financial crisis and transformation of korean business groups: the rise and fall of chaebols

http://www.cambridge.org/9780521814355

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Financial Crisis and Transformation ofKorean Business Groups

This book argues that the Korean financial crisis of 1997 was due tothe inertia of both the business groups known as chaebols and theKorean government, which prevented adaptation to changing externalenvironments. After the Korean government stopped central economicplanning and pursued economic liberalization in the 1980s, the tran-sition created a void under which neither the government nor marketscould monitor chaebols’ investment activities. Chaebols pursued am-bitious expansions that often lacked a strong economic rationale. Theintricate web of cross-shareholding, debt guarantees, and vertical in-tegration resulted in extensive cross-subsidization and kept chaebolsfrom shedding unprofitable businesses. The government’s continuedinterventions in banks’ lending practices created “moral hazards” forboth chaebols and banks.

This treatment demonstrates how the structure of chaebols, whichwas once optimal for their rapid growth, later inhibited other adapta-tions and for all practical purposes became nearly dysfunctional. Thebook argues that restructuring of chaebols should focus on improvingcorporate governance systems.After such restructuring, the author pre-dicts, chaebols will reemerge as stronger, more focused global players.

Sea-Jin Chang is Professor of Business Administration at Korea Uni-versity. Previously, he was a faculty member at the Stern School ofBusiness at New York University. He has also held visiting appoint-ments at Stanford University and INSEAD, France. Prior to his doc-toral study at theWharton School of theUniversity of Pennsylvania, heworked for large telecommunication companies in Korea and Japan.

Professor Chang’s research focuses on understanding the processof creating operating synergies among diversified lines of business andbuilding a strong local organization after foreign entry.His researchhasbeen published in journals such asReview of Economics and Statistics,Journal of Industrial Economics, Journal of Management Studies, andtheAcademy ofManagement Journal. He sits on the editorial boards ofseveral leading journals in strategy and international business. He hasalso written several textbooks in strategy and international business.

To my teachers and colleagues

Financial Crisis andTransformation of

Korean Business Groups

The Rise and Fall of Chaebols

SEA-JIN CHANG

Korea University

Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo

Cambridge University PressThe Edinburgh Building, Cambridge , United Kingdom

First published in print format

isbn-13 978-0-521-81435-5 hardback

isbn-13 978-0-511-06490-6 eBook (NetLibrary)

© Sea-Jin Chang 2003

2003

Information on this title: www.cambridge.org/9780521814355

This book is in copyright. Subject to statutory exception and to the provision ofrelevant collective licensing agreements, no reproduction of any part may take placewithout the written permission of Cambridge University Press.

isbn-10 0-511-06490-X eBook (NetLibrary)

isbn-10 0-521-81435-9 hardback

Cambridge University Press has no responsibility for the persistence or accuracy ofs for external or third-party internet websites referred to in this book, and does notguarantee that any content on such websites is, or will remain, accurate or appropriate.

Published in the United States of America by Cambridge University Press, New York

www.cambridge.org

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-

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http://www.cambridge.org

http://www.cambridge.org/9780521814355

Contents

Preface page ix

1 Introduction 1From Asian Miracle to Asian Crisis 3Chaebols: The Korean Business Groups 9The Theoretical Framework of this Book 24

2 The Evolution of Chaebols 43The Development of Chaebols in Korea 45Brief Histories of the Top Five Chaebols 62The Growth Strategy of Chaebols 70The Environmental Shift 75

3 Chaebols’ Diversified Business Structure 79The Extent of Chaebols’ Diversification 81Intragroup Resource Sharing 87Organizational Structure of Chaebols 98Diversification and Economic Performance 105

4 Vertical Integration of Chaebols 111The Scope of Chaebols’ Vertical Integration 113

v

vi Contents

Motives for Vertical Integration: Pros and Cons 118Performance Implications of Chaebols’

Vertical Integration 123

5 The Capital Structure of Chaebols 131Financial Market Environments in Korea 133Capital Structure of Chaebols 141Chaebols’ Internal Capital Markets and

Cross-subsidization 149Collapse of Chaebols and Financial Institutions

During the Crisis 157

6 Chaebols’ Ownership and Governance Structure 161Characteristics of the Ownership Structure

of Chaebols 163The Corporate Governance System in Korea 170Agency Problems in Chaebols 176

7 The Restructuring of Chaebols 187The Restructuring Policy of the Korean

Government 189Restructuring of the Financial Sector 191Restructuring of the Corporate Sector 195Enhancement of the Corporate Governance

System 208Perspectives on the Restructuring of Chaebols 212

8 Conclusion 217The Crisis and the Fall of Chaebols: A Summary 219Business Groups in Other Countries 224The Taming of Chaebols 231The Future of Chaebols and the Developmental State 238

Contents vii

Appendixes1. Data Used in this Book 2452. Comparing the Profitability of Group-affiliated

Companies and Independent Companies 2493. Profitability of Group-affiliated Firms 2644. The Impact of Vertical Integration in Chaebols 2755. Determinants of the Capital Structure of Chaebols 2846. Profitability and Stock Ownership of Affiliates 2917. Intragroup Business Transactions and

Ownership Structures of the Top Five Chaebols 2998. Key Economic Statistics 309

Notes 311References 327Index 345

Preface

The Asian Crisis in 1997 affected almost everyone in Korea.Thousands of companies went out of business, and many work-ers lost their jobs. Foreign investors fled the country,major banksbecame insolvent, and the government depleted its foreign re-serves as the country went bankrupt. This crisis was financiallyand emotionally painful for me. I had returned to Korea in 1994.At that time, Korea’s prospects looked bright. Korean firms con-tinued to grow at a phenomenal rate and had expanded aggres-sively overseas. Every Korean I met was proud of his country,and businessmen were confident that Korea would soon catchup to Japan, which had served as a role model for Korea. As oneof the faithful, I sold my stock in U.S. companies and investedthe proceeds in Korean firms. Right after the crisis, however,my net worth in dollars had shrunk to one eighth of what it hadbeen. My wife once teased me, asking how a business schoolprofessor could be such a lousy investor. Like many Koreans,I was determined to find out who had ruined my country andstolen my pride.

The widespread consensus was that chaebols were to blamefor Korea’s downfall. Chaebols, which are powerful groups of

ix

x Preface

affiliated companies that helped catalyze Korea’s economic de-velopment, have long been admired and criticized. On one hand,people admired them. Korea’s top college graduates lined upto work for them. In downtown Seoul, where the insignias ofHyundai, Samsung, LG,Daewoo, and SKwere displayed every-where, the strength ofKorea’s economywas palpable. The chae-bol chairmen who managed these empires seemed glamorous.On the other hand, chaebolswere the subject of fear, disdain, andresentment. They were blamed for devouring Korea’s resourcesand squeezing out smaller companies. Newspapers reportedmany incidents of chaebols making illegal contributions topoliticians and receiving favors in return. Foreign governmentsoften charged chaebols with dumping and other unfair busi-ness practices. Western businessmen believed chaebols wereanalogous to cancer cells that grewwithout purpose and therebykilled neighboring cells before consuming themselves.

As I researched chaebols, I learned that they were neithercrazy nor irrational. Rather, chaebols had been efficient giventheir environment. By sharing financial and intangible resourcessuch as brands, technology, and human resources among affil-iates, their internal markets had created enormous synergies.Such resource sharinghadbeen the source ofKoreanfirms’ com-petitive advantage and had enabled Korea’s economy to growquickly. Yet the Asian Crisis revealed chaebols’ fatal weak-nesses. The resource sharing among legally independent af-filiates was possible only because chaebols were centralized,and their chairmen wielded immense power. There was no wayto guard against the ill-conceived strategies of these chair-men, who pursued diversification that lacked any economicrationale, cross-subsidized unprofitable affiliates, and divertedprofits to affiliates in which they and their families ownedlarge equity stakes. All these activities wasted the synergies

Preface xi

created through resource sharing. The intricate web of cross-shareholding, debt guarantees, and vertical integration furtherinhibited chaebols’ efforts to restructure. During the transitionfrom a state-controlled economy to a market-oriented economyin the years prior to the Asian Crisis, neither the Korean gov-ernment nor the markets could monitor or guide chaebols’ in-vestment activities.

This book argues that wholesale criticisms of chaebols andradical prescriptions for chaebols, such as breaking them up, arewrong. It proposes instead that the Korean government needsto build institutional infrastructures, especially corporate gov-ernance systems, which will help markets function better. Otherlaws that protect minority shareholders’ rights and strictly en-force the Fair Trade Act will make practices such as expropria-tion and cross-subsidization more difficult and will ensure thatchaebols’ investment decisions are sound. At the same time,increased international competition in their home markets willforce chaebols to focus on their core businesses. By revampingits corporate governance system and trade policies, the Koreangovernment can unleash the power of hardworking managersand workers, who were a key factor behind Korea’s dramaticeconomic growth. I have no doubt that when chaebols are re-formed, they will once again become strong global players.

As I researched and wrote about chaebols during the lastfive years, I realized how much I had learned – and continueto learn – from my teachers and colleagues. For this reason,I dedicate this book to them as a way of expressing my deepgratitude. Byung-Hyou Chong of the Seoul National Universitytaught me industrial organization economics in college and en-couragedme to pursue graduatework. EdwardBowman,HubertGatignon, Bruce Kogut, Dan Levinthal, and Harbir Singh ofthe Wharton School of the University of Pennsylvania were

xii Preface

exemplary scholars who guided me through my doctoral stud-ies. I am also indebted to my colleagues, who have been alwaysa source of insight and encouragement. Tom Pugel and othercolleagues at the Stern School of New York University cre-ated an intellectually stimulating environment. My colleaguesat Korea University also provided me an environment in whichI could concentrate on research. In particular, Linsu Kim helpedme start this book project and Dean Jangro Lee of the Insti-tute of Business Research provided me special funding for thisresearch.

While writing this book, I benefited from the detailedcomments and helpful suggestions of Neil Fligstein, MarkGranovetter, Mauro Guillen, Tarun Khanna, Bruce Kogut, TomPugel, Seungdon Oh, Harbir Singh, three anonymous readersfor Cambridge University Press, and seminar participants fromStanford University, University of Michigan, New York Uni-versity, University of British Columbia, and Ewha University.Jaebum Hong of the Korea Information Service and PanseopLee, Hyeonjung Park, Sekeun Park, and Kyungbae Son ofKorea University helped me greatly in accessing and process-ing data for this work. John Lafkas copyedited the manuscriptand provided helpful comments before I submitted it for review.Scott Parris, the editor at Cambridge University Press, and hisfellow staff members encouraged and endured me as I preparedthe manuscript. They did a wonderful job of turning my workinto a book. Last but not least, I would like to thank my family,whose kindness, love, and understandingmade this long journeypossible.

1

Introduction

1

From Asian Miracle to Asian Crisis

from asian miracle to asian crisis

Korean citizens will never forget November 21, 1997. Peoplewere dismayed by what they heard from the media that day.There had been rumors of skyrocketing foreign exchange rates.Then the minister of finance and economy resigned. Chang-Ryol Lim, the succeeding minister, immediately announced thathe would request funds from the International Monetary Fund(IMF). Korean media kindly added commentaries that theircountry was about to go bankrupt and was seeking a bailoutby IMF. A few days later, Michel Camdessus, the IMF’s man-aging director, visited Korea to announce that the IMF wouldassist Korea, provided that the government would restructureKorea’s economy.

Koreans were proud of their economic achievements andwere shocked by this turn of events. The per capita incomein Korea had increased from $82 in 1961 to $10,315 in 1997.1

The World Bank, a sister organization of the IMF, had pub-lished a book, Asian Miracle,2 that praised Korea as an exem-plar of economic development. Yet something was wrong withthe Korean economy. The Hanbo, Jinro, and Kia Groups, allmembers of Korea’s top thirty business groups, termed chaebols,went bankrupt earlier in 1997. Bankruptcies of large chaebolswere unprecedented in Korea because the government had tradi-tionally rescued large chaebols from bankruptcy; most Koreansbelieved that the bigger chaebols were, the less likely they wereto fail.

Yet informed citizens knew that these bankruptcies augureda situation that was not “business as usual.” In fact, the “TigerEconomies” of Asia were all on edge. The foreign exchangecrisis in Asia, which started with the plummeting of Thai baht

3

Introduction

in July 1997, spread quickly to Indonesia and Malaysia withintwo weeks, and other Asian countries were bracing for the worst.Unstable foreign exchange rates caused a dollar exodus from theregion, resulting in sweeping instability throughout SoutheastAsia. The Korean government had aggravated this instabilityby implementing the so-called antibankruptcy agreement af-ter Hanbo, Jinro, and Kia went bankrupt. This agreement ef-fectively blocked banks from demanding payments of overduedebts by already insolvent companies and forced these banks toprovide insolvent firms with additional financing. Fearing fur-ther losses, commercial and merchant banks in Korea reactedto these policies by recalling loans to other companies that hadfinancial problems. The resulting contraction in the financialmarket drove additional companies into bankruptcy.

Observing these events, foreign investors began reexamin-ing the fundamentals of the Korean economy. They then startedwithdrawing their funds from Korea en masse, liquidating theirinvestments at a loss and converting them to dollars. Foreignfinancial institutions also sharply reduced advances to Koreancompanies and then began calling in their loans to financial in-stitutions in Korea. These actions in turn created even largercontractions in the stock and foreign exchange markets and in-duced the bankruptcies of larger Korean firms. The Bank ofKorea vainly intervened in the market to protect the won’s value,thereby reducing its foreign currency reserves to $5 billion at onepoint.3 Yet it continued supplying funds to financially troubledbanks, which now owed large debts to foreign creditors. Foreignexchange rates soared from 864 won per dollar in January 1997to 1,695 won per dollar by December 1997 (see Figure 1.1).The Korean stock exchange index tumbled from 669 to 390,and the number of Korean companies that went bankrupt in-creased from 1,000 per month to 3,500 per month. The Korean

4


0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

97. 1

97. 3

97. 5

97. 7

97. 9

97. 1

198

. 198

. 398

. 598

. 7 98. 9

98. 1

1

Number ofbankruptcies

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

97. 1

97. 3

97. 5

97. 7

97. 9

97. 1

198

. 198

. 398

. 598

. 798

. 998

. 11

99.1

99.3

99.5

99.7

99.9

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

0

2

4

6

8

10

12

14

16

18

20Interest rate (%)

Exchange rate Stock market index Interest rate

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

economy, which had created the miracle on the Han River fromthe ashes of the Korean War, returned to ashes.

The IMF demanded that the Korean government adopt dra-conian measures in return for the relief fund. It wanted to re-store confidence in the Korean economy and to fundamentally

5

Introduction

restructure Korea’s financial and corporate sectors. To achievethe first goal, it raised short-term interest rates to 25% and ush-ered in a floating exchange rate regime. These initiatives resultedin soaring exchange rates, and their effectiveness was question-able. Notable economists, including Joseph Stiglitz, the vicepresident of the World Bank, and Jeffrey Sachs, publicly crit-icized the high interest rate policy because it triggered morebankruptcies and insolvencies.4

To achieve the second goal, the IMF pushed the Korean gov-ernment to reorganize the chaebols. To do so, the Korean gov-ernment first rescued virtually insolvent banks with an injectionof public funds. It then sought to reorganize the chaebols finan-cially by leveraging the banks to help chaebols lower their debt–equity ratio. Second, it forced the so-called Big Deal, which re-quired the chaebols to swap and reorganize their businesses sothat each chaebol would focus only on a select few lines of busi-ness. Various problems, however, beset this project. Chaebolsinitially objected to the plan by arguing that it was impracticalfor them to reduce their debts so quickly. They then tried topoliticize the Big Deal to delay being restructured.5

Despite the government’s failure to restructure the chaebolspromptly, the Korean economy gradually recovered from theshock of the foreign exchange crisis. The source of the reliefwas rather unexpected. The Asian economic malaise started toinfect first Russia and the South American countries, and thenfinally even the advanced countries, including the United States.For example, one of the biggest hedge funds in America,Long-Term Capital Management, was saved from the verge ofinsolvency by the U.S. government in 1998. As the crisis in afew Asian countries began to snowball globally without control,the Federal Reserve Bank of the United States hurriedly low-ered the interest rate to cool down the situation.6 Other countries

6


followed suit. As a result, the exchange rate of the Korean wonstabilized at 1,100 won per dollar by the end of 1999, market in-terest rates decreased to less than 10%, and the stock exchangeindex surged past 1,000 by the middle of 1999. Further, theKorean government announced in November 1999 that it wishedto repay the IMF relief fund ahead of schedule and that addi-tional assistance would be unnecessary.

Many have speculated about why Korea got caught in theAsian crisis.7 Some have speculated that the flood of “hotmoney” heightened the instability of the foreign exchange mar-ket and ultimately led to the crisis.8 There is room for debateabout how deeply short-term speculative funds contributed tothis crisis throughout Asia. Also, the IMF pointed out severalmishaps by the Korean government that made Korean financialinstitutions vulnerable.

Until the financial crisis in late 1997, Korea had experi-enced a long period of rapid growth, low inflation, anda sustained improvement in the standard of living. Pru-dent macroeconomic policies and high domestic sav-ings and investment contributed to the rapid transfor-mation of Korea into an advanced industrial economyin four decades. The government had begun an eco-nomic reform program – which gained momentum in1993–96 – to gradually liberalize financial markets andthe capital account. Capital account liberalization, how-ever, was not well sequenced nor accompanied by thenecessary reforms and strong prudential supervision ofthe financial system. The vulnerabilities of the econ-omy to external events stemming from weaknesses inthe corporate and financial sectors were not fully rec-ognized. Controls on short-term external borrowing by

7

Introduction

banks were eased, but controls on medium- and long-term capital remained in place.9

The Western popular press and financial community, how-ever, blamed chaebols for being the main culprits of the crisis.10

They argued that chaebols are analogous to cancers that pursuedpurposeless growth and thereby killed neighboring cells beforeconsuming themselves. The IMF’s assessment was worded moremildly, but it also identified the debt-ridden chaebols with an un-holy alliance with financial institutions as the root cause of thecrisis:

In 1994–96, Korean conglomerates undertook an ag-gressive investment drive financed by large increases inborrowing from domestic banks, which, in turn, sharplyincreased short-term external borrowing. During 1997,an unprecedented number of highly leveraged conglom-erates went into bankruptcy as the buildup in capac-ity proved unviable owing to the depreciation of theyen, a sharply adverse movement in Korea’s terms oftrade, and the slowing of domestic demand in 1996.The bankruptcies resulted in a severe deterioration inthe balance sheets of Korean financial institutions.11

Even now, after the apparent recovery, the crisis raises manyquestions about how robust Korean economic institutions are.Chief among these institutions is the chaebol, which is a ma-jor force in the Korean economy. Some have argued that chae-bols drove Korea’s rapid economic growth.12 Could they havecaused the foreign exchange crisis? How then, did they come tobe the destroyer of their own creation? Several questions mayalso be raised about foreign financial institutions. Why did they

8

Chaebols: The Korean Business Groups

continue providing loans to chaebols prior to the crisis, knowingthat chaebols were heavily leveraged? How did chaebols and theKorean economy recover so quickly after the crisis even thoughthey did not change much? Was the crisis an unforeseeable ran-dom event where investors and creditors showed a herd reaction?Were chaebols simply susceptible to external turbulence? If so,what is the real problem with the chaebol phenomenon? Whatare their strengths and weaknesses? Should they be dissolved asargued by the Western critique? Should the Korean governmentforce them to restructure further? If so, what would this restruc-turing involve? Can chaebols once again continue to grow andprosper?

Numerous books look at chaebols. Most focus on how theywere formed and their relationship to the government. None,however, pursues chaebols in sufficient depth to show how theyoperate. This book thoroughly examines chaebols’ internal op-erations and evaluates their performance prior to the crisis andtheir subsequent restructuring. In doing so, it offers the broad,in-depth perspective necessary for answering the questions setout earlier. It also considers how chaebols might be restructuredand whether they can once again become major players in theworld market.

chaebols: the korean business groups

The Role of the Chaebol in the Korean Economy

As mentioned, a chaebol is a Korean business group. It encom-passes many subsidiary firms under the same name. Chaeboloriginally meant money clique in Chinese and was used to referto a group with a vast fortune. Some chaebols, such as Hyundai,Samsung, LG, Daewoo, and SK, are well known in the West.

9

Introduction

There are many Korean companies with more than two sub-sidiaries that are controlled by one family, but the Korean gov-ernment and media typically use “chaebols” to denote the thirtylargest Korean business groups. The Korean government annu-ally identifies the thirty largest business groups and publishesa listing of their affiliates under the “Monopoly Regulation andFair Trade Act” (known as the Fair Trade Act) to block anyanticompetitive behaviors. The act defines chaebols’ affiliatesas those for which “either more than 30% of whose issuedshares are owned by one person, his relatives, or a companycontrolled by him, or whose management such as appointing itsofficers is substantially affected.”13 This book uses that defi-nition. Table 1.1 briefly describes their size, the trend of theirintra-group business transactions, ownership of shares, and debtguarantees.

The chaebols play a critical role in Korean markets. Figure 1.2shows the portion of the Korean gross national product (GNP)attributable to the thirty largest chaebols from 1985 to 2000.To make these data comparable to GNP data, we calculated thevalue-added production of chaebols by adding up income be-fore taxes, wages to workers, various financial expenses, anddepreciation of all chaebol firms in our database except thosein financial services and several small affiliates that were not“statutory audited firms.”14 In 1995, chaebols accounted for ap-proximately 16% of the Korean GNP, and this portion would bemuch bigger if it included all the chaebols’ affiliates. Figure 1.2also shows two important trends. First, it indicates that the chae-bols’ share of the national GNP increased from 12% in 1985 to16% in 1995, which proves that the national wealth had beenincreasingly concentrated into a few chaebols’ hands during theperiod. Second, it shows that almost all this increase during thistime (an increase from about 6% to about 10%) accrued to the

10


0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

1985 1987 1989 1991 1993 1995 1997 1999 2000

%

Top 5 % Top 6-30 %

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

top five chaebols. There is a big difference between the sizesof the five biggest chaebols and those of the other twenty-fivechaebols. In studying the chaebols, we shall thus focus on under-standing the operations of the five biggest chaebols – Hyundai,Samsung, LG, Daewoo, and SK.

The chaebols are also major global players (Ungson, Steers,and Park, 1997). As of 1997, ten affiliates of the top thirty chae-bols made the Global Fortune 500 listing. The chaebols aggres-sively pursued globalization strategies during the 1990s: theyengaged in various kinds of direct investments, mergers, and

11

Tabl

e1.

1.T

heli

stin

gof

the

top

thir

tygr

oups

in19

97

#.of

Ass

ets

Sale

sE

quity

Deb

t–D

ebt

Fam

ilyA

ffilia

ted

1997

Bus

ines

saf

filia

te(b

illio

n(b

illio

n(b

illio

neq

uity

Intr

agro

upgu

aran

tee/

owne

rshi

pow

ners

hip

rank

ing

grou

psfir

ms

won

)w

on)

won

)ra

tio(%

)tr

ade

(%)

equi

ty(%

)(%

)(%

)

1H

yund

ai57

52,8

2167

,990

9,84

243

6.7

31.6

102.

513

.841

.62

Sam

sung

8050

,705

60,1

1313

,809

267.

228

.217

.63.

542

.53

LG

4937

,068

46,6

748,

302

346.

523

.728

.15.

434

.04

Dae

woo

∗32

34,1

9738

,243

7,81

733

7.5

35.6

129.

46.

131

.25

SK46

22,7

2326

,640

4,70

338

3.2

21.4

16.8

14.1

30.1

6Ss

angy

ong

2515

,804

19,4

453,

102

409.

535

.492

.53.

637

.57

Han

jin24

13,9

078,

708

2,11

855

6.6

8.3

385.

918

.720

.38

Kia

∗28

14,1

2112

,001

2,28

951

6.9

33.8

110.

820

.89.

69

Han

wha

∗31

10,5

929,

657

1,24

475

1.4

20.2

159.

35.

926

.710

Lot

te30

7,75

37,

192

2,65

419

2.1

11.6

20.8

3.4

19.4

11K

umho

257,

399

4,44

31,

281

477.

67.

112

1.4

2.0

37.8

12H

alla

∗18

6,62

75,

293

306

2,06

5.7

31.0

891.

018

.830

.513

Don

gah∗

196,

289

3,88

51,

383

354.

72.

620

2.4

12.0

42.2

14D

oosa

n25

6,36

94,

042

808

688.

215

.888

.113

.435

.915

Dae

lim20

5,84

94,

832

1,11

842

3.2

26.4

256.

28.

825

.116

Han

sol

234,

214

2,51

31,

075

292.

026

.850

.83.

733

.217

Hyo

sung

182,

131

5,47

787

914

2.4

14.5

42.1

13.5

30.7

18D

ongk

uk17

3,69

83,

075

1,16

121

8.5

6.3

56.1

15.6

32.5

19Ji

nro∗

243,

826

1,39

199

3,76

4.6

8.6

473.

316

.628

.320

Kol

on24

3,84

04,

134

919

317.

87.

784

.87.

636

.521

Koh

ap∗

133,

653

2,52

152

959

0.5

50.5

80.3

8.5

30.8

22D

ongb

u32

3,42

33,

154

946

261.

87.

292

.812

.833

.223

Don

gyan

g24

2,63

11,

847

646

307.

316

.491

.94.

844

.024

Hai

tai∗

153,

398

2,71

544

865

8.5

8.9

57.0

3.9

24.9

25N

ewco

re∗

182,

797

2,27

921

11,

225.

628

.317

2.5

36.4

62.3

26A

nam

212,

638

1,98

445

647

8.5

55.9

361.

39.

832

.027

Han

nil∗

72,

599

1,27

738

457

6.8

6.8

215.

811

.225

.228

Keo

pyun

g∗22

2,29

61,

058

513

347.

622

.135

4.3

17.4

41.5

29M

iwon

252,

233

2,11

443

241

6.9

26.5

150.

415

.736

.230

Shin

ho∗

251,

139

1,21

036

221

4.6

16.9

300.

19.

923

.3To

p30

aver

age

2711

,159

11,8

642,

328

600.

721

.217

3.5

8.5

33.7

Not

es:

1.*

deno

tes

firm

sei

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atio

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rvic

e.

Introduction

acquisitions throughout the world. For example, Samsung, LG,and Hyundai all enlarged their semiconductor production capac-ities and acquired such American companies as AST Research,Zenith, and Maxter, respectively. Daewoo Motors acquired FSOof Poland and constructed large auto manufacturing plants inIndia, Uzbekistan, and Romania.

The Performance of Chaebols Prior to 1997

Although “hot money” and inappropriate government policiescontributed to the crisis in Korea, the chaebols’ performance hadgreatly deteriorated before the financial crisis began. Chaebolswere thus vulnerable to external events. Figure 1.3 shows thatthe profitability of the thirty largest chaebols, gauged by thereturn on invested capital (ROIC), had fallen steadily since themid 1980s. The ROIC is defined as the sum of net income beforetax plus interest payments, deflated by total assets, to provide areturn metric that is comparable across firms. This measure ofperformance assesses operating efficiency without being biasedby the relatively high debt–equity ratios common in Koreanfirms. The higher profitability of the chaebols during the late1980s was due primarily to external factors such as low oilprices, low interest rates, and undervalued currency. In manycases, chaebol affiliates were not profitable enough to covereven their financing cost, which is calculated by dividing interestpayments by interest-bearing liabilities. This statistic suggeststhat many affiliates were very inefficient.

The figure also shows that the profitability of the top thirtychaebols was quite low relative to firms in other countries.15

The top thirty chaebols were sometimes less profitable thanwere smaller groups and independent companies, although thestatistical analysis in Appendix 2 indicates that this difference

14


0.00

2.00

4.00

6.00

8.00

10.00

12.00 (%)

1985 1987 1989 1991 1993 1995 1997 1999

ROIC Financial Expense

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

may be due largely to industry factors and various internaltransactions. Many chaebols were in low-profit industries suchas heavy equipment and chemical industries, which had chronicovercapacity. Because chaebols often used cross-subsidizationthrough various forms of international transactions, it is hardto compare the profitability of chaebol and nonchaebol firms.Figure 1.3 also shows that the profitability of chaebols declinedduring the 1990s.

15

Introduction

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

19851986

19871988

19891990

199119

9219

931994

199519

9619

9719

981999

2000

Year

Out

goin

g F

orei

gn D

irect

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stm

ent

(mill

ion

$)

0

200

400

600

800

1,000

1,200

1,400

1,600

Rea

l wag

e (t

hous

ands

won

)

Outgoing foreign direct investment Real wage

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

There are three apparent reasons for this decline. First,Korean companies became uncompetitive in both low-end andhigh-end exports. After economic liberalization in the early1980s, labor disputes intensified. As a result, Korean workers’real wages doubled between 1985 and 1995 (see Figure 1.4),thus making Korean exports less competitive than were theirequivalents from developing countries such as Indonesia andChina. To make things worse, the Korean won was overvalued.Figure 1.5 displays the trends of the exchange rates for the wonand the Japanese yen, as well as the surplus/deficit on capital andcurrent accounts. Many Korean products directly or indirectlycompete with Japanese counterparts in the world market. Thesharp appreciation and eventual overvaluation of the Japaneseyen against the U.S. dollar during the late 1980s generated huge

16


-30,000

-20,000

-10,000

0

10,000

20,000

30,000

40,000

50,000

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000

Balance of payments (U.S.$ million)

0

50

100

150

200

250

Exchange rate

Current Account Capital Account

$/W(1985=100) $/¥(1985=100)

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

trade surpluses for Korea and an economic bubble. In response,the Korean government liberalized foreign travel and foreigncapital exports to reduce the amount of trade surpluses dur-ing the same period. This initiative induced extravagant foreigntravel and conspicuous consumption, both of which decreasedKorean trade surpluses during the first part of the 1990s. Koreancompanies, however, were forced into cutthroat price competi-tion against Japanese companies during the mid 1990s. Suchcompetition was exacerbated by the relative stability of the wonand the sharp depreciation of the yen.

Korea’s trade deficit therefore increased drastically during1994–6. It was covered only by surpluses in Korea’s capitalbalance, which barely maintained the stability of the foreign

17

Introduction

0.00

50.00

100.00

150.00

200.00

250.00

1985 1987 1989 1991 1993 1995 1997 1999

Labor productivity,Capital/Labor ratio

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Capital productivity

Capital/Labor ratio Labor productivity Capital productivity

Figure 1.6. Chaebols’ capital investment.

exchange market. Capital balance surpluses, however, meant in-creased borrowing of foreign capital. The influx of short-termforeign capital into the Korean stock market was conspicuousduring this period, and banks and other financial institutions inKorea were financed by the increasing funds from foreign fi-nancial institutions. The won’s value did not depreciate in thisperiod only because of this influx of capital. Ultimately, though,the vicious cycle between the trade deficit and debt helped in-duce the exchange crisis. The exodus of foreign capital thatoccurred in late 1997 was the final blow to the won.

Second, chaebols responded to the wage hike and the won’sovervaluation by increasing capital expenditures for both fac-tory automation and factory construction overseas. Figure 1.6illustrates the inflation-adjusted capital productivity, labor

18


productivity, and the degree of capital intensity of chaebol com-panies as a whole for 1985–2000. The capital productivity wascalculated by dividing the chaebols’ value-added production bytheir total amount of tangible fixed assets. The labor productivityindex was calculated by dividing the value-added production bythe number of total employees. The capital intensity is measuredby the total amount of tangible fixed assets per employee.16 Therelationship between these values is established by the followingequation:

Labor Productivity = Capital Productivity × Capital Intensity

The indices of capital and labor productivity let us infer howmuch chaebols invested in fixed equipment such as factory andmachinery and how much they benefited from these investments.Figure 1.6 shows that labor productivity, a concept similar toper capita GNP, increased continuously from 1985 to 2000.Capital productivity declined dramatically, however, because ofthe skyrocketing capital intensity of chaebol companies duringthe 1990s. Chaebols also aggressively built factories worldwideand increased their importation of technology and capital goods.Figure 1.4 shows the trends of wage rates and foreign direct in-vestment. Korean firms stepped up foreign direct investment in1990s. Chaebols’ short-run profitability and cash flow sufferedbecause of these investments whose benefits could be reapedonly in the long run. These trends are consistent with Krugman’sargument that the Asian miracle is the result of large inputs ofcapital and labor rather than productivity growth.17

Third, as we will discuss further in Chapter 3, chaebols en-gaged in unrelated diversification even when doing so was eco-nomically unviable. For example, the auto industry was plaguedby overcapacity, especially after Hyundai and Kia increased

19

Introduction

their capacity to deter Samsung from entering the industry.Hanbo Group, which ultimately went bankrupt, made econom-ically unviable investments in minimill technology. Jinro wentbankrupt after rapidly expanding its retailing businesses whilerelying on bank loans. Chaebols’ pursuit of unrelated diversifi-cation did not dwindle even during the economic downturn inthe 1990s. The top thirty chaebols became more focused only af-ter the crisis hit them in 1997.18 Such careless investments lendcredence to criticisms that chaebols pursued growth relentlessly.

Here, several questions arise. Why did chaebols expand inirrational ways? Why were there no control mechanisms in placethat would have guarded against such risky investments? Whathappened to the Korean government, whose prudent guidancewas considered crucial to Korea’s economic growth? What roledid the banks play in evaluating investment projects? The nextsection reveals that there was no functioning governance systemto guide chaebols’ investment activities.

The Korean Economy in Transition

Korea was experiencing a major transition to its economic sys-tem prior to the crisis. Among the elements that help define aneconomic system are the governance system, property rights,and rules of exchange it employs (Fligstein, 2001). In this book,we define the governance system broadly as institutionalizedeconomic processes that organize and coordinate economic ac-tivity among organizations in the economy. Thus, markets, cor-porate hierarchies, networks, and the government itself are somespecific forms of governance systems (Campbell and Lindberg,1990). On the other hand, the corporate governance system,which is a central focus of Chapter 6, refers more specifi-cally to firms’ internal organization and power structure, which

20


encompass the functioning of the board of directors, the own-ership structure, and the interrelationships among senior man-agers, shareholders, and other stakeholders such as the com-pany’s workforce and creditors (Hopt et al., 1998). Governancesystems and corporate governance systems differ by country.The U.S. governance system is largely market-based, and thegovernment is not very involved in it. On the other hand, laborplays an important role in Germany’s governance system.19

In Korea, the government played a major role in the gover-nance system as the economy developed. It tightly controlledcapital allocation, as we will discuss in detail in Chapter 2, bydesignating several “strategic” industries and allocating capitalto them at favorable rates. It also nationalized all banks andtightly controlled foreign sources of capital. Further, it assessedthe performance of individual companies and rewarded success-ful ones by allocating more funds to them (Amsden, 1989). Bydoing so, it supplanted the market-based economy.

By the early 1980s, however, it was uncertain whether thegovernment could manage the economy as it had in the past.As the economy matured, the private sector had become morecomplex. Further, since the government had regarded the heavyequipment and chemical industries as “strategic,” its credibilitywas eroded after firms in these industries did poorly during the1970s. At the same time, foreign pressure, especially from theIMF and World Bank, which in turn were heavily influencedby the U.S. government, to open up Korean markets intensified.The government finally stopped directly subsidizing businessesand pursued deregulation and economic liberalization.

The transition from a state-based system to a market-basedsystem, however, was neither well planned nor well executed.For example, while privatizing the financial services industryand easing foreign exchange controls, the government paid no

21

Introduction

attention to providing institutional infrastructures that were nec-essary for the capital market to function properly. Here institu-tions denote formal constraints such as rules, laws and regu-lations, and informal constraints such as norms of behavior,conventions, self-imposed codes of conduct, and enforcementmechanisms, which structure human interaction to reduce uncer-tainty in exchange and provide incentives (North, 1991, 1994).Without institutions, markets neither develop nor function prop-erly. For instance, during this transition, the government intro-duced no explicit mechanism to monitor the financial health offinancial services institutions (Fields, 1995). Although chaebolseither acquired or set up nonbanking financial firms and tappedtheir reserves as if they owned them, the government did noteffectively guard against such abuse.

During the 1990s, the government also deregulated access tothe international capital markets. Banks and nonbank financialaffiliates of chaebols were free to borrow from foreign banks andissue bonds. Yet the government continued to dictate banks’lending practices and thereby prevented the private financialservice sector from developing (Amdsen and Euh, 1993; Woo,1991). Even after privatization, around 60% of bank credit in1985 was lent for government-designated purposes.20 Often, thetop management positions of commercial banks were filled byex-Ministry of Finance officers. The ministries and the politi-cians could also influence the lending decisions, and thus cre-ated ample opportunities for crony capitalism. In short, Korea’sbanks were heavily controlled even after they were privatized.

By abrogating its role in developing institutional infra-structures, the Korean government helped undermine Korea’seconomy. The chaebols’ investments during the 1990s clearlyshowed that no functioning governance system was in place.Such investment would not have been possible in the 1960s

22


and 1970s when the government allocated capital to businessesand monitored their performance. Nor would it have occurred ifcapital markets, creditors, and shareholders could evaluate thesoundness of these investments.

In a sense, this crisis resembles those that swept LatinAmerican countries such as Chile, Argentina, and Uruguay inthe early 1980s. In each of these nations, under pressure from theIMF, the government ignited currency and debt crises by dereg-ulating the economy without establishing an appropriate regula-tory framework (Galvez and Tybout, 1985; Corbo, de Melo, andTybout, 1986; Banuri, 1991; Khanna and Palepu, 2000). Mexicoand Brazil, which also pursued economic liberalization, experi-enced currency crises in 1994 and 1999, respectively (FernandezJiberto and Mommem, 1996; Baer and Love, 2000). After yearsof import substitution development strategies that relied heavilyon extensive government intervention, all these countries liber-alized by both removing various controls on prices, trade barri-ers, and constraints on capital flows and privatizing state-ownedfirms, including financial service firms. Domestic firms tried tocapitalize on the opportunities created by this rapid deregulationand privatization by borrowing from foreign creditors. Businessgroups in Chile, in particular, acquired banks and used theirfunds to acquire companies that were being privatized (Tybout,1986). Debt and foreign exchange crises swept these nationswhen the firms that borrowed from foreign creditors could notpay their loans. The governments had to bail out failed banksby injecting massive public funds.

The importance of institutional infrastructure is furtherdemonstrated by the recent privatization experiences of EasternEuropean countries. Unlike the prescriptions by market lib-eralists, markets in these countries did not develop automati-cally when governments deregulated their nations’ economies.

23

Introduction

Russia’s and the Czech Republic’s privatization efforts, whichinvolved little effort to build institutions, failed. Managers andcontrolling shareholders of many privatized firms stripped thesecompanies’ assets. They left poorly informed minority share-holders with worthless pieces of paper and firms teetering onthe edge of bankruptcy (Stark and Bruzst, 1998: Dyck, 1999).In contrast, Poland allowed regulatory mechanisms that safe-guarded the operations of financial markets to be developed atthe same time it liberalized its economy. Its privatization effortswere relatively successful (Kogut and Spicer, 2002).

the theoretical framework of this book

Chaebol as a Universal Phenomenon

The chaebol may seem peculiar to Korea. Yet it is similar toorganizational forms found throughout the world. These formsare different from country to country and reflect distinctionsin economic, social, and cultural environments, but they sharecommon features in the ways they enable business groups, suchas conglomerates in the western hemisphere, Japanese zaibatsuand keiretsu, grupos economicos in Latin American countries,and business houses in India to pursue unrelated diversificationunder centralized administrative control.

First, chaebols share many traits with the conglomerates ofthe United States and Europe. Both pursued unrelated diversifi-cation. They are different, however, in that affiliates of chaebolsare bound with each other by cross-shareholding and mutualdebt guarantee practices, even though they are legally indepen-dent, while business divisions within conglomerates are legallypart of the same organization. Many underperforming U.S. con-glomerates disappeared during the restructuring boom of the

24

The Theoretical Framework of this Book

1980s, although GE remains a conspicuous exception to thistrend. Conglomerates also exist in Europe. Although many pre–World War II konzern in Germany were separated into many in-dividual companies, groups such as Daimler-Benz and Siemensgrew by diversifying their businesses. France has also a longtradition of conglomerates, many of which organized into hold-ing companies. Many new conglomerates in France were cre-ated during the nationalization and reprivatization of Mitterand’sgovernment.21 Unlike chaebols, however, the conglomerate isnot usually subject to the influence of strong family owners anddoes not pursue vertical integration nearly as much as chaebolsdo.22 Chaebols are also distinct from conglomerates in their useof general trading companies to control and orchestrate other af-filiates toward the export market. Figure 1.7 shows a schematicdescription of chaebols.

Korean chaebols also are strikingly similar to the pre–WorldWar II Japanese zaibatsu. Chaebol and zaibatsu literally sharecommon Chinese characters in their nomenclature. Chaebolswere heavily influenced by the zaibatsu and have operat-ing characteristics similar to those of the zaibatsu. Familiesowned the holding companies of the four biggest zaibatsus –Mitsubishi, Mitsui, Sumitomo, and Yasuda. These holding com-panies practically controlled many other affiliated companiesby equity ownership (Hadley, 1970). At one time, the produc-tion of these four zaibatsu amounted to 25% of Japanese GNP(Imai, 1987). In addition, trading companies within each grouppurchased raw materials and sold final products for their affili-ated companies, and financial institutions within the group pro-vided necessary funds to the companies. Almost every Japanesezaibatsu was formed during the Meiji Renovation Era, dur-ing which the Japanese government granted sizable benefitsto a small class of capitalists to establish capitalism, and they

25

F

amily

equi

ty

e

quit

y

equ

ity

dire

ctfa

mil

yow

ners

hip

Vert

ical

Inte

grat

ion

Maj

or

lo

ans,

deb

t gua

rant

ee

Ins

uran

ce/

lo

ans,

deb

t gua

rant

ee

Gen

eral

Ind

ustr

ial

Mer

chan

t

T

radi

ng

C

ompa

nies

equ

ity

Ban

k

equi

ty

Com

pani

es

in

dire

ctow

ners

hip

equi

tylo

an

deb

t gua

rant

eeeq

uity

loan

d

ebt g

uara

ntee

thro

ugh

cros

s-sh

areh

oldi

ng

par

ts

par

ts

par

ts

sm

all

n

ew

ser

vice

s

hipp

ing

sup

plie

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s

uppl

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lier

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ffil

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entu

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Figu

re1.

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atic

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chae

bols

.


accumulated great wealth under the government policy of sup-porting military-related industries.

A few years after the defeat of Japan in World War II and theformal dissolution of the zaibatsu, ex-zaibatsu affiliates reorga-nized themselves to facilitate voluntary cooperation (Gerlach,1992). These affiliates called themselves keiretsu and had agroup membership structure similar to that of zaibatsu. Al-though no one family controls a keiretsu, affiliates within akeiretsu voluntarily swapped stock shares with each other and in-tensified internal transactions among themselves. The affiliatedcompanies and the keiretsu concentrated their scarce resourcesinto the industries designated by governmental industrial policyas strategic. Naturally, they formed strong bonds among them-selves around a bank. The postwar Japanese government alsoassisted the growth and formation of keiretsu with various in-dustrial policies. The keiretsu is different from the zaibatsu andthe chaebol in that there is no formal control mechanism on in-dividual affiliates. Chaebols do not have the network-type orga-nization that keiretsu do, although recent restructuring efforts topromote independence of affiliate companies have tried to trans-form them into that direction.23 Rather, precrisis chaebols aremost accurately described as multidivisional structures, in whichindividual affiliates function as business divisions despite theirlegal independence, while the intricate web of cross-ownershipand debt guarantees among affiliates simply reflect the maxi-mum utilization of external sources of capital with minimuminjection of equity capital by chaebol families. We will discussthe financial structures of chaebols further in Chapters 5 and 6.

Business groups similar to chaebols are more frequently ob-served among developing countries.24 The “Salim Group” ofIndonesia and “CP Group” of Thailand are examples of simi-lar organizations in Southeast Asian countries. Other examples

27

Introduction

include grupos economicos in South American countries, whichgrew while their home governments pursued import substitutionpolicies (Guillen, 2001). Business groups in Eastern Europeand China that emerged during the recent privatization processalso bear similarities to chaebols. For instance, during the rapidprivatization in the Czech Republic, various forms of cross-ownership among banks and investment trust funds wereformed, and many of those investment trust companies turnedthemselves into holding companies (Coffee, 1999). Similarly,Stark (1996a) showed how previously state-owned firms inHungary purchased small firms and formed groups on their own.

Theoretical Framework

Conventional Theories on Business Groups

There has been extensive research on business groups. Thiswork can be roughly classified into three major categories. First,economists generally conceive the business group phenomenonas a result of market imperfections prevalent in developingcountries. According to Leff (1978), in such countries, businessgroups perform several functions. First they provide access tocapital and information, neither of which flows naturally in un-derdeveloped markets. Second, the unrelated diversification ofbusiness groups provides an alternative to portfolio diversifica-tion when markets for risk and uncertainty are absent. When thepurchase of shares of stock in other companies is either imprac-tical or impossible for chaebol families, they are forced to diver-sify the group itself to distribute risk and manage their portfoliomore securely. Third, vertical integration provides a solution tothe problems of bilateral monopolies and oligopolies that stemfrom imperfect intermediary goods markets. Recently, Khanna

28


and Palepu (1997) echoed Leff by arguing that business groupssuch as chaebols replace poorly performing or nonexistent eco-nomic institutions (e.g., banks or external labor markets) thatare taken for granted in developed countries. For example, cre-ating an internal capital market is unnecessary and redundant ifthe banking system is well developed. There is also no need toutilize the internal labor market if the demand is met by a suffi-cient supply of high-quality personnel such as MBA graduatesor technicians.

The second line of research points out that active marketinterference by governments of developing countries has alsogreatly impacted the creation of business groups. Korea pursuedan unbalanced growth strategy by focusing its resources on a fewsectors that its government deemed “strategic” (Gerschenkron,1962; Hirshman, 1958; Johnson, 1984). Amsden (1989) andKim (1997) described how effectively the Korean governmentused chaebols as a way to “catch up” with more industrial-ized nations. Chaebols capitalized on government subsidies togrow, as is analyzed further in Chapter 2. The Japanese govern-ment’s support clearly was essential to the rise of both zaibatsuand keiretsu (Hadley, 1970; Johnson, 1982). Business groupsin other developing countries have resulted from governmentinterventions. For instance, import-substitution industrial poli-cies pursued by Latin American countries induced the forma-tion of business groups, which exploited their political contactsand access to the local markets by forming alliances with for-eign multinationals (Evans, 1979; Guillen, 2001). Thus, somedifferences between business groups in different countries aremerely a result of distinct patterns of government intervention,which further distort already imperfect markets in developingcountries.25 Accordingly, the formation and growth of thesebusiness groups cannot be viewed in isolation from national

29

Introduction

circumstances. Chapter 2 will deal with these issues in greaterdetail.

The third line of research points out that business groups suchas chaebols are socially and culturally embedded in the specificcountries where they operate (Granovetter, 1995; Evans, 1995;Orru et al., 1997).26 According to this view, Korean firms enacta patrimonial logic, which is deeply rooted in the history andculture of Korea and expresses itself in the relationship betweenthe state and businesses, between employers and employees,and within Korean families. Guillen (2001) extends this viewthat business groups should be conceived as a resource, notan obstacle, for a country’s modernization. He maintains thatlarge, hierarchical organizations such as chaebols may be themost efficient organization form in mass production industries,such as those in which Korea holds competitive advantages.

These three perspectives are useful in understanding whybusiness groups such as chaebols are prevalent in developingcountries. Indeed, chaebols are the creatures of market inef-ficiency, government intervention, and the sociocultural envi-ronment of Korea. Those three perspectives, however, do nothelp us understand how business groups evolve and why theypersist over time. The economic approach would lead us toconclude that business groups would naturally disappear asan economy develops and market imperfections disappear. Itfails to explain how markets develop over time. It is possi-ble that the dominance of business groups deters the develop-ment of markets. For instance, chaebols’ dependence on internalcapital and labor markets may obviate their need for externalmarkets.

The late development theory and the state intervention per-spective do not help us understand how long state interventionshould continue and whether it remains effective as the economy

30


develops. Evans (1995) argued that it is possible that the devel-opmental state could continue even after the economy matured.Kim (1997), however, discussed how the developmental stateof Korea lost power to the private sector, especially to chaebols.Furthermore, the state interventionists do not discuss whetherthe transition from a state-controlled economy to a market-basedeconomy is smooth. Several works that have examined the pri-vatization of Latin American and Eastern European economiessuggest that such transitions are often difficult and hazardous(Stark and Bruszt, 1998; Coffee, 1999; Kogut and Spicer,2002).

The perspective that emphasizes the sociocultural environ-ment of each country, on the other hand, neglects the pressuresof global convergence. These researchers tend to focus only onthe national-level institutional environments that exercise coer-cive and imitative conformity pressures onto organizations. Asglobalization progresses, businesses and states alike are undergreater conformity pressures to global standards (Meyer et al.,1997). For instance, domestic firms become increasingly moresubject to global accounting standards (Jang, 2001). Similarly,shareholder activism, which originated in the United States, hasbecome a global phenomenon as institutional investors diversi-fied their portfolio internationally (Davis and Thompson, 1994;Useem, 1996).

Evolutionary Perspective and Structural Inertia

To understand why chaebols were instrumental in the early stageof Korea’s economic development and why many became in-solvent in the recent crisis, we need a dynamic perspective thatplaces the roles of the markets and the state in the context ofchanges in external economic and political environments at both

31

Introduction

the national and global level. Figure 1.8 summarizes the frame-work employed in this book. Following the resource-based view(Penrose, 1959; Wernerfelt, 1984) and the evolutionary theoryof Nelson and Winter (1982), business groups may be viewedas possessing productive resources and as being engaged in acontinuous search and selection process to improve their per-formance, given their environments. Organizational search de-notes firms’ review of current businesses, entrance into newbusiness, and exit from existing businesses to improve perfor-mance. Firms’ selection environments, on the other hand, de-termine their performance and hence the extent to which theyexpand or contract.

The Korean government and the general geopolitical envi-ronment in the 1960s and 1970s posed a favorable selectionenvironment to chaebols and were critical in their forma-tion. Amidst cold war politics, Korea could pursue export-oriented development without much conflict with trading part-ners. The government provided various subsidies to firms instrategic sectors and encouraged exports; at the same time,it protected its domestic markets. The internal capability ofKorean firms was based on low wages while importing foreigntechnologies. To keep this low-cost advantage, the governmentseverely suppressed any kind of labor movement.

During the 1980s and 1990s, the political and economic en-vironment turned unfavorable both to chaebols and the countryas a whole. The cold war ended and Western countries includingthe United States, Korea’s closest ally, had trade disputes withKorea and pressured it to open up its domestic markets. Exter-nal contingencies such as the IMF and the World Bank, heavilyinfluenced by the U.S. government, pressured the Korean gov-ernment to stop providing direct subsidies to businesses.27 Therewere also increasing challenges from competitors in emerging

32

Cha

ebol

s

Kor

ean

gove

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Introduction

economies such as China and south Asian countries, which hadlower wages than Korea did.

These environmental changes demanded fundamentalchanges from both the government and chaebols, which weresupposed to respond by shifting their focus from imitation toinnovation (Kim, 1996). To remain competitive, they had to pro-duce high-quality items with new designs and innovative ideasto compensate for their higher level of wages. The governmentwas expected to transform itself from a developmental orienta-tion in which it micromanaged the economy to a role in which itset the rules and provided a regulatory framework under whichmarkets would develop.

It is debatable, however, whether these transformations areeasy. Within the field of organization theory, there are two dis-tinct opinions about the ability of organizations and institutionsto adapt to changes in their environments. On the one hand,adaptation theorists argue that effective organizations adapt toenvironmental threats and opportunities, although their abili-ties to sense and react to those environmental changes maybe bounded (March and Simon, 1958; Katz and Kahn, 1966).According to Hamilton and Biggart (1988), enterprise struc-ture represents a situational adaptation of preexisting organi-zational forms to specific political and economic conditions.On the other hand, organizational ecologists emphasize inertialforces that prevent organizations and institutions from adaptingwhen change occurs in their environments (Hannan andFreeman, 1977). As a consequence of these two conflictingforces, organizational changes are often characterized by “punc-tuated equilibrium,” which denotes relatively long spans of onlyincremental changes and adaptations and relatively short peri-ods of reorientation during which there is discontinuous change;strategy, power, structure, and controls are fundamentally

34


realigned to match the changed environment (Tushman andRomanelli, 1985). Researchers note that sudden shifts in en-vironments or serious deteriorations of performance such asfinancial crises are often the impetus for reorientation.

The Korean financial crisis made it manifest that both chae-bols and the government failed to respond to their changing con-straints. The transitions of chaebols and the government did notentail the scrapping of the old system and starting from scratch.Rather, the routines and practices, organizational forms, and so-cial ties persisted and functioned as sources of inertia. The inertiaof the government can be attributed to the inherent limitations ofthe developmental state, which focuses primarily on economicdevelopment (Johnson, 1982). Evans (1995) argued that Koreawas the most successful developmental state since its internallycoherent group of elite bureaucrats brought about the autonomyof the state, and the embeddedness of its social networks enabledthe government to carry out policies more effectively. These twobuilding blocks, came under fire as the economy matured andglobalization intensified. The state lost autonomy as the stateelites mixed their interests with those capitalists (i.e., chaebolowners; Kim, 1997). Chaebols, which were the greatest benefi-ciaries of the developmental state, became the most vociferousprotesters of the state’s power and became powerful enough toinfluence politicians and bureaucrats to turn regulations to theirfavor. Any reforms that could affect the chaebols’ status quowere blocked, and any rules that block chaebols’ interests werechallenged in the name of deregulations and economic liber-alizations. Under the name of deregulation, state-owned bankswere privatized and chaebols were allowed to set up or acquirenonbank financial institutions.

The state bureaucracy also lost its ability to manage the econ-omy. The closed network of the state bureaucracy could not keep

35

Introduction

up with the globalized capital markets and fast-paced changesin the private sector. As the economy developed and the pri-vate sector gained more resources and know-how, the provisionof long-term goals, capital, technology, and indirect supportby the government often hindered the vitality of private en-terprise by miring firms in red tape. Furthermore, organizedlabor undermined the authoritarian government and furtherweakened the developmental state’s ability to implement anychanges.

Lacking both the internal coherence and the capability tohandle the complex nature of global competition, the state bu-reaucrats became paralyzed and failed to adapt to changing cir-cumstances. As Kim (1997) observed, such a transformation waschallenging, as the authoritarian regime broke down and democ-ratization occurred in the late 1980s. There was also no strongleadership at the state level to make the government respondmore quickly to the changing global environment.28 The gov-ernment failed to set up the rules and infrastructure upon whichmarkets could develop. Instead, it kept on meddling in businessaffairs, particularly those involving banks’ lending practices.It thereby further impeded the development of markets (Woo,1991). It also continued to rescue near-bankrupt companies. Al-though many observers wondered why so many chaebols wentbankrupt simultaneously during the financial crisis, the more in-teresting question is why so few went bankrupt before that time.Implicit guarantees by the government toward large chaebolsencouraged moral hazards by chaebols themselves, as well asthe financial institutions that advanced loans to them. Chaebolsrecklessly pursued growth, and banks were there to finance theirexpansion blindly.

The absence of functioning governance systems left chae-bols completely unaccountable for their actions. Furthermore,

36


the structural characteristics that chaebols developed during theeconomic planning period created enormous inertia that fur-ther impeded their ability to adapt to the changes they faced.The synergies that chaebols created by developing internal la-bor and capital markets and thereby overcoming market im-perfections were possible only through a centralized controland command structure that concentrated strategic decision-making power in the hands of chaebol founders and their fami-lies. Without proper governance systems that would ensure thesoundness of their investments, these individuals made impor-tant decisions that served their own personal interests at theexpense of minority shareholders and that were sometimes noteven beneficial to themselves. Without any effective corporategovernance system in place, cross-subsidization proliferatedwithout control, thus prolonging the lives of unsuccessful af-filiates at the expense of more promising ones. The intricateweb of cross-debt guarantees, cross-shareholding, and inter-nal business trade made it difficult for chaebols to shed un-profitable affiliates and to focus on core competencies. In ad-dition, the absence of effective corporate governance systemsmade chaebols resist change even more. Such inertia ultimatelycontributed to chaebols’ eventual collapse during the financialcrisis.

Thus, the crisis of 1997 was due to this mismatch betweenchanging the external environments and internal capabilities ofboth chaebols and the government. This mismatch was causedby inertia of both institutions.29 More fundamentally, these in-ertias were exacerbated by the lack of functioning governancesystems during the economic transition. Although several stud-ies have addressed the limitations of the developmental statein Korea that lead to its inertia,30 little is understood aboutchaebols’ inertia. This book attempts to fill this research gap

37

Introduction

by examining chaebols’ internal operation and evaluating thechaebols’ performance.

The Structure of this Book

This chapter has provided an overview of chaebols. It discussedtheir role in the Korean economy and reviewed their decline inperformance since the late 1980s. It explained this decline asthe result of capital inefficiency and the overvaluation of thewon relative to the currencies of Japan and emerging competi-tors in developing countries. It also pointed out, however, thatthe most fundamental problem of chaebols lies in the void ofeffective governance mechanisms as Korea changes from a state-controlled economy to a market-based economy. It also high-lighted similarities between chaebols and organizational formsfound in other countries. Although conglomerates in Westerncountries and the zaibatsu of Japan are somewhat similar tochaebols, companies that are most similar to the Korean chae-bol are often found in developing countries. These descriptionsform the basis for the accounts of the chaebols’ history andstructural characteristics that will be developed in the rest ofthis book.

Chapter 2 fleshes out the historical perspective by consid-ering the growth strategies of chaebols. Consistent with theinsights about business groups, it attributes the formation ofKorean chaebols to two elements. First, after Japanese impe-rialism and the Korean War, Korean markets for capital andintermediate goods were imperfect. These inefficiencies com-pelled chaebols to internalize transactions. In addition, theKorean government intervened in Korean markets from 1961onward to foster economic development, thus further distortingflawed market mechanisms and inducing more internal growth

38


by chaebols. This chapter explains the major economic back-ground of postliberation Korea and then briefly depicts the de-velopment of the Korean chaebol. It focuses primarily on thefive biggest chaebols. In particular, this chapter emphasizes howmuch the Korean state’s influence has subdued and how power-ful the chaebols became prior to the crisis.

Chapter 3 details chaebols’ multifaceted business structureand economic performance. Following Chapter 2, it argues thatgiven market imperfections, chaebols might have offered an ef-ficient way to allocate scarce resources and generate synergiesbetween affiliated companies. Korean chaebols shared humanresources, brands, and technology among their affiliates and cre-ated enormous synergies and prioritized investments by creatinga common pool of available funds for affiliates. Such sharingwas possible because of the chaebols’ staff organization, whichcoordinated and fine-tuned the use of shared resources. Sucha centralized structure, however, has its own weaknesses. Thischapter addresses how such value creation was wasted in ill-conceived diversification moves prior to the crisis. The ineffec-tive governance system exacerbated such weaknesses.

Chapter 4 examines how chaebols used vertical integra-tion and whether they did so efficiently. It argues that chae-bols’ use of vertical integration is generally inefficient andproposes that chaebols could increase efficiency by rearrang-ing the vertical relationships among their affiliates. Chaebols’core manufacturing companies have multiple links to variousaffiliates that supply parts, and their general trading compa-nies function as distributors to foreign markets. Although ver-tical integration can reduce transaction costs when the marketfor the intermediary goods is unstable, it can also create in-flexible supply lines within a chaebol and decrease incentivesto innovate that might contribute to long-run efficiency. The

39

Introduction

costs of vertical integration became more acute in the 1990swhen the economy slowed down. Chaebols could not shedinefficient part-supplying affiliates not only because of debtguarantees but also because of their own equity and governancestructure.

Chapter 5 sketches the capital structure of the chaebols, fo-cusing especially on chaebols’ use of debt. It depicts how thechaebols’ internal capital markets evolved and concludes thatthe unstable system of chaebol financing, which emphasized theuse of debt rather than equity, was a key factor behind the Koreaneconomic crisis. Also, the use of mutual debt guarantees amongaffiliated companies enabled them to borrow more funds thanthey otherwise could. Korean banks, which were long deprivedof the power and capability to evaluate investment projects, ad-vanced funds only to companies that could secure debt guaran-tees. The result was a vicious cycle in which the bankruptcy ofone chaebol affiliate triggered the bankruptcies of its affiliatesuntil every member of the chaebol went bankrupt. This chapterhighlights how much the group-affiliated financial institutionswere abused as they supplied capital to their affiliates regardlessof their own financial health.

Chapter 6 describes the chaebols’ ownership and corporategovernance structures. Family members of the thirty biggestchaebols virtually control all group affiliates even though theyown only about 8.5% of these affiliates’ total shares. Theycan do so because of cross-shareholding among affiliates. Thistype of ownership structure, combined with the underdevel-oped corporate governance system, was a second key factorbehind the financial crisis in Korea. Family control of chae-bols meant that there were few checks and balances to restrictinefficient investment activities. Furthermore, this ownershipstructure made it possible to transfer secretly the capital and

40


wealth of one affiliate into another affiliate by artificially ma-nipulating transfer-pricing schemes, for intragroup transactions.Therefore, this chapter suggests that any earnest restructuringeffort of the chaebols must begin with the reform of chaebols’corporate governance structure.

Chapter 7 discusses the efforts to restructure Korean chaebolsafter the foreign exchange crisis and analyzes the effectivenessof these efforts. As discussed earlier, the Korean governmentsupplied commercial banks with public funds, used these banksto restore the chaebols, and attempted to restructure the chae-bols. Chaebols have, however, actively resisted more substantialrestructuring. The restructuring efforts taken by the Korean gov-ernment had only limited success because they did not addressthe fundamental problem of chaebols – the lack of effectivecorporate governance systems. This chapter concludes that thefurther corporate restructuring of chaebols should focus moston improving these systems.

Chapter 8 attempts to decipher the formation and problemsof the chaebols that drove both the rapid economic growth andcollapse of Korea. It uses the analysis of the Korean experience,as well as accounts of break-ups of underperforming conglom-erates in other countries. This book argues that chaebols arecreatures of their environments, and they will not change un-less the institutional environments facing themselves change inadvance. After the crisis, however, chaebols are under tighterscrutiny from the international financial community. Chaebolshave to respond more to foreign investors and creditors becausethey depend heavily upon foreign capital. These external par-ties have demanded that chaebols develop transparent account-ing procedures, eliminate illegal and improper internal trans-actions, and enhance the rights of minority shareholders. Suchincreased pressure from financial markets will make it harder

41

Introduction

to divert profits to poorly performing affiliates, and thus en-ables those firms that perform well to invest further in their corecompetence. At the end of such restructuring, chaebols will betransformed into loosely coupled networks of core affiliates,which are more focused on their core competencies and volun-tarily cooperate with other affiliates on a few selected projects.This chapter concludes with implications for other developingcountries, which stress astute governmental policies to cultivatemarkets and ensure that orderly shifts in power are important toguarantee a smoother transition from a developmental state to amarket-based economy.

42

2

The Evolution of Chaebols

43

The Development of Chaebols in Korea

This chapter will examine the evolution of chaebols. Chaebolsare creatures of their political, economic, and cultural environ-ments, all of which changed dramatically in the last half century.This chapter will focus, in particular, on chaebols’ relation-ship with the government, which shaped the environmentsthat chaebols faced. From 1945 to 1980, the government helpedchaebols grow by subsidizing them and protecting theirdomestic markets.1 After the government deregulated the econ-omy in the 1980s, chaebols financed their growth internally. Wewill highlight how chaebols, especially the five largest ones, re-sponded to changes in the government’s policies, and identifyhow chaebols altered their growth strategies.

the development of chaebols in korea

Inception of Chaebols after World War II

Korea was once called the country of the morning calm byWesterners. Despite being invaded incessantly by China, Mon-golia, and Japan, Korea maintained its independence until theearly twentieth century. At that time, Japan, which industrializedearly, won its wars against China and Russia and annexed Koreain 1910. During the Japanese occupation, the Japanese govern-ment allowed Koreans to own only agricultural and mining con-cerns and small businesses, while Japanese trading companiescontrolled all other businesses in Korea. There were, however,some families who built businesses during this period. Sung-SooKim established Samyangsa, a spinning and a sugar-producingfactory, and once owned a small bank. Heung-Sik Park estab-lished a paper manufacturing company, ran a department store,and traded with China and Southeast Asia. Those indigenousbusiness activities, however, remained small.2

45


Korean businesses could grow only after the liberation in1945. After the Japanese left, however, there were institutionalvoids. All the legal systems, regulations, business rules, andpractices that were established and developed by the Japaneseno longer existed. The fledgling Korean government was notable to build political, social, and economic institutions swiftly.Moreover, between 1950 and 1953, the Korean War destroyedvirtually the entire industrial base built by the Japanese and leftKorea divided into two countries, North Korea and South Korea.While it occupied Korea, Japan had concentrated industrial de-velopment in northern Korea and used southern Korea to growcrops.

Despite these impediments, chaebols did have opportunitiesto grow between 1945 and 1960. Without any institutions set up,many important government decisions were made by a handfulof people. An event that greatly facilitated the development ofchaebols was the sale of the assets owned by Japan’s govern-ment and firms. Those assets, including factories, production,equipment, and inventory, accounted for 30% of the Koreaneconomy.3 They were initially taken by the government andthen sold to individuals. Sales were based not on auctions buton the personal preference of high-ranking government offi-cials. Friends and relatives of these officials thus had the bestchance to buy such items (Kang, 1996) and reaped huge windfallprofits by doing so since sales prices were based on the assets’book values. Because inflation at this time was very high, buy-ers bought assets for only a fraction of their fair market value.Further, buyers had to pay only 10% upon purchase and thenpay off the outstanding balance over 15 years without any in-terest. Chaebols such as Hanwha, Doosan, Samsung, SK, andHyundai picked up those assets and used them as the footholdfor further growth.

46


Syngman Rhee, the first elected president, concentrated on se-curing a political foundation to win against the communist Northand neglected economic development. The government reliedheavily on foreign aid. The only other source of foreign currencywas the sale of natural resources such as tungsten and gold. Rheeinitiated an import substitution policy and allowed only raw ma-terials to be imported. The Korean won was not convertible toother currency, and the government allocated foreign currencyonly to those who held import licenses. Such licenses were akey source of profits. In return for import licenses and alloca-tion of foreign currency, established businessmen contributedto Rhee’s political fund. These close ties between the govern-ment and businesses enabled some businesses to grow quickly.Samsung, LG, and SK became chaebols during the Rhee regime.Widespread corruption, however, led to the collapse of the Rheegovernment in 1960, and the subsequent military coup.

The Economic Development Plans of the 1960s

After the collapse of the Rhee regime, there was a brief periodof democratic government, which ended with the military coupby Chung-Hee Park. As a military junta, the Park governmentwas fragile. To achieve legitimacy, the Park government madeeconomic development its top priority. It initially indicted thosewho collaborated with the Rhee government, including Byung-Chul Lee, a founder of Samsung Group, but soon realized thatit needed to get cooperation from these collaborators to showvisible benefits to Korean citizens in a relatively short period oftime.4

The government launched a series of five-year plans toachieve such results quickly. During the time of the first(1962–6) and the second (1967–71) plans, it focused on

47


export-oriented industries such as textiles and clothing and someimport substitute industries such as consumer goods.5 To fa-cilitate development, it fostered a strong, centralized bureau-cracy, which had enormous power over resource allocation.6

The choice of an export promotion strategy rather than the im-port substitution strategy that most Latin American countriesused might be attributable to Korea’s lack of large domestic mar-kets and natural resources. With a cheap and well-educated laborforce, it was logical for Korea to import raw materials, manufac-ture goods domestically, and export them to foreign countries.In a sense, Korea closely followed the footsteps of its precursor,Japan.

During this time, the geopolitical environment for Korea toemphasize an export-based strategy was favorable. Given thecold war, the United States provided significant aid to Korea andprovided a market for Korean exports (Mason et al., 1980). Japanalso loaned funds to Korea after the two countries reestablisheda diplomatic relationship in 1965. The government thereby setout ambitious targets and allocated foreign loans for investment.It also effectively nationalized all banks by denying them theright to examine the validity of investment projects. Instead,the banks were to raise and allocate funds according to plansestablished by the Economic Planning Board. Most large-scaleinvestments were allocated to only a few companies selectedby the government. Through such means, the government virtu-ally controlled Korean businesses and determined whether theysucceeded or failed. It also influenced chaebols’ diversificationstrategy during this period, as it provided incentives to firms thatit believed were able to carry out a project and punished poor per-formance by stripping firms of specific assets, and letting othercompanies acquire these properties. As a consequence, the gapbetween firms that the government selected and firms that it did

48


not choose widened considerably. Amsden (1989) argued thatthis policy was efficient and suggested that by performing theresource allocation and governance functions normally done bythe market,7 the government spurred Korea’s economic success.In contrast, such government monitoring and intervention didnot occur in other countries.

Amsden’s argument minimized how much incumbent firmsused their political connections to entrench their positions;the rise of chaebols is attributable to more than their relativeefficiency.8 The entrepreneurship of chaebol founders such asJu-Yung Chung of Hyundai Group and Byung-Chul Lee ofSamsung Group cannot be overlooked,9 although chaebols atthis time enacted the grandiose plans of bureaucrats who se-lected industries to invest in and allocated funds to appropriatecompanies.10 To assimilate new technologies, Korean firms ini-tially copied foreign firms’ designs and technology and laterrelied on licensing and OEM (original equipment manufac-turing). The government sponsored research institutions thathelped firms with such activities (Kim, 1996). Entrepreneursbecame more important only as Korean firms shifted from imi-tation to innovation.

The first two five-year plans are generally regarded as suc-cessful. The Korean economy grew at an annual average rateof 8.9 and 11.1%, respectively, during these two periods (Kim,1997). The government-led economic planning generated sev-eral consequences. First, the winner and losers were determinedby the government. Capital-intensive industries such as oil re-fining, fertilizers, synthetic textiles, and cement manufacturingbenefited most from these plans. Table 2.1 highlights the rank-ings of the top ten chaebols, which vary dramatically from thepreplanning period to the postplanning period. For example, sixchaebols on the top ten list in 1960 were not on it in 1972. The

49


Table 2.1. Top ten chaebols in 1960, 1972, 1984, and 1996

Ranking 1960 1972 1984 1996

1 Samsung Samsung Hyundai Hyundai2 Samho LG LG Samsung3 Kaepung Hanjin Samsung LG4 Daehan Shinjin SK Daewoo5 LG Ssangyong Daewoo SK6 Dongyang Hyundai Ssangyong Ssangyong7 Kukdong Daehan Kukje Kia8 Hanglass Hanwha Hanyang Hanjin9 Dongrib Kukdong Hanhwa Hanwha

10 Taechang Daenong Daelim Lotte

Source: Korea Fair Trade Commission.

ranking of chaebols stabilized only in the 1980s, when sucheconomic planning officially ended.

Second, the allocation of cheap loans substantially raisedKorean firms’ debt–equity ratios and induced chaebols to preferdebt. The government used the banks to allocate and guaran-tee low-interest loans and foreign capital to selected companiesin the strategic sectors. Figure 2.1 shows the interest rates andinflation rates during 1960 and 2000. Since interest rates inthe so-called export industries were often lower than the actualinflation rates were, securing a loan was equivalent to receiv-ing a subsidy. Firms that could not receive such loans had torely on the curb market, in which interest rates were very high.Figure 2.2 also shows the trend of debt–equity ratios during thesame period. In 1960, the debt–equity ratio was a little over100%, but it increased to nearly 400% in 1970 and becameeven higher in later periods. It dropped only after the financialcrisis.

50


0

10

20

30

40

50

60

70

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

inflation (consumer price index) interest rates in the export sector

curb market rate average loan interest rates

%

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

Third, not surprisingly, the government thwarted the devel-opment of capital markets by allocating resources. Banks weredeprived of their capacity to evaluate investment projects. Thegovernment’s implicit guarantee to pay for bad loans encour-aged moral hazards and set a precedent for support even afterprivatization and deregulations in the 1980s and 1990s.11

The government also favored chaebols by blocking foreignersand other domestic competitors from entering strategic sectors.Therefore, incumbent chaebols could gain monopolistic profits.

51

0.0

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In addition, the government provided various tax credits, pref-erential tariffs, and loans to firms in strategic sectors even asthere was a capital shortage. Further, by privatizing state-ownedcompanies, such as Korean Airlines, in the mid 1960s, it createdseveral chaebols that had political connections.

Chaebols’ Foray into the Heavy Equipment andChemical Industries and the Formation of General

Trading Companies in the 1970s

The government’s original export-oriented policy encounteredproblems in the 1970s, however, as labor shortages occurredand real wages increased. The government responded by in-vesting in the heavy equipment and chemical industries be-cause it believed that developing these capital-intensive indus-tries would be more appropriate given the labor shortages. Inaddition, President Park, who suspended the Constitution andbecame a dictator, wanted to show some grandiose plans topeople and convince them that their country was a rising eco-nomic power. Furthermore, the government believed it neededto develop these defense-related industries at this time becausethe U.S. government indicated that it would no longer defendKorea from invasions by communist regimes.12 Yet Korea didnot have capital, technology, or other supporting infrastructureto make firms in these industries economically viable. The bigpush for heavy and chemical industries were mainly politicallymotivated (Kim, 1997).

During the third economic development plan (1972–6), thegovernment designated steel, petrochemicals, nonferrous met-als, machinery, shipbuilding, and electronics as “strategic” in-dustries and subsidized industry participants. Between 1975 and1979, it allocated 70% of its economic development funds to

53


these industries (Kang, 1996). Figure 2.3 shows the total amountof various subsidies as a proportion of GNP. To achieve scaleeconomies, the government allocated licenses to only a few com-panies. For example, it chose Hyundai and Daewoo to developpower plant facilities and Hyundai, Samsung, and Daewoo tobuild ships. As a result, from 1971 to 1979, the proportion ofheavy equipment and chemical industries to total manufactur-ing shipment increased from 39 to 55%, while the proportion ofexports to GNP increased from 16 to 36%. Although multina-tional corporations were not allowed to make direct investmentsin Korea during this period, some industries, including electron-ics, entered into joint ventures with firms like NEC, Sanyo, andCorning. These ventures facilitated technology transfers to theKorean partners (Woo, 1991; Kim, 1997; Guillen, 2001).

The government’s actions during this period seriouslydistorted market mechanisms. First, firms receiving preferentialtreatment grew phenomenally, while those that didn’t suffered.In addition, government subsidies induced overcapacity instrategic industries. Second, in pushing chaebols into newindustries, the government failed to consider the need for infra-structure from supporting industries. It evaluated comparativeadvantage only in terms of low wages. Since Korean firms builtassembly plants but had no parts suppliers, they had to importcore parts and could not create much value added. Later, theyhad to integrate vertically by establishing affiliates that suppliedparts. Third, the oil shocks and the subsequent worldwiderecession drove the companies close to bankruptcy. The govern-ment bailed them out by writing off loans, providing additionalcheap loans, and swapping loans for stock (Woo, 1991). Theserescues created a dangerous precedent, as chaebols assumed thegovernment would be always there to pick up the check if theyfailed.

54

5.09

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The government also set up general trading companies mod-eled after Japanese sogo shosha to spearhead Korean exportsamidst the worldwide economic recession after the oil shock.13

For each dollar of exports, the government allowed trading com-panies to secure an equivalent amount in loans with an 8% in-terest rate. Since the average interest rate at that time was 20%,the government subsidized the difference. It also gave generaltrading companies the license to import various raw materialsand exempted them from various taxes. All the largest chaebolsset up general trading companies to tap such subsidies and usedthese ventures as the export windows for their group affiliates.

Because the achievement of export targets was directly linkedto the actual subsidies, there were enormous incentives to meetthose targets, however high they might be. Chaebols thus tookover many small companies to add these firms’ exports into theiraccounts. To increase their exports, the trading companies oftensold goods at prices below cost. So long as the subsidies coveredtheir losses, it was to their advantage. As a result, the generaltrading companies’ share of Korean exports jumped from 12.4%in 1975 to 31.5% in 1979. During this period, the governmentalso began to allow chaebols to advance into nonbanking fi-nancial institutions such as insurance, securities, and merchantbanking. The ten largest chaebols quickly developed or boughtfourteen financial institutions between 1972 and 1978. Theyused these institutions to supply capital to their affiliates.

To sum up, these strategic initiatives had their desired effect;Korea enjoyed rapid economic growth. By 1978, it achieved thegovernment’s targets of $1,000 per capita GNP and $10 billion inexports. Kim (1997) summarized this period as one of a fruitfulalliance between the state and businesses. Yet by offering incen-tives to pursue sales growth rather than profitability, these poli-cies seriously distorted competition in key industries because

56


they induced overcapacity and low margins. Further, the gov-ernment’s repeated bailouts of failing companies increased themoral hazard associated with these firms’ investment strategies.Many bailed out firms remained unprofitable and survived onlybecause of debt guarantees and cross-subsidization by affili-ate companies. They became insolvent again during the crisisin 1997.

Deregulation in the 1980s

The Park regime ended abruptly when Park was assassinated in1979. Another brief moment of democracy was interrupted bya military coup staged by Doo-Hwan Chun in 1980. His regime(1981–8) enacted economic policies that were very differentfrom those of the Park regime. This transition was prompted byshifts in the external environment. First, the IMF and the WorldBank pressured the government to reduce government expendi-tures, tighten the money supply, and pursue economic stability.Korea, at that time, was one of the largest foreign debtors, andthe international financial community was concerned about itsfinancial health (Woo, 1991). Furthermore, because of its eco-nomic success, Korea became a target of U.S. trade wars. Facedwith pressure from the United States, the government had toopen up its barriers to imports and foreign direct investment.

Second, many companies in the heavy equipment and chem-ical industries became insolvent. The effectiveness of govern-ment intervention was questioned by many, including chaebols(Kim, 1997). Third, the labor movement, which had been sup-pressed during the Park regime, became more militant in the1980s. It helped break the authoritarian state, and a direct presi-dential election was held in 1987. Yet its disputes eroded the low-wage advantage of Korean products and forced Korean firms to

57


introduce more innovative products to create another source ofcompetitive advantage. Thus, in 1980, the government cameup with a new policy directive that emphasized liberalizationand privatization. Although the government set out a fifth andsixth five-year economic plan, it decreased direct financing tobusiness drastically, lowered the inflation rate, eradicated exportsubsidies, and shifted its attention to welfare issues.

The cozy relationship between the government and businesstherefore soured. Chaebols had grown strong enough to raisevoices against the government, which, on the other hand, hadtried to tame chaebols. Upon his inauguration, Chun announcedseveral measures to force chaebols to divest a number of theirsubsidiaries, sell speculative real estates holdings, and lowertheir debts, but these initiatives had only modest success becausechaebols strongly resisted them (Fields, 1995). Later, chaebolsfiercely opposed President Tae-Woo Roh’s executive order forthem to dispose of their speculative real estates holdings andto focus on three core business areas, and Roh had to rescindthis order.14 The only effective measure to curb the power ofchaebols was the enactment of the Monopoly Regulation andFair Trade Act (known as the Fair Trade Act) in 1980. Thelaw designated the top thirty chaebols and put limits on theirbank loans, cross-shareholding, and debt guarantees. It is worthemphasizing that executive orders by presidents to curb chae-bols’ power never achieved their goals. The law made the realchange.

Despite these reforms, chaebols were able to grow on theirown during the 1980s. In part, they could do so because thefinancial sector became less regulated. In 1983, the govern-ment started privatizing banks. Chaebols purchased large blocksof stock in these banks. Although the percentage of sharesthey could own was limited (see Table 2.2), their blocks were

58

Tabl

e2.

2.Cha

ebols’ow

nershipof

commercial

banks

Ban

kC

haeb

olH

yund

aiSa

msu

ngD

aew

ooL

GSK

Top

5ch

aebo

ls

Nat

ionw

ide

Com

mer

cial

Cho

heun

g1.

243.

054.

29B

ank

Com

mer

cial

0.97

6.91

7.88

Che

il0.

160.

180.

190.

53H

anil

2.73

4.9

2.48

10.1

1K

orea

Fore

ign

Exc

hang

e1.

240.

441.

68K

ookm

in2.

020.

960.

420.

40.

484.

28Sh

inha

n0.

423.

493.

91K

oram

18.5

618

.56

37.1

2H

ana

3.61

3.61

Bor

am1.

160.

217.

570.

249.

18K

orea

Peac

e0.

371.

280.

820.

730.

924.

12H

ousi

ng&

Com

mer

cial

0.55

0.55

Reg

iona

lBan

ksD

aeku

5.3

5.3

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n1.

311.

31C

heju

2.17

2.17

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npuk

1.5

1.5

Kan

gwon

11.8

91.

540.

6314

.06

Kyu

ngna

m2.

682.

68C

hung

buk

0.92

0.92

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ernm

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125.

311.

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677.

92

Note:

As

ofD

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ber

1997

,%of

owne

rshi

p.So

urce:

Min

istr

yof

Fina

nce

and

Eco

nom

y.


large enough to let them influence the banks’ lending decisions.During the Roh regime (1988–93), which followed the Chunregime, there was a de facto elimination of the limits on owner-ship of nonbank financial institutions such as insurance, invest-ment trust, securities, and merchant banking firms. Such institu-tions became a key source of the chaebols’ capital, as chaebolspurchased controlling shares of stock in them. Table 2.3 showsthe extent of chaebols’ ownership in nonbank financial institu-tions. Through both direct and indirect means such as mutualdebt guarantees, which will be discussed in Chapter 5, chae-bols used their control over financial institutions to secure farlarger loans from these institutions than was economically justi-fiable. With their in-house financial service arms, chaebols han-dled daily cash flow problems and bypassed the official bankingsystem, which was still under government influence. By do-ing so, chaebols became independent from the government,although they were probably not strong enough to overpowerit. With its control over commercial banks, the government stillretained enough power to disband the Kukje Group in 1985,when this entire group of affiliates went bankrupt, and to sellthese affiliates to other chaebols.15

Also, chaebols could prosper without governmental supportin the 1980s because they had a favorable external environment.As the yen appreciated after the Plaza Accord in 1985, Koreanexports became much more competitive. Low interest rates andlow oil prices made the general economic environment evenmore favorable. Thus, chaebols were able to self-finance theirgrowth during this period. Kim (1997) described how the rela-tionship between the government and businesses shifted from acozy symbiosis in the 1970s to an overt conflict over control ofthe economy by the 1990s.

60

Tabl

e2.

3.Chaebols’ow

nershipof

nonbankfinancial

institutions

Oth

erM

erch

ant

Inve

stm

ent

Lif

eIn

dem

nity

finan

cial

bank

Secu

ritie

str

ust

insu

ranc

ein

sura

nce

serv

ices

Tota

l

Hyu

ndai

22

––

12

7Sa

msu

ng–

11

11

37

Top

5D

aew

oo–

11

1–

36

LG

11

1–

13

7SK

–1

–1

–1

3To

p6–

306

52

53

2546

Tota

l9

115

86

3776

Note:

As

ofD

ecem

ber

1997

.


Liberalization and Globalization of the 1990s

As the chaebols’ prominence in the economy increased, theybecame powerful enough to vie for political influence. Thistrend was epitomized when Ju-Yung Chung, the late chairmanof the Hyundai Group, ran in Korea’s presidential election in1992. Chaebols also tried to bribe politicians and governmentofficials. In 1994, several chaebol chairmen publicly acknowl-edged illicit contributions of political funds to Chun and Rho.The state bureaucrats who Evans (1995) argued were criticalto Korea’s early economic success were no longer a coherentforce. Chaebols were no longer passive subjects of the govern-ment’s intervention, but instead actively participated in attemptsto turn the regulations to their favor. In several cases, chaebolsopenly defied government policies and even derided them. In1988, Chairman Kim of the Daewoo Group threatened to letDaewoo Shipbuilding, a formerly state-owned company, gobankrupt unless the government would provide additional fund-ing. The government, which initially refused to accede to sucha blatant demand, eventually provided these funds. In 1995,Chairman Lee of the Samsung Group infuriated Korean officialsas well as President Young-Sam Kim by openly denouncing theKorean government as being third-rate. Although Chairman Leelater apologized, the fact that he felt free to make this commentrevealed the decline of the government’s power.

Under the Kim government (1993–8), privatization andderegulation further accelerated. The Kim government sup-ported both deregulation and globalization. It did so in responseto continued pressure from the international capital markets andfrom the chaebols themselves. Chaebols were free to issue bondsand stocks in overseas markets. Banks were also free to borrowshort-term money from international capital markets. Thereby,

62

Brief Histories of the Top Five Chaebols

foreign supplies of funds to Korean enterprises and financialinstitutions rapidly increased. In general, virtually all the cur-rency flowing into Korea eventually went to chaebols, whichwere actively investing in capacity in both domestic and inter-national markets. This mismatch between short-term liabilitiesand long-run investment contributed to the foreign exchangecrisis of 1997, as we will discuss further in Chapter 5.

brief histories of the top five chaebols

Hyundai Group

Hyundai is the largest chaebol. In 1997, it had fifty-seven affili-ates, assets of 52 trillion won, and sales of 67 trillion won.16

Hyundai Group is in many industries, including construc-tion, automobiles, shipbuilding, heavy equipment, retailing, andfinancial services. Hyundai’s founder, Ju-Yung Chung, startedhis career as a clerk in a small store selling rice and worked fora motor repair shop. In 1950, he established Hyundai Construc-tion Company. Hyundai Construction worked on constructionprojects for the U.S. Armed Forces during the Korean War andaccumulated a large sum of capital. Hyundai continued growingas it participated in the country’s infrastructure projects, includ-ing dams, bridges, and highways. Eventually, it expanded intooverseas markets.

Hyundai’s growth peaked during the first two economic de-velopment plans. In 1967, it established Hyundai Motor andlicensed auto-assembly technology from Ford. Hyundai Motorbrought in parts from Ford and assembled cars in Korea. It de-veloped its own car in 1976 and started exporting to Canada, theUnited States, and other countries. In 1973, Hyundai establishedHyundai Heavy Industries and started shipbuilding.

63


In the 1970s, Hyundai Group pursued vertical integration.The construction, automobile, and heavy equipment industriesneeded various parts and suppliers. During this time, Hyundaiestablished many affiliates in upstream operations. For example,Hyundai Cement provided cement, Hyundai Pipe providedbuilding chassis, Dongsuh Industries provided concrete andtiles, and Livart made furniture for Hyundai Construction.Hyundai Heavy Industries, which concentrated on shipbuilding,worked with Hyundai Engines, Hyundai Electric Machinery,and Hankuk Flange to provide various components for ships.Also, Hyundai Motor had other subsidiaries such as HyundaiPrecision and Kepico that supplied a variety of components.

During the 1980s, Hyundai pursued unrelated diversification.First, it established the Hyundai Department Store, which gener-ated good cash flow for Hyundai Group. It also acquired severalsecurities companies (Hyundai Securities, Hyundai Investmentand Trust) and insurance (Hyundai Marine & Fire Insurance)to procure sources for funding. In addition, it diversified intomemory semiconductors (Hyundai Electronics), the petrochem-ical industry (Hyundai Petrochemical), and shipping (HyundaiMerchant Marine). The Hyundai Group had a hard time secur-ing bank loans during the Kim presidency because its chairmanhad run against Kim in 1992.17

Samsung Group

Samsung Group is the oldest of the five big chaebols.18 In 1997,the Samsung Group had eighty affiliates, assets of 50 trillionwon, and sales of 60 trillion won. It has engaged in diversebusinesses such as trading, food processing, electronics, petro-chemicals, machinery, shipbuilding, financial services, hotels,department stores, and the media. Its founder, Byung-Chul Lee,

64


inherited land from his father during the Japanese occupa-tion and ran small shipping businesses. When he establisheda trading company, now known as Samsung Corporation, in1938, it originally focused on the export of Korean agriculturalproducts.

After Korea was liberated from the Japanese occupation in1945, Samsung expanded into the importing of goods that werenot available in Korea. It imported daily necessities like sugar,fertilizer, paper, wool, nylon, and medicine. With the profitsearned from this business, Samsung expanded into manufactur-ing. It first established Cheil Jedang in 1953 and built a factorythat produced sugar, which until then had been imported. Itschairman’s close relationship with Korea’s president helped itsecure foreign currency. In 1954, it received a million dollars inaid from the United States and used this money to purchase themanufacturing facilities for its new subsidiary, Cheil IndustriesInc., which produced woolen goods. At the same time, the gov-ernment banned the import of woolen goods and sugar, whichgave Samsung a monopoly on these goods within Korea. It soontook over Ankuk Fire Insurance Company, now known asSamsung Insurance, and also bought more than half the sharesof three banks. Again, its chairman’s personal relationship withKorea’s president gave it the latitude to gain control of thesebusinesses (Kim, 1997).

Samsung initially faced many difficulties when Park tookpower in 1961. The Park regime charged Chairman Lee withcorruption. After Park realized he had to compromise with chae-bols to achieve his economic objectives, Lee actively accommo-dated the government’s goals. Lee assembled the businessmenof all other chaebols and organized the Federation of KoreanIndustries. Lee eventually handed over his banks to the gov-ernment. Later, as a goodwill gesture, Lee established Hankuk

65


Fertilizers and donated it to the government. In 1969, Samsungestablished Samsung Electronics, Dongyang BroadcastingStation, and Joongang Daily Newspaper.

Like other major chaebols, Samsung invested heavily ingovernment-designated strategic sectors during the 1970s, al-though it was not as enthusiastic about doing so as wereother chaebols, such as Hyundai and Daewoo. It diversi-fied into petrochemicals (Samsung Petrochemical), machin-ery (Samsung Heavy Industries), and shipbuilding (SamsungShipbuilding). Samsung Corporation was the first chaebol sub-sidiary to be registered as a general trading company. At the sametime, Samsung vertically integrated into parts-manufacturingbusinesses such as Samsung SDI, Samsung Corning, andSamsung Electro Mechanics.

As the government scaled back its economic interventionduring the 1980s and 1990s, Samsung continued to expand. Itdiversified into semiconductors (Samsung Semiconductor, latermerged into Samsung Electronics), financial services (SamsungSecurities, Samsung Credit Card, Samsung Merchant Banking),aeronautics (Samsung Aeronautics), and automobiles (SamsungMotors). This last market entry was a costly failure, how-ever, and Samsung Motors had to file for bankruptcy in 1999.It was later sold to Renault. Also, Samsung Group spun offShinsegae and Cheil Jedang in the late 1990s, which reflectedthe inheritance of the late chairman Lee’s holdings by hischildren.

LG Group

In 1997, LG had 37 trillion won in assets and 46 trillion won insales, making it the third-largest chaebol. In-Hwoi Koo foundedLG Group after Korea was liberated from Japan. The original

66


firm was a trading company. Koo then established a consumergoods manufacturing company, now known as LG Chemical,in 1947 to manufacture cosmetics and soaps, which were veryprofitable businesses at that time. LG then entered the plas-tic industry to vertically integrate into cosmetics containers.It was soon equipped with modern facilities to produce soapcontainers and toothbrushes and acquired a monopoly in thosebusinesses.

During the 1960s, LG Group grew under the government’seconomic development plan. It vastly expanded the operationsof Goldstar, established in 1959 and now called LG Electronics.It began to produce consumer electronics and appliances suchas radios, TVs, and washing machines. It entered the petroleumprocessing industry and established Honam Oil Company (now,LG Caltex Oil) in 1966. It eventually diversified into the insur-ance industry (LG Marine and Fire Insurance) to support itsoil refinery business and save money on insurance premiums.Because LG Oil had to employ many ships for transportingcrude oils, it paid insurance premiums that represented over halfthe total profit of Korea’s insurance industry. It also diversifiedinto several related businesses in chemicals and electronicssuch as carbon black (LG Continental Carbon), communicationequipment manufacturing (LG Information Communication),and electronic wiring (LG Cable).

It continued to focus its related diversification and verti-cal integration around chemicals and electronics in the 1970s,when it established electronics-parts manufacturing affiliatessuch as Alps Electronics, LG Electric Machinery, and LGInstruments and vertically integrated in the chemical industryvia LG Polychemical. During the 1970s, LG International wasselected as one of the general trading companies sponsored bythe government.

67


Like other large chaebols, the LG Group was able to grow onits own during the 1980s. It expanded into financial services byestablishing merchant banking (LG Merchant Bank), investmenttrust (LG Investment Trust), and securities companies (LGSecurities) and also ventured into semiconductors when it es-tablished LG Semiconductor. During the 1990s, it focusedon telecommunications, setting up LG Telecom, a wirelesstelecommunication company, and acquiring DACOM, the lead-ing internet service provider and long distance service provider.

Daewoo Group

The Daewoo Group has been the fastest growing of the top fivechaebols since being founded in 1967 by Woo-Choong Kim.Its affiliates faced bankruptcy in 1999, however, and DaewooGroup itself was being dismantled. The major reason it grewso rapidly was that it participated more actively in the Koreangovernment’s economic policy than did any other large chaebol;its history closely parallels that of the government’s economicpolicies.

In line with the government’s focus on export of items liketextiles, apparel, and leather during the 1960s, Daewoo firstgrew by exporting those products and building a large clothingfactory. When the United States imposed textile import quotasin 1972, Daewoo produced 40% of Korea’s textile exports. Byachieving export targets set by the government, Daewoo couldtap into export finances at low interest rates and obtain muchtax exemption. Using the profits it made in textiles, Daewooadvanced into overseas construction projects, particularly inthe Middle East, during the 1970s. The government officiallydesignated Daewoo Corporation as a general trading companyin 1975.

68


Because it participated enthusiastically in the government’spolicy to boost heavy equipment and the chemical industry, andtook over many insolvent companies in those industries,Daewoo continued to be favored by the government. In 1976,it acquired Hankook Machinery, a troubled machinery manu-facturer, and renamed it Daewoo Heavy Industries. In 1978, itacquired the financially troubled Okpo Shipyard and renamedit Daewoo Shipbuilding, and the bankrupt Saehan Motors,now known as Daewoo Motors. The government appreciatedDaewoo’s taking over these insolvent enterprises and rewardedit handsomely for doing so by writing off loans and providingvarious subsidies, preferential loans, and tax breaks. Daewoowould not have enjoyed such treatment had it not been closelyconnected to the Park regime.

Daewoo continued this growth strategy in the 1980s. In1983, it took over the home electronics and telecommunicationbusinesses of Daehan Group and renamed them Daewoo Elec-tronics and Daewoo Telecom, respectively. It entered the finan-cial services industry by taking over Sambo Securities Com-pany in 1983 and renaming it Daewoo Securities, which becamethe biggest securities company in Korea. It also set up KoramBank as a joint venture with Bank of America in 1983. DaewooMotors integrated vertically into auto parts by establishingDaewoo Auto Parts, Daewoo HMS Industry, and DaewooCarrier.

In the 1990s, Daewoo actively pursued globalization. It set upoverseas production plants for Daewoo Motors, Daewoo Elec-tronics, and Daewoo Corporation and entered emerging mar-kets such as Poland, Rumania, India, Vietnam, and Sudan. Itsexpansion plans were too ambitious, however, and the foreignexchange crisis of 1997 further weakened it. These factors ledto its collapse in 1999.

69


SK Group

SK Group was the fifth largest chaebol in Korea as of 1997,with assets of 22 trillion won and sales of 26 trillion won. LikeDaewoo, SK Group’s relationship with the government has beenvery close. An interesting aspect of SK Group is its repeated ac-quisition of previously state-owned companies. Jong-Kun Cheyfounded it in 1953 when he purchased from the government atextile manufacturing plant, which was previously owned by theJapanese. SK Group grew rapidly through continued exporting.In 1962, it established SK Construction. Under the government’seconomic development plan, it established SK Chemical in 1969to produce synthetic fibers out of imported petrochemical prod-ucts. In addition, SK Global was selected as a general tradingcompany in 1976.

In 1980, SK Group stunned many when it acquired Yukong,a state-owned enterprise in oil refinery. At that time, the rev-enue of Yukong (now known as SK Corporation) was 5.5 timeslarger than that of SK Group. The government arranged a loan of$100 million to SK Group at a very low interest rate, and SKGroup did not pay anything to acquire Yukong (Kang, 1996).The government also awarded SK Corporation with exclusiverights to import oil from Saudi Arabia. There was much specu-lation as to how SK Group could acquire Yukong on such favor-able terms. It is likely that its close connection with the Chungovernment helped SK Group do so. After taking over Yukong,SK Group established SK Shipping to internalize shipping ofcrude oil and pursued vertical integration by establishing SKGas and SK Oxychemical.

SK Group also took over Korea Mobile Telecom, a state-owned monopoly of mobile telecommunication service, nowknown as SK Telecom, in 1994. Chaebols competed intensely

70

The Growth Strategy of Chaebols

to get this enterprise, which generated hefty profits and hadsound prospects of long-term growth. One factor that mighthave helped SK group secure this asset was the marriage ofits chairman’s son to the daughter of President Rho. Duringthe 1990s, SK Group expanded its financial services arms byestablishing SK Securities and acquiring an insurance company(now SK Insurance).

the growth strategy of chaebols

In this section, we will extract some common elements of chae-bols’ growth strategies from the historical accounts set forth inthe previous sections. These strategies have consisted of threeelements: taking advantage of government policies, tappinginternal and external capital markets, and pursuing unrelateddiversification and vertical integration.

Taking Advantage of Government Policies

All the major chaebols grew by following the government’seconomic policies and using political connections to win gov-ernment contracts. The Korean government sold to only a fewfirms property that reverted to it after the Japanese left. Suchpreferential treatment provided chaebols a foundation to grow.The government also favored chaebols by allocating foreigncurrency, which let them grow rich by importing scarce prod-ucts. Samsung and LG started as trading companies at the timeand were able to accumulate funds that were essential for futureinvestment.

In addition, the government’s economic development plansprovided huge subsidies for expansion into strategic industries

71


such as heavy equipment and chemicals. The plans continuedthrough the 1970s, when massive subsidies were given to generaltrading companies. Large chaebols such as Samsung, Hyundai,Daewoo, LG, and SK were all appointed as general tradingcompanies and were given many privileges.

Close connections with the government were also essen-tial in winning government contracts and support. For exam-ple, SK Group’s takeover of Yukong and Korea Mobile Tele-com would not have been possible without close connectionsto the incumbent government. Similarly, Daewoo’s takeover ofinsolvent companies, which gained it large subsidies, was at-tributable to its close government ties. Figure 2.4 summarizesthe role of the government during the chaebols’ development.From this perspective, chaebols’ successful lobbying of the gov-ernment was a core competence that was vital for growth, justas political connections were important resources that helpedbusiness groups form in Latin American countries (Guillen,2001).

It is, however, worth emphasizing that the relationship be-tween the government and chaebols in general turned sour inthe 1990s. Chaebols became powerful and self-sufficient withtheir own financial service arms. The government lost leverageagainst chaebols after it abolished various subsidies. Chaebolsalso became actively involved in politics to turn regulations totheir favor.

Exploitation of Internal and ExternalCapital Markets

Another critical element of chaebols’ growth was their ability toraise capital internally and externally. Although this competence

72

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might not be a source of competitive advantage in countrieswhere capital markets were well developed, access to capitalwas critical for chaebols because Korea suffered from a chronicshortage of capital. Chaebols tapped into internal and externalcapital markets in several ways.

First, they generated cash from their incumbent subsidiariesand invested it in new ventures. To facilitate investment, chae-bols created the group-level staff organization, which controlledthe free cash flows of affiliates. Because several companies par-ticipated in the equity investment of new venture, some degreeof cross-shareholding resulted from these joint investments. Inaddition, by providing debt guarantees to new affiliates, exist-ing affiliates helped their less established counterparts securebank loans. This financing practice made it easier for chaebolsto expand by creating new affiliates rather than by diversifyinginternally by adding business divisions. In addition, chaebolsartificially increased their equity bases by exchanging sharesamong themselves, thereby securing more loans. From this per-spective, chaebols’ capital structures, which were characterizedby high debt–equity ratios, cross-shareholding, and mutual debtguarantees, were designed to maximize the loans they could se-cure from the banks. We will discuss chaebols’ capital structuresmore extensively in Chapters 5 and 6.

Second, chaebols entered the financial services industry tosecure more loans from financial institutions. Ultimately, theyused these institutions’ reserves as their own private vaults. Al-though the government regulated the chaebols’ ownership ofbanks, chaebols ventured into less regulated financial serviceslike merchant banking, insurance, securities, and investmenttrusts. Those financial service arms played the most significantrole in chaebols’ expansion and downfall, as is illustrated inChapter 5.

74

The Environmental Shift

Pursuit of Diversification and Vertical Integration

Chaebols’ growth strategy encompassed unrelated diversifica-tion, related diversification, and vertical integration. They en-tered unrelated business lines to capture government subsidies.As a consequence, several chaebols participate in industriessuch as shipbuilding, heavy equipment, automobiles, chemi-cals, and electronics and compete fiercely with each other. With-out an infrastructure to supply these industries, chaebols thenneeded to integrate vertically to secure parts and raw materi-als. The general trading companies served as an export chan-nel to overseas markets. Thus, chaebols show extensive verticalintegration. In addition, chaebols also pursued related diversi-fication, often within incumbent affiliates. In Chapters 3 and4, we will examine the nature of chaebols’ diversification andvertical integration and assess the performance implications ofthese activities.

the environmental shift

In this section, we will summarize some important changes in theexternal environments that chaebols have faced in the 1980s and1990s. In the past, the chaebol was a successful organizationalform. Yet the recent crisis demonstrated that chaebols couldnot continue reproducing this success because of the changes intheir external environment. As creatures of market imperfectionand state interventions that characterized the economic environ-ment in Korea during the 1960s and 1970s, chaebols prosperedunder the favorable geopolitical environment during that time.As they expanded into foreign markets and Korea liberalized itsown economy, however, they faced challenges that they were illequipped to handle.

75


Intensified Global Competition

One of these challenges, which first became important in the1980s, was intensified competition in both export and domesticmarkets. When Korea pursued export-oriented strategies in the1960s and 1970s, it had few competitors from emerging mar-kets. Since the 1980s, however, several other countries such asIndonesia and China have emulated Korea’s success. As a re-sult of intensified labor disputes and shortages of labor, Koreanworkers’ wages rose, further eroding the conventional competi-tive advantages of Korean firms. The removal of various exportsubsidies further weakened the competitiveness of the Koreanexport sector.

The global competition also intensified within Korea’s do-mestic markets. Since World War II, the General Agreementon Tariffs and Trade (GATT) helped remove tariff barriers andother nontariff barriers among its members. The World TradeOrganization (WTO), which began operating in 1995, furtherstrengthened the enforcement of GATT rules. Due to the GATT’scontinued efforts and increasing pressures from trading partners,especially the United States, Korea had to open up its domesticmarkets. As a consequence, Korea increased its imports duringthe 1990s, sometimes more than it increased its exports. Theresulting intensified competition in the domestic markets hurtchaebols because they were accustomed to compensating lossesfrom export with profits from protected domestic markets.

Increasing Influence of Foreign Capital

There have been some significant structural changes in theKorean capital market during the 1990s. In the past, the govern-ment tightly regulated foreign sources of capital and guaranteed

76

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Yearbo

ok.


that these funds would be repaid. The economic liberalization ofthe 1980s and 1990s removed such restraints. By the mid 1990s,banks, chaebols, and chaebol-owned financial institutions werefree to borrow from foreign sources. Figure 2.5 shows three im-portant trends. First, the inflow of foreign capital, as both foreigndirect investment and portfolio investment, jumped in the 1990s.As it became more integrated into the global economy, Koreathus became more vulnerable to external turbulence, includingexchange crises. Second, most of the inflow of foreign capitalwas in the form of portfolio investment as short-term specula-tive funds, rather than foreign direct investment, which oftenaccompanied technology transfers and was long term in nature.Thus, Korea was especially subject to short-term fluctuations offoreign capital inflows/outflows. Third, because of these foreigncapital flows, the composition of the capital market changed. By1999, foreign ownership increased to 12.4% of the total num-ber of stocks and 27% of the total market capitalization. Aswill be discussed in Chapter 7, the increased presence of for-eign investors has led to greater shareholder activism, anothersignificant structural change that has influenced the behavior ofKorean listed companies. Foreign investors have both activelymonitored performance and worked with domestic shareholderactivists such as People’s Solidarity for Participatory Democ-racy to file lawsuits against chaebols.

These two important environmental shifts required chaebolsto narrow their business focus to a few core competencies andimprove their technology, brands, and productivity to remainviable. Chaebols failed to make this transition. The followingchapters will focus on the structural characteristics of chaebolsthat caused this inertia.

78

3

Chaebols’ DiversifiedBusiness Structure

79

The Extent of Chaebols’ Diversification

As discussed in Chapter 2, chaebols have pursued both unrelateddiversification and vertical integration. At the same time, theirmajor affiliates engaged in related diversification. This chapterwill focus on chaebols’ patterns of diversification and assesswhy they diversified as well as how they have implementedthese efforts. In doing so, it will consider how chaebols havecreated synergy and value by diversifying. The success of thiseffort was not guaranteed, and chaebols could not have done sowithout centralized coordination and control systems. Finally,we examine the performance implications of chaebols’ diversi-fication. In particular, we explore how chaebols became suscep-tible to the crisis. We argue that operating synergies, created byresource sharing among affiliates, were often offset by failuresin strategic decision making.

the extent of chaebols' diversification

Measuring Chaebols’ Diversification

Most research on diversification has focused on two issues.Some of it, such as Chandler (1962), has emphasized firms’ useof diversification to capitalize on economies of scale and scopeand utilize idle capacity. Other scholars (e.g., Rumelt, 1974)have distinguished between related and unrelated diversifica-tion and suggested that the former creates more value than thelatter does because it enables firms to share resources and trans-fer skills among related business units (Porter, 1987; Prahaladand Hamel, 1990).1

Such research has concentrated primarily on firms in coun-tries with well-developed markets, however, and it may not gen-eralize to different contexts. For example, according to Rumelt’s

81

Chaebols’ Diversified Business Structure

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

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

Total diversification Unrelated diversification Related diversification

82


classification scheme, which classified firms’ strategies asfalling into one of four categories (i.e., single business, re-lated diversification, unrelated diversification, and verticalintegration), all the top thirty chaebols are unrelated diversi-fiers, providing no way to compare among themselves. Giventhis book’s focus, it is important to compare the extent to whichindividual chaebols diversified into related and unrelated ar-eas. We thus adopted the entropy measure of diversification(Palepu, 1985), which decomposes total diversification into re-lated and unrelated diversification, using the industry classifi-cation scheme. Related diversification captures distribution ofsales by business segments defined by the four-digit KoreanStandard Industry Classification (KSIC) within the same two-digit KSIC code and unrelated diversification by distribution ofsales across different two-digit KSIC code.

Figure 3.1 shows the trend of diversification of the top thirtychaebols with this index. The figure shows that chaebols’ di-versification increased continuously from 1985 to 1997. Most

←−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−Figure 3.1. Degree of related and unrelated diversification of the topthirty chaebols, 1985–2000.Note: The entropy measures of diversification are defined as follows.Consider a firm operating in N industry segments (defined by thefour-digit KSIC industries). Those N industry segments aggregateinto M industry groups (defined by the two-digit KSIC industries).Let Pi be the share of the i th segment in the total sales of the firm.Then, the total diversification (DT) is defined as DT= �N Piln(1/Pi ). The unrelated diversification (DU) is defined as DU = �M

Pj ln(1/Pj ), and the related diversification (DR) is defined as DR =�M�iε j P

ji ln(1/P j

i ). The entropy measure of diversification isdecomposed into related and unrelated portions (DT = DU + DR).See Palepu (1985).

83


of those increases came from unrelated diversification, and chae-bols kept diversifying into unrelated areas even during the eco-nomic decline of the 1990s. Chaebols became somewhat morefocused only after the financial crisis. As shown in Figure 3.1,chaebols also pursued related diversification, often within exist-ing affiliates. Figure 3.2 shows the business composition of thetop five chaebols. Samsung and LG have a large presence in theelectronics industry, while Hyundai and Daewoo emphasize au-tomobiles and heavy equipment, and SK and LG derive a largeproportion of their revenues from the chemical industry. All re-tain general trading companies; consequently, sales in retailingand wholesaling are important to all of them.2

The Motivations for Diversification

Chaebols are often depicted as irrational economic organiza-tions pursuing growth at the expense of profits. They are indeedruthless competitors, undercutting their rivals in both domesticand overseas markets. In Korea, many have contended that chae-bols drove out small and medium-sized firms and bought themwhen they went bankrupt (Lee, 1996; Kim, 1997). Yet it is notclear whether chaebols were irrational. To address this issue, wemust consider why chaebols pursued unrelated diversificationrather than focusing on a few core businesses.

Modern management theories specify three main motives fordiversification – pursuit of growth, risk aversion, and economiesof scope. They are skeptical, however, about the first two mo-tives, criticizing the first as a way to satisfy CEOs’ egos and thesecond as being more concerned with reducing firms’ own risksthan maximizing shareholder value (Marris, 1964; Amihud andLev, 1981) because shareholders can reduce risk by diversifyingtheir own portfolio. Thus, these theories consider the pursuit of

84


34.7

62.24

32.33

39.5

6.31

11.55

0

00

0.83

3.55

4.98

0

0

0.58

3.47

0.16

21.07

26.35

12.39

0.06

3.38

0.35

0

0

1.65 1.75

6.18

1.71

0.51 1.01 0.332.61

wholesaleand retail

44.69

motor vehicletransportation

22.87

construction10.03

5.57

fiber,chemical32.65

5.27

electric30.6

machinery,iron, and steel

10.16

finance24.42

telecommunication9.91

0%

20%

40%

60%

80%

100%

Hyundai Samsung Daewoo LG SK

Wholesale and retail trade Motor vehicle transportation Construction

Transportation Fiber, chemical Electric

Machinery, iron and steel Finance Telecommunication

6.02

3.66

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

85


synergies or economies of scope as the only legitimate reasonsfor diversification.

Although chaebols have pursued growth rather than short-term profits, they did not do so indiscriminately. In Korea,growth was directly related to long-term profit maximization.Figure 3.3 shows the composition of sales for Samsung Groupin 1965, 1976, 1987, and 1998. It indicates that Samsung Groupgrew more by diversifying into new businesses than by ex-panding existing ones. In 1965, Samsung’s sales volume was25.8 billion won and came mainly from textile, food, and in-surance businesses. By 1976, its sales volume had increased to640 billion won with consumer electronics contributing sub-stantially to this growth. Samsung’s sales volume in 1987 was16.7 trillion won; much of this growth stemmed from Samsung’sforays into machinery, shipbuilding, trade, and semiconduc-tors. Still new sources of growth in automobiles, logistics, andtelecommunications were seen in 1998.

Those newly entered businesses contributed to both growthand profitability.3 For instance, in 1995, a boom year forsemiconductors, the semiconductor division posted a profit of2.5 trillion won, which was 84% of the profit of the entireSamsung Group. Since the Korean government had providedchaebols with many monetary incentives to expand into strate-gic business areas, as discussed in Chapter 2, unrelated diversifi-cation offered chaebols many kinds of opportunities to increaseprofits, such as subsidies, funds for investment, and protectionfrom taxation and import barriers. Such expansion was thereforenot motivated solely by growth.

Chaebols also diversified to reduce the risk of their found-ing families, which invested all their assets into affiliates. Thesefamilies wanted to earn stable profits from their investments.Of course, this goal did not serve the interests of minority

86

Intragroup Resource Sharing

shareholders. This reason for risk reduction did not create muchtension in the 1970s when only a few affiliates were listed onthe stock exchange.

Chaebols’ diversification is also motivated by their desire tocreate synergies by sharing intangible resources such as technol-ogy and brands, tangible resources, human resources, and capi-tal. The next section analyzes how intragroup resource sharingcreated synergies and has been the factor underlying chaebols’competitiveness.

intragroup resource sharing

Sharing Technology, Brand, and ManagementKnow-how

A chaebol’s affiliates freely share technology with each other.To facilitate groupwide technical support for affiliates, chaebolsestablished group-level R&D centers, organized along broadlydefined business lines such as automobiles and electronics tomeet these affiliates’ common needs (Kim, 1996). For example,Samsung Group established the Samsung Advanced Technol-ogy Institute to support a group-level effort for basic research.This institute offers sophisticated technological information toall affiliates. Several of these affiliates, including both final as-semblers and parts suppliers, finance their joint R&D effortsand share any technological innovations from this research.Such sharing is more effective when several vertically inte-grated affiliates join forces. For instance, Samsung Electronicsmanufactures finished television products, Samsung SDI pro-duces TV tubes, and Samsung Electro-Mechanics manufacturesvarious TV electronic parts. Samsung Corning, a joint ven-ture with Corning, delivers glass for TV tubes. In such cases,

87


Food

Textiles 40%

48%

12%Insurance

Insurance

Food

Textiles

Paper

Construction

HomeAppliance

1%

24%

3%

28%

25%

18%

Nonmetallic Minerals (1%)

Machinery, Iron & Steel (0.1%)

Other Services (0.1%)

Semiconductor (0.8%)

Telecommunications (0.1%)

1965

(25.8 billion won)

1976

(640 billion won)

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

88


(Insurance)

Construction

HomeAppliance

HomeAppliances

Finance

(Insurance)

Finance

Food &Leisure

TextilePaper

Paper

Vehicles Vehicles

Wholesale&Retail Trade 35%

3.3%

2.4%

18.3%

0.5% 3.7%

4.4%

30.2%

TextilesFood & Leisure

(1.1%)

(Automobile)

Other Services (1.6%)

Semiconductor

Wholesale & Retail Trade

Nonmetallic

Minerals (1%)Machinery,Iron & Steel (0.4%)

Telecommunications (1%)

6%

35%

6.3%

19.9%

0.3%

3.5%

24.4%

1987

(16,767 billion won)

1998

(93,766 billion won)

89


technological innovation in one affiliate can directly contributeto cost savings and new product development in another affiliate.

Another noteworthy characteristic of chaebols is that all affil-iates in a group share its unique brand name. Group advertising,which emphasizes the image of a group rather than individualaffiliates, generates considerable scale and scope economies.4

Figure 3.4 is a sample of Samsung’s group advertising that ap-peared in Business Week. It highlights Samsung’s brand nameand mentions the names of individual affiliates in the fine print.In another example, Samsung’s sponsorship of Seri Park, thegolfer who won the 1998 LPGA (Ladies Professional GolfAssociation) championship promotes awareness of Samsung’sbrand name, which in turn helps every affiliate company inthe Samsung Group. Similarly, Hyundai Group advertises thatit manufactures “from chip to ship.” The empirical study inAppendix 3 provides strong evidence for the conjecture that theintragroup sharing of technology and brand improve the prof-itability of individual affiliates.

Chaebols’ sharing of management know-how is also im-portant, particularly when they enter a new business. WhenSamsung entered the specialty chemicals industry, many af-filiates supplied the necessary investment funds as well asother managerial know-how (Chun and Han, 1994). SamsungEngineering designed the factory, and real estate experts fromSamsung Life Insurance helped purchase the necessary land.Samsung Construction built the plant, and Samsung HeavyIndustries supplied the materials for the plant’s construction.Also, Samsung SDS and Samsung Engineering designed thefactory automation, Samsung Corporation helped expedite thesupply of raw material and export of products, and SamsungPetrochemical and Cheil Industries helped secure necessarytechnology. Branch offices of Samsung Corporation took care of

90


the foreign correspondence, and the group-level training centertrained newly hired and transferred employees. In short, whenentering into new business areas, existing affiliates supplied var-ious management resources and know-how for free so that thenew businesses could enter at far lower costs than they couldotherwise.

This group-level sharing of resources may be the most crit-ical factor that discriminates chaebols from business groups inother countries. Althoughgrupos economicos in Latin Americancountries might also learn how to set up new ventures or takeover privatized companies quickly and economically, their affil-iates did not share brands, technology, and human resources asextensively as did chaebols. For instance, an Argentine businessgroup, Perez Companc, grew by leveraging its political connec-tions but did not attempt to share technology or brands among itsgroup affiliates (Guillen, 2001). No group-level organizationalstructure was implemented to help member firms learn fromeach other’s organizational experience. This lack of attempts tocreate synergies among affiliates might be partly attributable tothe fact that many affiliates in business groups in Latin Americancountries were created in joint ventures with multinational cor-porations (Evans, 1979). While pursuing import substitutionpolicies, the governments handed out licenses to a few localcompanies that in turn borrowed technologies from multina-tional corporations. It would be hard to share resources amongaffiliates when each has its own joint venture partner.

Sharing Human Resources

Chaebols share human resources among affiliates throughgroup-level recruiting and intragroup transfers. Unlike advancedcountries with efficient labor markets and ample supplies of

91


Figure 3.4. An example of group-level advertising.

92


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

93


employees, they have set up groupwide training centers to doso. After training these new employees, they send them to af-filiates after they calculate these affiliates’ need for personnel.These centers also provide ongoing management training to em-ployees. They create economies of scale, instill group-level cul-ture, and promote cooperative human resource sharing amongaffiliates.

The intragroup labor market is also important for chaebolswhen they diversify into new businesses. It is very costly to hireand train the substantial personnel that such expansion requires.By transferring personnel into new affiliates, chaebols can savemuch time and money and further facilitate the sharing of tech-nological resources and management know-how. For example,when Samsung Group established Samsung Electronics, it dis-patched the existing employees of Cheil Industries and CheilJedang to a joint venture partner of Japanese NEC to obtainthe required technology (Chun and Han, 1994). As recently as1994, Samsung Group transferred a large number of employeesto Samsung Motors.

The extent of these transfers is manifested clearly whenwe examine the career path of executive officers in chaebols.Table 3.1 shows statistics on the job careers of incumbent presi-dents of the top five chaebols’ affiliates. It shows the companiesthey joined as new employees, the companies where they tookexecutive positions for the first time, and their last appointments.Of the forty four presidents of Samsung Group affiliates, fivestarted their career in Samsung Electronics, six in JoongangDaily News, four in Samsung Corporation, and twenty-two inother Samsung affiliates. Many presidents assumed their firstexecutive positions at Samsung Electronics, Samsung Corpora-tion, and Joongang Daily News. Furthermore, Table 3.1 indi-cates that eight incumbent presidents of affiliates in Samsung

94


Group had their latest appointment in Samsung Electronics, fivein Samsung Corporation, and two in Joongang Daily News. Suchcareer tracks are also common in the other large chaebols.

Internal Pool of Capital

There is a saying that “cash is king.” It certainly was in Korea,which experienced a shortage of capital throughout the devel-opment period. As elaborated in Chapter 2, the Korean capitalmarket did not grow sufficiently during the turmoil after the lib-eration and the era of economic development, when almost allfunds were distributed to the small business areas specified bythe government. In this situation, it was necessary for chaebolsto supply capital by channeling investment funds from exist-ing affiliates to support new ventures. Chaebols collected fundsfrom each affiliate and allocated them in the order of strate-gic importance. This use of free cash flow created an internalcapital market. Unlike firms in developed countries with well-developed capital markets, an internal capital market can createenormous synergies and be a source of competitive advantagesin firms in developing countries (Williamson, 1975; Leff, 1978).

For instance, when entering new business areas, affiliates ofchaebols provided their capital resources in the form of equityinvestment. When the venture capital found in developed coun-tries was not available and a new business entity could not securea loan from banks, group affiliates were the only source of cap-ital. Figure 3.5 shows the equity investments Samsung affiliatesmade for Samsung Motors in 1994. Samsung Electronics pur-chased 30.6% of Samsung Motors’ equity; Samsung Electro-Mechanics, 8.8%; Samsung SDI, 10.8%; Samsung HeavyIndustries, 3.6%; and Samsung Everland, 1.8%. The remaining44.3% of Samsung Motors’ equity was purchased by executive

95

Tabl

e3.

1.Careerpathsof

CEOsof

major

affiliatesin

topfivechaebols

Sam

sung

Sam

sung

Sam

sung

Joon

gang

Oth

erC

ivil

Ele

ctro

nics

Cor

p.D

aily

New

saf

filia

tes

Mili

tary

serv

ant

Oth

ers

Tota

l

Firs

thir

ed5

46

221

24

44Fi

rste

xecu

tive

posi

tion

94

424

00

344

Lat

esta

ppoi

ntm

ent

85

229

00

044

Hyu

ndai

Hyu

ndai

Hyu

ndai

Hyu

ndai

Hea

vyO

ther

Civ

ilC

onst

ruct

ion

Mot

orIn

dust

ries

affil

iate

sM

ilita

ryse

rvan

tO

ther

sTo

tal

Firs

thir

ed8

63

160

19

43Fi

rste

xecu

tive

posi

tion

84

221

00

843

Lat

esta

ppoi

ntm

ent

14

331

00

443

LG

LG

LG

LG

Oth

erC

ivil

Che

mic

alE

lect

roni

csC

alte

x-O

ilaf

filia

tes

Mili

tary

serv

ant

Oth

ers

Tota

l

Firs

thir

ed11

126

70

24

42Fi

rste

xecu

tive

posi

tion

67

719

00

342

Lat

esta

ppoi

ntm

ent

64

228

00

242

Dae

woo

Dae

woo

Dae

woo

Dae

woo

Hea

vyO

ther

Civ

ilC

orp.

Ele

ctro

nics

Indu

stri

esaf

filia

tes

Mili

tary

serv

ant

Oth

ers

Tota

l

Firs

thir

ed7

10

20

413

27Fi

rste

xecu

tive

posi

tion

74

310

00

327

Lat

esta

ppoi

ntm

ent

54

214

00

227

SK Oth

erC

ivil

SKC

SKC

hem

ical

SKG

asaf

filia

tes

Mili

tary

serv

ant

Oth

ers

Tota

l

Firs

thir

ed11

20

20

010

25Fi

rste

xecu

tive

posi

tion

114

15

00

425

Lat

esta

ppoi

ntm

ent

61

312

00

325

Source:

Exe

cutiv

epr

ofile

data

base

,Kor

eaIn

form

atio

nSe

rvic

e,as

of19

97.


Samsung SamsungElectronics Electro-Mechanics (30.6%) (8.8%)

Samsung Samsung SamsungEverland Motors SDI(1.8%) (10.8%)

Employees Samsung Heavy(44.3%) Industries

(3.6%)

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

officers and employees of Samsung Group, making SamsungGroup the sole owner of Samsung Motors. Affiliates also pro-vide additional funding to new ventures by providing directloans and debt guarantees. We will discuss these intragrouploans and debt guarantee practices in Chapter 5.

organizational structure of chaebols

Although we have examined how chaebols’ affiliates share var-ious resources, we have not considered why it is fairly easyfor them to do so despite their independent legal status. Un-derstanding chaebols’ organizational structures helps us answerthis question.

98

Organizational Structure of Chaebols

Multidivisional Structure

In Western countries, firms with diversified businesses are or-ganized as multidivisional structures. Under this system, onlythe CEO of a diversified company makes strategic decisions; thehead of each business division determines only matters relatedto the business operations of his division (Williamson, 1975).Corporate staff personnel exist as a bridge linking the CEO toheads of business divisions. Similarly, the chairman of a chaebolacts as if he is CEO of a diversified company while presidents ofaffiliates play a function similar to heads of business divisions.As “CEO” of a chaebol, the chairman sets the direction for thechaebols’ corporate culture and personnel management and de-cides when the affiliates should make groupwide investmentsand divestitures. In fact, the term “chairman of the group” is afictitious title since the group does not exist in a legal sense. Aswe will see in Chapter 6, extensive cross-shareholding ensuresthat each affiliate behaves just like an operating division in adiversified corporation even though it has its own shareholdersand board of directors.

As do multidivisional organizations, all chaebols have staffpersonnel that support and assist the chairman of the group.Samsung Group invented group-level staff organization by in-troducing the “Office of Secretaries” in 1959. At that time,Samsung Group was establishing a solid business base as achaebol with Samsung Corporation, Cheil Jedang, and CheilIndustries as its core companies. As the group expandedinto trade, manufacturing, and financial businesses, the lateChairman Byung-chul Lee could not control and coordinate allthese businesses on his own. LG Group followed suit by creat-ing the Office of Chairman in 1966. SK, Daewoo, and Hyundaimade similar moves in 1974, 1976, and 1979, respectively.

99


In its early years, Samsung Group’s Office of Secretariesplayed a limited role in allocating funds and human resourcesin the process of financial control and personnel management.It initially had only about twenty employees.5 As SamsungGroup advanced into a wide array of new businesses in linewith the Korean government’s economic development pol-icy, it increased in size to ten teams and 139 employees by1980.6 Its role also expanded considerably, and eventuallyconsisted of the planning team (new investment and manage-ment planning), the human resources team, the financial controlteam (managing groupwide funds), the financial team (externalfinancing), the research team (new business opportunity andmarket information), the audit team (management evaluationand financial auditing of each affiliate), and the governmentpolicy team (information collection related to government pol-icy and lobbying). In addition, it began to offer advice toand support for other affiliates by promoting public relations,internationalization, and groupwide investment in informationtechnology.

A key function of this group-level staff organization is to de-termine the transfer price of intragroup business transactions.Group-affiliated companies conduct extensive internal sellingand purchasing of intermediate and final goods. Further, intra-group loans, debt guarantees, and equity investment are preva-lent. Among multidivisional firms in the United States, there hasbeen much conflict in determining transfer prices for internaltransactions because they have a direct impact on performanceevaluation and compensation of divisional managers (Eccles andWhite, 1988; Poppo, 1995). This group-level staff organizationcan determine internal transfer price so as to support underper-forming affiliates or to minimize the tax liabilities by shiftingprofits from highly profitable affiliates to loss-making affiliates.

100


It does so to maximize profit at the group level, not the affiliatelevel.7 It can exercise such control over internal transfer pricesbecause it has the authority to evaluate the performance of in-dividual affiliates and to recommend appointment/dismissal ofaffiliates’ presidents to the group chairman.

At this point, someone may wonder how it is possible for in-dividual affiliates, many of which are publicly owned companieswith separate shareholders and boards of directors, to maximizeprofits at the group level but not their own profits. R&D andadvertising expenses were often paid by an affiliate that wasgenerating profits at that time. Other affiliates often used thoseresources without paying for them. Resources in the form ofpersonnel transfer and loans were often transferred to newly es-tablished and unprofitable affiliates for no fee. Such activitiescould take place because the corporate governance system inKorea is ineffective, as we will discuss in detail in Chapter 6.Cross-ownership confered the control to chaebol families, whilethe rights of minority shareholders were severely restricted. Be-cause managers and executives of individual companies wereoften transferred within the group, they maintained their iden-tities with the group itself rather than with individual affili-ates. The lack of external labor market opportunities, as wellas seniority-based promotion, further ensured these employees’strong loyalty to the group (Lee, 1996).

Despite the existence of this office, Samsung’s group chair-man found it difficult to deal with all the group’s affiliates be-cause the number of these affiliates increased substantially in the1990s. As a consequence, Samsung Group divided the groupbusinesses into five major industries and built up subgroups.Under the subgroup scheme, the head of each subgroup dealswith affiliates belonging to each subgroup, which is equivalentto adding another layer in the multidivisional structure. As of

101


Group Chairman

Secretarial Office

Group Steering Committee

ElectronicsSector

Financial Machinery Chemical OthersService Sector Sector Sector

SamsungElectronics

SamsungLife Insurance

SamsungHeavy Ind.

SamsungChemical

SamsungCorporation

SamsungSDI

SamsungSecurities

SamsungFine Chem.

SamsungPrecision

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

1997, the organizational structure of Samsung Group consistedof the electronics, financial, machinery, chemical, and indepen-dent business subgroups, as shown in Figure 3.6. Under thisnew system, the group chairman delegated more authority tothe heads of subgroups, who in turn created their own staff or-ganizations to support their decision making. As a consequence,the Office of Secretaries reduced its headcount to around 100employees by 1997 and delegated authority over decisions likestrategic planning to the heads of subgroups.

Substantial changes have occurred to chaebols’ organiza-tional structure after the foreign exchange crisis. The Koreangovernment prohibited this organizational structure becausechaebols were believed to be one of the major culprits of the

102


crisis. Despite the ban, these staff organizations were transferredto major affiliates. They are now called group restructuringcommittees or group coordination teams, but their functionsare identical to their predecessors.

Presidents’ Meetings

In order for the group chairman to keep direct or indirect contactwith and control over the presidents of affiliates, chaebols usethe presidents’ meeting and the group steering committee. Bothconsist of presidents of major affiliates and play an importantrole in group-level decision making. As described in Table 3.2,presidents of all affiliates of a group participate in the presidents’meeting on a weekly basis, at maximum, or on a half-yearlybasis, at minimum. As chaebols increased their numbers ofaffiliates, it was difficult in practice to summon presidents ofall affiliates for a meeting where they exchanged their opin-ions. Thus, many chaebols run smaller group steering commit-tee meetings, which presidents of core affiliates attend. Im-portant matters related to the group such as entry into newbusiness, capital mobilization, and appointments/transfers ofexecutive officers are considered at these meetings. SamsungGroup’s Group Steering Committee comprises presidents oftwenty-six major affiliates. LG Group and SK Group convene,respectively, for biweekly or monthly meetings of the steeringcommittee.

In practice, the timing and frequency of the presidents’ meet-ings are closely interlinked with a chaebol’s culture. For in-stance, in the Hyundai Group, where authority is more cen-tralized, the presidents’ meeting is convened rather frequentlybecause the group chairman often presents his opinions aboutthe business operations of affiliates. In contrast, the group

103

Tabl

e3.

2.Group-levelstaff o

rganizationandexecutivecommittees

intopfivechaebols

Nam

eof

grou

p-le

vel

Dat

eof

Num

ber

Gro

ups

orga

niza

tion

foun

ding

ofst

aff

Des

crip

tion

Hyu

ndai

Offi

ceof

Cor

pora

tePl

anni

ng19

7960

Four

team

s(s

trat

egic

anal

ysis

,per

sonn

elde

velo

pmen

t,fin

anci

alan

dC

oord

inat

ion

man

agem

ent,

and

inve

stm

entp

lann

ing)

Gro

upSt

eeri

ngC

omm

ittee

CE

Os

of6

maj

orco

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chairman of Samsung Group refrains from contacting presi-dents of affiliates directly, and these presidents often discussimportant matters among themselves. Although presidents ofaffiliates can determine matters that require small investmentrelated to their existing business, they cannot make indepen-dent decisions on matters such as new business entry thatrequire large investments or possibly overlap with the busi-ness lines of other affiliates. The group chairman decides suchmatters.

Relative to the presidents of Japanese keiretsu affiliates, whoalso have presidents’ meetings to convene opinions amongstthemselves, presidents of chaebol affiliates have very littlepower. The Japanese keiretsus maintain voluntary cooperationamong affiliates (Gerlach, 1992) and do not exercise strong con-trol over their affiliates. In effect, the Korean chaebols are sim-ilar to diversified corporations in the western hemisphere andpresidents of chaebol affiliates are divisional managers.

diversification and economicperformance

Operating Efficiency

This chapter has considered the various ways chaebols shareresources. Such active sharing is expected to influence the eco-nomic performance of affiliates substantially. It is not easy, how-ever, to analyze the performance of chaebols at the group levelbecause all financial information appeared only on affiliate-levelfinancial statements until 2000, when laws that require chaebolsto release consolidated financial statements went into effect.This section, therefore, assesses whether intragroup resourcesharing influences the profitability of individual affiliates.

105


The results of an empirical study, presented in Appendix 3,show that these shared resources are important determinants ofthe affiliates’ profitability. A company receives indirect benefitsfrom the R&D investment and advertisement of other affili-ates. In addition, when other affiliates have extra cash or arefinancially healthy, a company can easily borrow funds fromthese affiliates or obtain loans from financial institutions thatare backed by debt repayment guarantees from other affiliates.To sum up, chaebols generate enormous synergies by sharingresources at the group level.

After looking at the results of the empirical study, some mayask whether the chaebols maximized profitability or growth.Although the growth patterns of chaebols may indicate that theymaximized growth, there should be no doubt that the chaebolspursued long-term profit maximization by pursuing unrelateddiversification, which should be understood as an effort to findfuture sources of profits. To generate funds to finance thesenew ventures, on the other hand, individual affiliates sought tomaximize their short-term profitability. In other words, chaebolscould invest in new business opportunities to maximize growthand long-term profitability only when each affiliate maximizedits profits and generated much-needed cash.

The creation of synergies through sharing resources amonggroup affiliates, however, became more difficult to achieve asmore affiliates were listed on the stock exchange. Up until the1970s, the Korean stock exchange had only about 200 listedcompanies. During the 1980s, however, the government pushedchaebols to list as many affiliates as possible. The numberof public firms increased from 277 in 1986 to 641 in 1996;those public firms affiliated with the top thirty chaebols in-creased from 50 in 1986 to 122 in 1996. In this chapter, wedescribed how chaebol affiliates shared technology, brands,

106


human resources, and financial resources as if they were di-visions of a diversified company. Within such a system, it wasnot clear who bore the costs and who benefited. A profitableaffiliate usually picked up the tab and all other affiliates enjoyeda free ride, which did not create many problems when affiliateswere privately owned. As more firms went public, however,minority shareholders objected to investing in and subsidizingother affiliates. For instance, minority shareholders of SamsungElectronics protested when this affiliate invested in SamsungMotors.

Strategic Effectiveness

Here another question arises, “If the Korean chaebols createdsuch operating efficiencies by sharing resources, why did theyface such difficulties amid the nation’s foreign exchange crisis?”To answer this question, we need to distinguish between individ-ual affiliates’ performance and group performance. The valuecreation that occurred at the individual level through resourcesharing was often totally wasted in some other part of the groupdue to ill-conceived strategies or to cross-subsidization of poorlyperforming affiliates. We believe that operating synergies cre-ated by resource sharing among affiliates were frequently offsetby failures in strategic decision making. Samsung’s entry intothe automobile industry during global industry consolidation isone prominent example of misguided diversification. Samsungfailed not because its individual affiliates failed to create syn-ergies but because its decision to enter the automobile industrywas wrong. Several Samsung affiliates pledged equity capitaland human resources to this new venture, which could not es-tablish a niche in the auto industry as it experienced global con-solidation. Other chaebols that went bankrupt in the financial

107


crisis all pursued diversification strategies that were grandiosebut lacked any economic rationale.

This weakness of chaebols (i.e., the ineffectiveness of group-level strategy) stems from their centralized structures, whichwere essential for creating synergies between affiliates at theoperational level. By centralizing decision making, chaebolscould quickly concentrate resources in a strategic area (e.g., anew business venture). Since the 1980s, however, several factorsmade this centralized apparatus more a liability than an asset.

First, prior to the 1980s, chaebols diversified, largely framedunder the government’s planning. The government not only des-ignated which industry to enter and who would enter it but alsopicked up the check when something went wrong. In the 1980s,however, chaebols became responsible for their own actions.They followed their own strategies with their own funding. Al-though the government provided a governance system prior to1980s, chaebols have had no functioning governance system toguard against wrong decisions since then. This problem becamemore acute when the chaebol chairmanship was passed downto the second and third generations of founding families. Fre-quently, these new chairmen, who had yet to demonstrate theirmanagement prowess, desired to prove their ability by embark-ing on ambitious, costly, economically unviable expansions thatthey financed with funds from their chaebols’ internal capitalmarkets. There was no mechanism to stop them from doing so.These issues will be discussed further in Chapters 5 and 6.

Second, by extensively sharing human resources among theiraffiliates, a chaebol created a homogenous group of managers.Managers were mostly internally promoted, and chaebol chair-manships were inherited within a family. In addition familymembers often assume presidentship in individual affiliates. Forinstance, Hyundai Group had five family members who took

108


presidentship in eleven affiliates. Similarly, LG Group had six;SK Group had two; and Samsung Group and Daewoo Grouphad one each, acting as presidents. As a consequence, a chae-bol chairman and presidents of affiliate companies alike pos-sessed fairly homogenous management philosophy and prac-tices, which can help transfers of existing knowledge more easilybut can stifle creativity. Management literature stresses that themore homogenous the managers, the harder it is to change strate-gic orientation (Tushman and Romanelli, 1985). This inertialforce may explain why chaebols continued unrelated diversifi-cation even when doing so was obviously unwise.

In this chapter, we have examined how chaebols created oper-ating synergies by sharing resources among group affiliates andhighlighted how much value creation can be wasted by an inef-fective group-level strategy. Without the presence of a function-ing governance system, it is difficult to stop ill-conceived movesby group chairmen. Furthermore, internal promotions and ahomogeneous group culture make it hard to change strategicorientation, which may help us understand why the chaebolsrelentlessly diversified. The further restructuring of chaebolsshould include stronger corporate governance systems, whilepreserving the chaebols’ capability to create synergies throughresource sharing and coordination at the group level since thiscapability was the real source of chaebols’ competitive advan-tage prior to the crisis.

109

4

Vertical Integration ofChaebols

111

The Scope of Chaebols’ Vertical Integration

In Chapter 3, we discussed how chaebols create synergies be-tween different lines of business. Chaebols also use verticalintegration extensively. This chapter will examine the scope ofvertical integration in the chaebols and discuss the performanceimplications of their using it. It shows how vertical integration,which was necessitated by the absence of domestic support-ing industries during the economic planning periods, turned in-efficient and why chaebols ended up subsidizing unprofitableaffiliates.

the scope of chaebols' verticalintegration

Vertical integration means an internal transfer of goods andservices within a firm. In this book, we measure the extent ofchaebols’ vertical integration by dividing their intragroup salesvolume by their total revenue. By doing so, we measure theextent of vertical integration among group affiliates. This mea-sure does not reflect the vertical integration within an affiliate.Table 1.1 manifests percentages of intragroup sales of the topthirty chaebols. Anam Group showed the highest level of ver-tical integration, chalking up 55.9% of intragroup transaction,while Dongah Group, which specialized in overseas construc-tion, showed the lowest level of vertical integration. The top fivechaebols were 20 to 30% integrated (Hyundai 31%, Samsung28%, LG 23%, Daewoo 36%, SK 21%). Simple averages, how-ever, can disguise the extent of vertical integration in affiliates.Individual affiliates, which supply parts to chaebols’ core man-ufacturing companies in distinct industries (e.g., chemical andelectronics affiliates), usually have a higher volume of the in-tragroup transactions. Furthermore, because this measure does

113

Vertical Integration of Chaebols

not reflect within-affiliate vertical integration, the actual levelof vertical integration of chaebols is far more substantial thanthis number suggests.1

Figure 4.1 shows the Hyundai Group’s internal businesstransactions as of 1997. This group has two major construc-tion companies, Hyundai Construction for overseas projectsand Hyundai Industrial Development for domestic needs. Inits chemical business, Hyundai Petrochemical and HyundaiOil Refinery are the core firms. Hyundai Group’s other corecompanies include: Hyundai Heavy Industries in shipbuilding;Hyundai Electronics,2 the second largest manufacturer of mem-ory semiconductor in the world; and Hyundai Motor in theautomobile industry. These companies maintain backward (orupstream) integration with very extensive and intricate networksof smaller affiliates that supply intermediary goods and parts tothem.

For instance, Hyundai Pipe delivers construction pipes toHyundai Construction and Hyundai Industrial Development.Hyundai Livart supplies furniture and interior decoration ma-terials to Hyundai Construction and Hyundai Industrial De-velopment. Hyundai Elevator distributes elevators to the coreconstruction companies. Hyundai Pipe, Hyundai Livart, andHyundai Elevator have a level of intragroup transactions ashigh as 38%. Inchon Steel derives about 27% of its total rev-enue from intragroup transactions. On the other hand, HyundaiEngineering designs and supplies major manufacturing facili-ties to Hyundai Oil Refinery, Hyundai Electronics, and HyundaiHeavy Industries. Korea Flange manufactures flanges and otherautomobile parts for the shipbuilding and automobile manufac-turing companies. Firms such as KEPICO, Hyundai Precision,and Hyundai Aerospace supply Hyundai Motor. These suppliers

114


may derive as much as 90% of their revenues from sales toaffiliates.

There are also instances of forward (or downstream)integration for manufacturing companies in Hyundai Group.Hyundai Corporation is a general trading company set up inaccordance with the Korean government’s export drive duringthe mid 1970s.3 During this period, the government designateda number of general trading companies and supported themwith low-interest loans as an export subsidy. Although thesefirms no longer receive this subsidy, they continue to be theintermediary of their affiliates’ exports and imports. HyundaiCorporation, for instance, imports raw materials and equipmenton behalf of its affiliates, which presents 43% of its totalrevenue in 1997. It also purchases finished products from theaffiliates and sells them in overseas market. Such transactionsrepresent about 52% of the company’s total revenue.4 Inaddition, Hyundai Merchant Marine provides services to otheraffiliates that need to ship exports.

Forward integration also takes place through domestic sales-related affiliates. For instance, Hyundai Motor uses HyundaiMotor Service to distribute its products in Korea, KumkangDevelopment for its retail business, and Hyundai Logistics fordomestic and overseas transportation services. Diamond Ad pro-vides a variety of advertisements/commercials services to itsaffiliates so that most of its revenue comes from these affili-ates. The chaebols’ various financial institutions also cater to thegroups’ financial needs through internal financial transactions.5

Such vertical integration is not unique to Hyundai; similar pat-terns of activity are found in Samsung, SK, Daewoo, and LG(see Figures A.7.1–A.7.4) for the extent of vertical integrationfor each group). Such extensive vertical integration is unique

115


Hyundai Pipe

38%

Hyundai Elevator38%

Hyundai Aerospace71%

Daehan Aluminum26%

HyundaiPrecision Mfg.

50%

Hyundai Engineering

Hyundai Info. System72%

Kepico

90%

Korea Flange

78%

Hyundai Construction

2%

Hyundai Industrial Development

20%

Koryo Industry

1%

Hyundai Petrochem.

26%

Hyundai Refinery52%

Hyundai Heavy Industries

16%

Hyundai Mipo Shipyard

10%

Hyundai Electronics

20%

Hyundai Motor32%

499778

570

475

314

305

718

793

750

797

511

324

355

483

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484

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366

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3,127

690

709

1,513

Hyundai Livart

27%

Inchon Steel

27%

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

116


Kumkang Development

11%

Hyundai Oils

Hyundai Corp.

43%

Hyundai MerchantMarine

19%

Hyundai Motor Service

2%

Diamond Ad.

9631,882

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8,561

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610

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36,967

All data are as of December 1997. Unit is 100million won

1. Large circles are for affiliates with over 5 trillion won in assets.

2. We show internal sales that are over 30 billion won.

3. The percentage in a circle denotes the proportion of intragroup sales relative to the total sales of that affiliate.

Hyundai MerchantBank

Hyundai Marine& Fire Insurance

Hyundai Capital

Hyundai Securities

HyundaiInvestment Trust

to chaebols with respect to business groups in other countries. Inthe following sections, we will examine in more detail why thechaebols adopted the vertical integration and its performanceimplications.

117


motives for vertical integration:pros and cons

The Advantages of Vertical Integration

Differences in chaebols’ use of vertical integration stem from thedistinct characteristics of the industries the chaebols are involvedin. Hyundai Group, for example, uses much vertical integrationbecause of its extensive engagement in construction, automo-biles, heavy equipment, and chemicals. These industries involvecomplex assembly of numerous parts or multi-stage productionprocesses. During the era of Five-Year Economic DevelopmentPlans, the Korean government forced chaebols into these in-dustries without building any infrastructure of parts suppliersor supporting services. Since the chaebols found it difficult topurchase or otherwise secure necessary parts and the Koreangovernment pushed domestic firms to industrialize, there wereclear and seemingly inevitable reasons to integrate vertically.

Table 4.1 shows the types of industries the top thirty chaebolgroups are in, and the average internal sales and purchases ofaffiliates in each industry. Forward integration, measured by theintragroup sales ratio, is often found in industries such as foods,textile, pulp, oil refining, chemicals, plastics, metals, machin-ery, electronics, mining, and automobiles. Backward integra-tion, measured by the intragroup purchasing ratio, is frequentamong the textile, leather, oil refining, plastics, computing,medical equipment, and automobile industries. Vertical inte-gration is conspicuous not only in machinery and constructionindustries like Hyundai but also in the electronics and chemicalindustries.

For example, Samsung Electronics is closely interlinked withSamsung SDI, a manufacturer of television tubes, which inturn relies on Samsung Corning, which produces glass bulbs

118

Motives for Vertical Integration: Pros and Cons

Table 4.1. The extent of vertical integration of chaebolaffiliates by industry participation

No. of Average backward Average forwardIndustry chaebol firms integration integration

Food 22 8.0 28.1Textile 5 20.6 27.5Clothing 1 2.7 1.4Leather 1 20.0 14.8Pulp and paper 8 7.1 45.0Publishing 3 0.7 5.8Petroleum refining 3 23.0 51.7Chemicals 43 18.8 22.2Plastics 8 26.4 32.9Nonferrous metals 10 16.9 37.8Metals 15 11.7 18.1Fabrication metals 4 12.9 16.8Machinery 9 2.2 31.5Computing 1 27.1 17.3Electric machinery 6 12.7 23.2Electronics 30 11.4 40.6Medical equipment 3 37.8 13.5Auto & transportation 26 13.4 53.3

equipmentOther transportation 6 5.9 16.5

equipmentFurniture 1 22.7 1.0Mining 1 8.7 100.0Utilities 7 18.8 7.2Construction 33 2.2 22.4Automobile sales 5 80.4 8.5Wholesale 33 28.6 21.4Retail 14 3.9 3.6Hospitality industry 13 4.4 4.7Warehousing 8 8.0 18.4Transportation 7 9.1 21.0

119


Table 4.1 (cont.)

No. of Average backward Average forwardIndustry chaebol firms integration integration

Air transportation 1 0.0 0.0Travel services 11 2.9 55.0Telecom services 3 3.9 33.3Information processing 17 7.9 51.3Others 27 0.9 44.0

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

for the tubes, as indicated by the fact that 61% of its total rev-enue comes from Samsung SDI. Samsung SDI, in turn, sup-plies 52% of its products to Samsung Electronics. SamsungElectro-Mechanics, a producer of electronic parts, sells 69%of its products to Samsung Electronics. The chemical industryalso has many examples of vertical integration such as thosefound in SK Group, which is devoted to energy and chemicals.SK Chemical, a leading producer of polyester fibers and otherpetrochemical products, secures raw materials from SK Corpo-ration, a petroleum refinery. SKC, a producer of polyester film,in turn purchases raw materials from SK Chemical.

Vertical integration in such industries tends to be efficientbecause it helps companies maintain better quality and punc-tuality than they could achieve through outsourcing. For exam-ple, if problems of defects or delay occur, the purchaser, whomaintains large assembly lines under the economy of scale, willsuffer greatly because it is forced to suspend the remaining as-sembly processes. They will then incur significant costs in find-ing, selling, negotiating, contracting, monitoring, and resolving

120

Motives for Vertical Integration: Pros and Cons

disputes with suppliers in open market transactions (Coase,1937; Williamson, 1975).6 Extensive vertical transactions mayalso allow efficient coordination, such as reduction of inventoryand transportation costs and immediate adoption of efficienttechnology (Harrigan, 1983; D’Aveni and Ravenscraft, 1994).Furthermore, vertical integration means that the fruits of R&Din one stage of production are more likely to be shared withother stages, thereby increasing the overall competitiveness ofboth upstream and downstream operations.

Therefore, chaebols’ core affiliates prefer vertical integration,which lets them control the quality of important parts and de-livery schedules and carry lower inventories. In addition, whenfew companies manufacture a product, a buyer is subject to op-portunistic behavior such as unstable prices. Conversely, suppli-ers are unwilling to make substantial asset-specific investmentsfor customers with unique needs because buyers may also be-have opportunistically. In such circumstances, vertical integra-tion may be the most efficient alternative. In addition, increasedinformation exchange between buyers and sellers can enhancetechnology development (Scherer and Ross, 1990). Finally, ver-tical integration reduces marketing and sales-related expenses.All those virtues suggest that chaebols can reap huge efficiencygains from vertical integration.

Disadvantages of Vertical Integration

Yet vertical integration is not always efficient. Since the corpo-rate restructuring boom of the 1980s, firms in the United Stateshave moved away from vertical integration and toward exten-sive outsourcing. Some of the largest U.S. firms have even spunoff divisions because they believed these units would be morecompetitive if they were not constrained by a corporate parent.

121


For example, AT&T spun off its hardware manufacturing unitand the Bell Laboratory into Lucent Technologies in 1996.7

Similarly, GM reversed a long-standing strategy of vertical in-tegration by divesting automobile parts businesses, most notablywith the spin-off of Delphi in 1999.8

One of the potential hazards of vertical integration is that ver-tically integrated suppliers lack the incentive to be more efficientor innovative because they have captive customers (Mahoney,1992). This lack of incentives can be severe in the case of chae-bols’ affiliates because large portions of their sales go to otheraffiliates. Efficiency can also be jeopardized when firms fac-ing different market constraints are placed under one corporateumbrella. For example, small parts-supplying affiliates maywant to use different payment and benefit structures than dolarge assembly affiliates. If grouped together, however, they arebound by the same payments and benefits, which may not fitany of them very well. To create a homogenous group cultureand to facilitate the intragroup transfer of personnel, chaebolsused the same level of payments and benefits for all affiliates;these levels were often too stringent for successful affiliates andtoo generous for poorly performing affiliates.

Vertical integration is also not sufficiently flexible to adjust todifferent transaction volumes, which is especially important dur-ing periods of economic instability and fluctuations (Harrigan,1985; D’Aveni and Ilinitch, 1992). In highly competitive andturbulent environments, firms are better off selecting the bestexternal suppliers, switching suppliers when new technologyappears, and avoiding idle capacity and inventory swings in itsproduction. For example, Alcoa reduced its vertical integrationfrom mining ores to rolling can sheets to avoid what was knownas the “aluminum cycle.”9 Such risks could have been par-ticularly detrimental to chaebols, which went through serious

122

Implications of Chaebols’ Vertical Integration

economic downturns in the 1990s, as in Figure 1.3. Tied intocobwebs of debt guarantees and cross-shareholding, and con-strained by external parties (i.e., the chairman of their group),chaebol affiliates might have found it extremely difficult tounravel themselves from vertically integrated relationships be-cause doing so would affect the well-being of other verticallyintegrated affiliates. Eventually, financially troubled affiliatesmay survive only with support from their parent company, whichis exactly what happened to chaebols. Chaebols supported un-profitable affiliates via various forms of internal transactionsand could not shut down these affiliates until after the crisis.10

performance implications of chaebols'vertical integration

This section will review the economic effects of chaebols’ ver-tical integration. It will analyze the cost structures of chaebols’affiliates and the impact of vertical integration on each cost fac-tor. This analysis helps us understand the balance of benefits andcosts associated with vertical integration. It is based on an em-pirical study of the cost structure of vertical integration, whichcan be found in Appendix 4.

Cost Structure and Performance Implicationof Vertical Integration

To estimate the magnitude of benefits and costs, we decom-posed the cost factors of chaebols’ manufacturing affiliates intocost of goods sold and various expense items such as generaland administrative, research and development, advertisement,and sales expenses for 1985–96. We use the return on investedcapital (ROIC) measure that we used in Chapter 1 to assess

123


performance. We then examined the impact of forward and back-ward integration on the cost structure. Again, forward integra-tion is measured by the intragroup sales ratio, and backwardintegration, by its intragroup purchasing ratio.

As summarized in Table 4.2, the empirical analysis showsthat the cost of goods sold, which include payrolls, raw mate-rial, factory depreciation, and rental expenses, tends to increaseaccording to the degree of forward or backward integration,suggesting that vertical integration is inefficient for chaebols.Some costs, such as sales, general, and administrative expenses,seem to decrease with vertical integration. Advertising expensesdecrease for forward integration. R&D expenses increase withbackward integration. All these effects of vertical integrationcollectively influence profitability, which increases for forwardintegration but decreases for backward integration. A more fine-grained analysis by time period shows that vertical integrationbegan to hurt chaebol firms’ profitability in the 1990s, when theeconomy contracted.

Overall, the results imply that chaebol affiliates gain fromforward integration and lose from backward integration. Morespecifically, suppliers gain from vertical integration, but only atthe expense of their affiliate assemblers. Both buyers and sellersseem to suffer from operating inefficiency, however, as cost ofgoods sold increases with vertical integration. Chaebols wouldbe more profitable if they divested their parts manufacturers andpurchased goods in competitive markets.

Cross-Subsidization

This analysis poses some intriguing questions. Why did chae-bols maintain vertical integration despite such inefficiency? Inparticular, why were downstream assemblers willing to pay the

124

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higher prices of their upstream affiliates? There are two possibleanswers to these questions.

As we discuss in Chapter 5, one possible answer is the iner-tia toward changes, such as restructuring, which was createdby mutual debt guarantee practices and cross-shareholding.Assemblers, which extended the debt payment guarantees toaffiliated suppliers, could not let them go bankrupt because theassemblers themselves would then become liable for these debts.Also, if suppliers went bankrupt, assemblers would lose theirequity investments in these affiliates. Bringing in third-partysuppliers to increase competition might not be a viable optionbecause it would hurt already weakened affiliates. Thus, assem-blers might have to come and rescue the suppliers by extendingsubsidies in a variety of forms.

Cross-subsidization, which is defined as “when a multi-product firm prices one good below average cost and makes upfor the losses through revenues collected from the sales of othergoods that are priced above the average cost” (Viscusi, Vernon,and Harrington, 1992: 313), is, however, common in diversifiedbusiness organizations. Firms often use artificial transfer pricingschemes to reallocate losses and profits among related businessunits. Such behavior is not consistent with profit maximiza-tion or welfare maximization for individual product lines butis consistent with maximizing the overall goal of a diversifiedcorporation (Posner, 1971). Likewise, it does not make sensefor individual affiliates to support poorly performing affiliates.Doing so does make sense, however, for the group headquar-ters, which wants to maximize the profits of the entire group.Several studies of the Japanese keiretsu found strong evidenceof cross-subsidization.11

Cases of cross-subsidization were not very well documentedin the past. The Fair Trade Commission of Korea, however,

126


started investigating these intragroup transactions in 1998.12

Two such investigations found evidence of subsidies in the topfive chaebols: in 1998, the transaction volumes for these in-stances were 4 trillion won and 1.5 trillion won, respectively,and the subsidies affected summed to 209 billion won and55 billion won, respectively. In 1999, there was evidence of53 affiliates supporting 38 affiliates for 250 billion won on atransaction volume of 12 trillion won. The government foundfurther evidence that chaebols continued to cross-subsidize af-filiates in its fourth investigation in 2000. The governmentlevied penalties on the chaebols for these transactions. They aresummarized in Table 4.3 and are perhaps only a small fractionof the total amount of cross-subsidization.

Chaebols apparently cross-subsidize many different types oftransaction. For instance, Hyundai Merchant Marine assistedHyundai Logistics by allowing it to operate its own logistics fa-cilities and by neglecting for over a year to collect payments of10.8 billion won Hyundai Logistics received from shipping com-panies. When Hyundai Logistics finally reimbursed HyundaiMerchant Marine, it did not pay any overdue interest rates.13

Another example includes Hyundai Securities, which launcheda series of joint advertisements with Hyundai Investment Trustfrom March to April 1999 and paid the expenses by itself with-out requesting reimbursement from its joint advertiser.14 Thegovernment authorities also revealed other examples of intra-group support subsidies in Samsung Group, LG Group, and SKGroup.15

What makes these actions more complicated and troublingis that they exploit chaebols’ ownership and corporate gover-nance structures, which we discuss in Chapter 6. Most largedownstream chaebol affiliates are listed in the stock exchange,and chaebol families hold but a small portion of their stock.

127

Tabl

e4.

3.T

heto

tali

ntra

grou

pbu

sine

sstr

ansa

ctio

ns(i

nbi

llio

nw

on)

that

wer

eid

enti

fied

ascr

oss-

subs

idiz

atio

nby

the

Kor

eaFa

irTr

ade

Com

mis

sion

Firs

tinv

estig

atio

nSe

cond

inve

stig

atio

nT

hird

inve

stig

atio

nFo

urth

inve

stig

atio

n(J

uly

1998

)(N

ovem

ber

1998

)(O

ctob

er19

99)

(Dec

embe

r20

00)

Vol

ume

ofE

stim

ated

Vol

ume

ofE

stim

ated

Vol

ume

ofE

stim

ated

Vol

ume

ofE

stim

ated

unfa

irbu

sine

ssam

ount

ofun

fair

busi

ness

amou

ntof

unfa

irbu

sine

ssam

ount

ofun

fair

busi

ness

amou

ntof

tran

sact

ions

subs

idie

str

ansa

ctio

nssu

bsid

ies

tran

sact

ions

subs

idie

str

ansa

ctio

nssu

bsid

ies

Hyu

ndai

770

3334

829

4,09

394

565

44Sa

msu

ng72

022

200

739

957

331

35D

aew

oo42

233

418

5430

86—

—L

G1,

057

3768

71,

098

1250

418

SK1,

055

7883

44

1,31

12

1,06

328

Tota

l4,

026

209

1,49

255

12,3

3225

02,

463

126

Not

e:D

aew

ooG

roup

,whi

chw

entb

ankr

upti

n19

99,w

asex

clud

edin

the

four

thin

vest

igat

ion.

Sour

ce:

Kor

eaFa

irT

rade

Com

mis

sion

.


However, because they have major shareholdings in the affili-ates that supply these downstream manufacturers, it is possiblethat chaebols intentionally reduce the profitability of the listedcompanies by cross-subsidizing these suppliers. According tothe investigation of intragroup business transaction by the KoreaFair Trade Commission, as summarized in Table 4.3, HyundaiMotor, Hyundai Heavy Industries, Hyundai Merchant Marine,and Hyundai Securities, all publicly traded companies, subsi-dized Hyundai Livart, Daehan Aluminum, Kumkang Develop-ment, and Hyundai Investment and Trust, which were privatelyowned and incurring heavy losses, via various forms of internaltransactions such as providing interest-free loans or not collect-ing their accounts receivables. The SK Telecom case, which wewill discuss in more detail in Chapter 6, provides further supportfor this conjecture.

Vertical integration in Korean chaebols has been inefficientin recent years. Large assemblers have suffered from cross-subsidization. Further, they are stuck in inflexible supply re-lationships that reduce their ability to innovate in the long run.The analysis in this chapter shows that the ownership and cor-porate governance system created great inertia that prohibitedfaster restructuring of vertical integration. Chaebols should thusinitiate business reforms that will reduce their scope of verticalintegration. The reform in the corporate governance system willprecipitate this restructuring process. In addition, the govern-ment should work harder to eradicate cross-subsidization withinchaebols.

129

5

The Capital Structureof Chaebols

131

Financial Market Environments in Korea

In this chapter, we will examine the financial market environ-ment in which chaebols operate and then analyze chaebols’capital structure. Specifically, we will focus on the correlationbetween Korean financial markets and chaebols’ heavy use ofdebt. We will also consider the practices that chaebols use intheir internal capital market, including loans, debt guarantees,and cross-shareholding. This analysis will lead to a deeper un-derstanding of how chaebols were vulnerable to the foreign ex-change crisis in 1997.

financial market environments in korea

The Korean Government’s Intervention

Korean economic development was spurred on by active govern-mental intervention and Economic Development Plans, whichaggressively channeled necessary capital into “strategic” in-dustries, including export-oriented industries and heavy andchemical industries.1 After the 1961 coup d’etat, PresidentChung-Hee Park nationalized all private banks, which after-ward ceased to function as credit examiners and instead func-tioned as a tool of Korean government’s industrial and resourceallocation policies.2 He also placed the nation’s central bank,the Bank of Korea, under the supervision of the Ministry ofFinance, which made major monetary decisions such as settinginterest rates and discount rates and conducting open marketoperations.

During this period, the Korean government also absorbedand mediated the risks faced by embryonic firms in the indus-tries it supported. In many cases, it pledged payment guaran-tees to secure foreign loans for industrialization. When compa-nies that enjoyed preferential credit from the government went

133

The Capital Structure of Chaebols

bankrupt or faced financial difficulties, the government inter-fered by freezing the debts, arranging a relief fund at lowerinterest rates from banks, converting debt to equity, or forcinghealthy companies to acquire these troubled firms.3 In the gov-ernment’s eyes, private companies’ financial crises could leadto a national crisis, and thus merited governmental intervention.This assumption was particularly relevant for chaebols and cre-ated the belief that chaebols were “too big to fail.”

As a result, chaebols were able to shift all risks accompany-ing their business enterprise to the government and ultimatelythe public, while hoarding all the benefits if they succeeded. Be-cause the government would support them if they failed, chae-bols had a huge incentive to disregard risk and to diversify intobusiness areas favored by the government. Thus, “moral hazard”became prevalent in Korea.4 In fact, Krugman (1998) argued thatexistence of moral hazard was common to all Asian countriesaffected by the crisis.

Banks, on the other hand, lacked the power, commitment,and capacity for strict credit analysis because they were butan extension of the government. Even after the privatizationof commercial banks in 1981, the Ministry of Finance inter-vened extensively in their lending practices and in setting in-terest rates.5 Because of this continued intervention, bank man-agers had very little latitude in their asset management, andtherefore had little accountability for their banks’ performance(Fields, 1995; Park, 1994). As partial compensation for thisextensive governmental intervention, the regulations on bank’slending practices were lax. For instance, all commercial banksmaintained trust accounts, for which there were no specific ex-posure limits or provisioning rules on loans, and no reserverequirements, and yet they were just like deposits becausethe banks guaranteed both the principal and the yield. These

134


accounts exacerbated the crisis (Balino and Ubide, 1999). Thegovernment-owned specialized and development banks werenot even subject to the minimal standards and supervision thatcommercial banks were.6 Because banks lacked the ability tofunction properly, they began to require high levels of collat-eral as well as debt guarantees to protect their assets. Chaebolsresponded by extending debt guarantees between affiliated com-panies. Ultimately, chaebols with more affiliates that could ex-tend collateral and debt guarantees received better financialtreatment and opportunities for further expansion than did other,smaller companies. These circumstances led to skyrocketingdebt–equity ratios among chaebol affiliates that would havebeen impossible without governmental support; the govern-ment’s policies not only allowed such behavior but also en-couraged it.

Chaebols’ Financial Service Arms

Chaebols’ appetite for capital did not end with the loans theysecured from banks. They wanted to own banks so that theycould tap banks’ reserves as if these reserves were their own. Infact, chaebols used to own banks. Upon the advice of Americanexperts, the Korean government privatized banks in 1957 to propup the financial service sector (Woo, 1991). Chaebols snatchedup these banks, however, thereby nullifying the original intent ofprivatization. Banks were then nationalized immediately afterPresident Park seized power in 1961.

When banks were gradually privatized once again in the1980s, chaebols immediately began aggressively purchasingstock in them.7 Before the Bank Act was revised in 1998, no oneentity could own more than 4% of a national bank or 15% of aregional bank, except for foreign investors operating through a

135


Table 5.1. Shares of top thirty chaebols in loans from bankand nonbank financial institutions in Korea as of 1997

Total loans to top30 chaebols Top 30 chaebols’(in billion won) share (%)

Commercial banks 73,827 20.3Nonbank financial 55,949 32.9

institutionsAll financial institutions 133,776 24.5

Source: Financial Supervisory Board.

joint venture.8 As of 1997, Samsung Group owned more than 3%shares of Choheung Bank, 3.5% of Shinhan Bank, and 18.5% ofKoram Bank in a three-party joint venture with Bank of Amer-ica and Daewoo Group, and 3.6% of Hana Bank (see Table 2.2).For two other national commercial banks, Commercial Bankof Korea and Hanil Bank, Samsung owned more than the law-ful limit (6.9 and 4.9%, respectively). It also had large stakesin several regional banks such as Taegu Bank. Hyundai Groupowned more than 2% of Kookmin and Hanil Banks, as wellas 11.9% of Kangwon Bank, a regional bank. Daewoo Grouphad a 18.5% interest in Koram Bank. Chaebols used this equityboth to enhance their bargaining power during credit negotia-tions with banks and to prepare for acquiring banks if and whenfurther deregulation of bank ownership occurred. In all, loans totop thirty chaebols by commercial banks amounted to 73 trillionwon in 1997, representing 20.3% of these banks’ total loans (seeTable 5.1).

Chaebols also invested heavily in many nonbank financial in-stitutions, including insurance companies, securities companies,

136


investment trusts, merchant banks, credit cards, and installmentfinancing.9 Because nonbank financial institutions were notdirectly involved in the payment settlement system, the Koreangovernment did not heavily regulate ownership of them. Manychaebols also invested in nonbank financial institutions afterthe regulation of such businesses became more lax in theearly 1990s. For instance, the top five chaebols all own lifeinsurance companies. Most large chaebols, including the topfive, own securities companies, investment trust companies,and merchant banks. For example, Daewoo newly establishedDaewoo Installment Financing (1994), Daewoo VentureCapital (1996), and Daewoo Futures (1997), while it had ownedDaewoo Securities since 1983. Hyundai, Samsung, SK, and LGalso added many new nonbank financial companies. Table 2.3depicts the top thirty chaebols’ ownership of these nonbankfinancial companies.

Chaebols aggressively marched into the financial sector,partly because they believed it had high growth potential, whichthey could exploit for further expansion. More importantly, how-ever, they wanted to use financial companies as the channel ofcapital procurement and portfolio management for all their af-filiates. They were successful in doing so; Table 5.1 shows thattheir share of loans held by all nonbank financial institutionswas 32.9%, which was much higher than their share of loansheld by commercial banks was.

For example, Samsung Life Insurance lent a total of502.8 billion won to Samsung affiliates, which amounted toabout 3.2% of its total lending. Hyundai Fire and MarineInsurance extended 6.7% of its total loans to Hyundai affiliates.These relatively low percentages resulted from the governmentlimiting such firms’ lending to no more than 3% of their totalassets to affiliates. These firms did, however, provide much more

137


favorable terms for loans to affiliates than they did for loans tononaffiliates. According to the report by Ministry of Financeand Economy, affiliated companies enjoyed preferential lend-ing rates. For example, the average interest rates charged byKyobo Life to other Daewoo affiliates were 10.7% while itsaverage interest rates were as high as 11.8%.10

Security companies, which were subject to far less regula-tion than were banks or insurance companies, supported theiraffiliates more actively. In Table 5.2, for instance, SamsungSecurities assumed rights to 1.07 trillion won of corporate bondsissued by Samsung affiliates from January to July 1997, whichis 69.3% of all corporate bonds acquired by Samsung Securitiesduring the same period. Daewoo Securities undertook 1.4 trillionwon of corporate bonds issued by Daewoo affiliates, accountingfor 51.1% of its corporate bond acquisitions. Such acquisitionsallowed affiliates to sell various bonds through affiliated secu-rities companies, securing funds directly from affiliated com-panies or external sources. It is difficult to gauge the lendingstructure of merchant banks because they were not subject toany restriction of intragroup lending. The Korean governmentallowed chaebols to own merchant banks in an effort to absorbcurb markets. Their role, however, as the capital supplier for af-filiated companies must be more extensive because one of theirmost prominent roles is to acquire and apply discounts on corpo-rate promissory notes or commercial paper issued by affiliates.

Chaebols’ financial companies play two additional impor-tant roles. First, they function as holding companies withintheir groups. For instance, Samsung Life Insurance owned762.1 billion won worth of Samsung companies’ shares, about9.4% of its stock portfolio. Similarly, Samsung Fire Insurancehad 7.2% of its total stock interest in Samsung companies.Other insurance and securities companies as shown in Table 5.2

138

Tabl

e5.

2.C

ontr

ibut

ions

asof

July

1997

(in

billio

nw

on)of

top

five

chae

bols

’no

nban

kfin

anci

alin

stitut

ions

Sam

sung

Hyu

ndai

Dae

woo

LG

SK

Sam

sung

Sam

sung

Hyu

ndai

Kyo

boL

ife

Fire

Sam

sung

Fire

and

Hyu

ndai

Lif

eD

aew

ooL

GFi

reL

GSK

Insu

ranc

eIn

sura

nce

Secu

ritie

sM

arin

eSe

curi

ties

Insu

ranc

eSe

curi

ties

Insu

ranc

eSe

curi

ties

Secu

ritie

s

Loa

nto

othe

r50

2.8

035

549.

60

grou

paf

filia

tes

(3.2

%)

(0%

)(6

.7%

)(5

.0%

)(0

%)

(%of

tota

lloa

ns)

Acq

uisi

tions

1,07

62,

350

1,43

6.4

1,38

944

6of

bond

s(6

9.3%

)(7

6.6%

)(5

1.1.

%)

(62.

6%)

(60.

4%)

issu

edby

othe

raf

filia

tes

(%of

tota

lbon

dac

quis

ition

)St

ock

762.

179

.811

.619

.530

.910

3.4

34.1

81.5

18.8

hold

ings

of(9

.4%

)(7

.2%

)(2

.9%

)(6

.3%

)ot

her

grou

paf

filia

tes

(%of

tota

lsto

ckho

ldin

gs)

Not

e:SK

Gro

upac

quir

edSK

Lif

eIn

sura

nce

inD

ecem

ber

1997

. Thu

s,it

isno

tsho

wn

inth

ista

ble.

Sour

ce:

Min

istr

yof

Fina

nce

and

Eco

nom

y.


perform a similar function. Second, these financial institutionsserve as portfolio managers for the chairmen and their fami-lies. Life insurance and securities companies can manipulateand control their own stock prices through this practice. For ex-ample, the chief executive officer of Hyundai Securities wasconvicted for his company’s price manipulation of HyundaiSemiconductor’s shares in 1999.11

By allowing chaebols to own financial companies, thegovernment seriously distorted the flow of financial capital.12

Nonbank financial institutions gradually were turned intoprivate vaults for the chaebol and did not direct capital flowsto healthier businesses. Chaebol companies began investingmoney procured from their own financial institutions intoinefficient businesses. There was no mechanism, such as creditanalysis, in place to control these firms’ capital flows efficiently.In short, efficiency in capital allocation evaporated. Thus, whenthe financial crisis hit Korea, international liquidity problemsquickly hit financial institutions and chaebols, resulting inchains of insolvencies. These events show that both inadequatefinancial supervision by the government and the resultingabsence of a corporate governance system were the mostfundamental causes for the financial crisis.

There were some precedents to similar crises caused byinadequate financial supervision, most notably in Chile andArgentina in 1981 under their economic liberalizationprograms.13 In Chile, Pinochet, who took power through a coupd’etat, aggressively liberalized the economy. This liberaliza-tion plan balanced the budget, reduced inflation, and stabilizedforeign exchange. It also raised the real interest rate to attractforeign investors and lowered tariffs to encourage imports. Inaddition, it privatized many companies nationalized by theAllende government. Despite its liberalization policies, Chile

140

Capital Structure of Chaebols

experienced a foreign exchange crisis in 1981. The root causefor the crisis was that banks did not control their lending prac-tices. Instead, banks owned by large business groups recklesslyborrowed from foreign creditors and lent funds to their affiliates.When Mexico announced it was suspending its debt payments,foreign creditors withdrew their lending to all Latin Americancountries.14 Similarly, Argentina, which pursued economic lib-eralization from 1976 to 1981, had a foreign exchange crisis in1981 for the same reasons that Chile did.

capital structure of chaebols

High Debt–Equity Ratios

The average debt–equity ratio of the top thirty chaebols is600%. Some chaebols have ratios approaching 4,000% (seeTable 1.1).15 These ratios are much higher than are those of firmsin countries with well-developed equity capital markets such asthe United States, United Kingdom, and Canada.16 Japanesecompanies, which rely mainly on bank financing, have ratiosalmost as high as their Korean counterparts. German, Austrian,and Spanish firms, which use both equity and debt financing,maintain average ratios between those of U.S. and Korean firms.

Higher debt–equity ratios do not, however, necessarily meanthat the firms with them are inefficient. Capital structures ofcompanies are based on external factors, such as the macroeco-nomic or financial regulatory environments that companies mustface. Numerous studies of the optimal corporate capital struc-ture have hitherto failed to present any definitive conclusions.17

Rather, La Porta et al. (1998) showed that corporate capital struc-ture is contingent on the legal environment in which the companyoperates. For example, the United States and United Kingdom

141


stress the rights of minority shareholders, extend comprehen-sive support to hostile corporate takeovers, and prefer dissem-ination of corporate information and exercise of shareholders’rights. These legal environments lower the costs of raising cap-ital from equity markets and lead firms to prefer equity financ-ing to debt financing. On the other hand, Germany and othercountries that followed the German trajectory, such as Austria,Japan, and Korea, have weaker structures for minority share-holders’ rights protection, management monitoring, informationdissemination, and accounting audits, resulting in a higher costfor equity financing because investors demand higher premiumsto compensate for potential risks associated with incompleteinformation.18 In such countries, companies opted for indirectfinancing through banks to avoid the higher costs of equity fi-nancing. Chaebols’ high debt–equity ratios are also a result ofrecent Korean history. Under the Economic Development Plansduring 1961–80, the government extended various special fundsat low interest rates, inducing firms to increase their use of debt,and ultimately resulting in higher debt–equity ratios.19 Also,Korean companies that experienced rapid growth often had lim-ited internal funds to meet their expansion needs. Unlike com-panies in mature economies with ample capital available, theyhad to rely on external sources of capital, which flowed intoKorea as debt.20 Similarly, late economic developers such asGermany or Japan had to rely on the state or banks for capitalbecause it was hard to secure capital from individuals.21 Thus, inKorea, it became inevitable that the government and the bankscontrolled by it would play a crucial role in allocating capital tobusinesses.

Korea also used foreign capital to finance its long-term in-vestment and to cover for the balance of payment deficit sincethe first economic planning period. Korea was the third largest

142


debtor, following only Mexico and Brazil in the mid 1970s, andcreditors were concerned it would default (Woo, 1991). The ra-tio of foreign debt to GNP rose from 4% in 1963 to 32% in 1979(Amsden, 1989). The IMF stepped in several times to slow downthis increase. Thus, we need to consider not just how chaebolshave become so indebted but also whether this debt is shortterm or long term, where it comes from, and how efficientlychaebols use it. Figure 5.1 shows changes in the debt–equityratios of individual affiliates of the top thirty chaebols and thecomposition of their debts from 1985 to 2000. This ratio reachednearly 500% in the early 1980s, decreased somewhat during theeconomic boom in the late 1980s, and then increased duringthe 1990s. Figure 5.1 further classifies debts as short term, de-fined as having less than a year until maturity, or long term aswell as by source – domestic versus foreign. Figure 5.1 alsoshows that from 1995 to 1997, affiliates’ use of every kind ofdebt instrument, especially short-term debt from domestic andforeign sources, rose dramatically. Because Korean financialinstitutions underwrote a large portion of short-term domesticdebt, which they in turn borrowed from foreign financial insti-tutions, chaebols depended even more on foreign currency thanthese data suggest. This dependence made them and Koreanfinancial institutions vulnerable to contractions in supplies offoreign capital.

Why did chaebols take on so much debt prior to the crisis?Table 5.3 analyzes cash flow statements to review the details ofcapital procurement and expenditure of the top thirty chaebols.From 1995 to 2000, internal funds from retained earnings, de-preciation, and other sources at these chaebols decreased from36.8% in 1995 to 22.4% in 1996 to 12.3% in 1997, and in-creased slightly to 12.6% in 1998. The Korean economy begancontracting in 1995, thus reducing corporate profits and making

143


note

domestic short-termdebt

foreign short-term debt

long-term domestic debt

bond foreign long-term debt

0.00

100.00

200.00

300.00

400.00

500.00

600.00

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

Year

%

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

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

144


Table 5.3. Analysis of chaebols’ cash flow statements

(a) Capital procurement

External

Internal Equity Long-term Short-term Subtotal Totalfund (%) issue (%) loans (%) loans (%) (%) (%)

1995 36.8 1.4 12.2 49.6 63.2 1001996 22.4 1.3 12.7 63.6 77.6 1001997 12.3 1.1 11.0 75.6 87.7 1001998 12.6 2.2 22.6 62.6 87.4 1001999 17.4 9.5 10.1 63.0 82.6 1002000 25.0 2.8 13.6 58.6 75.0 100

(b) Capital expenditure

Investment Investment Short-term Short-termin production in securities financial operating Others Totalfacilities (%) (%) investment (%) capital (%) (%) (%)

1995 8.1 1.4 1.4 83.7 5.4 1001996 9.2 1.3 1.6 87.7 0.2 1001997 7.1 1.6 1.5 84.8 5.0 1001998 4.9 4.5 1.6 76.5 12.5 1001999 4.5 5.8 0.5 78.4 10.7 1002000 8.8 4.3 0.9 76.3 9.7 100

Source: Choi (2001).

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

145


was only half of what it was prior to the crisis. This is consistentwith the fact that the capital intensity ratio skyrocketed dur-ing the same time period, as can be seen in Figure 1.6. Thismeans that chaebols continued to invest in long-term productionfacilities while relying heavily on short-term loans. The resultof this mismatch was a series of bankruptcies, which startedas soon as domestic and foreign financial institutions that hadmade short-term loans to Korean companies began demandingimmediate repayment.

Table 5.3 also shows that chaebols’ investment in produc-tion facilities rose back to the precrisis level in 2000 whenchaebols recovered from the crisis. Chaebols’ investment insecurities has increased since 1998, reflecting the increasedcross-shareholding during the postcrisis restructuring process.Chaebols responded to the government’s pressures to reducedebt–equity ratios by buying new equity issues by otheraffiliates.22

Determinants of Capital Structure of Chaebols

Why didn’t the chaebols raise equity when they made these hugecapital investments? How did chaebol firms continue makingsuch a huge investment amidst a capital shortage? Figure 5.2,which is based on a survey Kook, Park, and Lee (1997) sent tothe CFOs (chief financial officers) of the top fifty chaebols,may provide answers to these questions. When asked aboutthe most important consideration in finance-related decisions,72% answered the maximization of group’s growth and 26%, themaximization of short-term profit. Only 2% responded the max-imization of stock prices of individual affiliates. When asked ifthey considered group-level or individual company profitability,52% pointed to group-level profit as their prime consideration.

146


1.What is the most important consideration in corporate finance decisions?

2%

72%

26%maximize stock price of individual affiliatemaximize growth ofgroupmaximize profits

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

52%48%Entire group

Individual firm

3. When you consider the cost of capital, do you do so for an individual firm or for theentire group?

40%

60%

Entire group

Individual firm

4. Among various means of raising capital, other things being equal, which of thefollowing do you prioritize?

52%48%

maintaining the equitystake of largeshareholder

capital cost

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

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

147


equity (i.e., avoiding dilution of chaebol chairmen’s equitystakes), and 48% pointed to the cost of raising capital. The re-sults show that, on average, chaebols put far more emphasis onthe group-level profit and cost of capital and avoided dilutingkey shareholders’ interests. Accordingly, even if the financialcost of equity capital is low, chaebols prefer debt to equity.Given this attitude, it is not surprising that chaebols dependedmore on external loans when their internal sources of capitaldried up. This discussion leads us to conclude that the chaebols’capital structure was biased toward debts as chaebol familiesattempted to maintain their controlling ownership stakes. It alsopoints to the problems in the corporate governance systems ofchaebols.

Thus, the chaebols’ capital structure depended largely ontheir ability to secure debt. The more debt chaebols could se-cure, the better off they were since they could invest in far moreprojects than could other chaebols. Appendix 5 empirically ex-amines the determinants of the capital structures of chaebolaffiliates with data for 1985 to 1996. The results of this analysisindicate that debt-carrying capacity depends on the followingfactors: first, larger companies have higher debt–equity ratios.Because Korean financial institutions based their lending deci-sions mostly on the existence of collateral, companies that hadgreater access to it maintained higher debts. Second, companiesthat exploited more debt payment guarantees were liable formore debt. Third, affiliates in chaebols that owned financial in-stitutions were more likely to borrow. The results also show thatthe type of financial company owned by a chaebol affects thetype and source of debt that affiliates use: affiliations with mer-chant banks lead to more short-term debt, while affiliations withsecurities companies lead to more long-term debt and domes-tic debt. These results provide strong evidence that chaebols’

148

Internal Capital Markets and Cross-subsidization

financial affiliates have served as the private chests of chaebols.The results of this research are summarized in Appendix 5.

chaebols' internal capital market andcross-subsidization

In this section, we look more closely at how chaebols’ internalcapital markets operate. Chaebols adopted the business unit sys-tem to take full advantage of the internal capital market withina group.23 By controlling cash flow at the group level, chaebolscan enhance financial efficiency. This capital market is com-posed of loans, debt guarantees, and cross-shareholding betweenaffiliates. Figure 5.3 shows the size of major components of in-ternal capital markets for the top thirty chaebols from 1993 to2000.

Interaffiliate Loans

As discussed earlier, chaebols’ affiliates function as operatingdivisions in a diversified portfolio of businesses. The basic prin-ciple of portfolio management in a diversified corporation isgathering excess cash from the operational units and reallocat-ing it to promising businesses or units that need financial sup-port. Figure 5.3 suggests that interaffiliate short-term borrowingis not substantial. For example, in 1997, the size of interaffiliateloans amounted to only 1.5% of total equity capital. This figure ismisleading, though, because it shows only the short-term creditbalance among affiliates at the end of the fiscal year; the actualamount of short-term lending between affiliates during the yeardoes not appear in the financial statements.

Furthermore, chaebols do not always use direct loans to af-filiates simply because such loans are too transparent. Affiliates

149


1. Intragroup loans over equity

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

93 94 95 96 97 98 99 2000

%

2. Debt guarantee to equity

0.050. 0

100. 0150. 0200. 0250. 0300. 0350. 0400. 0450. 0500. 0

93 94 95 96 97 98 99 2000

%

3. Cross-shareholding

0.05.0

10. 015. 020. 025. 030. 035. 040. 045. 050. 0

93 94 95 96 97 98 99 2000

%

Figure 5.3. Internal capital markets of chaebols.

150


often adopt various creative methods of financially supportingeach other, as demonstrated by the cross-subsidization discussedin Chapter 4.24 The volume of intragroup financial transactionsthat is classified as “supportive” by the FTC reached nearly20 trillion won (see Table 4.3). The FTC estimates that the actualvolume of subsidies emanating from these transactions may beas much as 640 billion won.

In many cases, chaebols’ financial arms were heavily in-volved in such transactions, usually by purchasing promissorynotes issued by another affiliate at a higher price. For example,Daewoo Capital and Diners Card acquired 3.8 trillion won worthof promissory notes from Daewoo Corporation, a flagship com-pany in the Daewoo Group, at discount rates that were 2.5 to8.9% lower than the normal rates (see Figure 5.4). In doingso, Daewoo Capital and Diners Card effectively transferredtheir financial resources to Daewoo Corporation in the form ofdiscounted interest. Seoul Investment and Trust also acquired200 billion won worth of promissory notes from Daewoo Corpo-ration at rates from 3.9 to 7.5% lower than normal rates. DaewooSecurities even exceeded its credit limit to lend 194.3 billionwon to Daewoo Corporation, which in turn has extended sup-port to its affiliates. For example, it supported Daewoo Securi-ties by acquiring 200 billion worth of nonguaranteed subordi-nated bonds from it in 1997. It also intentionally failed to collectconstruction expenses or sales income from Daewoo Precisionand Daewoo Telecom, which constituted an interest subsidy tothem until they paid it. Similarly, Daewoo Heavy Industries ne-glected to collect money from its sales of real estate to DaewooCorporation. Other large chaebols typically engage in similartransactions.

In general, these intragroup financial transactions haveseveral characteristics. First, major affiliates support weaker

151

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affiliates. Affiliated financial institutions then acquire promis-sory notes from weak affiliates or extend credit over the legallimit to provide them with short-term capital. These weak affil-iates are in very precarious shape; more than 75% of them wereclose to bankruptcy for at least one of the last three years. Thus,this assistance protected nonviable companies from having tofile bankruptcy, while reducing the overall amount of investmentfunds for major affiliates.

Second, this intragroup support mechanism strengthens thefamilies’ position within the chaebol group. For example, ason of the main family in the Samsung Group was able tobuy its warrant bonds at a discounted price, thereby effectivelyevading inheritance taxes and enjoying further profit from thetransaction.25 We will discuss this type of internal trade in moredetail in Chapter 6.

Third, these transactions assume many forms and may be di-rect or indirect. For example, Samsung Life Insurance extendedsubordinated loans to four commercial banks, which in turn tookover private placement bonds of another Samsung affiliates.26

Hyundai Heavy Industries created offshore funds, which in turnacquired overseas bonds issued by other sister companies athigh prices to support these companies.27 In short, chaebol fundstravel wildly among sister companies through many means.

Debt Payment Guarantees

As mentioned before, debt payment guarantees are promi-nent in chaebols. Although these guarantees nominally ensurethat a firm’s affiliates will pay debts that the firm cannot, thewidespread use of these agreements may result in situations inwhich nobody can really guarantee repayment. If one company

153


involved in this practice becomes insolvent, its bankruptcy mayhave a domino effect on its affiliates. Consider a situation inwhich company A guarantees payment of company B, companyB guarantees company C, and company C in turn guarantees A.So long as all these companies operate well, there is no problem.If company A files bankruptcy, however, company C may notbe able to pay A’s debts, and B may not be able to pay C’s debts.

Figure 5.5 shows the structure of the mutual guarantees in theDaewoo Group. Very often, the guarantor was either DaewooCorporation, one of the major affiliates of Daewoo, or oneof several other core companies, such as Daewoo Electronics,Daewoo Motors, or Daewoo Heavy Industries. The parent com-pany, Daewoo Corporation, often extended payment guaranteesto all other affiliates, but sometimes sister companies acted asguarantors of each other as well. Daewoo Corporation guar-anteed payment of 1.4 trillion won by Daewoo Heavy Indus-tries, and Daewoo Heavy Industries also guaranteed payment of5.2 trillion won by Daewoo Corporation. Daewoo Corporationalso guaranteed payment of 58.6 billion won by DaewooElectronics, and vice versa. Thanks to the payment guaranteepractice, affiliates were able to undertake new enterprises that re-quired more financial resources than they could afford to spend.In fact, when Daewoo Group collapsed in 1999, all its affiliateswent bankrupt simultaneously due to these debt guarantees.

The Korea Fair Trade Commission knew of the problemspresented by debt guarantees, and first revised the Fair TradeAct in 1993 to limit payment guarantees among affiliates inlarge business groups to 200% of an affiliates’ equity. It furthercurbed this practice in 1996, when it lowered the limit to 100% ofan affiliate’s equity. As Figure 5.3 shows, chaebols have reducedthis practice since 1993. The ratio once reached as high as 500%

154

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of equity in 1985, and it hovered above 200% during the mid1990s. In light of the failures of affiliates to make good onthese guarantees, the Korean government revised the Fair TradeAct once again in 1998 and abolished the practice by 2000.It is encouraging that the government is trying to abolish thepayment guarantee regime. Successfully eradicating the practicewill, however, require financial institutions, especially banks, tochange their lending practices. Banks should make loans whenfirms have promising investment opportunities or when firmscan provide collateral. Otherwise, the payment guarantee systemwill persist, thereby defeating the government’s intent.

Cross-shareholding

Figure 5.3 also shows a trend of cross-equity investment amongaffiliates, from about 33% in the mid 1990s to 43% by 1999. Asdemonstrated by the Samsung example discussed in Chapter 3,affiliates initially used cross-shareholding to secure necessaryinitial funds when they began a new enterprise. Under the groupstructure, decisions about how to use capital surpluses for large-scale investment were made at the group level. Another functionof cross-shareholding is, however, to maintain control over affil-iates. Because expansion into new businesses via new affiliatesmeant that chaebol chairmen had to be able to influence thenew affiliates, they ensured that existing businesses held sub-stantial shares in these new ventures. Yet if A invests in B, Bin C, and C in A, virtually no money had in fact been invested.By using such schemes, chaebol owners were able to controla whole group of companies and exert unlimited power overthem as if they actually owned the group. We will examine suchcross-equity ownership more closely in Chapter 6.

156

Collapse of Chaebols and Financial Institutions

collapse of chaebols and financialinstitutions during the crisis

The Bankruptcies of Chaebols

The collapse of Hanbo and Kia Groups, two of the top thirtychaebols, in early 1997 shocked many. The chain reaction ofaffiliates’ insolvencies and bankruptcies became even moreconspicuous during the financial crisis. Ten other top thirtychaebols – Hanhwa Group, Halla Group, Dongah Group, JinroGroup, Kohap Group, Haitai Group, Newcore Group, HanilGroup, Keopyung Group, and Shinho Group – either voluntarilyfiled for bankruptcy, were forced into bankruptcy proceedings,or narrowly escaped bankruptcy through government-sponsored“cooperative” emergency loans advanced by banks. These co-operative loans meant that the debtors were technically bankruptand were subject to debt restructuring led by banks. Daewoo,the fourth largest chaebol, collapsed in July 1999. Many smallerbusiness groups – such as Kapeul, Kukdong, Nasan, TaeguDepartment Store, Sungwon Construction, Cheonggu, Tongil,and Hwaseung – also faced a similar fate.

Table 1.1 shows the difference in debt–equity ratios be-tween bankrupt and surviving companies in the top thirty chae-bols. Troubled companies share two traits: they were heavilyleveraged, and they tried to manipulate their capital resourcesto heavily invest in facilities.28 For example, Halla Group wasexposed to great risk by engaging in overseas constructionprojects, which put heavy stress on its flagship companies, suchas Halla Heavy Industries, and which, in turn, weakened thegroup as a whole. Jinro and Newcore went bankrupt because oftheir reckless forays into the retail industry. Haitai also facedsevere problems in its effort to participate in heavy equipmentand consumer electronics industries. Daewoo set up automobile

157


plants all over the world. In all these cases, widespread use ofdebt guarantees accelerated bankruptcy.

Stress upon Financial Institutions

The failure of chaebols has also weakened Korean financial in-stitutions, which cannot be insulated from the effect of mas-sive bankruptcies. As of June 1998, 40 trillion won out of471.6 trillion won loaned by banks and 23.5 trillion won of153.2 trillion won loaned by nonbanks was classified as in-solvent. In total, 63.5 trillion won, which is 10.2% of the to-tal credit extended in Korea, was insolvent. This calculationunderestimates the situation, however, because a much morelenient standard is used in Korea for classifying bad loans.When we use the international standard to classify bad loans,total defaults amounted to 85.7 trillion won at banks and32.2 trillion won at nonbank financial institutions, or about18.9% of total loans. Loans earmarked “substandard, doubt-ful, and loss” reached 67 trillion won at banks and 12.8 trillionwon at nonbanks. In sum, the accumulated bad credits amountto 197.7 trillion won, or about 31.6% of the total credit extendedin Korea (see Table 5.4). During and after the financial crisis,most Korean banks in Korea had to face the risk of bankruptcy.The situation was even worse for many small nonbank financialinstitutions.29

To sum up, chaebols’ huge debts and the financial crisiswere created by dysfunctional corporate governance systemsand the distortions in financial markets. Chaebol families’ de-sire to maintain controlling equity stakes made them prefer debtto equity financing, and the government’s meddling in the finan-cial service sector allowed these families to build up huge debts

158

Tabl

e5.

4.N

onpe

rfor

min

glo

ansof

Kor

ean

finan

cial

inst

itut

ions

Con

vent

iona

l sta

ndar

dIn

tern

atio

nal s

tand

ard

Loa

nscl

assi

fied

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nscl

assi

fied

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las

subs

tand

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subs

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lam

ount

ofB

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loss

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ks47

1.6

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921

.485

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.015

2.7

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bank

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tions

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%31

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sth

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arre

ars

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thre

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1998

.Bad

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ere

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orea

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e.


to finance their reckless expansion even during the economicdownturn in 1990s, as we discussed in Chapter 3. Thus, therestructuring of chaebols should address these fundamentalweaknesses. In addition, the government should guard againstabuses of the internal capital market by continuously monitoringchaebols’ internal business transactions.

160

6

Chaebols’ Ownership andGovernance Structure

161

Characteristics of the Ownership Structure of Chaebol

Following upon the previous chapter, this chapter looks at theuses of equity in chaebols. It focuses particularly on how fami-lies wholly control chaebols despite owning only a small portionof their affiliates’ shares. In this context, this chapter will exam-ine the ownership and governance structure of affiliates, whichmake such control possible. It also addresses the agency prob-lems of chaebols, which stem from the lack of proper corporategovernance systems in Korea.

characteristics of the ownershipstructure of chaebol

Trends of Family Ownership andCross-shareholding

Figure 6.1 details the ownership structure of chaebols since1983. It divides equity stakes into two components: those ownedby chairmen and their families and those held by affiliates.Equity holdings by chairmen and their families have declinedsteadily since 1983 because these individuals cannot maintainlarge stakes in all affiliates as the number and volume of theseaffiliates grow. In contrast, the equity stakes held by other af-filiates remains stable; ownership in chaebols has increasinglyrelied on cross-shareholding among affiliates. The aggregatedsum of cross-shareholdings of chaebols decreased from 40% in1987 to 32% in 1989 because the Fair Trade Act restricted thecross-shareholding of each individual affiliate to 40% of its netassets.1 Chaebols incurred penalties when they exceeded thislimit. The Fair Trade Act was revised in 1994, further reduc-ing the ceiling to 25% of the net assets of individual affiliates.The penalties imposed by the Fair Trade Commission were nothigh enough to encourage chaebols to comply with the law. Onthe contrary, cross-shareholding jumped sharply in 1998 and

163

Chaebols’ Ownership and Governance Structure

0

5

10

15

20

25

30

35

40

45

50

83 87 89 90 91 92 93 94 95 96 97 98 99 2000

Chaebol family Cross-shareholding

%

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

1999 due to the corporate restructuring efforts after the crisis.The government urged chaebols to reduce debt–equity ratios bybringing in foreign partners or by selling assets. Chaebol firmsdid issue equity, but their affiliates bought these issues with theproceeds from their own equity issues. As a consequence, sucha reduction of debt–equity ratios did not involve net infusion ofequity capital.

The Mechanism of Cross-shareholdings

The restriction on cross-shareholding was designed to limitchaebol families from wholly controlling all affiliates when they

164


held little equity in these firms. Figure 6.1 shows, on average,chaebol families held 5.4% of the shares of their affiliates in1999. Their control, however, was based upon 44.1% of equityownership by other affiliates. Figure 6.2 explains how a cross-shareholding scheme works to help chaebol families control thewhole group. In this example, a business group has core com-panies of A, B, and C, each with equity of 100 billion won, andsmaller affiliates D, E, F, G, H, I, and J with equity of 10 bil-lion won each. The chairman owns 10% each of A, B, and C.Company A then owns 20% of company B, company B owns20% of company C, and company C owns 20% of company A.Therefore, the chairman effectively owns 30% each of A, B, andC; these stakes are sufficient to control each firm because thecore companies are more likely to be listed on the Korea StockExchange. Furthermore, A owns 50% of D, 25% of E, and 25%of F, while B owns 25% of E, F, H, and I, and 50% of G. In sum,major affiliates effectively control smaller affiliates by owningthem singly or jointly, and the chairman controls all these firmswith a very small ownership stake. In this instance, the chair-man controls all the chaebols’ affiliates with a total investmentof 30 billion won, or only 8.1% of the group’s total equity.

Further, the investments of A, B, and C in each other fre-quently involve no actual transfer of funds, thus creating fic-titious capital. The Fair Trade Act prohibits obviously circularinvestments, such as those between A and B only, but it does notprohibit transitive investments such as the cross-shareholdingbetween A, B, and C. Therefore, Korean chaebols have devisedmore complicated cross-shareholding schemes to increase eq-uity stakes by affiliates far larger than actual capital infusion.High debt–equity ratios also help chaebols control large amountsof assets. For example, if affiliates have an average debt–equityratio of 400%, the chaebol can borrow 1.4 trillion won with

165

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re6.

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total equity of 370 billion won. Therefore, the chaebol can use1.8 trillion won in assets, and the chairman controls these assetswith his equity investment of 30 billion won.

Figure 6.3 shows a simplified version of the equity stakesheld by SK Group’s chairman and the stakes held by the ma-jor affiliates in SK Group as of 1997. The chairman and hisfamily own equity stakes of core affiliates (i.e., SK Global, SKChemical, SKC, and SK Construction). These core affiliateswere established early in the history of SK Group. SK Globalwas established in 1956, and its chairman and his family own5.1% of it. The chairman of the SK Group and his family own12.3% of SK Chemical. In addition, they own 31.8% of SKCand 22.9% in SK Construction.

When SK Group acquired an oil refining business from thegovernment in 1980, SK Global and SK Chemical took 13.8and 2.7% equity stakes, respectively, in this venture, which waslater renamed SK Corporation. At a later stage, SK Corporationowned large equity holdings in Daehan City Gas, SK Gas, SKEnergy Sale, and SK Oxy-Chemical. SK Corporation also par-ticipated in the acquisition of SK Telecom from the governmentin 1994, by acquiring 18.5% equity stakes. For SK Securities,established in 1991, SKC, SK Construction, and SK EnergySale took substantial equity stakes. The ownership structure ofthe SK Group indicates that timing of affiliate foundation andcash availability determine which affiliates hold equity stakesin other affiliates.

There is also circular investment among SK Group’s affili-ates. For instance, SK Global owns 13.8% of SK Corporation,while SK Corporation holds 18.5% in SK Telecom. SK Telecomin turn holds 4.1% of SK Global. In another case, SKC holds7.1% in SK Chemical, SK Chemical has 2.7% in SK Corpora-tion, and SK Corporation owns 2.3% of SKC. Another notable

167

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feature of the ownership structure of SK Group is that theseaffiliates hold equity stakes in other affiliates whose businessesare not related to each other, which is not common in Westerncompanies. For example, SK Telecom invested in Daehan CityGas, SK Global, or SK Capital. Similarly, SK Securities wasfunded by several affiliates such as SKC, SK Construction, andSK Energy Sale. Again, availability of cash, not related diversi-fication, influences which affiliates will invest in the chaebol’snew business ventures.

Other groups have ownership structures very similar to thatof SK Group. For instance, in Hyundai Group, four companies –Hyundai Heavy Industries, Hyundai Construction, HyundaiMotor, and Hyundai Merchant Marine – serve as holding com-panies of the group. In Samsung Group, Samsung Electronics,Samsung Life Insurance, and Samsung Corporation play simi-lar roles. In Daewoo Group, Daewoo Corporation and DaewooElectronics are the core companies. LG Group has LG Chem-ical and LG Electronics as its major holding companies (seeFigures A.7.5–A.7.8).

Note that many affiliates in chaebols are publicly traded com-panies. Chaebols resisted the government’s repeated request tolist their affiliates on the stock exchange. The government hadto pressure them to increase their sale of stock to the public.For instance, in 1984 the Hyundai Group agreed to sell sharesof Hyundai Engineering and Construction publicly only afterthe Ministry of Finance had officially asked it to do so 28 times(Fields, 1995). Due to the government’s efforts, the numberof affiliates of the top thirty chaebols listed on the stock ex-change jumped from 50 in 1986 to 122 in 1996. Until the 1980s,there was less conflict between large shareholders and minorityshareholders because there were only a few listed companies,and the chaebol families’ own shares in those companies were

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substantial. By listing their affiliates involuntarily, chaebols hadgreater incentives to shift funds from public companies to pri-vate companies. We will discuss how SK Telecom shifted fundsin this way later in this chapter.

the corporate governance systemin korea

This section will examine chaebols’ corporate ownership/governance structures in more detail and assess whether they en-able effective monitoring to take place. In Chapter 1, we definedthe corporate governance system as the internal organizationsand power structure of the firm, the functioning of the boardof directors, ownership structure, and interrelationships amongthe management board, shareholders, and other stakeholderssuch as the company’s workforce and creditors (Hopt et al.,1998). Economists tend to focus on corporate governance as theways both investors and creditors ensure that management willnot appropriate their investments (Shleifer and Vishny, 1997).They also refer to managers’ (i.e., agents) pursuit of personalinterests at the expense of the interests of shareholders (i.e.,principals) as “agency problems.” Countries differ in the rulesthey have to protect investors’ and creditors’ interests. AlthoughLa Porta and co-worker’s (1998) study does not suggest whatinstitutional safeguards are superior, it does indicate that effec-tive corporate governance systems have two common elements.First, they legally protect investors’ rights, especially those ofminority shareholders. Second, they offer direct exercise of con-trol through concentrated ownership, which can occur throughblock ownership, hostile takeover, and the exercise of control by

170

The Corporate Governance System in Korea

large creditors.2 We will examine various aspects of corporategovernance systems in Korea later.

Dual Role as Owner and Manager

Unlike most large firms in the United States and Japan, Koreanchaebols do not have a separation of ownership from control.As Berle and Means (1932) and many others have observed,this separation creates acute agency problems in many Westerncompanies. In Japan, salaried professionals manage keiretsuaffiliates. In contrast, the chairman of a chaebol acts as if heis the chief executive officer of the chaebol even though all theaffiliates are legally independent entities with their own boardsof directors and presidents. The term “chairman of the group”is a fictitious title since the group does not exist in a legal sense.The presidents of chaebols’ affiliates function like divisionalmanagers do in a diversified corporation in Western society.

The lack of separation of ownership from control is more ap-parent if we look at the succession of the chaebols’ chairmen.Cho (1997) found that twenty-one out of twenty-two chaebolchairmen inherited their positions from family members. Mostcommonly, second-generation “chairmen” joined their groups atthe executive level (55%) or at the general manager level (45%).On average, it took them fifteen years to become chairmen af-ter joining their groups, and many of their immediate familymembers also directly participated in corporate management,as discussed in Chapter 3. The fact that these positions passedon not only to the second generation of founders families butalso to the third generation is possibly a result of Korea’s im-perfect inheritance tax system. Otherwise, high tax rates wouldhave reduced the equity stakes of the founders’ heirs. The fact

171


that these transitions happened seamlessly clearly indicates thatfounders used various loopholes in this tax system and passed ontheir equity to their successors without paying much inheritancetax. For instance, they used various tax-exempt cultural foun-dations, run by their chaebols, to avoid paying these taxes.3

Second, chaebol families have utilized initial public offeringsas an avenue to pass on wealth and hence management control;we will examine how they did so later in this chapter.

Therefore, principal–agent problems in chaebols do not as-sume the same form as they do in Western firms. Rather, largeshareholders in chaebols, who are often top managers, pursuetheir own interests to the detriment of minority shareholders, asillustrated in Figure 6.4.

The Board of Directors

One of the important legal rights of shareholders is the right toelect boards of directors, which have certain rights and duties inregard to the incumbent management. In the United States, theboards of directors, which rely heavily on directors from out-side a firm, have enormous power in appointing and dismissingtop executives and in determining their compensation.4 In Japan,creditor financial institutions, which are often large shareholdersas well, often dispatch directors to monitor managerial decisionmaking. Korean Commercial Law also identifies the board of di-rectors as the top-level decision-making body of a company. Un-der it, directors are appointed at general shareholders’ meetings.In practice, however, the authority and prestige of Korean boardsare comparatively low relative to those in the United States be-cause shareholders cannot appoint board members by mail butinstead must show up at the shareholders’ meeting to vote. Inpractice, the chairman of a business group appoints the directors.

172

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At general shareholders’ meetings, the management of a com-pany presents proposals concerning appointment of directorsverbally, and any minority shareholders are completely ignored.

Furthermore, the Korean boards comprise mainly executiveofficers so they do not monitor how effectively business opera-tions are carried out. They merely offer ex post facto approval ofmajor decisions. In addition, the few outside directors on theseboards are generally chosen from lists of individuals who main-tain close personal relations with chaebol families. Outside di-rectors seldom represent the interests of minority shareholders.Therefore, chairmen of the groups essentially make decisionson their own, completely unchecked by anyone else.

Rights of Minority Shareholders

Some countries, including the United States, ensure that minor-ity shareholders can aggressively exercise their rights via classaction lawsuits or proxy fights. In contrast, minority sharehold-ers in Korea have very limited rights. Under the CommercialLaw prior to the crisis, minority shareholders were granted theright to file a lawsuit against a company or to review accountingbooks only if they owned at least 5% of the company; this stan-dard can be prohibitively high for individual investors.5 Sinceminority shareholders did not know each other, they had only aslim chance to collaborate with other minority shareholders toaccess account books or file a lawsuit. Therefore, they tendedto be short-term investors who sought quick capital gains. Atthe same time, the old Commercial Law also restricted institu-tional investors such as banks and investment trust companiesfrom exercising their voting rights at shareholders’ meetings.Although the Korea Securities and Exchange Commission had

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The Corporate Governance System in Korea

the power to arrest suspected wrongdoers, regulation was car-ried out through persuasion rather than through legal means(Fields, 1995).

Capital Market Control

The discipline created by the active market for corporate controlis one of the key elements of the corporate governance systemsin the United States. In a typical hostile takeover, a bidder makesa tender offer to the shareholders of the target firms, often poorlyperforming firms, and if it solicits enough votes, it acquires thecontrol of the target and replaces the incumbent management.Jensen and Ruback (1983) found evidence of performance im-provement after takeovers. In Korea, hostile takeover has beenall but impossible because of severe restraints. According to se-curities regulations, a potential acquirer who wanted to own atleast 10% of a firm had to make this intention public. Further,this party had to purchase more than 50% of the firm’s equity,further limiting hostile takeovers.6

Unlike the United States, Japan has developed a corporategovernance system via “main banks,” which are both share-holders and large creditors and steadily monitor corporatemanagement.7 A “main bank” typically dispatches a directoror an executive to a company. The firm’s board of directors su-pervises managerial decision making and replaces managers ofpoorly performing companies.8 Although Korea adopted a sys-tem very similar to Japan’s, Korean banks have not conductedaggressive audits of companies. As discussed in Chapter 5,Korean banks also have only limited ability to evaluate the creditcapacity of their corporate customers. Put simply, Korea did nothave any capital market controls on chaebols in practice.

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agency problems in chaebols

In this section, we will examine specific agency problems thatthis lack of corporate governance system might have caused.

Lack of Accountability

The chairmen of Korean chaebols clearly have almost totalcontrol over their groups. Yet CEOs of U.S. firms have strongcontrol over their companies. For instance, Jack Welch ofGeneral Electric carried out large-scale corporate restructuringduring the 1980s. He sold off affiliates that were not rankedfirst or second in their markets and slashed GE’s number of em-ployees from more than 400,000 to almost half that. Yet it wasassumed that he would be responsible for all the consequencesof the restructuring, and he had to obtain consent from GE’sboard of directors, which had many outside members, when hemade any significant decisions that affected GE as a whole. If hisefforts had failed, he would have lost his job. Chaebol chairmen,however, have no accountability when they make bad decisions.They also do not have to seek consent from a board of directors.After all, the group does not exist in a legal sense.

Sometimes these chairmen have used this power to makesuccessful decisions that they would have been unable to imple-ment under U.S. forms of governance. The late chairman Leeof the Samsung Group ventured into the semiconductor busi-ness, despite opposition from both the government and his ownlieutenants.9 The late chairman Chung of the Hyundai Groupgambled in diversifying into shipbuilding without any prior ex-perience by building a shipyard and the ship concurrently.10

Such decision often invited large-scale failure, however, asdemonstrated by Samsung Group’s venture into the automobile

176

Agency Problems in Chaebols

industry in 1994. It appeared to do so less for sound strategic rea-sons than because of the personal desires of Samsung Group’schairman,11 who was a serious auto collector with a strong de-sire to be in the automobile business himself.12 At that time, theindustry was undergoing substantial consolidation. Larger autofirms were acquiring smaller auto firms in an attempt to reapeconomies of scale for many related activities. When SamsungGroup announced this venture, many in Korea raised objections.Despite these concerns, it introduced technology and productionfacilities from Nissan and started its automobile business. BothSamsung Motors’ affiliates and many employees and execu-tives of Samsung Electronics, Samsung SDI, Samsung HeavyIndustries and Samsung Electro-Mechanics purchased stock inthis new venture. Ironically, the chairman did not himself investin this risky business because he was apparently reluctant to in-vest in a company that was certain to lose large sums for severalyears. Ultimately, Samsung Motors applied for court receiver-ship in 1999, and all its investors lost money. The chairmanhimself was not held responsible. If Samsung had been run ac-cording to a U.S. model of corporate governance, it would likelyhave never embarked on such an ill-advised venture. Althoughthe absolute power of chaebols’ chairmen may have been an as-set when the government developed economic plans, providedfunds for new businesses, and saved failing ventures, it can benow a liability since the government stopped these activities inthe early 1980s and chaebols became responsible for their ownstrategic decisions.

The liability of such power is even more apparent now thatsecond- and third-generation chaebol chairmen are now in con-trol. Such individuals controlled most of the business groupsthat went bankrupt after the crisis in 1997. Since they inheritedtheir empires, these chairmen feel more pressure to show their

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managerial aptitude. Often, they attempt to do so by diversify-ing aggressively, as part of a “second founding” of their groups.For example, Jinro Group expanded its Korean traditional liquorbusiness and tried to be a leader in wholesaling/retailing. Therapid buildup in distribution facilities, however, induced Jinro’scollapse. Haitai Group faced default after the group diversifiedinto electronics and heavy machinery. Unlike wealth, the man-agement prowess of chaebols’ founders does not seem to beinherited. Thus, familial succession seems to create a seriousagency problem because a successor’s job competence is notknown and his power is unchecked.

Expropriation Through Inside Trading

Not surprisingly, chaebols’ chairmen have insider informationabout the operations of affiliates. Such information is obviouslyadvantageous to chairmen and their families and detrimentalto the interests of minority shareholders. Quite often, chaebolfamilies purchase stock of companies at low prices before an-nouncements that these firms will be listed and earn large capitalgains after such announcements. A conspicuous example is thecase of Samsung Group chairman Kun-Hee Lee and his sonJae-Young Lee.13 As of 1999, chairman Kun-Hee Lee’s wealthwas estimated to be two trillion won, and his son’s wealth wasestimated to be several hundred billion won. Jae-Young Lee wasstill a student and had never run a business. When he inheritedassets worth several hundred billion won, he paid an inheritancetax of only 1.6 billion won. His increase in wealth is attributableto the large capital gains of Initial Public Offering (IPO) stocks.Figure 6.5 shows that Kun-Hee Lee donated 6 billion won toJae-Young Lee in December 1995. This is the only instance ofKun-Hee Lee officially donating cash to his son. After paying the

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inheritance tax, Jae-Young Lee used the remaining 4.4 billionwon to purchase stocks of unlisted affiliates of Samsung Group.He bought 124,800 shares of S-one, a home security company,with 2.3 billion won and 470,000 shares of Samsung Engineer-ing with 1.9 billion won. When S-one and Samsung Engineeringbecame listed on stock market several months later, the value ofhis stock in S-one and Samsung Engineering was 35.7 billionwon and 23 billion won, respectively. He sold these shares for58.7 billion won, or twelve times his original investment.

Using these proceeds, he bought convertible bonds of CheilCommunication, then unlisted, worth 1.8 billion won. Thesebonds were subsequently converted into stock that gave him29.7% ownership of the company. When Cheil Communicationwas listed on the stock market in March 1998, his investment of1.8 billion won soared to 15.3 billion won. He also purchasedconvertible bonds in Samsung Everland for far less than theirmarket price. These bonds were then converted to a 31.9% eq-uity stake in this firm, which then used the proceeds of thisconvertible bond issue to purchase 20% ownership in SamsungLife, which is one of the core holding companies in the SamsungGroup. He also bought 23 billion won of convertible bonds is-sued by Samsung SDS at the issue price of 7,150 won, whichwas far below then-market price of 54,000 won.14 As SamsungSDS is soon to be listed, the value of this investment is antic-ipated to increase by twenty times the acquisition price. Fur-thermore, he invested 45 billion won to buy convertible bondsof Samsung Electronics. The convertible bonds were issued ata below-market price and provided high interest rates. He thenconverted these bonds to stock, thus securing 0.78% of SamsungElectronics.

Such activities capitalize on loopholes in the Korean tax sys-tem that let family members inherit wealth and managerial

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control without a heavy tax burden. At the same time, suchactivities take away the assets of minority shareholders of listedfirms. Furthermore, buying shares of unlisted companies at lowprices and reaping large capital gains after these firms are listedis a clear abuse of insider information and represents anotherfacet of the agency problems in chaebols’ governance structure.

Expropriation Through Internal TransferPricing Scheme

As discussed in Chapter 4, chaebol firms frequently cross-subsidize their affiliates through artificially derived transferprices. Chaebol chairmen can also use this device to transferprofits into affiliates in which they have large equity stakes. Onesuch example of this behavior is provided by internal transac-tions between SK Telecom and its affiliates – Daehan Telecom(now called SK C&C) and SK Distribution.

As shown in Figure 6.6, SK Group acquired Korea MobileTelecommunication in 1994 from the government. It renamedthis firm SK Telecom and made it an affiliate of SK Group.As of 1994, SK Telecom posted 782.8 billion won in revenuewith a 36.7% operating margin. After it became an affiliate,it engaged in many intragroup transactions, particularly withDaehan Telecom (now SK C&C) and SK Distribution, whichwere both small businesses. The chairman of SK Group andhis family owned 100% of Daehan Telecom and 95% of SKDistribution. SK Telecom subcontracted purchasing of someequipment to Daehan Telecom, which charged hefty marginsof 200%. It also signed service contracts with Daehan Tele-com for services it could handle itself. The service contractswith SK Telecom helped Daehan Telecom earn large profits.In 1994, Daehan Telecom posted minuscule operating income

181

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of 64 million won and net losses after deducting payments forinterest and other nonoperating expenses. By 1997, its revenuehad multiplied thirty times, and its operating income increasedto 18.2 billion won. SK Distribution similarly benefited fromits transactions with SK Telecom, charging high fees with largemargins,15 and became profitable. Conversely, SK Telecom’soperating margins dropped from 36.7% in 1994 to 16.6% in1997.

One other notable feature of this set of transactions is that SKTelecom was listed on the Korean Stock Exchange but DaehanTelecom and SK Distribution were not. Further, equity stakeby the chairman and his family in SK Telecom was low, whilehis family was the majority owner of the two other companies.This phenomenon poses some intriguing issues about the con-ventional wisdom regarding the relationship between ownershipand performance. After the study by Berle and Means, it wasbelieved that concentrated ownership generates higher perfor-mance due to tighter monitoring by owners.16 In Korean chae-bols, ownership concentration leads to higher performance notbecause of tighter monitoring and control but because of manip-ulation of internal transfer prices. Furthermore, the causal rela-tionship can be reversed so that high performance leads to own-ership concentration. Chaebol families frequently increase theirdirect shareholdings in highly profitable companies. Chaebolchairmen then induce affiliate firms to increase their equitystakes in less profitable firms so that they can exert managerialcontrol without having direct ownership. Cho’s (1998) studyof the behavior of U.S. companies, which showed that prof-itability exerts a strong influence on the ownership structureof a company, provides additional support for this conjecture.Appendix 6 examines the possibility of reverse causality witha sample of chaebol firms. According to this study, chaebols’

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families tend to own larger stakes in more profitable companiesand smaller stakes in less profitable ones. They tend to controlless profitable companies through cross-shareholding. Thesefindings suggest that chaebol families use insider informationto decide how much of an affiliate they will own directly. Thistrend is further evidence for the problems in corporate gover-nance in Korea.

Such explicit cases of expropriation by large shareholdersare commonly found in many other countries. As La Porta et al.(1999, 2000) noted, large shareholders in most countries havecontrol rights in excess of their cash flow rights because theyuse pyramid and cross-shareholding mechanisms and directlyparticipate in management.17 With such control, these own-ers have the power to expropriate value from minority share-holders (Shleifer and Vishny, 1997; Wolfenzen, 1999).18 Ev-idence indicates controlling shareholders exercise such powerthrough such means as not paying dividends, transferring profitsto other companies they control, providing high or low inter-est loans, selling or purchasing intermediate products at non-market prices, and offering debt guarantees to other affiliates.Such instances occur even in well-developed countries: Barclayand Holderness (1989), Bergstrom and Rydqvist (1990), andZingales (1994) found evidence of small shareholder expropri-ation in the United States, Sweden, and Italy, respectively, whileWeinstein and Yafeh (1998) found that Japanese firms belong-ing to bank-controlled keiretsus pay higher interest rates on theirliabilities than do unaffiliated companies.

Explicit cases of minority shareholder expropriation by largeshareholders, however, occur in firms in emerging economiesbecause these firms are largely owned and controlled by fami-lies and there are few rules and procedures to protect minorityshareholders. With a sample of Indian firms, Bertrand, Mehta,

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and Mullainathan (2000) found strong evidence of “tunneling,”which they defined as transferring resources from companiesin which a controlling family has few cash flow rights to onesin which it has substantial cash flow rights. Coffee (1999) re-ported that some Czech investment funds sold significant own-ership packages to related companies at a fraction of their realvalue. Dharwadkar, George, and Brandes (2000) also discussedthe expropriation that occurs when state-owned enterprises inemerging economies are privatized. Another study by Claessens,Djankov, and Lang (2000) and Claessens et al. (1999) showedthat many of the firms affected by the Asian crisis used pyramidstructure and cross-shareholding, which was negatively asso-ciated with a firm’s market value. Johnson et al. (2000) foundthat the stock market decline in individual countries during thecrisis was negatively correlated with protections for minorityshareholders.

This chapter has documented several substantial problemswith chaebols’ ownership and governance structures. In par-ticular, there exist no systematic controls to avert chairmen’sill-conceived strategies. These problems greatly diminish thepotential for synergies that chaebols can create. Therefore, therestructuring of chaebols must start with the restructuring oftheir corporate governance systems. As discussed in Chapter 4,the Fair Trade Commission has effectively begun one suchchange by launching aggressive in-depth investigations into in-ternal transactions. By ferreting out such abuses, it will preventone form of wealth transfer that hurts the interests of minor-ity shareholders. Clearly, the Korean government needs to takeadditional steps in this area.

185

7

The Restructuring of Chaebols

187

The Restructuring Policy of the Korean Government

In the preceding chapters, we discussed how various structuralaspects of chaebols made chaebols resist the shifts to their en-vironment and become dysfunctional. Our results suggest thatchaebols’ creation of operational synergies was wasted in ill-conceived diversification strategies. Vertical integration resultedin inefficiency and massive subsidization. Chaebols’ in-housefinancial services and mutual debt guarantee practices con-tributed to high debt levels. We pointed out, however, that thefundamental problems of chaebols are instead attributable tochaebols’ weak corporate governance systems and the distor-tions in Korean financial markets. We thus concluded that therestructuring of chaebols should address these fundamentalweaknesses. In this chapter, we will examine the restructuringefforts by the Korean government and chaebols after the for-eign exchange crisis in 1997. This chapter will also discuss thefurther restructuring of chaebols.

the restructuring policy of thekorean government

When Korea applied for emergency funds from the IMF, Koreawas nearly bankrupt. The Bank of Korea’s foreign reserves werealmost depleted. Foreign creditors demanded the redemption ofloans from both local banks and companies. Under such cir-cumstances, the Korean government had no leverage againstthe IMF and the World Bank, also known as the InternationalBank for Reconstruction and Development (IBRD), in bargain-ing conditions of loans. The guidelines imposed by the IMF andthe World Bank greatly influenced the Korean government’ssubsequent restructuring policies.

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Under articles 32 and 37 of the agreement, the IMF de-manded that the Korean government implement the followingmeasures:1

1. Liberalization of foreign investment in the Korean equitymarket by increasing the ceiling on aggregate ownershipfrom 26 to 50% by the end of 1997, and to 55% by the endof 1998. The ceiling on individual foreign ownership willbe lifted from 7 to 50% by the end of 1997.

2. Improvement of corporate governance structures. In par-ticular, the IMF demanded that the government adopt in-ternational accounting principles to enhance the trans-parency of the Korean accounting system. As part of suchefforts, the IMF requested that the Korean chaebols dis-close information and make public their combined finan-cial statements.

3. No government interference with banks’ business opera-tions and lending decisions.

4. Improvement of bankruptcy procedures and eliminationof any subsidies to bail out individual companies.

5. Reduction of debt levels ofKorean companies and changesto the system of mutual guarantees within conglomeratesto reduce the risk these guarantees entail.

The World Bank demanded similar restructuring efforts in itsagreement with the Korean government, further requiring rein-forcement of the Fair Trade Act to promote competition and theremoval of any regulations against entry and exit.The Korean government followed these guidelines rather

closely. President-elect Dae-Jung Kim realized that the restruc-turing of chaebols was necessary to regain confidence fromforeign investors. The government announced the following five

190

Restructuring of the Financial Sector

principles for corporate restructuring on January 13, 1998. First,the government would require chaebols to introduce combinedfinancial statements and adopt Western accounting practices toimprove transparency.2 Second, it would force chaebols to abol-ish debt guarantee practices to avoid serial bankruptcies. Third,chaebols would reduce their debts substantially and sell un-profitable assets. Fourth, chaebols would improve internationalcompetitiveness by focusing on core businesses. Fifth, the gov-ernment would improve the governance system of companiesand would enforce the responsibilities of family owners to mi-nority shareholders. In a sense, these principles simply reiteratedwhat the IMF andWorld Bank demanded in return for a bailout.In the next section, we will examine the restructuring of the fi-nancial sector. The subsequent sectionwill detail changes to debtpractices, diversification activities, and corporate governance.

restructuring of the financial sector

The analyses in prior chapters indicated the tight relationshipbetween chaebols and Korean financial institutions. Chaebols’overall problems contributed heavily to the financial problemsthese institutions faced. As of June 1998, 40 trillion won inloans were officially classified as bad (see Table 5.4). Thisstatistic excludes loans classified as substandard, doubtful, andloss. Using a 55% loan recovery rate, the total amount of re-quired write-offs was estimated to be 47.1 trillion won, whichwas about 2.6 times the equity capitals of all banks at the endof 1998.3 This estimate is based on the lenient definition ofbad loan used by the Korean government. Using the interna-tional standard for bad loans increases this figure to 85.7 trillionwon. In other words, most banks were technically bankrupt.

191


Furthermore, there was an impending financial crisis as peo-ple withdrew their deposits from banks and firms continuedto go bankrupt as banks restricted additional loans. Hence,the Korean government had no other option than to delay re-structuring in the corporate sector and fix the financial sectorfirst.In early 1998, the government infused 3 trillion won into two

large national commercial banks that were insolvent – ChielBank (also known as the Korea First Bank) and Seoul Bank –and shut down five smaller regional commercial banks. In aparallel move, four financially weak banks were merged withhealthier ones – the Commercial Bank of Korea and Hanil Bankwere merged into Hanvit Bank; Boram Bank, into Hana Bank;the Long-term Credit Bank of Korea, into Kookmin Bank; andKangwon Bank, into Choheung Bank. This consolidation re-duced the total number of commercial banks from thirty threeat the end of 1997 to twenty four by June 1999. The govern-ment also injected an additional 13.5 trillion won of publicfunds to prop up the equity capital of other weak banks and9.6 trillion won to pay for the deposits of liquidated banks.In addition, the government chipped in public money to buyback bad loans held by the surviving financial institutions.The government-owned Korea Asset Management Corporation(KAMCO) bought 17.3 trillionwon of default assets from banksat a discounted price.4 By 1999, the government infused a totalof 45.2 trillionwon to restructure commercial banks. In doing so,it helped financially sound commercial banks exceed Bank forInternational Settlement (BIS) ratios of 10%, which is the inter-national standard. International accrediting organizations suchas S&P and Pitch IBCA upgraded the sovereign rating of Koreain February 1999 to investment grade, and the spread on 5-year-maturity foreign currency stabilization bonds steadily declined.

192

Restructuring of the Financial Sector

Table 7.1. Infusion of public funds to the financial sector

Public funds raised in Additional public funds1998 and used by raised in December 2000December 1999 and planned usage(trillion won) (trillion won)

Nonbank Nonbankfinancial financial

Bank institutions Bank institutions

Infusion of 16.5 4.0 10.7 9.8equity capital

Paying deposits 9.6 11.4 — 16.9on behalf of thebankrupt financialinstitutions

Purchase of assets 1.8 — — —Purchase of bad loans 17.3 3.2 5.9 —by KAMCO

Others — 0.2 — 6.7Subtotal 45.2 18.8 16.6 33.4Total 64.0 50.0

Source:Ministry of Finance and Economy, A White Paper on Public Funds:Interim Report for the Completion of Financial Restructuring, September2000.

Similarly, nonbanking financial institutions experienced ma-jor shakeouts. Eighteen out of thirty merchant banks were shutdown or merged. Additionally, six securities firms, five insur-ance firms, and three investment trust firms were shut down.Forty savings and loans and 131 cooperatives were shut downas well. The government infused 4.0 trillion won of equity cap-ital into troubled life insurance companies and paid 11.4 trillionwon for the deposits of the closed nonbank financial institu-tions.KAMCOpurchased 3.2 trillionwonof bad loans. (Refer to

193


Table 7.1 for details.) In all, the infusion of public funds to all fi-nancial institutions reached 64 trillion won byDecember 1999.5

This massive bailout of commercial banks resembles the 1981foreign exchange crises that hit Chile andArgentina,whichwerecaused by group-affiliated banks lending recklessly to other af-filiates. Commercial banks in those countries were practicallynationalized when the government rescued them. Similarly, theHungarian government’s effort to save banks after privatizationby purchasing their bad loans in 1992 was nullified only afterone year when the same banks became again insolvent (Stark,1996a). After recapitalizing banks, the government became thedominant shareholder of large commercial banks.Yet these efforts were not sufficient to salvage the finan-

cial industry. Although a massive injection of public fundsto the failed financial institutions was necessary, the Koreangovernment depleted its financial resources as a consequence;the total government budget and the gross national productof Korea for 1999 were only 80 trillion won and 483 trillionwon, respectively. Furthermore, this infusion set another badprecedent of bailing out failed financial institutions with taxmoney and created a moral hazard for domestic financial in-stitutions. In December 2000, the government reported that sixcommercial banks that received government funds in 1998, in-cluding Seoul Bank and Hanvit Bank, once again needed addi-tional funds to remain solvent. The government announced that50 trillion won of additional public funds were needed to cleanup the balance sheets of commercial banks and to close outbankrupt financial institutions. In short, injecting public fundsinto finance companies without changing these institutions’management and lending practices was an inadequate solu-tion. Furthermore, government interventions, such as forcingbanks to extend additional loans to near-bankrupt companies

194

Restructuring of the Corporate Sector

and to acquire bonds issued by them, did not stop after thecrisis.In the meantime, foreign ownership of financial institutions,

which had been strictly restricted, was substantially increased.Newbridge Capital acquired majority ownership in Cheil Bank.Kommertzbank became the largest shareholder of Korea Ex-change Bank. Goldman Sachs became the largest shareholder ofKookmin Bank. The ING Bank and International Finance Cor-poration (IFC) participated as the second largest shareholdersfor the Housing and Commercial Bank and Hana Bank, respec-tively. Foreign securities firms such as Regent Pacific, QuantumEmerging, H&Q, and Prudential bought shares of Korean firms.MetLife, Allianz, and New York Life took equity positions inKorean insurance firms. The increase in foreign ownership offinancial institutions is expected to result in tighter monitoringof these institutions’ lending practices and restrict the govern-ment’s meddling in the financial sector. For instance, in De-cember 2000, the government forced banks to acquire bondsissued by financially weak companies. Only the Cheil Bank,under the management of Newbridge Capital, could refuse thisrequest.6

restructuring of the corporate sector

Financial Restructuring of Chaebols

Financial restructuring of Korean chaebols has focused on threemain reforms. The first focused on chaebols reducing their debt–equity ratios to less than 200%. The second involves chaebolscompletely eliminating cross-debt guarantees among their af-filiates by the end of 2000. The third requires smaller chaebolsto improve their financial structures through corporate workout

195


programs. To implement these measures, chaebols were placedunder the close supervision of banks that were practically na-tionalized through the massive capital infusions described ear-lier. Again, it should be noted that the government initiated therestructuring of chaebols.Under the government-led corporate restructuring plan, sub-

stantial progress was made in cutting bloated corporate debts.The government used the technically nationalized banks to forcechaebols to reduce their debt–equity ratios to 200% by the endof 1999. The top thirty chaebols’ average debt–equity ratio fellfrom 516.4% at the end of 1997 to 344.6% at the end of 1998,to 189.6% by the end of 1999 (see Figure 5.1). During the sameperiod, the top five chaebols reduced their average debt–equityratios from 477.9% in 1997 to 329.5% in 1998 and 144.9% in1999.7 These statistics show dramatic reductions of debt–equityratios in a short period of time.A detailed analysis, however, suggests a more complicated

picture than these statistics indicate. The top five chaebols ac-tually saw an increase in total debts from 221.2 trillion wonin 1997 to 234.6 trillion won in 1998 (see Table 7.2). Theirdebt–equity ratios dropped because their shareholders’ equityrose from 46.9 trillion won in 1997 to 69.9 trillion won in 1998.Of this amount, 12.2 trillion won came from new equity issues,most of which went to affiliates. Thus, the cross-shareholdingdiscussed in Chapter 6 actually increased and artificially de-creaseddebt–equity ratios as a side effect. The remainingportionof this equity increase is attributable to massive asset revalua-tion. Chaebols revalued their real estate and securities holdings.In contrast, the rest of the top thirty chaebols, which gener-ally had lower credit ratings than the top five chaebols did,had actually slashed their total debts from 136 trillion won atthe end of 1997 to 132 trillion won at the end of 1998, while

196


Table 7.2. Changes in the debts and equities of the top fivechaebols, 1997–1999

1997 aggregated financial statements

Hyundai Samsung LG Daewoo SK Sum/Average

Debt 61.7 50.0 42.9 42.7 23.9 221.2Equity 10.7 13.5 8.5 9.1 5.1 46.9Debt–equity 576.6 370.4 504.7 469.2 468.6 477.9ratio

Number of 62 61 52 37 45affiliates



Debt 72.6 43.2 36.4 59.8 22.6 234.6 (174.6)Equity 15.0 17.1 11.5 16.9 9.4 69.9 (53.1)Debt–equity 484.0 252.6 316.5 353.8 240.4 329.5ratio

Number of 57 62 48 36 41 244affiliates



Debt 52.6 38.4 27.5 — 22.6 141.1Equity 34.6 26.3 18.6 — 16.9 96.4Debt–equity 152.0 146.0 147.8 — 133.7 144.9ratio

Number of 35 45 43 39 162affiliates

197


Table 7.2 (cont.)

1999 combined financial statements


Debt 60.2 41.5 30.6 — 23.1 155.4Equity 26.2 21.4 11.2 — 10.2 69.0Debt–equity 229.8 193.9 273.2 — 226.5 230.8ratio

Number of 103 (30) 159 (39) 118 (35) 57 (33) 437 (137)affiliates

Notes: 1. The aggregated financial statements simply add the accounting itemsfrom the financial statements of individual affiliates without any consolida-tion. The combined financial statements consolidate all the affiliates that areeffectively controlled by the chaebol chairmen.2. Both aggregated and consolidated statements here exclude financial servicesaffiliates.3. “Sum/Average” denotes sum of debts, equities, and number of affiliates offive (four excluding Daewoo) and average for debt–equity ratios.4. The 1999 combined financial statements include both domestic and foreignaffiliates. Number of affiliates in parentheses denotes domestic affiliates.5. Daewoo Group went bankrupt. Figures in parentheses in 1998 statementsare sum of those excluding Daewoo.Source: The aggregated financial statements are from the Korea Fair TradeCommission, and the combined financial statements are from the KoreaFinancial Supervisory Board.

only slightly increasing their equity base. It was only after theDaewoo Group went bankrupt in 1999 that the other top chae-bols engaged in substantive restructuring. The four remain-ing biggest chaebols further reduced their debt–equity ratios.They increased their equities from 53.1 trillion won in 1998 to96.4 trillionwon in 1999 and reduced their debts from 174.6 tril-lion won in 1998 to 141.1 trillion won in 1999 by raising capital

198


from new equity issues and paying down their debts. The boom-ing stock market contributed to their ability to make these debt–equity swaps. As a consequence, their average debt–equity ratiowent down to 144.9% in 1999.Table 7.3 uses LG Group as one example of this restruc-

turing. LG issued 2.4 trillion won in equity in both 1998 and1999. Between these issues, asset revaluations (0.9 trillion wonin 1998 and 1.4 trillion won in 1999), and profits (almost nonein 1998 and 3.6 trillion won in 1999), LG Group increased itstotal equity from 8.5 trillion won in 1997 to 11.5 trillion wonin 1998 and 18.6 trillion won in 1999. Most of the new equityissued in 1998 was assumed by other affiliates, thus increasingcross-shareholding from 36.3% in 1997 to 48% in 1998. In con-trast, outside investors bought most of LG Group’s new equityissues in 1999, and affiliates sold 953 billion won of their eq-uity holdings in their affiliates to outside investors to pay backtheir debts. As a consequence, cross-shareholding in LG Groupdropped from 48% in 1998 to 36.2% in 1999. In addition, LGsold its semiconductor business to Hyundai Semiconductor in1999 as a part of the Big Deal, which we will discuss in thenext section. Several LG affiliates converted their businessesinto joint ventures with foreign partners such as Rohm & Hass,Dow Chemical, PowerGen, Philips, British Telecom, NipponMining, and OTIS, and sold their own joint venture partnershipshares off to foreign partners such as LG Allied Signal and LGHoneywell. LG raised $1.7 billion in 1998 and $2.7 billion in1999 by selling assets to foreigners.The true degree of chaebols’ indebtedness was revealed only

when chaebols’ combined financial statements became avail-able for the 1999 financial year. The government required thatchaebols present the combined statements of all domestic andforeign affiliates after subtracting all internal sales transactions.

199

Table7.3.Restructuring

ofLGGroup

Equityissue(inbillionwon)

1998

1999

Domestic

1,878

1,460

Foreigncapitalinflow

528

973

Total

2,407

2,434

Assetsales(inbillionwon)

1998

1999

Realestate/facilities

2,499

1,553

Financialasset

423

953

Others

207

1,211

Total

3,130

3,719

Foreigncapitalattraction

Company

Amount

Partner

Contents

Date

LGChemical

U.S.$30million

Rohm&

EstablishedLG-ShipleyCo.,Ltd.,a

Jan.98

Haas

jointventurephotoresistmanufacturer.

U.S.$1.52million

Allied

SoldLGAlliedSignaltoAlliedSignal.

Sept.98

Signal

U.S. $320million

Dow

Establishedapolycarbonatejoint venture

Oct. 98

Chemical

firm.

U.S. $170million

Degussa

SoldcarbonblackbusinesstoDegussa.

Nov. 98

LGEnergy

U.S. $210million

PowerGen

Sold49.9%stake(U.S.$60million)to

Feb.99

PowerGen. PowerGenarrangedloans

forLGEnergy(U.S.$150million).

LGLCD

U.S.$1.6billion

Royal

Establishedajointventure,LGPhillips

May99

Philips

LCDandsold50%staketothejoint

Electronics

venture

LG

15billionwon

LG

SoldallLGsharesinLGHoneywellto

April99

Honeywell

(U.S.$figuren/a)

Honeywell

Honeywell.

LGTelecom

U.S.$400million

British

Sold23.49%

stakeinLGTelecomtoBT.

Oct.98

Telecom

LGIndustrial

U.S.$830million

Nippon

Establishedajointventurefirmwithequal

July99

Systems

Mining

sharesandLGIS’scoppersmelting

andrefiningbusinessunitwassoldto

thejointventure

U.S.$66million

Carrier

Soldavendingmachinebusinessunit.

June99

U.S.$500million

OTIS

Establishedajointventure,LGOTIS

Nov.99

Elevator,andthejointventuretookover

LGIS’sbuildingfacilitiesbusiness.


Table 7.2 shows the equities and debts of the four largest chae-bols as listed in the combined financial statements of 1999 andhighlights the substantial differences between chaebols’ debtand equity levels for the aggregated and combined accountingdata. In the combined statements, debts incurred by foreign sub-sidiaries were added, and cross-shareholdings were crossed out.As a consequence, the average debt–equity ratio was 230.8%,which was much higher than was the average from the aggre-gated statements.The second important element of chaebols’ financial restruc-

turing was the elimination of mutual debt guarantee practices.As we saw in Chapter 6, such practices created ripple effectsof bankruptcies among chaebol affiliates.8 After the financialcrisis, the Korean government attempted to rapidly eliminate allsuch guarantees by 2000. In 1997, the top thirty chaebols’ totalcross-debt guarantees, excluding payment guarantees related toindustry rationalization, overseas construction, and technologydevelopment, which were qualified for exemption, amounted to63.5 trillion won. These chaebols reduced this amount to ap-proximately 22.4 trillion won in 1998 and to only 1.3 trillionwon by 2000. Most notably, the top four chaebols eliminated allsuch guarantees by the end of 2000 (see Figure 5.3).This restructuring program is also attempting to facilitate the

smooth exit of nonviable companies and to transformfinanciallyweak, yet promising companies into financially sound ones. Toaccomplish this, creditor financial institutions have been im-plementing corporate workout programs centered on smallerchaebols. Corporate workouts, by definition, mean financiallyweak firms negotiate with their creditors to restore their finan-cial health by restructuring their debt profiles before they have tofile for bankruptcy and be liquidated.9 In doing so, these firmscan reduce their debts and begin the recovery process. They

202


continue to operate and serve their customers, thus increasingtheir cash flows, and thereby improving creditors’ prospects foreventually recouping the loans they made to these firms.In June 1998, 210 Korean financial institutions signed the

Creditor Banks Agreement on Accelerating Corporate Restruc-turing with the government. This agreement specified that ap-proval from a majority or 75% of financial creditors is neededto place a company under a corporate workout program. In ad-dition, using the Technical Assistance Loans from the WorldBank, the Korean government appointed six external advisorygroups to the commercial banks to provide them with muchneeded professional expertise and skills for implementing cor-porate workout programs. The advisory groups were composedof experts in various fields, including accountants, lawyers, andinvestment bankers from leading firms. These experts evaluatedthe progress of the corporate workout programs and providedadvice on restructuring and financing.Themajor tools utilized in these corporate workout programs

included interest rate reductions, interest expensewrite-offs, anddebt–equity swaps. New credit extension was minimal. Com-panies were required to sell or merge assets and business unitsthat were either outside their core business lines or had littlechance of recovering. Creditor banks required equity write-offsbefore they made debt–equity swaps. Both creditors and exist-ing shareholders lost money on these swaps, thus limiting moralhazard by both parties. Before initiating the corporate workoutprogram, the Financial Supervisory Board announced the liqui-dation of fifty-five bankrupt companies in June 1998. By 1999,fifty-four companies belonging to seventeen business groupsand thirty-nine medium-sized and large independent companiesoperated under the workout program. Many of these companieswere not performing well, however, and twenty-nine of them

203


were liquidated in November 2000.10 The Korea DevelopmentInstitute, a government-sponsored research agency, contendedthat the workout program merely extended financially troubledcompanies’ lives rather than helping turn them around.11

In sum, the financial restructuring program was only moder-ately successful. By selling assets and issuing equity, chaebolsstrengthened their finances. They alsomade themselves less vul-nerable to the ripple effects of bankruptcy by eliminatingmutualdebt guarantee practices. Yet this program also needlessly de-layed the lives of many technically bankrupt companies.

Business Restructuring

By implementing the Big Deal plan, the Korean governmentalso attempted to consolidate industries and induce chaebols tofocus only on their core competencies. This plan involved eightindustries: semiconductors, petrochemicals, aerospace, railroadvehicles, power generation machinery, ship engines, oil refin-ing, automobiles, and electronics. Highly capital intensive withhuge fixed assets, these industries faced serious overcapacityand inefficiency as a result of the Korean government’s eco-nomic development policies in the late 1970s, which inducedchaebols to enter these businesses.In a sense, this Big Deal policy resembles past methods of

dealing with prior economic crises and bankruptcies. After thesecond oil crisis, many Korean firms, particularly those in theheavy equipment and chemical industries, were in deep finan-cial trouble. The total external debts to GNP rose from 32%in 1979 to 48% in 1981. The government then lowered the in-terest rates and depreciated its currency. The government alsobailed out many failed firms by letting healthier firms take themover or merge with each other. For instance, Saehan Motors, a

204


passenger car manufacturer, was acquired by Daewoo Group,andKiaMotorswas forced to concentrate on the commercial ve-hicle while exiting the passenger car business. Large ship enginefirms were consolidated into Hyundai and Korea Heavy Indus-tries, and small ship engines, into Ssangyong. Heavy equipmentmachinery businesses of Ssangyong and Kolon were merged toHyosung. Samsung, Hyundai, andDaewoowere ordered to giveup the power generation business to Korea Heavy Industries,but they managed to have this order rescinded. Large subsidieswere provided to firms involved in restructuring (Amsden, 1989;Woo, 1991).In the semiconductor industry, Hyundai Electronics acquired

LG Semiconductor, while in the oil refinery industry, Hyundaitook over Hanwha. In railroad vehicles, Hyundai, Daewoo,and Hanjin jointly established a new business entity. Similarly,Hyundai, Daewoo, and Samsung formed a joint businessentity for the aerospace industry. In power generation ma-chinery, Korea Heavy Industries was to take over Samsungand Hyundai’s power generation machinery units; however,Samsung and Korea Heavy Industries were pursuing the estab-lishment of a separate entity with independent management forship engines. In petrochemicals,Hyundai andSamsungwere ne-gotiating with potential foreign investors to form an integratedentity within the Daesan petrochemical complex and becomejoint majority shareholders. In the automobile and electronicsindustries, however, Samsung Electronics failed to take overDaewoo Electronics while Daewoo Motors could not acquireSamsungMotors. It is worth noting that the same industries thatwere subject to the 1981 restructuring were again reorganizedafter the 1997 crisis. It suggests the negative consequences thatthe government’s drive to develop the heavy equipment andchemical industries had on the future development of Korean

205


industries and demonstrates that the previous government-driven restructuring was ineffective.This program had several embedded problems, however. The

biggest problem was that the rationale for the program wasbased on political rather than economic motives. During the1970s and 1980s, the government initiated several industrialpolicies to rescue unviable companies by extending loans, em-ploying debt–equity swaps, and merging with others. In thatsense, the Big Deal represented another attempt by the govern-ment tomanage the economy, despite the fact that its past effortsto do so had proved unsuccessful. The government wanted toshow visible results to its citizens and the international financialcommunity very quickly and failed to evaluate the economicbenefits of swapping assets. Many argued that this idea wasmore window dressing than a real restructuring.12 For instance,studies suggested that a merger between LG Semiconductorand Hyundai Electronics was not feasible and would create fewsynergies because of these firms’ technological and productionincompatibilities. Nonetheless, the Korean government pushedthe two companies to merge. Similarly, many also raised ques-tions over the long-term business prospects of the joint venturein aerospace. Some even suggested that all Korean firms shouldexit the aerospace industry. For power generation machinery,ship engines, and oil refineries, industry experts argued that theconsolidation of businesses would create economically ineffi-cient monopolies rather than provide economies of scale andcost efficiencies.As of December 2000, the Big Deal plan is generally re-

garded as a big failure (see Table 7.4).13 Hyundai Electronics,after acquiring LG Semiconductor, suffered from huge debtsand a plunge in the price of DRAMs. Hyundai Electronics (nowHynix) is surviving only because the government pressured

206

Table7.4.BigDealsamongchaebols

Industry

Government’splan

ImplementedasofDecember1999

ResultsasofDecember2000

Semiconductors

LGSemiconductorand

AcquisitionofLGSemiconductor

Duetothelostsynergiesandtheplunge

HyundaiElectronics

byHyundaiElectronicswas

ofpriceofDRAMs,HyundaiElectronics

mergeintoonecompany.

completedinJuly1999.

istechnicallybankrupt. Thegovernment

askedbankstobuybondsissuedby

HyundaiElectronics.

Petrochemicals,

AffiliatesofHyundai,

Aerospacebusinesseswere

Themergedcompanykeptmakinglosses.

aerospace

Daewoo,Samsungmerge

combinedintoonein

Thegovernmentprovided530billion

intoonecompany.

October1999.

wonaidsin2000.Petrochemicaldeal

didnotgothrough.

Railroad

Hyundai,Daewoo,Hanjin

Hyundai,Daewoo,Hanjin

Laborunionsofthreecompaniesopposethe

vehicle

mergetheiroperations.

mergedtheiroperations

postmergerintegrationprocess.

inOctober1999.

Overcapacityproblemdidnotease.

Thegovernmentisseekingabuyer.

Powergeneration

SamsungandHyundaiselltheir

KoreaHeavyIndustriesacquired

Doosan,the12thlargestchaebol,

machinery

businessestoKoreaHeavy

SamsungandHyundai’s

acquiredKoreaHeavyIndustries.

Industries.

business.

Shipengines

Samsungsellsitsbusinessto

Mergedasplanned.

Makingaprofit.DoosanacquiredKorea

KoreaHeavyIndustries.

HeavyIndustries

Petroleumrefinery

HyundaiacquiresHanwha

HyundaiacquiredHanwha

Postacquisitionintegrationhasyettotake

Refinery.

RefineryinJune1999.

place.

Automobile

DaewooacquiresSamsungMotors.

Dealdidnotgothrough.

Electronics

SamsungacquiresDaewooElectronics.

Dealdidnotgothrough.


banks to buy its bond issues. The combined aerospace businesshas never made money, and the government provided it with530 billion won to help it avoid bankruptcy. The railroad vehi-cle concern has suffered from labor disputes, as three separatelabor unions from the previous companies have opposed any in-tegration and rationalization efforts. The government is seekinga buyer for this combined unit. The petroleum refinery businesssuffered from similar problems. Only the ship engine businessmade amodest profit. Doosan, the twelfth largest chaebol, even-tually acquired it in 2000. Overall, it appears that politicallydriven intervention has not created economically successfuloutcomes.

enhancement of the corporategovernance system

As reviewed in the previous chapters, corporate governance inchaebols is weak. Chaebols’ founders, along with their fami-lies, have pursued their own interests at the expense of minorityshareholders. They have engaged in ill-conceived diversifiedexpansion, subsidized unprofitable affiliates, and expropriatedfunds by using inside information and other forms of subsidies.Ultimately, these practices helped precipitate the financial cri-sis in 1997. Consequently, the IMF and World Bank required areform in the corporate governance structure of Korean corpo-rations in the agreement with the Korean government.The Korean government initially seemed determined to re-

form the corporate governance structure of the chaebols andenhance corporate management transparency and accountabil-ity. As a first step to improve transparency and accountability,it required the top thirty chaebols to prepare combined financial

208

Enhancement of the Corporate Governance System

statements that are in line with international standards as ofthe 1999 financial year.14 The roles of outside directors andindependent auditors were strengthened. Independent auditorswould be punished if they failed to produce accurate informa-tion about the companies they audited. An electronic reportingsystemwas adopted and regulations on inadequate reporting forcontingent liabilities, including cross debt guarantees amongaffiliates, were strengthened.Second, the commercial laws were amended to simplify

merger and acquisitions (M&A) procedures for both friendlyand hostile M&As. In early 1998, the ceiling on foreign equityownership in a Korean firm was 55%. This ceiling was com-pletely eliminated to allow100%foreign ownership in late 1998.Also, the ownership limit by a single foreign national, which re-quires approval from the board of directors, was increased from10 to 33%. The rule on tender offers, which previously requiredthat when acquiring more than a 25% stake, one must place atender offer publicly for more than 50% plus one share, wasdeleted. Moreover, the government streamlined regulations oncorporate spin-offs and small-scale mergers. These steps to easeregulations on foreign ownership facilitated a rapid growth inforeign investment inKorean companies.Despite these changes,hostile mergers and acquisitions in Korea are unlikely due tohigh cross-ownership among affiliates of the chaebols.Third, the Korean government also required chaebols to abol-

ish their group-level staff organizations. Chaebols, however,resisted this demand and simply shifted this function to theirflagship companies. Because chaebols continued to need tocoordinate activities of group affiliates, the government’sdemand was naıve. Along with these measures, in an attempt toincrease accountability, the government persuaded the chaebol“chairmen” to assume the chief executive officer (CEO)

209


positions in individual affiliates and thus made them liable forall wrongdoing.Furthermore, to improve monitoring of top management,

listed companies were first required to appoint at lease one out-side director. Starting in 1999, these firms had to ensure thatoutside investors represented at least 25% of their boards ofdirectors.15 As a result, for the 554 companies listed on theKorea Stock Exchange (KSE) at the end of 1997, 667 outsidedirectors were selected. Since the majority of these directorswere simply appointed by the dominant shareholders, how-ever, most of them had close relationships with the dominantshareholders.16 A survey by theKSE in 2000 indicated that theseoutside directors attend fewer than 66% of board meetings andapprove over 99% of the business items presented during thesemeetings.17 Thus, this measure has brought limited change. Itwill likely be some time beforeKorea has a sophisticated outsidedirector system that helps institutional investors exert significantinfluence.In tandem with these measures, the rights of minority share-

holders stipulated by the Securities and Exchange Act havebeen slightly improved. In the past, shareholders with an eq-uity stake of 1% or larger for at least six months could fileclass action lawsuits. The representation requirement for filingclass action lawsuits against the “listed” firms was drasticallyreduced from 1 to 0.01% in May 1998. The equity thresh-old for being able to examine a firm’s accounting data wasreduced from 3 to 1%, again with the six-month holding re-quirement. Yet the government remained reluctant to furtherease the requirement for filing class action lawsuits.18 In ad-dition, it has not yet acceded to minority shareholders’ de-mand to be allowed to elect directors by accumulating votesamong themselves.19 The chaebols and their trade association,

210

Enhancement of the Corporate Governance System

the Federation of Korean Industries, have fiercely opposed thesemeasures.According to a survey conducted in 2000 on the effectiveness

of the Korea corporate governance systems, 98.5% of foreignfundmanagers and 77% of domestic fundmanagers believe thatKorean companies still suffer from transparency problems, and93.9% of foreign fund managers and 77% of domestic fundmanagers contended that Korean companies fail to serve theinterests of shareholders.20 Ninety-seven percent of foreign fundmanagers and 77% of domestic fund managers demanded theimmediate introduction of class action lawsuit reforms, as wellas the right to accumulate votes. These results suggest that thecorporate government systems are not yet effective.The fourth investigation by theKorea Fair TradeCommission

on internal business trade in the four largest chaebols, whichwasconducted in December 2000, shows that chaebols had not re-duced their unfair internal business trade practices such as sub-sidizing other affiliates or transferring wealth to chaebol familymembers, even after they paid huge fines ensuing from the firstthree investigations (see Table 4.3).21 The total amount of unfairbusiness trade and estimated amount of subsidies amounted to2,463 billion won and 126 billion won, respectively. Chaebolshave become much more sophisticated in how they subsidizeaffiliates than they were during the first three investigations.Rather than using their own financial services affiliates, chae-bols deposited funds into unaffiliated financial institutions andlet them lendmoney to thefinanciallyweak affiliates at favorableterms while using these deposits as collateral. Also, in severalcases, listed companies transferred wealth to chaebol families.For instance, LG Chemical and LG Telecom, both of which arelisted firms, sold shares of unlisted affiliates at low prices toseveral chaebol family members. The Fair Trade Commission

211


estimates that these sales thereby expropriated 146 billion wonfrom minority shareholders.22

Overall, the corporate governance systems in Korea need tobe improved considerably. In the face of fierce resistance fromchaebols, the government has been lax in initiating legislationon class action lawsuits and accumulating votes. Quicker actionis required to protect the interests of minority shareholders.

perspectives on the restructuringof chaebols

This chapter evaluated the restructuring efforts of chaebols. Itshould be noted that these efforts were engineered and forcedby the government. After the crisis, the government rescued thefinancial services industry and used it as a vehicle to restructurechaebols. In other countries, market forces have driven similarrestructuring efforts. For instance, the extensive corporate re-structuring activities ofU.S. companies in the 1980swere drivenby increased competition from overseas and hostile takeover ac-tivities by corporate raiders (Bowman et al., 1999). Many cor-porations, including most conglomerates, divested their unre-lated businesses and focused on their core competencies (Chang,1996). We will examine such market-driven efforts in othercountries in Chapter 8.In a sense, the restructuring of chaebols shows some inter-

esting parallels to the dissolution of zaibatsu after World WarII.23 To avoid resurrection of Japanese imperialism, GeneralMcArthur formally dissolved the zaibatsu into many indepen-dent firms (Hadley, 1970). After the occupation ended, how-ever, the firms rebuilt their network linkages, though in a lesscentralized fashion, into keiretsu. Although the zaibatsu reform

212

Perspectives on the Restructuring of Chaebols

resulted in removing the founding family entirely, the ex-zaibatsu firms simply regrouped voluntarily by exchangingshares and pooling resources. As a consequence, the internaloperations of keiretsu remain a closed system, although directcontrol over individual affiliates has been weakened in compar-ison with the pre-war zaibatsu. The chaebol reforms in Koreawere triggeredby the collapse of theKorean economyand forcedby the IMF and World Bank. The Korean government followedtheir guidelines rather closely to escape the default risk. TheJapanese experience, however, illustrates the limitation of cor-porate restructuring initiated by external forces.The chaebol restructuring program consisted of three com-

ponents: (1) restructuring business to produce visible resultsover the short term, (2) revising financial structures to improveresults in the next few years, and (3) strengthening corporategovernance mechanisms to induce long-run stability. Businessrestructuring was a complete failure in that it created no effi-ciency gains. It was driven by politicians’ desire to show im-mediate results rather than by sound economic rationales. Onthe other hand, the government’s effort to reduce debts and re-move debt guarantee practices showed some visible results: asof 2000, chaebols reduced their debt–equity ratios substantiallyand eliminated almost all the mutual debt guarantees. In part,however, they did so by revaluing their assets and increasingcross-shareholding. Furthermore, the government’s efforts to re-structure companies through bank-sponsoredworkout programsresulted in miserable failures. The banks merely extended thelives of already bankrupt companies.Although the government worked very hard to achieve re-

sults through business restructuring and financial restructuring,it did not put much effort into improving corporate governancesystems, which are less visible but can be potentially more

213


important in the long run. Although there was some improve-ment in the underlying legal framework, the current systemstill favors large shareholders in many respects, and the gov-ernment is reluctant to introduce rules for broader protectionof minority shareholders such as class action lawsuits and ag-glomeration of votes. It is likely that many problems aris-ing from the Korean chaebols can be addressed over the longrun only after the government strengthens these mechanismsfurther.Rather, the real force behind the further restructuring of chae-

bols is the shareholder activist. Since 1998, the People’s Solidar-ity for ParticipatoryDemocracy, a nongovernment organization,has coordinated minority shareholders and foreign institutionalinvestors. It filed a lawsuit against explicit cases of expropri-ation such as those in Samsung Electronics and SK Telecom(see Chapter 6) and exercised rights of minority sharehold-ers at annual general shareholders’ meetings.24 Such effortspressure the government to make changes in the legal frame-work that hold chaebols for their behavior. In the case of SKTelecom, foreign investors such as the Tiger Fund collaboratedwith domestic minority shareholders to wage a proxy fight inthe general shareholders’ meeting. They obtained the right toappoint two outside directors. SK’s founding family agreed togive these directors the authority to approve internal transactionsabove a certain amount. The People’s Solidarity for Participa-tory Democracy also caused a stir at the general shareholders’meeting of Samsung Electronics over the company’s unfair in-ternal transactions. Backed by the nongovernmental organiza-tions’ (NGOs’) movement to reinforce the rights of minorityshareholders, the further strengthening of the legal frameworkwill improve corporate governance and further prompt restruc-turing of the chaebols.

214

Perspectives on the Restructuring of Chaebols

After being bailed out by the IMF, the Korean governmentcarried out various programs to restructure Korea’s financialinstitutions. It also aggressively intervened to restructure chae-bols, which is ironic because previous governmental regimeshad originally initiated and subsidized chaebols’ developmentand growth. In this chapter, we can conclude that the success ofthese efforts was limited for two related reasons. First, the gov-ernment, rather than market forces, initiated these efforts. Sec-ond, these efforts did not fully address the fundamental problemsin chaebols’ corporate governance. The analysis of this chapterleads us to conclude that the earnest restructuring of chaebolsshould begin with improvements in the corporate governancesystem.

215

8

Conclusion

217

The Crisis and the Fall of Chaebols: A Summary

the crisis and the fall of chaebols:a summary

The Financial Crisis as a System Failure

This book began by posing several questions about the financialcrisis that hit Korea in 1997. Twelve of the top thirty chaebolsand Korea as a whole went technically bankrupt at this time.Foreign and domestic observers were amazed by such a spec-tacular collapse, as the Korean economy had been praised as theexemplar of economic development. Several plausible causesfor the crisis have been raised: currency speculation, inadequategovernment policies, and heavily indebted chaebols.Are chaebols the main culprit of the crisis? In a capitalist

society, there are always some companies that go bankrupt.Schumpeter (1937) called this process, by which ineffi-cient firms are replaced by new innovative firms, “creativedestruction.” Although chaebols’ performance had deterioratedthroughout the 1990s, it is astonishing not only that none wentbankrupt prior to the crisis but also that all went bankrupt duringand after the crisis. The analysis in this book showed that tech-nically bankrupt chaebols stayed solvent only through cross-subsidization and government intervention. To the extent thegovernment propped up failing chaebols, is it to blame for im-peding the orderly exit of already failed companies? Further,why did the international financial community advance loans tochaebols, knowing that they were heavily indebted? Why didforeign investors suddenly recall the loans?By highlighting the interrelationships between chaebols, the

Korean government, and foreign investors, this book has shownthat the financial crisis was a systematic problem for whichall these parties were to blame. Although the government pro-claimed a policy of economic liberalization, it continued to push

219

Conclusion

banks to make guaranteed loans to chaebols. As a consequence,it createdmoral hazards for chaebols and banks.Moreover, therewere no governance mechanisms for monitoring chaebols’ in-vestment activities. Chaebols’ ownership of nonbank financialservices institutions further jeopardized the capital market dis-cipline of firms’ investment decisions. Chaebols collapsed onlywhen foreign investors and creditors suddenly realized that theKorean government could neither credibly guarantee loans anylonger nor manage the economy as it had in the past.Nonetheless, chaebols were financially vulnerable. If not for

the crisis in 1997, their performance would have declined con-tinuously and the Korean economy might have had an extendeddepression. Although the financial crisis dramatically exposedthe weaknesses of chaebols and the Korean economy, some sortof crisis was probably inevitable.

Structural Inertia of Chaebols

The system failure denotes that the developmental state andthe chaebols, two main pillars of the Korean economy, becameno longer viable to the environments they faced in the 1990s.Both the government and chaebols showed enormous inertiato the changes brought about by economic success, deregula-tion, global competition, and the influx of foreign capital. Asthe economy developed, the private sector became too com-plicated for government bureaucrats to control. Global com-petition intensified, and other countries and international in-stitutions pressured Korea to reduce its trade barriers. Foreigncapital could swiftly move in and out of countries. State bureau-crats became paralyzed. The structures of chaebols, which wereoptimal for Korea’s economic environment during the period

220


of economic development and were the sources of competi-tive advantages, inhibited adaptation, and became dysfunctionalwhen the environment changed. The absence of effective gov-ernance mechanisms during the transition period further exac-erbated this inertia.Chaebols’ diversified business structure was geared to gen-

erate operating synergies by sharing financial and intangible re-sources such as brands, technology, and know-how embeddedin human resources among affiliates. Such sharing was possibleonly because of chaebols’ centralized organizational structure.Yet this strength was also a weakness because there was no wayto guard against the ill-considered strategies of chaebol chair-men, who had the final say in resource allocation and diver-sification decisions. Further, these chairmen cross-subsidizedunprofitable affiliates and diverted profits to affiliates in whichthey and their families owned large equity stakes. All these ac-tivities wasted the synergies created through resource sharing.Moreover, because the chaebols’ chairmanship was inheritedwithin families, there was no opportunity to change the courseof action (i.e., strategic reorientation). These problems mightexplain chaebols’ continued pursuit of unrelated diversificationeven during the economic declines of the 1990s.Chaebols also used vertical integration extensively. Within

chaebols, many small affiliates supplied parts and intermediategoods to the affiliates that assembled final products. Chaebolshad to integrate vertically when the government pushed theminto the heavy equipment and chemical industries when othersupporting industries were underdeveloped. Although verticalintegrationmight have eliminated transactions costs in acquiringnecessary parts and services from imperfect markets, especiallyduring periods of rapid economic growth, it also made chaebols

221

Conclusion

increasingly inefficient and inflexible because it did not giveenough incentives to firms in upstream operations to be innova-tive and cost-effective and prohibited assemblers from switch-ing suppliers. Furthermore, intricate webs of cross-ownershipand debt guarantees made buying goods from external suppliersdifficult. Assemblers had to support unprofitable affiliates bycross-subsidizing them.The overall capital structure of chaebols shows another aspect

of inertia. Chaebols favored debt to equity financing becauseit enabled chaebol families to maintain their controlling stakeseven as their empires grew too large for them to infuse additionalequity. We observed that two mechanisms served to maximizethe amount of debts they could carry. One was to have their ownin-house financial affiliates and the other was to use mutualdebt guarantees. The former became a major source of capitalafter the government deregulated the financial service industryin the 1980s. The mutual debt guarantees increased affiliates’debt levels to unsustainable levels. As a consequence of debtguarantees, chaebol affiliates became tightly coupled with eachother so that a bankruptcy of one affiliate would lead to the col-lapse of the entire group. These guarantees impeded the exit ofunprofitable affiliates because their guarantors became liable fortheir debts. They thus also stifled investment in more promisingaffiliates.Chaebols’ ownership and governance structure was a fur-

ther source of inertia. Cross-ownership was devised to ensurethe controlling ownership stake of chaebol families. It artifi-cially inflated ownership stakes controlled by affiliates’ compa-nies and insulated them from capital market control. Further,no corporate governance systems functioned to prevent ill-conceived strategies or even explicit cases of expropriation.

222


Limitations of the Crisis-Driven Transformation

This book also examined the various restructuring programsimposed on chaebols after the crisis. The government tried tonarrow the chaebols’ business focus by ordering them to swapbusinesses, reduce their debt–equity ratios, and eliminate theirdebt guarantee practices. Such reforms had only limited success:the so-called Big Deal failed when chaebols resisted it. Eventhough several mergers were completed, the combined entitiesremained uncompetitive because there was no sincere effort toreduce overcapacity. The government’s effort to force chaebolsto reduce debt–equity ratios was hindered after chaebols merelyrevalued their assets and bought new equity issues by otheraffiliates. The government was successful only in eliminatingthe debt guarantee practices.The restructuring of chaebols indicates the limitations of such

reforms when there are no changes in underlying institutionalarrangements. Such forced changes are analogous to the ordersthat dissolved the zaibatsu after World War II. Although theSupreme Command of the Occupation Force succeeded in tak-ing ownership away from zaibatsu families, former zaibatsu af-filiates voluntarily formed keiretsu afterU.S. forces left Japan. Incontrast, the restructuring of conglomerates in the United Stateswas initiated from within these organizations. Conglomerates’managers and boards accepted the financial conception of con-trol, which ultimately led to changes in their strategy (Fligstein,1990). The Korean experience demonstrates that furtherrestructuring of chaebols entails changes in the institutionalenvironments facing them, especially changes that improvecorporate governance systems. The fact that the most effectivemeans of controlling chaebols’ power to date was enacting theFair Trade Act provides additional support for this argument.

223

Conclusion

business groups in other countries

As we pointed out earlier, chaebols are not unique to Korea.Business groups like chaebols are found worldwide. They in-clude conglomerates in Western countries, keiretsu in Japan,and grupos economicos in Latin American countries. Althoughmany of these business groups are currently doing poorly, busi-ness groups are not likely to disappear in the near future. Thissection will examine this trend and the reasons behind it.

Conglomerates in the United States and Europe

During the 1980s, many U.S. firms dramatically changed theircorporate strategies. In the 1960s, many large U.S. firms hadaggressively pursued growth through unrelated diversification,mainly through mergers and acquisitions. In the 1980s, corpo-rate raiders took over many of these conglomerates and divestedmost of their holdings. Still other firms reversed their diversifica-tion strategy by selling off unrelated business units and focusingon their core businesses (Markides, 1990; Chang, 1996).1

Fligstein (1990) described the U.S. corporate restructuringin the 1980s as a crisis in the market for corporate control, justas the financial crisis in Korea was a crisis in the governancesystem. He argued that this period of restructuring reflectedinvestors’ more aggressive use of capital markets to wrest con-trol from the managers of poorly performing firms. Accord-ing to him, high inflation during the 1970s pushed up interestrates and depressed returns on investments. Furthermore, for-eign competitors penetrated U.S. firms’ market and challengedtheir home base. U.S. companies had to focus their resources oncore businesses to improve profitability.2 Managers, however,failed to comply with investors’ demands.

224

Business Groups in Other Countries

Investors wanted to gain control in two ways. First, some in-vestors, termed corporate raiders, engaged in hostile takeovers,in which they fired managers of firms that were doing poorly.New financial instruments such as junk bonds, which carry highrisk andhigh returns, contributed to the increasednumber of hos-tile takeovers.3 Second, the influence of institutional investorssuch as pension funds andmutual funds,which became the dom-inant owners of listed companies, on top management becamestronger. CEOs of firms such as K-Mart, GM, Philip Morris,and W. R. Grace did not pay attention to institutional investors’demands and were replaced. Other managers, paying heed tothis trend, worked hard to restructure their firms, enhance ef-ficiency, and improve profitability to keep their jobs. Overall,increased international competition and an activemarket for cor-porate control have effectively limited careless diversification byU.S. firms.European conglomerates also refocused on their core busi-

nesses and divested unrelated concerns in the 1990s. For in-stance, when Schrempf became CEO of Daimler Benz in 1995,he liquidated many poorly performing unrelated businesses andrestructured the remaining business divisions under the bannerof “transportation-related konzern.”4 A French conglomerate,CGE, sold nonrelated businesses and decided to focus on watermanagement and telecommunications. It altered the companyname in 1998 to Vivendi to reflect its new strategic focus and tomake it easy for foreign investors to pronounce its name. Again,these conglomerates in Europe were in crisis.The factors that led to these firms shifting their strategies

are the same as those that influenced U.S. conglomerates.First, competition from both firms inside Europe and Americanand Japanese companies increased.5 As once-heterogeneousEuropean markets, which used different distribution channels

225

Conclusion

and pricing schemes, were integrated, firms throughout Europehad to improve their competitiveness by merging with othercompanies and thereby tapping economies of scale. The intro-duction of the Euro hastened integration and increased com-petition. Firms had to divest unrelated businesses to generatecapital and free managers to focus on their core businesses.Second, increased pressure from capital markets facilitated thistrend (Useem, 1998). In the past, European corporations feltlittle pressure from investors. In Germany, banks have pos-sessed large stakes in big conglomerates and exercised votingrights on behalf of other shareholders. As a consequence, hos-tile takeovers have been almost impossible. In France, cross-shareholding among conglomerates eliminated the possibility ofa hostile takeover. Cross-shareholding among European compa-nies, however, has been declining. Institutional investors, espe-cially U.S. institutional investors, have filled the gap generatedby weakened cross-shareholding. For example, foreign invest-ment in the French stock market in 1997 accounted for approx-imately 35% of this market’s total capital, and U.S. institutionalinvestors such as CalPERS and Fidelity had purchased substan-tial portions of French companies. These investors have initiatedhigher standards for performance, thereby increasing the pres-sure on European managers to focus only on core businesses.In addition, European firms are now more willing to attempt

hostile takeovers of other firms. The much-publicized case ofVodafone’s takeover of Mannesmann is but one prominent ex-ample of this trend.6 Top managers in European firms clearlyhave strong incentives to enhance their firms’ performance.Another new development in European capital markets in the1990s, somewhat different from events in the United States dur-ing the 1980s, is the creation of new capital markets domi-nated by high-tech companies. New capital markets modeled

226


after the NASDAQ (National Association of Securities DealersAutomated Quotation), such as Neuer Markt of Germany andNeuveau Marche in France, were opened in Europe. Theyhave attracted large sums of capital and thereby created short-ages of capital for incumbent listed companies on conventionalexchanges.Overall, the factors that have forced U.S. and European con-

glomerates to restructure are very similar to each other. Yet GE,Daimler Benz, and Vivendi are still vastly diversified, and itis premature to announce the demise of conglomerates in theUnited States and Europe.7 Furthermore, significant legal andsocial barriers inhibit European firms’ latitude to sell off or closedown divisions.8 Nevertheless, unsuccessful conglomerates thathave no clear reason for combining unrelated businesses underone corporate umbrella clearly are no longer in vogue in eitherthe United States or Europe.

Keiretsu Network in Japan

As briefly discussed in Chapter 1, the keiretsu is a voluntaryassociation of corporations that was established to replace theprewar zaibatsu.9 Affiliatesmaintain theirmembership by cross-shareholding, exchanges of executive officers, internal trade,and joint investment. Thus, the keiretsu remains a closed sys-tem with favorable business relationships among insiders. In1992, intra-keiretsu trade was as high as 38.7%, meaning thatsome keiretsu engaged as extensively in intragroup trade as didchaebols.10 In the late 1990s, however, there were signs that thekeiretsu systemwas in crisis. Japanesebanks, the core of this sys-tem, began having financial problems because of the Japaneserecession and the collapse of real estate markets in Japan andelsewhere. As the major sources of capital to affiliates, keiretsu

227

Conclusion

banks had made many loans to affiliates that the affiliates couldno longer repay. Banks began to merge with other banks asso-ciated with other keiretsu to survive. For example, MitsubishiBank, hit by its own investments in the real estate market and bythe cost of rescuing its affiliates such as Mitsubishi Real Estatesand Nippon Trust, including the bankruptcy of RockerfellerCenter, tried to overcome its financial crisis by merging with theBank of Tokyo.11 Similarly, the Industrial Bank of Japan, FujiBank, and Daiichi Kangyo Bank, the three pillars of three sepa-rate keiretsu, merged in 1999 in a restructuring attempt. In addi-tion, Sumitomo Bank and Sakura Bank of Mitsui Group, whichresulted from amerger ofMitsui, Taiyo, andKobeBank in 1989,announced their merger in 2000. Because of these mergers, thekeiretsu system is losing its most important building block.In addition, nonbank affiliates in a keiretsu are now form-

ing alliances or merging with affiliates of other keiretsu to in-crease their competitiveness and reduce overcapacity, thus fur-ther weakening the keiretsu system. Another source of the crisiswas foreign, in particular the U.S. pressure to break open theprocurement arrangements of keiretsu, to open up financial mar-kets, and to allow the market for corporate control to operate. In1998, Nikko Securities of Mitsubishi Group sold one-fourth ofits shares to CitiCorp without consulting its affiliates. In 2000,Nissan and Mitsubishi Motors transferred their controllingshares toRenault andChrysler, respectively. Furthermore, cross-keiretsu mergers, as exemplified by the mergers of SumitomoChemical and Mitsui Chemical, and Mitsubishi Oil and NipponOil, are also becoming more common.As in theUnited States and Europe, intensified global compe-

tition and a crisis in the financial service sector is driving thesechanges. In the past, keiretsu affiliates were profitable becausethey received favorable exchange terms from their affiliates.

228


This inward-looking attitude and closed system, however, couldnot deal with either the changing demands of customers or ac-tive competition. Globalization exposed the vulnerability of thissystem when some affiliates in a keiretsu were not doing welland needed help.12 It is nonetheless premature to announce thedeath of the keiretsu system.13 Although the level of cross-shareholding by affiliates has decreased significantly since theearly 1990s, it still averaged 38% in 1999.14 Yet given the de-velopments discussed here, the keiretsu systemwill likely neverbe as closed as it used to be.

Business Groups in the Developing Countries

As mentioned in Chapter 1, business groups similar to chaebolsare often found in developing countries, where market imper-fections provide ample opportunity for business groups to createvalue by internalizing resource allocation (Leff, 1978). Variousgovernment interventions such as export-promotion and import-substitution, which further distort these imperfect markets, pro-vide additional ground for business groups to grow (Amsden,1989; Kim, 1997; Guillen, 2000). There is little evidence thatbusiness groups are dismantling in other developing countries,whatever the effects of the recent economic and financial crises.Business groups will thrive so long as they can capitalize onmarket imperfection and government intervention. In this re-gard, events in Spain and Chile, where some business groupswere disbanded, provide insight into how business groups willbe changed as markets develop and government interventionsdiminish.Although Spain is a developed country, it experienced the

decline of business groups when economic liberalization oc-curred there during the 1970s. Under Franco, the government

229

Conclusion

implemented various foreign exchange controls and protection-ist measures. This economic environment provided a basis forbusiness groups to grow because it prohibited natural flows offoreign capital and technology and favored those who alreadyhad contacts in government, local businesses, and banks. Asa consequence, several business groups were formed aroundbanks and large industrial companies. Spain was hit hard, how-ever, by the oil crises and the subsequent downturns in the 1970s,and many Spanish business groups became financially weak.When Spain joined the European Union and removed its re-strictions on trade and foreign investment, these groups facedintense competition. Under these pressures, some groups col-lapsed. Others succeeded in refocusing their core businesses orwere acquired by foreignmultinationals. By themid 1990s, onlya few business groups, which had focused around banks such asBCH and BBV or large retailers (El Corte Ingles), had survived(Guillen, 2001).Postcrisis Chile provides another example of groups volun-

tarily disbanding. After experiencing a financial crisis in 1981,the Chilean government privatized banks by selling them to for-eign investors. As a consequence, Chile built the most sophis-ticated capital market among Latin American countries. Thiswell-developed capitalmarket affected the operations ofChileanbusiness groups. As financial markets develop, however, busi-ness groups have less opportunity to create value by using inter-nal capital markets to share resources among affiliates.15 Fur-ther, after the 1981 foreign currency crisis, Chile’s governmenthas prevented the pension funds from subsidizing their affiliates.In addition, several Chilean companies successfully raised cap-ital from the global capital market by issuing ADR (Americandepository receipts). As a result, some groups such as CompanıaAcero del Pacifico (CAP) voluntarily dismantled themselves.16

230

The Taming of Chaebols

Other business groups in Chile that shared managerial talentand technology as well as financial capital still survive. Thisdifference in approaches suggests that efficient sharing of man-agement resources is the sine qua non of business groups.Whenbusiness groups no longer create value by sharing resourcesamong affiliates, they have no reason to exist. The CAP casemay be an isolated instance, however, of voluntary disbanding.

the taming of chaebols

Our examination of business groups throughout theworld showssome important trends; First, business groups can create valueby internalizing transactions only to the extent that markets, es-pecially capital markets, are not well developed. The marketsfor some intangible resources such as technology, brands, andmanagement know-howare inherently imperfect, thus providingopportunities for business groups to prosper even in developedcountries. Second, as a government loosens restrictions on in-ternational trade and investment, business groups are subject tointense international competition and become less viable. Asglobalization has increased international competition and en-sured free flows of capital across borders, it has been a keyunderlying cause for these trends. Korea has become subjectto these forces, and the power of its government has declinedaccordingly. We will examine various external and internal fac-tors that force chaebols to restructure further.

Foreign Investors and Creditors

Foreign investors and creditors will be an important forcethat will force chaebols to restructure further. Fligstein (2001)pointed out that exogenous forces often cause economic crises

231

Conclusion

and transformations of markets. Sociologists view markets associal constructions that reflect the unique political–cultural ar-rangements of their firms and nations (White, 1981; Fligstein,1990; Granovetter, 1995).17 According to Fligstein, a marketbecomes unsettled and creates the possibility for a crisis whenforeign trade arrives with a new concept of control. Incumbentlocal firms will resist the new concept of control that threatenstheir own interests. When they can no longer resist it, the na-tional market becomes absorbed into the international marketas firms adopt this new concept of control. This adoption can bevoluntary or involuntary (Meyer et al., 1997). The concepts offinancial control, shareholder value, and a market for corporatecontrol are becoming diffused worldwide as foreign investmentincreases (Useem, 1996).The United States at the beginning of the twentieth century is

one example of how foreign capital led to a voluntary changein the governance system.18 At that time, the United States wasa debtor nation with an enormous demand for capital to de-velop capital-intensive industries such as railroads. A large por-tion of this capital came from foreign investors. At that time,the expropriation of minority shareholders and manipulation ofstock prices were prevalent. Robber barons such as Jay Gouldand Commodore Vanderbilt even bribed judges for favorableinjunctions regarding control over the Erie Railroad.19 Giventhese legally primitive conditions and the need to attract foreigncapital, investment bankers placed one or more representativeson the stock issuers’ boards. Such self-regulation assured for-eign investors that their investments were safe, and showed thatdemand for foreign capital could itself initiate a new governancesystem.Foreign investors can also institute coercive changes in gov-

ernance systems. Institutional investors, who ushered in the

232


decline of U.S. and European conglomerates, have expandedtheir portfolio of foreign stock. For instance, in Korea, foreignownership increased to 27% of the total market capitalizationin 1999. As discussed in Chapter 7, this increase has led togreater shareholder activism. Foreign investors have both ac-tively monitored performance and worked with domestic share-holder activists such as People’s Solidarity for ParticipatoryDemocracy to file lawsuits against chaebols, as we discussed inChapter 7.We expect that the global integration of financial markets will

continue and that countries will become more subject to the in-fluence of foreign capital. Table 8.1 shows that the inflow of for-eign capital increased sharply during the 1990s. We also expectthat the increasing influence of foreign capital will entail mea-sures to ensure that such investments are safe and that those whowish to attract foreign capital will come up with ways to meetthose demands. Even in developed countries, there is move-ment toward cross-national stock exchanges, increased activityby securities analysts, convergence of international accountingstandards, and international waves of mergers and acquisitions.If the globalization of financial markets continues, local firmswill have to adopt international accounting standards, whichwill ensure more transparency (Jang, 2001).

Strengthened Banks and Local Capital Markets

Although the previous section argued that foreign investors andcreditors will drive the further restructuring of chaebols, it doesnot imply that Korea’s banking system, which was modeled af-ter those of Germany and Japan, will not vanish overnight. MostKoreans still deposit their savings in banks, and Korean corpo-rations rely mainly on bank loans to conduct businesses. These

233

Table8.1.Financialflowtolowandmediumincomecountries

Bondportfolio

Equityportfolio

Netprivatecapital

Foreigndirect

investment

investmentflow

Bankandtrade-related

flow($billion)

investment($billion)

flow($billion)

($billion)

lending($billion)

1990

1999

1990

1999

1990

1999

1990

1999

1990

1999

EastAsia&

19.4

51.1

11.1

56.0

1.2

1.1

2.3

21.1

6.8

−27.2

Pacific

Europe&

7.6

43.2

1.1

26.5

−0.8

6.2

0.2

3.6

4.5

6.9

CentralAsia

LatinAmerica&

12.6

111.4

8.2

90.4

1.9

19.1

1.1

3.9

3.2

−2.0

Caribbean

MiddleEast&

0.4

1.0

2.5

1.5

0.1

0.2

00.7

−2.0

−1.3

NorthAfrica

SouthAsia

2.2

2.1

0.5

3.1

−0.1

−1.2

0.1

1.3

1.5

−1.1

Sub-Saharan

1.4

10.5

0.9

7.9

0.1

0.2

0.0

3.9

0.5

−1.6

Africa

Total

43.6

219.1

24.3

185.4

1.2

25.4

3.7

34.5

14.5

−26.2

Source:WorldBank,WorldDevelopmentIndicators,2001.


relationships will last for a while. Further, Rajan and Zingales(1998b) argued that the arm’s length, market-based financialsystem is not necessarily superior to the relation-based financialsystem, especially when there is a shortage of capital.As we examined in Chapter 7, most Korean banks went tech-

nically bankrupt during the crisis. The government infusedmas-sive public funds to revive them.As a result, it became the largestshareholder in many commercial banks. By the end of 2001, ithad used this leverage to force banks to merge with each other.For instance, it was able to compel Kookmin Bank, a leadingbank with a relatively sound balance sheet, to merge with theLong-term Credit Bank in 1999 and with Housing and Com-mercial Bank, another bank with a sound balance sheet, in 2001because of its large shareholdings in all three banks. The ratio-nale for this merger was to create a strong, large bank that couldeffect operational economies of scale and improve the quality ofits credit analysis. The government expected this merger to pro-voke voluntary mergers by the remaining commercial banks.If such consolidation continues to takes place, there will beonly a few large banks left in Korea. These remaining bankscan potentially have a stronger position when bargaining withthe chaebols and thereby better monitor chaebols’ investmentactivity.Furthermore, foreign banks operating in Korea will diffuse

advanced banking practices to the banking industry in Korea.Cheil Bank,whichwas sold toNewbridgeCapital, remains inde-pendent from the government’s pressure to provide extra loansto Hynix Semiconductor, as mentioned in Chapter 7. Citibankand Hong Kong Shanghai Bank are expanding their retail bankpractices in Korea. The intensified competition between foreignbanks and large local banks will further develop the local capitalmarkets.

235

Conclusion

Another important structural change in the Korean capi-tal market has been the relative decline in importance of theKorean StockExchange, a conventional exchange for “brick andmortar” firms that is similar to the New York Stock Exchange(NYSE), and the emergence of KOSDAQ (Korea SecuritiesDealers Automated Quotation), a Korean version of NASDAQfounded in 1996 that is designed for small start-ups and tech-nology firms. The rise of KOSDAQ induced many talented en-gineers and managers to leave established companies, mostlychaebols, to set up their own ventures. This exodus would havebeen unthinkable in the past.20 Venture capital firms andwealthyindividuals were eager to fund ex-chaebol employees. These in-frastructures will facilitate start-ups and spur innovations (Kim,1996). Koreans joke that start-ups, not the government, restruc-tured chaebols. If this phenomenon continues, Korean chaebolswill no longer enjoy a monopoly position in securing fundsor talent. Under this scenario, especially in light of the otherdevelopments we have discussed, the chaebol’s economic sig-nificance will decrease further.Globalization can also create internal sources of change.

For instance, shareholder activism has become a global phe-nomenon, as shareholders from all countries, including Korea,demand transparency and higher returns (Davis and Thompson,1994; Useem, 1996).21 The People’s Solidarity for ParticipatoryDemocracy is but one example of home-grownactivistswhowillspur changes in governance mechanisms.

Increased International Competitionin Local Markets

Chaebols are also facing tougher competition both domesti-cally and internationally. In the past, chaebols had practical

236


monopoly in many markets in Korea. The government aggres-sively blocked imports and protected the domestic market. Re-cently, however, the Fair Trade Commission in Korea has ac-tively policed chaebols’ predatory behavior against domesticcompetitors and, as discussed in Chapter 4, has investigatedchaebols’ cross-subsidization practices.At the same time,Koreais removing trade and investment barriers to comply with theIMF’s conditions for relief. For instance, Japanese auto andelectronics manufacturers are now able to sell their productsin Korea. The U.S. government has asked the Korean govern-ment to reform its tax scheme to be more favorable to U.S. cars.Furthermore, chaebols’ aggressive price cutting in internationalmarkets, often dubbed “dumping,” is increasingly difficult topractice due to the World Trade Organization’s rules.At the same time, many financially troubled companies were

sold to foreign multinationals during the crisis. Philips acquiredLG Group’s LCD business, and Volvo acquired Samsung’sheavy equipment business. Renault and GM acquired SamsungMotors and Daewoo Motors, respectively. Such acquisitionswill spur intensified competition in Korea. As a consequence,Hyundai,which acquiredKia, has to focus on its car business andrefrain from diversifying into unrelated businesses. The overallimpact of intensified international competition will force chae-bols to reduce unrelated diversification and to focus on a fewcompetencies.

The Government

After the crisis, there have been several attempts to remove barri-ers to international competition. There have also been some im-provements in financial transparency and corporate governance.The Korean government announced that it would allow class

237

Conclusion

action lawsuits from 2002 onward. Initially, firms with morethan 2 trillion won in assets are subject to this law. The gov-ernment plans to allow shareholders to file class action lawsuitsagainst all public firms in the near future. In addition, the gov-ernment suspended the licenses of several accounting firms thathelped chaebols manipulate accounting; this action sent clearsignals to other auditors. The Korea Fair Trade Commissionhas played a key role in restraining chaebols’ expansion. Itscontinued investigation of unfair business practices of chaebolshelped restrain chaebols’ cross-subsidization practices. Its reg-ulation of cross-shareholding has also blocked chaebols fromcontrolling affiliates without real infusion of capital. Contin-ued enforcement of such regulations will help reduce explicitexpropriation of minority shareholders and subsidies to poorlyperforming affiliates.

the future of chaebols and thedevelopmental state

Next, wewill draw implications for business groups and the eco-nomicmodel of the developing state in the light of globalization.

The Future of Chaebols

Because we believe chaebols are creatures of market imper-fections and government intervention, we argue that, as theseforces diminish, chaebols will decline in the long run. TheKorean financial market has undergone big changes. Institu-tional investors, especially foreign ones, have assumed biggerroles in the Korean capital market. Korean companies increas-ingly list their shares in the foreign stock market. Both trends

238

The Future of Chaebols and the Developmental State

have increased outsiders’ influence on chaebols. Shareholderactivism and stricter enforcement of the Fair Trade Act will alsomake practices such as cross-subsidization more difficult. Atthe same time, increased market competition will force chae-bols to focus upon their core businesses.Chaebols and business groups in other countries will not,

however, disband overnight. It takes time to build institutionsand for the effects of competition to be felt. As institutional andmarket forces diffuse, business groups can survive or even pros-per by focusing on sharing resources for which markets are stillimperfect, such as human resources, brands, and technology. Ifbusiness groups evolve in that direction, chaebols in themediumtermmay bemore or less like Japanese keiretsu, loosely coupledand voluntarily cooperating on a few investment projects whenthere is mutual strategic advantage in doing so.In the meantime, the revamping of the corporate governance

systems in Korea will unleash the power of professional man-agers. The dramatic economic growth of Korea was based onmore than the few entrepreneurs who founded chaebols and theelite group of government bureaucrats. It was also attributableto hardworking Korean workers andmanagers. The recent crisisshowed that much of their effort has been wasted due to chaebolchairmen’s ill-conceived strategies. Although there were manycompetent managers in chaebol affiliates, they could not fullyutilize their managerial expertise because they were given onlyoperational responsibilities in business divisions. The improvedcorporate governance system will limit the power of chaebolchairmen and enable these professional managers to use theirstrategic acumen.For instance, professional managers can introduce market

discipline into the groups’ internal markets. Although business

239

Conclusion

groups in other countries actively share resources and tradeamong their divisions, their interdivisional transfer prices reflectmarket prices. Professional managers whose performance in-centives are tied to their divisional performance cannot favortheir affiliates against their outside customers. The introductionof market-based internal transfer-pricing will instill disciplineinto the internal markets, thereby ending the perennial cross-subsidizationwithin the chaebols. The key challenge to avoidinganother crisis and ensuring chaebols’ further successwill be howto maintain discipline in tapping internal markets while creat-ing synergies from them. The resource sharing within chaebolshas been the reason for their existence. It was, however, easyto lose discipline and let cross-subsidization proliferate with-out control. In addition, allowing greater freedom to profes-sional managers will further encourage the creativity of Koreanworkers.Some chaebol families have already initiated changes.

Doosan Group, the fourteenth largest group as of 1996, under-took serious restructuring before the Asian crisis hit the countryand other chaebols. It hired a foreign consulting company andturned the group around by selling underperforming businessesto foreign investors. Had it not been proactive, Doosan Groupcould have been the first casualty of the crisis.Another mechanism for proactive change may stem from the

chaebols’ efforts to access capital from foreignmarkets. SeveralKorean companies, including Korea Telecom, Hyundai Motors,and Samsung Electronics, have listed their stocks in foreignmarkets, especially by issuing ADRs.22 This voluntary listingmeans that these firms have adopted governance and contractualreforms that require them to make more transparent accountinginformation available to the general public.

240


Implications for the Developmental State

The previous discussion leads us to conclude that globalizationwill continue and financial markets will be increasingly subjectto international scrutiny. These trends give rise to several ques-tions.What is the government’s role under these circumstances?Should the government just leave everything to the markets?How can other emerging countries have a smoother transitionto a market-based economy while avoiding a similar crisis? LaPorta et al. (1998) argue that deep and liquid securities marketsand dispersed ownership arose only in common law countrieswhere the legal system provided adequate protection for minor-ity shareholders. This news is not good for countries that havea tradition of civil law, as well as countries that are undergoingthe transition to market-based economies.Several scholars praised the developmental state, which fo-

cused mainly on promoting economic development (Johnson,1982; Evans, 1995). By definition, in the developmental state,the government replaces the role of capital market and allocatesresources to strategically important areas. Although Korea hasbeen praised as the most successful development state, its suc-cess resulted in underdeveloped capital markets.Coffee (2001) argued that the lack of direct governmental

interference, not a tradition of common law, was the impor-tant factor for the development of financial markets. He sug-gested that some common law countries, such as the UnitedStates and the United Kingdom, protect minority shareholdersbecause they are decentralized. Decentralization made it possi-ble for private entities to develop laws and for self-regulatorybodies to develop. In turn, this development facilitated the riseof market-based institutions such as the stock exchange. With-out governmental intervention, the NYSE regulated itself by

241

Conclusion

listing only large, high-quality issuers, and therefore imposedhigh listing standards and higher disclosure requirements. Incontrast, French financial markets were strictly regulated by thegovernment. Neither the securities markets nor dispersed own-ership developed as much as they did in the United States andthe United Kingdom. The French government often misusedlistings of foreign stock as a cheap alternative for foreign pol-icy. The government provided no adequate supervision over thestock exchange. TheBourse, a heavily regulated statemonopoly,did not have any incentives to innovate to improve its business,unlike its counterparts in the United Kingdom or the UnitedStates. In Germany, the government stunted the stock market’spotential growth.On the other hand, some believe that the state should play

an important role in the transition to a market-based economy.They argue that the government can do a better job by settingup institutional infrastructures upon which markets can developfurther. The massive privatization process in former communistcountries, such as the Czech Republic and Russia, showed thatmarkets would not automatically develop by privatization alone.Without adequate regulatory infrastructures, mass privatizationresulted in poorly informed shareholders and created system-atic expropriation through various forms of tunneling (Stark,1996b; Kogut and Spicer, 2002). In contrast, Poland imposedhigh disclosure standards from the outset of privatization, cre-ated an SEC-like law-enforcement agency, provided for own-ership transparency, and regulated takeovers. Due to its setupof this institutional infrastructure, Poland’s privatization wasmore successful, albeit slower. Experiences in Korea and LatinAmerican countries provide further evidence that markets donot develop automatically and that the state should be astutein building up institutions upon which markets will develop.

242


These institutions, which involve property rights, governancestructures, conception of control, and rules of exchange, enableactors in markets to organize, compete and cooperate, and ex-change.Bydoing so, the state ensures the formation andongoingstability of markets (Kogut and Spicer, 2002; Fligstein, 2001).The experiences of Korea this book describes stress that astutegovernmental policies to cultivate markets and ensure orderlyshifts in power are important to ensure a smoother transitionfrom a developmental state to a market-based economy, whichis an important lesson for other developing countries.For instance, developing countries may want to enact laws

and create law enforcement agencies. Drawing evidence fromthe experience of privatization in the Czech Republic andRussia, Coffee (1999) argued that the failure to enforce laws, notthe absence of law, makes expropriation possible. During the1920s, U.S. holding companies and investment trusts formeda pyramid structure under which control rights and cash flowright were widely separated. After the 1929 crash, the U.S.Congress demolished some of these pyramids, and most of therest collapsed on their own. Between the 1960s and 1980s, ma-jor European countries followed the United States in creatinga strong regulatory agency modeled after the American Secu-rities and Exchange Commission (SEC). The governments indeveloping countries may wish to benchmark institutions in thedeveloped market economies and put some regulatory empha-sis into their own legal codes. For instance, in countries withweak legal protections for minority shareholders, they suggestthat firms should bond themselves, install credible monitoringcontrols, and meet higher standards of disclosure to sell stockto dispersed shareholders. Similarly, in the United Kingdom, aseries of stock market scandals resulted in stronger regulationsfor the London Stock Exchange (LSE). Note that the enactment

243

Conclusion

of the Fair Trade Act has been the only effective way to controlthe power of chaebols.This study has some other interesting implications for coun-

tries that industrialized only recently. Amsden (1989, 1994) de-picted the Korean experience as one in which the state played acritical role and criticized those who endorse basic liberal mar-ket discipline. She arguedwhy it is right tomake prices “wrong”or, in other words, to introduce market distortions. State inter-vention helped Korea gain momentum in its early stage of de-velopment. The recent crisis in Korea, however, showed that thepotential costs of distorting themarkets could be severe. Further-more, it demonstrated that a transition from a state-controlledeconomy to a market-based economy was neither automatic noreasy. The crisis, for which Korea is still paying the huge priceof past market distortions, reminds us of a simple dictum: thereis no free lunch.

244

Appendix 1. Data Usedin This Book

This book relies largely on the database built by the Korea In-formation Service (KIS). The Korea Information Service is aleading credit rating agency in Korea, equivalent to Standard &Poors or Moody’s, both of which collect, analyze, and evaluatecorporate financial data. It collaborates with Moody’s to supplyinformation onKorean companies for an international audience.The Korea Information Service’s corporate information

database includes financial information not only for companieslisted in the stock exchanges and registered for securing promis-sory notes but also for every company with assets of more than6 billion won from 1985 onward. All Korean firms meeting thiscondition have to be audited by third-party accounting firmsand are thus called statutory audited companies. For instance,the database includes financial information for 641 listed com-panies and 3,411 statutory audited companies in nonfinancialsectors as of 1996. Financial services firms were not used in thestatistical analyses in this book because their accounting datawere not compatible with those of firms in other industries.This book also identifies the business group membership of

our sample firms. The Korean Fair Trade Commission (KFTC)

245

Appendix 1. Data Used in This Book

legally defines a business group as “a group of companies, morethan 30% of whose shares are owned by some individuals orby companies controlled by those individuals, and whose man-agement such as appointing officers is substantially affected.”Because ownership is widely dispersed, chaebol families cancontrol some public firms even when the combined family andaffiliate ownership is below 30%. In such cases, the KFTC iden-tifies a firm as a chaebol affiliate even though the criteria of 30%ownership is not met. Using this definition, the Fair Trade Com-mission annually announces the thirty biggest chaebols in orderto block the concentration of economic power. In addition, theBank Supervisory Board (now, Financial Supervisory Board)used the same definition to decide group membership of smallbusiness groups for the purpose of credit management. A totalof 461 business groups were identified as of 1996.The statistical analyses in the appendixes use several subsets

of this original database. Because many firms went bankruptor underwent restructuring after Korea entered a recession as aresult of the Asian Crisis in 1997, the analysis was restricted to1985–96. Appendix 2 uses this full data set of both listed com-panies and statutory audited companies (hereafter, Sample A)during 1985–96 to compare the profitability of group-affiliatedcompanies and independent companies. Appendix 3 examinesthe determinants of profitability of group-affiliated companiesand therefore uses only firms that are associated with businessgroups. Because financial information was available only forlisted or statutory audited companies, 144 out of the 461 busi-ness groups identifiedby theKFTCandBankSupervisoryBoardhave only one company or no company that appears in ourdatabase. Because the groupwide resource variables needed tobe computed, the definition of business groups was restrictedto the ones that have at least two listed or statutory audited

246

Appendix 1. Data Used in This Book

companies in the database. Thus, the final sample in Sample Bconsists of a total of 1,248 companies associated with 317 busi-ness groups as of 1996. Appendixes 4 and 5, which examine theperformance implications of vertical integration and the deter-minants of debt structure of group-affiliated companies respec-tively, use Sample B.Appendix 6 examines the simultaneous relationship between

ownership structure and firm profitability. For this study, oursample was restricted to the public companies that are also af-filiated with business groups. Information about ownership isavailable from the KIS database from 1986 onward and only forpublic companies. Ownership information on private compa-nies is not available in this database until the mid 1990s. Thus,for Appendix 6, Sample B′, which samples only publicly tradedgroup affiliates and is a subset of Sample B, was used.In each analysis, observations for firms that were either

bankrupt or showed negative equity were eliminated becausesuchfirmsare technically bankrupt. Thesefirms survive inKoreabecause of the cumbersome bankruptcy procedures and debtguarantees provided by other companies. Further, several ob-servations from the sample were excluded as a result of missinginformation or unrealistic values for some variables. TableA.1.1shows the number of samples in each year.

247

TableA.1.1.

Sam

ple

com

posi

tion

Wholesampleoffirms

Independent com

panies

Group-affiliatedcompanies

Group-

Total

affiliated

Total

Total

casesof

public

publicly

cases

Publicly

group-

Group-

companieswith

traded

oftraded

affiliated

affiliated

ownership

Total

companies

independentindependentTop5

Top6–30

Small

companies

public

information

Year(Sam

pleA)(Sam

pleA

′ )companies

companies

groups

groups

groups

(Sam

pleB)companies

(Sam

pleB

′ )

1985

1,652

263

1,041

3574

113

424

611

228

n/a

1986

1,856

277

1,180

3577

122

477

676

242

104

1987

2,199

308

1,436

3782

130

551

763

271

153

1988

2,475

387

1,624

4991

134

626

851

338

198

1989

2,739

477

1,795

54103

146

695

944

423

270

1990

2,955

510

1,954

61103

153

745

1,001

449

258

1991

3,302

544

2,195

73109

165

833

1,107

471

324

1992

3,410

546

2,267

75109

156

878

1,143

471

317

1993

3,527

552

2,349

75114

177

887

1,178

477

342

1994

3,827

600

2,593

77122

182

930

1,234

523

358

1995

4,090

603

2,827

78124

192

947

1,263

525

370

1996

4,052

641

2,804

84123

194

931

1,248

557

392

Total

36,084

5,707

24,065

733

1,231

1,864

8,924

12,019

4,975

3,086

Appendix 2. Comparing theProfitability of Group-affiliated

Companies and IndependentCompanies

This appendix compares the profitability of group-affiliatedcompanies vis-a-vis independent companies. As a precedent,previous work (Chang and Choi, 1988) used the data of pub-licly traded Korean companies during 1975–84 to show thatgroup-affiliated Korean firms, especially those affiliated withthe top four groups, which clearly showed characteristics sim-ilar to those of multidivisional structure, performed better thanindependent firms did. These results were interpreted as evi-dence for the efficiency of business groups, which are able tominimize transactions costs prevalent in developing countriessuch as Korea (Williamson, 1975; Leff, 1978).This appendix extends Chang and Choi (1988) to a more re-

cent time frame (i.e., 1985–96) and compares the profitabilityof group-affiliated companies vis-a-vis independent companieswith dummy variables that note groupmembership. Table A.2.1shows the results based on all the firms in the sample (i.e.,

249

TableA.2.1.

Pro

fitab

ilit

yof

Kor

ean

com

pani

esfr

om19

85to

1996

Wholesample

Period1(1985–88)

Period2(1989–92)

Period3(1993–96)

Variable

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

Constant

12.19

11.54

12.28

11.48

11.87

12.62

11.86

13.07

(2.19)

∗∗∗

(2.21)

∗∗∗

(2.51)

∗∗∗

(2.51)

∗∗∗

(2.12)

∗∗∗

(2.12)

∗∗∗

(1.55)

∗∗∗

(1.54)

∗∗∗

Firm-levelresources

Advertising

0.07

0.06

−0.15

−0.16

0.12

0.12

0.15

0.14

(0.02)

∗∗∗

(0.02)

∗∗(0

.05)

∗∗∗

(0.05)

∗∗∗

(0.04)

∗∗(0

.04)

∗∗(0

.03)

∗∗∗

(0.03)

∗∗∗

R&D

−0.11

−0.11

−0.50

−0.52

−0.40

−0.38

0.12

0.16

(0.04)

∗∗(0

.04)

∗(0

.15)

∗∗∗

(0.15)

∗∗∗

(0.08)

∗∗∗

(0.07)

∗∗∗

(0.06)

∗(0

.06)

∗∗

Liquidity

0.59

0.58

0.88

0.90

0.66

0.65

0.40

0.35

(0.04)

∗∗∗

(0.04)

∗∗∗

(0.10)

∗∗∗

(0.10)

∗∗∗

(0.08)

∗∗∗

(0.08)

∗∗∗

(0.06)

∗∗∗

(0.06)

∗∗∗

Leverage

−0.14

−0.12

−0.17

−0.16

−0.16

−0.15

−0.11

−0.08

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.01)

∗∗∗

Firm

size

−0.32

−0.28

−0.25

−0.19

−0.42

−0.39

−0.30

−0.35

(0.03)

∗∗∗

(0.03)

∗∗∗

(0.07)

∗∗∗

(0.07)

∗∗(0

.05)

∗∗∗

(0.06)

∗∗∗

(0.05)

∗∗∗

(0.05)

∗∗∗

Businessgroupmembership

Top5group

−0.78

−0.53

−1.90

−1.39

−0.81

−0.63

0.15

0.39

(0.21)

∗∗∗

(0.21)

∗∗(0

.42)

∗∗∗

(0.43)

∗∗(0

.35)

∗(0

.35)

†(0

.31)

(0.31)

Top6–30group

−0.73

−0.50

−1.39

−1.05

−0.73

−0.53

−0.32

−0.05

(0.16)

∗∗∗

(0.16)

∗∗(0

.33)

∗∗∗

(0.33)

∗∗(0

.28)

∗∗(0

.28)

†(0

.25)

(0.25)

Smallgroup

−0.16

−0.02

−0.83

−0.63

−0.04

0.07

0.11

0.28

(0.08)

∗(0

.08)

(0.18)

∗∗∗

(0.18)

∗∗∗

(0.14)

(0.14)

(0.12)

(0.12)

∗

250

Internalbusinesstransactions

Supplyofdebt

−0.15

−0.15

−0.12

−0.15

guarantee

(0.03)

∗∗∗

(0.06)

∗∗(0

.04)

∗∗(0

.04)

∗∗∗

Receptionofdebt

0.02

−0.01

−0.00

0.04

guarantee

(0.01)

†(0

.03)

(0.02)

(0.02)

∗

Equityinvestto

−0.14

−0.20

0.05

−0.33

affiliate

(0.08)

(0.25)

(0.16)

(0.12)

∗∗

Equityinvestfrom

−7.81

0.65

−10.34

−12.01

affiliate

(0.58)

∗∗∗

(1.34)

(1.40)

∗∗∗

(0.74)

∗∗∗

Salestoaffiliates

−0.09

−1.64

0.50

0.19

(0.18)

(0.42)

∗∗∗

(0.31)

(0.26)

Purchasefrom

−1.17

−2.22

−1.84

0.08

affiliate

(0.29)

∗∗∗

(0.66)

∗∗∗

(0.49)

∗∗∗

(0.41)

Adjusted

R2

0.13

0.14

0.16

0.16

0.12

0.12

0.08

0.10

Not

es:1.11yeardummies,45industrydummies,and451industry–yearinteractiontermstoreflectthefixedeffectsmodel

arenotshown.

2.Numbersintheparenthesesarestandarddeviations.

3.∗∗

∗ p<

.001,∗

∗ p<

.01,

∗ p<

.05,

† p<

.10.

4.N

=36,084.

251

TableA.2.2.

Pro

fitab

ilit

yof

Kor

ean

publ

icco

mpa

nies

from

1985

to19

96

Wholesample

Period1(1985–88)

Period2(1989–92)

Period3(1993–96)

Variable

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

Constant

5.28

5.02

11.00

9.37

3.70

4.59

−1.29

−0.56

(4.49)

(4.49)

(4.91)

∗(4

.88)

†(4

.68)

(4.68)

(4.67)

(4.69)

Firm-levelresources

Advertising

0.19

0.19

0.05

0.06

0.27

0.27

0.19

0.18

(0.03)

∗∗∗

(0.03)

∗∗∗

(0.07)

(0.07)

(0.05)

∗∗∗

(0.05)

∗∗∗

(0.05)

∗∗∗

(0.05)

∗∗∗

R&D

0.21

0.21

−0.39

−0.39

−0.01

−0.01

0.38

0.39

(0.08)

∗(0

.08)

∗(0

.27)

(0.28)

(0.14)

(0.14)

(0.11)

∗∗∗

(0.11)

∗∗∗

Liquidity

0.46

0.45

1.22

1.21

0.32

0.30

0.38

0.32

(0.11)

∗∗∗

(0.11)

∗∗∗

(0.27)

∗∗∗

(0.27)

∗∗∗

(0.18)

†(0

.18)

†(0

.15)

∗(0

.15)

∗

Leverage

−0.13

−0.12

−0.20

−0.26

−0.14

−0.10

−0.11

−0.06

(0.02)

∗∗∗

(0.02)

∗∗∗

(0.04)

∗∗∗

(0.04)

∗∗∗

(0.04)

∗∗∗

(0.04)

∗(0

.02)

∗∗∗

(0.03)

∗∗

Firm

Size

−0.25

−0.23

−0.64

−0.53

−0.16

−0.20

−0.24

−0.26

(0.07)

∗∗(0

.07)

∗∗∗

(0.16)

∗∗∗

(0.16)

∗∗∗

(0.11)

(0.11)

†(0

.09)

∗(0

.10)

∗∗

Businessgroupmembership

Top5group

0.05

0.31

0.41

1.11

−0.09

0.29

−0.20

0.39

(0.33)

(0.34)

(0.71)

(0.76)

(0.56)

(0.58)

(0.50)

(0.51)

Top6–30group

−1.03

−0.84

−1.11

−1.09

−1.41

−1.17

−0.67

−0.52

(0.25)

∗∗∗

(0.25)

∗∗(0

.52)

∗(0

.54)

∗(0

.41)

∗∗∗

(0.42)

∗∗(0

.38)

†(0

.39)

Smallgroup

−0.29

−0.18

−0.13

−0.18

−0.14

0.00

−0.42

−0.33

(0.15)

†(0

.15)

(0.35)

(0.36)

(0.25)

(0.26)

(0.22)

†(0

.22)

252

Internalbusinesstransactions

Supplyofdebt

−0.03

−0.17

0.10

−0.02

guarantee

(0.04)

(0.09)

†(0

.07)

(0.06)

Receptionofdebt

−0.01

0.11

−0.10

0.00

guarantee

(0.03)

(0.04)

∗(0

.05)

∗(0

.04)

Equityinvest

−0.23

1.30

−0.66

−0.91

toaffiliate

(0.26)

(0.52)

(0.43)

(0.41)

∗

Equityinvest

−2.48

0.35

−20.01

−13.09

from

affiliate

(1.52)

(1.68)

(6.13)

∗∗(3

.84)

∗∗∗

Salesto

−0.70

−2.66

−1.15

0.17

affiliates

(0.42)

†(0

.97)

∗∗(0

.74)

(0.59)

Purchasefrom

−1.51

−2.66

−0.61

−1.52

affiliates

(0.67)

∗(1

.97)

(1.23)

(0.87)

†

Adjusted

R2

0.21

0.22

0.30

0.31

0.16

0.16

0.10

0.11

Not

es:1.11yeardummies,45industrydummies,and451industry–yearinteractiontermstoreflectthefixedeffectsmodelarenot

shown.

2.Numbersintheparenthesesarestandarddeviations.

3.∗∗

∗ p<

.001,∗

∗ p<

.01,

∗ p<

.05,

† p<

.10.

4.N

=5,707

253

Appendix 2. Comparing the Profitability

Sample A), and Table A.2.2 shows the results for Sample A′,which is based only on public firms. Sample A′ is compara-ble to Chang and Choi (1988), which was also based only onpublic firms. The prime interest in this appendix is to examinethe signs of business group dummies after controlling all otherindependent variables that affect profitability. If the businessgroup dummy variables are positive and significant, this resultwill suggest that firms associated with business groups are moreprofitable than are comparable independent firms.1

Although it is difficult to identify a single indicator for afirm’s performance, this study used profitability to measure thisvariable. Some argue that Korean firms pursued growth ratherthan profitability. To some extent, this study agreed with thisview. This study, however, proposed that Korean firms pursuedgrowth at the business group level but pursued profitability atthe individual affiliate level. Even though Korean firms pursuedgrowth at the business group level, such growth was directly re-lated to long-term profitability as discussed in Chapter 3.2 Un-der the multidivisional structure, Korean business groups typi-cally pursued growth by venturing into new businesses. Suchexpansions took place through the creation of new affiliatecompanies in which several existing group affiliates assumedequity positions. Individual affiliates were expected to maxi-mize profits so that the group headquarters could invest them innew ventures or investment opportunities in other affiliates. Fornongroup-affiliated firms, it is even more imperative to maxi-mize profits.Although it is also true that some Korean companies empha-

sized market share (and sales growth), particularly when firstentering a business, they pursued profitability in the long term.Because the data set of this study spans a 12-year interval, itwas reasonable to expect that the economic performance of an

254


individual affiliate could be measured by its profitability. Firm-level economic performance was measured by the return oninvested capital (ROIC), which is defined as the sum of net in-come before tax plus interest payments, deflated by total assets,to provide a return metric that is comparable across firms. Thismeasure of performance was supposed to measure operating ef-ficiency without being biased by the relatively high debt–equityratios common in Korean firms.

PROFITABILITY: ROIC, measured at time t.

To explain firm profitability, this study included two types ofproductive resources commonly used in strategy research. Thestrategy field has conventionally emphasized the important rolethat firm-specific resources play in influencing superior finan-cial performance (Penrose, 1959). Intangible resources such astechnology or brand loyalty are particularly important sources ofsustainable competitive advantage (Prahalad and Hamel, 1990;Kogut and Zander, 1992; Teece, Pisano, and Shuen, 1997).Teece et al. defined capabilities as “a set of differentiated skills,complementary assets, and routines that provide the basis fora firm’s competitive capacities and sustainable advantage in aparticular business.” Thus, a firm possessing more intangibleresources was expected to exhibit higher performance. Intangi-ble knowledge-based resourceswere identified through researchand development (R&D) and advertising intensities. Previousstrategy research has used these measures as proxies for intan-gible knowledge-based resources (Caves, 1982; Chatterjee andWernerfelt, 1991; Montgomery and Hariharan, 1991; Sharmaand Kesner, 1996).3

Physical resources are also important determinants of firmperformance. As in all economies that have experienced rapid

255


growth, the demand for capital in Korea far exceeded its supply.Because Korea’s external capital market was inefficient, easyaccess to financial capital played a key role in determining firmperformance. This study therefore used indicators of liquidityand the level of debt carried by the firm to reflect the availabilityof capital raised (Myers, 1977;Myers andMajluf, 1984). A highdebt–equity ratio will increase the likelihood of bankruptcy andfinancial distress and thereby limit the firm’s ability to finance itsinvestment by borrowing (Froot, Scharfstein, and Stein, 1994).Thus, this study expected that firms with more cash and debt-carrying capacity can better finance their investments and expectto show higher performance. In addition, firm size was includedto control for any size-related factors.

R&D: The R&D expenditure divided by total sales, measuredat time t.

ADVERTISING: The advertising expenditure divided by totalsales, measured at time t.

LIQUIDITY : Current assets divided by current liabilities, mea-sured at time t.

LEVERAGE: Long-term debt to equity, measured at time t.FIRM SIZE: Log of total assets in thousands won, measured attime t.

Comparing individual firm-level performance between inde-pendent companies and group-affiliated companies can be mis-leading because of extensive intragroup business transactionsthat may used to cross-subsidize affiliates that are eitherpoorly performing or strategically important (Nakatani, 1984;Fudenberg and Tirole, 1986; Lincoln, et al., 1996). This study,therefore, introduced various internal financial and businesstransactions variables. Although such data are difficult to obtain

256


in countries where business divisions do not report their inter-nal transactions, intragroup internal transactions are explicitlyreported in Korea as footnote items in the financial statementsof group-affiliated companies. The extent of intragroup finan-cial transactions was measured by capital outflows and inflowsin the form of debt guarantees, as well as equity participation.This study could not measure the extent of direct loans betweenaffiliates because they are carried out only for short-term financ-ing and rarely show up in the financial statements. It was ex-pected that the outflow of capital in the form of debt guaranteesand equity would be negatively associated with the profitabilityof the contributors, and that the inflow of such capital will bepositively associated with the profitability of the recipients. In-ternal business trade is also measured by sales to and purchasesfrom affiliated companies to the total sales for each company.This study did not have any a priori expectation for the signof internal purchases and sales. The discussions in Chapter 4,however, suggest that cross-subsidization often takes place fromdownstream operations to upstream operations.

SUPPLY OF DEBT GUARANTEE: The debt guarantee supplied togroupmembers divided by the equity base of the providingfirm, measured at time t.

RECEPTION OF DEBT GUARANTEE: The debt guarantee receivedfrom group members divided by the equity base of therecipient, measured at time t.

EQUITY INVESTMENT TO AFFILIATES: The equity participation ofgroup members divided by the equity base of the provider,measured at time t.

EQUITY INVESTMENT FROM AFFILIATE:The equity participation bygroupmembers divided by the equity base of the recipient,measured at time t.

257


SALES TO AFFLIATES: The amount of sales to affiliated com-panies divided by the total sales of a firm, measured attime t.

PURCHASE FROM AFFLIATES: The amount of purchases from af-filiated companies divided by the total sales of a firm,measured at time t.

To compare the profitability of group-affiliated companiesand that of independent companies, this study employed threedichotomous variables to denote group membership for the topfive chaebols, the top six through thirty chaebols, and smallerbusiness groups. The number of companies in each category canbe found in Table A.1.1.Because a sample of companies over a 12-year period was

used, an appropriate methodology was needed to analyze thepanel data (Hsiao, 1986). If Yit is defined as the profitabilityof firm i at time t and Xkit is defined as the kth independentvariable of firm i at time t , the model can be described as

Yit = α + �k=1,K βk Xkit + εi t , i = 1, 2, . . . , N , t = 1, 2, . . . , T (1)

To fully exploit the panel data, it was necessary to test whetherparameters, α and β, stay constant across all i and t . As a firststep, it was tested whether the intercept term, α, stays constantfor all firms at all times. If the intercept term, α, shifts over timeand over individual firms, the intercept may be described as

αi t = µ + νi + γt + δi t (2)

where µ represents the constant intercept term, νi is thefirm-specific effect, γt is the time-specific effect, and δi t is the

258


interaction effects between firm- and time-specific factors. Away to estimate these various factors affecting the intercept termis to use the fixed effects model, which includes dummy vari-ables for each firm, year, and firm–year interaction terms.4 Be-cause this study had panel data for more than 4,000 companiesover 12 years, it was difficult to include firm dummies and theirinteraction terms into the regression. Further, the inclusion offirm-specific dummies probably would not have suited the pur-pose of this study, which tried to explain firm profitability witha set of firm-specific independent variables. It was, therefore,decided to include industry-specific dummy variables instead offirm-specific dummy variables, which assume that firm-specificfixed effects can be approximated with industry-specific fixedeffects. Chow’s F-test confirmed the conjecture that the interceptterm varies over time and across industries.As a second step, it was checked whether the slopes, βk , are

homogeneous across firms and over time. Because the data sethas only a 12-year time span, the slopes could not be allowed tovary across firms; however, whether the slopes are constant overtime could be considered. Again, the fixed effects model, wherethe slope coefficients shift from year to year, was assumed.Chow’s F-test for the homogeneity of the slope coefficients overa 12-year time period suggested that the slope coefficients varyalong the time dimension. This study then sequentially addedthe yearly data, performed a series of F-tests for the pooledyears, and finally concluded that the slope coefficients were ho-mogeneous for the periods of 1985–8, 1989–92, and 1993–6.This study, therefore, performed the analysis by separating theobservations into three time periods. As shown in Figure 1.3,Korean firms enjoyed stable growth and strong performancefrom 1985 to 1988. From 1989 onward, however, Koreanfirms faced much tougher global competition and experienced

259


stagnant growth and low profitability, particularly from 1993to 1996. Thus, the model was formulated with the followingequation:

Yit = µ + ν j + γt + δ j t + �k=1,K βpk Xkit + εi t ,

i = 1, 2, . . . , N , t = 1, 2, . . . , T, j = 1, . . . , J, p = 1, 2, 3 (3)

where i represents the firm, t represents the year, j is the indus-try, and p is three timeperiods.A total of 45 dummyvariables foreach two-digit KSIC industry dummy variables, 11 year dummyvariables, and 451 year–industry interaction dummy variableswere introduced.Table A.2.1 shows regression results based on all the sam-

ple firms in the data set (Sample A), and Table A.2.2 showsthe results based on the subsample of public firms (Sample A′).The equations in the tables incorporate firm-level resources,business group membership, and control variables for indus-try and year. In Table A.2.1, the firm-level resource variablesshow a somewhat interesting pattern. The liquidity ratio is posi-tively signed and significant, and the leverage ratio is negativelysigned and significant in all equations. The financial resourcevariables, reflected in the liquidity and leverage ratios, lead tohigher performance. Themarketing-related resources contributepositively to firm performance but the technical resources havea negative impact on firm performance with the whole sample,as in models (1) and (2). The subsample analysis according tothe time period in models (3)–(8), however, showed that bothadvertising and R&D were negative and significant during thelate 1980s but turned positive and significant in the 1990s. Ina sample consisting only of public firms, both advertising andR&D were positively related to firm performance in the whole

260


sample as in models (1) and (2) of Table A.2.2. In a subsam-ple analysis, both variables were insignificant in late 1980s butturned positively significant in the 1990s. The results indicatedthat firm size is negatively related to firm performance.A possible explanation for the negative sign for the adver-

tising and R&D variables in the late 1980s is that the payofffor such investments takes some time. Korean firms based theircompetitive advantage on lowwages until the early 1980s. Theybegan to invest in brands and technology only in the late 1980s.Faced with increasing challenges from low-wage countries suchas China and Indonesia, Korean firms had to increase their in-vestment in technology and brands. Subsample analysis for dif-ferent time periods provided support for this conjecture. Thisresult may reflect the shift in sources of competitive advantagenoted previously.Tables A.2.1 and A.2.2 examine the profitability of group-

affiliated companies vis-a-vis independent companies with aset of dummy variables. There are two important trends. First,model (1) in Table A.2.1 shows that the group-affiliated firmsare on average less profitable than independent companies are.Subsample analyses inmodels (3)–(8) showed that suchnegativegroup affiliation effects were most severe in the late 1980s butdiminished in the 1990s. From 1993 to 1996, there were nosignificant differences between group-affiliated companies andindependent companies.Second, the negative impact of group membership on firm

performance diminished appreciably when various internaltransactions variables were introduced. The even-numberedmodels in Table A.2.1 introduced various internal transactionsvariables. Compared to the odd-numbered equations in the sametable, the size and the significance level of each business group

261


dummy variable are much smaller than are those in the even-numbered equations. Similar patterns are found in a sample ofpublic firms: as shown in Table A.2.2, group-affiliated firmsperformed worse than independent firms did at least during thelate 1980s. Most of this difference vanished in the mid 1990s,and those differences almost disappeared when various internaltrade variables were introduced.In general, debt guarantee provisions are found to depress the

profitability of the guarantor significantly, while they improvethe profitability of the borrower. The results also showed thatinternal purchasing significantly decreases firm profitability;these findings suggested that it is likely chaebols cross-subsidizeaffiliates via internal trade. Although the business group as awhole may benefit from vertical integration, affiliate buyers ap-pear, on average, to support unprofitable affiliate suppliers bypaying higher than market prices. Appendix 4 examines this is-sue more fully. Furthermore, affiliate buyers in chaebols are of-ten large, publicly listed firms, while affiliate sellers are usuallysmaller companies that are often privately held by themajor fam-ily shareholders. Chaebols likely use internal pricing schemesto transfer profits to these privately held companies. The recentexample of SK Telecom, as discussed in Chapter 6, providessome support for this conjecture. The outflow of equity invest-ment, however, had a negative impact onfirmprofitability duringthe economic slump in the mid 1990s. The inflow of equity in-vestment was negatively significant for firm performance, againduring the economic slowdown since the early 1990s. Theseresults suggested that business groups may use debt guaranteesto subsidize weak affiliates. Furthermore, investing in other af-filiates may hurt the investor when it is very short of capital.One possible reason why the sign of the equity inflow vari-able was negative is that the primary recipients of equity capital

262


might be new firms in industries that business groups have en-tered only recently. These equity inflows might also be relatedto large investment projects that firms have undertaken becausesuch projects are often not very profitable in their initial periods.These conjectures are, however, highly speculative.The fact that group-affiliated firms performed poorly in the

late 1980s countered the results of earlierwork (Chang andChoi,1988), which found that group-affiliated public firms performedbetter than independent companies did.5 The period of 1985–8was extremely favorable toKorean firms. Koreans often referredto it as the “three low” economic boom: low oil prices, lowinterest rates, and low exchange rates (yen appreciation). It ispuzzling not only that chaebol-affiliated firms performed poorlycompared to independent firms during this period but also thatthis gap narrowed during the economic slump. Chaebols mighthave diverted profits through various forms of internal transac-tions during the economic boom of the 1980s in ways that werenot fully captured by internal transactions variables. Caves andUekusa (1976) and Nakatani (1984) found that group-affiliatedJapanese firms not only had poorer performance on average thanindependent firms did but also had less variance in profitabil-ity. They explained that these affiliates might have been cross-subsidizing their less successful affiliates. The results presentedhere could be demonstrating a similar phenomenon. Lower prof-itability of group-affiliated firms in the late 1980s might havebeen caused by this cross-subsidization and by internal transac-tions other than those captured by various internal transactionsvariables used in this study.

263

Appendix 3. Profitabilityof Group-affiliated Firms

Appendix 2 showed that group-affiliated firms performed worsethan independent firms did, especially during the late 1980s.This result may indicate that group affiliates diverted their prof-its by either subsidizing poorly performing affiliates or investingin group-level projects. This appendix focuses on how groupaffiliation may positively affect firm performance by enablingaffiliates to share resources with each other.6 The resource-based theory emphasizes the role of corporatewide resourcesharing in building competitive advantage. Corporate strategy,according to Andrews (1980), “defines the business in whicha company will compete, preferably in a way that focuses re-sources to convert distinctive competence into corporate ad-vantage” (pp. 18–19). Prahalad and Hamel (1990) argued thatcorporate strategy and structure significantly and positively in-fluence firm performance. This view is consistent with Porter(1987), who argued that corporate strategists can create value bytransferring skills and sharing rent-generating activities amongindividual business units.

In Korea, chaebol affiliates freely share intangible resourceswith their affiliates, as discussed in Chapter 3. Kim (1996)

264

Appendix 3. Profitability of Group-affiliated Firms

illustrated how group-level R&D activities were the sources ofcompetitive advantage in several leading industries such as au-tomobiles, electronics, and semiconductors. Chaebols typicallyset up group-level R&D centers organized along broadly de-fined business areas such as electronics or automobiles. Severalaffiliates, including both final assemblers and parts suppliers,finance their joint R&D efforts. They share any technologicalinnovations from these efforts to an extent that is not necessar-ily proportional to their contributions. They also transfer keypersonnel to facilitate further the sharing of technological re-sources. Groupwide advertising, which emphasizes the imageof a business group rather than individual affiliates, also gen-erates considerable scale and scope economies. Affiliates alsoshare a reputation simply by being associated with a particularbusiness group. A firm can obtain loans from banks more eas-ily and at lower rates if it is associated with a business groupof strong credit and good reputation. On the other hand, a firmaffiliated with a group that has poor credit and a bad reputa-tion suffers from this association, no matter how profitable it is.Therefore, the firms that have affiliates with more cash and lessdebt can more easily finance their own investments and therebybe more profitable.

This study treated an affiliated company as an operating di-vision just like a strategic business unit (SBU) in a diversifiedcorporation. To measure group-level productive resources, thisstudy developedmeasures using the weighted averages of finan-cial indicators of other firms associated with the same businessgroup. For instance, if a member firm heavily invests in ad-vertising, it will benefit other firms in the same business groupsince all its affiliates share a common group name. Likewise,active research work by a member firm will benefit other firmsin the same group who develop intermediate goods or related

265


products. In a similar fashion, the availability of financial re-sources of other member firms, reflected in their liquidity andleverage ratios, will affect the performance of a firm in the samebusiness group. Firm profitability was, therefore, expected to bepositively associated with group-level R&D, advertising, andliquidity and negatively associated with group-level leverage.To calculate the group-level resource variables, this study usedSample B, which consists only of group-affiliated companies. Ifresources owned by other affiliates in the same business groupinfluence the economic performance of an individual firm, thisfinding will suggest that firms in business groups benefit fromsynergies.

GROUP R&D: The weighted average of R&D intensity of allother firms (excluding itself) in the same business group,where the weighing factor is sales. More specifically, theGROUP R&D variable for a firm i can be measured by �l �=i(R&Dl)wl , where i = 1, 2, . . . , I and l = 1, 2, . . . , I,wlis the proportion of sales of a firm l to the aggregated totalsales of all other firms associated with the same businessgroup, measured at time t .

GROUP ADVERTISING: The weighted average of advertising in-tensity of all other firms (excluding itself) in the same busi-ness group, where the weighing factor is sales, measuredat time t, analogous to the GROUP R&D variable.

GROUP LIQUIDITY : The weighted average of liquidity ratiosof all other firms (excluding itself) in the same businessgroup, where the weighing factor is each firm’s currentliability. More specifically, the group liquidity variable fora firm i can be measured by �l �=i (liquidityl) wl , wherei = 1, 2, . . . , I and l = 1, 2, . . . , I,wl is the proportionof current liability of a firm l to the aggregated total current

266


liabilities of all other firms associated with the same busi-ness group, measured at time t .

GROUP LEVERAGE: The weighted average of leverage ratios ofother firms (excluding itself) in the same business group,where the weighing factor is each firm’s equity base.More specifically, the group leverage ratio variable fora firm i can be measured by �l �=i (leveragel) wl , wherei = 1, 2, . . . , I and l = 1, 2, . . . , I,wl is the proportionof equity of a firm l to the aggregated total equity basesof all other firms associated with the same business group,measured at time t .

This study also adopted the entropy measure of group-leveldiversification as a control variable. Thismeasure is widely usedin strategy research (Jacquemin and Berry, 1979; Palepu 1985;Amit and Livnat 1988; Hill, Hitt, and Hoskisson, 1992), al-though some criticize it because it depends on the SIC (StandardIndustry Classification) scheme (Robins and Wiersema, 1995).This measure is useful, however, because the degree of totaldiversification (DT) can be decomposed into related (DR) andunrelated diversification (DU) portions. Related diversificationarises out of operating segments within an industry group, andunrelated diversification picks up the portion of diversificationbetween industry groups. The two-digit Korean Standard Indus-try Classification (KSIC) was used as the definition of industrygroup. To calculate the diversification indices, this study brokedown the sales of all group-affiliated firms using the two-digitSIC code.

GROUP UNRELATED DIVERSIFICATION: The entropy measureof unrelated diversification at the group level betweentwo-digit KSIC industry groups, measured at time t .

267


GROUP RELATED DIVERSIFICATION: The entropy measure of re-lated diversification at the group level within two-digitKSIC industry groups, measured at time t .

The size of business groups was also controlled for:

BUSINESS GROUP SIZE:The sumof total assets in thousandswon,measured at time t , of all firms associatedwith the businessgroup, in a log transformation.

This analysis also performed the pooling test to checkwhether the intercept terms and the slopes were homogeneousacross firms and over time, as we specified in Appendix 2,and found that the slope coefficients are homogeneous for theperiods of 1985–8, 1989–92, and 1993–6. This study, there-fore, performed the analysis by separating the observations intothree time periods and also used the fixed effects model byincluding industry, year, and year–industry interaction dummyvariables. Additionally, the residuals from the ordinary leastsquared (OLS) regressions were analyzed to detect any het-eroscedasticity problems. If the error terms, εi t , were not inde-pendent across observations, the estimated coefficients mightnot be the most efficient ones. The Durbin-Watson statisticsshowed no evidence for autocorrelation. The residuals fromthe OLS method, however, increased monotonically with thesize of the business groups (Bgsize). Several standard tests forheteroscedasticity – including the Goldfelt-Quandt test, theGlesjer test, and the Breusch-Pagan test – confirmed that theerror terms are proportional to the size of the business group.

Var(εi ) = σ 2 ∗ Bgsize (4)

268


This study, therefore, estimated models in Table A.3.1 with1/Bgsize as a weight. The weighted least squared (WLS)regression is a type of generalized least squared method thatsignificantly improves R2 relative to OLS regressions, whilethe estimated coefficients of the two regressions are consistentwith each other.

Table A.3.1 shows the results. In models (1)–(3), the sets ofindependent variables were sequentially added in order to de-tect any possible multicollinearity and to observe changes in theexplanatory power. In particular, this study attempted to avoidany multicollinearity between the firm-level and group-level re-source variables. Various diagnostic tests for multicollinearity,including Belsley, Kuh, and Welsch, detected no evidence ofmulticollinearity (Johnston, 1984). None of the signs for firm-level variables changed as the group-level resource variableswere added in model (2). In general, firm-level resource vari-ables show a similar pattern with the results in Table A.2.1. Themarketing-related resources and financial resources, reflectedin liquidity and leverage ratios, are positively related to firmperformance, while the technical resources have no significantimpact on firm performance.

Model (2) showed that group-level intangible resources andfinancial resources turn out to be important factors of an indi-vidual firm’s profitability. The weighted averages of R&D andadvertising intensities of other firms in the same business grouphad a positive and significant impact on the profitability of anaffiliate. R&D expenditures, which had no significant impact onfirm-level profitability, had a positive impact at the group level,suggesting that a firm’s R&D expenditures may generate posi-tive spillover effects to other firms in the same business group.For instance, a TV picture tube innovation will help cut costs orimprove quality for an affiliate TV assembler. Also, advertising

269

TableA.3.1.Profitabilityofgroup-affiliatedcompanies

Period

1Pe

riod

2Pe

riod

3Fu

llsample(198

5–96

)(198

5–88

)(1989–92)

(1993–96)

Variable

(1)

(2)

(3)

(4)

(5)

(6)

Con

stant

12.16

15.48

14.54

13.38

20.69

13.97

(3.36)

∗∗∗

(3.41)

∗∗∗

(3.41)

∗∗∗

(4.11)

∗∗(3

.47)

∗∗∗

(3.34)

∗∗∗

Firm

-levelresources

Advertising

0.28

0.21

0.22

0.06

0.20

0.20

(0.04)

∗∗∗

(0.04)

∗∗∗

(0.10)

∗∗∗

(0.07)

(0.06)

∗∗(0

.05)

∗∗∗

R&D

0.10

0.04

0.06

0.40

−0.37

0.22

(0.10)

(0.10)

(0.10)

(0.32)

(0.13)

∗∗(0

.10)

∗

Liquidity

1.21

1.18

1.15

1.10

1.07

0.48

(0.08)

∗∗∗

(0.08)

∗∗∗

(0.08)

∗∗∗

(0.17)

∗∗∗

(0.13)

∗∗∗

(0.12)

∗∗∗

Leverage

−0.14

−0.14

−0.14

−0.18

−0.12

−0.09

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.02)

∗∗∗

(0.02)

∗∗∗

(0.01)

∗∗∗

Firm

size

−0.28

0.03

0.10

0.30

−0.22

−0.29

(0.06)

∗∗∗

(0.07)

(0.10)

(0.12)

∗(0

.10)

∗(0

.09)

∗∗

270

Group

-levelresources

Group

advertising

0.17

0.16

0.21

0.24

0.18

(0.03)

∗∗∗

(0.03)

∗∗∗

(0.07)

∗∗(0

.05)

∗∗∗

(0.05)

∗∗∗

Group

R&D

0.50

0.52

0.83

0.59

0.35

(0.11)

∗∗∗

(0.12)

∗∗∗

(0.41)

∗(0

.18)

∗∗(0

.13)

∗∗

Group

liquidity

0.50

0.51

1.09

0.14

−0.21

(0.10)

∗∗∗

(0.10)

∗∗∗

(0.24)

∗∗∗

(0.18)

(0.18)

Group

leverage

−0.03

−0.03

−0.06

0.02

−0.09

(0.01)

∗∗(0

.01)

∗∗(0

.03)

∗(0

.02)

(0.02)

∗∗∗

Unrelated

diversificatio

n0.39

0.38

0.52

0.71

−0.15

(0.19)

∗(0

.19)

∗(0

.35)

(0.29)

∗(0

.25)

Related

diversificatio

n1.80

1.80

1.84

2.82

0.37

(0.22)

∗∗∗

(0.22)

∗∗∗

(0.45)

∗∗∗

(0.35)

∗∗∗

(0.29)

Group

size

−0.53

−0.55

−0.73

−0.58

−0.07

(0.22)

∗∗∗

(0.78)

∗∗∗

(0.13)

∗∗∗

(0.11)

∗∗∗

(0.09)

Internalbusiness

transactions

Supp

lyof

debt

guarantee

−0.22

−0.16

−0.14

−0.18

(0.04)

∗∗∗

(0.08)

∗(0

.07)

∗(0

.05)

∗∗

Receptio

nof

debt

guarantee

0.08

0.00

0.07

0.09

(0.02)

∗∗∗

(0.04)

(0.04)

∗(0

.02)

∗∗∗

271

TableA.3.1.(coont.)

Period

1Pe

riod

2Pe

riod

3Fu

llsample(198

5–96

)(198

5–88

)(1989–92)

(1993–96)

Variable

(1)

(2)

(3)

(4)

(5)

(6)

Equ

ityinvestto

affiliate

−0.11

−0.27

0.03

−0.31

(0.13)

(0.32)

(0.21)

(0.18)

†

Equ

ityinvestfrom

affiliate

−4.89

0.03

−13.99

−9.68

(1.00)

∗∗∗

(2.02)

(2.35)

∗∗∗

(1.13)

∗∗∗

Salesto

affiliates

0.93

0.66

1.35

1.10

(0.26)

∗∗∗

(0.54)

(0.44)

∗∗(0

.35)

∗∗

Purchase

from

affiliates

−0.98

−0.90

−2.00

−0.77

(0.43)

∗(0

.85)

(0.72)

∗∗(0

.60)

AdjustedR2

0.22

0.23

0.24

0.20

0.17

0.13

Notes:1.

11year

dummies,45

indu

stry

dummies,and45

1indu

stry–y

earinteractionterm

sto

refle

ctthefix

edeffectsmodel

are

notshown.

2.Num

bersin

theparenthesesarestandard

deviations.3

.∗∗∗p

<.001

,∗∗ p

<.01,

∗ p<

.05,

† p<

.10.

4.N

=12,0

195.

Thistableisadaptedfrom

Chang

andHon

g(200

0).

272


that emphasizes the name of the business group allows affiliatesto enjoy the free benefits of brand equity.

The group-level financial resource variables were also con-sistent with expectations. The results showed that when a firm’saffiliates had higher levels of debt, the firm itself was less prof-itable. This result may reflect the fact that the financial risks ofaffiliates are tied to those of other affiliates through extensivedebt guarantees. A failure of one firm will result in the serialbankruptcies of other member firms that provided debt guaran-tees to it. A higher level of liquid capital at the group level alsoleads to higher firm performance.

Model (3) introduced the internal transaction variables. Theresults were consistent with those in Tables A.2.1 and A.2.2.Debt guarantee provisions significantly depressed the profitabil-ity of the guarantor but improved the profitability of the bor-rower. The results also showed that internal selling had a pos-itive and significant impact on firm profitability. The internalpurchase variable, however, had a negative and significant im-pact on firm profitability, suggesting the possibility of cross-subsidization via internal trade. The outflow of equity invest-ment had no significant impact on firm profitability. The inflowof equity investment was negatively significant for firm perfor-mance. As for controls, both unrelated and related diversifica-tion led to higher performance. The group size is negativelycorrelated with individual firm performance.

The subsample analysis for each of the three time pe-riods showed a similar pattern to information presented inTablesA.2.1 andA.2.2. Themost striking difference across timewas the impact of internal transactions on firm performance.Most internal business transaction variables, with the exceptionof the supply of debt guarantees, were not significant in pe-riod 1 but became significant in the later time periods. Even the

273


outflows of capital through equity investment variable, whichwas not significant in periods 1 and 2, was negatively signifi-cant, albeit weakly, in period 3. Period 1 was a time of economicexpansionwhenKoreanfirms enjoyedhigh profitability.Variousforms of cross-subsidization did not appear to affect firm prof-itability during such periods. These forms may hurt providers,even chaebol affiliates, when the economy slumps and everyoneis short of capital. The subsample analyses provided additionalsupport for the conjecture that business groups extensively usedvarious forms of internal transaction for cross-subsidization.

The overall results suggested that business groups are in factgenerating real economies of scale and scope. This study foundthat both firm-level and group-level resources are important de-terminants of firm performance. Further, internal transactionsreveal the complex patterns of cross-subsidization via debt guar-antees, equity investments, and vertical integration.

274

Appendix 4. The Impact ofVertical Integration in Chaebols

This appendix examines the impact of forward and backwardintegration on costs and profitability. Vertical integration canreduce the transaction costs involved in finding, selling, negoti-ating, contracting,monitoring, and resolving disputeswith otherfirms in market transactions (Coase, 1937; Williamson, 1975).Through internalization, corporate managers can harmonize in-centives in the vertical value chain and therefore achieve jointprofit maximization. Vertical integration can also improve in-formation exchange between vertical chains of production andcontribute to collaborative R&D efforts. Such information ex-change can reduce inventory carrying costs and transportationcosts (Harrigan, 1983). In addition, vertical integration can re-duce advertising and sales expenses of upstream operations, aswell as ensure stable supplies of parts and intermediate goods.

On the other hand, vertical integration results in increasesin organizational size and complexity, and thus increases bu-reaucratic control. It may be costly to manage both upstreamand downstream operations that require totally different corecompetences (Prahalad and Hamel, 1990). For example, smallparts-suppliers may want to use different payment and benefit

275

Appendix 4. The Impact of Vertical Integration

structures than do large assemblers. If these firms are groupedtogether, however, they are bound by the same payment and ben-efit schemes, which may not fit either of them very well. Theefficiency loss from vertical integration can be sizable becausevertically integrated suppliers lack the incentive to be more effi-cient or innovative for their captive customers (Mahoney, 1992).Vertical integration is also not sufficiently flexible to adjust todifferent transaction volumes,which is especially important dur-ing periods of economic instability and fluctuations (D’Aveniand Ilinitch, 1992; Harrigan, 1985). In highly competitive andturbulent environments, firms are better off selecting the bestexternal suppliers, switching suppliers when new technologyappears, and avoiding idle capacity and inventory swings in itsproduction.

This empirical study attempted to identify the relative bene-fits and harms of vertical integration analogous to D’Aveni andRavenscraft (1994). Forward integration was calculated as theproportion of a company’s intragroup sales to its total sales, pre-viously measured as SALES TO AFFILIATES in Appendixes 2 and3, and backward integration as the company’s intragroup pur-chase deflated by its total sales, measured as PURCHASE FROM

AFFILATES. The cost factors of chaebols’ manufacturing affili-ates were decomposed into costs of goods sold, general and ad-ministration expenses, research and development expenses, andadvertising and sales expenses. Thus, each dependent variable isa percentage of the cost item relative to total sales. ADVERTISINGand R&D EXPENSES are the same measures used in Appendixes2 and 3. These cost items were expected to be lower with ahigher level of vertical integration if vertical integration wasefficiency-enhancing. If they are higher with a higher level ofvertical integration, the result would indicate that vertical inte-gration is value-destroying.

276


COSTS OF GOODS SOLD: The cost of goods sold item in theincome statement of a firm divided by its total sales, mea-sured at time t .

SALES EXPENSES: The sales expense item in the income state-ment excluding advertising expense divided by its totalsales, measured at time t .

GENERAL AND ADMINISTRATIVE EXPENSES: The general and ad-ministrative expense item divided by its total sales, mea-sured at time t .

In addition to vertical integration indixes, several control vari-ables were added to control for economies of scale and scope.First, market share, asmeasured by the firm’s sales in the respec-tive industry, was included to control for economies of scale. Itwas expected that the higher the market share was the lowerthe individual cost items would be. RELATED and UNRELATED

DIVERSIFICATION, which were previously used in Appendix 3,were included to examine any scope-related factors. The ex-istence of common inputs was expected to lead to lower costsin a diversified firm, and these costs were expected to be muchlower for related diversification than they would be for unre-lated diversification. FIRM SIZE and BUSINESS GROUP SIZE variables,previously used in Appendixes 2 and 3, were included to controlfor size-related factors.

MARKET SHARE:A firm’s total sales divided by the aggregatedsales of all firms in the same two-digit industry, measuredat time t .

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

277

TableA.4.1.Cost andprofit impactofverticalintegration

Who

letim

eperiod

s

(1)

(2)

(3)

(4)

(5)

(6)

Variable

Costo

fgo

odssold

Advertisingexpense

Salesexpense

Generaladminis-

R&Dexpense

Profi

tability

trativeexpense

Con

stant

62.35

−0.60

2.32

20.69

−0.57

14.87

(21.16

)∗∗∗

(0.31)

∗(3

.49)

∗∗∗

(2.44)

∗∗∗

(0.17)

∗∗∗

(1.19)

∗∗∗

Forw

ardintegration

6.34

−0.48

−1.28

−2.56

−0.03

0.96

(0.58)

∗∗∗

(0.06)

∗∗∗

(0.13)

∗∗∗

(0.48)

∗∗∗

(0.03)

(0.23)

∗∗∗

Backw

ardintegration

6.68

0.14

−0.48

−1.62

0.13

−1.81

(0.99)

∗∗∗

(0.11)

(0.22)

∗(0

.82)

∗(0

.06)

∗(0

.40)

∗∗∗

Marketshare

−0.00

−0.01

−0.01

−0.05

0.00

0.04

(0.03)

(0.00)

∗∗∗

(0.01)

(0.02)

∗(0

.00)

(0.01)

∗∗∗

Firm

size

0.20

0.18

0.18

−0.49

0.04

−0.20

(0.13)

(0.01)

∗∗∗

(0.03)

∗∗∗

(0.11)

∗∗∗

(0.01)

∗∗∗

(0.05)

∗∗∗

Group

size

0.59

−0.06

−0.19

0.04

0.06

−0.38

(0.12)

∗∗∗

(0.01)

∗∗∗

(0.03)

∗∗∗

(0.10)

(0.01)

∗∗∗

(0.05)

∗∗∗

Related

−1.04

0.05

0.72

0.97

−0.16

1.42

diversificatio

n(0

.49)

∗(0

.05)

(0.11)

∗∗∗

(0.41)

∗(0

.03)

∗∗∗

(0.19)

∗∗∗

Unrelated

−0.99

0.03

0.41

0.15

−0.04

0.42

diversificatio

n(0

.35)

∗∗(0

.04)

(0.08)

∗∗∗

(0.29)

(0.02)

†(0

.14)

∗∗

AdjustedR2

0.31

0.20

0.16

0.16

0.15

0.09

Notes:1.11

year

dummies,45

indu

stry

dummies,and451industry–yearinteractionterm

sto

reflectthefix

edeffectsmodelarenotshown.

2.Num

bersin


deviations.

3.∗∗

∗ p<

.001

,∗∗ p

<.01,

∗ p<

.05,

† p<

.10.

4.N

=12

,019

278

Tim

eperiod

I(198

5–88

)

(7)

(8)

(9)

(10)

(11)

(12)

Variable

Cost o

fgo

odssold

Advertisingexpense

Salesexpense

Generaladminis-

R&Dexpense

Profi

tability

expense

trative

Con

stant

64.43

0.34

2.89

2.90

0.15

16.93

(5.94)

∗∗∗

(0.59)

(1.17)

∗(6

.48)

(0.20)

(2.30)

∗∗∗

Forw

ardintegration

5.15

−0.47

−1.21

−1.65

−0.03

0.52

(1.33)

∗∗∗

(0.13)

∗∗∗

(0.26)

∗∗∗

(1.44)

(0.04)

(0.51)

Backw

ardintegration

8.37

0.15

−1.17

−2.17

−0.02

−1.36

(2.25)

∗∗∗

(0.22)

(0.44)

∗∗(2

.45)

(0.08)

(0.87)

Marketshare

−0.04

−0.00

−0.03

−0.11

0.01

0.06

(0.05)

(0.01)

(0.01)

∗(0

.06)

†(0

.01)

(0.02)

∗∗

Firm

size

−0.17

0.14

0.15

−0.86

0.01

−0.08

(0.28)

(0.03)

∗∗∗

(0.06)

∗∗(0

.31)

∗∗(0

.01)

(0.11)

Group

size

0.70

−0.05

−0.15

1.05

0.05

−0.59

(0.27)

∗∗(0

.03)

∗(0

.05)

∗∗(0

.29)

∗∗∗

(0.01)

∗∗∗

(0.10)

∗∗∗

Related

1.72

0.20

0.46

1.00

−0.14

1.22

diversificatio

n(1

.13)

∗(0

.11)

†(0

.23)

∗(1

.24)

(0.04)

∗∗∗

(0.44)

∗∗

Unrelated

−0.35

0.16

0.37

−2.76

−0.03

0.40

diversificatio

n(0

.77)

(0.08)

∗(0

.15)

∗(0

.84)

(0.03)

(0.30)

AdjustedR2

0.31

0.18

0.16

0.21

0.15

0.13

Notes:1.11

year

dummies,45

indu

stry

dummies,and451industry–yearinteractio

nterm

sto

reflectthefix


2.Num

bersin


deviations.

3.∗∗

∗ p<

.001

,∗∗ p

<.01,

∗ p<

.05,

† p<

.10.

4.N

=2,90

1

279

Tim

eperiod

2(198

9–92

)

(13)

(14)

(15)

(16)

(17)

(18)

Variable

Costo

fgo

odssold

Advertisingexpense

Salesexpense

Generaladminis-

R&Dexpense

Profi

tability

trativeexpense

Con

stant

57.90

−0.97

3.43

38.77

−0.18

18.72

(5.09)

∗∗∗

(0.56)

(1.16)

∗∗(3

.88)

∗∗∗

(0.30)

(2.09)

∗∗∗

Forw

ardintegration

5.99

−0.48

−1.12

−3.15

−0.13

1.69

(0.99)

∗∗∗

(0.11)

∗∗∗

(0.22)

∗∗∗

(0.75)

∗∗∗

(0.06)

∗(0

.42)

∗∗∗

Backw

ardintegration

6.28

0.21

−0.07

−1.42

0.32

−2.72

(1.64)

∗∗∗

(0.18)

(0.37)

(1.25)

(0.10)

∗∗(0

.67)

∗∗∗

Marketshare

−0.09

−0.00

−0.00

−0.00

0.01

0.08

(0.05)

†(0

.01)

(0.01)

(0.04)

(0.00)

∗∗(0

.02)

∗∗∗

Firm

size

0.66

0.17

0.16

−0.75

0.01

−0.28

(0.21)

∗∗(0

.02)

∗∗∗

(0.05)

∗∗(0

.16)

∗∗∗

(0.01)

(0.09)

∗∗

Group

size

0.42

−0.05

−0.22

−0.06

0.06

−0.56

(0.21)

∗(0

.03)

∗(0

.05)

∗∗∗

(0.16)

(0.01)

∗∗∗

(0.09)

∗∗∗

Related

−2.65

−0.02

0.77

0.79

−0.16

2.49

diversificatio

n(0

.81)

∗∗(0

.09)

(0.19)

∗∗∗

(0.62)

(0.05)

∗∗(0

.33)

∗∗∗

Unrelated

−0.86

−0.02

0.44

1.05

−0.03

0.72

diversificatio

n(0

.59)

(0.06)

(0.14)

∗∗(0

.45)

(0.03)

(0.24)

∗∗

AdjustedR2

0.29

0.20

0.15

0.12

0.14

0.10

Notes:1.11

year

dummies,45

indu

stry


sto

reflectthefix


2.Num

bersin


deviations.

3.∗∗

∗ p<

.001

,∗∗ p

<.01,

∗ p<

.05,

† p<

.10.

4.N

=4,19

5

280

Tim

eperiod

3(199

3–96

)

(19)

(20)

(21)

(22)

(23)

(24)

Variable

Cost o

fgo

odssold

Advertisingexpense

Salesexpense

Generaladminis-

R&Dexpense

Profi

tability

trativeexpense

Con

stant

64.72

−1.26

0.93

20.19

−0.89

8.40

(4.73)

∗∗∗

(0.53)

∗(1

.14)

(2.74)

∗∗∗

(0.32)

∗∗(1

.92)

∗∗∗

Forw

ardintegration

7.26

−0.48

−1.42

−2.42

0.05

0.82

(0.84)

∗∗∗

(0.09)

∗∗∗

(0.20)

∗∗∗

(0.49)

∗∗∗

(0.06)

(0.34)

∗

Backw

ardintegration

6.74

0.07

−0.68

−1.82

−0.05

−1.18

(1.47)

∗∗∗

(0.16)

(0.36)

†(0

.85)

∗(0

.10)

(0.60)

∗

Marketshare

0.03

−0.02

−0.00

−0.02

0.01

0.02

(0.05)

(0.00)

∗∗∗

(0.01)

(0.03)

(0.00)

∗(0

.02)

Firm

size

0.18

0.21

0.21

−0.15

0.06

−0.24

(0.19)

(0.02)

∗∗∗

(0.05)

∗∗∗

(0.11)

(0.01)

∗∗∗

(0.08)

∗∗

Group

size

0.67

−0.07

−0.18

−0.45

0.05

−0.15

(0.18)

∗∗(0

.02)

∗∗∗

(0.04)

∗∗∗

(0.11)

∗∗∗

(0.01)

∗∗∗

(0.08)

∗

Related

−1.49

0.03

0.80

1.09

−0.20

0.92

diversificatio

n(0

.71)

∗(0

.07)

(0.17)

∗∗∗

(0.41)

∗∗(0

.04)

∗∗∗

(0.29)

∗∗

Unrelated

−1.71

0.02

0.35

1.18

−0.06

0.36

diversificatio

n(0

.53)

∗∗(0

.06)

(0.13)

∗∗(0

.31)

∗∗∗

(0.04)

†(0

.21)

†

R2

0.31

0.22

0.19

0.19

0.17

0.06

Notes:1.11

year

dummies,45

indu

stry


sto

reflectthefix


2.Num

bersin


deviations.

3.∗∗

∗ p<

.001

,∗∗ p

<.01,

∗ p<

.05,

† p<

.10.

4.N

=4,92

3

Adjusted

281


were used as dependent variables in regressions. Industry-specific dummy variables, year dummy variables, and their in-teraction terms were included to handle the panel data, as inprevious appendixes. Chow’s F-test confirmed the conjecturethat the intercept term varies over time and across industries.

Table A.4.1 shows the regression results with each costitem as a dependent variable. Here the samples were furtherdivided into three time periods, consistent with the analyses inAppendixes 2 and 3. Models (1)–(6) showed the results basedon the entire time period. The empirical analysis showed that thecost of goods sold, which included payrolls, raw material, fac-tory depreciation, and rental expenses,was positively and signif-icantly correlated with both forward and backward integration,implying that greater integration into upstream and downstreamoperations leads to higher costs. This result supported the argu-ment that the costs of vertical integration exceeded the benefits.However, some cost items seemed to decrease with vertical in-tegration. For instance, both forward and backward integrationseemed to lower sales expenses and overhead expenses. Ad-vertisement costs were lower only for companies integratingforward. R&D expenses were actually higher for firms in thedownstream operation. Profitability, reflected in ROIC in model(6) of Table A.4.1, is essentially the same as in model (3) ofTable A.3.1. It is positively related to forward integration butnegatively related to backward integration.

Models (7)–(24) showed the regression analyses accordingto each time period. The cost of goods sold variable was positiveand significant in all regressions, suggesting that the inefficiencyin production costs associated with vertical integration persistedduring the entire time period of study. The profitability equa-tion in each time period showed that forward and backwardintegration did not hurt firms’ performance in period 1 when

282


the economy was strong but that it began to hurt their perfor-mance during the economic slump. Backward integration had aparticularly strong negative effect during this period, consistentwith the results inAppendix 3. General administrative expenses,which did not show any cost saving associated with vertical in-tegration in period 1, became negatively associated with verticalintegration in period 3. Vertical integration apparently did nothelp downstream operators improve their profitability duringthe economic downturn.

As for controls, market share was associated with a decreasein advertising andgeneral administrative expenses and increasedprofitability. Firm size was associated with increased advertis-ing, sales, and R&D expenses. Group size was positively asso-ciated with cost of goods sold and R&D expenses but negativelyassociated with advertising and sales expenses. Both related andunrelated diversification reduced costs of goods sold and R&Dexpenses but were associated with higher sales expenses andgeneral administrative costs.

Overall, the results implied that forward integration helpedchaebol companies reap higher profits, but that backward inte-gration reduced their profitability. More specifically, the suppli-ers of parts gain fromvertical integration, but only at the expenseof assemblers. This asymmetric impact was stronger when theeconomy was weaker.

283

Appendix 5. Determinantsof the Capital Structure

of Chaebols

This appendix examines the determinants of chaebol affiliates’capital structure. A firm’s capital structure comprises its debtsand equity capital. Modigliani and Miller (1958) argued thatcapital structure (i.e., whether a firm uses equity or debt) doesnot affect a firm’s value when taxes are not an issue.More recenttheory emphasized, however, that that cross-country variationsin capital structure depend largely upon institutional factors.7

Here, this study attempted to identify the factors that lead chae-bol affiliates to increase their debts by focusing on the debt–equity ratio as the dependent variable. This study further dis-tinguished debts into two categories according to their maturityand their sources, and examined whether there are any differ-ences in the factors that determine the type of debt used. Inparticular, this study tried to assess what role group-affiliatedfinancial institutions play in determining the capital structuresof their affiliates.

For this study, only interest-bearing corporate debts wereconsidered, excluding liabilities such as accounts payable. The

284

Appendix 5. Determinants of the Capital Structure

debt–equity ratio was calculated by dividing interest-bearingdebts by equity capital. This study further classified debts asshort-term or long-term debts according to whether they ma-tured in less than a year (SHORT-TERM DEBTS) or more than a year(LONG-TERM DEBTS). It also classified the debts as DOMESTIC orFOREIGN according to their sources of origin.

This study used several explanatory variables, including sev-eral thatwere employed inAppendix 3 such as the PROFITABILITY ,measured by the return on invested capital. It was expected thatwhen the profit rate was high, more internal capital would be ac-cumulated and lower debt ratios would be achieved (Myers andMajluf, 1984).8 This study also included the firm growth rate,as fast-growing firms would likely have a greater demand forcapital and thus have higher debt levels.9 The fixed asset ratio isthe ratio of tangible fixed assets to total assets, which is the basisof collateral. The existence of collateral makes it much easierto obtain debt and tends to increase the dependency on debt(Harris and Raviv, 1991; Berger and Udell, 1994). Debt pay-ment guarantees from other affiliates, reflected in the RECEPTION

OF DEBT GUARANTEE variable, also makes these companies moreattractive to investors. This study expected that firms that cansecure debt payment guarantees from other affiliates can securemore debts than thosefirms that cannot.Adichotomousvariable,PUBLIC FIRM, which notes firms listed on the stock exchange, wasalso included. Listed firms can raise equity capital by issuingequity and are likely to have a lower debt–equity ratio than un-listed firms have. In addition, the FIRM SIZE and BUSINESS GROUP

SIZE variables were added to control for size-related factors.Larger firms and chaebols have a greater access to collateraland lower likelihood of default, which were expected to lead toa higher debt–equity ratio. Large firms are also more capable ofissuing information sensitive securities.

285


SALES GROWTH: The annual percentage growth of sales of afirm from time t − 1 to time t .

FIXED ASSETS:A ratio of tangible fixed assets to total assets ofa firm, at time t .

PUBLIC FIRM: The dichotomous variable assigning a value ofone for a listed firm and zero for a private firm.

One of the interesting features of this study was that it em-ployed several dichotomous variables noting the existence offinancial service institutions within the same group.When therewas a merchant bank, an investment trust company, a securitiescompany, a life insurance company, or a fire insurance companyin the group with which a firm is associated, the variable for thistype of institution was assigned a value of one. This study wasinterested in examining whether the existence of a financial ser-vice institution in a group increases the debts of the firm and, ifso, which type of debts will be higher.

This study used Sample B, which consists only of group-affiliated companies from 1985 to 1996. Industry-specificdummy variables, year dummy variables, and their interactiontermswere included to handle the panel data. Chow’s F-test con-firmed the conjecture that the intercept term would vary overtime and across industries. Table A.5.1 shows the regressionresults.

The results showed that when the profit rate was high, moreinternal capital would be accumulated, and lower debt ratioswould result, consistent with the expectation. Sales growthtended to be associatedwith a higher debt–equity ratio. InKorea,fast-growing firms tended to rely more on debts than equity cap-ital. Firms with large fixed assets, which reflect the availabilityof collateral, tended to have lower debt–equity ratios, contraryto the expectation. Publicly traded chaebol affiliates had lower

286


debts than did unlisted chaebol affiliates because they could raiseequity capital from the stock market. Debt payment guaranteesfrom other affiliates contributed to higher debt–equity ratios.The size of individual firms, measured as the logarithm valuesof affiliated firms’ assets, was positively significant, suggestingthat large firms tend to be more leveraged. The larger the groupwas, the lower its affiliates’ debt–equity ratios were.

This study tried to see if chaebols’ ownership of financialinstitutions actually made higher debts possible. In the formula,chaebols’ ownership of financial institutions such as securitiesfirms, merchant banks, life insurance and fire insurance com-panies, and/or investment trust companies was added as an ex-planatory variable. Model (1) showed that a chaebol that ownsat least one financial company depended more on debt than didchaebols that owned no financial concerns. In model (2), sev-eral binary variables noting different kinds of sister financialinstitutions were included. The result showed that ownership ofmerchant banks, securities companies, and life insurance com-panies increased debt dependency.

Models (3) and (4) separated debts into short-term and long-term categories. Several differences emerged: high values offixed assets led to more long-term debt but less short-term debt,which was consistent with the conventional wisdom that fixedassets should be financed by long-term debt. The ownership ofmerchant banks, whose main function was to purchase firms’promissory notes, increased short-term debt, whereas the own-ership of securities companies meant more long-term debt, in-cluding corporate bonds. Table 5.2 shows that group-affiliatedsecurities firms purchased a large portion of corporate bondsissued by other affiliates. For instance, Samsung Securities as-sumed rights to 1.07 trillion won of corporate bonds issued bySamsung affiliates from January to July 1997, which was 69.3%

287

TableA.5.1.Determinantsofdebt–equityratio

Short-term

debt

Lon

g-term

debt

Dom

estic

debt

Foreigndebt

Totald

ebttoequity

toequity

toequity

toequity

toequity

(1)

(2)

(3)

(4)

(5)

(6)

Con

stant

4.16

4.30

5.21

−0.90

5.28

−0.97

(1.09)

∗(1

.11)

∗(0

.90)

∗∗∗

(0.40)

∗(1

.08)

∗(0

.15)

∗

Profi

tability

−0.14

−0.14

−0.10

−0.04

−0.14

−0.00

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.00)

∗∗∗

(0.01)

∗∗∗

(0.01)

∗∗∗

Salesgrow

th0.00

10.00

10.00

10.00

10.00

10.001

(0.00)

∗∗∗

(0.00)

∗∗∗

(0.00)

∗∗∗

(0.00)

∗∗∗

(0.00)

∗∗∗

(0.00)

∗∗∗

Fix edassets

−1.05

−1.08

−2.70

1.62

−1.49

0.41

(0.28)

∗∗∗

(0.29)

∗∗∗

(0.23)

∗∗∗

(0.10)

∗∗∗

(0.28)

∗∗∗

(0.04)

∗∗∗

Public/private

−2.45

−2.44

−1.89

−0.54

−2.26

−0.18

(0.14)

∗∗∗

(0.14)

∗∗∗

(0.11)

∗∗∗

(0.05)

∗∗∗

(0.13)

∗∗∗

(0.02)

∗∗∗

Receptio

nof

debt

0.49

0.49

0.37

0.12

0.47

0.03

guarantee

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.01)

∗∗∗

(0.00)

∗∗∗

(0.01)

∗∗∗

(0.00)

∗∗∗

Firm

size

0.35

0.36

0.18

0.17

0.28

0.07

(0.05)

∗∗∗

(0.05)

∗∗∗

(0.04)

∗∗∗

(0.02)

∗∗∗

(0.05)

∗∗∗

(0.01)

∗∗∗

288

Businessgrou

psize

−0.35

−0.36

−0.26

−0.10

−0.35

−0.02

(0.04)

∗∗∗

(0.05)

∗∗∗

(0.04)

∗∗∗

(0.02)

∗∗∗

(0.04)

∗∗∗

(0.01)

∗

Group

’sow

nershipof

0.56

financialservice

(0.17)

∗∗

affiliates

Merchantb

ank

0.41

0.43

−0.02

0.36

0.05

(0.20)

∗(0

.16)

∗∗(0

.07)

(0.19)

†(0

.03)

†

Securitie

scompany

0.60

0.20

0.39

0.62

−0.02

(0.24)

∗∗(0

.20)

(0.08)

∗∗∗

(0.23)

∗∗(0

.03)

∗∗

Investmentand

0.03

0.18

−0.15

−0.00

0.04

trustcom

pany

(0.31)

(0.25)

(0.11)

(0.30)

(0.04)

Lifeinsurance

0.48

0.40

0.08

0.41

0.07

company

(0.23)

∗(0

.19)

∗(0

.08)

(0.22)

†(0

.03)

∗

Fire

insurance

−0.40

−0.20

−0.19

−0.38

−0.02

company

(0.29)

(0.24)

(0.10)

†(0

.28)

(0.04)

AdjustedR2

0.20

0.20

0.20

0.14

0.20

0.16

Notes:1.

11year

dummies,45

indu

stry

dummies,and45

1indu

stry–y

earinteractionterm

sto

refle

ctthefix

edeffectsmodelarenot

show

n.2.

Num

bersin

parenthesesarestandard

deviations.

3.∗∗

∗ p<

.001

,∗∗ p

<.01,

∗ p<

.05,

† p<

.10.

4.N

=12

,019

.

289


of all corporate bonds acquired by Samsung Securities duringthis period.Theownership of a life insurance company increasedshort-termdebts,whereas ownership of fire indemnity insurancecompanies reduced long-termdebts, albeitweakly. These resultsdemonstrated very clearly that ownership of financial service in-stitutions increased the actual debts a business group carried andthat the type of financial company owned influenced what typeof debt affiliates used, suggesting that group-affiliated financialservice firms functioned as sources of capital for their groups.

Models (5) and (6) distinguished domestic debt from foreigndebt. Again, fixed assets, reflecting collateral, increased foreigndebts but decreased domestic debts. Firms in groups that owneda merchant bank or a life insurance company were more likelyto have higher levels of both domestic and foreign debt. Onthe other hand, firms in groups that owned securities companieswere more likely to have a higher portion of domestic debt and alower portion of foreign debt. Again, the type of financial com-pany owned influenced the type of debt used. It is evident thatchaebol affiliates have served as the private vaults of chaebols.

290

Appendix 6. Profitability andStock Ownership of Affiliates

This empirical study examined the simultaneous relationshipbetween profitability and the stock ownership of affiliates. Eversince Berle and Means’ (1932) seminal work, researchers ar-gued that professional managers with little equity in the firmsthey run seek their own interests at the expense of shareholdervalue and asserted that concentrated ownership helps reducethis agency problem (Jensen and Meckling, 1976; Shleifer andVishny, 1986).

This conventional line of research is currently being chal-lenged on two theoretical grounds. Some have argued that strat-egy scholars need to consider non-Western contexts, in whichkey owners often not only manage their own firms but mayalso control other affiliated firms through cross-shareholding(La Porta et al., 1999). According to their view, the greatestsource of agency problems in most countries is not professionalmanagers but instead controlling shareholders, who expropriatevalue from minority shareholders. A second, distinct line of re-search suggests that it is wrong to accept ownership structureas exogenously given (Demsetz, 1983; Demsetz and Lehn,1985). Others, building on this insight, have instead posited that

291

Appendix 6. Profitability and Stock Ownership

performance may influence ownership structure but not viceversa, as previous studies argued. Kole (1996) provided relatedevidence for this conjecture by showing thatmanagers prefer eq-uity compensation only when they expect their firms to performwell, suggesting that managerial ownership represents an en-dogenous outcome of compensation contracting practices. Cho(1998) used the simultaneous equations estimation technique toshow that corporate value affects ownership structure, while thereverse relationship does not hold.

When controlling shareholders directly or indirectly man-age a firm, the possibility of reverse causality can be muchgreater because these individuals can use insider informationabout their firms for their personal gain, much in the same waythat managers prefer stock options when they think their firmswill perform well. For instance, they may use insider informa-tion to increase their own shares of an affiliate that is likely todevelop a breakthrough technology or to win a large contractand decrease their own shares in affiliates that have only lacklus-ter prospects. By doing so, large shareholders expropriate valuefrom minority shareholders who do not have access to such in-formation. Just as chaebol families may increase their shares ofprofitable affiliates, they may wish to decrease ownership of anaffiliate that has potential liabilities.

This study used a simultaneous equation model to identifyhowequity stakes held by the chairman and other affiliates deter-mine a company’s profits, as well as how equity ownership itselfgets determined. This study restricted the sample firms tothe public companies affiliated with business groups (i.e.,Sample B′). The ownership information for public firms wasavailable from 1986 onward; however, the same information forprivate firms was not available until the mid 1990s. The KIScarefully established information on the family membership of

292


controlling shareholders, who are often founders and their de-scendants, and calculated the family ownership. Identifying af-filiate ownership is straightforward and follows the definition ofbusiness groups by KFTC.

FAMILY OWNERSHIP: the percentage of equity shares owned bythe family members who are identified as the controllingshareholders of a business group at time t .

AFFILIATE OWNERSHIP: the percentage of equity shares ownedby other affiliates in the same business group at time t .

It is necessary to control for both firmand business group size,as eachmay affect the ownership decision andfirmperformance.This study incorporated both FIRM EQUITY and GROUP EQUITY inthousands of won. It was expected that the larger the firm’sequity was, the smaller the portions of inside ownership wouldbe, given wealth constraints. The same logic held for the totallevel of equity at the group level because it would be hard fora family or an affiliate to maintain a higher level of ownershipfor every affiliate. There was no a priori expectation of firm sizevariable in the profitability model. YEARS OF LISTING is definedas the number of calendar years since a firm was listed. Bothfamily and affiliate ownership were expected to be dispersedover time. This study also incorporated ameasure of uncertaintyfaced by the firm.Demsetz andLehn (1985) argued that themoreuncertain the firm’s environment was, the greater was the firm’sneed to maintain tight ownership control. This study measuredVOLATILITY by the standard deviation of profitability during thepast 5 years (Cho, 1998). SALES GROWTH, as used in Appendix 5,was included as a determinant for firm performance.

FIRM EQUITY : Equity of a firm in thousands won, measured attime t .

293


GROUP EQUITY :Sum of equities of all firms associated with thebusiness group, in thousands won, measured at time t .

YEAR OF LISTING: Years since establishment, measured attime t .

VOLATILITY : The standard deviation of the profitability mea-sured by ROIC during the time t and time t-4.

This study used the panel data analysis technique and the two-stage least squared (2SLS) regression methods to estimate theprofitability and ownership structure with panel data for publicgroup affiliates for 1986–96. Initially, this study estimated indi-vidual equations with the OLSmethod while incorporating onlythe year and industry effects variables, based on the two-digitKSIC level. Himmelberg, Hubbard, and Palia (1999) observed,however, that there could be spurious causal relationships be-tween ownership and firm performance because of unobservedfirm heterogeneity. This study adopted the panel data techniqueof Himmelberg et al. by including a set of firm and year dummyvariables (Hsiao, 1986). Nonetheless, the panel analysistechnique did not resolve the endogeneity problems betweendependent and independent variables. This study thus used thesimultaneous equation technique to explore this endogeneity asCho (1998) did in studying ownership concentration and perfor-mance for U.S. firms. The 2SLS method first estimates individ-ual endogenous variables with instruments that are independentof these variables. It then replaces the endogenous variableswiththe estimates from thefirst-stage regressions. It is not easy to findsuitable instruments that are both conceptually and empiricallyexogenous to the system. This study used firm characteristicssuch as sales growth, firm equity, group equity, volatility, andyears of listing because there was no a priori reason why theywere endogenous to ownership or firm performance.

294


Models (1)–(3) of Table A.6.1 show the results accountingfor firm heterogeneity. Two-stage models (4)–(6) handle bothfirm heterogeneity and endogeneity. In model (1), family own-ership is associated with higher profitability, which supports theagency theory hypothesis that concentrated family ownershipensures more effective monitoring of managers. In model (2),profitability was also associated with family ownership, whichin turn suggested that family ownership was higher in moreprofitable firms. Affiliate ownership and profitability were notsignificantly related to one another in models (1) and (3).

The study then reestimated equations with two-stage regres-sion models. In order to avoid over-identification, we selectedonly a partial set of potential instruments (Johnston, 1984).10

Sales growth was a significant indicator of profitability and wasselected as an instrument for a profitability model. As for theownership models, group equity and volatility became the pri-mary candidates. Years of listing and firm equity were includedas controls in all models. Variables for firm investment (R&D,advertising, liquidity, and leverage) and intra-group transactionvariables might be endogenous to firm performance and own-ership (Cho, 1998; Himmelberg et al. 1997; Chang and Hong,2000) and were not used as instruments.

After controlling for endogeneity, the effects of family own-ership to performance vanished, as in model (4). In contrast, therelationship between performance and family ownership waspositively significant in model (5), albeit weakly. The resultssuggest that firm profitability affected the ownership structurebut not vice versa, and demonstrates that endogeneity problemsindeed affect the results in models (1)–(3). Family ownershipand affiliate ownership had significant and negative coefficientsin models (5) and (6), suggesting that they are really substitutes,even after controlling for endogeneity. In order to maintain a

295

TableA.6.1.OLSand2SLSmodelsofprofitabilityandfamilyandaffiliateownership

With

firm

effects

2SLSwith

firm

effects

(1)

(2)

(3)

(4)

(5)

(6)

Profi

tability

Family

ownership

Affilia

teow

nership

Profi

tability

Family

ownership

Affiliateow

nership

Intercept

9.18

22.99

17.97

2.44

5.68

35.67

(1.31)

∗∗∗

(2.12)

∗∗∗

(1.96)

∗∗∗

(7.99)

(10.64)

(12.36)∗

∗

Profi

tability

0.11

0.01

0.56

0.87

(0.05)

∗(0

.02)

(0.34)

†(0

.56)

Family

0.05

−0.16

0.41

−1.54

ownership

(0.02)

∗(0

.02)

∗∗∗

(0.28)

(0.90)

†

Affiliate

0.01

−0.22

−0.04

−0.65

ownership

(0.01)

(0.03)

∗∗∗

(0.12)

(0.38)

†

Firm

1.72

∗ 10−

92.08

∗ 10−

91.99

∗ 10−

91.23

∗ 10−

92.03

∗ 10−

93.13

∗ 10−

9

equity

(8.29∗10

−10)∗

(7.37∗10

−10)∗

∗(1

.27∗10

−9)

(9.35∗10

−10)

( 1.46∗10

−9)

(2.58∗10

−9)

Group

−3.98∗10

−10

−7.10∗10

−10

−6.78∗10

−10

−1.05∗10

−9

equity

(1.66∗10

−10)∗

(2.52∗10

−10)∗

∗(3

.84∗10

−10)†

(3.79∗10

−10)∗

∗

Yearsof

−0.16

0.34

−0.90

−0.42

1.69

0.16

listin

g(0

.65)

∗(0

.16)

∗(0

.16)

∗∗∗

(0.34)

(0.89)

†(1

.01)

Volatility

0.07

0.11

0.08

0.13

(0.06)

(0.05)

∗(0

.08)

(0.12)

Sales

0.02

0.02

grow

th(0

.01)

∗(0

.01)

∗

R2

0.43

0.87

0.88

0.25

0.84

0.54

Notes:1.Num

bersin

parenthesesaretheWhite’sheteroscedastic

ity-consistent robuststandarderrors.

2.∗∗

∗ p<

0.00

1,∗∗p

<0.01,∗p

<0.05

,†p

<0.10

,N

=3,086.


controlling stake, a family should have either a higher directownership stake or a lower affiliate ownership stake, or viceversa. Chaebol families are not likely to hold more equity thanthey need to ensure control since they would rather invest innew ventures.

In general, the instrument variables were consistent with ex-pectations. Sales growth was an important predictor of firmperformance. The group equity variable was negative for bothfamily and affiliate ownership, reflecting wealth constraints.Volatility was insignificant, however. These results indicatedthat chaebol families increased their ownership stakes of moreprofitable firms and decreased their stakes in less profitablefirms. There was no evidence for the conventional argumentlinking ownership concentration to better firmperformance. Theoverall results from this empirical study confirm that chaebolsposed severe agency problems because chaebol families maxi-mized their own profits at the expense of minority shareholders.

297

Appendix 7. IntragroupBusiness Transactions and

Ownership Structures of theTop Five Chaebols

Chapter 4 examined the Hyundai Groups’ internal transactions.The core manufacturing companies maintained backward (orupstream) integration with smaller affiliates that supply inter-mediate goods and parts to them. On the other hand, thereare instances of forward (or downstream) integration througha general trading company and domestic sales-related affiliates.Figures A.7.1–A.7.4 show similar patterns of vertical integra-tion in Samsung, LG, Daewoo, and SK Group, respectively.Chapter 6 examined the ownership structure of the SK Group.Figures A.7.5–A.7.8 show a simplified version of equity stakesheld by group chairmen and the stakes held by the major affil-iates in Samsung, Hyundai, LG, and Daewoo Group, respec-tively. They demonstrate how major affiliates in each groupeffectively control small affiliates by owning them singly andjointly, and the chaebol chairmen control all these firms withvery small ownership stakes.

299

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301

Appendix 7. Intragroup business transactions

KyungnamMetal

Koram Plastics

Daewoo PrecisionIndustries

Orion ElectricComponents

KyungnamEnterprises,

Korea Automotive Fuel System

Daewoo HeavyIndustries

Daewoo Electronic Components

DaewooElectronics

Daewoo Automotive Components

Daewoo InformationSystems

Orion Electric

Daewoo Motor

DaewooTelecom

2,511

178

202

619

150

4,190

551

722

5,946

678

5,578

2,476

1,771

2,412

294

404

197

566

285

747 796

156

157

295

302

Appendix 7. Intragroup business transactions

Daewoo Corporation

Daewoo Capital

Diners Club of Korea

Daewoo Securities

Daewoo Development

15516,821

533

1,465

36,080

2239,603 4,906

Figure A.7.3. Intragroupbusiness transactions ofDaewoo Group. Source: KoreaInformation Services.Note: All data are as ofDecember 1997. Unit is100 million won: 1. Largecircles are for affiliates withover 5 trillion won in assets;2. We show internal sales thatare over 30 billion won.

303

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308

Appendix 8. Key EconomicStatistics, 1960–2000

Gross Currentdomestic Exchange accountproduct Per capita rate Export balance

Year (billion $) income ($) (won/$) Inflation (%) (billion $) (billion $)

1960 2.0 79 65.0 0.03 0.011961 2.1 82 130.0 0.04 0.031962 2.3 87 130.0 0.05 −0.061963 2.7 100 130.0 0.09 −0.11964 2.9 103 256.0 0.1 −0.031965 3.0 105 272.1 0.2 0.011966 3.7 125 271.5 11.3 0.3 −0.11967 4.3 142 274.6 10.9 0.3 −0.21968 5.2 169 281.5 10.8 0.5 −0.41969 6.6 210 304.5 12.4 0.6 −0.51970 8.0 249 316.6 16.0 0.8 −0.61971 9.4 286 373.2 13.5 1.1 −0.81972 10.6 316 398.9 11.7 1.6 −0.41973 13.5 394 397.5 3.2 3.2 −0.31974 18.8 540 484.0 24.3 4.5 −2.01975 21.1 592 484.0 25.2 5.1 −1.91976 28.9 799 484.0 15.3 7.7 −0.3

309

Appendix 8. Key Economic Statistics, 1960–2000

1977 37.1 1,009 484.0 10.1 10.0 0.01978 52.0 1,399 484.0 14.5 12.7 −1.11979 61.9 1,636 484.0 18.3 15.5 −4.21980 62.2 1,598 659.9 28.7 17.2 −5.31981 69.6 1,749 700.5 21.4 20.7 −4.61982 74.4 1,847 748.8 7.2 20.9 −2.51983 82.3 2,020 795.5 3.4 23.2 −1.51984 90.6 2,190 827.4 2.3 26.4 −1.21985 93.4 2,229 890.2 2.5 26.6 −0.71986 107.6 2,550 861.4 2.8 34.1 4.71987 135.2 3,201 792.3 3.1 46.5 10.01988 180.8 4,268 684.1 7.1 59.9 14.51989 220.7 5,185 679.6 5.7 61.8 5.31990 252.5 5,886 716.4 8.6 63.6 −2.01991 295.1 6,810 760.8 9.3 70.5 −8.31992 314.7 7,183 788.4 6.2 76.1 −3.91993 345.7 7,811 808.1 4.8 82.0 0.91994 402.4 8,998 788.7 6.3 94.9 −3.81995 489.4 10,823 774.7 4.5 124.6 −8.51996 520.0 11,385 844.2 4.9 129.9 −23.01997 476.6 10,315 1,415.2 4.4 138.6 −8.11998 317.7 6,744 1,207.8 7.5 132.1 40.31999 405.8 8,595 1,145.4 0.8 145.1 24.42000 461.7 9,770 1,259.7 2.3 175.9 12.2

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

Gross Currentdomestic Exchange accountproduct Per capita rate Export balance

Year (billion $) income ($) (won/$) Inflation (%) (billion $) (billion $)

Appendix 8. (cont. )

310

Notes

chapter 1

1 Figures are in nominal U.S. dollars from theEconomic Statistics Yearbook,Bank of Korea.

2 World Bank, 1993.3 At the end of 1996, the foreign currency reserve of Korea was $32 billion.At the end of 2000, it increased to $96 billion, according to the FinancialStatistics Yearbook, Bank of Korea.

4 Jeffrey Sachs, “The Wrong Medicine for Asia,” The New York Times,November 3, 1997; Jeffery Sachs, “IMF Is a Power onto Itself,” FinancialTimes, December 11, 1997; Joseph Stiglitz, “Must Financial Crises BeThis Frequent and This Painful?,” manuscript, 1998; “World Bank, IMFat Odds Over Asian Austerity – Some Economists Contend That HarshMeasures Could Worsen the Crisis,”Wall Street Journal; January 8, 1998.

5 “The Chaebol That Ate Korea,” Economist, November 12, 1998.6 See Frenkel and Roubini (2000) for more in-depth discussion on this topic.7 See Corsetti, Pesenti, and Roubini (1998) for a survey on this topic.8 Prime Minister Mahatir of Malaysia was the strongest proponent of thishypothesis. Between 1996 and 1997, there was a $109 billion reversal ofnet private capital flows (more than 10% of GDP) overall in East Asianregion (Institute of International Finance, 1998, quoted in Joseph Stiglitz,“Must Financial Crises Be This Frequent and This Painful?,” manuscript,1998). See Figure 2.5 for inflow of foreign capital to Korea.

311

Notes to pages 8–25

9 IMF, Press Information Notice, 98/39, “IMF Concludes Article IVConsultation with Korea.”

10 “The Apologist,” Economist, August 27, 1998; “Chaebols That AteKorea,” Economist, November 12, 1998; “Korean Inc. Balks,” BusinessWeek, January 19, 1998.

11 IMF, Press Information Notice, 98/39, “IMF Concludes Article IVConsultation with Korea.”

12 For a representative proponent, see Amsden (1989).13 See Appendix 1 for more details.14 See the data appendix for more information on sample composition.

According to the Korea Development Institute, the top thirty chaebolsaccounted for 40% of Korea’s output in the mining and manufacturingsectors in 1996.

15 The average ROIC of U.S. public firms during 1981 and 1991 was14.5%.

16 The preceding productivity indices calculate the average productivity bydividing the total value added by one unit of capital or labor withoutdecomposing their respective contribution to the total value added. Themarginal level of labor and capital productivity or total factor productivityis calculated by estimating the production function with time series data.See Kim and Lau (1994, 1996), and Young (1995) for examples of thisapproach.

17 Krugman (1994). Krugman’s argument was based on the empirical find-ings of Kim and Lau (1994, 1996), which decomposed the sources of thepost-war period of economic growth into factors attributable to capital,labor, and technical progress. They estimated the contributions of capital,labor, and technical progress in the growth of Korea as 86.3, 12.7, and1.0%, respectively.

18 See Figure 3.1.19 See Blair and Roe (1999, chapters 5–7) for a detailed description of

Germany’s governance system.20 Fields (1995, p. 96).21 His administration encouraged private French companies to buy shares

in reprivatizing companies. For example, CGE (Compagnie Generaledes Eaux), a water and waste treatment service company until the mid-1970s that had already diversified into real estate, telecommunications,

312


construction, and hospital management, purchased 11 billion Frf. worthof shares in other French companies such as St. Gobain, Alcatel Alsthom,Accor, Paribas, and Societe Generale bymid 1990. At the same time, othercompanies such as Societe Generale, AXA, andBanqueNationale de Parispurchased shares of CGE.

22 Some conglomerates, particularly French ones, are subject to family con-trol. Unlike chaebols, members of the controlling families did not managethese firms’ affiliates.

23 For example, Orru, Biggart, and Hamilton (1997) and Powell and Smith-Doer (1994) describe chaebols as networks. Characteristics such as ex-tensive debt guarantee, cross-ownership, and internal transactions maygive the impression of a network. Considering that individual affiliates aretightly controlled and coordinated by group-level headquarters, chaebolsare more accurately described as a hierarchical structure. Shin and Kwon(1999) also warned against the view that considers chaebol as a type of anetwork.

24 See Granovetter (1995) for a review. Ghemawat and Khanna (1998) pro-vide a table that summarizes the evidence of business groups prevalent indeveloping countries. See McVey (1992) and Orru et al. (1997) for exam-ples of business groups in Southeast Asia, Strachan (1976) for Nicaragua,Ghemawat and Khanna (1998) for India, and Khanna and Wu (1998) forChile.

25 Similarly,North (1981) argues that the state tends to create inefficient prop-erty rights for political reasons, which generate high transactions costs.According to him, economic organizations such as business groups canbe viewed as natural evolution that reduce transactions cost and improveperformance.

26 This view can be generally referred to as the institutional approach or com-parative institutional approach. See Orru et al. (1997) and Evans (1995)for more theoretical discussion of this topic.

27 See chapter 7 of Woo (1991) and chapter 6 of Kim (1997) for more de-tailed descriptions of the changes in geopolitical environments during the1980s.

28 Furthermore, its prior success was an important source for inertia becauseit is difficult to change a course of action that was successful in the past.March (1994) refers to this difficulty as a competency trap.

313


29 Johnson et al. (2000) argue that the weakness of legal institutions forcorporate governance had adverse effects on asset prices and exchangerates in all countries affected by the Asian crisis.

30 See Kim (1997) and Woo-Cumings (1999).

chapter 2

1 There are several books that examine the historical development of chae-bols. See Amsden (1989), Kang (1996), and Kim (1996).

2 See McNamara (1990) for more information on the economic activitiesof Korean companies during the Japanese occupation. Eckert (1991) alsoprovides a history of Sung-Soo Kim and his family during the Japaneseoccupation.

3 Kang, 1996, p. 45. See also chapter 2 of Kim (1998) for detailed informa-tion on the formation of chaebols during this period.

4 There have been numerous studies of the early development of chaebols,including Amsden (1989) and Kim (1997).

5 See Jones andSakong (1980) andKim (1997) formore details on economicplanning during this era.

6 Evans (1995) argued that such an elite group of state bureaucrats is acritical element of the developmental state.

7 It was possible since the government owned all commercial banks andcontrolled the loans.

8 Under this system, incumbent firms had an advantage, whichwas furtheredthrough their political connections. Amsden (1989), however, justifiedthe government’s repeated patronage of a few chaebols on the basis ofefficiency rather than political connections.

9 Several scholars, including Kim (1997), argued that chaebols were notmerely puppets for the intervention-oriented government, and that chae-bols chose somewhat different paths from each other. For instance,Samsung and LG were not as enthusiastic about the government’s driveinto heavy and chemical industries in the 1970s as were Hyundai andDaewoo. Although chaebols had some degree of freedom in their actions,their strategies were largely based on what the government wanted.

10 Hirshman (1958) argued that a dearth of entrepreneurs was a critical miss-ing element in late entrants. Amsden (1989) also pointed out that in the late

314


industrialization, the state and the salaried engineers were two key figuresbut private entrepreneurs were squeezed between them because the statewas the overall allocator of resources and the latter were the gatekeepersof foreign technology transfer.

11 Woo (1991), Fields (1995), and Cho and Kim (1997) provided detailedanalysis of the government’s intervention in the financial service sectorand its consequences.

12 TheNixon doctrine in 1969 declared to leave the defense of the PacificRimto the countries of that region. President Carter also vowed to withdrawtroops from Korea.

13 See Cho (1987) for more information on the Korean general tradingcompanies.

14 Those presidents might have done so to appeal to populism and gain le-gitimacy for their own regime.

15 The dissolution of Kukje Group is widely believed to be a political pun-ishment for its refusal to contribute political funds to President Chun. SeeFields (1995) and Kim (1997) for more details of the fall of the KukjeGroup.

16 See Steers (1999) for more information on Hyundai.17 In 2002, Hyundai Group was broken into several minigroups focusing on,

among other things, automobiles and heavy industries. This split reflectsthe inheritance of Chairman Chung’s holdings by his sons rather thanearnest restructuring effects.

18 See Kim (1998) for a history of Samsung. Chun and Han (1994) alsoprovided an overview of Samsung’s history.

chapter 3

1 See Christensen andMontgomery (1981) and Rumelt (1982) for empiricalstudies on this topic.

2 The sales information in this figure is based upon aggregation of salesof individual affiliates, not upon consolidated income statements, whichbecome available in 2000. Thus, intragroup sales are double-counted.

3 Of course, not all of these efforts were successful. Many government-induced efforts in the chemical and heavy equipment industries duringthe economic development era resulted in heavy losses as a result ofovercapacity.

315


4 Profitable affiliates often bear group-level image advertisement expenses,while unprofitable affiliates share intangible resources free of charge. SeeChapter 4 for more discussion of such cross-subsidization.

5 Samsung Group, 50 Year History of Samsung.6 Chun and Han, 1994.7 Sometimes, the goal is the maximization of the wealth of the group chair-man and his family. Chapter 6 will discuss this topic further.

chapter 4

1 Many subcontractors supply parts and services to chaebol affiliates. Be-cause we define chaebol membership according to the 30% ownershipcriterion specified by the Korea Fair Trade Commission (see Chapter 1),the extent of vertical integration in chaebols is more substantial if we addthose subcontractors with less than 30% of chaebol ownership.

2 Hyundai Electronics was renamed Hynix in 2001.3 See Chapter 2 for more details.4 The export portion has gradually declined since itsmanufacturing affiliatesare increasingly engaged in developing overseas markets themselves.

5 Chapter 5 analyzes how chaebols’ internal capital markets operate.In-house financial service firms play a critical role in these markets.

6 Coase (1937) and Williamson (1975) pointed out that vertical integrationenhances efficiency by reducing transactions costs caused by imperfectintermediate goods markets.

7 “Bell Labs Faces Mundane Future under Breakup Plan,” Wall StreetJournal, September 22, 1995.

8 “Major Overhaul,” Wall Street Journal, October 23, 1992; “GM IsExpected to Distribute the Remainder of Delphi to Shareholders, NextMonth,” Wall Street Journal, April 12, 1999.

9 “Reynolds Metals, Alcoa Split on Strategy – But Both Remain Captive tothe Aluminum Cycle,” Wall Street Journal, November 7, 1990.

10 See Chapter 7 for more discussion on restructuring the chaebols.11 Lincoln, Gerlach, and Ahmadjian (1996) argue that keiretsu grouping en-

hances the viability of the group as a whole by realigning its members’prospects and resources. These adjustments amount to subsidization byprosperous members to guarantee the survival and hasten the recoveryof financially troubled companies. They found strong evidence that the

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current profitability of a firm is negatively correlated with the interactionterms between its lagged profitability and the various keiretsu ties that ithas. This result suggests that unprofitable firms benefited while profitablefirms suffered from cross-subsidization. They argued that, in the long run,the successful rescue and turnaround of a business partner might pay foritself through loans and contracts otherwise lost to failure. In the short run,however, the burden on the firms providing the subsidies may be severe.Other research on Japanese business groups found that the group member-ship was often associated with negative performance (Caves and Uekusa,1976; Nakatani, 1984).

12 The Korea Fair Trade Commission conducted four rounds of investigationon the unfair business practices during 1998–2000. The details of findingsfrom those investigations are available from press releases, dated July 30,1998, November 13, 1998, October 1, 1999, and December 14, 2000.

13 Korea Fair Trade Commission, press release of July 30, 1998.14 Op. cit.15 Many instances of such support involve an affiliated financial institution.

Financial institutions affiliated with a chaebol serve as a coffer for theirgroups. The financial institution purchases corporate bills issued by itsaffiliate at a low discount rate or disburses cheap loans to an affiliate. Inaddition, the issue of bonds with warrants at low prices involves intensivesupport to financially unhealthy affiliates. Chapter 5 examines this role ofin-house financial institutions in more detail.

chapter 5

1 See Chapter 2 for more details.2 See Woo (1991), Nam (1994), Park (1994), and Fields (1995) for morediscussion of the government interventions in the financial service industryin Korea.

3 Themost notable casewas themassive government bailouts of the troubledfirms in the heavy equipment and chemical industries in 1980 (Woo, 1991).

4 Moral hazard refers to the tendency to take more risks if one knows it willbe rescued in cases of failure.

5 Borensztein and Lee (1999) argued empirically that the capital allocationof the Korean financial sector was largely inefficient, both before and afterthe financial reforms.

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6 See Balino and Ubide (1999) for details about the lack of financial super-visions in Korea prior to the crisis.

7 See Chapter 2 for a more in-depth discussion of this point.8 Under the revised Bank Act, legal entities or persons who meet certainconditions may own up to 10% of national commercial banks and 15% ofregional banks. One of these conditions was an obligation to report to theFinancial Supervisory Commission.

9 See Fields (1995), Chapter 4 for a history of the deregulation and privati-zation of the Korean financial service sector.

10 Report by Ministry of Finance and Economy to the Finance and BankingCommittee, National Assembly, 1998.

11 “South Korean Finance:Murkier andMurkier,”Economist, September 11,1999.

12 Balino and Ubide, 1999.13 Cho (1986) pointed out that financial liberalization in the absence of well-

functioning equity markets could generate a much worse outcome thancould occur under financial repression.

14 Khanna and Wu, 1998.15 Chaebols’ debt structures show debts of only the mother companies in

Korea. They do not reflect debts of their overseas subsidiaries. Localfinancing for chaebols had increased from $187.6 billion in 1993 to$514.6 billion in 1997 – a 170% increase. The top five chaebols had con-sumed about $359.4 billion as of 1997, about 69% of total local financing.In short, overseas debts during this period were mainly held by these topfive chaebols.

16 Bank of Korea, Business Statistics, 1998.17 See the survey by Harris and Raviv (1991) and Rajan and Zingales (1995).18 Coffee (2001) argued that relative decentralization, which enabled private

entrepreneurs to devise their own techniques to attract foreign capital andto develop their own financial institutions, is a better way to develop themeans to protect minority shareholders than is the legal tradition (civil lawversus common law) itself.

19 See Chapter 2 for an in-depth historical review of this issue.20 Nevertheless, not all Korean companies are saddled with high debt–equity

ratios. In fact, financial structures vary according to company size: thesmaller the company is, the lower the debt–equity ratio. Small firms didnot benefit from the government’s industrial policy, nor did they have the

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luxury of debt guarantees or support from their own financial affiliates, asdid chaebols.

21 Gerschenkron (1962) pointed out that an equity-based financing system isan artifact of early industrialization.

22 See Chapter 7 for details.23 See Chapter 3 for details.24 The Korea Fair Trade Commission conducted three rounds of investi-

gations of these practices during 1998–9. The details of its findings areavailable from press releases from July 29, 1998, November 13, 1998, andOctober 1, 1999.

25 Korea Fair Trade Commission, press release of October 1, 1999.26 Korea Fair Trade Commission, press release of July 30, 1998.27 Korea Fair Trade Commission, press release of October 1, 1999.28 NamandHong (1999) provided empirical support for this conjecture. They

found that the main reasons for distress were high debts and a high levelof fixed investment.

29 Chapter 7 deals with the restructuring of financial institutions in detail.

chapter 6

1 The Korea Fair Trade Commission defines net assets as paid-in capitalminus equity investment by other affiliates.

2 Please refer to the extensive survey by Shleifer and Vishny (1997).3 Refer to Kang, Choi, and Chang (1991, p. 55).4 The effectiveness of the board is not without dispute. There is evidence thatboard intervention had always been too late (Warner, Watts, and Wruck,1988) and that corporate boards, even in the United States, were controlledby management (Jensen, 1993).

5 Under the Commercial Law, amended in 1998, minority shareholders withmore than 1% ownership can bring a lawsuit and those with more than 3%can demand the opening of accounting books. For public companies, thenewly enacted Securities Transaction Law allows minority shareholderswith a stake greater than 0.01% to file a lawsuit.

6 Such restraints were officially lifted in 1998.7 Several scholars argue for the effectiveness of corporate governancesystem in Japan. For instance, Hoshi, Kashiyap, and Scharfstein (1991)showed that firms with main banking relationships recover quickly from

319


financial distress. Porter (1992) argued that the Japanese system ensureslong-term investment.

8 See Kang and Shivdasani (1995) for empirical evidence.9 See Chun and Han (1994) for a history of Samsung’s semiconductorventure.

10 See Steers (1999) for the background history of Hyundai’s shipbuildingbusiness.

11 “The Crises in Samsung,”BusinessWeek, March 23, 1998; “Samsung: NotJust Chips Are Down,” Business Week, July 29, 1996.

12 Lee, 1997.13 Fair Trade Commission, press release, October 1, 1999.14 Op. cit.15 Fair Trade Commission, case number 9712.16 For example, see Franks and Mayer (1994) for Germany, Kang and

Shivdasani (1995) for Japan, and Morck, Shleifer, and Vishny (1998) forthe United States.

17 La Porta et al. (1999) defines a pyramid as “an ownership structure inwhich a firm has an ultimate owner and at least one publicly traded com-pany between it and the ultimate owner in the chain of voting rights.”They define cross-shareholding as “any instance when a firm owns anyshares in its controlling shareholder or in the companies along thatchain of control.” According to their classification scheme, chaebols useboth pyramids and cross-shareholding. In this study, we do not distin-guish between pyramids and cross-shareholding, and use the term cross-shareholding to denote the percentage of ownership by other public orprivate affiliates.

18 See Wolfenzon (1999) for a formal model of this feature.

chapter 7

1 International Monetary Fund, “Republic of Korea – IMF Standby Agree-ment: Summary of Economic Program,” press release, December 5,1997.

2 The combined financial statements consolidate financial statements of allsubsidiaries that are effectively controlled by one individual (see Account-ingResearchBulletin,No. 51, by theAmerican Institute ofCertified PublicAccounts formore details). They differ from the conventional consolidated

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statements whose consolidation criteria are based on direct equity hold-ings. As a consequence, several affiliates in a chaebol had reported theirconsolidated financial statements reflecting their own equity holdings. Thecombined statements require chaebols to consolidate all the affiliates thatare effectively controlled by the chaebol chairmen.

3 Kim (1999).4 See Balino and Ubide (1999) for more information on the operations ofKAMCO and financial sector reform in Korea.

5 See the Ministry of Finance and Economy (2000) for more informationon the source of public funds and the details of its expenditures.

6 “Financial Supervisory Board will punish Cheil Bank for resisting theacquisition of bonds of troubled companies,” Chosun Ilbo, January 5,2001.

7 Because many chaebols were bankrupt as of 1999, the averages for the topthirty chaebols in 1999 are for only twenty-three surviving chaebols, andthe average for the top five chaebols excludes Daewoo’s ratio.

8 Lieberman and Mako (1998), p. 63.9 See Solomon and Saret (1992) for more information on the corporateworkout procedure.

10 “29 Companies Were Liquidated,” Chosun Ilbo, November 4, 2000.11 “KDI Severely Criticizes the Government’s Restructuring Policies,”

Donga Ilbo, December 9, 2000.12 “Big Deal Became Empty Deal after Two Years,” Chosun Ilbo,

December 20, 2000.13 Op. cit.14 In December 1998, the Corporate Accounting Standards were amended

to conform to international standards and a new rule for account-ing of financial institutions has been enacted. In September 1999, theKorea Accounting Research Institute was founded to propose accountingstandards that are in line with international practices.

15 The proportion of outside directors on the boards of U.S. firms was 78%in 2000 (“Outside Directors,” Economist, February 10, 2001).

16 “The Chaebols Spurn Change,” Economist, July 22, 2000.17 Korea Stock Exchange, press release, November 30, 2000.18 Giving in to the demands of the People’s Solidarity for Participatory

Democracy, a nongovernmental organization, the government planned toallow anyone with one share in a listed firm with more than 2 trillion

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won in assets to initiate a class action lawsuit from the year 2002onward.

19 No director has been appointed through such procedures as of 2000.20 This survey was conducted by the Hangil Research Center at the request

of the People’s Solidarity for Participatory Democracy. The survey wasconducted by eighty-seven domestic fund managers and sixty-six foreignfund managers during the month of December 2000. The detailed surveyresults are available at http:\peoplepower21.org.

21 The Korea Fair Trade Commission, “The Report on the 4th Unfair InternalBusiness Trade of the Four Largest Groups,” press release, December 15,2000.

22 Op. cit.23 The main elements of the zaibatsu dissolution program included (1) the

dissolution of zaibatsu holding companies, (2) barring of old zaibatsufamily members from resuming positions as company officers in the ex-zaibatsu enterprises, as well as (3) prohibition of the use of the traditionalzaibatsu trade names and insignia.

24 “Scourge of the Chaebol,” Economist, March 27, 2000; “This TimeAround, Goliath May Strike Back,” Business Week, March 29, 1999.

chapter 8

1 See Davis, Diekmann, and Tinsley (1994) for more information on theinstitutional factors behind the decline of conglomerates in the 1980s.

2 Bowman et al. (1999) showed that among financial, business, and or-ganizational restructuring, only financial restructuring has been value-enhancing. Business restructuring induced mild improvements, whileorganizational restructuring negatively impacted performance. This pat-tern is similar to the Korean case, where financial restructuring had amoderate but positive impact, while business restructuring failed. Animportant difference is that U.S. firms used new financial instrumentssuch as leveraged buyouts (LBOs) and management buyouts (MBOs) toswap equity for debt, which disciplined managers to run firms efficiently,whereas the financial restructuring of chaebols involved debt for equityswaps.

3 For instance, corporate raiders issued junk bonds to do LBOs of listedfirms. They then took these firms private and divested most of their

322


noncore assets. Sometimes the top managers of a firm took over theircompany in MBOs.

4 “Daimler Taking Over Mercedes Subsidiary in Restructuring Bid,” WallStreet Journal, January 24, 1997; “Daimler-Benz’s DASA to Cut 9000Jobs,” Wall Street Journal, October 24, 1995.

5 “Survey: European Business,” Economist, April 27, 2000.6 In 1999, $393 billion of $1,500 billion worth of M&A deals were hostiletakeovers. “Bidding for the Future,” Economist, February 10, 2000.

7 “Neat but Not Yet Tidy,” Economist, September 23, 1999.8 For instance, Hoechst’s attempts to divest unprofitable basic chemicalbusinesses and focus on life science were blocked by the oppositionof labor unions. “Survey: European Business,” Economist, April 27,2000.

9 According to Dodwell Marketing (1992), 713 of 1,687 listed Japanesefirms are associated with eight bank-centered horizontal keiretsu –Mitsubishi, Mitsui, Sumitomo, Daiichi Kangyo, Sanwa, Fuyo, Tokai, andIndustrial Bank of Japan – or thirty-one vertical keiretsu linked with ma-jor manufacturing companies. This definition is conservative, however,because there are different definitions of group affiliation.

10 Japanese Fair Trade Commission, 1992.11 “Fall of a Keiretsu,” Business Week, March 15, 1999.12 “Japan’s Keiretsu: Mindset,” Economist, October 23, 1999.13 Gerlach and Lincoln (2001) argued that keiretsu were still very much

intact.14 “Japan’s Keiretsu: Regrouping,” Economist, November 23, 2000.15 Khanna and Palepu (2000) provided additional support for this conjecture.

According to their study, Chilean business groups showed higher perfor-mance than independent companies from 1988 to 1992. Such performancedifferentials, however, disappeared after early 1990.

16 See Khanna and Wu (1998).17 Critical to such markets are property rights, governance structures, and

rules of exchange. Markets require stable and reliable conditions for firmsin them to organize, compete, cooperate, and exchange without difficulty.In the past, national culture has produced unique social relationshipswithinand between firms. Each country therefore had very different ownershipstructures, business firms, forms of competition and capital markets, andrelations between workers and managers. Because of such differences,

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some scholars argue that global convergence is unlikely to take place(Hamilton and Biggart, 1988; Fligstein, 1997; Guillen, 2001).

18 Rajan and Zingales’ (1998a) study showed that financial developmentfacilitates faster economic growth and provides additional support to thisargument.

19 See Coffee (2001), p. 25.20 “Career Path,” Economist, April 1, 2000.21 “Europe’s Revolting Shareholders,” Economist, May 12, 2001.22 As of June 2000, therewere twenty-nineKorean companies issuingADRs.

appendixes

1 See Caves and Uekusa (1976), Nakatani (1984), and Lincoln et al. (1996)for similar approaches as applied to Japanese keiretsu.

2 An additional analysis with sales growth as a dependent variable generatedweaker results than those with profitability as a dependent variable, furthersuggesting that profitability is a better measure of performance at theaffiliate company level. The results from the same analysis using the ROA(Return on Asset) as a dependent variable are similar to those using theROIC measure.

3 In Korea, the government provides tax credits for firms’ R&D expenses.R&D expenditures are also an important factor for securing loans frombanks. Further, Korean accounting regulations allow firms to report R&Dexpenditures as expense items either in the income statement, in the costof goods manufactured statement, or as a deferred asset on the balancesheet. Korean firms, therefore, have no incentives not to report their R&Dexpenditures in their financial statements, unless they are “immaterial.”About 22% of this study’s observations, however did not report R&D-related expenses. The KIS database treats such cases as zero spending onR&D.SeeSon (1997) formore information onR&D-related tax incentives,and Choi and Choi (1998) for Korean accounting practices regarding R&Dexpenditures.

4 Alternatively, a random effects model, which assumes that the levels ofthe effects are randomly selected from an infinite population, could beused (Searle, 1971, p. 383). This model assumes, however, that individualeffects are uncorrelated with other effects or other independent variables.Hausman’s specification test, which tests the equality of the coefficients

324


estimated by the fixed and random effects estimators, assesses whetherthis critical independence assumption is satisfied (Hausman, 1978). Theresults suggested that this assumption is violated.

5 Choi and Cowing (1999), using the data of Korean public firms, found thatgroup-affiliated firms were less profitable than independent firms wereduring 1986–91, but the difference in profitability became insignificantduring 1992–3, which is consistent with the findings presented here.

6 This appendix is based on the published article byChang andHong (2000).7 See Rajan and Zingales (1995) for a review.8 Jensen (1986), on the other hand, suggested a positive relationship betweenprofitability and leverage if themarket for corporate control is efficient andforces firms to pay out cash by increasing their debt burdens.

9 Myers (1977) argued that firms expecting high future growth should usea greater amount of equity capital.

10 To demonstrate the robustness of our results, we reestimated the systemof equations including other potential instruments such as firm sales andmarket share. Results from these over-identified models were generallyconsistent with those from just-identified models.

325

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343

Index

accountability, of chaebols, 41,176–78, 208

Act for Monopoly Regulation andFair Trade Promotion. See FairTrade Act, 10

adaptation, by organizations, 34ADR (American depository

receipts), 230, 240advertisingby chaebols, 90, 92, 101, 127,256, 265, 266, 269

expenses of, 125aeronautics, Samsung in, 66aerospace industry, chaebols in,

208affiliatessales to and from, 258, 276stock ownership of, 291, 296

agency problems, in chaebols, 170,173, 176–85

agricultural products, Samsungexport of, 65

Alcoa, 122Allende, Salvador, 140

Allianz, 195Allied Signal, 200Alps Electronics, 67aluminum cycle, 122American depository receipts. See

ADR (American depositoryreceipts)

Amsden, Alice, 49, 244, 310 (n10)Anam Group, structure and assets

of, 12, 113Ankuk Fire Insurance Company

(now known as Samsung LifeInsurance), 65

antibankruptcy agreement, 4Argentinacurrency and debt crises in, 140,141, 194

privatization in, 91Asian Crisis, 3–9, 185, 246Asian miracle, 3–9, 19AST Research, chaebol acquisition

of, 14AT&T, 122Austria, 141

345

Index

automobileschaebol manufacture of, 63, 64,66, 75, 84, 86, 114, 118,176–77, 204–5, 207, 237

chaebol overproduction of, 19–20

backward integration, 118, 124, 125,278, 279, 280, 281, 283

bailouts, of chaebols, 57Bank Act [rev. 1998], 314 (n8)Bank for International Settlement

(BIS), 192bank mergers, 228Bank of America, 69, 136Bank of Korea, 133, 189role in financial crisis, 4

Bank of Tokyo, 228bankruptciesof chaebols, 126, 154in Korean crisis, 3–9, 54, 107–8ripple effects of, 202, 204

bankschaebol ownership of, 59, 63, 74,135–41

deregulation of, 35financing by, 48in Japan, 228, 233, 319 (n9)in Korea, 233–34privatization of, 58–60, 134,135

Bank Supervisory Board, 246BBV, 230BCH, 239Bell Laboratory, 122, 312 (n7)Big Deal plan, 6, 199, 204, 206,

207, 223block ownership, 170board of directors, 21, 170, 172–74,

209Boram Bank, 59, 192

brand name, chaebol sharing of, 90Brazil, 143Breusch-Pagan test, 268British Telecom, 199, 201bureaucratic control, of Korean

business, 35, 48business composition, of chaebols,

85business groupschaebols compared to, 91, 224conventional theories on, 28–31definition of, 246in developing countries, 27,28–31, 38, 229–31

diversification of, 28, 268formation of, 27–28in Latin America, 91size control of, 268

business houses (India), chaebolscompared to, 24

business restructuring, 204–8business structure, diversification of,

79–109

cable manufacturing, by chaebols,67

CalPERS, 226Camdessus, Michel, 3Canada, 63, 141capital account liberalization, in

Korea, 7capital allocation, 313 (n5)capital balance, Korean surpluses of,

17–18capital expenditures, of chaebols,

145capital inefficiency, Korean crisis

from, 38capital-intensive industries,

chaebols as, 19, 49, 95–98

346

Index

capitalism, in Meiji Japan, 25–26capital market control, 173, 226capital productivity, of chaebols, 18capital structure, of chaebols, 40,

72–74, 131–60, 284–90carbon black, LG manufacture of,

67Carrier, 201cash flows, in chaebols, 95–98, 145cement, chaebol manufacture of, 49,

64centralized control, of chaebols, 221CGE, 225chaebolsbank holdings of, 59bankruptcies of, 3–9, 36, 40,157–60, 277, 317 (n7)

bureaucratic control by, 35capital structures of, 40, 72–74,131–60

chairmanship of, 103–5, 108corporate governance of, 40diversification of, 19–20, 39, 48,75

evolution of, 43–78family control of, 158–59,163–64, 171, 178, 183, 191,221, 262, 295

future of, 238–44governance structure of, 161government relationship to,71–72, 73

government subsidy of, 55growth of, 38, 71–74management of, 103–5as networks, 309 (n23)nonbank holdings of, 61organizational structure of,98–105

ownership of, 40, 161–85

prior to 1997, 14–19profitability of, 14–15ranking of, 50restructuring of, 41, 42, 160,185–215, 236, 312 (n10)

role in Korean economy, 9–14schematic of, 26structural inertia of, 31–38,220–22

structure and assets of, 12–13, 14,39

study of, 9–19taming of, 231–36in transition, 33as universal phenomenon, 24–28vertical integration of, 39–40, 64,66, 75, 221

chairman of the group. See chairmenof chaebols, 171, 312 (n7)

chairmen, of chaebols, 99, 163, 167,171, 185, 209–210, 221

Cheil Bank. See Korea First Bank,59, 192, 195, 235

Cheil Communication, 180Cheil Industries, Inc., 65, 66Cheil Jedang, 65, 66, 94, 99Cheil Textile, 90, 94, 99Cheju Bank, chaebol ownership in,

59chemicals, chaebol manufacture of,

15, 53–57, 67, 69, 72, 75,90–91, 102, 113, 114, 118, 120,205–6, 221

Cheonggu, bankruptcy of, 157Chey, Jong-Kun, 70chief executive officers (CEOs)of chaebols, 96–97, 99, 104, 176,209–10

diversification and, 84of U.S. firms, 225

347

Index

chief financial officers (CFOs), ofchaebols, 146–47

Chilebusiness groups in, 319 (n15)financial crisis in, 23, 140–41,229, 230–31

China, 45, 261business groups of, 28as Korean competitor, 16, 76wages in, 34

Choheung Bank, chaebol ownershipin, 59, 136, 192

Chow’s F-test, 259, 282, 286Chrysler, 228Chun, Doo-Hwan, 57, 58, 60, 62,

70, 311 (n15)Chung, Ju-Yung, 49, 62, 63, 176,

311 (n17)Chungbuk Bank, chaebol ownership

in, 59Chung-Hee Park. See Park,

Chung-HeeChunpuk Bank, chaebol ownership

in, 59circular investment, 167–169CitiCorp, 228clothing, chaebol manufacture of,

68cold war, 32, 48Commercial Bank of Korea, 59,

136, 192commercial banks, 194role in chaebol restructuring, 41,60, 192

Commercial Law (Korea), 172, 174,315 (n5)

commercial paper, 138common law, 241Compagnie Generale des Eaux,

308 (n21)

Compania Acero del Pacifico(CAP), 230–31

competitive advantage, chaebolsource of, 109

conglomerateschaebols compared to, 24–25, 38,223, 224–27

decline of, 318 (n1)underperformance of, 41

construction, by chaebols, 63, 64,68, 90, 113, 114, 118

consumer goods, chaebolmanufacture of, 67

cooperative loans, 157Corning, 54, 87Corporate Accounting Standards,

317 (n14)corporate governanceof chaebols, 20–21, 40, 41, 127,147, 184

enhancement of, 208–12corporate governance system, in

Korea, 170–85corporate sector, restructuring of,

195–208corporate strategy, 264corporate workout program, 203cost of goods sold, 123, 277, 282cost structures, vertical integration

and, 123–24CP Group, chaebol compared to,

27creative destruction, bankruptcy as,

219Credit Bank, 235Creditor Banks Agreement on

Accelerating CorporateRestructuring, 203

cross-debt guarantees, in chaebols,37

348

Index

cross-ownershipof business groups, 28in chaebols, 27, 101, 222

cross-shareholdingin chaebols, 24, 37, 40, 58, 74, 99,123, 126, 156, 163–64, 184,291

in Europe, 226mechanism of, 164–170

cross-subsidization, in chaebols, 37,57, 107, 124–29, 149–156,181, 238, 239, 240, 256, 274

cultural foundations, tax-exempt,172

curb market, interest rates in, 50currency, foreign, 71Czech Republic, 185, 242, 243privatization in, 24, 28

DACOM, 68Daehan Aluminum, 129Daehan City Gas, 167, 169Daehan Group, rank of, 50Daehan Telecom. See SK C&C,

181–83Daeku Bank, chaebol ownership in,

59Daelim Group, structure and assets

of, 12rank of, 50

Daenong Group, rank of, 50Daesan petrochemical complex,

205, 207Daewoo Auto Parts, 69Daewoo Capital, 151Daewoo Carrier, 69Daewoo Corporation, 69, 97, 151,

154, 169Daewoo Electronics, 69, 97, 154,

169, 207

Daewoo Futures, 137Daewoo Group, 9, 11, 66, 69, 70,

151bank holdings of, 59, 136bankruptcy of, 157debt guarantees of, 154–56equity ownership of, 306family members in, 109as general trading company, 72growth of, 310 (n9)history of, 68–69, 72intragroup transactions in, 300–1labor practices of, 97management of, 104nonbank holdings of, 61, 138,139

power plants of, 54rank of, 50restructuring of, 195–96, 205,207

shipbuilding by, 54structure and assets of, 12, 14, 99unfair business practices in, 152vertical integration in, 113, 115,127, 297

Daewoo Heavy Industries, 69, 84,97, 151, 154

Daewoo HMS Industry, 69Daewoo Installment Financing, 137Daewoo Machinery, 69Daewoo Motors, 69, 154, 205, 237Daewoo Precision, 151Daewoo Securities, 69, 137, 138,

139, 151Daewoo Shipbulding, 62Daewoo Telecom, 69, 151Daiichi Kangyo Bank, 228Daimler-Benz, 25, 225, 227,

319 (n4)debt, chaebol use of, 133

349

Index

debt-equity ratios, of chaebols, 14,50, 52, 74, 135, 141–46, 157,165, 195–96, 213, 222, 223,255, 285, 287, 314 (n20)

debt guarantees, 100, 123, 153–56,222, 257, 273, 274

Korean banks and, 40, 57, 58, 135debt structures, of chaebols,

314 (n15)decentralization, 241Degussa, 201Delphi, 122, 312 (n8)democratization, 236department stores, Samsung

ownership of, 64deregulation, by Korean banks, 35,

51, 57–61developing countriesbusiness groups in, 27, 28–31, 38,229–31, 309 (n24)

as Korean competitors, 16market imperfections in, 28

developmental state, of chaebols,31, 241–44

Diamond Ad, 115Diners Card, 151diversificationof chaebols, 19–20, 39, 48, 64,70–109, 75, 221, 277

economic performance and,105–9

entropy measure of, 83group-unrelated, 267–68measurement of, 81–84motivations for, 84–87unrelated, 81, 83–84

Dongah Groupbankruptcy of, 157structure and assets of, 12vertical integration of, 113

Dongbu Group, structure and assetsof, 12

Dongkuk Group, structure andassets of, 12

Dongrib Group, rank of, 50Dongsuh Industries, 64Dongyang Broadcasting Company,

66Dongyang Grouprank of, 50structure and assets of, 12

Doosan Group, 46, 207, 208,240

structure and assets of, 12Dow Chemical, 199, 201downstream integration, 115, 121,

129, 207DRAMs, 206, 207dumping, 237Durbin-Watson statistics, 268

Eastern European countries,privatization in, 23, 28, 31

economic liberalization, 219economic performance,

diversification and, 105–9Economic Development Plans

(Korea), 53–54, 133, 142Economic Planning Board (Korea),

48economic reform, in Korea, 7El Corte Ingles, 230electronics, chaebol manufacture of,

53, 54, 64, 69, 75, 84, 86, 102,113, 207

emerging economies, 241entrepreneurs, chaebol founders as,

49, 310 (n10)entropy measure of diversification,

83–84, 267

350

Index

environmental shift, effect onchaebols, 75–78

equity investments, of chaebols, 95,100, 164, 257, 262, 272, 274

equity ownershipof chaebols, 303, 304of zaibatsu, 25

Erie Railroad, 232Euro [currency], 226Europe, conglomerates in, 224–27European Union, 230Evans, Peter, 62evolutionary perspective, of

chaebols, 31export industries, 48, 50, 53, 56,

76export subsidies, Korean eradication

of, 58, 76expropriationof minority shareholders, 238,292

through inside trading, 178–81through internal transfer pricing,181–85

external labor market, chaebol useof, 72–74

Fair Trade Act, 10, 57, 58, 165, 223,239

Fair Trade Act (1993), 154Fair Trade Act (1994), 163Fair Trade Act (1998), 156Fair Trade Commission (Korea),

126–27, 128, 129, 151, 152,154, 163, 185, 190, 211–12,237, 238, 244, 245–46, 293,312 (n1), 313 (n12),315 (n1; n24)

familial succession, in chaebols,221

family ownershipof chaebols, 12, 25, 26, 40–41,108, 158–59, 163–64, 171,178, 183, 191, 262, 295

of conglomerates, 25Federal Reserve Bank, effects on

Korean bankruptcy, 6Federation of Korean Industries, 65,

211Fidelity, 226financial crisis (Korea), 3–9, 35, 37,

69, 133, 140chaebol bankruptcies in, 157–58as system failure, 219–20transformation from, 223–24

financial distress, 256financial institutionschaebol failure effects on,158–60

chaebol ownership of, 63, 69,102, 115, 313 (n15)

nonperforming loans of, 159financial markets, in Korea, 133–41financial restructuring, of chaebols,

195–204financial sector, restructuring of,

191–95financial services, as chaebol

business, 64, 66, 68, 71, 74–75,135–41, 220, 311 (n11)

Financial Supervisory Board, 203,246, 314 (n8)

fire insurance companies, chaebolholdings in, 286, 290

Five-Year Economic DevelopmentPlans, 118

Fligstein, Neil, 231–232floating exchange rate, 6foods, chaebol manufacture of, 64,

86

351

Index

Ford Motor Company, as Hyundaisupplier, 63

foreign aid, to Korea, 47foreign capitaleffect on chaebols, 41, 50, 63,76–78, 142–43, 220

effect on early U.S., 232foreign capital attraction, to Korean

stock market, 18foreign currency reserve, in Korea,

307 (n3)foreign debts, 285foreign direct investment, in Korea,

19foreign exchange crises, in Latin

America, 141, 194foreign exchange crisis, in Korea,

41, 102, 107, 133, 189foreign exchange rates, escalation

of, 3, 4, 5, 7foreign investment, in Korea, 4, 54,

133, 135–36, 190, 209, 219,231–32

forward integration, 115, 119–20,124, 125, 278, 279, 280, 281,283, 297

France, 25, 225, 242conglomerates in, 309 (n22)

Franco, Francisco, 229–30FSO (Poland), chaebol acquisition

of, 14Fuji Bank, 228

General Agreement on Tariffs andTrade (GATT), 76

general and administrative expenses,277

General Electric (GE), structure of,25, 176, 227

general trading companies, chaebolsas, 53–57, 66, 67, 68, 70, 72,84, 115, 311 (n13)

Germany, 141, 142, 225, 226governance system of, 21,308 (n19)

Glesjer test, 268global competition, effect on

chaebols, 36, 76, 220global convergence, of businesses,

31, 319 (n17)Global Fortune 500 List, chaebols

in, 11globalizationeffect on keiretsu, 229in Korea, 62, 69, 231, 236

GM (General Motors), 122, 225, 237Goldfelt-Quandt test, 268Goldman Sachs, 195Goldstar, 67Gould, Jay, 232governance structures. (See also

corporate governance)of chaebols, 109, 127, 161–85

governance systems. (See alsocorporate governance)

of chaebols, 36–37, 39, 170–85,190

definition of, 20–21foreign investors and, 232–33

governmentchaebol relationship to, 71–72, 73intervention by, in Korea, 133–35in Korea, 237–38restructuring policy of, 189–91,208

Granovetter, Mark, 309 (n24)gross national product (GNP)chaebol contribution to, 10–11,54, 56, 194, 204

352

Index

zaibatsu contribution to, 25group-affiliated companies,

profitability of, 249–74group-level advertising, 90, 92group-level staff organization, of

chaebols, 100, 104, 209group-level strategies, 108, 109Group Steering Committees, of

chaebols, 103, 104growth, of chaebols, 84, 86, 106grupos economicos (Latin America),

chaebols compared to, 24, 28,91, 224

Haitai Group, 12, 157, 178Halla Group, 12, 157Halla Heavy Industries, 157Hana Bank, 59, 136, 192, 195Hanbo Group, bankruptcy of, 3, 4,

13, 20, 157Hangil Research Center, 318 (n20)Hanglass Group, rank of, 50Hanhwa Group, bankruptcy of, 157Hanil Bank, 59, 136, 192Hanjin Group, 206, 207rank of, 50structure and assets of, 12

Hankook Machinery, 69Hankuk Fertilizers, 65–66Hankuk Flange, 64Hanil Group, structure and assets of,

13bankruptcy of, 157

Hansol Group, structure and assetsof, 12

Hanvit Bank, 192, 194Hanwha Group, 46, 206, 207rank of, 50structure and assets of, 12

Hanyang Group, rank of, 50

Hausman’s specification test,320 (n4)

heavy equipment, chaebolmanufacture of, 15, 53–57, 63,64, 69, 72, 75, 84, 118, 221,237

hedge funds, Asian bankruptcyeffects on, 6

heteroscedasticity tests, 268H&Q, 195Hoechst, 319 (n8)Honam Oil Company, 67Hong Kong Shanghai Bank, 235hostile takeovers, 170, 175, 225hotels, Samsung ownership of, 64hot moneyeffect on foreign exchange, 7role in Korean crisis, 14

Housing & Commercial Bank, 59,195, 235

human resources, sharing of, 91–95,108

Hungary, 28, 194Hwaseung, bankruptcy of, 157Hynix. See Hyundai Electronics,

206, 235, 312 (n2)Hyosung Group, 12, 205Hyundai Aluminum, 114Hyundai Construction, 63, 64, 96,

114, 169Hyundai Corporation, 115Hyundai Department Store, 64Hyundai Electric Machinery, 64Hyundai Electronics, 64, 114, 140,

199, 205, 206, 207, 312 (n2)Hyundai Elevator, 114Hyundai Engineering, 114, 169Hyundai Engines, 64Hyundai Fire and Marine Insurance,

137, 139

353

Index

Hyundai Group, 9, 11, 46, 62, 66,237

advertising by, 90bank holdings of, 59, 136diversification of, 64equity ownership of, 304family members in, 108–9financial companies of, 137, 139founding of, 49, 63as general trading company, 72growth of, 310 (n9)history of, 63–64, 311 (n16)internal transactions in, 103, 104,297

labor practices of, 96, 108management of, 103, 104nonbank holdings of, 61overcapacity of, 19–20ownership structure of, 169power plants of, 54rank of, 50restructuring of, 195–96, 205,207, 311 (n17)

shipbuilding by, 54, 64structure and assets of, 12, 14,99

vertical integration of, 64, 113,114, 116–17, 118, 128

Hyundai Heavy Industries, 63, 64,96, 114, 129, 153, 169, 205

Hyundai Industrial Development,114

Hyundai Investment Trust, 64, 127,129

Hyundai Livart, 64, 114, 129Hyundai Logistics, 115, 127Hyundai Marine & Fire Insurance,

64Hyundai Merchant Marine, 64, 115,

121, 129, 169

Hyundai Motor, 63, 64, 96, 114,115, 129, 169, 240

Hyundai Motor Service, 115Hyundai Oil Refinery, 114Hyundai Petrochemical, 64, 114Hyundai Pipe, 64, 114Hyundai Precision, 64, 114Hyundai Securities, 64, 127, 129,

139, 140

imitation, by chaebols, 49import substitute industry, in Latin

America, 23, 28, 48import substitution policyin Korea, 47in Latin America, 29

Inchon Steel, 114indemnity insurance companies,

chaebol holdings in, 61Indiabusiness houses in, 24chaebol plants in, 14, 69“tunneling” in, 185

Indonesiabusiness groups of, 27as Korean competitor, 16, 76, 261money crisis in, 4

Industrial Bank of Japan, 2228inertia force, 222inflation rate, in Korean crisis, 51infrastructure, regulatory, 242ING Bank, 195inheritance tax, 171–72, 178In-Hwoi Koo, 66Initial Public Offering (IPO) stocks,

178innovation, by chaebols, 49inside trading, expropriation

through, 178–81

354

Index

installation financing, by chaebols,137

insurance companies, 60chaebol holdings in, 64, 67, 71,74, 86, 136, 195

interaffilate loans, 149–53interest ratesof chaebol affiliates, 138in Korean bankruptcy, 5, 6, 50,133

internal business trade, by chaebols,37, 38

internal capital marketchaebol dependence on, 30, 40,72, 149–56

creation of, 29internalization, in chaebols, 38,

275internal labor marketsbusiness groups and, 29chaebol dependence on, 30

internal pricing schemes, 262internal transfer pricing, 181–85International Bank for

Reconstruction andDevelopment (IBRD), 6, 189,191, 203, 208

international competition, 236–37International Finance Corporation,

195International Monetary Fund (IMF),

aid to Korea by, 3, 5–6, 7, 8,21, 32, 57, 143, 189, 190, 191,208, 215, 237

intragroup loans, 100intragroup sales, of chaebols,

113intragroup transactions, among

chaebols, 41, 100, 127,297–306

investment trusts, chaebol holdingsin, 60, 68, 74, 137, 286

irrationality, chaebols perceived as,84

Italy, 184

Japan, 142, 225. See also keiretsu;zaibatsu

corporate governance systems in,171, 172, 175, 315 (n7)

debt-equity ratios in, 141as Korean competitor, 16Korean occupation by, 48, 65, 66,71

zaibatsu dissolution in, 212Japanese yen. See yen [Japanese

currency]Jinro Groupbankruptcy of, 4, 20, 157structure and assets of, 12

Joonang Daily News, 66, 94, 95,96

junk bonds, 318 (n3)

Kaepung Group, rank of, 50Kangwon Bank, 59, 136, 192Kapeul, bankruptcy of, 157keiretsuchaebols compared to, 24, 27,105, 171, 184, 224, 239

formation and structure of, 27, 29,212, 223, 227–29, 310 (n1),312 (n11), 319 (n9; n11; n12;n13; n14)

Keopyung Groupbankruptcy of, 157structure and assets of, 13

KEPICO, 64, 114Khanna, Tarun, 28–29

355

Index

Kia Group, 237bankruptcy of, 3, 4, 157overcapacity of, 19–20rank of, 50structure and assets of, 12

Kia Motors, 205Kim, Dae-Jung, 190Kim, Eun-Mee, 36Kim, Sung-Soo, 45Kim, Woo-Choong, 68Kim, Young-Sam, 62, 64K-Mart, 225Kobe Bank, 228Kohap Group, 12Kolon Group, 12, 205Kommertzbank, 195konzern (Germany), 25, 225Kookmin Bank, 59, 136, 192, 195,

235Koram Bank, 59, 69, 136Korea, 142, 242economic transition of, 20–24,47–53

Japanese occupation of, 45, 46,310 (n2)

postliberation period in, 39restructuring policy of, 189U.S. aid to, 48

Korea Accounting ResearchInstitute, 317 (n14)

Korea Asset ManagementCorporation (KAMCO), 192,193, 317 (n4)

Korea Development Institute, 204,308 (n14)

Korea Exchange Bank, 195Korea First Bank. See Cheil BankKorea Flange, 114Korea Foreign Exchange Bank,

chaebol ownership in, 59

Korea Heavy Industries, 205, 207Korea Investor’s Service (KIS), 245,

247, 293Korea Mobile Telecom, 70, 72, 181Korean Airlines, 53Korean Fair Trade Commission

(KFTC). See Fair TradeCommission.

Korean Standard IndustryClassification (KSIC), 83, 260,267

Korean War, 5, 38, 46, 63Korea Peace Bank, chaebol

ownership in, 59Korea Stock Exchange (KSE), 165,

183, 210, 236index fall of, 4–5

Korea Telecom, 240KOSDAQ, 236Krugman, Paul, 19, 134, 308 (n17)Kukdong Group, 50, 157Kukje Groupdisbanding of, 60, 311 (n15)rank of, 50

Kumho Group, 12Kumkang Development, 115, 129Kyobo Life Insurance, 138, 139Kyungnam Bank, chaebol

ownership in, 59

labor, shortages of, 53, 76labor force, in Korea, 48, 91–95,

170labor movement, Korean

suppression of, 32, 36, 57labor productivity, of chaebols,

18–19labor productivity index, 19Ladies Professional Golf

Association (LPGA), 90

356

Index

La Porta, Rafael, 141, 170, 184,316 (n17)

late development theory, ofchaebols, 30–31

Latin America, 48, 91, 242. See alsogrupos economicos

business groups in, 29, 72currency and debt crises in, 23,141

foreign exchange crises in, 141,194

privatization in, 31LCD, 237Lee, Byung-Chul, 47, 49, 62, 64–66,

99, 176Lee, Jae-Yong, 178, 180Lee, Kun-Hee, 178Leff, Daniel, 29leverage, of chaebols, 256, 267leveraged buyouts (LBOs),

318 (n2; n3)LG Allied Signal, 199LG Cable, 67LG Caltex-Oil, 67, 96LG Chemical, 67, 84, 96, 169, 200,

211LG Electronics, 67, 84, 96, 169LG Energy, 201LG Fire Insurance, 139LG Group, 9, 47, 71, 237bank holdings of, 59equity ownership of, 305family members in, 109, 211–12financial companies of, 137as general trading company, 72,84

growth of, 310 (n9)history of, 66–68intragroup transactions in, 299labor practices of, 96, 97

management of, 103, 104nonbank holdings of, 61, 139ownership structures of, 169rank of, 50restructuring of, 195–196, 199,200–1

structure and assets of, 12, 14, 99vertical integration in, 113, 115,127, 297

LG Honeywell, 199, 201LG Industrial Systems, 201LG Information Communication, 67LG Instruments, 67LG International, 67LG Investment Trust, 68LG LCD, 201LG Marine and Fire Insurance, 67LG Merchant Bank, 68LG Polychemical, 67LG Securities, 68, 139LG Semiconductors. See Hynix, 68,

205, 206, 207LG-Shipley Co., 200LG Telecom, 68, 201, 211liberalizationof foreign investment, 78by Korean government, 58, 62,75

life insurance companies, chaebolholdings in, 61, 137, 139, 140,286, 290

liquidity, of chaebols, 256, 266–67liquor business, chaebols in, 178Livart. See Hyundai Livartloan(s), to chaebols, 129, 136,

149–53, 158logistics, of chaebols, 86London Stock Exchange, 243–44Long-term Capital Management,

Asian bankruptcy effects on, 6

357

Index

Long-term Credit Bank of Korea,192

long-term debts, 285Lotte Group, 12, 50Lucent Technologies, 122

machinery, chaebol manufacture of,86, 102

Mahathir bin Mohamad, 307 (n8)main banks system (Japan), 175management buyouts (MBOs),

318 (n2; n3)Mannesmann, 226market imperfections, effects on

chaebols, 37market share, 277, 278, 279, 280,

281Maxter, chaebol acquisition of, 14McArthur, Douglas A., 212media holdings, of Samsung, 64Meiji Renovation Era, zaibatsu

formation in, 25merchant banks, chaebol holdings

in, 60, 74, 137, 138, 286mergers and acquisitionsof chaebols, 209in U.S., 224

Metlife, 195Mexico, 141, 143Middle East, chaebol construction

in, 68minimill technology, 20Ministry of Finance, in Korea. See

Ministry of Finance andEconomy, 22, 133, 134, 183,169, 314 (n10)

minority shareholdersin chaebols, 37, 41, 86–87, 101,107, 142, 170, 181, 184–85,208, 210, 241, 314 (n18)

expropriation of, 238, 292rights of, 174–175, 214

Mitsubishi Bank, 228Mitsubishi Group, family ownership

of, 25Mitsubishi Motors, 228Mitsubishi Oil, 228Mitsubishi Real Estates, 228Mitsui Bank, 228Mitsui Chemical, 228Mitsui Group, 25, 228Mitterand, François, 25Miwon Group, structure and assets

of, 12Mongolia, 45monopolistic profits, of chaebols, 51Moody’s, 245moral hazard, of chaebol bailouts,

57, 134, 313 (n4)multicollinearity tests, 269multidivisional structure, of

chaebols, 99–103multinational corporationsbusiness group alliances with, 29,91

chaebols and, 29in U.S., 100

mutual debt guarantees, of chaebols,74

mutual funds, 225

Nasan, bankruptcy of, 157NASDAQ, 227, 236NEC, chaebol venture of, 54, 94networks, chaebols as, 309 (n23)Neuer Markt, 227Neuveau Marche, 227Newbridge Capital, 195, 235Newcore Group, 12, 157New York Life, 195

358

Index

New York Stock Exchange (NYSE),241–42

Nikko Securities, 228Nippon Mining, 199, 201Nippon Oil, 228Nippon Trust, 228Nissan, 177, 228nonferrous metals, manufacture by

chaebols, 53nongovernment organizaitons

(NGOs), 214

OEM (original equipmentmanufacturing), of chaebols, 49

Office of Chairman, 99Office of Secretaries, 99, 100, 102oil refining, as chaebol industry, 49,

205oil shocks, effects on Korean

industries, 54, 56Okpo Shipyard, 69operating efficiency, of chaebols,

105–7ordinary least squared (OLS)

regressions, 268, 294, 295organizational structures, of

chaebols, 98–105organizational ecologist, on

adaptation, 34OTIS, 199, 201outsourcing, 121overcapacity, of chaebols, 57ownership structure, of chaebols,

161–85, 297–306

Palepu, Krishna, 29Park, Chung-Hee, 47, 53, 57, 68,

133, 135Park, Heung-Sik, 45Park, Seri, 90

patrimonial logic, of chaebols, 30pension funds, 225People’s Solidarity for Participatory

Democracy, 78, 214, 233, 236,317 (n18), 318 (n20)

per capita income, of Korea, 3Perez Companc, 91performance, vertical integration

and, 123–124personnel, intragroup transfer of,

122petrochemicals, chaebol

manufacture of, 53, 64, 66,205, 206

petroleum industry, chaebols in, 67,207

Philip Morris, 225Philips, 199, 201, 237Pinochet, Augusto, 140Pitch IBCA, 192plastic goods, chaebol manufacture

of, 67Plaza Accord (1985), 60Poland, 24, 69, 242portfolio diversification, in business

groups, 28portfolio investment, in chaebols, 78PowerGen, 199, 201power generation machinery, 207power plants, chaebol development

of, 54precision machinery, chaebol

manufacture of, 66presidents’ meetings, 103–105principal-agent problems, 172privatization, 242in Korea, 21–22, 51, 53, 58in Latin America, 91

productivity indices, 308 (n16)professional managers, 239–40, 291

359

Index

profitabilityof chaebols, 14–15, 86, 106, 247,255–56, 291–96

leverage and, 321 (n9)promissory notes, 138, 287Prudential, 195public companies (Korea), 106, 260,

286profitability of, 252–53

punctuated equilibrium, inorganizational change, 34

Pusan Bank, chaebol ownership in,59

pyramid structure, of shareholding,184, 316 (n17)

Quantum Emerging, 195

railroad vehicles, 205, 207random effects model, 320 (n4)R&D. See research and development

(R&D)real estate, chaebol holdings of, 58reception of debt guarantee, 285Regent Pacific, 195regression analyses, 282related diversification, 278relief funds, 134Renault, 66, 228research and development (R&D),

by chaebols, 87, 101, 106, 121,124, 125, 255, 260–61, 265,269, 275, 283, 320 (n3)

resource-based theory, 264resources, allocation of, 51resource sharing, 87–98, 107restructuring, of chaebols, 41, 42,

109, 187–215, 223retailing, chaebols in, 63, 84Return on Asset (ROA), 320 (n2)

return on invested capital (ROIC)of chaebols, 14, 123, 255, 282,288

of U.S. firms, 308 (n15)reverse causality, 183–84Rhee, Syngman, 47Rho, Tae-Woo, 58, 60, 62, 71risk aversion, by chaebols, 84, 134Rockerfeller Center, 228Rohm & Haas, 199Romania, 14, 69Royal Philips Electronics. See

PhilipsRumelt, Richard, 81, 83Russia, 45, 242Asian economy effects on, 6privatization in, 24

Sachs, Jeffrey, 6, 307 (n4)Saehan Motors, 69, 204–5Sakura Bank, 228sales growth, 286, 293Salim Group, chaebols compared to,

27Sambo Securities Company, 69Samsung Advanced Technology

Institute, 87Samsung Aeronautics, 66Samsung Construction, 90Samsung Corning, 66, 87, 118–119Samsung Corporation, 65, 90, 94,

95, 96, 169, 177Samsung Credit Card, 66Samsung Display Devices. See

Samsung SDI.Samsung Electro-Mechanics, 66, 87,

95, 120Samsung Electronics, 66, 84, 86, 87,

94, 95, 96, 107, 120, 177, 180,214, 240

360

Index

Samsung Engineering, 90, 180Samsung Everland, 95, 180Samsung Fire Insurance, 138, 139Samsung Group, 9, 11, 20, 46, 47,

62, 205, 237advertising by, 90, 92–93bank holdings of, 59, 136cross-shareholding in, 156diversification of, 176–77equity ownership of, 303family members in, 109, 153, 178financial companies of, 137, 139founding of, 47, 49as general trading company, 72growth of, 86, 100, 310 (n9)history of, 64–66, 71, 311 (n18),312 (n5)

intragroup transactions in,178–80, 298

labor practices of, 94–98, 100,101

management of, 103, 104, 105,176

multidivisional structure of, 99,100, 101–2

nonbank holdings of, 61organizational structure of, 102ownership structures of, 169rank of, 50restructuring of, 195–96, 205, 207sales composition of, 86, 87,88–89

shipbuilding by, 54structure and assets of, 12, 14vertical integration in, 113, 115,118, 127, 128, 297

Samsung Heavy Industries, 66, 90,95, 177

Samsung Life Insurance, 65, 90,137, 138, 139, 153, 169, 180

Samsung Merchant Banking, 66Samsung Motors, 66, 94, 95, 96, 98,

107, 176–77, 205, 207, 237Samsung Petrochemical, 66, 90Samsung SDI, 66, 87, 95, 118, 120,

177Samsung SDS, 90, 180Samsung Securities, 66, 138, 139,

287Samsung Semiconductor. See

Samsung Electronics, 66Samsung Shipbuilding, 66Samyangsa, 45Samho Group, rank of, 50Sanyo, chaebol venture of, 54Saudi Arabia, 70Schrempf, Jurgen, 225Schumpeter, Joseph, 219scope, economics of, 84Securities and Exchange Act, 210Securities and Exchange

Commission, in Korea,174–75, 242

securities and exchangecommissions, in Europe, 243

securities companies, chaebolholdings in, 60, 61, 64, 68, 74,136, 138, 286

Securities Transaction Law, 315 (n5)semiconductors, chaebol

manufacture of, 54, 66, 68, 86,114, 176, 199, 205, 207

seniority-based promotion, 101Seoul Bank, 192, 194Seoul Investment and Trust, 151shareholder activities, effect on

chaebols, 78shareholdersexpropriation by, 184–85legal rights of, 172

361

Index

shareholder value, maximization of,84

Shinhan Bank, chaebol ownershipin, 59, 136

Shinho Group, structure and assetsof, 12, 157

Shinjin Group, 50Shinsegae, 66shipbuilding, by chaebols, 53, 63,

64, 66, 75, 86, 114, 176, 207shipping, chaebols in, 64short-term debt, 62, 146, 149short-term speculative funds, 78Siemens, diversification of, 25single business, diversification of,

83SKC, 97, 120, 167SK Capital, 169SK C&C. See Daehan Telecom, 181,

182SK Chemical, 70, 84, 97, 120,

167SK Construction, 70, 167, 169SK Corporation, 70, 120, 167SK Distribution, 181, 182, 183SK Energy Sale, 167, 169SK Gas, 70, 97, 167SK Global, 70, 167, 169SK Group, 9, 11, 46, 47bank holdings of, 59family members in, 109, 167financial companies of, 137as general trading company, 72history of, 70–71intragroup transactions in, 302labor practices of, 97management of, 103, 104nonbank holdings of, 61rank of, 50restructuring of, 195–96

structure of, 99vertical integration in, 113, 127,128, 297

SK Insurance, 71SK Oxychemical, 70, 167SK Securities, 139, 167, 169SK Shipping, 70SK Telecom, 70–71, 167, 169, 170,

181, 183, 214, 262cross-subsidization of, 129

sociocultural environment, of Korea,30, 31

sogo shosha, Korean companiesmodeled after, 56

S-one, 180South America. See also grupos

economicosAsian bankruptcy effects on, 6

South Asia, wages in, 34Southeast Asia, business groups inS&P. See Standard & Poors (S&P)Spain, 141, 229–30spin-offs, 209Ssangyong Group, 12, 50, 205standard of living, Korean

improvement of, 7Standard & Poors (S&P), 195, 245state bureaucracy, role in Korean

economy, 35–36steel manufacture, by chaebols, 53stock exchangeschaebols listed on, 106, 127,183

cross-national, 233stock market, in Korean crisis, 7, 17,

78, 185strategic business unit (SBU), 29,

265strategic effectiveness, of chaebols,

107, 109

362

Index

strategic industries, in Korea, 133structural inertia, of chaebols,

31–38, 220–22subsidization. See also

cross-subsidizationof chaebols, 127, 189

Sudan, 69sugar, chaebol production of, 65Sumitomo Bank, 228Sumitomo Chemical, 228Sumitomo Group, family ownership

of, 25Sungwon Construction, bankruptcy

of, 157Sunkyung Group. See also SK

Groupstructure and assets of, 12

Sweden, 184synergies, of chaebols, 37, 39, 87,

95, 106, 185, 189synthetic textiles, chaebol

manufacture of, 49

Taechang Group, rank of, 50Taegu Bank, 136Taegu Department Store, bankruptcy

of, 157Taiyo Bank, 228tariffs, removal of, 76tax credits, for chaebols, 86Technical Assistance Loans, 203technology, chaebol transfer of,

310 (n10)telecommunications, chaebols in,

68, 70–71, 86television products, chaebol

manufacture of, 87tender offers, 209textiles, chaebol manufacture of,

86

Thailandbusiness groups of, 27money crisis in, 3–4

“three low” economic boom, 263Tiger Economies, 3Tiger Fund, 214Tongil, bankruptcy of, 157trade wars, Korea as target of, 57trading companies, chaebol use of,

25transfer-pricing schemes, of

chaebols, 41, 126tunneling, 185

underdeveloped markets, businessgroup role in, 28

unfair business practices, ofchaebols, 211–12, 313 (n12)

United Kingdom, 241, 242debt-equity ratios in, 141

United States, 242aid to Korea by, 65Asian bankruptcy effects on, 6conglomerates in, 24–25,224–27

corporate restructuring in, 212debt-equity ratios in, 141governance systems in, 21, 171,174, 184

Hyundai exports to, 63unrelated diversification, 278upstream integration, 121Uruguay, currency and debt crises

in, 23Uzbekistan, chaebol plants in, 14

value creation, in chaebols, 39Vanderbilt, Cornelius, 232venture capital firms, chaebols as,

95

363

Index

vertical integrationadvantages of, 118–21of business groups, 28of chaebols, 39–40, 64, 66, 75,81, 83, 111–29, 189, 221, 274,275–83

definition of, 113disadvantages of, 39, 121–23performance implication of,123–29

Vietnam, 69Vivendi, 225, 227Vodafone, 226Volvo, 237

W. R. Grace, 225wages, of Korean workers, 16, 34,

57–58, 261Welch, Jack, 176welfare issues, in Korea, 58wholesaling, chaebols in, 84windfall profits, 46

won [Korean currency], 47, 63overvaluation of, 4, 7, 16, 17, 18

woolen goods, Samsung productionof, 65

World Bank, 3, 32, 57World Trade Organization (WTO),

76, 237World War II, 25, 27, 76, 223

Yasuda, family ownership of, 25yen [Japanese currency]depreciation of, 16, 17, 38Plaza Accord and, 60

Yukong. See SK Corporation, 70,72

zaibatsuchaebols compared to, 24, 25, 38dissolution of, 27, 212–13, 223,318 (n23)

growth of, 27Zenith, chaebol acquisition of, 14

364

financial crisis and transformation of korean business groups: the rise and fall of chaebols

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