Michael Han, CFA
Matthews International Capital Management, LLC
Korea has gone through crisis before—it was one of the worst hit during the 1997–98 financial turmoil. And yet, Korea emerged from that test even stronger than before. Korea used its experience of crisis as a spur for further reform. At a basic level, growth comes from productivity improvements in the domestic economy—Korea understands this and has been developing its internal markets and labor skills. It has also remained open to the global economy, eschewing protectionism and embracing trade. These have all helped it negotiate crises in the past and will do so again. Indeed, Korea remains one of the richest economies in Asia and its success in navigating crises and the challenges it faces are probably being studied with keen interest in capitals around the region.
Thus far, Korea has been weathering the storm caused by global financial crisis better than expected. Its GDP in the first quarter remained flat while most of its peers in developed economies reported sharp declines. The nation's major exporters in the auto, IT and industrial sectors gained market share during the downturn, thanks in part to Korea's devalued currency. As a result, sentiment toward the Korean market seems to be turning positive compared to what it was only three to six months ago. Looking ahead, we believe it is essential for investors to understand the country's economic fundamentals as well as the opportunities and challenges Korea presents for them.
Ironically, one reason why Korea seems to be enduring the current crisis relatively well is because the nation experienced a major financial crisis in the not so distant past. The collective experience of Korea's government and businesses became a valuable asset when the country was faced with the current global crisis.
Two years ago, in a commentary titled, "Then and Now", Mark Headley vividly described Korea during the Asian financial crisis. Specifically, he commented on how then President Kim Dae Jung's progressive reform ended Korea's long-time protectionist policy when he opened the market to foreign capital, recapitalized banks and eliminated debt-ridden Chaebol companies. Chaebols, large conglomerates which had previously enjoyed government-sponsored easy money and protectionist policies, were forced to go through an unprecedented restructuring of balance sheets and governance models. Chaebols that voluntarily restructured themselves became role models for corporate governance reform. For example, their money making businesses began investing more in themselves to become globally competitive rather than subsidizing the firm's unprofitable businesses. As a result, their companies have taken market share from domestic and global competition and enhanced their market status. Korea took the view that there was no easy way out—companies had to pay down their debt and most heavily levered chaebols have delevered their balance sheets since then. Today, well-capitalized Korean companies are investing aggressively while their global competitors are struggling with deteriorating financials.
During the Asian financial crisis, there were also reforms in the supervision and oversight of Korea's financial systems. The nation's old accounting standard—influenced by the Japanese system, but considered next to useless in investment analysis—was replaced by a U.S. GAAP-style standard. The infrastructure for investing, including public disclosure rules and shareholder protection schemes were also enhanced, making Korea's market more transparent and investable. Such measures shore up confidence in times of stress by reducing the amount of uncertainty that investors face.
The playbook from the late-1990s became a valuable intellectual asset for Korean bureaucrats. During the 2005–2007 bubble period, Rho Moo Hyun (Kim's successor) implemented stringent lending policies to contain real estate prices that were being pushed by the global liquidity boom. In addition, banks were forced to double the loan loss provisions in good times. Such prudent policies saved Korean banks from major disasters in the mortgage sector that punished their peers in the developed world. That said, Korean banks still have problems of their own; for instance, they relied on short-term overseas funding for long-term assets. As the global credit crisis deepened, Korean banks faced difficulties refinancing their short-term debt and had to rely on government/central bank support for funding.
Human Capital—A Sustainable Growth Driver
Korea's past success came from its passionate people who work among the longest hours in the world. Education is a national obsession in Korea—as The New York Times reported, a parking lot attendant whose son becomes a doctor or lawyer is more admired than a millionaire whose children do poorly in school. Korea has achieved the most significant advancements in higher education penetration rates among Organisation for Economic Co-operation and Development (OECD) member countries; roughly 55% of the country's younger generation (25–34 year olds) achieved a tertiary education while just 10% of their parents' generation (55–64 year olds) reached the same level.
Korea's long school year—230 days—is also noteworthy and drew attention when President Obama's public school reform agenda pointed to the United States' relatively short 180-day school year as a significant problem. Fundamentally, continuous investment in Korea's human capital supports a strong long-term case for the country.
A Nimble, Diversified Economy
Through financial crises, Korea never turned its back on global markets and this has surely helped many of its companies sharpen their competitive positions. Korea has demonstrated that it can be very nimble in adapting to the ever changing global economy. In the early-1990s, developed markets such as the U.S., Europe and Japan, accounted for 45% of Korea's exports; today they represent just 30%. Textiles and apparel previously accounted for 14% of exports and now their contribution is under 5%. Korean companies are well diversified across the IT, industrial, material and domestically oriented sectors. Today, it is not hard to find global champions in each sector among Korea's publicly listed companies. At the inception of the current crisis, market observers took an overly negative view on Korea's export-dependent economy because of falling demand from developed markets. However, Korea seems to have fared better than its peers thanks to its more diversified export businesses and sizable domestic economy.
A common misperception regarding Korea is that the country will be squeezed between a more-developed Japan and a faster-growing China—this is often referred to as the "nutcracker" or "sandwich" theory. In reality, Japan has provided great role models for Korean companies—Korean companies have been adopting high-end technology from their Japanese counterparts while also gaining on them by leveraging a second-mover advantage.
Korean companies and individuals alike have been looking for opportunities in China. Korean companies from a wide variety of industries have been entering China not just seeking lower wages, but also taking advantage of the country's significant market potential. While Korean exports to the Western world have been confined to IT and industrial products, the country's exports to China have been more diversified to include consumer goods and services such as cosmetics and food; Korean exporters have also been able to leverage their strong brands and cultural proximity. From this perspective, a number of Korean companies offer solid investment cases as their businesses are enjoying growth in China but are traded at much lower multiples than their Chinese peers.
Corporate governance, though improving, has been a challenge for investors in Korea. However, governance in Korea presents different issues than in the U.S. where problems have largely been derived from a conflict of interest between management and shareholders. In Korea, a company's founders typically control a large portion of the firm—as much as 30% to 50%. Therefore, issues regarding executive compensation and stock options are rare. Rather, Korea's governance challenges tend to arise from conflicts between a company's majority and minority shareholders. Low dividend yields and capital allocation issues are evidence of these conflicts. Given their high equity ownership, Korean management tends to be incentivized to invest for the company's long-term vision rather than with a focus on returning cash from operations to shareholders. Some insightful management teams have been successful in long-term wealth creation while others have not. In recent years, there have been significant improvements in the shareholder returns generated by companies that transformed into holding company structures. By transforming into a holding company, a company was separated into an operating business and an investing business. As a result, investors were given the option to own the operating business, which is required to increase shareholder return so that its majority shareholder can invest for future growth. Like in all markets, distinguishing management teams that can create value from those that will destroy it has been one of the most important criteria for achieving investment success in Korea.
Another significant challenge for Korea stems from the country's socio-demographic makeup. As the Korean economy advanced, the country's rigid labor market created a large pool of temporary workers. "Regular" workers are well protected by stringent labor laws, and the population of "temporary" workers—created to sidestep labor regulations during the Asian crisis—has grown rapidly among Korea's younger generation and women. As a result, the younger generation has been delaying marriage and starting families, causing Korea to have one of the most rapidly aging populations in the world. This brings new challenges, particularly in the development of pension systems and health care plans, but these challenges will also provide business growth for health care providers, insurance companies, asset managers and medical supply firms.
By any measure, Korea is far from perfect. However, recent history suggests that Korea has been largely successful in curing its own problems—and exceeding expectations in the process. More importantly, given that the nation still has room for improvement means it offers investors an opportunity for upside potential. Universally, a highly motivated people with a strong work ethic, ongoing investment in human capital, seasoned regulators, and continuous reform stand to make a sustainable investment case—we believe this is the case in Korea.
This month Asia Insight focuses on Korea and features a conversation with the following members of the Matthews investment team:
Robert Horrocks, PhD, Chief Investment Officer
Michael Oh, Matthews Korea and Matthews Asian Technology Funds
Michael Han, CFA, Matthews Korea Fund
The information below does not constitute a recommendation to invest in any sectors mentioned.
Q: What industries do you think stand to benefit from the changes taking place in Korea?
A: Michael Oh
The industries that come to mind as people get wealthier in Korea are related to "protection," specifically insurance, wealth management and home security. Also, I think the corporate pension fund market is going to be a beneficiary and will grow in the future which is one reason why we are positive on brokerage and insurance companies.
A: Robert Horrocks:
I think companies in the wealth management area will change remarkably in how they communicate with their clients. At the moment, in Korea—not unlike any other country in Asia—people make their own investment decisions. They buy mutual funds through brokers or banks who act like brokers, paying big fees up front because the sellers act as an access point. Currently brokers are not particularly providing advice and this is an area where we anticipate growth—in the advisor type market.
Actually, Korea has done more than most to spur its pension fund and encourage it to look outside just holding fixed income and government securities and to try to get involved in equities and higher risk type of securities. Aside from what this does for companies and for Korean citizens, it also has an impact on the markets—it means markets should remain quite liquid and it may also act to dampen volatility.
A: Michael Oh
What Robert just mentioned has been one of the biggest missing pieces in Korea for many years. We're now seeing more long-term domestic institutional investors that are seeking returns in the equities market. This is a positive development that will improve the experience for all long-term investors in the Korean market.
Q: How has Korea's bond market developed?
A: Robert Horrocks:
Again, Korea has tried more than most Asian countries to spur the development of its corporate bond market. It was a particular policy focus after the Asian financial crisis in 1997–98, to try to develop the market and lessen the dependence of companies on banks for financing. There has been some success—the corporate bond market is bigger and better than what it was. It had some success for a few years after the Asian financial crisis but bank loans have continued to be an important part of the financial structure of Korean companies. It's an area in which Asia hasn't been particularly successful in the past. Yes, Asia has been successful in decreasing its reliance on debt since the last crisis, but the composition of the debt has remained largely unchanged. It will benefit all companies with long-term assets to be able to finance with long-term capital rather than short-term bank loans. Swapping out of short-term bank loans to longer-term corporate bonds could be an incredibly important development.
A: Michael Han
Recently, Korean companies have been able to pay back short-term borrowings from banks by issuing longer-term (3–5 year) bonds. Some companies we visited a few months ago were refinancing their bank borrowing with 3–5 year bonds to lock in their financing cost at current low interest rates. Low interest rates coupled with growing liquidity from a renewed risk appetite, the first half of this year was great time to issue bonds. In fact, bond issuance in the first quarter increased 75% over a year ago. It remains to be seen whether this is a tactical or a strategic change in the way Korean corporates finance long-term assets. It appears companies still value long-term relationships with banks and the flexibility in loan terms over issuing bonds.
Q: What is happening with Korea's currency?
A: Michael Han
The currency volatility in Korea stems from the fact that long-term funding in U.S. dollars is limited. One of the reasons the Korean won depreciated so much last year was because Korean banks did not have access to the long-term U.S. dollar credit market and Korea's exporters needed this long-term hedge.
A: Michael Oh
Korea's currency crisis wasn't about the strength of its companies or the competitiveness of the economy but rather, it was a liquidity issue. This is evidenced by the fact that Korea is currently recording one of its biggest trade surpluses in history. This demonstrates that Korean companies are quite competitive, even at the current currency level. Korea is not at equilibrium right now, the currency is still weak because of the liquidity issue.
Q: What are your thoughts on North Korea?
A: Michael Han
I think people tend to overestimate North Korea's power. For example, look at North Korea's "economic" power: their GDP is about 5% of South Korea's and their military spending represents 20% of South Korea's. I don't think North Korea will be a meaningful threat to the region—unless they change philosophically and turn into terrorists.
A: Robert Horrocks
The perception about North Korea always surrounds the problems it can create, but the potential upside is never mentioned. I think people underestimate the possibility of reunification and what that means for South Korea. It would give South Korea a vast amount of cheap labor. Korea's textile industry stands to benefit from having access to that kind of low cost labor.
Q: How does Korea compare to Japan?
A: Michael Oh
First, I think Koreans have learned a lot from Japanese companies—they had a good benchmark to follow particularly in the area of technology. Korean companies in general have followed Japan's technological development path very successfully and have actually gained market share over the last few years. Where Japanese companies have been slow to restructure, Korean companies have been able to fill in the gap. I think companies in Korea make decisions faster and have stronger balance sheets. We have seen this in the past six months as Korean companies were able to invest more aggressively, execute more progressive marketing plans and gain market share. However, having said all this, Japanese companies still have some of the best technologies in the world, if not the best, and Korean companies still have a lot to learn from them.