October 29, 2011

The Progenitors of Chaebol

By Stephen E. Ronto, Department of Business & Economics Chung-Ang University, Korea
Proofreading: Simon Gillett

New Economic Slice 2011-2012 – KBC Senior Editor Eun-Shil Boots Park

A relatively unknown area of Chaebol is their historical roots. We can associate Henry Ford with Ford Motors, Thomas Edison with General Electric, and Bill Gates with Microsoft.  How about Samsung, LG, and Hyundai? It is common to relate the origins of Chaebol with their founders - Lee Byung-Chul of Samsung, Koo In-Hoi of LG, and Chung Ju-Yung of Hyundai.  A not so well-known relationship is the early modern business origins of numerous Chaebol which precede their founders. The business activities of early modern Korean entrepreneurs initiated the process of Chaebol formation.  Those progenitors of Chaebol evolved small, medium, and/or large-size businesses during the colonial period.

The First Businessmen
The mercantile class, Korea's first "businessmen," that emerged during the latter half of the 19th century was an intermediary for the delivery of goods from the producer (commoners) to the consumer (aristocracy).  Two distinct profit seeking groups evolved from the mercantile class. Itinerant peddlers, or "Pobusang"; and settled merchants  or "Kaechu". The Pobusang engaged primarily in barter trade and money lending, while the Kaechu engaged mostly in transport, consignment and financing, and wholesale and retail.  The Pobusang and Kaechu could well have been Korea's first entrepreneurial groups. Towards the end of the 19th century, Korea's mercantile class was competing directly with foreign merchants.  The opening of Korea's economy at that time entailed "friendship and commerce treaties".  When foreign businessmen entered the Korean economy, the Korean mercantile class found itself unprepared to meet the flow of foreign technology and business acumen.

The Advent of early modern Korean Business Enterprises
Between the period of the opening of Korea's economy (1876) and its annexation to Japan (1910), both Korean government and private merchants established corporations with the principal motive to expel "foreign aggression" from Korea.  Government and aristocracy established banks to compete against foreign banking in Korea. Meanwhile, to compete against the growing number of foreign firms who had established certain industries in Korea (e.g. railways, shipping, mining) Korean entrepreneurs from the common class and the aristocracy combined their resources to establish wholly-owned Korean business enterprises. These so-called "post-Kabo reformation" enterprises included several shipping firms, trading firms, and light-manufacturing firms.  Despite the rise of Korean business enterprises during this period, Korean entrepreneurs failed to effectively compete against modern foreign enterprises and in many cases Korean enterprises never got off the ground.

Doing Business with the Japanese Colonists
Within ten years after Japan's annexation of Korea (1910), the Korean economy fell under the control of Japan.  The Japanese held the reins of the Korean economy by monopolizing Korea's foreign trade, manufacturing and mining industries, as well as financial, transportation, and communication systems. Despite Japanese economic domination, Korean entrepreneurial spirit accelerated nevertheless and resulted in the rapid, although restricted, growth of Korean-owned business enterprises. Korean entrepreneurs during the colonial period can be divided into two groups.  The first group established enterprises from a base of landed assets and tended to be experienced merchants and wealthy aristocrats from the pre-colonial era.  Their motive for setting up Korean-owned business enterprises was based on nationalism. The second group consisted of commoners who established business enterprises for the single purpose of profit making. This group was more concerned with the well-being of their enterprise rather than achieving nationalistic goals, therefore they tended to ally closely with the Japanese colonial government.
Korean entrepreneurs exclusively used tactics such as accommodation and subservience to the Japanese colonial government to survive in a colonial business environment that favored Japanese enterprises over Korean enterprises.  In order for a Korean-owned enterprise to succeed, close relations with the colonial government was essential.  To facilitate the issue of licenses and other bureaucratic favors, knowledge of the Japanese language was required.  Therefore, successful Korean entrepreneurs for the most part were pro-Japanese and bilingual.  Although most Korean-owned business enterprises were small-scale operations and therefore did not require approval to operate, certain larger-sized Korean business enterprises required approval from the Japanese colonial government to engage in business. Through membership of the Japanese governed Seoul Chamber of Commerce and Industry or "Keisho," Korean businessmen forged political ties with Japanese officials and acquired business knowledge and skill. The "Keisho" became the most important organization for disseminating advanced management techniques among Korean businessmen. Those Korean businessmen who achieved recognition of the Japanese colonial government received financial support from state-owned banks, as well as government subsidies for selected projects.  Only a small group of Korean businessmen attained such recognition, and in having done so, they become the "core elite" of Korean entrepreneurs.  The Korean core elite were also recognized by Japanese business leaders.  Members of the Korean business elite became board members of Japanese investments in Korea.  Also, through their business cooperation with Japanese firms, the Korean business elite diversified into other industries and were given access to overseas markets. By forging partnerships among the Japanese government official, Japanese businessmen and Korean businessmen, the CCIs fostered a business elite among Korean entrepreneurs. This elite group of Korean entrepreneurs learned to adapt to a distinct form of corporatism characterized by concentration in industries by a few firms, collusion with government, and business diversification into a variety of business lines. These three characteristics of colonial corporatism would become key growth strategies for Korean business enterprises during the Rhee Sung-Man administration period.

Doing Business with the Rhee Administration
US economic policy in Korea after WWII focused on emergency relief and economic aid. Especially the Korean entrepreneurs' thirst for cash from ROK government allocation of US economic aid established a relationship between South Korean business and government which would endure for decades. This government-business relationship was based principally on Korean entrepreneurs' political support of the Rhee Sung-Man administration in exchange for government-controlled transfer of economic resources, e.g. monetary loans, trading licenses, and business contracts.  Through these transfers the formation of Chaebol was made possible to those entrepreneurs who were participants of this government-business relationship. The accumulation of diverse business enterprises resulted in the formation of Chaebol.  Between 1945 and 1961, 31 Chaebol were formed.  Of those 31 Chaebol, 13 were created between the years 1945 and 1952, and 18 Chaebol were created between the years 1953 and 1961. To be sure, ROK government economic policies determined the formation of Chaebol, just as Japan's colonial economic policy had determined the formation of early modern Korean enterprises. During the period of Chaebol formation, 1945 to 1961, Korean entrepreneurs can be divided into six groups based on their business backgrounds.  First, there were those Korean entrepreneurs who had engaged in business with the Japanese as members of the Keisho and other CCIs.  Second, the "Chongno Group" consisted of small and medium-sized enterprises active in the commercial district of Chongno, Seoul during the colonial period.  Third, there was a "Group of 31", emerging businessmen who had operated in the "Jinkoge" area, the center of Japanese business in Seoul.  Fourth, about 15 businessmen from Pyongyang and provincial cities made up another group. The fifth and six groups consisted of a small number of bankers and financers, and importers and exporters.. From among these 6 groups arose the founders of first generation Chaebol which were formed during the Rhee administration, including Lee Byung-Chul (Samsung), Chung Jae-Ho (Samho), Lee Chon-Lim (Gaepoong), Sull Kyong-Dong (Daehan), Lee Yang-Koo (Tongyang), Koo In-Hoi (Lucky), and Kim Sang-Hong (Samyang).

The Sources of Chaebol Formation
Five key methods of Chaebol formation that entailed economic and political interaction between business and government during the Rhee administration were: 1) non-competitive allocation of import quotas and import licenses by the government to business, 2) discount price acquisition of former Japanese assets, 3) selective allocation of aid funds and materials, 4) privilege access to low-cost banks loans, and 5) non-competitive award of government and US contracts for reconstruction activities.

In 1949 the Rhee administration set up the Office of Property Management (OPM) to dispose of the properties left behind by the Japanese colonist. These so-called "vested properties" included factories and firms, land inventories, and industrial machinery, amounting to an astonishing 80% of Korea's GDP.  The "vested properties" were sold by the OPM to entrepreneurs at prices below the pre-1945 book value.  For example, Korea Explosives Company (today's Hanwha group) acquired the Chosun Chemical Inchon Plant at 52% of the government's appraisal value, and Samho Company purchased the Chosun Spinning Plant at 65% of the government's appraisal value. 

The Rhee adminstration's allocation of foreign exchange and import licenses also assisted entrepreneurs in forming Chaebol.  The division of the Korean peninsula created a shortage of manufactured goods throughout South Korea dring the 1940s and 1950s since metal production, chemicals, and electric power industries were concentrated in  North Korea.  To relieve the shortage, South Korean entrepreneurs resorted to import-trading. Through import trading, entrepreneurs accumulated large profits through the high margins in re-selling the imported goods in the domestic market.  By the late 1940s, import trading had become a source of wealth accumulation and therefore it served as a ticket for entrepreneurs to join the ranks of Chaebol.  No less than 11 of 31 Chaebol formed during the Rhee administration had started their business operations through import-trading.

Importing foreign goods required entrepreneurs to have foreign currency.  By acquiring foreign currency entrepreneurs could also establish a domestic industrial base. With foreign currency, namely US dollars, entrepreneurs could build their plants by investing only 15- 20% of their own capital due to the overvalued won.  The entrepreneur's plant investment-capital was often financed by government-arranged long-term, low-costs bank loans.  Therefore, in an economic environment of hyperinflation and an overvalued domestic currency, the combination of having foreign exchange and government financial support became an important contributor to Chaebol formation. To be sure, foreign exchange acquisition and import trading were instrumental in the formation of Chaebol. All the 10 largest Chaebol in 1961 had participated in foreign exchange acquisition, and 9 of the 10 had engaged in import-trading during the Rhee administration.

Implications for non-Chaebol Companies
The attached table shows affiliate companies belonging to the current generation of Chaebol. The table lists the leading 10 Chaebol affiliate companies in terms of revenues as of July, 2011.  This list is representative of Chaebol engagement in Korea's strategic industries: chips, ships, autos, electronics, and petrochemicals - the cornerstones of South Korea's economy.  The comparison of total revenues with Japanese companies and global ranking of each Chaebol affiliate is a solid indication of Chaebol rise in world class industries. Also, the table shows that, with the exception of LG Display, all listed current Chaebol affiliates are offspring of first generation Chaebol Korean business enterprises.

Could the founders of early modern Korean business enterprises have ever imagined that their entrepreneurial efforts would have created the building blocks of today's Korean global businesses?  Or could they have ever forecasted that while success would come to a minority of entrepreneurs, doing business in a viciously punitive political and business arena would, for the majority of would-be entrepreneurs, continue into the 21st century?

The downside to the rise of Chaebol is voiced in ongoing critique among Korean business circles that while Chaebol have prospered, small and medium enterprises (SME) have been left out of the "Miracle on the Han" and the most recent "Digitalization of the Han".  As one associate bluntly commented,

"The Chaebol have created barriers to entry so great, a coliseum if you will, forcing SMEs to battle among each other for marginal earnings while the "emperor" Chaebol decides which SME perishes or survives."

Ironically, just as the progenitors of Chaebol struggled to do business under oppressive conditions, today's non-Chaebol business enterprises, especially SMEs are struggling to grow under the dominance, not of foreign empires, but of Chaebol business prowess.  Some of these non-Chaebol companies are growing within market niches and are competing head-to-head against Chaebol affiliates, growth paths very similar to early modern Korean business enterprises under Japanese colonial rule. Yet unlike the non-competitive market environment under Japanese colonial rule, today's non-Chaebol companies are competing under Korean capitalism which favors not necessarily financially the largest and strongest,  but the smartest, fastest, and most networked.  It's a tough hypothetical choice - to start a business under yesterday's foreign colonial rule or within today's Korean capitalism.  One cannot but admire the history of Chaebol growth. Also, one cannot but question whether the current Chaebol are doing business that will sustain long-term business growth. Koreans have already experienced the rise and fall of two generations of Chaebol. Doosan, Hanwha, Kumho, LG, Samsung, and SK are the surviving 5 of the 31 first generation Chaebol.

The patterns of corporate growth that early modern Korean enterprises established and which Chaebol adapted may no longer work in the 21st century.  Korea's democratic political environment and the growing social influence of Chaebol "watchdog" civic groups make business-government collusion much more difficult to pursue. Meanwhile, large-scale business diversification in Korean industry has become the exclusive domain of business groups. Furthermore, the 21st century global business arena has established new determinants of business success. For example, global fiber-optic networks and wireless mobile communication have made the speed of business activity a more important factor than the size of business in raising the bottom line.  Meanwhile business-government collaboration rather than collusion is the de facto relationship in most advanced industrialized economies. Non-Chaebol companies, Choongwae, Mando, Ottogi, and Pantech for example, should therefore forego adapting the traditional corporate growth patterns of Chaebol and pursuit alternative long term growth or extension strategies. Specialization rather than diversification, and partnering with government rather than working for government. More importantly, a sharp focus on business innovation must be at the top of the "let's do" list of non-Chaebol corporate managers. It would certainly be corporate death for non-Chaebol management to emulate and implement Chaebol growth strategies.  Instead the growth strategies of non-Chaebol companies should be unique and distinct from the growth patterns of Chaebol.

Top 10 Chaebol Affiliate Companies in Revenue Earnings (as of 25 July, 2011)