South Korea’s chaebol problem

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Eom Ha-yong is old enough to remember a time when South Korea's enormous conglomerates were as respected as they were powerful.

He was born in 1949, a few years after Korea was carved into North and South by the Cold War superpowers and one year before 10 per cent of the population would perish in the Korean War that razed much of the country. At the time, South Korea was as poor as many countries in sub-Saharan Africa.

In the war's aftermath, though, and particularly after a military coup in 1961, something remarkable happened. Family-owned, South Korean firms – recognizable companies such as Samsung and Hyundai – struck an unlikely alliance with South Korea's authoritarian government. Protected from competition, showered with cheap loans and encouraged to sprawl into new, strategic industries without fear of failing, these companies grew into global behemoths and built South Korea into a wealthy, export-oriented powerhouse in less than a generation.

But like many in South Korea, Mr. Eom, 66, has lost respect for the so-called chaebol – a term that combines the Korean words chae (wealth) and bol (clan). He works for a small manufacturing firm that sells to the chaebol, and he says the large firms often pay late, arbitrarily refuse shipments and use their huge market dominance to bully smaller firms. He and others have become increasingly frustrated with the chaebol's growing power and influence in South Korean society, as well as what many perceive to be the arrogance of the children now taking control of the family-run firms as a widely-respected, older generation passes on control.

"Things are not the same," Mr. Eom says. "The problem with the chaebol is that what they earn, they don't give back to society – they simply spread out with more tentacles."

The chaebol may deserve much of the credit for South Korea's rapid economic development, but many now fear the country's massive conglomerates have become far too powerful. Samsung Group alone now accounts for roughly 20 per cent of South Korea's gross domestic product.

South Korea's economy has slowed sharply in recent quarters, and is pushing up against the limits of its export-led growth. Economic observers say the chaebol's dominance is now suffocating the country's attempt to shift gears and foster a more innovative services-oriented economy powered by small businesses.

Powerful South Korean exporters are being hit at the low end by expanding Chinese manufacturers and at the high end by Japanese players who have benefited from a deliberately-weakened yen. Exporters are creating fewer jobs in South Korea as the chaebol move production offshore.

That has left large firms profitable, but the domestic economy hurting: South Korea's household debt is now rising fast, small and medium-sized businesses are still unproductive and failing to grow larger, and the high-value services sector is lagging well behind other countries.

"This has raised concerns about Korea's traditional catch-up strategy led by exports produced by large chaebol companies," the Organization for Economic Co-operation and Development said in a report last year.

Economic observers suggest the chaebol are now thriving to the detriment of other players in the economy – hoarding profits, increasingly focusing on overseas factories, squeezing domestic suppliers, and preventing the growth of small and medium-sized enterprises (SMEs) that employ nearly 90 per cent of South Korean workers. There are also ongoing concerns about crony capitalism and the massive firms' close relationship with the government.

The chaebol influence

In South Korea, long-simmering public anger against the chaebol resurfaced late last year after a sensational incident known now as the Korean Air "nut rage" fiasco, in which Cho Hyun-ah, an airline senior executive and daughter of the company's chairman, flew into a fit over being served macadamia nuts in a bag rather than on a porcelain dish.

Ms. Cho then ordered a taxiing Korean Air plane at New York's JFK airport back to the terminal to eject the offending flight attendant, violating air traffic regulations. The flight attendant alleged that Ms. Cho also screamed obscenities at her, and that she was later pressured to cover up the incident in interviews with government regulators. The flight's chief steward added that he was forced to kneel before her and ask for forgiveness. Ms. Cho was eventually sentenced to one year in prison in a case that was followed closely in South Korea.

The outrage in South Korea was amplified by concern that the large public companies that dominate the country's economy are being handed to a new generation of chaebol leaders who grew up wealthy and are simply inheriting executive positions. Korean Air, the country's flag carrier, is a division of the chaebol Hanjin, a global shipping giant. Cho Yang-ho, Ms. Cho's father, is Hanjin's chairman, and two of his other children also work at the airline.

In his office at Seoul's prestigious Yonsei University, Professor Sang-young Rhyu fumbles through the clutter on his desk and grabs a tin of macadamia nuts. He laughs as he shakes a couple out and hands some to a reporter. But he becomes subdued as he recalls the Korean Air scandal.

"That was very shameful," the professor says, noting that it was "exceptional," but also symbolic of "very routine behaviour" within the chaebol.

But he is more concerned with the broader ramifications for South Korea's economy and society. He says there is no trickle-down benefit from the chaebol's economic success to SMEs. Bigger firms are also able to restrict the flow of capital to certain industries and companies, since many have financial services units, and often promote business with other arms of their own companies.

"They enter anything that will make them money, from dynamite to ice cream, and they kill the medium-sized businesses in those sectors," Prof. Rhyu says.

He is also concerned that, because these companies are so huge – and because the failure of a firm like Samsung would be so devastating – the government is overly indebted to the chaebol, which sways government policy. The corporate tax rate remains much lower than other countries, even as social security costs soar, he says, suggesting the government is afraid to do anything that might hurt the massive conglomerates that drive the South Korean economy.

"If [the chaebol] fail, Korea would have a nightmare," he says. "They have intangible power over the government. It's a structural issue. They have to support the conglomerates to maintain popularity."

The issue is also evident in the justice system. Some chaebol leaders caught in corruption have gone to jail, but many others have been pardoned after clear criminality, which has raised concerns about corporate governance in South Korea. Outside directors have little power and firms remain controlled by the founder families – despite extremely small ownership stakes.

Samsung chairman Lee Kun-hee was pardoned in 2008 after being found guilty of criminal tax evasion, partly because he was helping the government with a Winter Olympics bid. Two other Samsung executives had convictions overturned after helping younger members of the Lee family – Lee Yae-yong, who is expected to take over the company, as well as his two sisters – obtain below-market-price convertible bonds.

Hyundai chairman Chung Mong-koo – whose six sons also work at Hyundai, and whose brother runs Hyundai Heavy Industries, the world's largest shipbuilder – was also pardoned after being found guilty of embezzlement and breach of trust. Kim Seung-Youn of the chaebol Hanwha Group was pardoned after being convicted of assaulting workers with a steel pipe at a karaoke bar after they scuffled with his son – and though he was later jailed again for embezzlement, a court suspended his sentence. The former chairman of the enormous SK Group, Chey Tae-won, was convicted of accounting fraud in 2003, was later pardoned in 2008 – and was then jailed again for embezzlement.

Although other countries also have strong links between politicians and business people, in South Korea the relationship between the chaebol and the government is almost symbiotic: Lee Myung-bak, a former South Korean president who did the pardoning, is himself a former Hyundai executive. Mr. Chey, of SK Group, is married to a daughter of a separate former South Korean president, while the current South Korean President, Park Geun-hye, is the daughter of Park Chung-hee, the former military dictator who lavished favours on the chaebol until he was assassinated in 1979.

Last year, Hyundai – the second largest chaebol – stunned investors by outbidding Samsung and paying $10-billion (U.S.) for a single plot of land in Seoul's famed Gangnam District for a new corporate headquarters. It was three times the appraisal value and the priciest land deal in Asia since the financial crisis, and renewed criticism that the family-run chaebol didn't care about corporate governance or maximizing shareholder value.

'Power is beyond description'

Korea was largely agricultural before it was annexed in the early 1900s by imperial Japan, which built up factories and imported machinery. Some chaebol trace their roots to the industrial assets left behind by the Japanese after its defeat in the Second World War, but the true acceleration came after 1961, when a military government led by Park Chung-hee seized power with a determination to transform South Korea into an industrial power.

In the late 1960s, Mr. Park's powerful Economic Planning Board – modelling off Japan's success with its zaibatsu and keiretsu conglomerates – encouraged expansion in strategic sectors such as shipbuilding, chemicals, automobile manufacturing and consumer electronics, and by the 1970s, conglomerates had spread into construction. Soon, Samsung and Lucky-Gold Star (now LG) had also opened hotels and department stores. By 1984, the top 50 chaebol accounted for 94 per cent of South Korea's GDP.

But the chaebol's loan-fuelled hyper-growth often veered toward collapse, with the government funding expansion into unrelated business lines that did not create enough profits to pay back the loans. In 1997, the Asian financial crisis roiled the region and the banking sector buckled under these non-performing loans. The indebted chaebol, which had sprawled across completely unrelated industries, turned in desperation to the South Korean government, which took a loan from the International Monetary Fund.

But it was not enough. Eleven conglomerates went bankrupt, including Kia, and 10 other chaebol in the top 50 teetered. Two years later, the Daewoo group – one of the four largest chaebol – was allowed to go bankrupt under $50-billion (U.S.) of debt, and was sold off.

The public anger led to a change in government – the first non-conservatives elected since the Korean War. The crisis scarred South Korea, and the new reform-minded government enacted a serious of corporate governance reforms and stricter regulatory guidelines. But the chaebol continued to grow.

A quick stroll through the financial district of Seoul reveals a skyline made up of chaebol firms – an office for Daewoo's Shipbuilding and Marine Engineering unit, an office tower for Hanwha (a listed Fortune 500 chaebol that has a solar panel business in Ontario) and a glowing building for the SK Group, which runs the country's largest mobile provider but has more than 90 affiliates that span chemicals, oil exploration and refining, semiconductors and a baseball team. By 2011, the five largest chaebol made up more than 55 per cent of South Korea's GDP, while the top 20 accounted for an astonishing 85 per cent.

"Their power is beyond description," says Sunnie Hong, who runs an executive search firm and works for some chaebol firms. "It's too late to control them. They're too powerful."

But at the same time, she concedes that all South Korean mothers dream of their children working at chaebol companies.

And she would know.

"My son is working at Samsung, and I enjoy that," Ms. Hong says. "Moms are similar worldwide, they just want to see their kids [be] successful. And success in Korea is Samsung."

The Samsung chaebol

On the gleaming main campus of Samsung Electronics in the city of Suwon, just within Seoul's endless sprawl, yet another new building is rising beneath towering cranes. Paralleling South Korea's growth, this area used to be farmland before it became a manufacturing zone.

"Right over here, there would be trucks going out with 40-foot containers" for export, says David Steel, a Samsung Electronics executive vice-president for communications as he stands among the company's streamlined skyscrapers.

Now the area is changing again. Most of the traffic these days are buses carrying in some of this complex's 40,000 employees, many of whom work in research and development.

Samsung Electronics has around 300,000 employees. And though it is the largest division of the broader Samsung Group, it is still just one part of the chaebol whole. Samsung Heavy Industries makes ships and oil platforms. Samsung Everland operates South Korea's largest amusement park. There is also Samsung Life Insurance, group joint ventures with oil giants Total and BP, a hospitality wing that includes the Shilla luxury hotels and duty-free shops, and various financial services wings that do venture capital, investments and credit cards.

Samsung Electronics is a conglomerate unto itself, and has benefited enormously from its scale as it purchases various cellphone components from its other divisions while selling those parts to other mobile phone makers. But Mr. Steel – although he admits "there are some synergies between some parts" – plays down Samsung's size and argues that the chaebol structure confers few advantages in the modern age and that the company now thrives on innovation and advanced research.

"At this point, the chaebol label is less relevant than at any other time before," he says. "Each business has to be globally competitive in its own right."

In January, Samsung reported its first annual earnings decline in three years – with profits dropping nearly 30 per cent – as competition from cheaper Chinese firms grew more intense and Apple released high-end iPhones with larger screens.

Rishi Ramachandran, the managing director of market intelligence and Asia advisory firm Group IBI in Seoul, knows the chaebol world intimately. He used to be a senior account director at Cheil Worldwide, the global ad agency wing of the Samsung Group where Samsung Electronics was the main international client. He describes the account as Cheil's "lifeline."

Since starting his own company, he's done work for some chaebol companies, but eventually stopped. He says the large chaebol would appoint an employee whose sole job was to liaise with Mr. Ramachandran's firm, leading to constant phone calls and irritations. Working with a chaebol was often so onerous and time-consuming that he was unable to take on other clients at the same time, and his staff ended each chaebol project absolutely exhausted.

"About five years ago, I decided not to work directly with the chaebol," he says.

Mr. Ramachandran describes the internal chaebol work culture as rigid and risk averse. Although South Korean companies such as Samsung spend huge sums on research and development, Mr. Ramachandran says the chaebol tradition of taking other people's products and making them more efficiently has bred a culture that discourages bold, new thinking. He remembers working on a campaign with Samsung and being told: "We're not innovators. We're fast followers."

But Mr. Ramachandran is still optimistic. "The reason I work here," says Mr. Ramachandran, whose firm operates across Asia, is that "Korean teams, when they work well, are amazing."

A lack of smaller firms

The struggle for South Korea now is to shift from an economy dominated by enormous conglomerates to one powered by SMEs.To many, the solution seems obvious: Encourage the growth of new creative industries in higher-value technology and services sectors, while boosting productivity at SMEs.

"The chaebol system in Korean society, which has its origins in Japan, is a significant obstacle to the growth of otherwise-sound small and medium businesses," said one technology startup co-founder who wished to remain anonymous. "Chaebol groups should not indiscriminately expand their businesses into other areas and take away the livelihoods of small and medium businesses."

The government has encouraged banks to lend to smaller firms, and bank loans to SMEs did soar after 1997 – surpassing that of loans to chaebol. But research has shown that the government's interventions and guaranteeing of loans for small firms, as elsewhere, encourages companies to remain small, may prop up unsuccessful companies, and leaves both banks and small firms unwilling to pursue commercial arrangements.

"The starting line is different, the chaebol have a head start," says Kyung-yong Koh, 32, who works for a small manufacturing company that makes dental equipment. "I think they're people who just live in a different world. There's a huge difference between us and them, in terms of finances and assets."

South Korea now has a dismal rate of small firms growing up, what analysts call the "Peter Pan Syndrome." In the decade from 2002 to 2012, only 696 SMEs out of several million companies actually grew beyond 300 employees, according to Statistics Korea.

Jungwook Lim, managing director of Seoul's Startup Alliance, says direct funding is less important than simplifying rules to start new businesses and grow existing ones, while shielding SMEs. "The government should make an effort to create a level playing field, where small companies can compete fairly against big conglomerates," Mr. Lim says.

In the end, though, for all the resentment about the power and excesses of South Korea's chaebol, the lure of a lifelong job is strong.

"I think chaebol definitely had an advantage from the government, and a lot of the burden has fallen on ordinary people," says Yoon Su-gyeong, a 23-year-old sociology student at Korea University. "Chaebol have a debt to give back to society, but all they do is pile up their wealth."

So what does she want to do when she graduates?

"It is my dream to work for a large company, and it's also my family's dream," she admits.

"It's a paradox. People will talk smack about the chaebol, but they still want to work for them."

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THE BIG FIVE

The chaebol are conglomerates that dominate South Korea's economy. They are responsible for the prosperous East Asian nation's remarkable development since the 1960s – and South Korea's current economic success – but there is constant hand-wringing about their enormous power and influence in society. The largest chaebol have dozens of affiliate companies that span various often completely unrelated industries.

Samsung Group

Samsung is the largest South Korean chaebol by far, with nearly 500,000 employees, total assets of around $530-billion (U.S.) and total group net sales of about $305-billion in 2013, according to its annual report. It is most well known for its Samsung Electronics unit, which is not only the largest mobile phone maker in the world but churns out fridges, air conditioning units, TVs, laptops, semiconductor and memory chips, and a host of other components it sells to other phone makers. The group also has hotel assets, a heavy industries division that makes ships and oil platforms, a chemicals arm and a global ad agency, as well as insurance and financial services units.

Hyundai

The Hyundai chaebol, which also owns Kia, builds much more than cars. Hyundai Heavy Industries is the world's largest shipbuilder – with a shipyard in Ulsan, South Korea, that stretches over four kilometres of coastline – and has expanded into construction for offshore oil and gas projects around the world. Hyundai Rotem, another division, builds everything from advanced train rolling stock to K2 tanks for the South Korean army.

SK

SK Group is best known for SK Telecom, but it has around 79,000 employees stretching across 80 affiliate companies that operate in the global energy sector, as well as chemicals, finance, shipping, insurance and construction.

LG

Originally known as Lucky-Gold Star, LG began as a chemicals and plastics company but expanded into electronics – making TVs and smartphones. In 2014, LG Electronics had global sales of nearly $56-billion (U.S.).

Hanwha

One of South Korea's largest chaebol, Hanwha has 52 domestic affiliates and 126 international ones that span manufacturing, construction, energy, chemicals and finance. It is the world's largest producer of photovoltaics (with operations in Canada) and recently won an $8-billion (U.S.) contract to build an entire city in Bismayah, Iraq.

Iain Marlow