Episode 4: The Miracle on the Han, the Asian financial crisis and South Korea today
August 6, 2019
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South Korea’s growth has been fast and furious. This episode will explore the country’s economic progress, how it fared during the Asian financial crisis and the 2008 financial crisis and where institutional investors interested in South Korea could look to allocate. How is the China-U.S. trade war impacting the country? And what sectors show promise? We’re joined by Dr. Michael Seth from James Madison University, Troy Stangarone, senior director of congressional affairs and trade at the Korea Economic Institute and Michael Oh, a portfolio manager at Matthews Asia.
(Run time: 22:48 min, size: 20.8 MB)
[Yaelle]: Hello, my name is Yaelle Gang and I’m the editor of Canadian Investment Review.
[Martha]: And I’m Martha Porado, associate editor of Canadian Investment Review and Benefits Canada. Thanks for joining us on Pension Passport where we’ll connect with investment experts from around the world to zero in on different countries. We’ll explore their economies, investment opportunities and risks, all with the lens of a pension investor.
[Yaelle]: In this episode, we’ll explore South Korea, which is one of the largest economies in Asia and the world. And interestingly, South Korea is classified by FTSE Russell as a developed market, but is classified by MSCI as an emerging market.
[Martha]: Either way, it’s a key player on the world stage. To delve into some of its history we’re going to kick things off with South Korean economic history expert Dr. Michael Seth from James Madison University. Dr. Seth is also the author of numerous books, including Education Fever: Society, Politics and the Pursuit of Schooling in South Korea. Welcome Dr. Seth.
[Michael Seth]: Thank you, morning.
[Yaelle]: Good morning. Can we start by you walking us through what drove the growth in South Korea’s economy since the end of the Korean War? Why do they call it the miracle on the Han?
[Michael Seth]: OK. When the South Korea’s economy grew extraordinarily fast, and before we talk about that I should just mention how poor South Korea was. In 1960 it had the same per capita income as Haiti. So, it was among the world’s poorest countries. And from about 1961, it grew very rapidly. In fact, from the mid 1960s to the mid 1970s it had one of the highest growth rates in the world and at times in the ‘80s it had the highest growth rate in the world. And this came rather unexpectedly by most outside experts. And it was certainly unprecedented that any developing country should transform itself as fast as South Korea. What drove it was a number of factors. But partly, it was that the South Korean government that played a big role in planning economic development hit upon some good strategies, which included export-oriented economic development, encouraging foreign investment and investing heavily in education.
[Martha]: And what really drove the economic and regulatory reform that happened in the 1990s?
[Michael Seth]: The short answer is the Asian financial crisis of 1997 to ’98. It was response to a financial crisis that began in Thailand and spread throughout Asia. And that financial crisis forced the South Korean government to carry out financial regulatory reforms that needed to be carried out. And two of the big problems was a crippled banking system that was over-burdened with bad loans and a corporate sector that had too much debt. It had expanded far more than it should have. They were developing too many competing lines and banks continued to lend the money. There was a kind of crony corp. capitalism going on in which governments looked the other way as banks continued to lend money to corporations that couldn’t pay them back. That financial crisis forced the government to act and it was able to do so politically, because the IMF, which intervened in Korea and sent the largest emergency package ever given to any country, $60 billion, set a series of guidelines, structural guidelines, and the South Korean government was able to use this idea of outside pressure to force many people, financial restructuring. They closed a third of the banks, forced corporations to sell off unprofitable lines, pay off debt and even caused some of the biggest corporations, including the second largest Daewoo to dissolve.
[Yaelle]: Great, thanks. So how was South Korea able to make the big economic turnaround happen?
[Michael Seth]: In 1997, ’98 you’re asking?
[Yaelle]: Yes, exactly.
[Michael Seth]: Well it was able to do so because there was the political will to do so. And there had been a newly elected president, Kim Dae-jung who came into office during the middle of the crisis, financial crisis, who saw the need to carry out sweeping economic reforms that were unpopular because those reforms resulted in restructuring, a loss of jobs. A million and a half Korean workers, seven per cent of the entire workforce, lost its jobs in just a few months as a result of corporate restructuring. And these are politically unpopular, Kim Dae-jung and his administration was able to convince the public that because of the crisis that they were necessary. And he was also able to kind of blame the IMF in forcing his hand. So the Koreans refer to it not as the Asian financial crisis, but as the IMF crisis.
[Martha]: And just to fast forward a bit, how did South Korea fare during 2008?
[Michael Seth]: Well, in 2008 it was in pretty good shape. The problems that Western countries had like in United States and Europe with the banking system, the Koreans had already tackled that. The banks were pretty sound in 2008. So this, South Korea was in a much better position, it had a large of trade surplus. I should point out that South Korea went from a debtor country in 1998 to a creditor country in 2008 with a large trade surplus and a large accumulation of dollars in other hard currencies. So, it was in good shape and corporations had already been substantially restructured. So, it didn’t have internal debt problems that many Western countries had.
[Yaelle]: Great, thank you so much Dr. Seth. Now for a more modern look at the country’s economy we’re joined by Troy Stangarone, who is the senior director of Congressional Affairs and Trade at the Korea Economic Institute. He oversees the institute’s trade and economic-related initiatives, as well as the Institute’s relations with Capitol Hill and the Washington, DC trade community. Prior to joining KEI, Stangarone worked on Capitol Hill for Senator Robert Torricelli on issues relating to foreign affairs and trade. He also served as an aide to Governor James McGreevey of New Jersey. Hello Troy, how are you?
[Troy]: Good, how are you?
[Yaelle]: Good thanks! So to get us started, what are some of the economic challenges that South Korea is facing today?
[Troy]: I think when we look at the South Korean economy, there are three short-term challenges that I would point out and one long-term challenge. On the short-term side, South Korea is heavily dependent on international trade and specifically on trade in semiconductors. Over the last few years, you’ve seen a growing demand for the types of semiconductors, specifically memory chips, that South Korea produces, as you’ve seen movement towards things cloud computing and more mobile phones.
This has caused exports of semiconductors to rise on the memory side from five per cent of total exports in 2014 to 14 per cent last year, and total semiconductor exports have risen to almost 18 per cent.
And so you have this challenge that now that we’re going through this period to where demand is declining for these types of semiconductors, you’ve seen prices drop, you’ve seen exports in terms of volume drop. And, so that’s really sort of hit, in the short term, the South Korean economy. Some of this is also tied into the broader U.S./China trade war, which is now starting to impact the economy as well. And so you have this tension between China and the United States which is slowing both global demand and also slowing South Korean exports to China.
The last sort of short-term challenge that I would discuss would be the Moon administration’s policy of income-led growth. They’ve taken, and over the past couple of years, put in two fairly significant increases in the minimum wage. At the same time, they’ve also reduced the working hours on the mandatory side and so what that’s done is it’s taken, and it’s really sort of pinched small- and medium-sized enterprises. And so that’s been a sort of drag on the economy, as well.
The one long-term challenge that I would mention is that South Korea’s demographic trends are fairly stark. You have an aging population that according to UN projections between now and 2040 will potentially lose between about a quarter and a half of its working-age population. So that’s going to mean significant change in both the structure of the South Korean economy and also the challenges that the government will face in terms of things like pension and healthcare.
[Martha]: So, with those challenges in mind, could you paint a picture of what some of the risks are to investing in Korea? For example, what’s the status of the relationship with North Korea?
[Troy]: So I think there’s two ways to look at this. One, is that because South Korea is highly dependent on international trade, you have a situation to where geopolitical risks, be they from North Korea or this current tension between the United States and Iran, that South Korea could become impacted. In the case of Iran, the vast majority of their petroleum imports come from inside the Strait of Hormuz, so if there’s a conflict there, that would impact both the cost and the access to energy for the South Korean economy. So you have these types of risk that are beyond control. When you look at North Korea, I think this is really a situation to where we are sort of at a potential inflection point. The relationship over the last year has been improving. But until we sort of see how the talks between the United States and North Korea go on denuclearizing North Korea, it’s hard to know if the North and South can really move the relationship sort of beyond where it is. But you’ll always have this sort of tension between the two, at least in the near- to medium-term.
[Yaelle]: Great, thank you. And so with these challenges in mind, where do you think some of the big opportunities lie for foreign investors looking to South Korea?
[Troy]: So there are three areas that I think are promising for foreign investors to consider. One is healthcare. As I mentioned previously, you have this fairly stark demographic change that is going to occur. The British medical journal Lancet, has estimated that South Korea’s expenditures on healthcare will increase by three per cent of GDP between now and 2040, and so you’re going to see, I think, a lot more expenditure there, but you’re also seeing a lot more investment on the South Korean side in things like on pharmaceutical production, specifically in areas like biologicals, so you’re seeing more growth in that industry. At the same time, South Korea, which is known for its tech sector, the Moon administration is also taking and significantly investing in ideas behind sort of the fourth industrial revolution and artificial intelligence. They would like to bring on in the near future about 20 artificial intelligence-led plants. And so I think there is going to be a lot of growth in the sector as all of the companies in South Korea try to move more in this direction.
The last area that I’d like to mention is environmental goods. South Korea in recent years has faced significant air pollution and this has become a major political issue. And so, you’re seeing things like investments in hydrogen fuel cells to try and reduce pollution from vehicles. But I think beyond hydrogen fuel cells, you’re going to see a lot more effort to try and develop environmentally friendly products to try and reduce the pollution within the South Korean airspace.
[Martha]: So given everything we’ve discussed, can you describe your outlook for the country generally?
[Troy]: Yeah, I think when we look at the South Korean economy, in the short term there’s clearly challenges. You’ve seen growth slow in the first quarter this year and on a quarter-to-quarter basis, it actually declined for the first time in about a decade. But, you’re seeing the growth-rate slow and this year it will probably end up somewhere around two per cent which would be a little slower than last year. But I think once we can get past these tensions with China and some of these broader systemic issues in the national economy, I think you have good growth prospects of around 2.5, three per cent growth in the economy going forward.
[Yaelle]: Great, thank you so much Troy. Alright, Martha. Before we move onto our next guest, let’s see how well you really know South Korea.
[Martha]: Oh goodness.
[Yaelle]: So, what year did the Republic of South Korea officially become a republic?
[Martha]: Oh goodness. Let’s see. You really are putting me on the spot here. I would say, 1965.
[Yaelle]: Close but no cigar. 1948.
[Martha]: Oh wow really? That early?
[Yaelle]: Yes, that early. It was basically after, after World War II, there was a military government from 1945 to ’48 and then in 1948 the official South Korean Republic began. Do you want a chance at redemption? A second quiz?
[Martha]: Sure, let’s do it.
[Yaelle]: OK, so South Korea is said to be one of the four tigers of rising Asian states. What are the other three tigers?
[Martha]: OK. OK. I’ve heard people use this term before, so I’m guessing China?
[Yaelle]: [Makes noise like a buzzer]
[Martha]: Oh really? Are you kidding me? OK. Rising. Indonesia?
[Yaelle]: [Makes noise like a buzzer]
[Martha]: Really? OK. Like these are, I’m genuinely expecting to get at least of one of these right. Um. Vietnam?
[Yaelle]: [Makes noise like a buzzer]
[Martha]: OK, uhhh.
[Yaelle]: It’s Singapore, Taiwan, Hong Kong and South Korea. Alright let’s bring on the next guest and forget about this quiz.
[Martha]: Yes please, as soon as possible.
I’d now like to introduce Michael Oh, who is a portfolio manager at Matthews Asia. He joins us from San Francisco. Michael has been managing the firm’s Asia Innovators and Korea Strategies and has been at Matthews Asia for almost 20 years. He also has a B.A. in the political economy of industrial societies from the University of California, Berkeley. Welcome, Michael.
[Michael Oh]: Hi, how are you? Thanks for having me.
[Yaelle]: Thank you. Within equities, are there particular sectors, themes or parts of the cap spectrum that are particularly attractive right now for pension plans?
[Michael Oh]: Within Korea I believe that the domestic investors are becoming more sophisticated. They used to want just the growth companies in the past and they didn’t really pay much attention to dividend-paying stocks in the past. But now things are changing, they’re becoming more sophisticated, they’re demanding more dividends, more shareholder return, they’re demanding more rights as minority shareholders. In responding to these demands, individual companies are responding by increasing their dividends, and providing more shareholder return in terms of share buy-backs as well. So, the companies that are paying more dividends are becoming more interesting in Korea. And dividend-paying stocks and companies with great care for shareholder return has been a very interesting area to watch in Korea lately.
[Martha]: So what are some of the risks for those investing in South Korea, if they’re a pension plan perhaps, and how can they mitigate against those?
[Michael Oh]: Just like any other market, there are always bad apples. We try to avoid, basically companies that are controlled by the state. State-owned entities that are doing national services, for example utilities, sometimes telephone companies, will fall into that category. We also try to avoid family-run companies with bad corporate governance. Family-run companies are called chaebol companies in Korea. And there are some bad . . . there are very good, great quality chaebol companies in Korea but also some bad companies with bad corporate governance history and poor capital allocation track records, so we try to avoid those companies. But, other than that, Korea compared to other emerging countries, they have a very, I would say better, more transparent financial control, accounting practices, accounting standards. So in that sense, I believe Korea probably has less risks compared to other emerging markets- the investment category.
[Yaelle]: Thank you. With current trade wars going on with the U.S. and China, is South Korea going to feel any impact? And if so, will it be an economic winner or loser?
[Michael Oh]: That’s actually a very interesting question at this juncture because of this trade ware between, the conflict between the U.S. and China. We sort of see this as a longer-term issue. If this trade war persists and become an ongoing issue many South Korean companies actually benefit. For example, some of the key exports that South Korea is producing are the semi-conductor components, and they actually do export a lot to China. But at the same time, they do compete against Chinese companies on the devices level, so the smartphones, 5G telecoms. So as this conflict expands, Korean companies could be negatively impacted when it comes to components. But they would actually benefit when it comes to devices. And any slack that is left by the Chinese companies could be picked up by other device makers. So at the end I think South Korean companies might actually benefit if this ongoing trade issue persists between U.S. and China.
[Yaelle]: Thanks. South Korea’s economy took a major downturn in Q12019. Why was that and what does this mean for foreign investors exposed there?
[Michael Oh]: That’s another very interesting question. I think the South Korean economy has been basically hurt by very poor decisions made by some of the domestic policy makers. For example, they raised the minimum wage too fast, too much. I think the general direction is correct, by raising the minimum wage, but I think the pace has just been a little too fast. And it doesn’t take the experts to figure out that if you raise the wages too much, too fast then actually that’s going to hurt the employment and the domestic sentiment. That’s exactly what happened in the domestic markets, so far this year. So that actually hurt a lot of the domestically oriented companies. But once again, the valuation has become very attractive and the return could be very rewarding for investors with long-term horizons. South Korea still has a very globally competitive companies, so you get to buy these companies at a pretty substantial discount to compare to other globally competitive companies based in other countries.
[Martha]: What’s your biggest piece of advice for a Canadian pension plan looking to allocate to South Korea?
[Michael Oh]: So South Korea, I think many investors are very much aware of the biggest exporters in the country. But Korea is more than just a few big, giant exporters. There are many interesting companies in health care, in domestic consumer discretionary sectors, in financial industries, so I would encourage investors to look just beyond some of the very well-known exporters in the country. The valuation is very attractive, not just compared to emerging markets, but if you actually compare South Korea to other developed countries as well, the valuation is attractive. You’re basically buying world-class companies at a pretty substantial discount and at the same time the corporate governance has been improving. Korea has one of the best financial accounting practices in the region with very transparent financial systems now. So I think if you have a longer-term investment horizon with patience for perhaps a better domestic policy coming in later this year or in the next few years, I think that reward would be pretty handsome.
[Yaelle]: Wonderful, thank you so much Michael. Before we head out here’s an investment spotlight from South Korea. Did you know that in 2018, the CPPIB partnered with GIC, the government of Singapore’s sovereign wealth fund, to buy a Grade A office building in South Korea for US$380 million?
Also in 2018, the CPPIB announced a partnership with ESR and its Seoul-based subsidiary Kendall Square Asset Management to invest up to US$500 million in an investment vehicle targeting modern logistics facilities in Korea.
Is your pension fund invested in South Korea? Let us know by emailing either firstname.lastname@example.org or email@example.com.
[Martha]: That’s all for now. Thanks for joining us on pension passport and don’t forget you can hear all our other episodes at www.investmentreview.com/podcasts. Till next time, or as they say in Korean ‘annyeoung’!