1

Taming the Chaebols

SEOUL – The indictment of Lee Jae-yong, the heir apparent at Samsung, is but the latest explosive development in the political scandal that has been rocking South Korea. Already, the National Assembly voted to impeach President Park Geun-hye, the daughter of former president Park Chung-hee, on December 9. The Constitutional Court now has six months to justify her permanent removal from office. Depending on its decision, a presidential election may be held in the next few months.

But, as Lee’s indictment demonstrates, more than the presidency is at stake in this crisis. At the heart of the scandal is the reciprocal relationship between politicians and the chaebols, South Korea’s giant family-owned conglomerates. If the government takes this opportunity to transform the economy’s chaebol-dominated structure, it would reshape the country’s economic future as well – for the better.

Park is accused of using her political influence to benefit her longtime confidante, Choi Soon-sil, who is charged with forcing the chaebols to funnel about 80 billion Korean won ($70 million) into two nonprofit cultural foundations that she effectively controlled. She is also suspected of interfering in various state affairs, including ministerial appointments and state visits, despite having no official position. Park is being ridiculed as Choi’s puppet.

To some extent, this is nothing new in South Korea. Most administrations have extracted money from the chaebols, often with the help of prosecutors and the tax authorities. In exchange for that money, which is used to finance costly state projects or even political campaigns, the chaebols gain favors, such as cheap bank loans or preferential regulations.

This reciprocal relationship has existed since the start of South Korea’s economic transformation in the 1960s. The country’s rapid progress is attributed to strong manufacturing exports, carried out by firms that were able to compete in global markets only with the help of government incentives.

Park’s father, who led South Korea from 1961 until his assassination in 1979, worked closely with the chaebols, helping them first to build comparative advantages in labor-intensive manufacturing and then to progress to more capital-intensive industries, including automobiles, shipbuilding, and chemicals.

Today, the chaebols produce almost two-thirds of South Korea’s exports – no small feat, in the world’s sixth-largest exporting country. Samsung Electronics is the largest chaebol, and accounts for 20% of total exports. Ranking 13th on the Fortune 2016 Global 500, Samsung’s market capitalization comprises one-fifth of the South Korean stock market.

Beyond government support, the chaebols’ ownership and governance structure has contributed to their success. With the founding families in charge, chaebols’ top management can focus on a long-term vision, instead of short-term profits, and can mobilize resources swiftly. The efficiency of this model is apparent in the chaebols’ success as “fast followers” of top US and Japanese firms.

Yet the chaebols’ hierarchical management structure is often too rigid to correct bad decisions. Many conglomerates went bankrupt during the 1997 Asian financial crisis, having made excessive and unprofitable investments.

Moreover, the chaebols’ ownership is often opaque, with webs of cross-shareholdings allowing founding families to exercise controlling power, despite holding only a small portion of equity. The Lee family has less than 5% direct ownership of Samsung Electronics, but holds a 31.1% stake in Samsung C&T, the group’s de facto holding company, which owns a 4.3% stake in Samsung Electronics and a 19.3% stake in Samsung Life Insurance. Samsung Life Insurance, in turn, has a 7.3% stake in Samsung Electronics, which indirectly invests in Samsung C&T and Samsung Life Insurance.

This type of ownership structure can be particularly problematic during transfers of ownership to new generations. As with any dynasty, no one is ever sure that the heir apparent is capable of doing the job. Lee recently took over as Samsung Electronics’ vice chairman. At a time of strong and growing market competition, he must provide the kind of visionary leadership that characterized his father and grandfather, the company’s pioneering founder, who transformed a small local trading company into a global semiconductor and smartphone powerhouse.

Like the rest of the chaebols, Samsung risks losing ground in global markets, owing to the narrowing technology gap with China. Though South Korea is still ahead of China in high-tech branches like memory chips and automobiles, its lead is diminishing in many major industries, such as steel, ships, petrochemicals, and electronics. In emerging markets, Samsung Electronics has already lost market share to Chinese smartphone makers such as Huawei and OPPO.

It is in this high-pressure context that, last year, Moon Hyung-pyo, South Korea’s then-health and welfare minister, allegedly pressured the National Pension Service to back a controversial merger of two Samsung group affiliates that was essential to ensure a smooth transfer of managerial control to Lee. Moon, who then became chair of the NPS, has now been arrested for that move.

Lee’s indictment, too, is linked to this effort. He is charged with donating to Choi’s two foundations, and of bankrolling Choi’s daughter, in exchange for the support he received. He is also accused of embezzlement and perjury. (The judge ruled that there was insufficient reason to issue the requested arrest warrant.)

While the government makes deals with the chaebols, start-ups and small and medium-size enterprises (SMEs) are struggling to make their way into the market. SMEs’ labor productivity is just 35% that of large firms. And labor productivity in the services sector is 45% that of the manufacturing sector – just half the OECD average.

To create a healthier business climate for innovative small firms and venture startups, the chaebols’ dominance must end. South Korea’s leaders must implement stronger regulations to prevent illegal transactions and unfair practices, including collusion between chaebols and government officials. They should also strengthen the rights of minority shareholders and outside directors to prevent expropriation by founding families.

There was a time when what was good for the chaebols was good for South Korea. But times have changed, and the chaebol system is now doing more harm than good. With Park’s impeachment, South Korea has gained an ideal opportunity to leave behind her father’s legacy as well.