South Korea's Aggressive Rebound

Back to Contents of Issue: June 2002

Lessons for Japan abound in neighbor's turnaround.

by Soichi Nakamura and Pascal Nguyen

At the beginning of 1998, South Korea's economy was a shambles. Its currency had lost half of its value to the dollar while the stock market had tumbled about 60 percent from its recent peak. Countless household names were on the verge of bankruptcy. GDP was collapsing. Rising unemployment, compounded by the absence of a social safety net, was pushing families back into poverty just as the country was joining the OECD club of rich nations. Yet, four short years later, South Korea is back on track with the other thrusting young Asian bucks, so what's the secret?

Like Argentina, which defaulted recently, South Korea was up to its neck in debt and couldn't meet payments to its foreign creditors. The IMF fire brigade had to rush in and provide its biggest emergency package to date. One of Asia's star performers appeared to have misled even its own people on the extent of its economic achievement.

Four years later, the picture is radically different. The stock market is red hot and creeping toward all-time highs. The won is holding firm against the dollar. Buyers are flocking back to department stores. Consumer spending is so brisk that it raises fears of sparking inflation. Amid a worldwide recession hurting many of its key exports, the Korean economy has managed to hold on well. Growth is expected to pick up further speed this year. The face-losing IMF loan has been proudly paid back. And finally, the country's rating has remarkably been upgraded.

South Korea's recovery can be attributed to a set of coherent and consistent, yet simple, measures introduced by the government to restore financial discipline and support market mechanisms. To understand the treatment, first consider the symptoms. In the wake of the crisis, it was widely recognized that the country's weakness lay in the mixture of excess debt and over-expansion of its industrial conglomerates, or chaebols as they are known in South Korea. Indeed, the chaebols had typical debt-to-equity ratios of 400 percent, about twice the level of Western firms. Some conglomerates had debt totaling 16 times their equity.

Why this fatal attraction toward debt? Of course, debt provides cheap and convenient financing. Troubled firms can also count on the artifice of debt to dress up their financial performance. The problem is that debt can quickly knock down borrowers when things go wrong. The chaebols were also engaged in scores of unrelated businesses in which they had no competitive advantage. Their over-expansion strategies resulted in a relatively small country having as many as five car producers where the much larger US economy has only three. No surprise, the Korean carmakers had miserable bottom lines. Likewise, only a quarter of Korean firms could generate enough cash to cover the interest payments on their debt. Because of poor corporate performances, and due to their unwillingness to sever ties with ailing borrowers, banks were piling up huge amounts of nonperforming loans, which in turn impaired their ability to service their own debts.

As seen in Enron's collapse, accumulation of debt and reckless expansion are often early signs that firms are trying to run away from their problems. Naturally, the whole thing is made easier if firms can hide excess debt, typically, in unconsolidated subsidiaries. Debt is assumed to buy distressed firms enough time to pull themselves out of trouble. Such gambles obviously present huge risks. Normally, market forces would contain them because good investors can see through financial gimmicks and will be quick to pull the plug if they smell a rat. Nobody obviously wants to see a poorly constructed house crumble over his head.

Unfortunately, in the case of South Korea, market mechanisms couldn't function properly. Firstly, because of poor corporate disclosure the chaebols were able to hide their problems and continue to tap the country's savings while, in fact, they were simply distracting precious resources from valuable use. Investors were not in a position to insist on receiving better information nor to push for first-rate corporate governance. What's more, the readiness of financial institutions to provide loans notwithstanding the creditworthiness of borrowers shielded the latter from capital market pressure. In short, financial discipline was deficient and firms were not forced to change their bad habits.

The policy followed by the government has thus focused on restoring the role of market forces. Since one must see clearly before taking any decision, better corporate transparency and financial disclosure have been a top priority. The purpose is to make it more difficult for inefficient and wasteful firms to hide themselves behind incomplete, if not manipulative, financial statements and remain quietly in business. In particular, it is now harder to postpone losses into the future only to see them crop up larger later on. Other significant measures have been to improve shareholder rights in order to increase their ability to monitor and control firms' behavior.

Equipped with new rights and better information, private investors could theoretically be left to decide how best to nurture their investments. Practically, however, private investors were still behind the learning curve. The country lacked experienced investors akin to US fund managers to deal with the humbled yet combative chaebols. For evidence, take the slow progress made in resolving Daewoo's bankruptcy since 1999. Despite eagerness on the part of foreign car makers to increase their stake in Asia, creditors have been unable to close the sale of Daewoo's core automobile division.

As a result, the government has assumed the role of global shareholder on behalf of the Korean people. This is a tremendous task, in which governments have in general failed pitifully. Fortunately, the Korean government has garnered unmatched experience combating economic devastation on all fronts. In addition, it has been wise enough to apply rule rather than discretion. Apart from requiring chaebols to cut debt ratios under 200 percent, it has ordered them to reduce the number of business lines. This has left little alternative to the chaebols but to streamline their operations, merge or swap assets with competitors and concentrate on their core strengths. The merit of this policy is that it was clear and precise, yet flexible enough to let the private sector decide on the appropriate way to achieve the result. Furthermore, to make sure that poor banking practice would not undermine corporate restructuring efforts, the government has required banks to clean up their books and comply with strict solvency ratios, or be put under receivership. These tough requirements, supported by a huge capital injection equivalent to 15 percent of GDP, have helped the financial sector return to health. In the long term, the measures provide incentives for banks to adopt a more arm's length policy with corporate borrowers and consider the real benefits of lending relationships. Otherwise, sick firms would continue to siphon off the country's savings with the help of careless banks.

Halfway through the government's reform agenda, results are truly impressive. Firms have generally returned to profit, even though these remain modest by Wall Street standards. Thanks to a favorable macroeconomic environment and cautious lending policies, nonperforming loans are finally coming down. Reassured of being on the payroll of a stronger economy, consumers are showing confidence in the future. Retail sales are booming and providing plenty of fuel to South Korea's robust recovery.

Meanwhile, Japan's credit rating has been cut down several times. The economy is still struggling with deflation as consumers restrict unnecessary spending. Firms are slow to reorganize their business. Banks are still supporting ailing firms in the desperate hope that they will miraculously recover from their current difficulties. As a result, bad loans continue to swell. On the bright side, corporate governance is improving. Companies no longer hold shareholder meetings simultaneously, as they used to be to minimize the almost institutional mafia disruption, and questions can now be raised at the meetings. Still, something critical is missing. It is the determination of the Japanese government to advocate the interest of the public above the opposition of special interest groups, as shown by the Korean administration in its stern warning to dismiss utility workers if they failed to put an end to their damaging strike. Changes like that take bravery beyond mere rhetoric. @

Soichi Nakamura and Pascal Nguyen are managing partners at WBP, a financial services and investment advisory firm based in Tokyo.

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