The Dangers Of Cracking Down In Korea

A hard line on the chaebol could cost millions of jobs

When state-backed Korean banks declared Daewoo Motor Co. bankrupt in early November, the move was deemed harsh but necessary medicine. Among other things, receivership could give court-appointed managers the power to lay off a fifth of Daewoo Motor's workers--thereby making the ailing auto maker more attractive to foreign buyers like General Motors Corp. and Fiat, as well as giving Daewoo Motor's remaining employees a chance to keep their jobs.

But Daewoo Motor is far from being the only business at risk. When companies its size are pushed to the brink, thousands of the small and medium-size enterprises that supply them also are threatened with extinction. Daewoo Motor has stopped paying its 3,500 suppliers and subcontractors. These companies are not so big or prominent that their passing would make headlines, but if they shut their doors, 300,000 Korean workers would feel the pain. "If you pull the plug on weak chaebol without providing a helping hand to their suppliers," says government economist Lim Wong Hyuk, "the impact on the economy will be serious."

CREDIT CRUNCH. That largely explains why the government of President Kim Dae Jung has not acted more ruthlessly against the wayward chaebol. To do so would trigger the wholesale bankruptcy of small suppliers, who often depend on just one or two contracts from chaebol for their financial survival. Besides, the nation's small- and midsize-business sector employs some 8 million people, or more than a third of the workforce. So before taking an ax to more chaebol, policymakers are searching for ways to help keep smaller enterprises afloat.

There is little time to lose. Already, the financial troubles of Daewoo, Hyundai, Ssangyong, and other chaebol are causing a credit crunch among suppliers and subcontractors. The Korea Federation of Small & Medium Business (KFSB) reckons 6,500 companies each are owed an average of $1.2 million, thanks to the insolvency of their main clients. Of those, an estimated 200 face bankruptcy, in part because the banks are reluctant to tide them over.

The small suppliers have fallen victim not only to the chaebol's hard times, but also to Korea's archaic billing system, which gives conglomerates all the advantages and their suppliers none. Essentially, the chaebol settle their accounts with IOUs rather than cash. Suppliers often wait months to collect on these promissory notes, selling them at a discount to a bank or even using them to pay their own bills.

Trouble is, these notes essentially become unpayable the moment a company is put in receivership. That's because few small or midsize Korean businesses are financially strong enough to wait years for payment. Across South Korea, outstanding promissory notes amount to roughly $70 billion, or some 16% of gross domestic product.

If a string of chaebol bankruptcies means a substantial number of the notes prove unprove uncollectible, Korea's recovery could evaporate. The Daewoo bankruptcy alone vaporized $1.1 billion worth of IOUs issued to its suppliers over the past four months. "We're doubly punished by Daewoo's bankruptcy," says Hwang Byong Hee, whose Wooil Precision Industrial Co. has sold the car company motor and transmission parts since 1979. "Not only have we lost our source of revenue, we're also deprived of payment for parts we've supplied."

The crisis of unpaid invoices does not stop with the chaebol's main suppliers. Over the years, the promissory notes have become a kind of currency, with the chaebol's big suppliers using them to pay their own subcontractors: supplier A takes the promissory note from a chaebol, then passes it to subcontractor B, who then hopes to collect.

The rickety system worked as long as the chaebol eventually coughed up the cash to pay the holders of the promissory notes. But a corporate bankruptcy like that of Daewoo Motor can rattle the whole supply chain. "This certainly accelerates the knock-on effect and amplifies a liquidity crisis," says Nam Joo Ha, who teaches economics at Seoul's Sogang University.

Moreover, when companies want to raise cash, they often sell the IOUs to banks at a discount to their face value. But the banks have no obligation to keep the promissory notes if they conclude that they are uncollectible. In September, Wooil's Hwang sold $1.8 million worth of Daewoo IOUs to Industrial Bank of Korea at 93.25% of their original value. Under normal circumstances, the bank would have collected the full amount from Daewoo Motor once the notes matured. But after the car company went bankrupt, the bank forced Hwang to buy the notes back.

Such demands could wipe out many small enterprises. Rho Man Sook, a researcher at the Korea Auto Industry Cooperative Assn., says that banks have demanded repayment of an estimated $790 million from Daewoo's main suppliers, giving them until the IOUs mature to pay. "Unless the government comes up with emergency aid," says Rho, "many of the 179 suppliers that are solely dependent on Daewoo will go under by the end of this year."

The fallout from chaebol bankruptcies is hurting various sectors, including cement, machinery, and furniture. But none is harder hit than the construction industry. A total of 112 contractors with combined annual revenues of $22.4 billion, or a third of the total industry, are under debt-rescheduling programs. "Banks are already refusing to buy promissory notes from most of the 112, and many thousands of their subcontractors face threats of failure as well," says Ryu Hyeung Jun, a KFSB manager.

The government, strapped as it is for revenue, has no choice but to gallop to the rescue. The Kim administration has unveiled plans to replace all promissory notes rendered unpayable with new ones that can be sold to banks at discounted prices. While a government-run fund will guarantee up to $352,000 worth of IOUs for each ailing supplier, that won't be enough, and the banks will bear most of the risk.

TAX BREAKS. In addition, officials are leaning on banks to offer loans to suppliers forced to buy back IOUs the banks want to get rid of. A government fund will guarantee bank loans to suppliers deemed healthy but suffering short-term cash-flow problems. Kim's regime has also earmarked $53 million for direct emergency government loans to distressed suppliers. And with an eye to the future, the government is offering tax breaks to chaebol that agree to settle bills in cash rather than with IOUs.

The threatened small businesses enjoy bipartisan support in the legislature. The opposition is urging the central bank to offer more soft loans at 3% interest to banks willing to keep lending to troubled suppliers. "We will back all legally possible steps to relieve small companies suffering from a short-term cash crisis," says Lee Hahn Koo, an MP from the Grand National Party.

Kill the chaebol, and you kill the small companies that employ millions. It's that simple. Kim's government has to find a way out--now.

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