South Korea’s family-run groups need a major makeover, and president Park Geun-hye says she is the one to implement it.
Since the 1950s, conglomerates such as Samsung and Hyundai have helped transform the country’s economy, and enriched themselves in the process. But they may have finally reached too far. The public and politicians have turned on the groups in recent months, accusing them of using webs of cross-shareholdings to shift capital and expand into new sectors.
Cross-shareholdings in Korean conglomerates, or chaebols, are nothing new. The founding families have their businesses own stakes in each other, which lets them keep control over a diverse array of companies even after listing substantial stakes on the Korean stock exchange.
The resulting lack of transparency distresses investors but politicians and the public have traditionally not questioned it too closely because the chaebols play such a key role in export industries.
But this delicate balance has been upset by a combination of meagre economic growth (less than 1% in the past two years), the slowest increase in household income in more than a year and the chaebols’ continued growth.
Top founding families such as Samsung, Hyundai and Lotte have used their large networks and wealth to expand into sectors such as supermarkets, bakeries, pizzerias, and information technology (IT), historically the preserve of entrepreneurs and small businesses.
“The public now understands that the trickle-down effect of helping the chaebols thrive so that the profit will flow down to lower-income earners is not going to help feed them and that it is an outdated growth strategy that needs to be changed,” says Kim Sang-jo, a professor at Hansung University. “The paradigm shift is something that even Park’s conservative political party could not ignore.”
Park was elected as the country’s new president in Korea’s December election after campaigning on her ability to crack down on the chaebols’ perceived unfair business practices and group expansion, a process referred to as “economic democratisation”. Her stated resolve is ironic given that it was her father, former president Park Chung-hee, who gave the conglomerates the necessary political and financial largesse to thrive during the 1960s and 1970s.
Those ties leave many opposition politicians sceptical about the commitment of today’s president Park to rein in the chaebols. Park Young-sun, a member of parliament’s judiciary subcommittee and a spokeswoman for the Democratic United Party (DUP), told Poli News on February 22 that she never believed that Park “could cut ties with the groups that received special treatment from her father”.
President Park needs to demonstrate that her campaign-trail talk about policing the chaebols was genuine, not just for her integrity but for competitiveness to thrive in Korea.
The country’s chaebols already dominate most of Korea’s industrial sectors; allowing them to make major inroads into service areas would risk stymieing competition and make them integral to every aspect of the economy.
One effective way to moderate the influence of the chaebols would be to phase out their cross-shareholding structures. Doing so could well improve the corporate governance of these sprawling companies too, while helping to level the playing field for the small and medium-sized businesses (SMEs) that accounted for 92% of the country’s jobs at the end of 2011
Unfortunately the signs of this happening are not prevalent. Such a move would outrage the chaebols, which are owned by some of the wealthiest and most politically connected people in the country. And the new president’s stated political goals shy away from tackling chaebols’ existing cross-shareholding structures.
For the sake of Korea’s economy, post-election Park needs to live up to her pre-election rhetoric.
RISE OF THE CHAEBOL
South Korea’s chaebols were created shortly after the country established its first modern-day government in 1948.
From the outset, a select few businessmen gained access to the country’s limited wealth and supply of aid goods; some also received additional financial and government support during the 16-year military dictatorship of Park Chung-hee from 1963. Exports boomed, with production shifting from manufactured goods to heavy industries in the 1970s. SMEs played a pivotal supporting role as domestic suppliers and subcontractors to the founding family-run companies.
Then in the 1980s the chaebols gained permission to take stakes in banks that guaranteed them favourable loans. The weakness of this became apparent in 1997-1998; the Asian financial crisis triggered a wave of debt defaults. The chaebols were forced to improve transparency, cut debt, sell non-core businesses and limit cross-shareholdings. The top-five groups ended up reducing their subsidiaries from 272 at the end of 1998 to 135 by 2000.
But this chastening experience was quickly forgotten amid Korea’s economic growth over the next decade. Samsung, Hyundai and SK emerged as the top-three chaebols, and Lee Myung-bak was even elected president in 2008 in part due to voter hopes that his experience working at Hyundai would facilitate pro-growth decisions. But the main result of his policies, which included cuts in corporate tax rates and the unwinding of group transaction limits, was growing the size of the conglomerates.
Total assets of the top five chaebols jumped from 36% of gross domestic product (GDP) in 2007 to 57% in 2012, according to a recent Nomura report. And group subsidiaries at the 10 largest groups (Samsung, Hyundai Motor, Hyundai Heavy Industries, Posco, LG, Hanjin, SK, Lotte, Hanwha and GS) soared from 364 to 638, according to an October 2012 report released by the Citizens’ Coalition for Economic Justice.
Their success came at the expense of others. SMEs account for 87.7% of all Korea’s employees, but their wages are on average 51.9% lower than chaebol wages, according to Park’s presidential agenda released on February 21. And while average chaebol wages rose 9% from 2009 to 2011, in addition to providing non-wage benefits, SME average wages rose 7.4% over the same period. Korea’s Gini coefficient, which is a standard measure of income inequality, soared faster during 2007-2012 than at any period since records began in 1992.
“The livelihood of the public was really falling off a cliff because their living standards were such a contrast to what the chaebols were experiencing since they were reaping record profits,” says Yoo Tae-in, an analyst at Tongyang Securities.
KEEPING IT IN THE FAMILY
The chaebols have traditionally used their cross-shareholding structures (see box, below) to dominate Korea’s industrial sectors. But fierce international competition has reduced their ability to expand market share. So the conglomerates have begun moving into services sectors.
The chaebols have typically done so by setting up new subsidiaries that offer services in areas ranging from catering to IT, logistics and transport, advertising and sales distribution – traditionally hallmarks of smaller independent companies. Younger-generation family members often hold big stakes in these service subsidiaries, which need little initial investment and provide steady cashflow.
The number of chaebol subsidiaries operating in wholesale distribution and sales, IT and real estate rose by almost 10% from 2007-2012, according to the Citizens’ Coalition for Economic Justice. That compares with a 3% increase in new subsidiaries competing in the manufacturing sector.
According to Lee Yong-sup, a lawmaker from the DUP, in 2011 Samsung’s entertainment subsidiary Samsung Everland made nearly half of its total revenue of KRW1.8 trillion (US$1.65 billion) from providing cafeteria services, which is classic SME territory. That’s in addition to the 74 other Samsung subsidiaries from 22 groups that operate in SME-catered industries.
Potential conflicts of interest surround these new subsidiaries. It’s not hard to envisage situations in which chaebol divisions hire service companies run by scions of the founding family for more than the market rate. This family link would leave the SMEs and entrepreneurs that traditionally offer such services struggling to get a look-in.
“The issue goes beyond the fact that this is an unfair business practice. Those subsidiaries get free support from the conglomerates, so for SMEs to compete with them is practically a death sentence,” says Hansung University’s Kim. “This has become a very serious trend.”
One example of such anti-competitive behaviour emerged on October 3, 2012, when Korea’s Fair Trade Commission (FTC) slapped three subsidiaries of Shinsegae with a KRW4 billion fine for setting minimum rates for commissions when selling brands of bakery Shinsegae SVN in their stores. It deemed the actions to have given SVN unfair support. The bakery is 40% owned by Chung Yoo-kyung, daughter of Shinsegae chairwoman Lee Myung-hee.
Shinsegae itself was spun off from Samsung, which is run by chairman Lee Kun-hee, the brother of Lee Myung-hee.
Inter-subsidiary transactions have become big business for companies owned by the second and third generations of chaebol families too. FTC data showed that inter-subsidiary deals comprised 56.3% of their revenues.
With Korea’s heavy industrial and manufacturing sectors showing few signs of growth, the conglomerates look set to dig even deeper into low-cost services businesses.
RESOLVE FOR CHANGE
President Park readily acknowledges that the chaebols are disadvantaging smaller, traditional service businesses.
In her February presidential agenda she stated: “My administration will protect the economically disadvantaged from unfair trade practices spurred by the conglomerates’ abuse of its advantageous economic status and the interference into business sectors of small- and medium-sized businesses and enterprises.
“We will also improve the transparency and responsibility of conglomerate structures, which are used to maintain and strengthen their ownership.”
Park’s agenda went on to say that she will ban new cross-shareholding transactions in an effort to prevent families from using these circular equity structures to transfer wealth or conduct any illegal transactions. She also vowed to amend the language of FTC laws to make it easier to prosecute conglomerates under suspicion of executing such deals.
Additionally Kim Dong-soo, who headed the FTC until the beginning of March, stated in a New Year address that “as a priority of achieving economic democratisation, we will do all that is necessary to root out actions by the families that allow them to boost their personal interests by giving and inheriting wealth through unfair methods such as related-party deals and actions that overly penetrate the territories of SMEs”.
Speaking to reporters at a luncheon meeting on January 29, Kim added that the FTC needed to create a new organisation to take the lead on dealing with problems related to large business groups, once again to help with “economic democratisation”, and he told journalists the following day that “in addition to the internal transactions between conglomerate subsidiaries, the actual conglomerates’ unfair transactions between family members is a serious issue”.
Asiamoney contacted Samsung Group, Hyundai Group, SK Group and Lotte Group to ask their views on president Park’s announcements about the need to better restrict the ability of chaebols to add new subsidiaries and to improve their transparency, and whether cross-shareholding group structures benefited the founding families but were damaging for minority shareholder rights.
SK Group’s spokespeople declined to comment on questions about their corporate structure, while a Lotte official declined to comment other than to say: "We should follow president Park's instructions."
Samsung’s spokeswoman also declined to comment. However a person familiar with the company argues that Samsung’s businesses did not have “bad” intentions and that cross-shareholding structure was a consequence of a natural progression into other industries that was needed during the early ages of Korea’s modern-day economy. Hyundai's spokeswoman declined to comment.
The stated crackdown by government and watchdog sounds promising, but in truth it is unlikely to greatly impact the growth of the chaebols into services industries.
True, in the event the language of the FTC laws is strengthened the conglomerates would find it tougher to pay service-providing subsidiaries in outsized lump sums. But the chaebols could still subcontract all their business needs to these divisions or prominently market the services offered by these affiliates to customers, keeping the subsidiaries in business and building their market share.
The founding families are also likely to seek other means to provide capital to and generally support these business subsidiaries.
Park’s proposed schemes also don’t address the proliferation of subsidiaries. Her proposals would prevent new cross-sharehol dings; they say nothing about existing money-making divisions.
These existing service-based subsidiaries are likely to see even more use if new ones are outlawed. And the chaebol families could decide to spend substantial proportions of the profits of these companies on marketing and capital expenditure to build market share, something that independent rivals would struggle to do.
TIME FOR TRANSFORMATION
There are two simple ways to moderate the chaebols’ expanding ambitions into services.
The simpler would be to make it illegal for subsidiaries of these conglomerates to sub-contract affiliates to conduct services. The conglomerates would then have no choice to but appoint more independent companies, helping ensure the survival of SMEs.
Of course such a move would likely be vigorously opposed by the chaebols, perhaps on the ironic grounds that it restricts competition. It may also force them to subcontract more deals with overseas suppliers that can expose them to currency risk and higher prices.
The far bolder strategy would be to force each conglomerate to entirely dismantle their cross-shareholding system.
Outlawing the cross-shareholding structure would force each business subsidiary to unwind its minority stakes in other units. First dibs on these stakes would go to the founding family, but any cross-subsidiary shares that they did not buy up would have to be disentangled.
Some cross-shareholdings could simply be dissolved, with two units exchanging the shares they own in each other. But this would not work for all. Many chaebol divisions would have to sell the stakes to the public, bring in strategic investors, merge, or go bankrupt.
Disentangling chaebol subsidiaries from cross-shareholder structures would involve some pain in the short term. It would also shake up the corporate landscape. But it would promote more competitiveness and better distribute public ownership of these companies, while preventing any families from enjoying financial and business sway well above their ownership level.
The impact of such restructuring could be administered in stages over several years to smooth out its impact. It could even be a boon for stocks. Share prices in many chaebol subsidiaries trade at a discount due to the governance problems that surround them. Clearing the cross-shareholder structures would probably eliminate those discounts.
Companies free of cross-shareholdings could also introduce more transparent management voting rules, while the government would be able to ratify laws that allow shareholders the right to sue the CEO and lower the ceiling for the minimum percentage of ownership at which an investor can demand increased company accountability.
Breaking cross-shareholdings would immediately cure the threat on SMEs too, because former chaebol service affiliates would no longer be able to rely on the backing of fellow divisions to secure business. Instead they would have to compete against SMEs to secure contracts from independent former chaebol companies.
These developments would ultimately breathe life into South Korea’s ailing economy by encouraging entrepreneurs to start their own businesses, thereby creating new drivers of growth.
A LANDMARK SHIFT
Unwinding the chaebol’s cross-shareholding structures would be both a time consuming and costly process. The Economic Reform Research Institute estimates that such a restructuring would cost about KRW9.6 trillion, while Tongyang Securities cites business leaders as approximating costs of more than KRW30 trillion.
Despite the cost, these reforms should be endured if Seoul wants to extract the root of the problem that threatens the competitiveness of large parts of Korea’s economy. Merely improving oversight of existing businesses and shareholder rights is not enough.
The chaebols are reluctant to talk publicly about unwinding their cross-shareholding structure, and privately the families behind the chaebols would almost certainly oppose any such attempts. Dissolving these cross-shareholdings would force them to entirely divest from many subsidiaries and retain minority positions in others. And they would lose their level of influence over each chaebol company.
This is exactly the reason it should be done. The chaebols’ complex corporate structure might once have helped these companies develop Korea’s economy, but today it has become a business model that can all too easily stymie competition, small businesses, investor rights and entrepreneurship.
For the good of Korea’s economic future, these cross-shareholdings should be dissolved. Given her history, Park might be better placed than any other politician to do it. Opposing politicians may scorn the role the new president’s father played in making the chaebols, but this background could make her better able to reason with these families instead of a candidate who may not fully understand how they operate.
Park is certainly tough enough to stand against Korea’s corporate elite. In 1974 she witnessed the assassination of her mother when she was just 22, in 1979 her father was also murdered and in 2006 she was slashed in the face by a man with a knife while on the campaign trail.
The question is whether Park has the resolve to take action.