Republic of Korea: Selected Issues

This note is on Korea’s transition to a knowledge-based economy, the prospects and challenges ahead, and the development of its financial sector. Assessment of recent government initiatives to develop capital markets has been presented. The note discusses restrictions on Chaebol ownership of Korean banks and strategy for restructuring the small and medium-sized enterprise sector in Korea. This note describes the key fiscal challenges and discusses possible ways to address them, arguing that there is already a great need to start taking remedial action.

Abstract

This note is on Korea’s transition to a knowledge-based economy, the prospects and challenges ahead, and the development of its financial sector. Assessment of recent government initiatives to develop capital markets has been presented. The note discusses restrictions on Chaebol ownership of Korean banks and strategy for restructuring the small and medium-sized enterprise sector in Korea. This note describes the key fiscal challenges and discusses possible ways to address them, arguing that there is already a great need to start taking remedial action.

IV. A Strategy for Restructuring the SME Sector in Korea41

A. Introduction

1. The small and medium-sized enterprise (SME) sector in Korea is facing numerous challenges arising from globalization and deeply rooted structural problems. The rapid pace of globalization and the rise of China have weakened the traditional supply links between SMEs and the larger chaebols and intensified competitive pressures on the sector. At the same time, the slow progress in restructuring since the crisis has left the SME sector weak, holding back overall growth and investment.

2. Looking ahead, Korea will need to rely more upon SMEs as source of innovation and growth. To make the successful transition to a knowledge-based service-oriented economy, Korea will need a dynamic and flexible SME sector that can redirect resources quickly and efficiently to new growth areas. A healthy SME sector can also help raise the low productivity of Korea’s service sector, providing an important boost to overall potential growth.

3. This chapter examines the nature of the problems in the SME sector and outlines a strategy for helping SMEs to meet these new challenges. The strategy centers around strengthening the incentives for restructuring, modernizing the financing system for small companies, and improving the business environment to help develop and nurture innovative start-ups. These reforms will also help SMEs become “more global” by upgrading their technology and enhancing their overall competitiveness.

B. Background and Nature of the Problem

4. Contrary to popular perception, SMEs are an important part of the Korean economy.42 SMEs account for almost 50 percent of manufacturing output and around 32 percent of exports. It is difficult to characterize a typical SME since they cover almost all sectors in the economy, ranging from construction and retail to information technology. However, in general compared to large companies, Korean SMEs are geared more towards the domestic sector and account for a higher share of service sector production (58 percent of sales). Also since SMEs account for nearly 87 percent of total employment, they are an important source of jobs and spending for the economy.

SMEs’ Share in Establishments and Employment, by Sector

(In percent)

article image
Source: NSO.

Figures for services, calculated excluding communication, financial intermediation and education.

Including mining and quarrying, electricity, gas and water supply and construction.

5. The role of SMEs in the Korean economy has largely been shaped by its pattern of industrialization. As the large chaebols drove Korea’s export expansion during the 1970s and 80s, SMEs played an important supporting role as domestic suppliers and subcontractors. With their more flexible (and largely non-unionized) labor force, SMEs provided low-cost inputs and savings for larger companies. As the chaebols rapidly made inroads in overseas markets, domestic SMEs also benefited and increasingly geared their production towards supporting the needs of the larger companies.

uA04fig24

Korean Overseas Direct Investment to China

(In millions of dollars)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A004

Source: The Export-Import Bank of Korea.
uA04fig25

SME’s Share in Total Exports1

(In percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A004

1/ The way that data was compiled by the KFSB was changed in 1999.

6. However, the rapid pace of globalization and the rise of China have weakened these traditional links and intensified competitive pressures on the SME sector. Korea’s rapid integration with China and hollowing-out pressures from other low-cost countries has intensified competitive pressures on small firms in traditional industries, such as textiles and basic manufacturing. SMEs in these sectors have either downsized or shifted production overseas. Research by the Korea Development Institute has shown that this trend began as far back as the 1980s as the polarization in Korea between low- and high-technology firms and sectors has widened steadily due to competition pressures from China (Kim and Lee, 2003). The pressures appear to be intensifying as indicated by the sharp rise in overseas investment to China which is being led largely by small companies which now account for more than 50 percent of the total, up from 28 percent in 1999. At the same time, SME’s share in exports has declined by about 10 percentage points in recent years compared to the average in the 1990s, largely in basic manufacturing.

7. At the same time, the chaebols are shifting more of their operations overseas and relying less upon Korean SMEs to meet their production needs. As large companies have moved up the value added ladder, they are depending more on advanced technology inputs and sophisticated services from global rather than domestic suppliers. Since inward FDI remains low by international standards, Korea SMEs have not been able to benefit from the global integration of production processes and the transfer of new technologies.43 As a result, unless they adapt, Korean SMEs face the risk of being left behind as production is becoming increasingly globalized.

uA04fig26

Debt Ratio

(In Percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A004

Source: BOK Financial Statement Analysis (2006).
uA04fig27

Profitability: Ordinary income to Sales

(In Percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A004

Source: BOK Financial Statement Analysis(2006).

8. Slow progress in restructuring since the crisis have also significantly weakened the SME sector. According to BOK Financial Statement Analysis, about 1 in 4 manufacturing SMEs in 2004 were unable to generate enough operating profits to meet their interest expenses. Although the reason is partly cyclical due to the weak domestic economy following the burst of the credit card bubble in 2002–03, the problem is more fundamental and structural in nature. Since the crisis, SMEs have lagged behind in operational and financial restructuring compared to large companies. In 1997, manufacturing SMEs had lower debt-equity ratios and higher profitability than large companies. However since then, the picture has reversed. While large companies have made good progress in deleveraging and boosting overall profitability, SMEs have fallen behind. In 2005, SME’s debt-equity ratio stood at 141 percent compared to 86 percent for large companies, while profitability has remained stagnant.

9. These structural weaknesses have held back overall growth and investment. According to research by the Korea Development Institute (KDI), the weak financial condition of SMEs is largely behind the recent slowdown in facility investment. They find that large listed companies have substantially increased their facility investment by 22 percent annually during 2003–05. On other hand, facility investment by SMEs has declined by 18 percent annually during the same period, keeping the overall level of investment flat (Lim, 2005). This can also be seen in the growing polarization between large and small companies which shows little signs of abating. Until the SME sector addresses these structural weaknesses, small companies will not be in a position to invest.

uA04fig28

Annual growth in Facilities Investment

(In percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A004

Source: Lim (2005).
uA04fig29

Production Index

(June, 1998=100, 6-month average)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A004

Source: NSO.

C. How then to Meet these New Challenges? A Strategy for Revitalizing the SME Sector

10. Looking ahead, a healthy and innovative SME sector will be crucial for accelerating Korea’s shift to a more knowledge-based service-oriented economy and sustaining rapid growth. The Korean economy has evolved from producing basic manufacturing goods to advanced technology products. To remain competitive in an increasingly globalized world, Korea will need to rely more upon a flexible and dynamic SME sector as source of innovation and change for the economy. Moreover, according to OECD data, with labor productivity in the service sector roughly one-half that of the manufacturing, the key for sustaining rapid growth over the medium-term is to restructure and enhance the competitiveness of the service sector. Boosting the productivity of SMEs which account for nearly 85 percent of service firms and employ 68 percent of service jobs will then be crucial.

11. How then can SMEs adapt to meet these new challenges? In order to help SMEs be a source of innovation and lead the transition to a more service-oriented knowledge-based economy, a three-pronged strategy for revitalizing the sector is needed.

  • First, the incentives for restructuring will need to be strengthened. By exiting nonviable firms and rehabilitating distressed but viable ones, SME restructuring will help to free up resources for innovate start-ups and new investment. Here, the large public credit guarantee funds (CGFs) could play useful role in creating a market for SME restructuring, just as was successfully done for large companies after the financial crisis. At the same time, further reform of the corporate bankruptcy system, especially aimed at small companies, would help make bankruptcy a more attractive option for restructuring weak SMEs.

  • Second, the financial infrastructure for SMEs will need to be upgraded to expand the sources of financing and better serve the needs of new economy SMEs. This will involve reforming the collateral laws to allow for a wider range of securitization, including for moveable assets such as trade receivables and even intellectual property. The venture capital industry will also need to be strengthened to help identify promising new technologies and guide creditor lending decision. As in other countries, to promote more risk-based lending and perhaps even a junk bond market for low-rated companies, the quality and coverage of positive credit information, such as through SME credit bureaus, will need to be improved. Deregulating the market for commercial credit insurance will also allow banks to better manage the risk of their SME lending and help develop a secondary market for SME loans.

  • Lastly, the environment for the growth of innovative SMEs should be improved. Here, to promote greater entrepreneurship, further reform of the personal bankruptcy system would allow failed entrepreneurs to learn from their mistakes and start new businesses. Further deregulation of the service sector will also create more investment opportunities for SMEs, while greater incentives for FDI will help SMEs to reduce their reliance on supplying domestic chaebols and allow them to link more easily into the global production network.

The remaining sections outline the details behind this strategy.

Strengthening the Incentives for Restructuring

12. Progress in restructuring remains slow. As mentioned earlier, despite Korea’s strong recovery following the crisis, SMEs continue to have high debt levels and low profitability compared to large companies. At the same time, sector suffers from excess capacity, limiting its ability to invest.

uA04fig30

Capacity Utilization Ratio

(Percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A004

13. One reason is that banks face little incentive for restructuring. Given the high degree of collateral-backed loans and the fixed costs of restructuring smaller companies, banks have a strong incentive simply to collect on their guarantees or liquidate the underlying collateral rather than participate in restructuring. By some estimates, some 50 percent of SME loans are secured by real estate, 25 percent by credit guarantee, and a large part of the remaining amount through personal guarantees.44 For distressed but viable firms, banks also face a strong incentive to rollover these credits given the low delinquency rates (2–3 percent) and risk premium. At the same time, the options for restructuring or selling to third parties are limited since the market for restructuring SMEs is largely inactive. Unlike for large companies after the crisis, the market for SME distressed assets has not had a chance to develop.

14. At the same time, SMEs themselves face little incentives to take pro-active measures due to the high costs and risk of bankruptcy. Given the strong tendency for banks to foreclose on collateralized loans, SMEs are reluctant to notify banks of emerging financial problems. Instead, they tend to wait, often until it is too late, hoping for a recovery. This has contributed to a large credibility gap between small companies and their banks. At the same time, the high cost of bankruptcy is a deterrent for SMEs to use bankruptcy for restructuring. Court procedural costs are estimated to be around W15 million ($15,800) which may be too high for troubled small companies to bear.

How then to provide stronger incentives for restructuring?

Gradually scale back the size of public credit guarantees to give a greater role to the market for allocating credit.

15. The rapid expansion of credit guarantees for SMEs after the crisis have held back needed restructuring. Between 1997–2001, SME credit guarantees roughly doubled in size, reaching a peak of nearly 8 percent of GDP, compared to only 1.5 percent of GDP in Taiwan Province of China, 0.2 percent in the United States and 0.6 percent in France (Ministry of Finance and Economy, 2004a). For a typical guarantees extended by the Korea Credit Guarantee Fund (KCGF), 85 percent of the risk of default is borne by the government and only 15 percent by the banks. Given the high degree of coverage, Korean banks tend to direct loans to those SMEs that can secure credit guarantees which are overwhelmingly well-established firms. Although these guarantees are typically given for only one year, they are usually rolled over. Therefore, the bulk of guarantees outstanding are directed towards existing firms, creating a barrier to new entrants.

uA04fig31

SME Credit Guarantees

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A004

Sources: Korea Credit Guarantee Fund, Korea Technology Credit Guarantee Fund, and Regional Credit Guarantee Funds.

16. In recent years, the government has been limiting the growth in public credit guarantees and redirecting them towards start-ups and technology firms. In addition, the government has resisted attempts to expand regional credit guarantee funds. Consequently, public credit guarantees as a share of GDP have fallen steadily from a peak of nearly 8 percent in 2001 to around 5.5 percent in 2005. Reducing further the reliance on public credit guarantees will promote restructuring in three ways. It will encourage banks to address their problem loans through either bankruptcy procedures or private workouts. This will also help strengthen risk management by the banks, forcing them to do their own risk analysis instead of simply relying on public guarantees when lending to SMEs. Reducing credit guarantees to existing firms will also lower the entry barrier for new SMEs, helping to promote restructuring in the sector.

17. In addition, there is a need to reduce further the coverage ratio of public credit guarantees. Lowering the coverage ratio to 60 percent, which is closer to the international average, would encourage banks to monitor more carefully and regularly the health of their SME borrowers. Transferring more risk to the banks would also provide greater incentives for banks to take proactive steps to address problems in their borrowers before they become intractable.

Strengthen the commercial orientation of the CGFs.

18. Enhancing the commercial orientation of the funds would provide stronger incentives for restructuring. To ensure that the CGFs have the proper incentives for restructuring, they could be given a clear mandate to maximize recovery value of their NPLs by whatever means are available. One possibility would be to spin-off their NPL portfolios into a separate AMC with such a mandate. This would also prevent a potential conflict of interest between the credit guarantee side that would prefer to avoid potential losses and the asset management side that is looking to maximize recovery returns. Such an approach has been effectively used by AMCs in other countries, such as Sweden and the United States, in order to clear out the backlog of NPLs following a banking crisis. Another way to strengthen their commercial orientation would be to give credit guarantee funds more flexibility in setting their rates according to risk, essentially charging riskier borrowers a higher rate.45

19. Credit guarantee funds would also need sufficient resources to write off past losses. In order for the credit guarantee funds to face the proper incentives for managing their NPLs, they should have sufficient resources to write off past losses. One potential constraint to selling or restructuring NPLs would be the upfront recognition of unrealized losses. As a result, the fund will have the tendency to hold on to these assets in hope for a miraculous recovery rather than to take early measures to stem further losses.

Give public credit guarantee funds more flexibility to restructure SMEs.

20. CGFs, with their large NPL portfolio, could help jumpstart restructuring by supplying the market with distressed assets. In 2005, KCGF and the Korea Technology Credit Guarantee Fund (KTCGF) had a combined NPL portfolio size of around W7.8 trillion ($8.2 billion). Because of ambiguities in the laws that govern these funds, the CGFs do not actively restructure these assets or sell them to the market. Instead, they mainly collect through foreclosure and liquidation. The estimated recovery rate over the past 3 years for these NPLs is low, at 2.3 percent.

21. One way to boost the recovery rate and create a complementary market for restructuring would be for CGFs to work more with the private sector in managing these NPLs. KAMCO’s experience after the financial crisis is a useful benchmark. By purchasing NPLs from banks and repackaging and selling them to market, KAMCO was able to create a new market for restructuring distressed debt that helped accelerate corporate restructuring. As KAMCO did for large companies, CGFs could help create a new market for SME restructuring by supplying the market with distressed assets from their NPL portfolio. This would imply a shift in the role of CGFs away from simply providing credit guarantees towards becoming more of an investor and promoter of restructuring.

22. To achieve this, the laws governing the CGFs need to be amended to allow the funds to work more with the private sector to restructure distressed SMEs. As done for large companies after the crisis, banks or restructuring funds could join with the CGFs to set up separate asset management companies or corporate restructuring vehicles to manage their SME NPLs. The CGFs could also sell directly to the distressed debt market or through an intermediary such as KAMCO. In order to retain some upside potential, the CGFs could include profit-sharing arrangements when selling the assets to the market.

Develop the distressed debt market for SMEs.

23. One of the key factors behind the success of large corporate restructuring after the financial crisis was the active market for distressed debt. The introduction of private corporate restructuring vehicles, NPL asset management companies, bank workout units, etc. helped to attract needed capital and widen the investor base in creating a competitive market for restructuring. With an active secondary market for corporate loans, banks were better able to lend and manage the risk in corporate lending.

24. As with large corporations, a private market for distressed SME debt could help accelerate restructuring. In some ways, the environment for SME restructuring is more favorable now than during the financial crisis. Banks are now well capitalized and able to absorb the credit costs resulting from restructuring. They also have experience and expertise in restructuring the large firms, which can be applied to solving the problems of smaller companies.46 Finally, compared to large company restructuring where foreign funds played an important role, local equity funds are likely to play a more prominent role in restructuring small companies given the high degree of local knowledge, higher fixed costs, and longer investment horizon that is required.

25. Allowing public credit guarantees to sell more to the market, including possibly through KAMCO, would help to increase the supply of available assets for restructuring. As proposed earlier, CGFs could play an important catalytic role by demonstrating that money can be made from restructuring distressed SMEs and drawing in other players, including commercial banks, to work with the private market. A distressed debt market would also provide valuable information on the pricing of risky assets, allowing banks and other institutions to do more risk-based lending to SMEs (see below).

Make corporate bankruptcy a more attractive option for restructuring viable SMEs and exiting the nonviable ones.

26. In April 2006, the courts began implementing a new unified insolvency law. By combining the three existing bankruptcy procedures for large companies, small companies, and individuals into one, the new insolvency law will help to streamline court procedures and remove some of the uncertainty involved in restructuring. In addition, the introduction of a “debtor-in-possession” system whereby debtors have the right to submit a restructuring plan to creditors and maintain management with creditor approval will encourage debtors to use bankruptcy to reorganize and to take proactive measures when problems emerge.

27. Further reforms could help make corporate bankruptcy a more attractive and effective instrument for restructuring for smaller companies. Because of the high fixed costs, corporate bankruptcy in Korea has typically been used for large companies while liquidation and to a lesser extent composition was for smaller companies. Improving the bankruptcy system for smaller companies would provide a valuable tool for court-led restructuring and help sharpen the incentives for out-of-court workouts. Such reforms could include: introducing an automatic stay on assets; reducing some of the legal uncertainties on debtor’s rights to submit a restructuring plan by removing the requirement of prior court approval, and streamlining further bankruptcy procedures for smaller companies.

  • Introducing an “automatic stay” would encourage distressed companies to use the court system for restructuring. An automatic stay is a provision where the debtor, upon filing for bankruptcy, is given temporary protection from creditor action, such as foreclosure or lawsuits, subject to oversight of a bankruptcy judge. In the United States, for example, this temporary protection from lawsuits or immediate foreclosure provides a powerful reason to file for bankruptcy and allows for a more orderly resolution of a company’s problem within the court system. It provides a “cooling off” period during which the debtor can submit a restructuring plan to the court. Although this would temporarily block creditor action, creditors would still retain the right to be paid out from court liquidation and have final approval of restructuring plan.

  • At the same time, removing the requirement for prior court approval for submitting a restructuring plan would help reduce uncertainty in filing for bankruptcy. Making automatic the right of the bankrupt debtor to be the first to propose a restructuring plan would provide a strong incentive for management to use the court system before their problems become intractable. Although removing the requirement for prior court approval and introducing an automatic stay in the bankruptcy system may conflict with the Korean criminal code (so-called “boo-do” provision which treats loan defaults as a criminal matter), the commercial and the criminal side of corporate bankruptcy could be treated separately in order to improve the efficiency of the workout process.47

  • Court procedures and costs for small companies could also be further streamlined. Court procedural costs are estimated to be around W15 million ($14,500) which may prohibitively high for troubled small companies. Reducing these costs and streamlining procedures for companies of below a certain asset size would help make bankruptcy a more viable commercial option for restructuring.

Modernizing the Financing System for SMEs

28. Upgrading the financing infrastructure for SMEs would help accelerate the transition to a more service-oriented economy. The financing system for SMEs is not well suited to support the creation of innovative knowledge-based firms. Because banks rely excessively on real estate or credit guarantees to lend to SMEs, start-ups with little or no fixed assets have difficulty in accessing financing and growing. Although this system may have been well suited for manufacturing SMEs, it is a constraint for service-oriented and knowledge-based companies that have few fixed assets.

29. To do this, SME financing will need to shift away from relying upon real estate and guarantee collateral to one that focuses more on measuring and pricing risk. Expanding risk-based lending would improve SME’s access to financing and provide a new source of business for banks. Developing new risk-based instruments, such as credit insurance and venture capital, would help to support innovative start-ups and allow them to grow and mature more quickly. It would also contribute to the overall stability of the financial system by diversifying the risk of SME lending across a wider market (and away from the government). The keys to having such a system in Korea are to improve the provision of credit information, reform the collateral laws, deregulate commercial credit insurance, and develop a secondary market for SME loans.

30. In addition, the venture capital industry in Korea could be further strengthened to help identify and support promising start-ups with new technologies. Start-ups currently rely too much on bank lending as opposed to equity to finance their initial investment, leaving them more vulnerable to financial risk. The shortage of longerterm and risk-based financing is perhaps one reason why according to some studies, SMEs in Korea tend to remain small by international standards. For example, the average size of manufacturing firms in Korea is smaller than in other countries, such as the United States and Japan.

uA04fig32

Manufacturing Value Added per business 1

(In millions of US Dollars)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A004

Sources: OECD Structural and Demographic Business Statistics, WDI (2006), and White paper of Taiwanes SMEs.1/ Number of establishments.
Reform the collateral laws to allow for a wider range of securitization

31. As in other countries, the collateral laws in Korea could be reformed to support the securitization of moveable assets. Because the Civil Code in Korea is very clear on the treatment of real estate as a fixed asset and because the market for real estate is liquid and deep, banks have a strong preference for real estate as collateral. In fact, because of the clear legal treatment and comprehensive coverage of real estate claims, title insurance, unlike in the United States, is not widely used in Korea. In contrast, because the law does not specifically address the issue of non-real estate assets or “movable” assets, such as future cash flow, inventory, or intellectual property, banks face some legal uncertainties and therefore additional costs in securing and enforcing collection of these moveable assets. Although some banks reportedly do use moveable assets for security, the amounts are small and the risk premiums are high. Clarifying the treatment of these alternative assets under the collateral law would enable SMEs with non-fixed assets to pledge these assets more easily when borrowing.

32. Other countries have reformed their collateral laws with good success. For example, Slovakia, as part of their collateral law reform in 2002, allowed debtors to pledge any asset, right or property interest, including future cash flow, when securing a loan. Following the reform, more than 70 percent of all new business credit was secured by movable assets and receivables (Bollardt, 2003, and World Bank, 2005b). In 2004–05, a wide range of countries, including Brazil, Croatia, India, and Japan, have also undertaken reforms that made it easier to create and enforce collateral contracts.

33. The first step would be to introduce a “universal security interest” in the Civil Code that covers all types of assets and debts. A universal security interest would allow a business to pledge all types of assets, fixed and movable assets, present and future cash flow, even copyrights and patents in order to secure a loan. It is a common feature of collateral laws in other countries, including the United States (Section 9 of the Uniform Commercial Code), the EU, and several CIS countries. Introducing a universal security interest in the Korean Civil Code would help elevate the treatment of moveable assets to the same legal status as real estate, both within and outside the bankruptcy courts. Since in Korea, this may imply a radical change in the treatment of moveable assets, consideration could be given to introduce a special clause in the Civil Code as an intermediate step that specifies which moveable assets are permissible, such as trade receivables, contracts, etc.

34. The next step would be to introduce an electronic registration system for all types of collateral, including for moveable assets. Changing the Civil Code may not be enough to allow banks to secure easily a wider range of moveable assets. Creditors and debtors will also need to be able to cheaply and easily register new claims and verify ownership of existing collateral. As in other countries, one simple way would be to introduce a centralized electronic system for all types of collateral. According to the World Bank, collateral registries work best when they cover all types of assets across the entire country.48 This avoids confusion and additional costs arising over different systems and different treatment of collateral. If the system can be unified across the country and cover all types of assets, creditors and borrowers can easily and cheaply access information on liens and security interests to verify a contract and enforce their collateral rights.49 To make access easy and inexpensive, the registry could be accessed electronically over the internet.

35. In Korea, such a system already exists for real estate and could simply be extended to include moveable assets identified under the Civil Code. Currently, owners of real estate register their claims with their local county (so-called “gun”) offices where anyone can for a nominal fee verify ownership of the property. As a result, it is relatively easy and inexpensive to verify who owns what property in Korea. Extending this system to include other moveable assets identified in the Civil Code would complement the proposed legal reform by allowing for cheap and easy verification of all collateral contracts, including for moveable assets.

36. At the same time, permitting out-of-court collateral enforcement would help minimize the cost of legal procedures and strengthen creditor collection. In addition to collateral registration, it would be important to make it easy and inexpensive for creditors to collect on their collateral, preferably without direct court involvement. This would help lower the burden on the corporate bankruptcy system and reduce the cost and uncertainty involved in collection.50 In Korea, this would require introducing in the Civil Code what is known as a “possessory right” or “self-help” featured in common law systems which allows a secured creditor to collect collateral on their own without court involvement, e.g., repossessing an automobile used to secure a loan. Since this may not be possible under the current civil law system in Korea, an intermediate step would be to amend the Civil Code to extend the same collection treatment for real estate to moveable assets. For example, local county offices could be given the same authority as for real estate to quickly approve the collection of moveable assets registered in their systems.

Create a market for pricing and insuring SME credit risk

37. The lack of adequate credit information is a major obstacle to pricing and insuring SME credit risk. Because of the lack of timely and accurate information on SME financial health, banks are forced to rely on collateral and short maturities to manage their SME lending risk. Although a SME credit bureau (CB) was introduced in May 2005, positive credit information on SMEs is still not widely shared. The lack of timely information has held back the development of credit scoring models for SMEs that would allow banks to do more risk-based as opposed to collateral-based lending. Research has shown that payment history and trade credit data is a much better predictor of default risk than simple financial statement data (Petersen and Rajan, 1997).

38. One constraint is the privacy laws that limit the wide sharing of credit information. Since the credit information law (“Use of Protection of Credit Information Act”) does not distinguish between personal and corporate data, corporate transaction data is treated the same way as personal data in terms of consumer protection and privacy rights. As a result, companies in Korea are reluctant to share payment information with SME credit bureaus because of the potential legal risk in providing potentially damaging information on other firms, such as on late payments or defaults.

39. One solution would be to simply exclude corporate data from the coverage under the Credit Information Act. This is in line with the privacy laws in other countries, such as the U.S. Fair Credit Reporting Act, which covers only personal, not corporate data. Excluding corporate data from the credit information law would then allow SME CBs to freely collect positive credit information, such as on payment transactions, and share them with other financial institutions. Looking ahead, SME CBs could also develop into becoming information providers under Basel II (so-called ECAI—“external credit assessment institutions”) which would help support banks’ own internal ratings model for assessing credit risk.

40. However, since data privacy concerns have affected other areas, more fundamental reforms may be considered. In Korea, since the multiple laws governing credit information are sector-specific, they tent to limit the sharing of positive information.51 Moreover, each law is governed by different ministries and agencies, creating the risk of regulatory overlap and conflict. As in other countries, one possible approach would be to create a comprehensive credit reporting law that covers all credit data and providers and strikes the right balance between privacy protection and the data needs of financial institutions to manage credit risk.52 In addition, since in Korea a close link exists between personal and SME credit information, expanding access to personal databases managed by public agencies, such as the tax authorities, public utilities, and health insurance, with appropriate safeguards would help to improve the timeliness and coverage of credit information.

41. Developing a market for SME credit risk insurance could also help expand SME’s access to financing. Commercial credit insurance, unlike a credit guarantee which is purchased by a bank, provides insurance to companies against default on trade receivables. As in other countries, commercial credit insurance could help to bridge the gap between riskaverse banks and their more risky smaller borrowers and help spread the risk of SME lending across a wider range of investors.53 Here, SMEs themselves would purchase credit insurance from a private insurer against the risk of default by a buyer. With this insurance against nonpayment, SMEs could then more easily apply for a bank loan. Credit insurers could then play a more important role the market, closely following the credit situation for small firms and setting a market price for SME credit risk (Kang and Yoon, 2003).

42. However, in Korea, the market for commercial credit insurance is fragmented, underdeveloped, and small. Part of the reason is that the market is split among three government agencies each of whom is granted a monopoly position.54 Because the market is fragmented and closed to new entrants, its size has remained small and the range of products is limited. For example, the outstanding amount of credit insurance issued by KCGF and SGIC in 2005 amounted to around W1.8 trillion and W5 billion respectively. Both institutions have recorded high loss rates, reflecting the risky nature of the business. Because of the limited availability of credit insurance, SMEs face difficulties in transferring default risk other than to the government while banks are unable to hedge credit risk without using real-estate or public guarantees as collateral.

43. Deregulating the commercial credit insurance market would help expand the market and introduce new risk-based products for SMEs. Opening up the commercial credit insurance market to banks, non-life insurers, SME credit bureaus, and even multinational credit insurers would allow for a wider of credit insurance products for SMEs. Banks could then lend more based on these private insurance products. Since the public credit agencies already have a dominant position in the market, consideration could be given to privatizing their commercial credit insurance business, starting with the SGIC.55 One criticism of this idea is that it would undermine the profitability of the credit guarantee funds and delay the repayment of public funds received after the financial crisis. However, since the funds are already experiencing losses from their credit insurance (not guarantee) business, deregulating the market may actually improve their profit margins by expanding the market and creating new demand for credit insurance products. This could eventually lead to the development of other instruments for risk-based lending, such as collateral loan obligations (CLOs) or even a junk bond market, which would depend very much on credit information and pricing.

44. Over the longer-term, developing a secondary market for SME credit would help to improve risk-pricing as well as expand financing options for creditors. Currently, Korea lacks an active market for SME loans and low-rated bonds, making it difficult for banks to price the risk of SMEs and restricting the liquidity of SME loans. Having a liquid secondary market for SME loans would not only make it easier for banks to manage their SME portfolio but also provide a market price for assessing SME risk. Banks would be more willing to extend unsecured credit to SMEs if they can sell the asset in the secondary market. A real-time market price for SME loans could also provide early warning signals of a problem and encourage banks to take proactive steps to address the situation. One way would be to create a standardized scoring system for SME credit risk that would could help banks to package their SME loans as asset backed securities (ABS) or as collateralized bond obligations (CBOs) and issue them in the secondary market. This could eventually lead to the development of other instruments for risk-based lending, such as collateralized loan obligations (CLOs) or even a junk bond market. However, developing this new market would also depend upon having adequate credit information and insurance mechanisms in place to price this risk.

Strengthen SME credit risk management

45. Because of the higher cost of gathering credit information for small companies, the supervisors apply a different standard for loan classification and provisioning for SMEs compared to large companies. In Korea, banks are required to apply so-called “forward-looking criteria” (FLC) only for loans greater than W500 million, covering about 20 percent of total SME loans. For the remaining 80 percent, banks rely on their own internal credit scoring system for classifying and provisioning. However, this lower standard for evaluating SME loans has limited the incentives for banks to upgrade their credit risk management.

46. Expanding the coverage of forward-looking criteria (FLC) to include more SMEs would encourage banks to examine more their borrowing capacity.56 To ensure more timely and accurate provisioning and loan classification, the supervisor could consider gradually lowering the loan size threshold for FLC to cover more SME loans. By encouraging banks to focus more on cash flow rather than on collateral, banks would then be able to better differentiate between borrowers and allocate more credit to promising firms. Tightening the loan standards would also raise the demand for better quality and more timely credit information from SME credit bureaus and from SMEs themselves. This would also help to address the credibility gap that exists between SMEs and their creditors on the transparency of their financial reporting.57 Although the direct cost for SMEs of providing better data would be higher, it could be offset partially by the savings from better risk pricing and lower borrowing rates.58

Develop further the venture capital industry

47. As in other advanced countries, an active venture capital (VC) industry can support the creation and growth of innovative start-ups. Venture capital can also play an important complementary role to bank lending by helping banks to identify promising new technologies and providing a source of equity financing. For SMEs themselves, venture capital firms can also provide useful management advice to start-ups and help manage their development to maturity.

48. The venture capital industry in Korea is held back by the small long-term institutional investor base. In Korea, the government is the largest investor in the venture capital industry (31 percent). Since the budget for VC investment is reviewed annually, VC firms face some uncertainty in their funding—a problem given the long time needed to bring a company to maturation. This is in stark contrast to the United States where pension funds with their long investment horizon account for 42 percent of VC investment, followed by financial firms and insurers (23 percent).59

uA04fig33

Limited Partners of VC Funds by Type

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A004

Source: KVCA and NVCA Yearbook 2004.1/ Equivalent to general partner contribution to VC funds.

49. A related problem is that average maturity (investment period) for VC funds is too short compared with the time needed for SMEs to mature. The average tenure of VC funds in Korea is around 5 years compared to 10 years in the United States. However, the average time it takes for a start-up to an IPO is around 9 years in Korea. As a result, many start-ups fail to receive sufficient funding over the course of their development to grow in size and graduate.

50. Given their large size and long-term perspective, the public pension funds in Korea could play an important role in developing further the VC industry. For example, the National Pension Fund (NPF) of Korea in 2006 with assets of around W192 trillion invests only 11.3 percent of its portfolio in equity and only 1.4 percent in alternative assets, such as venture capital, private equity, and real estate. Consequently, there is room for expanding the NPF’s allocation for VC with appropriate safeguards. CALPERS, for example, one of the largest public pension funds in the world, invests around 41 percent of its portfolio in equity and about 7 percent in private equity or venture capital. Pension fund investment could also help catalyze other private flows into the venture industry and reduce VC’s current reliance on government budget support which can be distortionary and undermine the markets’ pricing of VC risk.

51. For the public pension funds to invest more in VCs, some organizational changes would be needed. Given the different expertise required, the framework for evaluating VC investment should be separate from other investments, such as in fixed income and equity. One way would be to set up a separate investment sub-committee in the NPF for reviewing investments in alternative assets, such as VC. The sub-committee could also be given a longer-time horizon for evaluating VC investment performance. Currently, investment managers are given only a three-year time horizon and during that period face numerous audits and reviews that limit their incentives to accept long-term risk. Setting a time horizon of around five years would help to realize more of the full gains from VC investment.

52. More foreign investment in the venture industry would help develop the industry and attract more domestic capital. Foreign venture capital accounts for only 5.5 percent of VC financing, compared to 40 percent for all of Asia (Asian Venture Capital Journal). Some obstacles to foreign investment include the lack of tax haven benefits compared to other countries and the legal uncertainties surrounding limited partnership structures.60 To attract more foreign investment, one possibility would be to allow for tax incentives for off-shore funds to invest in Korea VC funds and for joint ventures with foreign VC firms. Greater foreign capital in the VC industry would not only provide an additional source of private capital, but also allow Korean venture firms to work with international VC firms to expand globally.

53. Relaxing the restrictions on M&A for SMEs would also help venture firms to graduate and grow. An active M&A market provides an important channel for start-ups to grow and mature. However in Korea, M&A accounts for only 9 percent of SME exit compared to 78 percent in the United States (KVCA). The M&A market in Korea is largely dominated by the chaebol, making it difficult for smaller companies to grow. Reducing some of the regulations on the use of stock swaps in M&As, such as by allowing companies to use treasury stocks, would help to facilitate M&A activity. To address the problem of fraud in corporate disclosure for small company mergers, the punishments for false disclosure could be raised to discourage such behavior.

Improving the Environment for Innovative SMEs

54. Fostering the development of innovative start-ups will be key for Korea to make the transition to a knowledge-based, service-oriented economy. To do so, the incentives for entrepreneurship will need to be strengthened, and the orientation of SMEs will need to be redirected to take advantage of the rapid pace of globalization.

“Decriminalize” personal bankruptcy to encourage more entrepreneurship

55. Research has shown a link between personal bankruptcy systems and the level of entrepreneurship for small companies. Because often the liabilities of small businesses are the personal liabilities of the owners, personal bankruptcy also functions as a system for small nonincorporated businesses. Tougher bankruptcy provisions, such as a lower coverage for exempted personal assets, may deter entrepreneurship by raising the cost of bankruptcy to the debtor. Although tougher bankruptcy provisions may better protect the creditor and lower the interest rate for safe borrowers, it may also reduce the supply of credit for riskier borrowers who are looking to start a business. On the other hand, making it easier to declare bankruptcy may reduce the overall available supply of credit and raise borrowing rates by increasing the risk to the creditor for a given level of interest rates. Research for U.S. states has shown that higher bankruptcy exemptions result in a higher probability of families owning and starting a business. In the United States, entrepreneurs who declare bankruptcy under Chapter 7 must give up all their assets, but all future earnings and those assets that are protected under the code, such as personal housing, are exempted. This partial wealth insurance provides a strong incentive for entrepreneurial activity and is known as the “fresh start” in bankruptcy (see Fan and White, 2003, and for a summary of the literature, see “Economic Focus: Life After Debt,” The Economist, 2005).

56. In Korea, the strict personal bankruptcy law limits entrepreneurial activity. Personal bankruptcy in Korea is very harsh on debtors, making it difficult for them to find jobs or start new businesses. For example, there are over 100 provisions in various laws discriminating against bankrupt persons. In some cases, bankrupt individuals have to give up their professional licenses and are unable to open a bank account; if they work for a public financial institutions, they must leave their job. This makes restarting a business or seeking new employment after bankruptcy very difficult. These tough bankruptcy provisions also produce perverse incentives for owners when their businesses suffer and their personal assets and future livelihood are at risk. Because of the high cost of bankruptcy, failed owners or those with personal guarantees may face strong pressure to cheat when businesses sour.

57. Since many SMEs will inevitably fail, especially in the risky high-tech sector, “decriminalizing” bankruptcy will help give failed entrepreneurs an important chance to learn from their mistakes and start new businesses. This is particularly important for the high-tech sector, where nine out of ten firms typically fail. To give entrepreneurs in Korea a better chance to “restart” even after bankruptcy, employment and credit restrictions on defaulters could be eased. For example, the range of exempted assets could be widened, and the process of discharge after completing their bankruptcy plans could be accelerated. Moral hazard is always a risk when easing bankruptcy restrictions, but this could be contained more effectively by prosecuting harshly businesspeople who loot their company under the Criminal Code, not the Commercial Code.

More inward FDI to help SMEs globalize and upgrade their technologies

58. By international standards, FDI inflows to Korea remain low. FDI in 2005 amounted to around 8 percent of GDP, compared to the OECD average of 14 percent. According to UNCTAD, Korea ranks 109 out of 140 countries in terms of inward FDI performance, but 20 out of 140 in terms of inward FDI potential. Some reasons cited for the low level of FDI include: labor market rigidities that have raised the cost of risk investment, high wages relative to the rest of the region, and complicated administrative procedures, and higher barrier to foreign ownership of domestic assets relative to the OECD average (see OECD, 2006).

59. Greater inward FDI could help Korean SMEs become “more global” and compete better with overseas supplies. As the chaebols expand overseas to take advantage of cheaper labor and to be closer to their final markets, they are relying less on domestic SMEs and are looking more to overseas suppliers to meet their production needs.

60. Encouraging more inward FDI by multinational companies would help SMEs in Korea to expand and diversify their supply dependence as well as to strengthen their relations with the domestic chaebol. More foreign investment would also allow SMEs to link more with rapidly expanding global production network and provide important benefits from the transfer of advanced technology.61 For this reason, the proposed FTA with the United States may be especially helpful to SME suppliers as it holds out the promise of more U.S. foreign investment in Korea.

D. Conclusion

61. As the Korean economy is evolving from basic manufacturing into an advanced technology, service-oriented economy, a dynamic and flexible SME sector will play an increasingly important role as a source of innovation and change. At the same time, underlying structural weaknesses, the rapid pace of globalization, and increasing competition from China have intensified pressures on the SME sector. The keys for meeting these new challenges and revitalizing the SME sector would be to strengthen the incentives for restructuring, upgrade the financing system for SMEs, and improve the environment for innovative small companies.

References

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41

Prepared by Kenneth Kang and Song-Yi Kim.

42

Here, we follow the Korean National Statistics Office (KNSO)’s definition of a SMEs as a company with 300 or fewer employees.

43

FDI in Korea amounted to around 8 percent of GDP in 2005, well below the OECD average of 14 percent.

44

For all loans (household and corporate) in Korea, the share of loans backed by real estate and credit guarantees is estimated to be around 59 percent. In the United States, the share of corporate loans secured by collateral is 38 percent. In Japan, the share of loans secured by real estate or third-party guarantee is 63 percent (FSS of Korea, Bank of Japan, and U.S. Federal Reserve Board).

45

Another possibility would be to allow CGFs more flexibility in setting their fees to support promising but cash-poor SMEs. For example, instead of receiving a payment fee, CGFs could accept in return an option on future profits or limited equity in exchange for guarantee. See Kang (2006).

46

Some domestic banks have already established SME workout units along these lines but the number of companies under workouts remains low.

47

For example, in the event of a loan default, the debtor would be subject to the criminal code only when he or she is found to have committed a criminal act.

48

Although most countries have some type of registry, usually over fixed assets such as real estate or vessels, only 30 countries, including Canada, New Zealand, Spain, and the United Kingdom, have registries that allow registration across all types of assets (see World Bank, 2005b).

49

As an example, in Canada, the Netherlands, New Zealand, the United Kingdom, and the United States, the fees, taxes, stamp duties are very small, and registration takes only one or two days (see World Bank, 2005b).

50

According to the World Bank, more than three-quarters of collateral enforcement takes place outside of bankruptcy. For example, in Australia, the creditor would appoint a receiver to serve notice to the borrower and then seize and sell the underlying assets. As long as the debtor cooperates, the courts are not involved and enforcement is typically completed within 10 days. In Spain in 2000, after allowing debtors and creditors to enforce collateral outside the courts, Spain was able to reduce the time for enforcing collateral from more than one year to three months (see World Bank, 2005b).

51

They include: the Protection of Communications Secrets Act (1993); the Telecommunications Business Act (1991); the Medical Service Act (1973); the Real Name Financial Trade and Secrecy Act; the Use and Protection of Credit Information Act (1995); the Framework Act on Electronic Commerce (1999); and the Digital Signatures Act (1999).

53

Although export credit insurance is more widely used, credit insurance for smaller domestic firms is used as a way of expanding SME’s access to bank financing.

54

They include: KCGF which provides credit insurance to SMEs with an annual turnover of below W15 billion; Seoul Guarantee Insurance Corporation (SGIC) which covers companies with a turnover above W15 billion, while the Korea Export Insurance Corporation (KEIC) provides insurance for exporters.

55

One model might be to follow the example of Coface, one of the top-3 companies worldwide in receivable management and credit insurance. Coface began as a French state-owned enterprise and was fully privatized in 1994. In addition to credit insurance, it also provides credit information to facilitate business-to-business trade.

56

In particular, expanding FLC to cover SME loans issued by nonbanking institutions, such as mutual savings banks (MSBs), would help to bring their loan classification and provisioning in line with commercial banks and limit the risk of regulatory arbitrage across different sectors.

57

For example, according to a MOFE survey of SMEs and creditors, 71 percent of SMEs responded that their accounting is highly transparent, compared to only 3.9 percent by financial institutions (see Ministry of Finance and Economy, 2004b).

58

Another possibility would be to lower the minimum asset threshold requiring companies to file audited financial statements to below the current level of W7 billion or by requiring external audits of loans above a certain size. Although SMEs would incur higher costs, the direct cost might be offset by the benefits from a lower borrowing charge and wider access to financing. Further simplification or standardization of financial statements could also help reduce this cost.

59

Korea Venture Capital Association (KVCA).

60

According to KVCA, because foreign VC funds are required to be domiciled in Korea, they are unable to take advantage of various tax treaties as commonly done in other countries.

61

See Kim, Joo Hoon (2005) for ways to upgrade the innovation capability of small firms in Korea.

Republic of Korea: Selected Issues
Author: International Monetary Fund