Department of Economics Seoul National University Explaining Performance Change of Chaebols Before and after the Crisis: Technological capabilities vs. Investment Inefficiency Kineung Choo Keun Lee* Keunkwan Ryu and Jungmo Yoon Department of Economics Seoul National University

What New Theoretical Perspective? Existing Theory: Environment->BG “BG emerges to fill the gap of institutional voids” Look at failures in various markets, product, labor and financial markets. Prediction: maturing of markets ->BG disappear: Wrong Prediction cf) post-crisis chaebol in Korea Why wrong prediction: b/c don’t look at various capabilities of BG and their evolution over time. This paper: BG -> Environment or, what are the real capabilities of BG? Are they fixed or changing over the course of their development?

A New Theoretical Perspective Capabilities of the Forerunning MNCs from the West: Innovation, Marketing, or Brands BGs from the EE have none of them in the beginning. So, less costly to diversify whenever profitable opportunities are present (cf: with specific or specialized capa. more costly to diversify: Maksimovic & Phillips (JF, 2002) -> new definition of BG = firms with less variations in across-sector productivity (capabilities)

View 1: Finance(agency cost)-based View Chaebols’ CMS (controlling minority structure) offers incentive for excessive investment arising from the so called agency problem -> We would like to study whether the Korean Chaebol firms have corrected themselves from investment inefficiency during and after the 1997 Asian crisis period whereas they were subject to serious investment inefficiency before the crisis

View 2 (Resource-based view) Importance of technological capabilities such as patent applications might have increased over time as the economy have become more mature and open. ->We also would like to study whether the Chaebol firms have technological advantages, and whether such advantages explain the long term change in productive efficiency. We proxy technological capabilities by patent applications by each firm.

Distinctive features of this study As performance measure, use productive efficiency instead of financial efficiency measures such as profitability or firm value. 2) Use longer-term data to examine long-term performance of Chaebols

Distinctive features of this study 3) To explain changes in performance, focus on internal causes such as investment inefficiency and technological capabilities rather than on external market institutions. 4) To check robustness of results, adopt several alternative definitions of business group.

Econometric Methodology Stochastic frontier production function (Aigner et al. 1977; Bauer 1990). In Y i t = 0 + L ln L i t + K ln K i t + v i t - u I i = 1 ... N , t = 1 ... T. v i t represents a pure statistical noise in production, ui represents technical inefficiency of firm I (capturing the gap between the frontier and the actual production)

Data KIS (Korea Information Service) data for listed companies (three balanced panels) Time periods to look at: Before the crisis 1) 1985-1989 2) 1990-97 After the crisis 3) 2000-03

3 Alternative Chaebol definitions 1) Top 30 business groups in terms of asset size 2) Among the top 30 business groups, select only those satisfying (affiliates’ share)/(owner’s share) > 0.7 => termed, CMS 1 3) owner’ share < 20% => CMS 2

Circular/Pyramidal Shareholding of SK Group Sheraton Grand Walkerhill Controlling Family 12.55 55.00 55.41 SK Global SKC SK Telecom SK Engineering& Construction 9.68 10.5 30.00 2.37 47.66 38.68 40.67 2.46 4.53 19.81 2.26 16.23 4.04 8.63 3.55 6.2 7.50 SKC&C SK Corp. SK Chemicals

<Table 1> Three Definitions of Chaebols: Share Composition and the Number of Affiliates

<Table 1> (Continued) Notes : 1) Above figures are as of 1989 2) Data for LG is unavailable, so relevant data have been obtained from Jeong & Yang (1992)

<Table 2> Size of the Sample Firms Notes: 1) Data covers 497 sample firms for 1985-1989, 492 firms for 1990-1997 and 502 firms 2000-2003 2) Figures in this table are not comparable to those in Table 1. This table only covers the listed firms which are actually used in our regression analysis.

<Table 3> Production Frontier Functions Estimation for the Three sub-periods Note: Industry dummies are used, but their coefficient estimates are not reported here.

<Table 3> (Continued)

<Table 4> Efficiency comparison (CMS 1 Chaebols) 1. The t-values are obtained using White’s formula. 2. Positive value of “difference” means that chaebols are less efficient than non-chaebol firms

Interpretation of the Results Chaebol firms turn out to be significantly less efficient than non-Chaebols in the 1980s, marginally less efficient than non-chaebols (90-97), and become more efficient than non-chaebol firms after the 1997 Asian economic crisis.

Interpretation of the Results When we divide the Chabol firms into more productive ones and less productive ones: (1) Superior Chaebol firms have been more efficient than non-chaebol firms throughout the sample period. (2) Inferior Chaebol firms were less efficient than non-Chabol firms during the two pre-crisis periods (3) Even the inferior Chaebol firms have become more efficient than the non-Chaebol ones after the 1997 economic crisis.

2 Causes for the Changes: Chaebol vs. non-Chaebol (1) over-investment: use residual from the investment function in the determinants of productive inefficiency equation -> bootstrapping estimation and Hausman-Taylor (2) technological capabilities: patent counts and diversification

<Table5> Chaebol vs. non-Chaebol: over-investment, patents, etc

<Table 6> Estimation results of investment equations

<Table 7> Determinants of Firms’ Inefficiency (Chaebol Firm definition=CMS1)

<Table 7> (Continued)

Determinants of Productive Efficiency 1 Over-investment tendency was stronger among the Chaebol firms during the first two periods, whereas it became weaker after the 1997 crisis. ->smaller investment inefficiency among the Chaebol firms explains the higher productive efficiency of the Chaebol firms after the crisis.

Determinants of Productive Efficiency 2 “Technological capabilities measured by Patent applications and/or technological diversification,” were not significant for the pre-crisis period but became more significant after the 1997 economic crisis. ->Higher technological capabilities contribute to higher productive efficiency in the post-crisis period.

Summary and Conclusion Korean Chaebols in the 1990s suffered from productive inefficiency arising from inefficient investment drives. Failure of many Chaebols before and during the crisis period implies that only those Chaebols that have succeed in curtailing investment inefficiency and building new technological capabilities have survived the crisis.

Implications 1: Law of decline: right and wrong Results in this paper suggest a need to restate the thesis of institutional or market imperfection in predicting performance of business groups: While market institutions must have affected the performance of all the business group firms, some survived the environmental challenges while others not. No general “law” of long term decline of business groups.

Implications 2: No more naïve comparison: we want to be the last paper doing this. * superior Chaebol firms have always been more efficient than the non-Chaebol firms throughout the whole periods, and that whereas the inferior Chaebol firms were less efficient than the non-Chabols during the two pre-crisis periods, even they have become more efficient than the non-Chaebols after the crisis. * Naiveness of comparing the “average” performance of group-affiliated and independent firms, when each business group has always been comprised of and been somewhat centrally managing both good and bad affiliates, simultaneously. -> The “average” conceals the inherent heterogeneity among affiliates.

all resources available many resources lacking Advanced Countries (High capa. Firms) Developing Countries (Low capa. Firms) all resources available many resources lacking optimization of resource uses development of resources profit maximized for distribution (dividends) Growth maximized with profits (re-investment) R&D capital, Brand capital, managerial capital Physical capital, workers human capital, social capital Profitability > growth Growth > profitability

Building-up Capability of (successful) BG Stage 1 Stage 2 Stage 3 Stage 4 capability Nothing Project Execution Vertical integration/ Horizontal integration Innovation/ Product Development Behavior Rent-seeking unrelated /related diversification Replication/ Geographical diversification Specialization Specificity random Less sector-specific Sector-specific/ Across several core sectors Technology- specific Samsung: 1960, 70s 1970-80s 1990s post-crisis BGs in Old view (Inst. Voids): those at stages 1 and 2

<Table 1-B> Three Definitions of Chaebols: Share Composition and the Number of Affiliates

<Table 1-B> Continued Note; Above figures are as of 2001.

<Table 2-B> Descriptive Statistics of the Sample Firms (sub-period 1985-1989)

<Table 2-C> Descriptive Statistics of the Sample Firms (sub-period 1990-1997)

<Table 2-D> Descriptive Statistics of the Sample Firms (sub-period 2000-2003)

<Table 4-A> Estimated Inefficiency (CMS2 and 30 Chaebols)

<Table 6-B> Determinants of Firms’ Inefficiency (Chaebol Firm definition=CMS2)

<Table 6-B> (Continued)

<Table 6-C> Determinants of Firms’ Inefficiency(Chaebol Firm definition=Top 30)

<Table 6-C> (Continued)