand tenth largest importer in the world.
Emergence/origins context (origins, contemporary issues)
2.1. From post World War II to 1997
2.1.1 The role of the government
Carney (2008a, p113) argued that chaebols were made through thefavorable government policies upon allocation of financial andmaterial resources to a small number of large family-ownedenterprises. In addition, the government helped chaebols grow bysubsidizing and protecting of domestic market (Chang, 2003).
Under the Japanese colonial era, certain industrialinfrastructure and assets were built in Korea. After theliberalization in 1945, these assets were sold at low prices andfavorable terms to personal preference, friends and relatives ofhigh ranking government officials. This built up the foothold andfacilitated the development of early business groups, such asHanwha, Doosan, Samsung, SK, and Hyundai. For example, the buyershad to pay only 10 percent of the sales price upon purchase and
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then paid off the rest in 15 years without interest. Further,under the Rhee regime in the 1950s, import substitution policywas chosen. The government allocated foreign currency fromforeign aids only to firms with import license to import rawmaterials. Those firms made huge profits and grew quickly;Samsung, LG and SK became chaebols during this period. In return,they contributed to Rhee’s political funds (Chang, 2003)
The following two decades were marked by the government’s heavyintervention in the economy with the establishment the EconomicPlanning Board, the Ministry of Finance, and the Ministry ofTrade and Industry. They formulated and monitored a series offive-year economic development plans with a focus onindustrialization (Carney, 2008a). The first two five-year plansstressed on export-oriented industries while the third and fourthfive-year plans concentrated on heavy and chemical industries.The government allocated of foreign loans and preferential fundsto only a few large selected companies. It also rewardedsuccessful companies and penalized those with poor performance byletting other firms to acquire their assets. This furthersupported chaebols’ development because they got cheap loans andincentives from the government by diversifying into strategicindustries and acquiring other poor-performing firms’ assets. Thechaebols were also able to gain monopolistic or oligopolisticprofits thanks to the government’s blocking of foreign anddomestic competition in the strategic sectors. In addition, thegovernment controlled the capital market. The bank system wasnationalized and the banks only took the role of raising andrelocating funds, not evaluating investment projects. The
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government also implicitly guaranteed to pay for bad debt loans,rescued large firms during the global oil shock in the 1970s byswapping loans for stocks, etc. Such policies encouraged chaebolsto increase investments horizontally to gain high growth andrevenue at low profit margin. On the other hand, the non-bankfinancial services sector was opened to chaebols and they rapidlyexpanded to insurance, securities and merchant banking to gainmore capital for investments (Chang, 2003).
In the 1980s and 1990s, chaebols grew strongly enough to developon their own, partly thanks to the continuing relaxation offinancial sector. In addition to the capital sources from non-bank financial institutions, chaebols held enough share toinfluence the bank’s lending decisions as the government startedprivatized banks in 1983. From this period, the government’sinfluence on chaebols gradually diminished and chaebols evensuccessfully resisted some of the government’s orders orpolicies. Further liberalization of capital market was carriedout in the 1990s, which allowed chaebols to issue stocks andbonds in foreign markets, and banks might borrow short termcapital from international market. As a result, additional short-term foreign funds went to chaebols to finance their long-terminvestment (Chang, 2003).
2.1.2 Growth strategies of chaebols
According to Chang (2003), the growth strategies of chaebols hadthree common characteristics: taking advantage of governmentpolicies, utilizing internal and external capital markets, andpursuing diversification and vertical integration.
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To taking advantage of government policies, first the largestchaebols granted Japanese industrial properties and allocation offoreign currency to import scarce goods, which helped them toaccumulated initial capital necessary for future growth. Second,the chaebols exploited subsidies and cheap loans from governmentpolicies for business expansion to national strategic industriessuch as electronics, heavy equipment and chemical, then furtherdiversification into trading. Third, their close connections tothe government helped chaebols to win major government contracts,as well as special supports and subsidies in buying insolventcompanies. Later, some chaebols even became powerful enough tomanipulate government policies to their favor (Chang, 2003).
By utilizing internal and external capital markets, the chaebolsnot only benefited from government subsidies and loans to investin strategic industries, but also raised more capital byinvestment in new ventures and management of cash flows amongaffiliates within a group. Cross-shareholding and mutualguarantees helped chaebols to increase the loans they couldsecure from banks. In addition, the capital sources from thefinancial institutions which they owned or held shares wereessential for their ambitious expansion and integration (Chang,2003).
Through diversification and vertical integration, they enterednew businesses to gain government subsidies which result instrong competition among chaebols in shipbuilding, heavyequipment, chemicals, automobile and electronics. When there wasa lack of supporting activities and supply infrastructure forsuch strategic industries, they integrated vertically to acquire
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raw materials and parts; and then established trading companiesto export their products. Related diversification was carried outmainly within existing affiliates of by acquiring low-performingfirms or insolvent companies (Chang, 2003).
2.1.3 Labor problems
Before 1987, the government applied an authorization regime,which considered strong labor as a threat to economicdevelopment, national security and capital accumulation. Undersuch regime, labor unions had no political power. There was aprohibition of union organization of government officials ormultiple labor unionisms; a ban on labor political activities andthird-party intervention in labor disputes; etc. After thedemocratic opening in 1987, labor organizations gained more powerand started to challenge the existing industrial relations, whichincreased the tension among state, capital and labor. The unionsobtained greater bargaining power against management and theirreal wages rose by nearly 50 percent between 1987 and 1990.Moreover, when Korea pursued globalization strategy and becamemember of WTO, increasing pressure from internationalorganization urged the Korean government to reform labor law.Chaebols blamed labor for the decline in internationalcompetitiveness and called for more flexible system of layoff orhiring substitute workers during labor disputes, etc. Inresponse, chaebols shifted to less labor-intensive industries,modernized production system, increased foreign investment toacquire location-specific advantages, and focused on innovativeproducts to create new competitive advantage at home (Kim andMoon, 2000).
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2.2. Restructuring and transformation of chaebols after thefinancial crisis in 1997
The Asian financial crisis in 1997 hit Korean economy heavily,especially chaebols. The world demands decreased sharply,especially electronics products, ships, automobiles and garment,affecting 50 percent of Korean exports. The excessive highleverage, once balanced by rapid growth, turn out to be the majorweakness of chaebols. They were not able to repay their debt,neither was the Korean government (Nicolas, 2001). During 1997,12 out of 30 top chaebols went bankrupted or called forgovernment-sponsored “cooperative” emergency loans. Daewoo, thefourth largest chaebol also collapsed in 1999 (Chang, 2003).
The Korean government introduced a number of measures, compliedwith IMF and World Bank proposals, to improve the system ofcorporate governance. A “combined financial statement” (CFS) isrequire to ensure disclosure of complicated intra-grouptransactions. The accounting practices were revised to be more inline with international accounting standards. The ownershipthreshold for filing stockholder derivative suits was reducedfrom 1 to 0.01percent of total shares. All listed companies wererequired by law to appoint at least one outside director. Thegovernment forced the top 64 largest companies to sign financialpacts with their respective creditor banks to reduce their debt-equity ratios below 200 percent. The government also prohibitedaffiliated chaebol firms from providing debt guarantees to eachother from April 1998; virtually all cross-debt guarantees havebeen wound down since the agreement. In addition, in 1998 theceiling on aggregate equity capital for chaebol-affiliates was
11
removed for the top 30 chaebols. Bankruptcy-related laws wereamended in February 1998 to facilitate both easier exit and entryto an industry. To facilitate corporate restructuring, agovernment-initiated corporate restructuring fund, amounting to1.6 trillion won, was launched in October 1998. The “businessswap” - also known as the “Big Deal” in Korea - was also tried asa way to restructure the larger chaebols and to reduceoverinvestment in such key industries as semiconductors,petrochemicals, aerospace, rolling stock, power plant equipmentand vessel engines (Lee and Lee, 2008). To a certain extent,these transformation and restructuring measures had beensuccessful and most of the largest chaebols survived the crisisand further developed (Chang, 2003).
3. The development of chaebols in Korea can be welldivided into two periods (before and after 1997) withdifferent strategy and environmental factors.
1. Formation and development of Korean chaebols frompost World War II to 1997
Chaebol evolution and the role of the state/ goverment
Carney (2008, p113) argued that Korea’s chaebol weremade through the favorable government policies uponallocation of financial and material resources to asmall number of large family-owned enterprises. In
12
addition, the government helped chaebols grow bysubsidizing and protecting of domestic market (Chang,2003, p45).
In fact, under the Japanese colonial era, certainindustrial infrastructure and assets were built inKorea. After the liberalization in 1945, many importantgovernment decisions were made by a few powerfulindividuals. In which, the decision to sell assetsowned by Japanese government and firms built up thefoothold and facilitated the development of earlyKorean business groups. Such assets as factories,production equipment, inventory, which accounted for 30percent of the Korean economy, were sold at very lowprice and favorable terms to personal preference,friends and relatives of high ranking governmentofficials. For example, the sales price was based onthe assets’ book value in the context of highinflation; in addition, the buyers had to pay only 10percent of the sales price upon purchase and then paidoff the rest in 15 years without interest. Chaebolssuch as Hanwha, Doosan, Samsung, SK, and Hyundaibenefited from these purchases. Further, under the Rheeregime in 1950s, import substitution policy was chosen.The government allocated foreign currency from foreign
13
aids only to firms with import license to import rawmaterials. Those firms made huge profits and grewquickly; Samsung, LG and SK became chaebols during thisperiod. In return, they contributed to Rhee’s politicalfunds (Chang, 2003, p46-47)
The following two decades were marked by thegovernment’s heavy intervention in the economy with theestablishment the Economic Planning Board, the Ministryof Finance, and the Ministry of Trade and Industry.They formulated and monitoring a series of five-yeareconomic development plans with a focus onindustrialization (Carney, 2008, p118). The first twofive-year plans stressed on export-oriented industrieswhile the third and fourth five-year plans concentratedon heavy and chemical industries. The governmentallocated foreign loans and preferential funds tostrategic industries with large-scale investments wentto only a few large companies selected by thegovernment. It also rewarded successful companies andpunished those with poor performance by letting otherfirms to acquire their assets. This further supportedchaebols’ development as they get cheap loans andincentives (e.g tax preferential, export subsidies)from the government by diversifying into strategic
14
industries, acquiring other poor-performing firms’assets. Not only benefited from cheaper capital ascompared to the normal market level, but chaebols werealso able to gain monopolistic or oligopolistic profitsthanks to the government’s blocking of foreign anddomestic competition in the strategic sectors (Chang,2003, p48-54).
In addition, the government controlled the capitalmarket. The bank system was nationalized and the banksonly took the role of raising and relocating funds, notevaluating investment projects. The government alsoimplicitly guaranteed to pay for bad debt loans,rescued large firms during the global oil shock in the1970s by swapping loans for stocks, etc. Such policyencouraged chaebols to increase investmentshorizontally to gain high growth and revenue at lowprofit margin. Therefore, the debt-equity ratio ofKorea increased from roughly 100 percent in the early1960s to 500 percent in the end of 1970s (Chang, 2003,p51-52). On the other hand, the non-bank financialservices sector was opened to chaebols and they rapidlyexpanded to insurance, securities and merchant bankingto gain more capital for investments (Chang, 2003,p56).
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The 1980s and 1990s witnessed the deregulations of bothgoods and financial market of Korean government underinternal and external pressures. Nevertheless, chaebolsgrew strongly enough to develop on their own, partlythanks to the continuing relaxation of financialsector. In addition to the capital sources from non-bank financial institutions, chaebols held enough shareto influence the bank’s lending decisions as thegovernment started privatized banks in 1983. From thisperiod, the government’s influence on chaebol graduallydiminished and chaebols even successfully resisted someof the government’s orders or policies. Furtherliberalization of capital market was carried out in the1990s, which allowed chaebols to issue stocks and bondsin foreign markets, and banks might borrow short termcapital from international market. As a result,additional short-term foreign funds went to chaebols tofinance their long-term investment (Chang, 2003, p57-63).
Growth strategies of chaebols
According to Chang (2003), the growth strategies ofchaebols had three common characteristics: takingadvantage of government policies, utilizing internal
16
and external capital markets, and pursuing unrelateddiversification and vertical integration.
Taking advantage of government policies: First, thelargest chaebols granted Japanese industrial propertiesand allocated foreign currency to import scarce goods,which helped them to accumulated initial capitalnecessary for future growth. Second, the chaebolsexploit subsidies and cheap loans from governmentpolicies toward business expansion toward nationalstrategic industries such as electronics, heavyequipment and chemical, then further diversificationinto trading. Third, their close connections to thegovernment helped chaebols to win major governmentcontracts, as well as special supports and subsidies inbuying insolvent companies. Later, some chaebols evenbecame powerful enough to manipulate governmentpolicies to their favor (Chang, 2003, p71-72).
Utilizing internal and external capital markets: Theynot only benefited from government subsidies and loanfrom investment in strategic industries, but alsoraised more capital by investment in new ventures andmanagement of cash flows among affiliates within agroup. Cross-shareholding and mutual guarantees helpedchaebols to increase the loans they could secure from
17
banks. In addition, the capital sources from thefinancial institutions which they owned or held shareswere essential for their ambitious expansion andintegration (Chang, 2003, p73-74).
Diversification and vertical intergration: They enternew businesses to gain government subsidies whichresult in strong competition among chaebol inshipbuilding, heavy equipment, chemicals, automobileand electronics. When there was a lack of supportingactivities and supply infrastructure for such strategicindustries, they integrated vertically to acquire rawmaterials and parts; and then established tradingcompanies to export their products. Relateddiversification was carried out mainly within existingaffiliates of by acquiring low-performing firms orinsolvent companies (Chang, 2003, p75).
Other issues affecting the development of chaebols
Investment efficiency
The chaebols pursued sales growth rather thanprofitability under the incentive programs of thegovernment in the 1960s and 1970s, which led to overcapacity and low margin (Chang, 2003, p56). In additionto the high indebtedness of the chaebols, the collusion
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among government, banks and businesses boostedinvestment in excess capacity and unprofitableactivities (Nicolas, 2001, p34).
The high level of cross-shareholding, as well as mutualguarantees and accessible capital sources frominternational financial institutions also contributedto the high debt/equity ratio of chaebols, which meanstheir large investments were heavily financed by debt.Foreign investment projects even showed higherleverage. For example, foreign investment projects ofover USD 50 million had the equity capital ratio of12.5 percent and debt/equity ratio of 927 percent in1995 (Kim, 2000, p18).
Labor
The low-wage labor competitive advantage of Korea haderoded over time due to the economic development,improved living standard and the upward trend of labormovement. Before the democratic transition in 1987,labor movement had been suppressed. The governmentapplied an authorization regime, which consideredstrong labor as a threat to economic development,national security and capital accumulation. Under suchregime, labor unions had no political power. There was
19
a prohibition of union organization of governmentofficials or multiple labor unionisms; a ban on laborpolitical activities and third-party intervention inlabor disputes; etc. After the democratic opening in1987, labor organizations gained more power and startedto challenge the existing industrial relations, whichincreased the tension among state, capital and labor.As a result, they obtained greater bargaining poweragainst management and their real wages rose by nearly50 percent between 1987 and 1990 (Kim and Moon, 2000,p56). Moreover, when Korea pursued globalizationstrategy and became member of WTO, increasing pressurefrom international organization urged the Koreangovernment to reform labor law. Chaebols blamed laborfor the decline in international competitiveness andcalled for more flexible system of layoff or hiringsubstitute workers during labor disputes, etc. Inresponse, chaebols shifted to less labor-intensiveindustries modernized production system, increasedforeign investment to acquire location-specificadvantages, and focused on innovative products tocreate new competitive advantage at home (Kim and Moon,2000, p57-59).
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2. Restructuring and transformation of chaebols afterthe financial crisis in 1997
The Asian financial crisis in 1997 hit Korean economyheavily, especially chaebols. The world demandsdecreased sharply; prices for electronics products,ships, automobiles and garment went down dramatically,affecting 50 percent of Korean exports. The excessivehigh leverage, once balanced by rapid growth, turn outto be the major weakness of chaebols. They were notable to repay their debt, either the Korean governmentwas (Nicolas, 2001, p35). During 1997, 12 out of 30 topchaebol went bankrupted or called for government-sponsored “cooperative” emergency loans. Daewoo, thefourth largest chaebol also collapsed in 1999 (Chang,2003, p157).
In order to receive support from IMF and World Bank,Korea government committed to carry out a number ofreforms such as improving transparency of chaebols byapplying Western accounting practices, abolishinginternal debt guarantees, selling unprofitable assets,focusing on core businesses and improving governancesystem by partly shifting responsibility of familyowners to minority shareholders (Chang, 2003, p191).The “Big Deal” among the top five chaebols in six major
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industries was reached in October, 1998 and then otherseven industries in 1999. The purposes were to detachnon-core businesses and form joint ventures among them;streamline business activities into core competence,thus, increasing competitiveness, reduce debt/equityratio (Kim, 2000a, p122).
To a certain extent, these transformation andrestructuring measures had been successful and most ofthe largest chaebols survived the crisis and furtherdeveloped.
Governance: Corporate and Organization Structure
The Korean chaebols are characterized by somewhat like the prewarJapanese zaibatsu structure with management at the top level bymembers of the founding family, and strategy is set centrally. Atthe early stage of economic development, the chaebols startaggressively diversification so as groups grew in size andbusiness scope, it was difficult for the chairpersons to processinformation and make proper decision. Hence the groupsestablished the headquarters to assist chairpersons. For example,Samsung group established its headquarter in 1959, twenty-oneyears after the foundation. The headquarters’ majorresponsibilities included the allocation of financial and humanresources and the coordination of decisions between affiliates(Kim, Hoskisson, Tihanya, and Hong, 2004Kim et al, 2004). Generaltrading companies within the chaebol began to develop from themid-1970s. By the mid-1980s, each of the major groups had created
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trading companies which focused on export activities. By theearly 1990s, the 9 largest general trading companies wereresponsible for over 50 percent of Korea exports (Channon, 1998).The evolution of chaebol structure is depicted in figure XX3.1.The first stage is characterized by direct and completeownership, the founder and his family ownhold all the affiliatedcompanies. In the second stage, the holding companies wereestablished. In the third stage, the family owns a holdingcompany which owns affiliated subsidiaries, Deawoo is an example.The fourth stage deepens interlocking mutual ownership, with thefounding family owning the group holding company and some form offoundation which, in turn, owns affiliated companies (SamsungGroup). In all these structures, the center office maintainsstrict control over strategy and monitors the performance ofoperating units (Channon, 1998). The managerial structure withinchaebols was founded on a system of personal relationships thattied managers directly to the owners. There are four types ofrelationships: patrilineal ties between males in the immediatefamily, affinal ties through marriage, classmate ties, andfellow-regional ties. Before 1990, most managers in the largestchaebols were tied to the owners by one or more of these ties(Feenstra and Hamilton, 2006).
The Korean government prohibits ownership of private banks withinchaebols but from 1980s chaebols have increased their involvementin financial services by including some non-bank financialinstitutions such as insurance companies, securities companies,etc. and acquired acceptable rates of shares in many banks. Thenumber of non-bank financial institutions within top ten chaebols
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rose from 21 in 1987 to 37 in 2001. The non-bank financialinstitutions were lucrative business and critical to helpchaebols less dependent on the domestic banks and the government.These institutions allow chaebols flexibility with day-to-daycash-flow problems and with lending within the organizations(Shim and Lee, 2008).
The Koreangovernmentprohibits ownershipof private bankswithin chaebols butfrom 1980s chaebolshave increasedtheir involvementin financialservices byincluding some non-bank financialinstitutions such
as insurance companies, securities companies…. and acquiredacceptable rates of shares inmany banks. The number ofnon-bank financialinstitutions within top ten chaebols rose from 21 in 1987 to 37in 2001. The non-bank financial institutions were lucrativebusiness and critical to help chaebols less dependent on thedomestic banks and the government. These institutions allow
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Owner
Intermediary
Core Co.
Owner
Stage I
Stage IV
Stage III
Stage II
Direct ownership
Owner
Holding Co.
Owner
Holding Co.
Core Co.
Figure XX3.1: The evolutionary structure of
chaebol.
chaebols flexibility with day-to-day cash-flow problems and withlending within the organizations (Shim and Lee, 2008). Thegovernment introduced measures to restructure the chaebols due tothe 1997 financial crisis as mentioned above.
Figure XX: The evolutionary structure of chaebol.
Source: Shim and Lee (2008).
The 1997 financial crisis swept the Korean economy. The Koreangovernment introduced a number of measures, complied with IMF andWorld Bank proposals, to improve the system of corporategovernance. A “combined financial statement” (CFS) is require toensure disclosure of complicated intra-group transactions. Theaccounting practices were revised to be more in line withinternational accounting standards. The ownership threshold forfiling stockholder derivative suits was reduced from 1% to 0.01%of total shares. All listed companies were required by law to
25
appoint at least one outside director. The government forced thetop 64 largest companies to sign financial pacts with theirrespective creditor banks to reduce their debt-equity ratiosbelow 200%. The government also prohibited affiliated chaebolfirms from providing debt guarantees to each other from April1998; virtually all cross-debt guarantees have been wound downsince the agreement. In addition, in 1998 the ceiling onaggregate equity capital for chaebol-affiliates was removed forthe top 30 chaebols. Bankruptcy-related laws were amended inFebruary 1998 to facilitate both easier exit and entry to anindustry. To facilitate corporate restructuring, a government-initiated corporate restructuring fund, amounting to 1.6 trillionwon, was launched in October 1998. The “business swap” - alsoknown as the “Big Deal” in Korea - was also tried as a way torestructure the larger chaebols and to reduce overinvestment insuch key industries as semiconductors, petrochemicals, aerospace,rolling stock, power plant equipment and vessel engines (Lee andLee, 2008).
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Figure XX: The equity ownership of SK Group.
Source: Chang (2003)
As a result of the corporate sector reform, the chaebols’absolute amount of debt decreased substantially and,consequently, owners’ control over chaebols weakened.Furthermore, the chaebols’ corporate strategy pursuing dependenceon debt would have to be reconsidered in the sense that the ‘toobig to fail’ idea would not be accepted under the new regime. Forinstance, in 1999, the government decided to force the huge,debt-ridden Daewoo and Ssangyong chaebols, which ranked the thirdand seventh, respectively, into bankruptcy. The government didnot save the life of, especially, Daewoo at that moment, whichshowed the government’s attitude toward chaebols (Mah, 2006). LGpursued “select and focus” strategy to reduce non-core businessesto survive and improve competitiveness. Hyundai Motor group was
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established in 2000 from Hyundai Motor and other automobile-related affiliates of the old Hyundai group. Hyundai Motor groupfocuses on automobile business and gains many successes sincethen. In April 1999, the Korean government lifted a ban oncreation of holding companies to help the groups manage theiraffiliates. Several groups implement the holding companystructure to decentralize decision-making authority to affiliates(Kim et al., 2004Kim et al, 2004). Governance reforms that arefocused on bringing outside directors onto boards do little toalleviate the problems facing minority shareholders in Koreanfirms. Shareholder rights have improved in several otherrespects, including decreases in the shareholding thresholdrequired to file derivative suits, allowing small shareholders tomake proposals at a general shareholders meeting, inspectcorporate accounts and dismiss directors. However, class actionsuits by shareholders against directors, which can be highlyeffective tools to ensure minority shareholder rights, were notintroduced in Korea (Lee and Lee, 2008). Changes to thecommercial code have strengthened the role of outside directorsby requiring the board’s approval on all intra-group transactionsabove a certain minimum size. In 1999, more than 73 percent ofnewly selected board members had been recommended by controllingshareholders, and the initiative taken by outside directors wasin many respects disappointing. Their agenda approval rates werevery high, exceeding 99 percent. Their attendance rate duringmeetings convened to approve transactions involving controllingshareholders was low, less than 37 percent in 2000. Hence, the
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oversight role of boards of directors is still very limited (Joh,2004).
Nonetheless, due to the reform measures triggered by thefinancial crisis, the structure of chaebol has become more soundand healthy. First, both insolvent companies and those which havefailed to undertake radical reforms have been liquidated. Second,the management of companies, which aims to maximize profits, hasbeen improved, thus the profits has increased alongside with therestructuring efforts and cost-cutting measures (Shim and Lee,2008).
4. Performance: Financial, Market, and Technology
4.1 Financial
4.1.1 Capital Structure of Chaebols
The financial performance of chaebols in the beginning was verypositive, and gradually became negative after the crisis. Changand Choi’s research in 1988 suggested that superior economicperformance took place in chaebols’ affiliates, with thetransaction cost efficiencies of a quasi-multidivisionalstructure. In contrary, those firms without such structure tendedto have a decreasing profitability (cited in Carney, 2008a).Korean firms developed rapidly; therefore they needed more fundsfor their expansion plans. Consequently, their use of debtincreased. In 1997, the average debt-equity ratio of the topthirty chaebols was 600 percent, with some reaching 4,000percent, which are remarkably higher than the ratio of businessgroups in developed countries. When the government pushedchaebols to decrease this ratio, they sold equity issues to their
29
own affiliates. Therefore, net infusion of equity capital did notinvolve in such a decrease of debt-equity ratios (Chang, 2003).Recently, the debt-equity ratio has been decreased dramaticallyto averagely 113.26 and 196.41 percent in top five and top thirtychaebols, respectively in 2006 (Lee and Lee, 2008).
On the other hand, chaebol families preferred to keep theircontrolling ownership stakes, which made their capital structurereliant on their debt-securing capability. The more debt theycould secure, the more projects they could invest (ibid.).However, over-expansion and higher sales growth might cause lowerprofits, misallocated investment, incurred extreme debts, andlost productive efficiency (Carney, 2008a). According to severalresearches on the period 1996-1999, chaebols’ investments werenot as efficient as those of non-chaebols, despite enjoyingfinancial efficiency deriving from resource sharing among theaffiliates. Furthermore, among top thirty chaebols, suchownership stakes dropped over time, from 15.1 percent in 1987 to8.5 percent in 1997, and less than 5 percent in 2000 (Choo, Lee,Ryu, and Yoon, 2006).
30
Figure 4.1: Net profit/sales of top 5 and top 30 chaebols from 1998 to
2006 (%). Source: Lee and Lee, 2008.
Moreover, long-term investments in manufacturing were dependent
on short-term loans. Subsequently, ‘domino’ effects happened with
a series of bankruptcies when financial institutions asked for
immediate payment (Chang, 2003). Only those business groups that
succeeded in building and sharing their capabilities could
survive during the crisis (Choo et al., 2006). It is also
noteworthy that group-provided insurance was significant during
that time (Carney, 2008a). Their investment in facilities
increased back to the pre-crisis level in 2000 (Chang, 2003).
Figure 4.1 shows net profit/sales of top five and top thirtychaebols from 1998 to 2006. Top five chaebols recovered from thecrisis faster than top thirty, especially from 1998 to 2000.Before 2003, the gap in net profit/sale between top five andthirty was large, peaking at 9.48 percent in 2000. After that,the gap became smaller, particularly after 2005 (Lee and Lee,2008).
4.1.2 Chaebols’ internal capital markets and cross-subsidization
Chaebols have invested more in securities since 1998, which ledto the increased cross-shareholding throughout the post-crisisrestructuring procedure (Chang, 2003). The more complex‘circular’ structure among intra-group businesses has beenestablished in order to avoid the tightening regulations ofcross-shareholdings. Large chaebols have several circles, each ofwhich includes many companies. For instance, Hanwha Corporation
31
owns 24.21 percent of Hanwha Petrochemical, which holds 100percent shares of Hanwha L&C Co., which has 6.44 percent ofHanwha Securities Co., which again owns 4.94 percent of HanwhaCorporation (Lee, 2008).
A significant linkage role in this new structure was played bynewly acquired financial institutions. In 2005, 23 of 38 chaebolsinvolved in cross-shareholding restriction had their ownfinancial institutions in their groups. Those financial/insurance institutions account for averagely 12.58 percent sharein intra-group businesses. For example, Samsung Group has fivefinancial institutions with the extensive capital investments in27 intra-groups companies, which indicates their attempts tocombine between financial and industrial capitals (ibid.).
Cross-subsidization structure also aims to fund poorly-performingconglomerates at the expense of profitable firms. During economicgrowth period, this structure do not appear harms to stronggroups, but do the other way around (Carney, 2008a). Chang andHong (2002) find out that the profitability of conglomeratedgroups decrease over time. Moreover, the scale of groupaffiliations’ advantages is inversely linked to the firm’sdiversification level (cited in Carney, 2008a).
4.2 Market
The Korean government had steadily interfered with market pricesand monopolized the capital supply for three decades since 1960s.President Park in 1969 chose a ‘select group of progressivemillionaires who would be allowed to enter the centre stage’,
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whose groups still remain as big players in the market nowadays(Amsden, 1989 cited in Carney, 2008b, p.600).
4.2.1 Chaebols’ vertical integration
The top five chaebols’ integration level varied from 20 to 30percent. Individual conglomerates, which supply to chaebols’ coreproduction firms in specific industries such as chemical andelectronics, often, have higher volume of intra-group dealings.In addition, integration can happen among different companies indifferent business groups. For example, Hyundai Motors’ nationaldistribution center is Hyundai Motor Service; its retail businessis Kumkang Development, and their domestic and overseastransportation service is Hyundai Logistics (Chang, 2003).
However, there are several issues with vertical integration.Vertical integrated suppliers may be less efficient andinnovative because they already established captive customers.Furthermore, chaebols’ payments and benefits for affiliates getstandardized, which affect efficiency under different marketconstraints. For instance, those standards might be too limitedfor effective affiliates, while be too generous for poorlyperforming firms. Especially during the economic instability andfluctuations period, it is also not appropriately flexible toadjust to diverse transactions volumes (ibid.)
4.2.2 Market diversification
Chaebols’ international production and marketing assets are evaluatedin negative industrial situations, with their own brands concentratedin developed and price-sensitive divisions. In addition, Bloom (1994)describe chaebols’ international positions as being ‘in a way that
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denies them many of the major benefits’ of being international (citedin Carney, 2008a, p. 132). Moreover, chaebols have reacted on the slowpace to leave declining businesses while their corporate scope hasbeen expanded broadly (ibid.). Chaebols are considered to belong tothe network perspective, which indicates their focal point onindustrial buyer-supplier relationship or alliance partnerships,rather than active business-to-customer context (Durme, Brodie, andRedmore, 2003).
Industry Hyundai Samsung LG Daewoo SKAutomobile √ √ √Aerospace √ √ √Construction √ √ √ √ √Consumer Electronics √ √ √
Financial Services √ √ √
Machinery √ √ √ √Oil Refinery √ √ √Petrochemical √ √ √ √Semiconductor √ √ √Shipbuilding √ √ √Telecom Equipment √ √ √ √Telecom Service √ √
Table 4.1: Business segments of top five chaebols. Source: Thomas
White, 2010, p. 3
On the other hand, chaebols are regarded as a single multi-product corporation (Chen, 2011). Companies within a chaebol often share the same brand name, which can be explained for chaebols’ concentration on a diversification strategy. With its established brand reputation for quality products and services, chaebols can gain more advantages on entering new markets and business segments (Sohn and Kim, 2004). Advancing one product’s reputation may lead to a growth in the entire products’ demand,
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which motivate chaebols to produce more high-quality goods (Chen,2001). Table 4.1 shows business segments of top five chaebols, which portrayed their diversification strategy. Hyundai and Samsung cover almost every business segments, while the other three also involve in different markets (Thomas White, 2010).
4.3 Technology
Korea has succeeded to transform from industrial catch-up totechnology leading level in three decades, which are divided intothree successive phases. In the second phase in the 1980s,chaebols headed the establishment of the industrial R&D, whichwas based mainly on the foreign R&D (Hemmert, 2007; Carney,2008b). Nevertheless, chaebol administrators recognized theessential of developing internal R&D capabilities for products’expansion. Since the third phase in the 1990s, they started todevelop their own basic research competencies (Hemmert, 2007). Inaddition, industrial R&D activities are highly intensive amongchaebols. Table 4.2 shows the concentration in R&D inmanufacturing in 2007. Top 5 business groups account for 44.3percent share in total, with the very high share in electrocomponents’ segment. Top 20 business groups hold averagely halfof the total share for every industrial segment, which indicatesthe important role of chaebols in Korea R&D (Chung, 2009).Therefore, chaebols can contribute greatly to advance Koreainnovation system as a part of the global technology leadership,particularly in their interesting industries, such aselectronics, automotive engineering and telecommunications(Pascha, 2007; Carney, 2008b).
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Manufacturing Top 5 Top 10 Top 20Chemicals 21.9 32.4 45.9Electro components 85.7 89.5 91.4
Communication Equip 64.9 69.4 73.1
Automobiles 67.6 76.4 88.3Total 44.3 50.2 55.7
Table 4.2: R&D Concentration in Manufacturing, 2007 (%). Source:
Chung, 2009, p.11
Vertical integration, as mentioned above, can encourage theknowledge sharing among different stages of conglomerates, which,consequently, advances the general competitiveness of upstream aswell as downstream operations (Chang, 2003; Choo et al., 2006).For example, Samsung, LG, and Hyundai have upgraded their brandpower by sharing technology among affiliates, which pay royaltiesto the headquarters. Moreover, effective innovation usually needsa diverse knowledge foundation, because the phenomenon oftechnology fusion has developed as a significant movement. Forinstance, the Samsung Group is more technologically diversifiedas a group of all conglomerates than Samsung Electronics alone.It also can develop a broader knowledge foundation in itsinnovation efforts (Choo et al., 2006). Besides, the knowledgesharing has been done in a decentralized style, with companies’voluntary tendency to exchange in order to advance theirperformance. Consequently, online or offline communicationschannels have been set up for this purpose, such as LG’s websitefor technological knowledge sharing, and Hyundai’s CAP meeting.However, smaller business groups tend to sharing knowledge fortheir instant optimistic effects. Only three largest groups have
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formal organizational mechanisms to promote knowledge exchangeamong business affiliates (Lee, MacMillan and Choe, 2010).
5. 1. Financial
Capital Structure of Chaebols
The financial performance ofchaebols in the beginning wasvery positive, and graduallybecame negative after thefinancial crisis in 1997. Changand Choi’s research in 1988suggested that superior economicperformance took place inchaebols’ affiliates, with thetransaction cost efficiencies of
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a quasi-multidivisionalstructure. In contrary, thosefirms without such structuretended to have a decreasingprofitability (cited in Carney,2008a). During 1961-1980, thegovernment carried out theEconomic Development Plans, withspecial funds at low interestrates. In addition, Korean firmsdeveloped rapidly; thereforethey needed more funds for theirexpansion plans. Consequently,their use of debt increased. In
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1997, the average debt-equityratio of the top thirty chaebolsis 600 percent, with somereaching 4,000 percent, whichare remarkably higher than theratio of business groups indeveloped countries. When thegovernment pushed chaebols todecrease this ratio, they soldequity issues to their ownaffiliates. Therefore, netinfusion of equity capital didnot involve in such a decrease
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of debt-equity ratios (Chang,2003, pp. 131-160).
On the other hand, chaebolfamilies preferred to keep theircontrolling ownership stakes,which made their capitalstructure reliant on their debt-securing capability. The moredebt they could secure, the moreprojects they could invest,compared to other chaebols(ibid.). However, over-expansionand higher sales growth mightcause lower profits,
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misallocated investment,incurred extreme debts, and lostproductive efficiency (Carney,2008a). According to severalresearches on the period 1996-1999, chaebols’ investments werenot as efficient as those ofnon-chaebols, despite enjoyingfinancial efficiency derivingfrom resource developments amongthe affiliates. Furthermore,among top thirty chaebols, suchownership stakes dropped overtime, from 15.1 percent in 1987
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to 8.5 percent in 1997, and lessthan 5 percent in 2000 (Choo,Lee, Ryu, and Yoon, 2006).
Moreover, investing in long-termmanufacture facilities, chaebolswere dependent on short-termloans. Subsequently, ‘domino’effects happened with a seriesof bankruptcies when financialinstitutions asked for immediatepayment (Chang, 2003, pp. 131-160). Only those business groupsthat succeeded in building andsharing their capabilities could
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survive during the crisis (Chooet al., 2006). It is alsonoteworthy that group-providedinsurance was significant duringthe crisis (Carney, 2008a).Their investment in facilitiesincreased back to the pre-crisislevel in 2000 (Chang, 2003, pp.131-160). 2. Chaebols’ internal capital markets and cross-subsidization
Chaebols have invested more insecurities since 1998, which ledto the increased cross-shareholding throughout the
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post-crisis restructuringprocedure (Chang, 2003, pp. 131-160). The more complex‘circular’ structure amongintra-group businesses has beenestablished in order to avoidthe tightening regulations ofcross-shareholdings. Largechaebols have several circles,each of which includes manycompanies. For instance, HanhwaCorporation owns 24.21 percentof Hanhwa Petrochemical, whichholds 100 percent shares of
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Hanhwa L&C Co., which has 6.44percent of Hanhwa SecuritiesCo., which again owns 4.94percent of Hanhwa Corporation(Lee, 2008).
A significant linkage role inthis new structure was played bynewly acquired financialinstitutions. In 2005, 23 of 38chaebols involved in cross-shareholding restriction hadtheir own financial institutionsin their groups. Thosefinancial/ insurance
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institutions account foraveragely 12.58 percent share inintra-group businesses. Forexample, Samsung Group has fivefinancial institutions with theextensive capital investments in27 intra-groups companies, whichindicates their attempts tocombine between financial andindustrial capitals (ibid.).
Cross-subsidization structurealso aims to fund poorly-performing conglomerates at theexpense of profitable firms.
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During economic growth period,this structure do not appearharms to strong groups, but dothe other way around (Carney,2008a). Chang and Hong (2002)find out that the profitabilityof conglomerated groups decreaseover time. Moreover, the scaleof group affiliations’advantages is inversely linkedto the firm’s diversificationlevel (cited in Carney, 2008a).
Future prospects
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The restructuring initiatives implemented after financial crisishave transformed the structure of chaebols and improved theircorporate governance. Some chaebols chose to focus on onebusiness while others still diversify. Even though big chaebolslike LG or Samsung diversify, they clearly identify their corebusinesses. For example, Samsung group now run major businessesin electronics, heavy and chemical industry, and financialservices (Samsung, 2011). On the other hand, Hyundai Motor groupnow focus on automobile industry and become one of the biggestautomobile producers in the world. The interlocking ownershipstructure will still be favored by chaebols because it ensuresthe owners’ control over all businesses. In 2004, LG group wasalso divided into two distinct groups, which are concentrated onelectronics and chemical products. Consequently, it indicatestheir transformation into the European-style, family-controlledglobal conglomerates in the near future (Choo et al., 2006). Theinterlocking ownership structure may still be favored by chaebolsbecause it ensures the owners’ control over all businesses.
According to Nicolò, Laevena, and Ueda et al (2008), improvementsin corporate governance quality have a positive and significanteffect on all measures of macroeconomic outcomes. In addition, atthe industry level, improvements in corporate governance appearto positively affect the performance of industries that depend onexternal finance. These results are consistent with the notionthat well-governed firms incorporate better managerial incentivesthat are likely to spur corporate sector growth and improve itsproductivity independently of the level of financial development.
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However, aA higher level of financial development boosts thepositive effects of improvements of corporate governance onmacroeconomic outcomes, consistent with the notion that well-governed firms are better able to attract outside financing(Nicolò et al., 2008). Corporate governance within chaebols gainssome improvements due to the government requirements. However,due tobecause of appreciation of close relationships in Koreanculture, the family ownership and appointing close-tied managerswill continue. The outside managers still look for owners’direction; they have little role in making decision. It is saidthat the growth of foreign investors in chaebols and thechaebols’ expansion to new market will help to increase the roleof outside managers; because the foreign investors will requireKorean companies to follow international standards and improvetransparency, especially intra-group activities.
From the influences of USA and Japan, with their own history andtraditions, Korean companies have evolved their own system ofmanagement, or K-Style management. This includes top-downdecision making, paternalistic leadership, clan management,harmony-oriented culture values, flexible lifetime employment,personal loyalty, seniority and merit-based compensation andconglomerate diversification strategies (Channon, 1998). Theinterlocking ownership structure will still be favored bychaebols because it ensures the owners’ control over allbusinesses.
Foreign investment supplements competitive advantage for Koreanchaebols. Since the launch of globalization policy by Koreangovernment in the early 1990s, chaebols have actively involved in
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FDI projects abroad. Affiliates and production facilities indeveloping countries are responsible for labor-intensiveactivities to exploit low cost of labor and raw material, as wellas access to emerging market. On the other hand, FDI in developedcountries is mainly for learning and catching up technologicalcompetences, utilize skilled labor, and enlarge market. And thisK-Style management will continue to dominate in Korean businessculture for a long time.
As mentioned above, the exchange of explorative and exploitativetechnological knowledge among conglomerates can advancetechnological capabilities. Consequently, chaebols should promotethose activities in order to enhance performance, as well asdevelop new advantages.
6. Conclusion
Chaebols were formed and developed rapidly from the 1960s thanksto the supportive government policies, their close relationshipwith government officials. Imperfect physical and financialmarket contributed to their phenomenal growth in the earlystages. However, chaebol’s over-diversified structure and highlyindebted investment model faced difficulties when the externalenvironment changed and Korea became open to the world economy.Chaebols have evolved from direct to interlocking ownershipstructure with the mixture of family owners’ control andmanagement. The deep relationship between affiliates and managershelped the chaebols to develop at the early stage but it raisedthe question of transparency to investors. The measures
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introduced by the government after the financial crisis hasweakened the close ties in chaebols’ structure and made thembecame more internationally accepted. The chaebols become moreflexible and sound to grasp new opportunities in domestic andinternational markets. Chaebols had extremely high debt/equityratio before the crisis because of their capital needs for rapidexpansion. This caused the ‘domin’ effects with a series ofbankruptcies during the crisis. Therefore, the government forcedchaebols to reduce it. The complex ‘circular’ structure wasdeveloped to avoid cross-shareholdings’ regulations. However, thegovernment also banned it due to its expected problems in thefuture. On the market perspective, despite of followingdiversification strategy, chaebols are considered to focus moreon business-to-business, rather than business-to-customer market,especially in the intra-group business. They also play veryimportant role in Korean R&D activities.
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