Case Study: The Daewoo Group and the Asian Financial Crisis

In 1999, Daewoo Group Korea’s second largest chaebol, or family-owned conglomerate, collapse under $57 billion in debt and was forced to split into independent companies. The Asian financial crisis and its aftermath finally took its toll on the expansion-minded Daewoo and forced both Daewoo and the Korean government to decide how to dissolve the chaebol. Kim Woo-Choong started Daewoo in 1967 as a small textile company with only five employees and $10,000 in capital. In just 30 years, Mr. Kim had grown Daewoo into a diversified company with 250,000 employees worldwide as well as over 30 domestic companies and 300 overseas subsidiaries that generated sales of more than $100 billion annually. However, some estimated that Daewoo and its subcontractors employed 2.5 million people in Korea. Although Daewoo started in textiles, it quickly moved into other fields, first heavy and chemical industries in the 1970s, and then technology intensive industries in the 1980s. By the end of 1999, Daewoo was organized into six major divisions:

· Trading Division

· Heavy Industry and Shipbuilding

· Construction and Hotels

· Motor Vehicle Division

· Electronics and Telecommunications

· Finance and Service

However, Daewoo was struggling. Its $50 billion debt was 40 percent greater than in 1998, equaling 13 percent of Korea’s entire GDP. A good share of that total, about $10 billion, was owed to overseas creditors. Its debt-to-equity ratio (total debt divided by shareholders’ equity) in 1998 was 5 to 1, which was higher than the 4 to 1 average of other large chaebol, but it was significantly higher than the U.S. average, which usually is around 1 to 1 but which rarely climbs above 2 to 1. Of course, there is no way of knowing the true picture of Daewoo’s financial information because of the climate of secrecy in Korean companies. In addition, it is possible that Daewoo’s estimated debt might be greatly underestimated because no one knows whether or not the $50 billion figure7.3 included debt of foreign subsidiaries. How did Daewoo get into such a terrible position, and how much did the nature of the Korean economy and the Asian financial crisis affect Daewoo?

Korean Economy

The impact of the Asian financial crisis on Korea was partly a result of the economic system of state intervention adopted by Korea in the mid-1950s. Modeled after the Japanese economic system, the Korean authoritarian government targeted export growth as the key for the country’s future. Initially, the government adopted a strategy of import substitution, and that later gave way to a strategy of “expo,”, or die.” Significant incentives were given to exporters, such as access to low-cost money (often borrowed abroad in dollars and loaned to companies at belowmarket interest rates in Korean won), lower corporate income taxes, tariff exemptions, tax holidays for domestic suppliers of export firms, reduced rates on public utilities, and monopoly rights for new export markets. Clearly, the government wanted Korean companies to export. The chaebol, of which the four largest were Hyundai, Daewoo, Samsung, and the LG Group, became the dominant business institutions during the rise in the Korean economy. They were among W largest companies in the world and were very diversified, as can b:: seen by Daewoo’s investment and business choices. They were held together by ownership, management, and family ties. In particular family ties played a key role in controlling the chaebol. Until the 1980s, the banks in Korea provided most of the funding to the chaebol, and they were owned and controlled by the government. Because of the importance of exporting, the chaebol were all tied to general trading companies. The chaebol received lots of support from the government, and they were also very loyal to the government, giving rise to charges of corruption. Most chaebol were initially involved in light industry, such as textile production, but the government realized that companies needed to shift first to heavy industry and then to technology industries. Daewoo transitioned to heavy industry in 1976 when the Korean government asked President Kim to acquire an ailing industrial firm rather than let the firm go out of business and create unemployment.

Asian Financial Crisis and Its Impact On Korea

The country continued to liberalize, and democracy finally came into being in 1988 with the introduction of a new constitution and the election of Kim Young-Sam, the first democratic president in Korea’s, history. The economy also continued to grow at 5 to 8 percent annually during the early to mid- 1990s, led primarily by exports, and the World Bank predicted that Korea would have the seventh largest economy in the world by 2020. However, the Asian financial crisis brought that growth to a halt. After the Thai baht was devalued on July 2, 1997, the Korean won soon followed, and the Korean stock market crashed as well. By the end of 1997, the South Korean won –as 46.2 percent lower than its predevaluation rate. At the time the Crisis hit. Korea’s external debt was estimated to be $110 billion to S’ 50 billion, 60 percent of it maturing in less than one year. In additional, Korea had another $368 billion of domestic debt. Korea’s banks had been a tool of state industrial policy, with the government ordering banks to make loans to certain companies even if they were not healthy. Banks borrowed money in dollars and lent them to firms in won, shifting the burden of the foreign exchange from the firms to the banks. Hanbo Steel and Kia Motors went bankrupt, leaving some banks with huge losses. The Korean won fell in the fall of 1997, causing the government to raise interest rates to support the won and resulting in more problem loans. Bad loans at the nine largest financial institutions in Korea ranged from 94 percent to 376 percent of the banks’ capital, making the banks technically insolvent. The chaebol were also very overextended. The top five chaebol were in an average of 140 different businesses, ranging from semiconductor manufacture to shipbuilding to auto manufacturing. This was happening during a time when most other companies in the industrial world were selling off unrelated businesses and focusing on their core competencies. Twenty-five of the top 30 chaebol had debt-to-equity ratios of 3 to 1, and 10 had ratios of over 5 to 1, as noted earlier. Compare this to Toyota Motor of Japan, which had a debt-to-equity ratio in 1998 of 0.7 to 1. During this crisis, Korea began to negotiate with the IMF for help. The IMF agreed to help, but only if Korea raised interest rates to support its currency, reduced its budget deficits, reformed its banks, restructured the chaebol, improved financial disclosure, devalued the currency (to stimulate exports even more), promoted exports, and restricted imports. In return for a pledge to introduce the reforms, the IMF released funds to Korea to help it payoff its foreign debt and to keep its banks from going bankrupt. This in turn brought in more money from foreign banks that were encouraged by Korea’s pledge to reform itself. One of the IMF’s key areas was banking reform. The IMF encouraged Korea to open up its banking sector to foreign investment, hoping that an infusion of foreign banking expertise might help the Korean banks make better loans. Of course, foreign banks had made a sizable number of bad loans in Asia as well. In addition, the IMF encouraged the Korean government to pass good bankruptcy laws to allow bad companies, including banks, to fail. However, the IMF hoped that Korean banking institutions would merge, forming fewer but stronger banks. In addition, the IMF encouraged banking reform in order to cut the links between bankers and politics, tighten supervision and regulation of the banking industry, and improve accounting and disclosure.

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