Sea-Jin Chang: Financial Crisis and Transformation of Korean Business Groups

The Rise and Fall of ChaebolsThe Rise and Fall of Chaebols (Cambridge, 2003)

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A welcome and very detailed examination of the history and structure of the Korean business conglomerates. The strengths of this book are manifold. First and foremost is the wealth of evidence sourced from the Korea Information Service which provides some raw data for some hard conclusions. And the evidence is marshalled in a user-friendly manner so that in general the arguments are clear.

The book starts with setting some of the economic background to the 1997 crisis. This is important because it highlights that what happened to Korea was not just a domino effect from the currency crisis which started with the collapse of the Thai Baht in July 1997 and which led to a mass exodus of western capital from the region. Korea was looking decidedly shaky before then.

Chang highlights some of the weaknesses of the chaebols going into the 1997 crisis: poor profitability, high levels of gearing and dysfunctional management, and describes some of the political and economic influences which brought them to that state of affairs. Chaebols initially grew as a result of close partnership with the government in the developmental agenda of Park Chung-hee. The core businesses of the groups were in capital-intensive strategic industries which had low margins because of global overcapacity. Their profitability had been cushioned in the 1980s because of low oil prices, the undervaluation of the won and low interest rates. But pressure to share the benefits of these profits with the hard-pressed workforce started a spiral of wage increases, while the won started to appreciate causing exports to become less competitive. This led to increasing investment in the mid 90s to improve efficiency – investment which further increased capacity and which was inevitably debt-funded (and, because of some financial market liberalisation, was often borrowed short term in foreign currencies, thus increasing the currency, interest rate and liquidity risk in the economy).

Chang explains why the chaebols were so highly geared. Firstly, in post-war Korea there was a chronic shortage of capital. Secondly, loans for investment in strategic industries were government subsidised. He also suggests that the cost of equity was high, though he does not provide any evidence for this, and by western standards the dividend yields on Korean companies were not high during the period under consideration. Ultimately though credit was relatively easily available from the banks, who didn’t have the skills to assess credit risk and relied on collateral, including cross-guarantees, which the big groups were able to provide with ease. But the killer piece of evidence Chang provides for the high levels of gearing is a 1997 survey of chaebol CFOs: asked what drove the method of financing capital investment, 52% of CFOs said they were chiefly motivated by trying to avoid diluting the equity stakes of the founding families.

The need to protect or promote the interests of the founding families involved activity which was not always in the interest of the group as a whole; and when the actions were in the interests of the group, this was at the cost of disadvantaging individual entities within the group – and the external shareholders in these entities.

This raises the question of how the chaebols came to be such sprawling masses of unconnected businesses. In part, the groups followed the money — wherever government subsidies were available, that’s where the chaebols expanded. And because subsidies were often volume-related, focus was on sales rather than profitability. Some robust statistical analysis shows that the chaebols grew increasingly diversified (or unfocused) over the 80s and 90s, until post-97 measures forced them to focus on core businesses.

Chang also plausibly suggests — though without evidence — that diversification into unrelated industries was motivated by the desire to obtain a portfolio effect to reduce the risk to the founding families’ investment. This was easier in the 70s when few affiliates were quoted and hence there were few minority shareholders to care about.

The chaebols’ expansion was done by creating new affiliates rather than expanding existing ones. The main reason for this (at least the reason which best stands up to scrutiny) is that with a tick-the-box approach to lending in banks’ credit departments it was easier to get a loan by setting up a new entity (B) and offering a guarantee from an existing entity (A). That met the banks’ flimsy requirements even though it gave no greater security than an unguaranteed loan to an expanded entity A. Also, the more entities there were in a group, the more shares there were sloshing around which should be used as collateral to secure yet more loans from the hapless banks. Chang also suggests that the complex web of cross shareholdings in a group enabled the chairman to control the entities with minimal ownership himself — but here Change’s arithmetic is as murky as the group structures. What is clear though is that the proliferation of entities made for a tangled web — and Chang has some fantastic and bewildering diagrams to illustrate this.

Chang suggests that diversification was also driven by a desire to reap economies of scale. He provides no evidence for this factor being a driver, though makes a good case for it being a by-product — if not always fully realised. Group-wide recruitment, training, resource management, brand management and R&D certainly provided benefits. A possible disadvantage was a homogeneous management culture ill-adapted to change — or to question the strategic blunders of the chairman (such as Samsung’s foray into auto manufacturing).

Another valuable feature of Chang’s book is his analysis of cross subsidisation within the chaebols. While recognising the benefits of vertical integration (itself a necessity in the early years when there was insufficient infrastructure to support the strategic heavy industries) Chang shows through painstaking and convincing analysis how in fact inefficient affiliates were propped up by other group companies — sometimes with the intention of enriching founder families at the expense of outside shareholders.

What is less good is some of the questionable conclusions concerning the extent to which chaebols regarded non-bank financial affiliates as captive treasure-chests to be raided whenever necessary. Chang produces amount of evidence that there certainly were intragroup financial services being conducted, but there is no killer piece of evidence to show that any of this was improper.

For example, he notes that certain Samsung insurance companies invested in other Samsung group companies1 (up to 9.4% of their portfolios were investments in group companies). But for a financial institution not to have a representative proportion of its portfolio invested in the nation’s second-largest conglomerate would be highly irresponsible. What Chang needs to demonstrate is that the portfolios were over-weight in Samsung — and because Chang does not provide the weighting of Samsung in the KOSPI at that time the case is not proved.

Similarly Chang notes that Daewoo Securities “undertook” (presumably he means “underwrote” — and this is one of the many errors which should have been corrected by a financially-literate proof-reader) 1.4 Trillion won of bonds issued by Daewoo affiliates — 51.1% of Daewoo Securities’ total purchases for 1997. Underwriting is very different from purchasing. If Daewoo Securities had likely buyers for all these bonds then there is no case to be answered. Why would Daewoo not channel profitable underwriting business through its securities affiliate? Far preferable to giving another house the profit. The important question to ask — and answer — here is whether Daewoo Securities ended up having to hold on to a significant chunk of the 1.4 trillion won in debt: that would be evidence that the affiliate’s coffers were being raided.

A similar criticism can be levelled against his comments that Samsung Securities “assumed rights” to 1.07 trillion won of affiliates’ bonds. Again, it is unclear what he means by “assumed rights” — which is not conventional capital markets terminology.

So although Chang may be right in saying that chaebols regarded in-house financial institutions as personal treasure-chests, he does not provide the evidence to back up his claim.

To end on a slightly sour note, it’s a pity that Chang didn’t have the benefit of a decent independent reader of his text before it hit the presses. In general, Chang’s is a well written book, but it’s a text which obviously didn’t get read by an English-speaker with a cursory understanding of business language. In the first few pages I had to get out my red pen twice, for word usage which was in the first instance2 just sloppy and in the second3 inexplicable.

The IMF pushed the Korean government to reorganise the chaebols. To do so, the Korean government first rescued virtually insolvent banks with an injection of public funds. It then sought to reorganise the chaebols financially by leveraging the banks to help lower their debt-equity ratio.

Don’t use the word “leverage” in its non-technical woolly business-speak sense (often in daily business parlance it means little more than “use”) in a context where you’re talking about debt/equity ratios (the technical use of the word leverage). Or if you really mean that the government lent the banks money to invest in chaebols’ equity, say so. And the second example:

The Return on Invested Capital 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.

I think he means “divide” rather than “deflate”, otherwise I’m stumped.

There are some academic authors who are incapable of writing more than ten consecutive sentences without creating so much fog that the argument becomes lost. Chang is not one of them. But a decent proof-reader would have got him an extra star from me.

  1. page 138 []
  2. page 6 []
  3. page 14 []

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