Republic of Korea: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
13 Feb 2018
eISBN:
9781484341636
Language:
English
Keywords:
ISCR; CR; firm; debt; wage; household debt; chaebol; firm valuation; chaebols face; chaebols affiliated companies; chaebols group; firms' investment; Currencies; Financial statements; Global; chaebols excl.
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Selected Issues

Abstract

Selected Issues

Recent Trends in Financial Performance and Investment of Korea’s Largest Companies1

A. Introduction

1. One distinctive feature of Korea’s corporate landscape is the prominence of conglomerate groups called chaebols. The denomination “chaebol” typically refers to a group of formally independent firms under the single common administrative and financial control of one dominant family. The many affiliated firms generally operate in a diverse number of industries and are often interlocked by circular shareholdings among them.

2. The origin of Korean Chaebols goes back to the 1950s when a few private companies arose out of the business opportunities surrounding U.S. foreign aid allocation (Lee, Kim and Lee, 2010). Over time, these business groups diversified into related or unrelated industries that were profitable owing to market demand or government industrial policy. While they used to be tightly owned by founding families, the families’ share become smaller as many became listed companies to raise more funds for growth. At the same time, the shares held by affiliated companies increased. This structure allowed the families to maintain control over the group affiliated firms while financing their growth.

3. Korea’s chaebols have greatly contributed to Korea’s economic success that led to impressive growth rates for decades and rapid increases in per capita income. Some of Korea’s chaebols are among the world’s most recognized companies. However, some have faced significant challenges in recent years due to sluggish global trade and increasing competition from emerging markets, particularly China (Shin, 2017). Corporate vulnerabilities have intensified especially in some of the heavy industrial sectors that underpinned Korea’s past growth.

4. Against this background, this papers review indicators of financial sector performance and balance sheet vulnerabilities of the chaebols, in comparison with a group of other large companies. The analysis is based on firm level data from the Orbis database between 2006 and 2015. It also analyzes the investment behavior of chaebols and other large companies, and estimates its determinants using an econometric model.

B. Data

5. Annual data on firm consolidated balance sheets and profit and loss accounts from 2006 to 2015 are obtained from the Bureau Van Dijk Orbis database for 200 very large Korean companies. These are defined as follows: (1) operating revenues are at least US$ 100 million, (ii) total assets are at least US$ 260 million, (iii) the number of employees is at least 1000, (iv) they are listed on the stock exchange.

6. The categorization of companies into chaebols affiliated is based on the Korea Fair Trade Commission (KFTC) classification. This approach is the same as that adopted in previous studies (e.g., Shin and Park, 1999; Lee, Kim and Lee, 2010). Since 1987, the KFTC has been compiling a list of the top 30 business groups as measured by asset size and has subjected them to special monitoring and restrictions. Even though the categorization criteria somewhat changed over time, the 30 groups are generally perceived as chaebols. In our sample of 196 firms, 98 were identified as chaebols affiliated. Of these, 55 were part of the top four Chaebols (Samsung, Hyundai, LG and SK).2

C. Stylized Facts

7. The average asset size of chaebols affiliated companies is much higher than that other Korean large companies. The size differential is even more prominent for the top four chaebols (Samsung, Hyundai, LG and SK). Indeed, as of 2015, the average size of the 55 affiliated companies of the top four chaebols groups in our sample was nearly double that of other large Korean firms. The average assets of the top four chaebols affiliated companies have also grown faster than other those of other companies in the most recent years, having recorded a growth rate of over 50 percent from 2011 to 2015, compared to less than 40 percent growth rates in the other two firm groups.

A08ufig1

Average Asset Size

(Trillions of KRW)

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.

8. Average profitability—as measured by return on assets—has typically been higher among the affiliates of the top 4 chaebols than in the other conglomerates. Nevertheless, it seems to have declined after the global financial crisis, and since 2013 it appears to be, on average, higher in large companies that are not part of conglomerates. Since 2009 chaebols excluding the top four have recorded the lowest profitability compared to the other firms in the sample. The share of firms with negative returns has increased quite steeply in the group of chaebols excluding the top four since 2010, and was as high as 30 percent in 2015.

A08ufig2

Return on Assets

(Using net income, Percent)

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations
A08ufig3

Share of firms with negative return on assets

(Using net income, Percent)

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.

9. The liquidity ratio—defined as the ratio between current assets and current liabilities—shows polarization between the top four chaebols and other large companies on one hand and chaebols excluding the top four on the other. An indicator of solvency—the ratio between shareholder funds and liabilities— also portrays a similar pattern, with the solvency of the chaebols excluding the top four much lower than that of the other two groups.

A08ufig4

Liquidity Ratio1

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.1 Current assets/current liabilities
A08ufig5

Solvency Ratio1

(Percent)

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.1 Shareholders funds/current and non-current liabilities.

10. Leverage—a measured by debt-to-equity and debt-to-asset ratios— is more elevated in chaebols excluding the top four than in the two other groups of firms. The relatively high leverage of the chaebols excluding the top four does not seem to be relate to the sector they operate in. First of all, all these conglomerates seem to be quite diversified. Moreover, an industry-adjusted debt-to-equity ratio—constructed as the difference between a firm debt-to-equity ratio and the average debt-to-equity ratio of all the firms operating in the same sector—is higher for chaebols excluding the top 4.

A08ufig6

Debt/Assets

(Percent)

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.
A08ufig7

Debt/Equity

(Percent)

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.

11. Reflecting the relatively higher debt levels and lower profitability, the interest cover ratio—the ratio of operating profits to interest paid—is low for chaebols excluding the top four. This indicates that for some of these companies meeting interest payment obligations may be challenging. The relatively weaker balance sheet soundness and profitability of the chaebols excluding the top four is also mirrored in the lower Tobin’s Q, which measures the market valuation of a firm relative to the book value of its assets.

A08ufig8

Interest Cover Ratio1

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.1 Operating profits/interest paid.
A08ufig9

Tobin’s Q1

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.1 Market valuation of the firm/book value of firm assets

12. Which group of firms is spending more on Research and Development (R&D) and investing more? The top four chaebols are spending double as much on R&D (as a share of their operating revenues) than the other companies, while R&D spending is the lowest among chaebols excluding the top four. In all the three groups R&D spending has increased somewhat since 2006. Conversely, investment growth has been on a slight downward trend in the three firm groups. While the investment growth pattern of the three groups of firms seems rather similar, in more recent years, it has been typically weaker in chaebols excluding the top four.

A08ufig10

Industry-Adjusted Debt-to-Equity 1/

(Percent)

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.1/ The industry-adjusted debt-to-equity ratio is constructed as the difference between a firm debt-to-equity ratio and the average debt-to-equity of all the firms operating in the same sector.
A08ufig11

R&D Expenses/Operating Revenue

(Percent)

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.
A08ufig12

Fixed assets growth

(Percent)

Citation: IMF Staff Country Reports 2018, 041; 10.5089/9781484341636.002.A008

Sources: Orbis; IMF staff calculations.

D. Determinants of Investment Growth

13. To better understand what drives investment in the Korean largest companies, an econometric panel model of 200 Korean firms is estimated over the period 2007 to 2015. The specification for the regressions follows the standard neoclassical investment model that relates investment to expectations of future profitability (as proxied by the Tobin’s Q) and cash flow (i.e., liquid assets such as cash, bank accounts money market holdings).3 The model also includes sector dummies and time effects as control variables.

14. The estimated model also tries to assess more specifically whether the determinants of investment differ for chaebols and non-chaebols. Earlier studies have found evidence that the sensitivity of investment to cash flow is low and insignificant for chaebol firms, but high and significant for non-chaebols, which seems to suggest that financing constraints are higher for non-chaebols (e.g., Shin and Park, 1999). Another relevant question is whether high leverage and low profitability or a limited ability to service debt (as proxied by the interest coverage ratio) in the chaebols excluding the top four have a negative impact on investment.

15. Estimation results indicate that expectations of future profitability are an important factor for overall investment behavior of Korea firms, but cash flow is not (Table). Indeed, the estimated coefficient of the Tobin’s Q variable is positive and significant. Conversely, the coefficient of the cash flow (as percent of assets) is not statistically significant (column 1). When the variable leverage (as measured by debt of equity) is added as a regressor, these results are not affected, with leverage having a significant and negative coefficient (column 2). These results seem to suggest that Korean firms’ investment is driven by growth opportunities and not constrained by cash flows, but negatively impacted by leverage. Other variables, such as profitability and the interest coverage ratio are found not to have significant estimated coefficients. The dummy for the sector in which firms operate is found to be not statistically significant, suggesting that the investment function is similar across sectors.

16. To assess whether the drivers of investment differ across firm groups, the explanatory variables are interacted with dummy variables for the top four chaebols, the other chaebols excluding the top four, and other large companies. The estimation results indicate that the coefficient of Tobin’s Q variable is significant only for chaebols (both the top four and the others), but not for other large companies that are not part of conglomerates. Moreover, the coefficient of the cash flow variable is positive, large and statistically significant for the large companies that are not chaebols, but not for chaebols (column 3). This result holds also when the variable leverage is added as a regressor (column 4). Overall, the estimation results suggest that for chaebols investment is driven by growth opportunities and is insensitive to availability of internal financing. On the other hand, for other large companies that are not part of conglomerates, investment is driven by the availability of funds rather than future growth opportunities perceived by the market. This seems to suggest that firms that are not chaebols face more binding financing constraints, confirming the results in Shin and Park, 1999.

Regression Results

article image
Source: IMF Staff estimates.P-values in parenthesis. Bolded coefficients are significant at least 10 percent.

E. Conclusions

17. Data on firm consolidated balance sheets and profit and loss accounts from 2006 to 2015 point to a polarization between the top four chaebols and the other conglomerates. Indicators of profitability, solvency, liquidity, leverage and market firm valuation are all weaker for the chaebols excluding the top four compared to the top four conglomerates as well as other large firms. A sizable and increasing share of firms with negative returns, elevated leverage and low interest coverage are all sources of vulnerability among the chaebols excluding the top four, suggesting a need for corporate restructuring. While challenging in the short term, corporate restructuring provides benefits in the medium term, including increased investment, capital productivity and employment (Chung and Ratnovski, 2016, Shin, 2017).

18. The econometric evidence from the paper seems to suggest a dichotomy in the investment behavior of Korea’s large firms. It appears that non-chaebols firms are more financial constrained and dependent on internal cash flows to finance investment projects than chaebols, even though they have lower leverage and better growth opportunities—as measured by the Tobin’s Q—than the chaebols excluding the top four. This finding points to a role for policy to make sure that credit and capital markets financing allocation are fair to all firms and based on consistent project evaluation criteria.

References

  • Chung, Jae and Lev Ratnovski, 2016, “Benefits and Costs of Corporate Debt Restructuring: An Estimation for Korea,” IMF Working Paper WP/16/204.

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  • Fazzari, S., G. Hubbard, and B. Petersen, 1988, “Financing Constraints and Corporate Investment,” Brookings Papers on Economic Activity 141-195.

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  • Hayashi, F., 1982, “Tobin’s marginal Q and average Q: a neoclassical interpretation,” Econometrica 50: 215–224.

  • Hubbard, R.G., 1998, “Capital-market imperfections and investment,” Journal of Economic Literature 36:193–225.

  • Joh, Sung Wook, 2003, “Corporate Governance and Firm Profitability: Evidence from Korea before the Economic Crisis”, Journal of Financial Economics 68 pp. 287–322.

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  • Lee, Keun, Ji Youn Kim and Oonkyu Lee, 2010, “Long-term evolution of the firm value and behavior of business groups: Korean chaebols between weak premium, strong discount, and strong premium”, Journal of the Japanese and International Economies 24, pp 410–440.

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  • Shin, Hyun-Han and Young S. Park, 1999, “Financing Constraints and Internal Capital Markets: Evidence from Korean ‘chaebols’, Journal of Corporate Finance 5, pp. 169–191.

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  • Shin, Jongsoon, 2017, “Corporate Restructuring and Its Macro Effects”, IMF Working Paper WP/17/17.

1

Prepared by Edda Zoli.

2

For robustness check, the categorization of firms into chaebols and non -chaebols was also compared with that used in previous studies (e.g., Joh, 2003).

3

Hayashi (1982) suggests that investment should depend only on Tobin’s Q which captures the expectations of future profitability. However, many empirical studies have found that cash flow has also significant effect on investment, even if Tobin’s Q is included as an explanatory variable, which has been interpreted as evidence of financing constraints facing firms (Fazzari, Hubbard, and Petersen 1988).

Same Series

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Cover IMF Staff Country Reports
Republic of Korea: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept
Volume/Issue:
Volume 2018: Issue 041
Publisher:
International Monetary Fund
ISBN:
9781484341636
ISSN:
1934-7685
Pages:
118
DOI:
https://doi.org/10.5089/9781484341636.002

Average Asset Size

(Trillions of KRW)

Return on Assets

(Using net income, Percent)

Share of firms with negative return on assets

(Using net income, Percent)

Liquidity Ratio1

Solvency Ratio1

(Percent)

Debt/Assets

(Percent)

Debt/Equity

(Percent)

Interest Cover Ratio1

Tobin’s Q1

Industry-Adjusted Debt-to-Equity 1/

(Percent)

R&D Expenses/Operating Revenue

(Percent)

Fixed assets growth

(Percent)