Chaebols and the Korea Discount

By Michael Chung

South Korea’s chaebols (image courtesy of Peter Schrank – economist.com)

Both economic researchers and financial analysts alike have documented the existence of a “Korea Discount.” The term refers to the low equity values of South Korean firms in relation to those in comparable capital markets (i.e. Japan, Taiwan, Singapore). In the past, researchers have suggested that the Korea Discount was a result of the perennial threat and instability of North Korea. Other theories have suggested that the South Korean economy is over-reliant on exports in cyclical industries, or that the capital structures of Korean firms are too debt-heavy. However, upon witnessing very little change in both the KOSPI and the Won following the news of Kim Jong Il’s death, researchers have posited a new theory – that the Korea Discount is a result of the poor corporate governance found in the family-run chaebols.

While the term “chaebol” was first used in the 1980’s to describe a form of Korean business conglomerate, the Korean Fair Trade Commission (“KFTC”) has since appropriated the term to designate any Korean firm, excluding banks, with over 5 trillion Won in assets (approximately $4.7 billion). Many, such as Samsung, Hyundai, and LG, are large multinational groups with operations that span several industries. Samsung, for example, maintains operations in electronics, engineering, life insurance, general insurance, hospitality, amusement parks, and even weapons manufacturing – among others.

While some chaebols are concentrated into one large corporation, and others, organized into loosely connected groups, each is usually owned and managed by one family group. This is largely facilitated by a “loop structure,” a complex system of crossholdings (subsidiaries owning shares in other subsidiaries), which allows chaebol heads to sustain control with relatively minimal capital. While this system was originally instituted to help finance investments across “looped” sister companies, it has since become a catalyst for nepotism, corruption, and exploitation instead.

According to a report by Tongyang Securities, “tunneling” and “propping” are two prevalent examples of poor governance practices in Korea’s chaebols. Tunneling, also known as “self-dealing,” is the practice of awarding contracts to firms owned by family members. For example, in 2007, Hyundai Motor Company was fined by the KFTC for awarding $1.4 billion of business, without any tendering, to Hyundai Glovis, a firm owned by the son of Hyundai’s chairman. Propping, on the other hand, is the practice of financially supporting untenable subsidiaries with funds from their more healthy “sisters.” Effectively, chaebol heads are able to use shareholder funds to sustain inefficient holds in a given industry, giving pause to would-be investors that are looking for positive returns on their investments.

In response, the Korean government has not remained idle. Following the 1997 Asian Financial Crisis, the Blue House passed a series of aggressive regulatory changes with regards to businesses at large. These changes included increased minimums for outside directors on company boards (25% for all public companies and 40% for banks and large companies), stringent accounting rules, and mandatory auditing committees. Chaebols, in particular, became required to disclose consolidated financial statements and obtain board of directors’ approval for self-dealing transactions.

Now, over a decade later, the impact of these regulatory changes remains complex and unclear. While the Korean government continues to institute checks and balances with regards to the market, the sheer market force of the chaebol cannot be denied. After all, the top 10 chaebol alone constitute nearly 80% of Korea’s $1.13 trillion GDP. Recently, in light of the slow economy, President Park’s administration has suggested it will scale back on its taxes and audits of chaebol operations. This statement stands in stark contrast with the president’s electoral campaign, which promised economic decentralization and harsh crackdowns on these same firms.

Still, there is no denying that Korean governance practices have increased across the board over the past 15 years. As a researcher, the recent structural shifts provide a unique opportunity to study the effects of governance and its correlation with equity values. Does corporate governance have an effect on firm value? Can the Korea Discount be fixed with better governance practices? While relations between the Blue House and Korea’s industrial giants can be, at times, tenuous and discordant, such research looks to ask the right questions and illuminate the ways in which all parties, especially the Korean people, can gain from this knowledge.

 

References:

Black, Bernard S., Hasung Jang, and Woochan Kim. “Does Corporate Governance Predict Firms’ Market Values? Evidence From Korea.” The Journal of Law, Economics, & Organization 22.2 (2006): 366-413. Web. 02 Feb. 2014.

Yang, Sung Jin. “Korea Discount Stems From Chaebol Governance: Report.”Koreanherald.com. The Korea Herald, 04 Dec. 2011. Web. 02 Feb. 2014. URL: http://www.koreaherald.com/common_prog/newsprint.php?ud=20111204000319&dt=2

“Minority Report.” The Economist. The Economist Newspaper, 11 Feb. 2012. Web. 02 Feb. 2014. URL: http://www.economist.com/node/21547255

Na, Jeong Ju. “President Backpedals On Chaebol Reform.” Koreatimes.com. Korea Times, 29 July 2013. Web. 02 Feb. 2014. URL: https://www.koreatimes.co.kr/www/news/biz/2013/07/488_140140.html