Directed Research in Economics
University of Northern Iowa
First Distributed Draft
March 5, 2001
South Korea: "The Miracle of Han River"
America and the West had plenty of reason to fear Japan and South Korea in the 1980s. The emergence of the East Asian nations as economic "miracles" gave the rest of the world considerable cause for concern. In a short time, those countries had developed their economies out of the ashes of war into fiercely competitive export machines that appeared certain to put other countries out of business forever. With "Japan, Inc." and "South Korea, Inc." leading the way, the stage seemed set for an Asian Century to rival America's hegemony over global trade for the preceding hundred years.
Then, even more quickly than they had emerged, Japan and South Korea fell nearly to the brink of collapse. A terrific crash in the Japanese market in 1990 [Melloan, 2001, A27] and the subsequent disastrous downturn in the South Korean financial markets in 1997 [Yoo and Moon, 1999, 272] demonstrated that these economic "miracles" had been built on inadequate foundations.
The economic crisis in South Korea is still not over. With the nation's largest firms, the chaebol, still in danger of collapse and the old structures still in place, it is relevant to ask: Is the managed economy in South Korea destined to fail?
Why the West Was Afraid
The Asian economic miracles of the post-World War II era had America and the rest of the world (economically) running scared. As companies like Hyundai, Sony, and Honda expanded and pushed Western balances of trade with countries like Japan and South Korea well into the red, many in business and economics began to ask whether those companies and their home nations knew something about post-modern capitalism that hadn't been covered by the Chicago school. Then, more abruptly than anyone had foretold, the Asian financial crisis of 1997 shook Eastern economies to their cores and left the survivors asking, "What happened?"
The devastating impact of the 1905-1945 Japanese occupation of Korea would be difficult to overstate [Chang and Chang, 1994, 19]. Koreans were kept out of education and prohibited from holding managerial positions, and the Japanese scattered heavy industries to the north and left light manufacturing in the south. After the Japanese were vanquished following their defeat in World War II, the peninsular nation was divided into north and south; South Korea was briefly occupied by the United States before being released to self-governance in 1948 [Chang and Chang, 1994, 21].
Industrial policy in South Korea is credited with taking that country from its dismal post-war state to a position of global prestige for its success in manufacturing and technology leading into the end of the 21st Century. Cohabitation between government and industry -- thought blasphemy by traditional Western capitalists -- was determinedly pursued in Korea between 1950 and 2000 [Hattori, 1997, 475] and took that country's per-capita GNP through a more than twenty-fold increase between 1965 and 1985 [Chang and Chang, 1994, 59].
The driving force behind the Korean economic policy was the chaebol, a uniquely Korean business organization [Gul and Kealey, 1999, 401]. The chaebol (note: some sources indicate the use of "chaebol" for the plural, while others use "chaebols"; "chaebol" will be used for the plural in this paper) are large, diversified family-run companies with extensive networks of subsidiaries and political connections [Gul and Kealey, 1999, 406; Chang and Chang, 1994, 37-43]. Political favor was especially important to the chaebol, which had their roots in extensive government intervention in the economy -- particularly the odious-sounding Five-Year Plans, which were initiated in 1962 [Chang and Chang, 1994, 30]. These plans sought to organize the nation's productive factors and reduce competition [Chang and Chang, 1994, 74] among South Korean firms in order to leverage greater power for those firms on the global market.
The Third Five-Year Plan was likely the most influential; it called for the development of Korea's heavy manufacturing and chemical industries [Yoo and Moon, 1999, 266; Hattori, 1997, 464]. GNP growth under this plan, which lasted from 1972-1976, averaged 9.7% per year [Chang and Chang, 1994, 31]. Importation of heavy manufactured goods was seen as a drag on Korea's growth [Yoo and Moon, 1999, 267] and the government chose to encourage the domestic creation of those industries in order to promote a sense of self-sufficiency.
In the long run, the development of heavy industry under the Third Five-Year Plan led to the concentration of wealth within the chaebol-owning families [Chang and Chang, 1994, 31] and the emergence of the dominant chaebol, which essentially crowded out the emergence of competing firms well into the 1980s [Yoo and Moon, 1999, 267]. It was this emphasis on heavy industry and the resulting dominance of a small cadre of chaebol that led to the precipitous fall of the Korean economy in the late 1990s.
Why the Miracle of Han River Failed
Korean culture has traditionally respected a hierarchy of occupations: scholars first, then farmers, manufacturers, and merchants [Chang and Chang, 1994, 12]. The culture also places the government before the people it serves [Chang and Chang, 1994, 29]. As a result, the best students in South Korea are sent to the best schools, where they are trained for government service. This binding respect for the authority of scholars and government forms the foundation for the private sector's capitulation to the demands of government, including centralized planning of the economy [Chang and Chang, 1994, 33].
The extent to which the South Korean government dominated the economy is significant. Besides providing the central planning authority, the government took an active role in soliciting foreign investment and in supervising the distribution of the nation's capital. Following its withdrawal from the governance of the Korean peninsula, the United States delivered massive amounts of aid (on the order of 8.4% to 18.5% of South Korea's GNP) through the 1950s [Chang and Chang, 1994, 23]. This influx of capital, which was distributed by the government, was a major source of capital formation for the first chaebol [Chang and Chang, 1994, 29].
Foreign capital continued to be an important source of growth for years to come. About 60% of the capital used during the First Five-Year Plan came from abroad [Hattori, 1997, 459], and the government actively encouraged the inflow with the Foreign Capital Inducement Promotion Act of 1960 [Yoo and Moon, 1999, 265]. In the words of Yoo and Moon, "the chaebols [sic] siphoned off the lion's share of Korea's financial resources" (1999, 267).
An influx of capital, though, is an insufficient condition for economic growth. The chaebol benefitted from the government's support in three major forms: export financing support, preferential loan treatment, and loan guarantees [Hattori, 1997, 466]. While export financing support simply "greased" the process for exporting firms (especially during and after the Third Five-Year Plan), the role of the South Korean government in the debt market cannot easily be exaggerated.
South Korean firms relied heavily on debt to achieve growth. The entrepreneurs behind the chaebol have displayed in common a considerable aversion of risk [Hattori, 1997, 458]. As a result, their firms have grown not through diversification within the original company, but through the establishment of subsidiaries. Because one central firm may own controlling shares in many subsidiaries without expending the entire amount of capital needed to run the firms, subsidiaries provide an effective means of avoiding risk while exercising extensive control [Hattori, 1997, 470]. Many of the subsidiaries have been financed through debt leveraging: debt ratios among South Korean manufacturing firms are nearly twice those of similar companies in the United States, and more than three times those of comparable firms in Taiwan [Yoo and Moon, 1999, 269].
The relationship between debt financing and government control in South Korea is significant. The government owned all commercial banks in the country through the early 1980s and retained supervision of personnel matters within the banks late into the decade [Hattori, 1997, 474]. As a result, firms needed government support in order to succeed; they couldn't receive loans without government favor, and without loans they couldn't expand [Chang and Chang, 1994, 68]. This does not mean that the capital was used efficiently. According to Yoo and Moon, "most chaebols [sic] have expanded their businesses recklessly" [1999, 268].
It is the contention of Gul and Kealey that the family owners of the chaebol performed an inadequate job of maximizing the value of their investments [1999, 403]. Others found similar results, noting in particular that over-investment by many chaebol in the same industries throughout the 1970s sapped the nation of valuable capital [Hattori, 1997, 475; Yoo and Moon, 1999, 268]. It was the structure of the chaebol -- particularly their emphasis on growth by subsidiaries -- that encouraged this over-investment. The controlling families behind the chaebol were sheltered from the impact of poor investment decisions by both their limited share of ownership and by government loan guarantees.
Further contributing to the instability of the debt structure in Korea has been the practice of borrowing by sister firms and cross-payment guarantees among subsidiaries within a chaebol [Gul and Kealey, 1999, 401]. As the debt market boomed, loan supervision weakened [Yoo and Moon, 1999, 273] and the chaebol were able to expand and make low-return investment choices. Gul and Kealey note that low interest rates were crucial to Korean debt policy [1999, 403]. Bad loans, which were at the center of the 1997 Asian financial crisis [Phillips, 2001 A1; Frank, 2001, A1], now threaten the continued viability of some of Korea's largest chaebol. Half of Korea's current corporate debt is considered non-investment-grade [Burton, 2001, 30]; Daewoo and Hyundai lead the way with the most bad debt [Financial Times, 2000, 30].
It is unlikely that the debt situation would have gotten out of control without the direct intervention of the state. The chaebol have little incentive to change their financing policies under the current system [Gul and Kealey, 1999, 414], and the government of South Korea appears intent on protecting the chaebol from punishment for the results of loan defaults [Burton, 2000, 22], offering payment extensions and pressuring banks to leave the chaebol in business, as well as continuing to offer loan guarantees and seeking foreign aid [Yoo and Moon, 1999, 274]. Efforts to remedy the shortcomings of the current system remain suspect, as noted by the Wall Street Journal: "The government's role in the new bank and the banking sector in general is of concern because government-directed loans to big companies that already have too much debt is what go many of Korea's banks in such trouble in the first place" [Choi, 2001, C10].
The relationship between the government and the chaebol is curiously close. The chaebol have benefitted from the beginning from the government's Five-Year Plans, and the relationship between the government and debt financing provides considerable reason for the chaebol to maintain favorable relations with the government. As noted by Chang and Chang, "[O]btaining accurate and reliable information from government agencies and competing companies is a suee way to guarantee their survival and prosperity" [1994, 128]. They further reveal what in the United States would be considered an inexcusable act: "Refusing to donate to government leaders and ruling politicians is simply a suicidal action" [Chang and Chang, 1994, 181].
"Donations" to government officials and the close -- often blood-related -- ties between government officials and chaebol owners created a market for government influence in South Korea that was, if nothing else, more transparent than similar markets in other open economies. Information flows both from government into industry and from industry into government through informal networks and official relationships in South Korea [Hattori, 1997, 472]. One's status as an alumnus of a particular school is one of the most significant bases for these relationships [Chang and Chang, 1994, 148], and it has become common practice for Korean firms to hire government officials once they leave public service [Hattori, 1997, 473].
Access to these government officials, whether by blood [Gul and Kealey, 1999, 403] or by payment, made it possible for the chaebol to expand. Among the opportunities created, besides the highly important designation of "critical industries" within the Five-Year Plans, were the opportunities to use assets being purchased as collateral for loans on those same assets [Hattori, 1997, 464]. This version of the leveraged buyout, when used in tandem with considerable foreign investments [Yoo and Moon, 1999, 265], meant that the chaebol were in some cases able to control domestic subsidiaries with small amounts of domestic capital. Only 14% of the funding behind Hyundai Cement, for example, came from Korea itself; the controlling family contributed only a portion of this total [Hattori, 1997, 464n]. By the 1980s, South Korea was "the fourth most heavily indebted nation in the developing world" [Yoo and Moon, 1999, 271].
With so much of the Korean economy dependent upon foreign capital and leverage, it should come as no surprise that when the Asian financial panic took hold in 1997, Korea was hurt badly. Foreign investors, no longer confident in the ability of the chaebol to drive consistent growth and aware of the South Korean government's failure to prevent the chaebol from competing with one another [Hattori, 1997, 475f; Levander, 2001, R34], have begun to leave Korea and move their investments elsewhere [Yoo and Moon, 1999, 272].
The Future of the Korean Miracle
Excessive expansion, government intervention, and bad financing all falling at the heart of the crisis, South Korea must determine how to overcome current instability without erasing half a century of growth [Yoo and Moon, 1999, 275]. Government intervention may be credited with much of South Korea's development up until now, but it also must share much of the blame for the shortcomings of the system. It is clear from the cases of Taiwan [Hattori, 1997, 476] and Hong Kong (prior to the Chinese takeover) that government intervention in a developing economy is not a prerequisite for growth.
Yet while the Korean government's interference in the economy may be blamed for many of the nation's problems, it also shares credit for the country's rapid growth. One might assume that an efficient market would eventually bring development to less-developed countries like postwar South Korea, but the rate of growth may be spurred by government intervention. In essence, the government's intervention pushed South Korea's production point much closer to its production-possibilities frontier than almost any other under-developed nation over the same period. Yet it also appears inevitable that the damage caused by the financial crisis will force South Korea to give up some of those gains before the situation is resolved.
The oversight laziness created by the government's extraordinarily liberal debt-financing policies, coupled with the unusual relationship between the economic and political sectors in South Korea (sometimes called "crony capitalism"), cast suspicion on the efficiency (and, thus, the effectiveness) of the Korean system. While South Koreans are probably better off than they would have been without the chaebol system, they were living atop an economic fault line that was destined to shift. South Korea should provide yet another warning sign to those who fail to believe that managed economies are bound to experience failure.
Future study in this field should include empirical study of the relationship between government intervention and an industry's growth, comparisons among similar economies that have taken different paths toward growth, and predictive models for the recovery of the Asian economies. The incredible growth and spectacular failure of these economies is worth understanding for any number of reasons, not the least of which is that much of the world lags behind these developing economies -- and thus could benefit from guidance in the path toward sustainable growth.
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Burton, John (2001), "Principles Seem Lost in South Korean Bail-Out Plan," Financial Times, January 17, p. 30 (retrieved via Lexis-Nexis).
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