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NIXON CENTER PERSPECTIVES

Volume 3, Number 2

by Lionel H. Olmer

June 23, 1998

(Lionel H. Olmer is a partner in the Washington office of the international law firm of Paul, Weiss, Rifkind, Wharton & Garrison. He is a member of the Board of Directors of The Nixon Center and is also a member of the U.S.-Korea Business Council. Mr. Olmer served as Undersecretary of Commerce for International Trade in the Reagan Administration. He also served in the White House under Presidents Nixon and Ford on the staff of the President’s Foreign Intelligence Advisory Board. These views are his own.)

Before leaving for Korea earlier this month, I had sensed a general impression that Washington believed the Asian financial crisis was under "control." That is, the International Monetary Fund had essentially sold its program of reforms in return for loans, that Thailand and Korea were complying with this program, and that post-Suharto Indonesia was coming around.

I did not share this rather optimistic perception because I knew that even solvent Korean manufacturers were unable to obtain bank credit, either to import intermediate goods or to engage in joint ventures with U.S. companies, and that banks were simply not lending, primarily because their capital-to-debt ratios were not in compliance with international standards. Thus, normal business seemed to be stalled and any hope of recovery had to be dim. I knew this to be the case for many companies, particularly small and medium-sized ones who were shutting down at the rate of close to one thousand a month. I was also aware that despite widespread public support for President Kim Dae Jung's reform pronouncements, many of the industrialists in Korea were resistant to change on his terms.

In a word, my assessment is that the situation is grim and is likely to get worse over the coming months. Economic growth will probably not resume until well into the year 2000; unemployment may increase by year's end to 10% of the labor force; high interest rates, forced on the government by the IMF to forestall inflation, are choking off credit to many worthwhile companies; and the problem of domestic debt, which is not part of the IMF program and which is just now coming to full light, may be as much as $300 billion. These debts are coming due soon and the preferred solution seems to be the offering of government bonds, business consolidations, and more bankruptcies. That the situation is grim and likely to get worse is the consensus among virtually everyone I spoke with during my trip to the ROK, including senior members of President Kim’s cabinet who are energetically developing and implementing his plan for fundamental, structural reform of Korea’s economy.

There are many reasons for this pessimistic outlook, but two stand out. First, the scandalous financial condition of the major industrial conglomerates was not (and is still not) fully comprehended. Many manufacturers and service companies (e.g., banks, insurance companies, brokerages, telecommunications providers, etc. ) were de facto insolvent but had been permitted to function for years by way of sweetheart arrangements with lending institutions, by a cozy relationship with the government, and because of extremely lax accounting standards that masked the true condition of the corporations.

Second, notwithstanding the exceptional competence and sincerity of the new Administration, the kind of changes that are required will simply take a lot of time to implement even under the best of circumstances. Laws must be written and passed by a legislature in which President Kim's party lacks a majority; regulations must be prepared and implemented by bureaucrats who are not uniformly supportive of reform (partly because many will lose their jobs); new supervisory institutions must be created and manned with effective people; fundamental attitudes must change, including the traditional bias against foreign products and investment; and labor, the wild card, must continue to give President Kim time and a fair opportunity to clean up the mess he inherited and set the stage for a rebirth of Korea’s economy.

Last year, Korea was the world’s 11th largest economy, the 8th largest U.S. trading partner, and the 4th largest market for American exports. The strength of its economy, in fact, masked the bankrupt nature of the underlying financial structure. But when the mountain of short term debt began to crumble, hastened by collapsing exchange rates in the region, not even robust economic growth could prevent exposure of the corroded underside of the system.

The causes for Korea’s financial crisis are beyond the scope of this brief presentation, but I do want to make a few observations that may help explain the extraordinary circumstances that now grip the country and that have engaged the world’s financial institutions in Herculean efforts to prevent Korea from defaulting on its debts.

Korea’s industrial success came about in no small measure because it was open to the introduction of foreign technology and management. The chaebols and the government understood that Korean manufacturing could not develop without "borrowing" from abroad, and the test of whether these skills had been effectively absorbed was measured by company success or failure in the international marketplace. Korean-made ships, steel, consumer products, semiconductors, cars, and trucks proved to be fully competitive with foreign manufactured goods. But this competitiveness did not extend to the financial structure: banks, insurance and securities companies, indeed the full range of financial services, were insulated from foreign competition at home. Thus the financial structure was sheltered from outside sources of competition and expertise.

Meanwhile, a variety of restrictions kept foreigners out of Korea’s domestic market, either as investors or as exporters. A government-directed industrial policy favored Korean companies, which received virtually unlimited credit from banks that applied no penetrating risk assessment in making loans. Moreover, companies typically cross-guaranteed debts among their subsidiaries (the strong covering for the weak) and were not required to maintain consolidated balance sheets so as to present a comprehensive and accurate picture of the financial status of the conglomerate.

Korea's booming economy fueled expansion of manufacturing capacity that was often uncoupled from a realistic appraisal of demand and that was sometimes fed by little more than the ego of the corporate leadership. Corporate governance, as we know it, was effectively lacking, inasmuch as companies were run by families. Outside directors were a virtual unknown phenomenon and audits were a sham since local accounting procedures made it relatively simple to cover up the truth.

The mantra in Korea today is foreign direct investment (FDI) and the government is doing what it can to encourage more of it, faster. (In the 25 years ending in 1988, the total amount of FDI in Korea was less than $6 billion; in 1997 alone Korea received more than $7 billion in investment and the government wants to increase the flow of FDI even more.) The conglomerates, on the other hand, want the cash but many are reluctant to give up control of their companies to foreigners. Nor do the conglomerates want to sell the gems in their inventory. Moreover, practicing due diligence is extraordinarily difficult for prospective foreign investors since the accounting system was not designed to reveal the accurate state of the conglomerate’s financial condition. Sometimes, even company officials are ignorant of important details.

Yet deals are being done and the pace will pick up. The government is forcing restructuring in the industrial and financial sectors, it is ordering the conglomerates to shut down unprofitable companies, and it is reorganizing the banks. More sick companies will be closed in the days ahead, and healthy ones will be downsized. The regulatory system is becoming more amenable to foreign investment and preferential treatment is available for foreign investors. Laws have been passed to permit foreigners to own land, and by the end of this year the ceiling on foreign investment (which had been 10% of a company's value two years ago and is 55% today) will be removed entirely.

The privatization of certain government-owned corporations (there are nearly five hundred of them) is beginning and this sell-off may create preferential opportunities for foreign investors. Steel, electricity, tobacco, chemical, and telecommunications monopolies are likely candidates. The government has not yet pulled the life support system on a few companies which are in fact bankrupt, such as Hanbo Steel and Kia Motors, but their time is limited. The fact that these firms remain in production represents a drain on available capital and is an open invitation to the filing of anti-dumping complaints by U.S. companies since these manufacturers continue to export.

A recent announcement that automobile production will be cut virtually in half (from about 3.0 million units to around 1.6 million) is emblematic of the dramatic changes taking place. Since motor vehicle manufacturing drives so many other industrial sectors (e.g., steel, textiles, rubber and electronics), a 50% cut in this basic sector will have profound consequences elsewhere.

Major changes are also taking place in the service sector. The insurance industry is a case in point. Of twenty-seven domestic insurance companies, only five meet requisite capital adequacy requirements; the twenty-two who do not are in the process of submitting restructuring plans. Meanwhile, there are ten foreign companies, all of which meet the capital adequacy ratios. Mutual funds will soon be introduced in the securities market, thus providing investors an alternative to bank savings accounts. Given the general lack of experience in Korea with sophisticated financial products, the opening of this market segment should provide new opportunities for foreigners.

Deregulation and anti-corruption policies are being implemented with intensity. Organized labor has failed to mount any serious challenges to the reform process thus far. Unions have so far failed to organize large-scale strikes and protests because it appears workers are willing to give President Kim a chance to succeed. Before the financial crisis hit, Korean labor rates were about three-and-a-half times less than those in Japan, and nearly three times less than labor costs in the U.S. With the won devalued by half, Korea's competitive advantage in cheap labor is even greater. An additional advantage for foreign companies is their access to capital at reasonable interest rates. Domestic companies borrowing locally suffer crippling costs of capital and are required to accept very short term repayment obligations, if they are able to borrow at all.

So far, FDI is increasing modestly but it does not yet come close to the demand for foreign capital. There is a risk that Korean companies could become desperate sellers over the coming months if the pace of investment is not increased. The pace is constrained, in my view, because companies have unrealistic valuations of their assets, because they have not yet accepted the need to divest profitable assets and close down unprofitable operations, and because of the difficulty prospective investors have in performing adequate due diligence. There may be a windfall opportunity for investors in this situation as desperation sets in, but there are serious risks in the process.

There are two additional fears that Korean government officials and business leaders have: first, that the Japanese yen will continue to devalue, making it even harder for Korean companies to remain competitive, and second, that the yen's drop will ultimately force China to devalue its currency. The combination of the two and the threat of a round of competitive devaluations across Asia is a frightening prospect. Among more than a dozen Korean businessmen I spoke with, in addition to some expatriate businessmen, not a single person doubted that China would devalue its currency by the end of 1998 if not sooner. It is less a matter of challenging the sincerity of China's verbal commitment than it is a perception that it will be an economic and political necessity for China's leaders to do so in their own self interest.

The U.S.-Korea Business Council held its annual meeting in Seoul from June 14-16 and produced a joint statement [see Appendix 1] reflecting the views of its Korean and American members regarding the current economic situation and the investment climate. It is a remarkably frank document in its criticisms of both the conglomerates and of the government's reform efforts, and in its assessment of what needs to change. Among other things, the statement calls for greater accounting transparency, the elimination of burdensome laws, and the swift implementation of a bilateral investment treaty. Given that the Council's membership includes most of the leading chaebols, the frankness makes the statement -- which was presented to President Kim and shared with many of his cabinet officials -- all the more credible.

On top of its economic woes, South Korea still faces a dangerous, isolated, heavily armed but economically debilitated enemy within artillery range of Seoul, which is home to a third of the South's population and much of its industrial base. Civil defense exercises regularly bring the city to a halt during regular work days, and while the probability of war breaking out is remote, few Koreans would dismiss the notion entirely. This month's announcement by the Democratic Peoples Republic of Korea (DPRK) that it would continue to develop and export missile technology brings home to ordinary South Koreans the fact that they still face real threats to their security. The latest incursion of the South's territorial waters by a submarine from the North underscores the hostile situation on the peninsula.

One feature of President Kim's reform program is the "sunshine" policy, that is, an opening with North Korea. Initially, he had proposed a lifting of economic sanctions now applied against the DPRK by his government and the U.S. After receiving a "slow-down" signal from Washington, Kim modified his proposal by tying a lifting of sanctions to a moderation of North Korea's behavior. Earlier this month, Hyundai's retired founding chairman Chung Ju Yung led a cattle drive across the demilitarized zone and donated 500 head to the North. This was precisely the kind of gesture we would expect to reduce tensions, but the DPRK's announcement regarding the export of missile technology and the capture of the midget submarine will probably set President Kim's sunshine policy back.

The resumption of the four-party talks (the two Koreas, the U.S. and China) and meetings in Panmunjom between U.S. and North Korean military commanders (which have not taken place for several years) may be useful in getting President Kim's DPRK policy back on track. For sure, America’s commitments to Korea must remain firm during this transformation period. That means no reduction in the 37,000 troops now stationed there and continued support for the ROK's economic restructuring.

Still, the full depth and broad scope of Korea’s financial mess are only now coming to the surface. Real economic growth is unlikely to resume until the year 2000 and, in the meantime, unemployment will increase, possibly to as many as two million workers by the end of this year. Companies are being permitted, essentially for the first time, to lay off workers. They must, however, give 60 days notice as to their intentions and are not allowed to lay off more than 30% of their employees. At the same time, the combination of company and government unemployment benefits last for only one month. As few of the jobless will benefit from an adequate social safety net, the unemployment problem will severely stress the ability of the political system to follow through on reforming the economy.

The reforms that President Kim is putting in place are nothing short of revolutionary. His economic team includes people who have studied and trained in the U.S., some of whom have been waiting years for this opportunity. Kim and his advisors are driven to make the changes necessary to reform and to do so as quickly as possible. The pace of government-directed change is astonishing, but while a great deal has been accomplished since February 1998, much more needs to be done. In addition to the forced breakup of the major conglomerates and consolidation in the banking sector, a huge amount of domestic debt will need to be refinanced by a combination of government bonds, extension of repayment periods, and, most importantly, by a substantial increase in foreign investment, both direct and portfolio. To root out the unhealthy core and reform the financial system, needless to say, will take time. It cannot be accomplished in a year and perhaps not even in two.

Despite the present hardships, it must be remembered that Korean companies still turn out world-class products and Korea's work force is educated, intelligent, well-managed, loyal, and highly motivated. The industrial competitiveness of Korea is not at question. Criticism and blame are being meted out in abundance during these early days of President Kim’s administration. But one should bear in mind that Korea has accomplished what few, if any, nations in history have achieved. In the brief span of slightly more than one generation, the Republic of Korea went from being an impoverished, undeveloped country run by a military regime to a democratic nation embracing free-market principles. South Korea has taken its place in the top tier of industrial societies with world class manufacturing, first-class technology, and capable management in steel, shipbuilding, motor vehicles, electronics, and telecommunications. Its economic trials will continue, but Korea will recover.

Korea-U.S./U.S.-Korea Business Councils Joint Statement

June 16, 1998

The Korea-U.S. Business Council and the U.S.-Korea Business Council, representing business leaders from the two countries, had their 11th Annual General Conference in Seoul, June 14-16, 1998.

Both Councils recognize the significant progress which has been made by the Korean government since our planning meeting in January 1998 towards the passage of legislation and implementing regulations designed to restructure Korea's corporate and financial structures. In particular, the public support for President Kim Dae Jung is making possible some of the difficult changes being made by the Korean government.

However, a major element of the restructuring required in Korea to attract significant amounts of foreign investment has not progressed as quickly as desired. The Korean government has begun very important changes in the direction of its economy which should lead to substantial amounts of foreign capital being invested in the increasingly market-driven economy over time, but the economic situation in Korea requires such capital now.

Both Councils discussed and identified key factors in the decision-making process of foreign investors and agree that attention should be given to them by government and business leaders. We observed the following ideas are important if the investment of foreign capital is to accelerate.

No matter what external factors are affecting the Korean economy, such as yen exchange rate or growth rates in other countries, it is important for the Korean economy to move as rapidly as possible to a market-driven system which is as efficient as possible. In times of decreasing resources, today is always better to start redeployment of resources to the future, because there will be even fewer resources to redeploy tomorrow.

In attracting foreign capital, the Korean economy is competing with other possibilities and will attract more foreign investment if it is improving the performance of all its businesses. A strong democracy, coupled with an open-market-driven economy, will be a competitive advantage, and the sooner assets are redeployed to the best parts of the economy, the more that advantage will be.

Foreign investment, whether direct or indirect, requires that buyers and sellers have a shared idea of the value of the asset in question. Transparency is a first priority, allowing the best information to be available when determining a price. However, that is not sufficient.

Accounting transparency is imperative to understand the past financial performance of the asset in question. Such information is only the beginning of determining value in the future. Labor regulations must not inhibit changes required to make the business change, nor can market restrictions. Is future financing available, and most importantly who will control the future deployment of assets in question? Are there other regulatory problems that will change future value? Businessmen are used to evaluating risk and adjusting value for risk, but unknowns may make the risk seem too great.

To improve these other factors to become as transparent as the accounting standards, the Korean government must publicize the current state of the changes in the legal framework and must continue to eliminate laws which limit the flexibility of business. Consideration should be given to the development of a currency exchange futures market to allow hedging of that risk. Mere declaration of the legal framework is not sufficient, but its implementation by bureaucrats and regulators must be evaluated for its effectiveness.

Synchronization of these changes using a designated coordination activity to lead major foreign investments through the new process will increase the chance of early success. In addition, the government should continuously evaluate the relative competitiveness of Korea's advantages over other possible investment locations in areas of tax policy, fair-trade policy, regulatory relief, incentives for training, and support of infrastructure for expatriates.

New investment comes most quickly from people already here. Perhaps their current projects should be the initial focus of such a coordination activity.

Foreign investors think time is on their side, but Korea needs investment now. The best way to break through this problem is to have key early successes. Such successes make foreign investors worry they will miss out on an opportunity if they wait and they will increase priority on working through problems.

Both Councils expressed great concern regarding the decline in the value of the Japanese yen, and the ripple consequences to competitiveness this will create in Korea and elsewhere in Asia, and recommend that their respective governments address this problem as a matter of urgency. In this regard, both Councils recognize the vulnerability to U.S. anti-dumping complaints to which Korean companies are placed, largely because of rapid currency fluctuations.

Both Councils noted the progress being made by the two governments toward concluding a Bi-lateral Investment Treaty (BIT) and give their strong endorsement for its rapid implementation. A U.S.-ROK BIT can make a significant contribution to the business relationship and help in restoring Korea's economy.