Competition, Gangnam Style

Fisher Investments |

Competition, Gangnam StyleAs South Korea’s presidential election campaign heats up, expect one rallying cry to dominate all others: “economic democratization.”

The snappy term refers to monopoly reform, the campaign’s central issue as all three candidates try to capitalize on the public’s rising anger with the country’s huge family-run conglomerates, known as chaebol (think any internationally well-known Korean brand). The chaebol have dominated Korea’s economy in the post-war era, driving the rapid post-war industrialization under former President (military dictator) Park Chung-hee and meteoric economic rise since democracy began following Park’s 1979 assassination. However, because of the chaebol’s vast political connections and monopolistic positions, many Koreans deem them responsible for the widening income gap in recent years—a source of increasing popular discord. Hence chaebol reform is a central issue in the December 19 election.

There’s no doubt Korea needs chaebol reform, but not because the firms drive economic disparity. Korea’s supposed income gap is rather like their American counterparts—it’s more a political than economic issue. Sure, the chaebol elite are the wealthiest of the wealthy, and the highest and lowest incomes have diverged over the years, but incomes have risen across the spectrum. Moreover, all of Korea has benefited from the chaebols’ gangbusters growth: The chaebols’ export boom has driven strong GDP growth, driving robust employment and income gains over time, as shown in Exhibit 1.

Exhibit 1: Korean Exports, GDP, Employment and Income

Sources: 1OECD, St. Louis Federal Reserve, 1970-2010. 2US Bureau of Labor Statistics, St. Louis Federal Reserve, 1960-2010. 3US Bureau of Labor Statistics, St. Louis Federal Reserve, 1963-2010. 4Bank of Korea, 1993-2011.

But Korea’s economy would benefit from an overhaul of chaebol corporate governance. A 2012 report from the Asian Corporate Governance Association) ACGA ranks Korean corporate governance eighth of the 11 major Asian economies studied—only the Philippines, Indonesia and China (with its 144,700 state-owned firms) fared worse. Even though the chaebol are publicly traded, their founding family members control their boards thanks to their large shareholdings in their group’s subsidiaries (known as cross-shareholding). As a result, CEO and other management positions are passed to heirs like royal titles, embezzlement is common, and true competition is rare—chaebol award contracts to subsidiaries and affiliates almost automatically, shutting out other would-be market participants. Compounding matters, chaebol have strong government connections, allowing them to enjoy extremely favorable tax treatment, a blind eye to corruption, pardons for many of those executives who are tried and convicted, and ongoing tolerance of their monopolist aims. Many small firms and would-be entrepreneurs simply can’t compete as a result. Analysts also suspect this is responsible for the so-called “Korean Discount” where chaebol shares chronically trade at low valuations relative to the market despite their strong fundamentals.

Corporate governance has improved a bit under outgoing President Lee Myung-bak. His government has improved enforcement of existing limits on cross-shareholding, toughened insider trading restrictions and proposed laws mandating family outsiders comprise a majority of chaebol boards. Yet there’s still much room for improvement, giving the current candidates ample campaign fodder. Park Geun-hye—the ruling Saenuri (NFP) party candidate and daughter of Park Chung-hee—calls for tougher limits on cross-shareholding. The opposition Democratic United Party (DUP) candidate, Moon Jae-in, and independent Ahn Cheol-soo—currently in talks to join forces in order to avoid splitting the vote—favor a much stricter regulatory overhaul. Moon pledges to outlaw chaebol from some industries and has proposed banning all new cross-shareholding, and Ahn would form a chaebol reform ministry and remove tax loopholes and exemptions.

While these measures might help crackdown on corruption, none seems the most efficient way of increasing competition within Korea. They increase government involvement in the private economy without tackling a primary driver of the chaebols’ dominance. Chaebol dominate Korea not because they lack internal competition, but because they lack external competition—notwithstanding recent free trade agreements with the US and EU, Korea is a historically protectionist nation. Foreign-made autos, electronics and other high-end goods encounter high barriers at Korea’s borders, either through tariffs or overly strict safety and technical standards designed to shut them out. Efforts to lower these are regularly met with mass demonstrations in Korean streets and brawls in parliament—hence why Moon has vowed to renegotiate the US-Korea free trade agreement if elected.

In my view, removing trade barriers and replacing the current tax system of loopholes and exemptions with a low, flat corporate rate would likely do far more than the current proposals to rein in the chaebols to move Korea closer to true economic democratization. Forced to compete with products from foreign firms, conglomerates would have to lower prices—and consumers would benefit from wider choice and cheaper goods. And with market share more fragmented, there’d be more room for new market participants—and a more favorable tax code would enhance these entrepreneurs’ and new firms’ ability to profit and grow. The chaebols might have to reform in order to stay competitive, but they’d likely still do just fine—over time, they’d merely have a smaller share of a much bigger Korean pie, while freer trade would likely boost their exports (beyond “Gangam Style”) and profits abroad.

As tough a sell as free trade is in Korea, however, this scenario seems a pipe dream at the moment. For now, a crackdown on corruption might be the best we can hope for—no small victory, to be sure, but only a start.

This article constitutes the views, opinions, analyses and commentary of the author as of November 2012 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. In addition, no assurances are made regarding the accuracy of any forecast made herein. Past performance is no guarantee of future results. A risk of loss is involved with investments in stock markets.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
CSH Cash America International Inc. n/a n/a n/a 0

Comments

Emerging Growth

IBC Advanced Alloys Corp.

IBC Advanced Alloys Corp is engaged in the production and development of specialty alloy products. Its products include copper alloys and berryllium aluminium alloys.

Private Markets

Ozobot by Evollve Inc

Ozobot is a world leader in compact super intelligent robots that entertain and educate through fun interactive gaming.

8tracks

Our mission is to be the best place for people who care about music to create and discover thoughtfully curated playlists. In essence, 8tracks is a platform for online mixtapes.