Invisible Hand: A Thirst for Funds Drives Change
Apr 26, 2001
By Hilton Root
Publisher: Asian Wall Street Journal

Asian Wall Street Journal

Corporate restructuring is still making progress in South Korea, especially when compared with Thailand or Indonesia, two nations that also received International Monetary Fund assistance in 1997. Reform in Indonesia, and to a lesser extent Thailand, requires very broad social and institutional changes due to the fact that trading networks are based primarily on personal relationships and communal, rather than legal, sanctions.

South Korea, by contrast, enjoys a number of comparative advantages that other crisis-affected nations do not have. Because South Korea has well-defined and enforceable property rights, reformers there are able to remove obstacles to shareholder control, thereby enhancing the capital structure of firms. With lowered barriers to transparency and increased accountability of corporate control, explicitly owned assets can be conferred on outside investors. So what is preventing South Korea from attracting greater investment and risk-taking?

The reform-minded president, Kim Dae Jung, is colliding with entrenched corporate tycoons, owners of the chaebols that dominate the economy. Concentrated ownership of the nation's wealth-producing assets affords these individuals, whose power is rooted in the current distribution of property, great political and social leverage.

To surmount the power of these corporate elites, Mr. Kim depends upon a strong executive office, a remnant of Korea's authoritarian past, through which political decision-making is monopolized. The South Korean President is an elected autocrat, free from checks and balances that would limit his authority. Whoever attains the office therefore can implement policies unilaterally and is not relegated to coalition-building to accomplish his aims.

As such, rather than a reflection of give-and-take democratic negotiations, the national assembly is no more than a rubber stamp. This strength, however, is also a weakness since policies derived this way rarely enjoy a broad consensus. South Korea's political culture therefore has yet to mature to the point where issues dominate elections; rather, factions, regionalism and personality rule.

This pattern was reflected in the parliamentary elections of 2000, during which votes were cast according to regional loyalty to local personalities. Mr. Kim won most of the vote in his home region of Cholla, but in Pusan, 90% voted against him. His opposition voted not against his political views but against him. No wonder that instead of sensible economics, Mr. Kim's reforms have been depicted as personal revenge against his political enemies, the chaebol owners.

Despite the stalled legislative progress, important economic changes seem likely. Where government has failed, necessity may still succeed. Even without the enactment of liberal labor legislation, the labor market is becoming more flexible. Unemployment may last for so long that many workers will find new jobs, most likely on a contract basis.

Banks are still years away from a full recovery, but the pre-crisis financial environment will not return. Businesses can no longer depend on easy credit with the government directing the banks where to lend. While efforts to clean up the financial regulatory regime drag on, the search for new sources of capital pressures firms to change. With Korea's banks too weak to sustain future growth, businesses will be forced to seek market-based financing. Banks' increasing selectivity in lending will weaken the links between chaebols and politicians while providing an opportunity for new forms of financial intermediation-Internet banks, bonds, equities, and venture funds-to take the place of bank loans. The surviving banks will be forced to concentrate more on consumer services and less on high-interest margins from loans of dubious quality.

The quest for equity finance and the rise of Internet transactions could create just the catalyst needed for firms to improve their management practices. More conservative lending practices, greater managerial attention to potential directors' liability and the influence (in some cases) of significant foreign shareholders should bring precisely the pressure needed to force major corporate clients to "bite the bullet" and restructure. The pressure on the Chung family, for example, to withdraw from active management of the Hyundai group came not from government but from the Korea Exchange Bank (now 30%-owned by Germany's Commerzbank).

Shareholder activism is beginning to play a role as well. In a shareholder derivative suit brought by Chamyoyundai, a public-interest group whose economic committee focuses on shareholder issues, directors of Korea First Bank were held liable for the bank's failure.

The activities of the World Trade Organization, the lowering of foreign investment restrictions during the financial crisis and the sale of assets at plausible post-bubble prices have all served to increase foreign competition in South Korea's domestic market. Foreign investors, tired of years of being forced into difficult joint venture relationships, are now free to compete fully in the domestic market and are taking advantage of the opportunity, building local management teams and introducing international standards. These factors are contributing to real changes in the corporate landscape, though the process is remarkably painful for all concerned.

Attracting finance from outside the region will compel a focus on shareholder value and levels of disclosure beyond that required by Korean law. Eventually, international shareholders will demand that a new generation of internationally trained professionals, hired and fired by independent boards, run South Korean companies, and that these companies become more transparent. And they are likely to do so despite governmental gridlock, as those firms that do not adopt tougher standards will fall behind the companies that embrace market-based financing.

A sustainable recovery from the financial crisis of 1997 will depend upon creating strong institutional foundations that can offer a new generation of financial services. Ultimately, a legal framework that includes strong provisions for bankruptcy and the protection of minority shareholder rights will be needed to undergird effective capital markets.

These changes will ensure capital market competition, which is the best hope for fostering a sound and prudently run banking system. But the sooner such changes are institutionalized the more certain it will be that the economy will resist future shocks.

Hilton L. Root is director of global studies at the Milken Institute, a non-profit, independent think tank based in Santa Monica, California.