The Chaebol Phenomenon Role in the Economy of Korea Essay

Introduction

The recent research on the public opinion concerning wealth and employment in Korea has shown that there is a general dissatisfaction with the job market in the country. Thus, the majority of young people have to work part-time in order to pay for their studies. In the meantime, they fail to find a well-paid job even when they receive a degree (Joy par.2). Whereas the social opinion might be treated as a subjective estimation of a real set of things, the statistic shows that there are valid reasons for that sort of disappointment. Thus, the Korea Institute for Health and Social Affairs reports that the unemployment rate among the young people is rising steadily (Joy par. 5). As a result, the question arises concerning the factors that determine these economic problems. Some specialists believe that one of the causes is the dominance of large conglomerates or “chaebols” (Baek, Kang and Park 300).

Large conglomerates tend to have a significant influence on a country’s economy. The extent of this influence is critical as it determines the extent of the economy’s self-dependency and, as a result, its competitive capacity. There is a widespread assumption that huge corporations take up the dominant position in Korean national economy, depriving small and middle size businesses of an opportunity to develop and extend (Feenstra and Hamilton 286).

In order to evaluate the impact that chaebols have over Korean economy, it is essential to perform a thorough analysis of their structure, background, as well as their strengths and weaknesses. Thus, the paper at hand is aimed at examining the chaebol phenomenon and its role in the national economy of Korea.

Corporate Governance

Before analyzing the chaebol phenomenon, it is essential to get acquainted with the notion of corporate governance and its basic aspects as they are of key importance for understanding the chaebols’ performance. Corporate governance consists of the relationships and accepted standards of behavior between the different members of a limited liability company. These members might be represented by shareholders, top managers, employees, clients, creditors and other important agents that, to a smaller or larger extent, determine the strategy of a particular firm (Feenstra and Hamilton 200).

The terms of relationships and the norms of behavior that represent the framework of the agents’ collaboration can be referred to the notion of corporate governance. The key principle of successful corporate governance resides in encouraging the creation of a healthy competitive environment and focusing on the prosperity and the growth of the national economy.

In other words, the principal aims of efficient corporate governance might be divided into five groups. The first group of aims focuses on protecting the rights and the interests of shareholders. The second group’s main target is to assure the equal treatment of all the shareholders, including the minority groups. This aim implies the necessity to reconsider every decision in case it is likely to violate shareholders’ rights. The aim of the third group is to encourage the shareholders to participate actively in corporate governance. The next group of aims implies maximizing the disclosure and the transparency of all the financial operations that are carried out inside the firm. The final group of aims concentrates on protecting the established norms and standards by performing regular monitoring on the part of management boards that are responsible to both the firm and its shareholders (Feenstra and Hamilton 217).

Therefore, the key concern of corporate governance is to focus on the protection of its shareholders’ capacity to manage the company’s performance. Shareholders are represented by the owners of a firm; therefore, their interests are essentially connected with the prosperity of this firm.

Moreover, corporate governance is concerned about maintaining integral reputation. The reputation of integrity is critical for any company as trusting relations reduce particular transaction costs within companies – the partners receive a relatively valid guarantee for consistent compensation and a potentially reliable partner in perspective (Feenstra and Hamilton 201). Therefore, transparency and reliability are critical factors describing effective corporate governance.

One of the most meaningful aspects concerning successful corporate governance is its managerial structure. Thus, managerial boards are to be separated from the ownership of the firm so that they are enabled to assure the transparency and accountability and to guard the interests of all the shareholders inside the corporate structure. Such boards should be unbiased in regard to the investors of a firm because they are supposed to provide a critical service that implies monitoring the performance of a company.

The relevant overview of the corporate governance will serve to be an assisting framework for evaluating chaebols’ structure as well as pointing out its principle benefits and disadvantages.

Chaebol’s structure

The term chaebol is borrowed from the Chinese language, where “chae” means “wealth or finance”, and “bol” stands for “lineage, faction or clique” (Kim 2005, 5). Chaebol’s structure has a series of distinguishing peculiarities that mainly concern its administrative and controlling aspect. Thus, Kim (2005) describes chaebol as “family-controlled, debt-dependent, diversified business groups that dominate the Korean economy” (4). In other words, the term “chaebol” might be applied to those groups of independent firms that are administrated and financially controlled by a single family.

There is also a scientific opinion that the relevant structure essentially has three key characteristics. First, and foremost, a chaebol firm should necessarily be comprised of several affiliated firms that operate in different industry fields. Secondly, the ownership and all the other controlling functions are performed by the dominant family exclusively. Finally, this entrepreneurship accounts for a significant percentage of the country’s economy (Almeida et al. 22).

It is, likewise, necessary to add that despite the fact that chaebol firms can be controlled by different professionals, the principal managing function belongs to the so-called “chongsu”, the main blockholder who comes from the owner family (Murillo and Sung 2). In order to provide a better idea of what a “chongsu” is, one might turn to the example of the Samsung Company. In this case, Mr.Lee, the firm’s chongsu, holds 0.57% of the entire group share and controls a vast spectrum of the company’s cross shareholding, even though he is neither the chairman nor CEO. Therefore, Mr.Lee is an unofficial general manager responsible for the final decision making in the company.

Weaknesses of the Chaebol System

Most of the drawbacks of the chaebol system are connected with its administrative structure. Thus, the fact that the controlling function is performed by the group’s chongsus creates a series of critical problems. To begin with, chaebols groups are more likely to perform unreasonable and risky investments. The relevant phenomenon might be explained by the simplified access to the loans provided by domestic banks. Moreover, chonguses’ decision making is often determined by the intention to retain control over the group and improve its general image and position in the society. In addition, they are highly concerned about expediting the property’s succession to their relatives which makes them invest into risky new firms in order to enhance power to their descendants. As a result, it is almost impossible to evaluate the outcomes of a particular investment (Murillo and Sung 7).

Secondly, the strong trading bonds within a chaebol group oblige the shareholders to purchase essential production from sister companies in spite of the fact that other firms might have a more beneficial offer. Hence, such groups neglect profit maximization, focusing, instead, on the stability (Murillo and Sung 7). In fact, they try to meet the interests of one company by means of damaging the interests of another.

Finally, it is the principles of delegation of power that have a negative influence on the performance of chaebol companies. Such groups prefer to delegate authority to the eldest son in the family regardless of his skills and abilities. One of the most vivid examples of this authority expansion is Samsung, where the authority is shifted only to the eldest children of its founder (Murillo and Sung 8). The unwillingness to adopt meritocratic principles in authority’s transfer often leads to the inefficient management and does significant harm to the company’s prosperity. In addition, chaebol firms show less business transparency in comparison with non-chaebol companies that is determined by the family relations inside the group (Park, Shin and Suh 60).

Benefits of the Chaebol System

Practice shows that chaebol companies are particularly successful in political lobbying and developing social networks. As a result, they normally receive a substantial support from the local government or different political leaders (Murillo and Sung 8). Moreover, due to the family oriented administration structure, such firms are normally more focused on the long-term perspectives from the management standpoint (Park, Shin and Suh 60). In other words, decision-makers feel highly responsible for the future outcomes of their policy.

In addition, Kim’s research has revealed a positive impact that family ownership has on the company’s general performance. According to Kim, this phenomenon might be explained by the fact that such administrative structure leads to the interpenetration of the shareholders’ interests as well as the encouragement of contributing to specific firm investments (Kim 2005, 26).

Some surveys also show that chaebol companies are beneficial from the new business opportunities perspectives as its shareholders often possess consistent knowledge in diverse business fields (Park, Shin and Suh 59).

Reasons for Diversification and Associated Problems

Nowadays, a diversified conglomerate is the principle form of operating for the majority of the large Korean companies. The most common examples of such business groups are Samsung, Hyundai Motor, SK and LG. Researchers point out a series of reasons for chaebols’ diversification. First of all, it is the risk of a one product company that prompts the owners to extend. Secondly, chaebols have to operate within a highly competitive environment. As a result, diversification is one of the solutions to maintain their competitive advantage. Moreover, diversification is often essential in order to maintain the tradition to pass the business on to the young generation inside the family (Park, Shin and Suh 59).

However, the diversification of chaebols, likewise, creates a series of critical problems. The major part of these difficulties resides in management costs. Specialists note that management costs are apt to rise as long as a company extends internally (Park, Shin and Suh 63). As a result, Korean chaebol groups tend to experience significant management bearings that can reduce their competitive capacity in the global market.

Another critical difficulty associated with chaebols’ diversification is the lack of transparency that creates problems with transfer pricing, cross-subsidy, and self-dealing (Park, Shin and Suh 64). As a result, exit costs increase as well as the inefficiency of chaebols’ performance.

Background

First of all, it is essential to note that close family ties represent a traditional element of Korean culture. Therefore, there is no surprise that company owners are inclined to pass their business on to their children and relatives (Park, Shin and Suh 58). Nevertheless, the chaebol system in Korea began developing rapidly only in the latter half of the twentieth century. At that point, the local government performed the selection of the top companies who received the exclusive privilege to supervise beneficial projects in military and building fields. Among the principal advantages that these companies received, it is necessary to point out various exporting subsides, considerable tax reduction, and loans. As a result, by 1980s, chaebol groups had become independent businesses that did not need any external assistance from the state. Their industrial abilities had become excessive, and the government was obliged to carry out certain measures in order to regulate these conglomerates and prevent the negative impacts they were likely to have on the national economy. One of such measure was the creation of the anti-chaebol campaigned initiated by the president.

Chaebol companies began experiencing critical difficulties at the end of the twentieth century when the Asian financial crisis broke out. A significant part of the Korean banking sector went bankrupt depriving, in such a manner, chaebols of the considerable support they used to receive. As a consequence, chaebols had no other choice but to turn for help to the local government, which, in its turn, asked for IMF’s assistance. The IMF’s participation improved the situation as well as brought in some significant changes. For, example, chaebols were, then, highly recommended to make their managing policy more shareholder-oriented in order to raise the activity of the latter. Moreover, the new tendency for corporate transparency appeared, and every big chaebol was obliged to provide its financial statements on the regular basis. Lastly, although firms received more direct financial assistance from foreign investors, such indirect financing as bank loans was reduced significantly. Some analysts note that this change was critical for chaebol companies the main problem of which resides in their considerable dependency on domestic debts (Kim 2005, 10).

Chaebol Groups in the Framework of Korean Crisis

Causes

First, and foremost, it is necessary to point out that one of the principal causes of the Korean financial crisis in 1997 was a widespread decline in corporate value within chaebol groups. Analysts tend to explain this phenomenon by the fact that family groups pursued private benefits (Kim and Kim 47). One of the clue factors, which prompted and gave chaebol groups a chance to dispossess their minor shareholders, was a considerable gap between their right for the cash flow and their voting right. Whereas chaebols’ right for the cash flow was always relatively small, comprising about 20% only, their voting right was almost unlimited due to the developed web of cross holdings within affiliated companies. Thus, the chaebol groups received a chance to avoid the disciplining forces of the controlling markets, and, as a result, this incentive led to profit decline, value destruction, and diversification.

Key Problems

The value destruction that chaebol groups provoked during the crisis period reduced shareholder wealth and had a negative impact on the national economy, in general. As a result, Korea was almost sure to undergo a sharp depreciation of the national currency. Nevertheless, the government managed to maintain the value at surprisingly high levels until November 1997 when it turned out to exhaust all the foreign reserves (Kim and Kim 49). As a result, the government was obliged to allow the exchange rate floating independently, and the value of currency decreased sharply. The crisis coincided with considerable changes in the administration. The new members of administration implemented a number of reforms that were mainly aimed at changing the structure of chaebol groups (Baek, Kang and Park 270).

The Negative Impact of Chaebol Groups

Unfortunately, the practice of dominant corporate governance in Korean chaebol groups is still widely spread in spite of all the reforms and measures taken. Despite the fact that it is obligatory for chaebol groups to introduce independent directors into the board, these people are still unwillingly admitted to the decision-making process within a firm (Choi, Park and Yoo 951).

As to the informational effectiveness in the local stock market, it failed to establish yet; therefore, the company value is poorly reflected in the stock price of the firm. Thus, the Korean market for corporate control works rather unproductively (Ferris, Kim, and Kitsabunnarat 264). As a result, managers and controlling members are more likely to violate their fiduciary duties, and they, generally, tend to be more criminally prosecuted (Song 3).

On the whole, specialists point out a series of negative aspects of the chaebols’ influence. First of all, it is the attempt of chaebol groups to concentrate the maximum of economic power within a single family. Thus, for example, in case if one of the top chaebols in Korea, such as Samsung Electronics, reports a decline in profits in one of the quarters, one might reasonably have concerns about the negative impact this decline might have on the national economy, in general (Jung 27). One of the key problems is that whereas the majority of Korean chaebol groups have a huge share of the local economy, their contribution to the real economy is rather insignificant. Hence, a large percentage of huge chaebols operating in the field of manufacturing prefer to invest their money into foreign subsidiaries rather than domestic economy.

The second negative factor connected with Korean chaebol is the tendency to practice an unwarranted evasion of tax. The justice system tries to be particularly careful in dealing with chaebol representatives. As a result, even if a chaebol leader is ever caught in corruption, there is little possibility of his going to jail. Thus, for example, Lee Kun-hee, Samsung chairman, was pardoned although he was found guilty of unwarranted tax evasion because of his help to the government (Jung 30). Moreover, the corporate tax rate in Korea is significantly lower than in other countries. This phenomenon might be explained by the fact that the government is highly indebted to large chaebols; hence, it does not take the risk of doing anything that may hurt the interests of massive corporations driving the national economy.

Another side of their negative impact on the local economy resides in the fact that the chaebols’ groups in Korea prevent small and medium-sized enterprises (SME) from development. This has a highly negative influence on the domestic economy – the national debt continuous to grow, while small business has no chances for expansion. Some economic analysts believe that chaebols intentionally try to do harm to the activity of other economic players. They hoard their profits, focus mainly on the foreign suppliers, discriminating, in such a manner, the domestic ones, and, most importantly, prevent SMEs from growing, while the latter provide workplaces for almost 90% of Korean residents. In addition, the problem becomes even more concerning with the fact that chaebols gradually encroach into the territories that typically belonged to SMEs such as, for example, bakery business.

Challenges that Chaebol System Faces

According to the recent survey, one of the key challenges that Korean chaebols are about to face is the transfer of authority that currently implies the shift from a parent to a child. Such approach has shown to be unproductive as the intention to delegate power to a daughter or a son prevents the owner from focusing on skills and talents of a potential manager. Therefore, decision makers will have to search for alternative solutions that will help them assure effective and high-quality management. It is essential to note that chaebols’ performance is not just the concern of their owners but also the government as the growth of the national economy depends largely on the companys’ performance. As a result, the society and decision makers should create an environment favorable for the development of various entrepreneurial activities. Many specialists believe that consistent changes in the policy of power delegation are likely to contribute significantly to the creation of such an environment (Park, Shin and Suh 59).

The Essential Changes in Chaebols

Chaebol groups have overcome considerable changes since the crisis. In the meantime, their structure has still numerous drawbacks. Specialists point out two important fields that need a reformation in order to achieve efficient corporate governance. First, and foremost, it is necessary to establish a strong interconnection between shareholder value and managerial incentives. Secondly, it is critical to assure consistent control on the part of the board of directors (Kim and Kim 51).

In the framework of the first option, analysts state that the simplest way to connect shareholder value with managerial incentives is to assure performance-based pay that can be achieved by linking stock prices and operating profitability. It is necessary to note that before the chaebol groups commonly avoided merit-based compensation; thereby, the majority of employees received their payments in accordance with rank and seniority. In other words, higher profits meant higher bonuses; however, the final amount of these bonuses was essentially connected with the rank and seniority instead of performance itself.

As a result, the only possibility for an employee to receive a higher reward was to receive a promotion, first. Meanwhile, rapid promotions were not commonly encouraged. Such payment practice was widely accepted by chaebol groups as it served to be the reflection of the cultural traditions that implied hierarchy. The inefficiency of such an approach was evident – company executives were focused on increasing their own rewards, they implemented schemes aimed at shifting profits out of their companies. During the crisis period, such a strategy resulted in a series of bankruptcies. The most vivid example is the Daewoo Group that used to be the one of the largest chaebol groups in Korea. After its bankruptcy, the business community turned highly concerned about rising shareholder value in order to assure a long-term survival and essential competitive advantage.

It is necessary to note that some measures have already been taken in this field. Thus, some chaebol companies adopted particular forms of performance-based pay. Recent studies of Korean chaebol companies showed that a significant part of managerial compensation is currently related to stock market performance. Moreover, the stock performance’s sensitivity of pay can be now compared to U.S. and Japanese rates (Kim and Kim 52).

In the framework of the second option, it is essential to introduce outside directors that will be able to perform independent control. This reform was thoroughly addressed after the crisis. Thus, each chaebol group was required to assure that at least one quarter of its board directors is comprised by independent members. Moreover, the number of independent directors increased up to 50% in 2001(Kim and Kim 55). Research has shown that this measure has a positive outcome. Thus, most of the companies that fulfilled the requirement showed significant profit raise, reduced number of tunneling issues, and the increased frequency of broad meetings. Therefore, it is evident that chaebol groups should admit independent directors to the inner decision making in order to assure a more consistent control as well as to protect the interests of minority shareholders.

Conclusion

The analysis of chaebols’ influence on the national economy of Korea has shown that the character of this impact is rather ambiguous. On the one hand, large conglomerates in Korea serve to be a substantial support for the local economic sector. On the other side, there is a series of factors that characterize this business form as negative. First, and foremost, the excessive influence of chaebols on Korean economy makes the latter riskily dependent on the performance of huge corporations. It means that in the case of a bankruptcy of one of the chaebols, Korean economy will experience significant damage.

Another critical point about the negative impact that chaebols have on the national economy is their dominance over all the other business forms, such as, for example, small and middle-sized entrepreneurship. Thus, the latter are deprived of the chance to develop effectively as large conglomerates take up more and more market sectors.

In addition, the research has shown that chaebols are particularly liable to breaking the law and exercising corruption due to the tolerant attitude of the government and the juridical institutions.

In the meantime, it is assumed that the complete destruction of such a business form as a chaebol would not be beneficial. Instead, it is suggested that a series of measures are implemented in order to reform some of the basic principles of chaebols’ structure. It is essential that such companies involve independent managers that will assure a more reliable and independent control of decision making processes within these firms. Moreover, it is, likewise, critical to reconsider the strategy of the shift of power that currently exists in chaebols.

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