LGFVs with Korean Characteristics
LGFVs with Korean Characteristics
Exploring the conglomerate aspect of LGFVs with lessons from chaebol reform after the AFC
This is the next installment of a series of deep dives into local government assets and financing vehicles (LGFVs) in China and related themes:
The previous essays were intended to establish foundational understanding of this oft-misunderstood $20+ trillion pool of assets. At the risk of repetition, the key themes to highlight include:
The importance of looking at things from an asset-centric perspective.
The centrality of land to local government activities.
The role that social policies such as poverty alleviation played in creating these assets.
The role that adverse selection bias played in asset formation.
The adversarial relationship between central and local governments.
Originally, I thought this would be the last post in the LGFV series, but as I contemplated Korean chaebols in the 1990s and its similarities with today’s LGFVs, I thought it would be helpful to take a detour before getting to the final segment discussing potential reform paths for LGFVs.
The Rise of the Chaebols
I began my career working in Asia in the early 2000s. One of the first live projects involved traveling to Seoul over several months working with SK Corporation’s energy division as it considered expanding into the power sector. Very much in-line with the free-market zeitgeist of that era, Korea Electric Power (KEPCO) was considering the privatization of some of its power generation assets. This was my first brush with chaebols.
Chaebols were family-run business groups that formed when the Korean economy was still in its early development stages, many starting as construction companies helping rebuild Korea in the aftermath of the war. Patterned after Japanese zaibatsu, these business groups developed major advantages during this period.
First, they established tight, inter-linked supply chains through both formal and informal links giving them a leg up over smaller domestic competitors. Chaebols had a tendency to vertically integrate the industries they entered. Second, they were able to access capital at a time when capital was scarce, especially debt: chaebols, like LGFVs, used significant debt financing to grow, taking advantage of close relationships with the government and banking sector. Third, they developed strong internal group cultures, often driven top-down by the controlling families, that would come to exemplify the Korean economy: paternalistic, hierarchical and very hard-working1.
With scale, established supply chains and strong group working cultures, they could deploy capital at attractive rates of return compared to the rest of the economy. They formed tight partnerships with the authoritarian Korean government, and played a critical role in General Park Chung Hee’s industrialization drive in the 1970s. In the process, chaebols diversified and became large, politically connected business groups that eventually came to drive the majority of economic activities.
SK Group was a typical Korean chaebol. Founded by Chey Jong-hyon in 1953, it got its start by taking over the assets of a former Japanese-Korean textiles plant, becoming Korea’s first producer of polyester. In the 1970s as part of General Park’s heavy industrialization drive, it expanded upstream into oil refining, following the vertical integration strategy that was common with many chaebols. It also started diversifying into other areas, notably purchasing the famous Walkerhill hotel (and casino). In the 1990s, it moved into telecom, taking over Korea Telecom and launching Korea’s first CDMA cellular network2. In 2012, through SK Telecom, SK Group moved into semiconductors with its takeover of Hynix, forming SK Hynix. Today SK Group is the second-largest Korean chaebol.
As their capital bases expanded, their advantages were eroded by the burden of managing a large, diversified business: less focus and misaligned incentives resulting in declining capital efficiency. It is impossible for a large conglomerate to be great at everything. Today, most successful companies are ones that have developed specific advantages under competitive conditions and emerged as focused operators with scale, company culture and expertise to continue building on these advantages.
As the Korean economy entered the 1990s, cracks started to appear: chaebols were experiencing declining capital efficiency and there were general worries that they wielded too much power, often squeezing or crowding out smaller businesses and trying to lower market competition. Chaebols would bribe politicians in exchange for government contracts or gain preferential treatment3.
That said, on the surface, the economy was strong and people’s spirits were high. The global economy was basking in the post-Cold War glow. Netscape had gone public in 1995, ushering in the Internet era and “New Economy”. Korea was about to join the OECD at the end of 1996, a symbolic culmination to a stunning rise from the war-torn aftermath of the Korean War to a fully developed country within two generations.
In 1996, SM Entertainment — not a traditional diversified chaebol4, but part of a new generation of entrepreneurs from the 1980s — created the first modern Korean boy band called Highfive Of Teenager, or H.O.T., for short. Long before BTS and Blackpink or turn-of-the-millenium groups like Jinusean and Turbo, there was H.O.T. On September 7th, 1996, the catchy single “Candy” was released and it came to epitomize the “shamelessly happy” cheerfulness and optimism of mid-1990s South Korea (as well as, clearly, “peak baggy” in fashion).
The Asian Financial Crisis and Aftermath
On July 2nd, 1997, the Thai baht collapsed as its government ran out of hard currency to maintain its hard peg to the U.S. dollar. This immediately triggered capital flight as investors pulled capital out of emerging Asian economies in cascading fashion. By November, the Korean won devalued by more than half, putting intense pressure on a banking sector that had borrowed heavily in U.S. dollars with short-duration debt5. This cut off liquidity to the over-leveraged chaebols and many of them were suddenly teetering on the brink of bankruptcy.
With Korea running out of hard currency, the IMF stepped in with a rescue plan that forced Korean chaebols to undergo significant reforms. Widely characterized as a “tough medicine” approach, the adjustment period was particularly difficult featuring large-scale job losses and sending Korean households scrambling to dig out their jewelry in a patriotic drive to meet the Treasury’s need for hard assets to pay off foreign creditors.
But looking back, these reforms were also responsible for setting the foundation for the “leveling up” of the South Korean economy we see today. Today, with the benefit of more than two decades of hindsight, the South Korean economy has continued its ascent into becoming one of the world’s most technologically advanced economies. Korean chaebols emerged from the aftermath of the Asian Financial Crisis more focused, stronger operationally, and more capital efficient. Groups such as Samsung Electronics and SK Group were able to make the leap from investing in capital-intensive heavy industrial businesses to investing in technology and R&D-intensive efforts like consumer electronics and semiconductors.
Not only that, they were able to build global brands and eventually catch up and surpass their Japanese counterparts whom they had modeled themselves for many decades. Along with Taiwan, South Korea is one of the most successful examples of economies that have been able to make the leap from “dirt poor” to “fully developed” in three generations.
Parallels and Lessons for LGFVs
Like chaebols, LGFVs are conglomerates that hold a diverse collection of assets, businesses and investments. Today, similar to chaebols in the 1990s, they are facing similar issues of declining capital efficiency, large debt burdens and most recently, liquidity issues.
Average Korean per capita GDP in 19966 was $13,400, which was around 44% of then-prevailing U.S. GDP. Today, China’s per capita GDP is approximately $13,700 which is around 17% of U.S. per capita GDP. On a PPP basis7, the percentages are closer: Korea was 47% of U.S. GDP while China is 29%. As described earlier, Korea had relied on more foreign debt (net off against fewer foreign assets) — which is what eventually led to its currency crisis — while China holds a large net foreign asset position8.
In lining up LGFVs and chaebols, there are several interesting parallels and potential lessons as we think through potential reform pathways.
Enforcing discipline via crisis
Export-oriented chaebols (or divisions of chaebols) had a natural disciplining mechanism in competition in the global markets9. But for domestic markets, there was less of a natural disciplining mechanism — and domestic units of chaebols had this tendency to vertically integrate in and dominate industries they participated in.
In the past, the Korean government was successful in “enforcing discipline” to make sure chaebols “toed the line” on national development policies. One way was to provide rewards to chaebols that were successful at the export game. But domestically it was trickier to maintain that natural competitive dynamic — by the 1990s, chaebols had gotten so big with “crony capitalist” behavior and corruption on the rise.
From that perspective, the Asian Financial Crisis may have ironically been a blessing in disguise for the long-term health of the Korean economy. The currency crisis and resulting debt crisis gave Korean policymakers the leverage they needed to push down significant reforms and force chaebols to adjust.
Today, LGFVs — which are exclusively domestic concerns — face similar issues. Here the central government in its oversight role has responsibility for enforcing discipline. One might even view the “Three Red Lines” tightening in August 2020 as a self-induced crisis for China analogous to the exogenous Asian Financial Crisis for Korea.
Today as a result of the tightening, many LGFVs are struggling with liquidity, which gives the central government more leverage for potential reforms. A critical question is whether or not they take advantage of that leverage. Because it is self-induced, there could be a higher temptation to forego “tough medicine” reforms that would likely be better in the long run, as South Korea has experienced.
Focus and specialization
Chaebols played a dominant role in powering the growth of the Korean economy participating in nearly every sector of the economy. However, this led to the problem of “di-worsification” and declining capital efficiency. The IMF reforms and bailout conditions targeted this by forcing consolidation of business groups around “core competence areas”10. This meant forcing chaebols to consolidate or get rid of under-performing divisions, e.g. Hyundai Motors taking over Kia, dissolution of Samsung Motors, and the sale of Daewoo Motors to GM.
In a similar way, LGFVs need greater focus and specialization. Assets may need to be moved around to create more focused operations with greater scale (sector consolidation). There should be a realignment of the best industry operators in charge of these more focused asset groups. The way in which different asset categories are financed could also use change — infrastructure assets attract a different type of investor and capital base compared to real estate, for example.
Corporate governance
Similar to inter-LGFV financial flows, chaebols were held together by intricate cross-holding structures that allowed the head families to exercise control with only minority ownership. Chaebols often lent to and borrowed from each other as well. Additional IMF reforms targeted corporate governance with the IMF recommending “capital structure improvements”, “elimination of cross-debt guarantees”, “reduction in indirect cross-ownership”, and “enhancement of management transparency and accountability”.
Many LGFVs also feature complicated cross-holding structures, the result of creating co-investing syndicates with other LGFVs on common projects. For example, HSR projects often involved multiple cities and counties along the proposed rail line, with many separate LGFVs involved. To improve corporate governance, in addition to the greater focus and specialization discussed in the previous bullet point, LGFVs may also need to unravel some of these cross-holdings.
Financial reforms
The close relationship between the government, banking system and chaebols was a target for reforms. Banks were critical to the growth of chaebols during their rise but this eventually contributed to moral hazard issues, over-investment and declining capital efficiency. The Korean financial sector was under extreme stress during the financial crisis and its need for capital injections helped to break the “too close” relationship between chaebols and banks.
Many of the working capital issues with LGFVs are the result of local officials of the “mayor economy”11 trying to get around the rigid formal banking sector and turning LGFVs into quasi-financial intermediaries. This has increased the risks posed by creating “hidden” informal debts in the form of inter-entity borrowing and lending, stretched payables and other types of liabilities.
Role of private capital
One interesting thing that emerged out of the Asian Financial Crisis was the rise of private equity’s role in the Korean economy12. The South Korean economy was desperately in need of capital and private equity firms rose to the occasion, attracted to potentially attractive investment opportunities in the aftermath of the crisis.
It is notable here that private capital also played a role during China’s own large-scale SOE reforms in the 1990s. Many assets that were “let go” by the state ended up in hands of the private sector and, motivated by wealth creation, managed the assets better. Industrial sector returns on capital improved through the 2000s and made many of these entrepreneurs very wealthy.
The role of private capital is related to focus, specialization and consolidation themes above. Bringing in capable operators and providing incentives to succeed (wealth creation) is a powerful force that could “level up” industries struggling with capital efficiency. It needs to be handled carefully to avoid asset-stripping and more clear rules need to be setup defining the role of the local government vs. the private sector — but these are the types of reforms that could usher in a multi-decade tailwind just as the 1990s SOE reforms did for China and the IMF reforms for Korea.
Differences between chaebols and LGFVs
It is also important to note the major differences between chaebols and LGFVs:
LGFVs are purely state sector entities; Korean chaebols were family-run private sector companies — with close linkage to the state.
LGFVs were restricted to operating in less attractive (from a financial perspective) sectors and subject to adverse selection bias.
While LGFVs also took a quasi-vertically integrated approach to real estate (e.g. investing in local construction companies, building tourist sites), supply chains are an order-of-magnitude less complex for land development as they are to industrial enterprises.
Korean chaebols had some crown jewels like Samsung Electronics and Hyundai Motors; the best asset held by provincial governments is probably Kweichow Moutai.
Perhaps it would be more accurate to draw parallels with chaebols if you exclude their better assets: e.g. Samsung Group excluding Electronics and Heavy Industries. In other words, LGFVs are most comparable to the lower-performing subsidiaries or smaller and less well-run chaebols like Halla Group, the “bottom of the barrel” of chaebol assets, if you will13.
However, this distinction does not change the fact that the 90s-era Korean chaebols had taken its model to its limits, reaching pareto efficiency, and needed significant reform just like Chinese LGFVs need major reforms today to be able to advance to the next level.
Hopefully in the next post I will be be able to finally discuss some potential reform pathways for LGFVs.
Two decades later, another oil refiner would exercise the same move in India: Reliance Industries launched its Jio network in 2015.
Phil Sang-Lee, “Economic Crisis and Chaebol Reform in Korea” (October 2000), Section 5
Chaebols also got involved in entertainment. CJ Entertainment, of Parasite fame, was part of the Samsung Group. Today CJ Group is independent, having split off from Samsung Group in the aftermath of the Asian Financial Crisis.
61% of external debt was short-term borrowings. IMF “The 1997-98 Korean Financial Crisis: Causes, Policy Response and Lessons”
Denominated in current U.S. rates. Source: World Bank
PPP is more accurate in describing the distance to the technology frontier, or amount of catch-up growth potential left. With the benefit of hindsight, South Korea’s GDP in 1996 was also overstated as the economy would stumble over the next five years. In nominal terms, the Korean Won’s halving also brought the Korean economy below 30% of U.S. GDP in nominal terms for a period of time.
Brad Setser estimates that China holds an approximately $6 trillion in net foreign asset position including reserves, assets held in state banks and development loans related to programs like Belt & Road — equivalent to approximately 30% of its GDP. South Korea held approximately $24 billion in net foreign assets at the end of 1996, equivalent to approximately 4% of its GDP. One of the outcomes of the Asian Financial Crisis was to spur Asian central banks to accumulate large foreign reserve balances to avoid future currency crises.
Joe Studwell “How Asia Works”
Phil Sang-Lee, “Economic Crisis and Chaebol Reform in Korea” (October 2000), Section 4.2
The “mayor economy” is a term used by Keyu Jin in her book “New China Playbook” referencing the critical role played by local officials (“mayors”) to partner with private entrepreneurs and develop the local economies.
If you were in the finance industry in the early 2000s, you will likely remember this infamous viral e-mail.
Other parts of the Chinese economy line up more cleanly with the better chaebol assets — for example, Huawei is probably China’s closest comparable to Samsung Electronics.