Korean reform: a job half done?
asiamoney
Dec. 1999/Jan. 2000

Despite improved conditions, structural weaknesses continue to undermine the recovery of the Korean economy. The shock collapse of the mighty Daewoo Group had been expected to spur the major chaebol along the road to reform, but most are still dragging their feet. Jack Lowenstein highlights the pressing issues outstanding.

After the mid-year collapse of Daewoo, Korea's second largest conglomerate, how much faith should investors have in the solidity of restructuring in Seoul? According to many of the country's most experienced observers there are serious reasons for concern. A dangerous complacency is emerging that will leave the Korean economy highly vulnerable to external shocks.

"The sustainability of strong growth is by no means assured," noted the World Bank's country head in Korea, Sri-Fam Aiyer, in a recent speech. "The crisis revealed deep structural problems in Korea's financial and corporate sectors, which will take much longer to be resolved. Although progress on this reform programme has been substantial, there is still much further to go, especially in corporate restructuring and reform."

The head of a Japanese bank in Korea agrees. "Without solving the fundamental problems there can be no real recovery," he says. "That is not just our view, but also the government's. "The threat is that reform-fatigue, and a growing belief that Korea can simply grow its way out of trouble, is restoring power to a government bureaucracy and a private sector that was never that keen on reform in the first place. The electoral cycle, which threatens to turn committed reformer Kim Dae-jung into a lame duck president from April 2000, is also working against those keen on taking some of the many tough decisions still outstanding.

On the surface, all looks bright--and certainly much brighter than it did in the immediate aftermath of the Daewoo fiasco. Buoyed by booming exports and a 'v-shaped' economic recovery, the same international ratings agencies that were slow to recognise the seed of the original crisis in Korea are quickly restoring its sovereign rating. Foreign and domestic institutional investors, excited by the same phenomena and catching a local strain of the global Internet frenzy, are pushing Korean indices to new heights. Intervention by Korea's corporate and financial watchdog, the Financial Supervision Commission (FSC), has even rescued the investment trust companies (ITCs), whose bond fund products lie at the core of the country's capital markets and which looked as though they might collapse with Daewoo. The foreign banking community, much of which was in early autumn refusing to roll over expiring facilities for Korea's largest and most indebted surviving chaebol, the Hyundai Group, is grudgingly rebuilding assets.

"Government handling of the Daewoo collapse has seen a hardening of attitudes to credit for Korea," says the Japanese bank head. In the end though, the sheer size of the Korean economy and its opportunities force them to maintain lending operations, suggest a number of bankers.

"The reality is that there is no one else to go bankrupt and the new rules should keep it that way," says the relatively upbeat Dresdner Kleinwort Benson research head, Brian Hunsaker.

In the short term, the confidence in Seoul is self-reinforcing. The strong stock market is helping the still stretched corporate sector - including- the Hyundai Group - de-leverage through a flood of rights issues. Even the strong won, which some fear as a threat to the country's resurgent exports, offers an opportunity for repayment of foreign-denominated debt on terms that two years ago would have been impossible to imagine.

For the more sober commentators, however, the key issues outstanding include:

The scale of rights issues in Korea over the last year has been astonishing. Already, the Hyundai Group alone has raised W7.6 trillion ($6.5 billion) and is hoping to raise another W4-5 trillion before the year-end. It must do so to meet the FSC's deadline for reducing its gearing down below a still high 200% from the 341% level it stood at in June.

Nature of the beast

The nature of rights issues in Korea is on Hyundai's side. The deep discounts (typically 25% to 30%) at which issues are conducted effectively coerce shareholders to participate if at all possible, and make it relatively easy for underwriting securities companies to place any shortfall. The securities companies themselves are strongly capitalised and should be able to carry a reasonable amount of paper on their own books if necessary.

Nevertheless, the Hyundai Group's stock prices remain depressed compared with the overall market and a market shock of any sort might see them among the worst hit. As a consequence, the attractive discounts could suddenly vanish.

This could be disastrous, as Hyundai is definitely an issuer of need: even if it gets all the money it hopes for from the planned rights issues, the group will have an expected gearing ratio of 199%. Failure would spark a worse shock than the Daewoo crisis, since Hyundai has combined debt of W60 trillion tops even Daewoo's W57 trillion. Already both foreign and domestic banks are trying to reduce exposure to the group, says ING Barings analyst Mok Young-chung. On balance, analysts believe Hyundai will survive.

Oh Kwang- hee, managing director of domestic rating agency NICE, believes that if reasonable asset revaluations are taken into account, Hyundai's debt to equity ratio will fall lower than the government-imposed ceiling of 200%, if not as low as the chaebol's goal of around 180%.A widespread view is that Hyundai's strength in the financial sector - which some see as a long-term negative in terms of systemic risk - has helped it ride out the crisis. The Japanese bank head contrasts the sophisticated way that Hyundai's executives explained their financial position and strategy with their counterparts at Daewoo. Perhaps because of their greater need they were more open than the managements of the other chaebol he says. However, many remain skeptical about Hyundai's strategy and commitment to change. Until the Daewoo collapse, Hyundai thought it was 'bullet-proof', contends Salomon Smith Barneys senior analyst Jon Chong-hwa.

Hyundai has outdone even the now defunct Daewoo Group, as the 'Pac-man?of Korean corporate restructuring. Since the crisis began, its assets have swollen further as it expanded its financial services empire and swallowed up bits of its competitors, such as Kia Motors and LG Semicon. Hyundai has reluctantly let go of only W2.6 trillion of assets - mainly through the disposal of its aluminum subsidiary and 50% of its troubled oil business. It is reported to be trying to sell off some or all of its petrochemical operations. "Let us hope that Hyundai doesn't end up owning everything," jokes Richard Samuelson, Seoul branch manager at Warburg Dillon Read.Family control is also stronger at Hyundai than any of the other major surviving chaebol. The septuagenarian family patriarch, Chung Joo-yong, remains firmly entrenched as chairman. Five of his sons head major subsidiaries.

Hyundai is seen as having a stronger inventory of businesses than Daewoo, especially in terms of the immediate future. The shipbuilding unit, Hyundai Heavy, is a world leader, and Hyundai Electronics is seen as having the potential to become one if it can bed down its merger with LG Semicon.

However, doubts endure about the longer-term viability of Hyundai Motors. Even after its acquisition of Kia, it lacks critical mass. Most seriously of all, the nearest thing in the group to a parent entity, the group's construction company, is itself weak in terms of cash flow. Overall, Hyundai has clearly lagged the other remaining large conglomerates in adjusting to the new era.

The Samsung Group, however, appears to have embraced reform aggressively. By September 1999 it had reduced its gearing to 192% and sold off once cherished units, including its motors subsidiary, to concentrate on a much reduced set of businesses focused on semiconductors, LCDs and finance. In addition, the controlling family appears increasingly willing to delegate management control to non-family professionals.

A similar pattern has been seen at LG, while the relatively less diversified SK Group has less difficulty reordering itself for the new era. The question for all the major chaebol is where they go from here. "What you have seen so far is financial restructuring, " says CS First Boston director of equity research, Yuri Seok. "Now we need to see operational restructuring."

Nor is it even clear that the public or a bureaucracy with a persistent deep ambivalence about foreign ownership really have an appetite for more, especially at the major chaebol. "Aspects of corporate restructuring for the top five Korean chaebol have been subject to a different set of rules, and this has impeded the process of reform," says the World Bank's Aiyer. There is certainly not much differentiation between the chaebol when it comes to improved corporate governance: despite a number of landmark changes to the regulations, most chaebol appear resistant to absorbing the spirit of those changes.

A typical example is the statutory requirement for at least a quarter of directors to be 'outsiders'. "There is a lingering question over who those outside directors are and how important they are," says WDR's Samuelson. "The consensus seems to be that most are 'friends' of management and therefore unlikely to mount a direct challenge."

While there has been progress on setting tougher accounting disclosure standards, more is needed, particularly in the corporate sector, argues CSFB's Yun. Auditors also lack independence and are underpaid, he says. "The problem is not the quality of the audit, but the influence of management and the dependence of auditors on the income, says Kim II-sup, president of the Korea Accounting Institute (KAI).Better corporate governance would be helped by more activist portfolio investors or greater levels of foreign M&-A. However, one of the most likely ways to activate these elements - aggressive dealing in restructured assets seems to be off the agenda.

The main means by which the banks have been encouraged to restructure troubled corporate loans - maturity extensions and interest holidays - may themselves have had unfortunate consequences for both the banks and corporate governance in putting off the day of reckoning and leaving failed management in place.

Digging deeper into the ways banks are treating restructured assets highlights just how fragile the Korean financial system remains, notwithstanding the current strong reported profits at the banks, and the never-ending stream of upbeat announcements from the FSC.

Rules on bad loan accounting still aren't tough enough. "Banks only need to make a 2% 'special mention' general provision for reduced interest rates and other restructured loans, regardless of whether that reflects accurately the risk of future defaults on loans," notes the World Bank's Aiyer. While international practice is for banks to continue to treat the loan as classified until borrowers have paid on time again for a year, in Korea restructured loans are immediately treated as performing unless the borrower defaults again. Similar loopholes apply to other restructured assets. Officially banks must carry converted equity and convertible bonds at market values. "With the lack of liquidity, market values are difficult to ascertain and, in practice, equity can be held by banks at any value, " says Aiyer. " [Convertible] bonds are typically carried at excessively high values. These practices imply an overstatement of banks' true capital positions and create a bias towards banks holding on to converted equity stakes, rather than selling them to investors more capable of managing non-financial institutions."

The loose rules also make it harder for new investors to get their hands on the banks' controlling equity stakes in companies they may wish to buy, as banks would have to acknowledge the full loss on their position.

Even if they want to deal they often can't. In negotiating debt to equity conversion, banks usually agree only to sell their equity stakes if all participating banks will do so. They also typically promise restructuring borrowers they will not sell the equity they hold for up to seven years, as well as providing management generous options over the holdings. This leads to weak restructuring deals. "Banks have neither the incentives nor the correct tools to restructure corporate operations beyond helping with the financial restructuring, or to perform their functions of corporate governance properly," says Aiyer. Instead, he believes, many borrowers and banks see debt to equity swaps as little more than interest free loans to be repaid when the borrower buys back the equity stake held by the bank.

WDR's Samuelson sees little short-term prospect for improvement, if only because of pervasive government intervention. "Experience suggests it is highly unlikely that you will get effective corporate governance in sectors controlled by the government," he notes in a recent report. "With the government driving the reform process as well as owning most of the banks, this constraint is likely to be with us for some time."

The sheer cost of financial sector recapitalisation to the government - estimated by WDR at $100 billion - is a concern in itself Financing the mountain of debt this has left will be a burden for a generation at least. This is hardly surprising given that for all its apparent recovery, Korea had the most acute problems of any country in Asia. Korea's non-performing loans to GDP ratio at over 50% was surpassed only by Thailand and its private sector claims to GDP ratio of nearly 200% was surpassed only by Japan. Some see danger of a public backlash about the effective result of the process. "The Korean taxpayer has bailed out the banks and the chaebol owed 70% of the money," says one development banker based in Seoul.

What public awareness there is of the cost does not appear to be matched by public understanding that this money is essentially sunk. As a result it has been politically difficult for the government to reach meaningful deals with 'buyers' of its bank portfolio when 'selling' an entity such as Korea First Bank (which has taken an estimated WI O trillion to recapitalise) effectively means paying someone to take it away. That difficulty is compounded if the 'someone' is foreign. "Ahead of the April 2000 elections you can't expect major sales of Korean companies to foreigners," says ING Barings' Mok.The looming demise of Daewoo over the first half of the year can't have helped the pace of deal-making and probably contributed to the respective delay and collapse of the government's proposed sales of Korea First Bank and Seoul Bank to Newbridge and HSBC. Views still vary on the timing and certainty of final completion on the revised Newbridge deal. At this stage, many analysts believe Korea Development Bank and Industrial Bank of Korea have no value. Hanvit (the merged Commercial Bank of Korea and Hanil Bank) and Cho Hung have also taken on more water and will take two years to fully provision, says one analyst.

The scale of the problems begs the question, 'Why aren't any of the institutions put out of their misery?' Suggests NICE's Oh: "Bankruptcy would be the right way, but the government is concerned about the social impact of the staff redundancies." The FSC expects to hold on to its stakes in Hanvit and Cho Hung for at least two years, according to spokesman Sandy Park. "KDB and IBK won't be sold. Korea Life will be turned around and sold. For the small life companies we will fill the holes and run them off the books," says Park. "The investment trust companies will be controlled by the state-owned banks. The disposal decisions will be left to them. " Milton Kim, chairman of Good Morning Securities, surmises: "The government is hoping time will take care of the problems."

Conditions ripe for sell-off

Nevertheless, analysts believe the government could sell its holdings in banks and other financial institutions it controls fairly quickly if it wanted to. "Foreign interest is good at the right price," says one. However, he believes the government is reluctant to do so for fear that the competitive forces unleashed by letting a foreign bank with top quality technical abilities take over a large domestic player would eventually see foreign domination of the entire financial sector.

Meanwhile non-bank financial sector domination by the chaebol has escalated, with potentially alarming implications. Immediately before the Daewoo collapse, chaebol-owned firms accounted for 81% of insurance company assets, with top five chaebol-related firms alone accounting for 54%. In merchant banking, chaebol- controlled firms own 55% of assets. Chaebol-controlled securities companies account for 60% of all assets in the sector. The big five companies' share of commissions has rocketed to 54% from 34% before the 1997 crisis.

A similar trend can be seen in the ITC sector, where 32% of trust funds are now controlled by chaebol-affiliated firms - up from just 6% before the crisis. The extent of this domination is underscored by the fact that the two largest ITCS, which are independent of the chaebol - Korea and Daehan - have effectively been taken over by the government as part of the bail-out after the Daewoo collapse.

The chaebol's central role in the financial sector, particularly in capital markets, is adding to systemic risk. The role of chaebol-owned securities companies in underwriting rights issues for their own and other chaebol constitutes double jeopardy. Some observers believe chaebol-owned securities companies are also not above occasional price manipulation for their parents. The ITCs' willingness to finance the major chaebol's cash flow needs since the 1997 crisis raises equally obvious issues. "The chaebol are effectively getting their own banks," says ING Barings' Mok.

A third of all ITC asset are claims on the top five chaebol. Over the period end-1997 to Mav 1999. ITC funds under management grew from W82 trillion to about W250 trillion, of which 90% was in the form of bond financing, calculates the World Banles Aiyer. "Daewoo, which had large negative cash flow from operations, attracted W24 trillion from these markets over this period, and further increased its already excessive debt by W18 trillion," he says. "Daewoo's share in the ITCs' total holdings of bond and commercial paper as of April 1999 was estimated to be 12%, a large share of which was held by Seoul ITC, which is controlled by the Daewoo Group."

The crisis in the ITC sector also highlights the extent to which moral hazard remains rampant in Korea. The FSC has patted itself on the back for having staved off panic redemptions of bond-related products after the Daewoo collapse, with investors having largely spurned opportunities to redeem at guaranteed maximum discounts of 50% and 20% at various points. But this is hardly surprising given that they have been promised a 95% recovery on a product that was generally sold, with explicit disclaimers of any guarantees as to interest or principal if they hold on until the end of February. To a cynic the lesson seems to be that chasing the riskiest product, that which contained most Daewoo paper, and there fore offered the highest yield, was a perfectly rational choice.

If anything, the treatment of the banks in the wash-up from the Daewoo affair has shown even worse moral hazard implications. Why should banks be careful, when, to quote WDR's Samuelson, "a preference for 'sharing the burden' has caused the government to impose a disproportionate burden on the stronger banks"? To KAI's Kim, the lack of a rational approach to risk sharing is a direct consequence of the government's huge direct and indirect stake in the industry. He warns: "As long as the government controls the banks there is no hope for real improvement."

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