History May Not Give Korea Another

History May Not Give Korea Another Chance
by Andy Xie(Morgan Stanley, Economist)

Empires rise and fall; countries prosper and impoverish. Prosperity is never a straight line. Unless people are vigilant and change with the world, hard-won prosperity can be lost for good. The history is full of examples that countries failed to make the right decisions at a critical moment in history and has remained poor and backward for decades.
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The above examples demonstrate two threats to a country's prosperity: technological revolution and new competitors. Unfortunately, Korea is facing both today. Unless Korea takes resolute actions now, its future may not be so bright.

Technological revolution has invalidated chaebol-based development model. This model focuses on resource mobilization and large-scale manufacturing. Unfortunately, the commercial revolution in the United States since mid-1980s has fundamentally changed the source of wealth creation. IT has made outsourcing easy and outsourcing has permanently destroyed pricing power associated with having a large fixed capital.

Where does pricing power lie today? Customer ownership and intellectual properties. Every product must be turned into a service or relationship to be profitable. One-time transaction is not. This is why top American companies are outsourcing manufacturing and back-office functions and focus on understanding and meeting customer needs. Such companies tend to own few real assets and their value is mostly classified as intangibles. Their business model is horizontal rather than vertical. The most valuable companies in the world are of such type today.

Restructuring in China and Japan puts a huge squeeze on Korea's pricing power. Japan is outsourcing to cut product price. This threatens Korea's strategy to offset low quality with low price in automobiles, machinery and consumer electronics. China's restructuring will massively improve the competitiveness of its capital-intensive commodity industries. China has cheaper labor and cheaper capital. Its labor-intensive industries will become even more competitive. If Korea doesn't change, it will become poorer and poorer.

The way out is to focus on service sector. East Asians have long harbored prejudice against the service sector. The thinking is that service is like barbershop, while manufacturing gets your cars. Wouldn't it be crazy to equate making cars with cutting hair? It cannot be more wrong! During an initial phase of industrialization people are poor and don't want to buy services. Better life is associated with saving enough to buy a big-ticket item. As income rises, expenditure increasingly tilts towards services. Believe it or not that Americans spend more on hair than cars. Tourism is by far the largest industry in the world. This is why living standard in a modern economy depends first and foremost on service sector efficiency.

Korea must deregulate the service sector aggressively to promote competition. Only competition leads to efficient businesses that have high valuation. Valuable service businesses symbolize service sector efficiency and, hence, living standard. Competition will guide service businesses towards customer focus and scope-the winning formula in the IT world.

This doesn't mean that Korea should abandon manufacturing completely. However, Korea must specialize and create intellectual properties ('IP'). Manufacturing without IP is for poor countries. Globalization makes cheap capital available to everyone. China has huge domestic savings and its capital is cheaper than Korea's. Manufacturing for its own sake is not in Korea's national interest. This is why so many manufacturing industries destroy value. Finland and Sweden have pioneered the right manufacturing strategy for small economies: specialize. While Korea may have a smaller manufacturing at the end, it will add value and lift living standard.
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However, chaebol model is about more production and not good profit. There is no corporate governance at chaebols. There is a total disconnect between shareholders and asset control. This is a recipe for losing money. The existing model can never raise RoA sufficiently to pay for the current cost of capital. Unless, Korea disbands chaebols and emphasizes corporate governance, it will become a poorer and poorer country.

Korean people love the job security associated with the chaebol mode. But at what cost! When the government bails out merchant banks, banks, and chaebols, you all pay for it. The job security is bought with low real wages, after taking into account of the government liability. Unless Korean people take this cost into account, you will become poor without knowing why. That is sad?

I see a three pronged approach for Korea to move forward. First, chaebols must fulfill their financial obligations or face bankruptcy. The chaebol business units will be sold, even to foreigners. No if's or but's. The economy may weaken somewhat in the short term. But Korean people will be so much better off as a result. Foreign involvement is essential in this process. They bring money to support the economy in the short term. More importantly, foreign presence breaks the collusive businesses among chaebols that harm Korean people's interest.

Second, Korea must pursue massive liberalization in service sector. The main objective is to promote competition, which will force consolidation and create competitive businesses with scale. This paves the way for Korea to have lasting prosperity and cope with shifting landscape in relative competitiveness among Asian countries.

Lastly, Korean government must nurture a creative society for IP production. The key is to create a freethinking environment. The conformist thinking tradition in Korea is not compatible with IP production. Young people, in particular, should be encouraged to think out of the box and develop breath as well as depth in their knowledge.

The time is running out for Korea. China and Japan are on the move. The pressure on Korea will only intensify over time. If Korea cannot deal with its chaebol problem, it may lose valuable time to address the more fundamental question of how Korea wants to position itself in a New Asia. History may not give Korea another chance.