Understanding Korean Chaebol Enterprise Week 2-7 PDF

2024-09-09 Economic Development & the Evolution of Chaebols Korean model in historical contexts Transformation of the Korean Economy Plans Economic Take-Off with...

2024-09-09 Economic Development & the Evolution of Chaebols Korean model in historical contexts Transformation of the Korean Economy Plans Economic Take-Off with Outward Looking Strategy Pitfalls of Government- led Development  2024-09-09 Korean model in historical contexts The paths Primary products export Import-substitution industrialization The paths of Export-led growth industrialization The key difference between East Asian countries and other late-late industrializers is their choice of industrialization strategy.  2024-09-09 The international system Domestic coalitions: Agriculture  2024-09-09 Domestic coalitions: Business, labor Institutions and Ideas  2024-09-09 Transformation of the Korean Economy Growth trend  2024-09-09 Changes in industrial structure Changes in Employment Structure Changes in GDP Structure Service Agriculture / Sector Service Sector Fisheries 28.3 Agriculture / 36.8 Fisheries 1960 47.3 63.0 7.9 Manufacturing 15.9 Manufacturing Agriculture / Agriculture / Fisheries Fisheries 9.3 4.3 19.2 2002 32.5 Manufacturing 63.2 Manufacturing 71.5 Service Service Sector Sector 11 Equity  2024-09-09 Poverty 2024-09-09  2024-09-09 Cheong-Gye-Cheon Stream in the 1950s Cheong-Gye-Cheon Stream, Today  2024-09-09 Development indicators (1962-2005) Economic take-off with outward looking strategy (1960-80)  2024-09-09 Largely rural peasant economy, wholly lacking natural resources Has the highest density of people on arable Korean land in the world Exports were 3% of GDP (88% of which were economy in primary products) the 1950s Crucially dependent on foreign aid-transfers (More than 10% of GDP) The third poorest country in Asia with no hope for growth Economic Conditions of the early 1960s  2024-09-09 Korean economic development should be achieved through industrialization Economic development should be achieved under Basic government control and leadership Although firms should be owned and managed philosophy privately, the government could implement private of the 5-year decisions in the case of major investments (“a variant of authoritarian capitalism”, Cho Soon) plan: To finance investments, foreign capital inflows should be induced five Growth should have a higher priority than principles! redressing imbalances in income distribution and unevenness in industrial development across geographical regions Policies Currency devaluation Interest rate reform for high savings Export-led Nationalization of commercial banks Establishment of specialized banks growth: Limited import liberalization 1962-1972 Export incentives: Industry Neutral Tax deduction, wastage allowances Export credit subsidies Based on export performance  2024-09-09 Continued High Growth Based on Strong Entrepreneurship and Government Support State entrepreneurial capitalism The emergence of big business, chaebol Chebol is the family-controlled, diversified big business group The size and resource concentration and the output share of domestic private big business in Korea are extraordinarily high because Korea had to make a big push in order to catch up. State entrepreneurial capitalism Because big business-focused growth and proactive state intervention have gone hand in hand Because both business and government have been entrepreneurial Because both have relied heavily on hierarchies of managers to execute their plans  2024-09-09 Heavy and Chemical Industry Development during 1970s Heavy and Chemical industrial promotion: 1973-79 Policies Designate the industries (steel, machinery, petrochemical, shipbuilding, electronics) Long-term subsidized loans: National Investment Fund (Credit rationing) Tax holidays and investment tax credits Accelerated depreciation Reduced export incentives Expansionary monetary policy Government guarantee of foreign loans  2024-09-09 Stabilization, liberalization and renewed growth: 1980-1996 Policies Anti-inflationary policy measures The HCI drive was toned down Abolished preferential lending rates Privatized the commercial banks Deregulation Market opening (goods and services, FDI, financial markets) Financial support for small and medium firms The developmental state Broad definition (idea or orientation): state strategic intervention into the market can facilitate industrial transformation and economic growth Narrow definition: the state using a specific set of policies to transform its economy and pursue economic growth Industrial policy Financial policy Social policy Labor policy State-business relations A pilot agency Autonomous state  2024-09-09 Explaining the Miracle: The Developmental State Elite bureaucracy that is “smart, autonomous, and clean.” - Japan (MITI), SK (EPB), Taiwan (IDB) Industrial policy: - Loans from public financial institutions, formation of cartels, tax breaks. Authoritarian regimes and economic performance - More effective, however, with side effects - Suppress workers (demand for wage increase) and students (demand for democracy). - Discomforting lessons about regime types and economic growth. Explaining the Miracle: The Neoliberal Interpretation Export-led growth - Contrast with Latin America’s Import-Substituting Industrialization (ISI). Sound economic management: low budget deficits and inflation. High savings and investment. Education: universal primary and secondary education. Criticism by P. Krugman, “The Myth of Asia’s Miracle” (Foreign Affairs, Nov./Dec. 1994). - Lack of labor/capital productivity growth; similarity to the Soviet Union.  2024-09-09 The evolution of chaebols History Lucky Goldstar founded 1947 – manufactured cosmetics and plastics After the Korean War – branched out to detergent and washing powders 1958 – creation of Goldstar Co. – televisions, electrical appliances “dual track entity” – manufacturing cosmetics and electronics  2024-09-09 History 39 affiliated companies 39 joint ventures 130 branches and offices $25 billion total sales figure – 1994 100,000 employees Chemicals and Energy Construction and Services. - Lucky LTD - Honam Oil -Lucky engineering -- LG mart -- LG Leisure development Electricals -Goldstar Software Public Services and Sports -- Goldstar information and communication -Yonam Foundation -- LG sports  2024-09-09 Chaebol in South Korea The growth Taking advantage of government policies Tapping internal and external capital markets strategy of Pursuing unrelated diversification and chaebols vertical integration  2024-09-09 Chaebols are not fixed Taking advantage of government policies  2024-09-09 Financial supports High debt-equity ratios  2024-09-09 Changes in government policy Tapping internal financial markets  2024-09-09 Tapping internal financial markets Any questions?  2024-09-23 BUSINESS GROUPS IN COMPARATIVE PERSPECTIVE BUSINESS GROUPS IN INDIA & SOUTHEAST ASIA  2024-09-23 Middle income country - common percep dev. country x modern. LIPPO business group- bicycle manu then banking sector. Prior 1997 Asian crisis LIPPO made real estate loans then couldn't repay loans - crisis. LIPPO VILLAGE IN INDONESIA BUSINESS GROUPS IN INDONESIA Indonesia: ‘The Indonesian business group is virtually interchangeable with “conglomerate”. Indonesian business groups are comprised of strategically and technologically unrelated unrelated diversification companies. Regardless of how diversified they are most Indonesian business groups are controlled and managed by their founders and the founders’ families and long-time friends’ (Hanani, 2006: 179). Who are their friends? = prominent politicians [close tie]  2024-09-23 BUSINESS GROUPS IN INDIA India: ‘Group firms in India are often linked together through the ownership of equity shares. In most cases the controlling shareholder is a family’ (Bertrand, Mehta and Mullainathan, 2002). TATA GROUP IN INDIA One of the biggest business groups in India originally UK Symbol of Brit manuf India colonised by Brit, master slave relationship  2024-09-23 EVOLUTION OF TATA GROUP IN INDIA RELIANCE INDUSTRIES IN INDIA (FOUNDER: DHIRUBHAI AMBANI) Have much influence and status - weddings HIS 2 SONS MUKESH AMBANI ANIL AMBANI BETTER JOB THAN ANIL Main areas of business Main areas of business Oil and gas Finance Retail Construction Telecommunications Telecommunications Media and entertainment Power generation Defense engineering Listed companies Reliance Industries Listed Companies Reliance Industrial Infrastructure Reliance Communications Reliance Capital Reliance Power Reliance Infrastructure Use a skyscraper as residence for 4-5 family members, 200 staff  2024-09-23 CONCENTRATION OF ECONOMIC POWER  2024-09-23 Business groups are state-owned enterprises QIYE JITUAN (NATIONAL TEAM) IN CHINA China’s business groups: ‘business groups are coalitions of firms from multiple industries that interact over long periods of time and are distinguished by elaborate inter-firm networks of lending, trade, ownership, and social relations’ (Keister, 1998: 408). China: ‘Business groups are coalitions of firms from multiple industries that interact the over long periods of time and are distinguished by elaborate interfirm networks of lending, trade, ownership, and social relations. The organizational structure of the business group resembles a conglomerate, but relatively exclusive internal relations make the group highly stable and resistant to reorganization’ (Keister, 2001: 336). QIYE JITUAN (NATIONAL TEAM) IN CHINA  2024-09-23 QIYE JITUAN (NATIONAL TEAM) IN CHINA KEIRETSU IN JAPAN Japanese business groups are best defined as clusters of firms linked through overlapping ties of shareholding, debt, interlocking directors, and dispatch of personnel to other levels, shared history, membership in group-wide clubs and councils, and often shared brands’ (Ahmadjian, 2006: 30).  2024-09-23 KEIRETSU IN JAPAN Before US family-owned; after US family-owned abolished and now Keiretsu [Vert and Hori] Keiretsu is an organizational structure that is comprised of several aspects: Financial – cross shareholdings Managerial – exchanging of management expertise, advice, training Trade – preferential treatment given to partner firms Exclusion – keeps foreign competition out of domestic economy Political – tightly interwoven relationships between government Social – “old boys network” of presidents and senior executives Bank/Manu sector four affiliate core forms - CEO each firm with 'old boys' TYPES OF KEIRETSU Horizontal keiretsu The primary aspect of a horizontal keiretsu (also known as financial keiretsu) is that it is set up around a Japanese bank. The bank assists these companies with a range of financial services. The leading horizontal Japanese keiretsu including Fuyo, Sanwa, Sumitomo, Mitsubishi, Mitsui, and Dai-Ichi Kangyo bank groups  2024-09-23 HORIZONTAL KEIRETSU HORIZONTAL KEIRETSU  2024-09-23 TYPES OF KEIRETSU Vertical keiretsu INDUSTRIAL KEIRETSU Vertical keiretsu (also known as industrial keiretsu) are used to link suppliers, manufacturers, and distributors of one industry One ore more sub companies are created to benefit the parent company Banks have less influence on distribution keiretsu This vertical model is further divided into levels called tiers. VERTICAL KEIRETSU Banks play a little role in vertical  2024-09-23 VERTICAL KEIRETSU DISTINGUISHING BUSINESS GROUPS FROM OTHER NETWORKS  2024-09-23 WHAT ARE TWO THEMES EMERGING FROM DIFFERENT DEFINITIONS? A business group is a diverse collection of unrelated and related business units that resembles a multidivisional conglomerate. Despite the absence of legal unity among affiliated business units, some type of governance mechanism exists to permit a central entity to exercise control and/or coordination over the actions of affiliated firms. WHAT MAKES ASIAN BUSINESS GROUPS DIFFER FROM OTHER BUSINESS GROUPS? Business groups have played an important role in economic development in Asian countries. It is in Asian countries that business groups dominate their domestic economies.  2024-09-23 WHY ARE BUSINESS GROUPS FORMED? THEORETICAL APPROACHES 1. Transaction cost theory Exchanges between independent agents may be organized by means of market transactions or intensified and governed within a hierarchical system called a ‘firm’ Under conditions of very high market uncertainty, agents discover that the vertically-integrated, hierarchically-coordinated firm lowers transaction cost. 2. Asian way of organizing exchange Asian countries have highly networked and interdependent economy Business groups function as an intermediate organizational form that is neither market nor hierarchical They EPB - business relations allow also informal informal and personal business relations relations MITI- officers retire mid-50s govt. jobs not well paid -> graduated top schools to become gov. employees, high ranking officers -> after retirement = can begin small business? In Japan, Amakudari, informal practice recruti retired (busienss associations) liasons between govtt and business associations / govt. regulate laws so they lobby to protect business groups/associations from laws - informal pracitce. COMPARATIVE INSTITUTIONAL FRAMEWORK RULES, NORMS, AND PRACTICES Institutions shape the behavior of individuals and governments Institutions are path-dependent – once it is taken, it is difficult to change Institutional arrangements vary country by country Economic crisis -> Dec 1997 K received bail national fund created Institutional change is incremental institutional change Enterprise/sectoral [industrial] level - wage bargaining K enter. Trade unions wage bargaining between them and business association. If wage set indus. level same wage increase will be applied across - called collective bargaining Was a practice, through sttrikes etc, became institution. Formal and informal practices = institutions [rules, norms, practices] Institutions shape firms and our behaviour - why they matter Path-dependant due to increasing cost. [E.g., QWERTY keyboard faster inventions disappeared] Why? Requires cost of change, practice - faster typing not needed. As a politican make business cuts or make society pay more -> pension system introduced and pepople enjoy benefits, elders don't vote so option 2: make people pay more - path-dependant.  2024-09-23 INSTITUTIONAL COMPLEMENTARITIES Liberal Market Economies Coordinated Market Economies Corporate governance & finance ‘Arms-length’ rules, equity ‘Insider’ rules; bank finance finance Labor mkt. organization Decentralized, low union Centralized, high union density; density; high labor mobility low labor mobility little protection Product mkt. competition Arms-length relations, strict Inter-firm cooperation, relational competition enforcement contracting Social protection Few restrictions on hiring and Stringent restrictions on hiring firing, investment in general and firing, investment in firm skills specific skills US master's degree to get promotion INSTITUTIONS AND SPECIALIZATION Different institutional environments favor different types of industrial specialization: CMEs: favor long-term investment in skills and incremental innovation (autos, capital goods, engines) LMEs: favor flexibility and radical innovation (software, biotech, telecoms)  2024-09-23 INSTITUTIONAL ARRANGEMENTS BRIGHT AND DARK SIDE OF ASIAN BUSINESS GROUPS VALUE CREATING VALUE DESTROYING Business groups lower transactions costs for affiliated firms Business groups are organized as pyramids that are designed to plunder their affiliates Business groups serve as a quasi-internal capital market for their members Business groups concentrate corporate control in the hands of small elite Business groups are a source of scarce human capital Business groups entrench their top management Business group reputation signals quality and helps acquire scarce resources in factor markets Business group insiders use their complex and opaque corporate structures to exploit outsider investors Business groups are a mutual insurance device Business groups are corrupt, crony, rent-seeking instruments Business groups are effective monitors of affiliate firm performance Business groups exercise monopoly power Business groups are a ‘catch-up’ mechanism Business groups facilitate moral hazard and inefficient investment Powerful business groups make implied contracts with the state  2024-09-23 Any question?  2024-09-30 CHAEBOL’S BUSINESS STRUCTURE CHAEBOL’S DIVERSIFIED BUSINESS STRUCTURE  2024-09-30 THE EXTENT OF CHAEBOLS’ DIVERSIFICATION LG cost matters?  2024-09-30 SAMSUNG Level of diversification has reduced Pursue business in mulit. indus.s CHAEBOLS’ AFFILIATES THE PATTERN: # affiliates increased  2024-09-30 DIVERSIFICATION OF KAKAO GROUP Example of related and unrelated diversification THE MOTIVATIONS FOR DIVERSIFICATION E.g., Apple doesn't have construction/life/security insurance company etc Chaebols are diverse Why did chaebols pursue unrelated diversification rather than focusing on a few core businesses? 1. Pursuit of growth Growth of indiv firm - no, of the entire Chaebol group Prioritise the growth of entire Samasung, LG Chaebols have pursed growth rather than short-term profits because growth was directly related to long-term profit maximization.  2024-09-30 SAMSUNG GROUP’S DIVERSIFICATION THE MOTIVATIONS FOR DIVERSIFICATION 2. Risk reduction of founding families Chaebols also diversified to reduce the risk of their founding families, which invested all their assets into affiliates. This goal did not serve the interests of minority shareholders. To lower the risk Goal: serve interest founding families = majority shareholders  2024-09-30 THE MOTIVATIONS FOR DIVERSIFICATION 3. Creating synergies by sharing intangible resources such as technology and brands, tangible resources, human resources, and capital. Building construction - factory needed - Samsung engineering and construction and resources LG/Samsung Aircon advertising: K- sell images vs elsewhere product itself Associations created, when seeing LG/Samsung in other sectors established bias. SHARING TECHNOLOGY THROUGH GROUP-LEVEL R&D CENTERS Samsung Group – the Samsung Advanced Technology Institute – to support a group-level effort for basic research Then vertical integration of affiliates: Samsung Electronics – manufactured finished TV Samsung SDI – TV tubes Samsung Electro-Mechanics – various TV electronic parts Samsung Corning – glass for TV tubes Technological innovation in one affiliate can directly contribute to cost savings and new product development in another affiliate  2024-09-30 SHARING BRAND All affiliates in a group share its unique brand name Group advertising generates considerable scale and scope economies e.g. aircon selling images SHARING BRAND Progressive brand and selling image  2024-09-30 SHARING MANAGEMENT KNOW-HOW Therefore entering a new industry is easy with this assistance Sharing management know-how – chaebols’ sharing of management know-how is important, particularly when they enter a new business. Samsung entering the specialty chemicals industry Samsung Engineering – designed the factory Samsung Life Insurance – real estate experts helped purchase the necessary land Samsung Construction – built the plant Samsung Heavy Industries – supplied the materials for the plant’s construction Samsung SDS and Samsung Engineering – designed the factory automation Samsung Corporation – helped expedite the supply of raw material and export of products Samsung Petrochemical and Cheil Industries – helped secure necessary technology Branch offices of Samsung Corporation – took care of the foreign correspondence The group-level training center – trained newly hired and transferred employees SHARING HUMAN RESOURCES: INTRAGROUP LABOR MARKET  2024-09-30 SHARING HUMAN RESOURCES: INTRAGROUP LABOR MARKET SHARING HUMAN RESOURCES Internal labor markets: create economies of scale, instill group-level culture, and promote cooperative human resource sharing among affiliates. are important for chaebols when they diversify into new businesses. outside labour was underdeveloped By transferring personnel into new affiliates, chaebols can save much time and money and further facilitate the sharing of technological resources and management know-how. Prior to the crisis, difficult to transfer across companies. Not hired by other groups. Uncommon to transfer officially and unofficially. Transfer underdeveloped. Trained as an employee - guaranteed lifetime employment. New culture, why move. For insiders - very generous corporate benefits.  2024-09-30 Procure capital quickly Internal capital markets Chaebols collected funds from each affiliate and SHARING allocated them in the order of strategic importance. CAPITAL Internal capital markets Chaebols collected funds from each affiliate and allocated them in the order of strategic importance. By law each company is an independent, the board makes the decisions. Each firm has their own board. Founder controls. ORGANIZATIONAL STRUCTURE OF CHAEBOLS STRUCTURE OF CHAEBOLS Why is it fairly easy for chaebols to share various resources despite their independent legal status? Multidivisional structure 1. The chairman of a chaebol - sets the direction for the chaebols’ corporate culture and personnel management and decides when the affiliates should make groupwide investments and divestitures CEO 2. Presidents of affiliates - determines only matters related to the business operations of his division not group Each group has 3. Staff personnel - exist as a bridge linking the CEO to heads of business divisions A key function of this group-level staff organization is to determine the transfer price of intragroup business transactions. This unit may be It does so to maximize profit at the group level, not the affiliate level. explicit/implicit It can exercise such control over internal transfer prices because it has the authority to evaluate the performance of individual affiliates and to recommend appointment/dismissal of affiliates’ presidents to the group chairman. As a manager you can be fired by the board, not stable employment. Therefore being a manager top level is extremely difficult. Who will evaluate manager - by staff under the chairman's office. Strategically co-ordinate and prioritise group-level growth rather than short-term. Determine transfer price - benefit one firm over another. This is what the personnel under the chairman do - exercise great power over affiliates/personnel. This unit is in each group unofficially.  2024-09-30 ORGANIZATIONAL STRUCTURE OF CHAEBOLS How is it possible for individual affiliates, many of which are publicly owned companies with separate shareholders and boards of directors, to maximize profits at the group level but not their own profits? The corporate governance system in Korea discount benefits - rent Managers and executives maintained their identities with the group itself for employees - mortgage [trap of death - 30/40 years] from group financial industry The lack of external labor market, seniority-based promotion, and strong loyalty to the group based not on performance but years of loyalty CORPORATE GOVERNANCE Share. Chaebol family does not own more than 50% if shares. 10-14% perosn. But voting rights are more than 40%.  2024-09-30 ORGANIZATIONAL STRUCTURE OF CHAEBOLS Did the chaebols maximize profitability or growth? Chaebols could invest in new business opportunities to maximize growth and long-term profitability only when each affiliate maximized its profits and generated much-needed cash. ORGANIZATIONAL STRUCTURE OF CHAEBOLS If the Korean chaebols created such operating efficiencies by sharing resources, why did they face such difficulties amid the nation’s foreign exchange crisis? Operating synergies created by resource sharing among affiliates were frequently offset by failures in strategic decision making. Why? The lack of functioning governance system to guard against wrong decisions since the 1980s A homogenous group of managers Agree with the chairman's decisions  2024-09-30 DISCUSSION Do you think that chaebols’ corporate governance system must be reformed?  2024-10-07 VERTICAL INTEGRATION OF CHAEBOLS CORPORATE STRATEGY Corporate strategy Corporate strategy is the way a company creates value through the configuration and coordination of its multi-market activities Quest for competitive advantage when competing in multiple industries Corporate strategy Growth strategies – expand the company’s activities M&A Horizontal integration Vertical integration Stability strategies – make no change to the company’s current activities Retrenchment strategies – reduce the company’s level of activities  2024-10-07 HORIZONTAL INTEGRATION Horizontal growth expansion of operations into other geographic locations and/or increasing the range of products and services offered to current markets Horizontal integration the degree to which a firm operates in multiple geographic locations at the same point on an industry’s value chain buying multiple oil refineries HORIZONTAL INTEGRATION Examples: The Standard Oil Company buying 40 refineries An automobile manufacturer buying a sport utility vehicle manufacturer A radio station that also owns a newspaper and magazine  2024-10-07 FIRMS VS. MARKETS: MAKE OR BUY Should a firm do things in-house (to make)? Or obtain externally (to buy)? Remeber Keiretsu vertical int. -indursty suppliers/distributors C- cost If Cin-house < Cmarket, then the firm should vertically integrate Building cars - land, labour, capital - parts [tyres etc] with vertical intergration produce internally. Vertical integration – an internal transfer of goods and services within a firm ORGANIZING ECONOMIC ACTIVITY: FIRM VS. MARKETS Competition. To win - be efficient, producing better quallity with lower cost = innovation Allow companies to walk away high quality, low cost Supply company without competition - l less incentives for inovation Shareholder and manager relationship information of seller to Shareholders are owners buyer documentation - Managers work for shareholders history of accidents Agents work for themselves need regulations Difficult to enforce contracts when parties don't come through  2024-10-07 BACKWARD AND FORWARD VERTICAL INTEGRATION ALONG AN INDUSTRY VALUE CHAIN low value-added activity VERTICAL INTEGRATION Backward Integration Company moves one step backward from its current line of business activity Hyundai Construction and Hyundai Industrial Development / Hyundai Petrochemical and Hyundai Oil Refinery maintain backward (or upstream) integration with very extensive and intricate networks of smaller affiliates that supply intermediary goods and parts to them Forward Integration Company moves one step ahead of its current line of business activity Hyundai Corporation operates as the intermediary of their affiliates’ exports and imports; Hyundai Motor uses Hyundai Motor Service to distribute its products in Korea  2024-10-07 korean firms pursue this VERTICAL INTEGRATION: HYUNDAI GROUP THE EXTENT OF VERTICAL INTEGRATION OF CHAEBOL AFFILIATES BY INDUSTRY PARTICIPATION  2024-10-07 THE EXTENT OF VERTICAL INTEGRATION OF CHAEBOL AFFILIATES BY INDUSTRY PARTICIPATION THE EXTENT OF VERTICAL INTEGRATION OF CHAEBOL AFFILIATES BY INDUSTRY PARTICIPATION  2024-10-07 BENEFITS OF VERTICAL INTEGRATION Market power Entry barriers Down-stream price maintenance Up-stream power over prices Securing critical supplies Lowering costs (efficiency) – reduction of transportation costs and marketing and sales-related expenses Improving quality Facilitating scheduling and planning (efficient coordination) – reduction of inventory and immediate adoption of efficient technology Increasing competitiveness Facilitating investments in specialized assets RISKS OF VERTICAL INTEGRATION Increasing costs Internal suppliers lose incentives to compete Maintaining a homogenous group culture and facilitating the intragroup transfer of personnel increase costs (the same level of payments and benefits for all affiliates) Reducing quality Single captured customer can slow experience effects Reducing flexibility Slow to respond to changes in technology (lack of the incentive to be more efficient or innovative) or demand (not sufficiently flexible to adjust to different transaction volumes) Increasing the potential for legal repercussions  2024-10-07 VERTICAL INTEGRATION INTRA-AFFILIATES TRANSACTIONS OF CHAEBOLS  2024-10-07 CROSS-SUBSIDIZATION Why did chaebols maintain vertical integration despite such inefficiency? The inertia toward change created by mutual debt guarantee practices and cross- shareholding The fear of losing their equity investments in these affiliates CROSS-SUBSIDIZATION Cross-subsidization - “when a multiproduct firm prices one good below average cost and makes up for the losses through revenues collected from the sales of other goods that are priced above the average cost” (126) Supporting poorly performing affiliates makes sense for the group headquarters, which want to maximize the profits of the entire group. Types of cross-subsidization No fee for using facilities Not collecting any overdue interest rates Providing interest-free loans  2024-10-07 CROSS-SUBSIDIZATION The listed companies are cross-subsidizing suppliers (usually owned by owner family), and by doing so chaebols intentionally reduce the profitability of the listed companies  2024-10-07 GOVERNMENT’S REGULATIONS Fair Trade Act Article 23(1)7 – prohibition of unfair assistance Article 23-2 – prohibition on provision of undue benefits to related persons Article 10-2 – prohibition of debt guarantee  2024-10-07 ALTERNATIVES TO VERTICAL INTEGRATION Taper integration Backward integrated but also relies on outside market firms for supplies OR Forward integrated but also relies on outside market firms for some of its distribution TAPERED INTEGRATION: ADVANTAGES Additional input/output channels without massive capital investments Information about costs and profitability from internal operations can help in negotiating with market firms Threat of self manufacture can impose discipline on external suppliers. Internal channels will be motivated by potential expansion of the use of outside sources. Internal supply capabilities will protect against potential holdups  2024-10-07 TAPERED INTEGRATION: DISADVANTAGES Possible loss of economies of scale Coordination may become more difficult since the two production units must agree on product specifications and delivery times Managers may be self-serving in continuing with internal production well after it has become inefficient to do so STRATEGIC OUTSOURCING Strategic outsourcing Moving value chain activities outside the firm's boundaries Strategic alliances involve cooperation, coordination and information sharing for a joint project by the participating firms.  2024-10-07 STRATEGIC ALLIANCES Strategic alliances and joint ventures fall between pure market exchange and full vertical integration. Alliances rely on trust and reciprocity instead of contracts. Disputes are rarely litigated but resolves through negotiation. VERTICAL INTEGRATION & DIVERSIFICATION: SOURCES OF VALUE CREATION AND COSTS  2024-10-14 THE CAPITAL STRUCTURE OF CHAEBOLS FINANCIAL MARKETS Channel funds from savers to investors, thereby promoting economic efficiency Affect personal wealth and behavior of business firms  2024-10-14 FUNCTION OF FINANCIAL MARKETS 1. Allows transfers of funds from person or business without investment opportunities to one who has them 2. Improves economic efficiency CLASSIFICATIONS OF FINANCIAL MARKETS Debt Markets Short-term (maturity < 1 year) Money Market Long-term (maturity > 1 year) Capital Market Equity Markets Common stocks Primary Market New security issues sold to initial buyers Secondary Market Securities previously issued are bought and sold Exchanges Trades conducted in central locations (e.g., Toronto Stock Exchange and New York Stock Exchange) Over-the-Counter Markets Dealers at different locations buy and sell  2024-10-14 CLASSIFICATIONS OF FINANCIAL MARKETS International Bond Market 1. Foreign bonds 2. Eurobonds FUNCTION OF FINANCIAL INTERMEDIARIES Financial Intermediaries Engage in process of indirect finance More important source of finance than securities markets Needed because of transactions costs and asymmetric information Transactions Costs Financial intermediaries make profits by reducing transactions costs Reduce transactions costs by developing expertise and taking advantage of economies of scale  2024-10-14 FUNCTION OF FINANCIAL INTERMEDIARIES Risk Sharing Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation). Also lower risk by helping people to diversify portfolios INTRODUCTION The financial market environment Chaebol’s capital structure - the correlation between Korean financial markets and chaebols’ heavy use of debt. Chaebol’s practices in their internal capital market – loans, debt guarantees, and cross-shareholding  2024-10-14 FINANCIAL MARKET ENVIRONMENTS IN KOREA State intervention in the financial market Channeling capital to strategic industries, including export-oriented industries and heavy and chemical industries Nationalization of all private banks Subordination of the central bank under the supervision of the Ministry of Finance Payment guarantees for firms to secure foreign loans for industrialization Protecting preferential firms Chaebols - “too big to fail” & moral hazard FINANCIAL MARKET ENVIRONMENTS IN KOREA Lack of autonomy of banks Banks lacked the power, commitment, and capacity for strict credit analysis because they were but an extension of the government Little accountability Little regulation of lending practices Because banks lacked the ability to function properly, they began to require high levels of collateral as well as debt guarantees to protect their assets. Chaebols responded by extending debt guarantees between affiliated companies.  2024-10-14 FINANCIAL MARKET ENVIRONMENTS IN KOREA High debt-equity ratios among chaebol affiliates Ultimately, chaebols with more affiliates that could extend collateral and debt guarantees received better financial treatment and opportunities for further expansion than did other, smaller companies. These circumstances led to skyrocketing debt–equity ratios among chaebol affiliates that would have been impossible without governmental support; the government’s policies not only allowed such behavior but also encouraged it. CHAEBOLS’ FINANCIAL SERVICE ARMS Investment in banks Banks were gradually privatized once again in the 1980s, and chaebols began purchasing stock in them. The Bank Act - no one entity could own more than 4% of a national bank or 15% of a regional bank, except for foreign investors operating through a joint venture Chaebols used this equity both to enhance their bargaining power during credit negotiations with banks and to prepare for acquiring banks if and when further deregulation of bank ownership occurred.  2024-10-14 CHAEBOLS’ FINANCIAL SERVICE ARMS Investment in nonbank financial institutions Chaebols also invested heavily in many nonbank financial institutions, including insurance companies, securities companies, investment trusts, merchant banks, credit cards, and installment financing. The government’s regulation of nonbank financial institutions was lax because they were not directly involved in the payment settlement system. Most large chaebols, including the top five, own securities companies, investment trust companies, and merchant banks CHAEBOLS’ FINANCIAL SERVICE ARMS  2024-10-14 CHAEBOLS’ FINANCIAL SERVICE ARMS While chaebols entered the financial sector because of its high growth potential, they wanted to use financial companies as the channel of capital procurement and portfolio management for all their affiliates Affiliated companies enjoyed preferential lending rates Security companies, which were subject to far less regulation than were banks or insurance companies, supported their affiliates more actively CHAEBOLS’ FINANCIAL SERVICE ARMS Merchant banks The Korean government allowed chaebols to own merchant banks in an effort to absorb curb markets. Their role, however, as the capital supplier for affiliated companies must be more extensive because one of their most prominent roles is to acquire and apply discounts on corporate promissory notes or commercial paper issued by affiliates Two additional important roles of chaebols’ financial institutions 1. they function as holding companies within their groups. 2. these financial institutions serve as portfolio managers for the chairmen and their families  2024-10-14 CHAEBOLS’ FINANCIAL SERVICE ARMS Consequences of ownership Chaebols’ ownership of financial companies seriously distorted the flow of financial capital – inefficiency in capital allocation Nonbank financial institutions gradually were turned into private vaults for the chaebol and did not direct capital flows to healthier businesses Chaebol companies began investing money procured from their own financial institutions into inefficient businesses. There was no mechanism, such as credit analysis, in place to control these firms’ capital flows efficiently CAPITAL STRUCTURE OF CHAEBOLS High debt-equity ratios Corporate capital structure is contingent on the legal environment in which the company operates Equity financing – stress the rights of minority shareholders, extend comprehensive support to hostile corporate takeovers, and prefer dissemination of corporate information and exercise of shareholders’ rights Debt financing - weaker structures for minority share holders’ rights protection, management monitoring, information dissemination, and accounting audits, resulting in a higher cost for equity financing because investors demand higher premiums to compensate for potential risks associated with incomplete information Underdeveloped financial markets and the government’s industrial policy resulted in higher debt- equity ratios  2024-10-14 CAPITAL STRUCTURE OF CHAEBOLS CAPITAL STRUCTURE OF CHAEBOLS Why did chaebols take on so much debt prior to the crisis? The Korean economy began contracting in 1995, thus reducing corporate profits and making the acquisition of new capital from intracompany sources much more difficult. Chaebols continued to invest in long-term production facilities while relying heavily on short- term loans  2024-10-14 CAPITAL STRUCTURE OF CHAEBOLS Why didn’t the chaebols raise equity when they made these huge capital investments? How did chaebol firms continue making such a huge investment amidst a capital shortage? On average, chaebols put far more emphasis on the group-level profit and cost of capital and avoided diluting key shareholders’ interests. Accordingly, even if the financial cost of equity capital is low, chaebols prefer debt to equity. CAPITAL STRUCTURE OF CHAEBOLS The chaebols’ capital structure depended largely on their ability to secure debt. The more debt chaebols could secure, the better off they were since they could invest in far more projects than could other chaebols. Debt-carrying capacity depends on the following factors Larger companies have higher debt-equity ratios. Companies that exploited more debt payment guarantees were liable for more debt. Affiliates in chaebols that owned financial institutions were more likely to borrow. Type and source of debt that affiliates use depended on the type of financial company owned by a chaebol - affiliations with merchant banks lead to more short-term debt, while affiliations with securities companies lead to more long-term debt and domestic debt.  2024-10-14 INTERNAL CAPITAL MARKET AND CROSS- SUBSIDIZATION Chaebols created internal capital market to enhance financial efficiency By controlling cash flow at the group level, chaebols can enhance financial efficiency. This capital market is composed of loans, debt guarantees, and cross-shareholding between affiliates Inter-affiliate loans – short-term lending usually by purchasing promissory notes issued by another affiliate at a higher price INTERNAL CAPITAL MARKET AND CROSS- SUBSIDIZATION Several characteristics of these intragroup financial transactions First, major affiliates support weaker affiliates - this assistance protected nonviable companies from having to file bankruptcy, while reducing the overall amount of investment funds for major affiliates Second, this intragroup support mechanism strengthens the families’ position within the chaebol group. Third, these transactions assume many forms and may be direct or indirect.  2024-10-14 INTERNAL CAPITAL MARKET AND CROSS- SUBSIDIZATION INTERNAL CAPITAL MARKET AND CROSS- SUBSIDIZATION Debt payment guarantees Although these guarantees nominally ensure that a firm’s affiliates will pay debts that the firm cannot, the widespread use of these agreements may result in situations in which nobody can really guarantee repayment. If one company involved in this practice becomes insolvent, its bankruptcy may have a domino effect on its affiliates. The regulations by the Korea Fair Trade Commission Limit payment guarantees among affiliates in large business groups to 200% of an affiliates’ equity in 1993; to 100% in 1996; and revised the Fair Trade Act again 1998 and abolished the practice by 2000.  2024-10-14 INTERNAL CAPITAL MARKET AND CROSS- SUBSIDIZATION Successfully eradicating the practice will, however, require financial institutions, especially banks, to change their lending practices. Banks should make loans when firms have promising investment opportunities or when firm can provide collateral. Otherwise, the payment guarantee system will persist, thereby defeating the government’s intent. INTERNAL CAPITAL MARKET AND CROSS- SUBSIDIZATION  2024-10-14 INTERNAL CAPITAL MARKET AND CROSS- SUBSIDIZATION Cross-shareholding Chaebols used cross-equity investment among affiliates heavily. Affiliates initially used cross-shareholding to secure necessary initial funds when they began a new enterprise. Another function of cross-shareholding is, however, to maintain control over affiliates BAD LOANS AND THE ASIAN FINANCIAL CRISIS  2024-10-14 CONCLUSION Chaebols’ huge debts and the financial crisis were created by dysfunctional corporate governance systems and the distortions in financial markets. Chaebol families’ desire to maintain controlling equity stakes made them prefer debt to equity financing, and the government’s meddling in the financial service sector allowed these families to build up huge debts to finance their reckless expansion even during the economic downturn in 1990s DISCUSSION Do you think that debt or loan guarantee among affiliates disappeared completely? Why is this reform so difficult?