Sunday, November 23, 2014

The Conglomerate Way to Growth

CAMBRIDGE – Countries do not become rich by making more of the same thing. They do so by changing what they produce and how they produce it. They grow by doing things that are new to them; in short, they innovate.

Many countries have been altering their growth strategies to reflect this insight. But they are being distracted by some of the greatest – but atypical – examples of success.

We all have heard of Steve Jobs, Bill Gates, and Mark Zuckerberg – twenty-something college dropouts who built billion-dollar companies at the cutting edge of global innovation. We have heard of the many start-ups that they and others acquired for hundreds of millions of dollars - Instagram, Skype, YouTube, Tumblr, and, most recently, Waze. So why not emulate these successes?

The main problem is that these examples are peculiar to the software industry, which provides a woefully insufficient blueprint for the rest of the economy.

The software industry is unique, because it has unusually low barriers to entry and ready access to a huge market through the Internet. A start-up is typically just a group of kids with a good idea and programming skills. All they need is time to write the code. Incubators provide them with space, legal advice, and contacts with potential clients and investors.

But consider a steel, automobile, or fertilizer plant – or a tourist resort, a hospital, or a bank. These are much more complex organizations that must start at a much larger scale, require much more upfront investment, and need to assemble a more heterogeneous team of skilled professionals. This is not something at which a young college dropout is bound to excel, because he lacks the experience, the organization, and the access to capital that these ventures require.

And, compared to software development, these activities also require more infrastructure, logistics, regulation, certifications, supply chains, and a host of other business services – all of which demand coordination with public and private entities. Most important, these activities are most likely to be central to economic growth in developing and emerging countries. So, how will companies in these sectors arise, and what can be done to stimulate their formation?

Many developing-country governments are ignoring that question. For example, Chile’s government, obsessed with so-called “horizontal” policies that do not tilt the playing field in favor of any industry, recently implemented Start-Up Chile, a program with standardized rules to encourage new ventures. Although the rules were designed for all industries, the scheme attracts almost exclusively software ventures – the only ones that can be formed with the low level of support that the program provides.

Other industries face more daunting chicken-and-egg problems: countries lack the capabilities that growth industries demand, yet it is impossible to develop these capabilities unless the industries that require them are present. One way to solve this coordination problem is through vertical integration – that is, firms that can solve internally the coordination of the supply and demand for any new capability.

That is why national business groups – conglomerates – often play a key role in transforming an economy and its exports. This is especially true in developing counties, where many markets are missing and the business environment is often extremely challenging.

Conglomerates can use their knowledge, managerial skills, and financial capital to venture into new industries. They can start things at a scale that would be impossible for a start-up. They can make credible commitments to future suppliers and influence the business ecosystem to make new industries feasible.

Consider South Korea. In 1963, the country exported goods worth less than $600 million at today’s prices, mostly primary products such as seafood and silk. Fifty years later, it exports goods worth almost $600 billion, mostly electronics, machinery, transportation equipment, and chemical products.

This transformation was not achieved through independent start-ups. It was done through conglomerates, or chaebols in Korean. For example, Samsung started as a trading company, moved to food processing, textiles, insurance, and retail, and then on to electronics, shipbuilding, engineering, construction, and aerospace, just to name a few activities. South Korea’s transformation was reflected in the transformation of its leading companies.

But, in many developing countries, conglomerates have not played an equivalent role. They have focused on non-tradable goods and services – those that cannot be imported or exported – and have eschewed international competition. They have focused on banking, construction, distribution, retail, and television broadcasting.

Once these companies dominate one market, they move to another that is equally sheltered from competition and devoid of export opportunities, often using their size and political influence to keep out would-be competitors. Instead of becoming agents of change, they often prevent change. (Indeed, the big economic debate in South Korea nowadays concerns whether the chaebols are stifling innovation by preventing start-up competitors from challenging them.)

The productive transformation that developing countries need is much easier to achieve with the support, rather than the obstruction, of their conglomerates. But ensuring such support requires policies that nudge (or even shove) conglomerates toward export industries that can grow beyond the limits of the domestic market – industries in which competition will encourage the discipline that they lack as a result of dominating local markets.

To succeed, conglomerates need the support of government and the acceptance of society. They must earn it through their contribution to the growth of employment, exports, and tax revenues, and to the country’s technological transformation. That is what General Park Chung-hee (South Korea’s longtime ruler, and father of current President Park Geun-hye) pressured the chaebols to do in the early 1960’s. And it is what governments and civil societies in developing countries today should demand of their conglomerates.

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    1. CommentedVS Aditya

      True - Innovation is the key. Without innovation & subsequent expansion even the largest conglomerates could not face competitors from others. innovate or die

    2. CommentedSanjay Jain

      Political system in a developing country also influences as the type of conglomerates it gets. In a democratic country with a multi party parliamentary system like India, there is close interdependence between business houses and the elected parliamentarians as both feed on each other. This does result in a conglomerate model which expands businesses which can benefit from government policies or spending. To call it crony or corruption is perhaps peripheral, it is more fundamental basis which directs profits of new projects. Conglomerates cater to political parties across spectrum and they are always open to entering a sector wherever they can derive specific policy benefits exclusively or first mover benefits. With time thus Conglomerates add new businesses. However there are exceptions to this and conglomerates have also entered and become big in industries devoid of government favors. Software for example in India is one such industry. However this is more of an exception in Indian context.

    3. CommentedJose araujo

      ahh the joys of corporate state, where all economy works for monopolies and society is rulled by few. Lets couple that with a fascist regime and we will have economic growth once again.....

    4. CommentedSira Maliphol

      The South Korean government took a comprehensive approach when developing its economy. It supported specific sectors (i.e. heavy and chemical industries), especially developing their R&D capacities. It also targeted specific HRD programs across the educational spectrum from secondary and vocational schools to PhD research, repatriating overseas experts as needed. These strategies also included localization policies for technology IP and business processes and capabilities.

    5. CommentedZsolt Hermann

      It is a very interesting article on one hand pointing to a possible solution, on the other hand hinting that in the present framework the solution could end in failure as many other good looking suggestions today.
      The key for us to consider is that we exist in an integral, global system.
      This means that each individual nation and nation is intricately connected to each other at all levels, and all depend on each other.
      Indeed in such an integral system the larger a "conglomerate" is, the more successful it gets as with integral inner communication, capability of organization, effective use of resources, mutually responsible and complementing cooperation such conglomerates can use the existing connections in the most optimal way.
      But as long as the main form of action in the world in general is ruthless competition, self centered, profit oriented calculations and action, such conglomerates destroy competition, exploit resources and avenues for themselves and behave like cancer that at the end kills the system and itself with it.
      We have to look at the whole world as a single conglomerate today and at the same time we also have to understand that in a global, integral system ruthless competition has become self-destructive.
      In today's human society only a global, mutually responsible and complementing "global conglomerate" is capable of providing sustainable well-being, "qualitative growth" instead of the impossible and unsustainable "quantitative growth".
      Mutual coordination and cooperation is good, but we have to place it into the system we exist in, fully adapted to the principles of integral systems.

    6. CommentedArvind Gupta


      In the 90s the received wisdom from economists was that conglomerates were bad. Korean chaebols were in part blamed for the Korean 1997 financial crisis. There was lots of handwringing about governance and risk taking. Before that Japanese Keiretsus were blamed for the supposed innovation and entrepreneurial deficit in Japan.

      Why now the change in thinking? Is there a new and more rigorous economic logic and new empirical evidence?

      The article does not answer the questions it raises in paragraph 7. Would be great to have specific examples and analysis of how creation of successful conglomerates can be achieved through policy.

        CommentedAdam Harper

        Your first mistake was believing economists have ever been in consensus about much of anything; certainly not the causes of financial crises. The second, and more fatal mistake, was believing that conglomerates are either inherently good or bad. Like people they should be judged based on their individual characteristics, and not by the actions of those who share the same label.

    7. CommentedWalter Gingery

      The key to support and acceptance is the openness of the government to participation by ALL citizens in making decisions about economic development. Roughly, states like Ukraine, Argentina, Russia, and Saudi Arabia, governed by a closed elite extracting wealth for themselves at the expense of the rest of society, vs. France, USA, Canada, South Korea. Mexico is an example of a state in transition.

    8. CommentedFabio Souza

      It shows the size of the labour in South Korea, low skilled workers in many industries throuth these decades, but they have improved due the need to produce more with quality and still compete globally.

    9. CommentedFabio Souza

      Developed countries are in different level of capitalism, so they invest more in banking and services and can import more goods with lower prices. We can see it with US-China trade. Many conglomerates saw the chance to produce a lot for cheap and it's related to the handful number of low income workers in Asia and many developing countries.

    10. CommentedGary Tucker

      I agree this is a very excellent article making very valid points for developing nations everywhere.

      While I live in the USA, I have a friend in Russia with whom I discuss over and over again what I feel Russia is, in some ways, not doing right to advance more quickly.

      The example I use is Bidvest of South Africa. While it is indeed a services conglomerate that you use as an example, it has very aggressively expanded beyond its SA base to become an international conglomerate. It brings the talents of so many of its divisions to the advancement of all. It promotes a very concrete sense of working together to create a better life for all. It is truly a company worth much more united than as several companies alone.

      I tell my friend that Russia really needs about 10 Bidvests much more than it needs a massive focus on high tech. If for the number of employees if nothing else.

      I also point out that Bidvest is very widely owned by pensions and other financial institutions. As long as any company, conglomerate or not is too heavily owned by a core group it is maintaining that control that becomes more important than growth and expansion.

      But I also believe that companies in Russia and elsewhere are also very hesitant to spread beyond their borders or very immediate neighbor countries. For this I used the example that a Russian company such as Yandex could very easily and quite sensibly acquire a company such as Unisys in the US for shares and go from a Russian information company to a worldwide information company. But the country that would most decidedly benefit from such expansion would be Russia itself.

      I have also debated with Ukrainian friends about how I believe that, in the long run, if the Ukrainian company Naftogaz Ukrainy were to merge the subsidiary UKRnafta and other assets into the South African energy giant SASOL it would be, in the short and long run, much more advantageous to Ukraine then to continue to run the company with massive Ukrainian control.

      Each of the above examples is a different side of the cross border development of international companies. Time and time again the barrier to not being in control or not being the country of headquarters for such combinations ends up being a detriment to sensible expansion and exchange of talents and expertise.

      As I also notice the author is from Venezuela it also brings up a second trend, that over time has come to stagnate world growth and development.

      Instead of the fiasco that is the EU or even other nations gathering together in trading or common markets, the tendency of nations to split apart but very seldom come together as a single nation has virtually ceased to be an option around the world.

      Just as egos, national loyalties and traditions stretching back in time prevent conglomerates forming in many developing countries, so too does the impediment of nations merging that would, in many cases, find much faster accelerated development if they were to do so.

      I use the following examples among friends and in articles and comments around the web.

      Venezuela, Columbia and Panama. (Ecuador as well but I fear as hard as the first three adding Ecuador would just be dreaming at this stage) But the reuniting of the old Simon Bolivar's Gran Colombia (perhaps as Gran Tierra or some other compromise name) would be a far more dynamic and potentially rapidly developing nation.

      Each nation would bring so much to the newly united nation that the other two nations lack or have not developed to any degree. The newly united nation would also be a relatively even more influential nation in the region and the world.

      In the recent news I also include Egypt, Libya and Tunisia. (With perhaps Sudan in 3 to 5 years)

      In the same region I truly believe that Lebanon, Syria, Iraq, Jordan and the Palestinian Territories have a much better chance, not only of long term peace, but dynamic growth in the coming years, united instead as 5 separate or even worse as countries divided even further into smaller countries.

      The final one to mention here, although I can think of a few more, to me if Cuba and Mexico were a single nation, with the capital in Havana and Mexico City just the largest city in the nation that, just as a conglomerate brings the best what makes individual companies great, makes the combined company even greater, that such an explosion of growth, culture, national safety and millions of people reaching their full potential in such a merged nation is so much more than if they continue as separate countries.

      But just as the author points to the lack of understanding among so many developing nations or even mid tier companies in developed nations, the advantages of being in a well managed conglomerate, at least for a substantial portion of their early or mid lives is such an overlooked tool for sustainable development.

      Thank you very much for the important article.

    11. CommentedAdam Harper

      Very insigtful article. One has to wonder what roles, if any, various governments may have played in helping reduce competition in their respective domestic markets for the conglomerates, and how those policies can be reversed. If a country has ample competition in their own markets, then conglomerates would not be de-incintivezed from competing in international markets. I imagine that some nations can "simply" end the pervasive crony-capitalist policies that plague so many developing nations and make significant steps achieve Prof. Hausmann's objectives.