Chang financial crisis and transformation of korean business groups; the rise and fall of chaebols (2003)

Korean Business GroupsThis book argues that the Korean financial crisis of 1997 was due to the inertia of both the business groups known as chaebols and the Korean government, which preve

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Korean Business Groups

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

This treatment demonstrates how the structure of chaebols, which was once optimal for their rapid growth, later inhibited other adapta- tions and for all practical purposes became nearly dysfunctional The book argues that restructuring of chaebols should focus on improving corporate 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 of Business at New York University He has also held visiting appoint- ments at Stanford University and INSEAD, France Prior to his doc- toral study at the Wharton School of the University of Pennsylvania, he worked for large telecommunication companies in Korea and Japan Professor Chang’s research focuses on understanding the process

of creating operating synergies among diversified lines of business and building a strong local organization after foreign entry His research has

been published in journals such as Review of Economics and Statistics, Journal of Industrial Economics, Journal of Management Studies, and the Academy of Management Journal He sits on the editorial boards of

several leading journals in strategy and international business He has

To my teachers and colleagues

Transformation of Korean Business Groups

The Rise and Fall of Chaebols

S E A - J I N C H A N G

  

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

Cambridge University Press

The Edinburgh Building, Cambridge  , United Kingdom

First published in print format

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

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© Sea-Jin Chang 2003

2003

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This book is in copyright Subject to statutory exception and to the provision of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press.

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

Preface pageix

vi Contents

Performance Implications of Chaebols’

Chaebols’ Internal Capital Markets and

Collapse of Chaebols and Financial Institutions

Characteristics of the Ownership Structure

The Restructuring Policy of the Korean

Enhancement of the Corporate Governance

2 Comparing the Profitability of Group-affiliated

7 Intragroup Business Transactions and

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 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 catch

con-up to Japan, which had served as a role model for Korea As one

of 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

x Preface

affiliated companies that helped catalyze Korea’s economic velopment, have long been admired and criticized On one hand,people admired them Korea’s top college graduates lined up

de-to work for them In downde-town Seoul, where the insignias ofHyundai, Samsung, LG, Daewoo, and SK were displayed every-where, the strength of Korea’s economy was palpable The chae-bol chairmen who managed these empires seemed glamorous

On the other hand, chaebols were 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 grew without 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 sharing had been the source of Korean firms’ 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 way

to guard against the ill-conceived strategies of these 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

chair-created through resource sharing The intricate web of shareholding, debt guarantees, and vertical integration furtherinhibited chaebols’ efforts to restructure During the transitionfrom a state-controlled economy to a market-oriented economy

cross-in the years prior to the Asian Crisis, neither the Korean ernment nor the markets could monitor or guide chaebols’ in-vestment activities

gov-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 needs

to build institutional infrastructures, especially corporate 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

gov-As I researched and wrote about chaebols during the lastfive years, I realized how much I had learned – and continue

to 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-couraged me to pursue graduate work Edward Bowman, HubertGatignon, Bruce Kogut, Dan Levinthal, and Harbir Singh of

at Korea University also provided me an environment in which

I could concentrate on research In particular, Linsu Kim helped

me start this book project and Dean Jangro Lee of the tute of Business Research provided me special funding for thisresearch

Insti-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 understanding made this long journeypossible

Introduction

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 that

he 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 bailout

by IMF A few days later, Michel Camdessus, the IMF’s aging director, visited Korea to announce that the IMF wouldassist Korea, provided that the government would restructureKorea’s economy

man-Koreans were proud of their economic achievements andwere shocked by this turn of events The per capita income

The World Bank, a sister organization of the IMF, had

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 were

to fail

Yet informed citizens knew that these bankruptcies augured

a 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

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 instability

by implementing the so-called antibankruptcy agreement 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 reacted

af-to these policies by recalling loans af-to other companies that hadfinancial problems The resulting contraction in the financialmarket drove additional companies into bankruptcy

Observing these events, foreign investors began 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 one

banks, which now owed large debts to foreign creditors Foreignexchange rates soared from 864 won per dollar in January 1997

to 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

Exchange rate (won/$)

Stock market index (point)

0 2 4 6 8 10 12 14 16 18 20

Interest rate (%)

Exchange rate Stock market index Interest rate

Figure 1.1 Movements of exchange rates, interest rates, stock

market 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 conian measures in return for the relief fund It wanted to re-store confidence in the Korean economy and to fundamentally

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 resulted

in soaring exchange rates, and their effectiveness was 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 more

To achieve the second goal, the IMF pushed the Korean ernment to reorganize the chaebols To do so, the Korean gov-ernment first rescued virtually insolvent banks with an injection

gov-of public funds It then sought to reorganize the chaebols 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 to

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-

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 wished

to repay the IMF relief fund ahead of schedule and that tional assistance would be unnecessary

addi-Many have speculated about why Korea got caught in the

money” heightened the instability of the foreign exchange

about 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 enced a long period of rapid growth, low inflation, and

experi-a sustexperi-ained improvement in the stexperi-andexperi-ard of living dent macroeconomic policies and high domestic sav-ings and investment contributed to the rapid transfor-mation of Korea into an advanced industrial economy

Pru-in four decades The government had begun an 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

banks were eased, but controls on medium- and

The Western popular press and financial community,

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 gressive investment drive financed by large increases inborrowing from domestic banks, which, in turn, sharplyincreased short-term external borrowing During 1997,

ag-an unprecedented number of highly leveraged 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 in

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-

caused the foreign exchange crisis? How then, did they come to

be the destroyer of their own creation? Several questions mayalso be raised about foreign financial institutions Why did they

8

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 passes many subsidiary firms under the same name Chaeboloriginally meant money clique in Chinese and was used to refer

encom-to a group with a vast fortune Some chaebols, such as Hyundai,Samsung, LG, Daewoo, and SK, are well known in the West

There are many Korean companies with more than two 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 publishes

sub-a listing of their sub-affilisub-ates under the “Monopoly Regulsub-ation sub-andFair Trade Act” (known as the Fair Trade Act) to block anyanticompetitive behaviors The act defines chaebols’ affiliates

as 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 its

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 those

in financial services and several small affiliates that were not

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

top five chaebols There is a big difference between the sizes

of 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

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 FSO

of 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 biased

by 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 thirty

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

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 such

as heavy equipment and chemical industries, which had chronicovercapacity Because chaebols often used cross-subsidizationthrough various forms of international transactions, it is hard

to compare the profitability of chaebol and nonchaebol firms.Figure 1.3 also shows that the profitability of chaebols declinedduring the 1990s

Outgoing foreign direct investment Real wage

Figure 1.4 Real wages of Korean workers and outgoing foreign

direct 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

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

Capital/Labor ratio Labor productivity Capital productivity

Figure 1.6 Chaebols’ capital investment.

exchange market Capital balance surpluses, however, meant 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

in-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 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 measured

relationship between these values is established by the followingequation:

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 of

Third, as we will discuss further in Chapter 3, chaebols gaged in unrelated diversification even when doing so was eco-nomically unviable For example, the auto industry was plagued

en-by overcapacity, especially after Hyundai and Kia increased

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-

credence 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 system

to guide chaebols’ investment activities

The Korean Economy in Transition

Korea was experiencing a major transition to its economic 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,

sys-we define the governance system broadly as institutionalized

economic processes that organize and coordinate economic 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,

ac-1990) On the other hand, the corporate governance system,

which is a central focus of Chapter 6, refers more cally to firms’ internal organization and power structure, which

specifi-20

encompass the functioning of the board of directors, the 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, labor

In Korea, the government played a major role in the 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 capital

gover-to 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 influenced

by 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

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 in

top 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 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

infra-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 years

of import substitution development strategies that relied heavily

on extensive government intervention, all these countries 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 banks

liber-by 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

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 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)

safe-the safe-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 distinctions

in economic, social, and cultural environments, but they sharecommon features in the ways they enable business groups, such

as conglomerates in the western hemisphere, Japanese zaibatsu and keiretsu, grupos economicos in Latin American countries, and business houses in India to pursue unrelated diversification

under 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

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’s

not usually subject to the influence of strong family owners anddoes not pursue vertical integration nearly as much as chaebols

of general trading companies to control and orchestrate other filiates toward the export market Figure 1.7 shows a schematicdescription of chaebols

af-Korean chaebols also are strikingly similar to the pre–World

War II Japanese zaibatsu Chaebol and zaibatsu literally share

common Chinese characters in their nomenclature Chaebols

were heavily influenced by the zaibatsu and have ing characteristics similar to those of the zaibatsu Families owned the holding companies of the four biggest zaibatsus –

operat-Mitsubishi, Mitsui, Sumitomo, and Yasuda These holding panies practically controlled many other affiliated companies

com-by 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 Japanese

zaibatsu was formed during the Meiji Renovation Era,

dur-ing which the Japanese government granted sizable benefits

to a small class of capitalists to establish capitalism, and they