Markets & Economy
South Korea’s Moon-Lit Road to RecoverySeptember 1, 2017
- Recently elected President Moon Jae-in has vowed to curb the influence of South Korea’s powerful conglomerates—the so-called chaebols—and improve standards of corporate governance.
- In truth, moves toward improving governance have been underway for some years in South Korea, as companies increasingly adopt global best practices.
- The corporate environment is undergoing a generational transition in South Korea. Longtime executives of the powerful chaebols are being replaced by younger leaders with modern views.
- As such, President Moon has a rare opportunity to potentially deliver meaningful corporate reform in South Korea, particularly where the powerful chaebols are concerned.
- If successful, we could see considerable improvement in equity market returns, potentially even leading to a positive rerating.
THE RISE AND RISE OF THE SOUTH KOREAN CHAEBOLS
Earlier this year, following months of mass demonstration, South Korea’s Constitutional Court formally removed former President Park Geun-hye from office amid a corruption scandal that exposed the cozy, cash-for-favors relationship that has often existed between politicians and the chaebols in South Korea. While the scandal has met with public outrage, it is not difficult to understand how such an environment developed.
South Korea’s rapid economic development really began in earnest in the 1960s, as then-President Park Chung-hee opened up the economy and pushed the country toward a free market, forging closer relationships with the U.S. and Japan, in particular. Leading this economic charge was a number of family-owned companies, including names like Samsung, Hyundai, and LG. These firms began their business in one particular field but, with the considerable support and encouragement of the government, quickly expanded into other industries, establishing an ever-widening sphere of economic influence. Given their ever-growing importance to the economy, the government actively encouraged these chaebols to expand into new, strategic industries without fear of failure, protecting them from competition, awarding them key contracts, and providing them with cheap financing. With this kind of support, these companies quickly grew into global behemoths, helping to establish South Korea as an export-oriented powerhouse in less than a generation.
Yet, while chaebols have undoubtedly been the engine of the country’s stunning economic growth over recent decades, their size and power today mean that they exert considerable influence, reaching to the highest levels of government. Long before the impeachment of former President Park, commentators and investors alike were already questioning the consolidation of wealth and power among such a small handful of families and the stifling effect of this on small businesses and innovation in South Korea.
A CORPORATE ENVIRONMENT ALREADY UNDERGOING CHANGE
Of course, recently elected President Moon is not the first South Korean leader to vow to curb the power of the chaebols and improve standards of corporate governance. A number of previous governments have also been publically critical of the chaebols’ power and influence, particularly as voters’ distaste toward their dominance has risen. However, in the end, all have faced practical limitations in pushing through reforms due to the economic power that the chaebols hold. Indeed, the country’s five largest conglomerates account for more than half of the total value of the South Korean stock market.1
What is different this time, however, is that President Moon comes to power at a time when the corporate environment in South Korea is already undergoing a transition. Over recent years, many of the largest chaebols have seen a generational change in leadership, with longtime, patriarchal leaders being succeeded by younger and more progressive executives. This transition, while a natural progression, also recognizes the need for new ideas and a more modern approach in order to drive the long-term future of these businesses. Indeed, the new generation of leaders appears more willing to embrace change and implement any reforms that will help ensure business success into the future. This environment is a supportive one for President Moon and, in our view, improves the chances of him actually delivering his reform-focused agenda.
UNTANGLING THE WEB
One of the main difficulties in trying to improve the transparency of chaebols is the spider’s web of interlocking cross-company shareholdings that currently exists. President Moon has flagged this as a key area for attention, proposing a restructuring model that would see the creation of a vertical ownership structure with a holding company at the top. This simpler kind of direct ownership structure would potentially help to unlock hidden value among many of the key businesses within the chaebol structure.
MINORITY SHAREHOLDERS HAVE A PIVOTAL ROLE TO PLAY
Another policy objective of the Moon administration is to improve corporate governance through strengthening the rights of minority shareholders. By introducing legislation giving minority shareholders more power to nominate Board members, President Moon plans to make minority shareholders and Board members the driving force for better corporate governance in the large conglomerates. Two of the largest chaebols, Samsung and Hyundai, have publicly stated that they are trying to enhance shareholder value through improved dividend payments and share buybacks, while plans to introduce governance committees have also been flagged. This kind of “self-reform,” as well as the measures promised by the new government, could prove significant in erasing the traditional discount applied to South Korean equities; due to complex corporate structures, weak governance, and underwhelming shareholder returns (Figure 2). If President Moon is able to encourage greater investor engagement, as he has vowed to do, then this could help drive improvement in these areas and potentially lead to significant value being unlocked—value that is currently buried in inefficient structures, poor capital allocation, and lazy balance sheets.
SHAREHOLDER ACTIVISM IS STILL IN ITS INFANCY
South Korea is also a fertile ground for shareholder activism. The opaque ownership structures of the chaebol and generally weak standards of governance have always meant that South Korea has been a relatively undervalued market. What has changed, however, is that many South Korean companies now boast large stockpiles of cash that are sitting inefficiently on their balance sheets. This is driving an increase in shareholder activism in South Korea, as investors look to unlock value by pressuring companies to become more efficient, resulting in higher returns on investors’ equity. There have been some instances of shareholder activism success in recent years, at Samsung for example, suggesting that investor-led change is possible, even among the powerful chaebols.
LABOR MARKET IMPLICATIONS
In trying to deliver corporate reform, one of the difficulties facing President Moon, and administrations before him, is the unique nature of the labor market. Given the chaebol conglomerates are so dominant across major businesses and industries, they also play a pivotal role in the labor market. This powerful influence was made clear during President Moon’s campaign, with some chaebols announcing that they would either reduce employment or not hire at all, undermining his promise to create jobs. The labor market is highly dependent on chaebol conglomerates, so the economic impact of such moves is significant.
Nevertheless, popular sentiment is with President Moon, affording him a rare opportunity to try and break the collusive ties that have long existed between government and the chaebols. This could have some negative implications for the economy in the short term, but it will likely prove beneficial in the long run, by diversifying the labor market and providing opportunities for small businesses to be developed and innovation fostered.
INVESTOR SENTIMENT HAS NOTICEABLY IMPROVED
South Korea’s KOSPI Composite Index has risen by almost 16% year-to-date,2 hitting all-time highs in July 2017. Yet despite the recent rally, it is worth noting that South Korea is still the cheapest major equity market in the world, according to certain valuation metrics.3
In part, the recent market rally reflects investors’ desire to draw a line under the country’s recent political and corporate turmoil and trust that President Moon can deliver on his reform promises, particularly where the chaebols are concerned. Given their primary importance to South Korea’s economy, this is no easy task. Should the economy begin to slow, for example, lawmakers may fear that constraining the chaebols in any way will further endanger growth.
However, with a new generation of business leaders coming through, we are beginning to see positive signs of change and “self-reform” in the corporate environment. President Moon’s reform-focused agenda only adds to the momentum toward corporate improvement and adopting global best practices. If he can deliver his reform objectives, then the traditional reasons for discounting South Korean equities—such as low shareholder returns, complex holding structures, and opaque governance—could see considerable improvement and, in turn, potentially lead to a rerating of the equity market.
1Korea Exchange, as of April 2017.
2Thomson Reuters, as of August 20, 2017, in local currency terms.
3StarCapital Research, as of July 31, 2017. Based on price-to-earnings and cyclically adjusted price-to-earnings (CAPE) valuation metrics.
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