Economic Environment- Key Macro Economic Issues, Inflation

Key Macroeconomic Issues Affecting Business Strategy In the 2001 Annual Report to Shareholders, the CEO of Hewlett-Packard stated: In terms of economic growth and stability, 2001 was one of the toughest years on record, particularly for the IT [information technology] industry. Triggered in part by the collapse of the hyper inflated dot-com sector, in Q3 of calendar 2001, the U.S. economy softened considerably. A dramatic slowdown in business investment, compounded by the events of September 11, tipped the United States into its first recession in a decade. During 2001, the world’s three leading economies slowed simultaneously for the first time since 1974. The European economy stalled, and Japan struggled to fight deflation and recession. Information technology spending plummeted. The telecommunications and manufacturing industries-two of HP’s largest customer sectors-were hit especially hard by the global economic slowdown. These factors had a significant impact on HP’s fiscal 200 1 results. This is an example of the impact of the global economy on company profits and operating strategy. Management must learn to scan the environment to determine market condition in the countries where it is either doing business or contemplating entering the market. We will discuss three key issues in the following pages: economic growth, inflation, and surpluses and deficits. Then we will follow with a section discussing the unique challenges facing countries in transition from a command to a market economy. Economic Growth Just as the world was recovering from the Asian financial crisis of 1997, the dot-com (Internet-based companies) bubble burst in 2000, thus triggering the slowdown in economic growth in the United States that has filtered throughout the world, particularly in Japan and the euro zone. The terrorist attacks of September 11 compounded this economic slowdown by eroding consumer and business confidence. The (IMF) listed the direct impact as one of the impacts of the attacks-that is, the destruction of life and property and the downturn of specific industries, such as the airline industry. The U.S. Bureau of Economic Analysis puts the figure 7.3 of damages and other insurance costs around $21.4 billion. The travel industry, including the airlines, and the insurance industry have lost billions of dollars and are still on the recovery path. It is highly probable that some airlines will either have to merge or completely go out of business as a result of the devastating downturn in that industry. For example, United Airlines was unable to meet its debt obligations in December 2002 and was forced to declare bankruptcy. Economists have a difficult time distinguishing the long-term effects of 9/ 11 from other economic events taking place. It is obvious that some of the

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short-term impacts, like a fall in the stock market, a decline in consumer confidence, and the downturn in the airlines industry, are the results of 9/11. As The Economist states, “The September 11 attacks killed thousands and irrevocably damaged the lives of thousands more. But the American economy is too large, and resilient, to be thrown off course even by such shocking and tragic events. It is impossible to quantify exactly the effects of the attacks. But it seems clear that other factors have played a bigger role. The corporate scandals in companies like Enron and WorldCom led to a large drop in the U.S. stock market, a development that has spread to international markets. Economic growth throughout major markets in the world has been bleak since the beginning of the new century. Companies would like every country in which they are investing or to which they are selling to have a high growth rate in GNI and per capita GNI. If this were the case, even if a company did not expand its share in each market, it would still be able to increase revenues at the same pace as the general growth in the economy. However, there are significant differences in growth rates worldwide, affecting the degree to which investments in or sales to a country can affect the bottom line of a company. In addition, given the stagnation of the global economy in 2001 and 2002, companies were forced to compete more aggressively, since their growth had to come from picking up more market share instead of relying on a growth in the overall market. How can a manager determine which markets will exhibit solid growth in the future so that resources can be committed to that market? The best approach is to look at past history and to try to forecast the future. The Organization for Economic Cooperation and Development (OECD) said at yearend 2001 that the global economy had slipped into its first recession in 20 years. However, it claimed that worldwide growth was returning but varied by region. The United States led the recovery with stronger growth after the end of 2001. The euro area recovered more gradually, with growth still slow in mid-2002. Japan’s recovery was also slow, but global demand for exports began to pick up. The rest of Asia has shown surprising resilience to the global downturn, with growth in China continuing around 7 percent and growth in the Asia Pacific region strengthening in 2002 as the tech sector turned up. However, future growth is bound to be unpredictable and variable by region. As illustrated by McDonald’s in emerging markers, a drop in economic growth can have detrimental effects on investment. New investors are hesitant to put money into emerging markets, whereas existing investors are forced to cut back operations and maybe even pull out of the market. The developing countries with high growth rates are often unstable politically or offer other challenges.

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LESSON 19 ECONOMIC ENVIRONMENT- KEY MACROECONOMIC ISSUES, INFLATION

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Many companies, including Intel, have been hurt by the recent slowdown. Intel’s net income for 2001 fell 70 percent from the previous year as a result of weak PC sales, a slowdown in the economy, and weak consumer confidence. Many companies built up technology inventory with the boom of the late 1990s because they expected continued growth; but when the recession hit, most companies cut technology spending and used up inventory. Although Intel hoped sales would pick up in 2002, they have continued to be low, particu1uly in Europe.

Finally, inflation also affects confidence in the government. Because of the devastating effects of inflation on the consumer, governments are always under pressure to bring inflation back under control. If governments have to raise interest rates and slow down the economy to slow down inflation, social unrest could occur. This would also occur if governments control wages while other prices are spiraling out of control, leading to animosity in the population.

High inflation often results in an increase in interest rates for two reasons. The first reason is that interest rates must be higher than inflation so that they can generate a real return on interest-bearing assets. Otherwise, no one would hold those assets. Second, monetary authorities such as the Federal Reserve Bank in the United States or the European Central Bank use high interest rates to bring down inflation. When interest rates rise, companies are more hesitant to borrow money, and this tends to slow down economic growth. In addition, consumers are hesitant to incur consumer debt because of the higher cost of repayment. As demand falls, prices should stabilize or fall.

A good example of the impact of inflation on corporate strategy is Pizza Hut in Brazil in the early 1990s. When inflation was running wild, no one really knew how to compare prices. Prices were changing daily, and salaries were going up as well, so people did not have a good reference point. After the new currency was implemented in 1994 and prices stopped rising, people began to compare prices and make more informed decisions. Consumers began to wonder if the relatively higher price of a Pizza Hut pizza was worth the price, given local alternatives. In the case of purchases, Pizza Hut used to collect sales immediately (the Stores operated on a cash and carry basis) and delay the payment of supplies. Because Pizza Hut was constantly increasing prices, it was generating more than enough cash flow to pay for supplies once they came due. In effect, it was paying expenses in one period that were incurred in a prior period, and the money it was using was worth less than it was at the beginning of the period, even though the company had more of it to spend. So Pizza Hut was paying for supplies with inflated sales revenues. However, this benefit disappeared once inflation slowed down. Pizza Hut was forced to control costs better and to price more aggressively in order to remain competitive. High inflation also creates problems for companies that deal in exports. If inflation is going up but the exchange rate is staying the same, the products will gradually become more expensive in export markets. For example, assume that a British exporter is trying to sell a product to a U.S. distributor for 100 pounds when the exchange rate is $1.59 per British pound. That means the product would cost the U.S. distributor $159.00. If due to inflation in the United Kingdom, the price were to rise to 110 pounds, it would now cost $174.90 (110 ´ $1.59). At that new price, U.S. consumers might start looking for substitutes. However, one would expect the exchange rate to eventually change, causing the British pound to become weaker. If the rate falls to $1.47 per pound, the new dollar cost of the product would be $161.70 (110 ´ $1.47), which is only a slight rise over the previous price. If the demand by U.S. consumers is very sensitive to changes in prices, an increase in prices would result in a fall in demand. So without a change in the exchange rate, inflation in Britain would take a toll on U.S. demand.

Inflation is also the most significant factor that influences exchange rates. Basically, the higher the inflation in a country, the more likely that that country’s currency will fall. Countries with low inflation should have stable or relatively strong currencies. Inflation also affects the cost of living. As prices rise, consumers find it more difficult to purchase goods and services unless their incomes rise the same or faster than inflation. During periods of rapid inflation (e.g., in Brazil in the early 1990s, when inflation was rising at a rate of 1 percent per day), consumers have to spend their paychecks as soon as they get them, or they won’t have enough money to buy goods and services later.

Through the 1990s and continuing into the present, the world has witnessed diminishing inflation. When the 1990s began, inflation was around 4 percent in advanced economies, and 100 percent in emerging economies. In emerging economies, inflation decreased to double digits by the mid-1990s and single digits (around 5 percent) by 2000. In advanced economies, inflation decreased to 2.5 percent by 2000. During the Asian financial crisis, inflation rates stayed surprisingly low-except in Indonesia. Russia experienced high inflation rates during its financial crisis of 1998-1999, but it has made strong progress in lowering inflation rates. Inflation is still high in Turkey,

The new century, which has tended to be very unstable economically, is proving to be a huge challenge for managers trying to determine where to invest. Even the high-income countries have proven to be a challenge. However, managers need to continue to monitor economic news and to try to predict where the growth areas will be in the future. The added dimension of global terrorism and its ability to quickly affect the global economy has forced companies to be much more cautious in predicting the future and in committing significant resources, especially in unstable areas. Inflation Another economic factor that management needs to consider is inflation. Inflation means mat prices are going up. The inflation rate is the percentage increase in the change in prices from one period to the next, usually a year. Economists use different types of indices to measure inflation, but the one they use the most is the consumer price index (CPI). The CPI measures a fixed basket of goods and compares its price from one period to the next. A rise in the index results in inflation. Inflation occurs because aggregate demand is growing faster than aggregate supply. The demand can occur because of government spending in which spending is rising faster than the tax revenues that are used to fund the spending or because of increases in the money supply. Inflation affects interest rates, exchange rates, the cost of living, and the general confidence in a country’s political and economic system.

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Surpluses and Deficits Other measures of a country’s economic stability-and potential as a location for investment-are external and internal surpluses and deficits. Managers need to monitor these balances as indicators of economic strength or weakness. Surpluses rarely are a problem, but deficits are. An external deficit is when a country’s cash outflows exceed its inflows. An internal deficit is when government expenditures exceed government revenues. The Balance of Payments The balance of payments records a country’s international transactions. These can be transactions between companies, governments, or individuals. U.S. International Transactions 2001,” the balance of payments is divided into the current account and the capital and financial account. The current account is comprised of trade in goods and services and income from assets abroad and payments on foreignowned assets in the country. Part of the current account is merchandise trade balance, or the balance on goods, which measures the country’s merchandise trade deficit or surplus. This can be found on line 71 of the Appendix at the end of the lesson, which is a more detailed version of Merchandise includes goods such as automobiles and wheat. A country derives this balance by subtracting imports from exports. In the case of the United States, this means subtracting the dollar value of its imports from that of its exports. If exports exceed imports, the country has a trade surplus, and if imports exceed exports, the country has a trade deficit. An export is considered positive because it results in a payment received from abroad-an inflow of cash. An import is considered negative because it results in a payment made to a seller abroad-an outflow of cash. For example, the investment and consumption boom of the 1990s led Americans to increase spending on imports. The U.S. dollar was very strong, thus leading to lower levels of exports. This trend became so great that by the middle of 2002, the United States hit a record monthly trade deficit of $35.9 billion. As the deficit continued to climb, the U.S. dollar came under pressure in foreign-exchange markets, and the dollar began to fall. This led to a decline in investor confidence, particularly among foreign investors, with expectations that the Federal Reserve Bank would raise interest rates. All of this could mean a slower economic recovery for the United States. The second component of the current account is services, which includes transactions such as travel, passenger fares, and other transportation, as well as royalties and fees on licensing agreements with foreign customers. Although the popular definition of the trade balance usually refers just to merchandise trade, it is probably more accurate to measure the goods and services trade balance together. For some economies, like that of the United States, which generates a large percentage of its GNI from services, the balance on goods and services is a more accurate measure than just goods. In 2001, for example, the United States had a merchandise trade deficit of $427.165

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billion, whereas it had a slightly lower goods and services deficit of $358.290 billion due to a services surplus of $68.875 billion. The third component of the current account is income receiptspayments on assets. This includes items such as receipts from foreign direct investments abroad. A final category, unilateral transfers, is typically not a significant component of the current account balance, but it includes government and private relief grants and income transferred abroad by guest workers, such as Turkish workers in Germany sending money back to their families in Turkey. The current account balance is an important long run and comprehensive measure of a country’s transactions with the rest of the world. The capital account shows transactions in real or financial assets between countries. For example, when the Turtle Bay Hilton Hotel on the north shore of Oahu, Hawaii, was sold to Japanese investors, the transaction was recorded as an inflow of capital to the United States, which is a positive transaction in the capital account. Other examples of capital account transactions include foreign direct investments, such as the purchase of Chrysler (United States) by Daimler Benz (Germany); the purchase and sale of securities, such as the purchase of Brazilian stocks by an American investor; and the purchase of U.S. treasury bonds by a Japanese investor. Also measured in financial assets are changes in the official reserve assets of a country, such as gold, special drawing rights and foreign currencies. What difference does it make to companies whether a country has a current account surplus or deficit? There probably is no direct effect. However, the events that comprise the balance-ofpayments data influence exchange rates and government policy, which, in turn, influence corporate strategy. As a manager is monitoring the investment climate of a country where the company has invested or is considering investing assets, it is important to watch for factors that might lead to currency instability. One of the problems leading up to the Argentine financial crisis was the large current account deficit that it accumulated throughout the 1990s. This deficit led Argentina’s foreign debt to grow to about one-half of one year’s GDP. A popular fiscal policy that can be used to combat a growing account deficit is to devalue the currency, making exports more popular to the rest of the world. Argentina was unwilling to devalue its currency, the peso, because Argentine policy kept the peso pegged to the U.S. dollar. The dollar-and thus, the pesowas very strong at the end of 2001, making Argentine exports unattractive and imports more appealing. Eventually, the recession and high interest payments on foreign debt took their toll, and Argentina defaulted on its $155 billion of foreign debt. In January 2002, the president of Argentina decided that the best course of action would be to let the peso float. By February 1, 2002, the peso had lost half its value, making it worth only 0.494 U.S. dollars. Foreign companies have lost all interest in expanding into Argentina until its economic climate stabilizes. By monitoring trends in the balance of payments, a manager can add one more piece of data when deciding whether or not to do business in a country.

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Venezuela, Indonesia, and Argentina. Managers need to monitor trends in inflation to determine how inflation could affect their company’s cost structure and competitiveness in world markets as well as to anticipate possible changes in monetary policy in response to increases in inflation.

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External Debt Many developing countries-in both the public and private sector-borrowed heavily abroad during the 1990s to fuel expansion. This external debt can be measured in two ways-as the total amount of the debt and as debt as a percentage of GDP. The larger these two numbers become, the more unstable the economies of those countries become. Foreign investors need to monitor debt to determine if the government will need to take corrective action to reduce its debt, normally by slowing down economic growth. The most heavily indebted countries in the world in terms of total debt are Brazil ($238.0 billion), Russia ($160.3 billion), Mexico ($150.3 billion), China ($149.8 billion), Argentina ($146.2 billion), and Indonesia ($141.8 billion). However, all of these countries are large in terms of GDP, so debt as a percentage of GDP was comparatively small. In the case of Brazil, external debt is 40 percent of GDP. However, many African countries have external debt in excess of 100 percent of GDP. The plight of the African countries is severe, because the only way to get access to foreign capital is to borrow it from international banks and institutions like the World Bank. They are not able to attract foreign investment because of small market conditions and political instability, so they must turn to foreign debt to expand. This is going to make it virtually impossible for them to payoff their debt. Most of the foreign exchange they earn from exports must be used to service the external debt (make principal and interest payments). Because Argentina’s currency was pegged to the U.S. dollar, many foreign investors willfully lent money to the country because they felt there was no risk of currency devaluation. Yet even when the economy started dropping in 1996, investors kept on, pouring money into Argentina believing things would pick up, and Argentina kept spending heavily. As noted earlier, in January 2002, Argentina defaulted on its $155 billion in external debt, the largest default by any country in history. Internal Debt and Privatization External debt results from borrowing money abroad. Internal debt results from an excess of government expenditures over revenues. The government budget deficits each year contribute to the overall debt. In the case of the European Union (EU), the target is to have annual deficits no greater than 3 percent of GDP and total debt no greater than 60 percent of GDP. In contrast, India has had serious problems with its internal debt. The general government deficit (central and state budget deficit) was estimated in 2002 to be 10.25 percent of GDP. Including state-owned enterprises, the public sector deficit was estimated to have exceeded 11.7 percent of GDP, and the public sector gross debt was over 90 percent of GDP. Government internal deficits occur for one of several reasons: The tax system is so poorly run that the government cannot collect all the revenues it wants to, government programs much as defense and welfare are too big for revenues to cover, and state-owned enterprises run huge deficits. All governments, including those in transition from command to market, snuggle with several issues, such as “rightsizing” government, setting spending priorities, working toward better expense control and budget management, as well as improving tax policy. Sometimes, however, governments may work hard to

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control expenditures but fall short due to a recession, which reduces the amount of taxes it collects. As countries move to control expenditures and reduce their budget deficits, one important strategy to pursue is the privatization of state-owned enterprises. Privatization reduces debt by removing the need of the government to subsidize the state-owned enterprises. When the government owns enterprises, it often feels an obligation to keep the enterprises a float to preserve jobs. Once it is free from ownership, the enterprises can succeed or fail on their own merits. However, privatization is not easy. It is a political as well as an economic process, and political objectives do not always result in the best economic results. Many state-owned enterprises, such as Pemex, the state-owned oil company in Mexico, are considered to be the crown jewels of a country, and it is difficult to allow them to be sold off to private investors, especially foreign investors. In addition to political objectives are political impediments, such as the obstructive attitudes of existing managers and employees of state-owned enterprises. Thus, consider again the example of India cited earlier, in which the deficits of state-owned enterprises raises raised the overall government debt from 10.25 percent to 11.7 percent of GDP and the stock of government debt from 80 percent to 90 percent of GDP. In most countries, the problem with privatization is selling the inefficient, unproductive enterprises-not those that have a chance to survive. Where permitted, the privatization process enables foreign companies to pick up assets and gain access to markets through acquisition. In Eastern Europe, Latin America, and East Asia, the number of foreign investors purchasing state-owned enterprises has been increasing, particularly in sectors like telecommunications, banking, oil, and gas. Foreign purchases account for about 76 percent of the total. Transition to a Market Economy So far, we’ve been learning about economic systems with the assumption that countries are in one economic system or another and that they were not in transition from one classification to another. However, many countries are undergoing transition from command economies to market economies because of the failure of central planning to generate economic growth. The process of transition has made the world of international business very interesting indeed. The breakup of the Berlin Wall and the overthrow of Eastern European communist dictatorships in 1989 renewed Western interest in doing business in countries throughout Eastern Europe as well as in the former Soviet Union that previously had been off limits. These countries were classified as command economies. Most of the command economies are in the process of transition to a market economy. Command economies in transition are typically grouped into East Asian (such as China and Vietnam) and European. Some have shown consistent economic growth since the transition process began, some have experienced growth reversals, and others have shown little or no growth. What does transition mean? In general, transition implies:

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Developing indirect, market-oriented instruments for macroeconomic stabilization. Achieving effective enterprise management and economic efficiency, usually through privatization. Imposing hard budget constraints, which provide incentives to improve efficiency. Establishing an institutional and legal framework to secure property rights, the rule of law, and transparent market-entry regulations. The process of transformation to a market economy differs from country to country-no single formula applies to all. In addition, the various economies in transition differ greatly in their commitment to and progress toward transformation into market economies. Why do these changes bring renewed Western interest in doing business with economies in transition? The answer is partly political and partly economic. Most economies in transition experienced slow economic growth during the Cold War years of the 1970s and 1980s. Consequently, the outlook for foreign investors who wanted to do business in those countries seemed bleak. But with the end of the Cold War came the hope that the governments of these countries would eliminate their trade barriers, thus encouraging economic growth and increased business opportunities. However, there is still significant volatility in the midst of change. As the Russian economic crisis in 1998 showed, the transition is not smooth. Russia is one of the countries in transition that is experiencing extreme volatility. Since the economic crisis, it has achieved macroeconomic stability, but weak institutional and structural systems leave companies facing a great deal of risk. The Process of Transition The transition process has provided significant opportunities for MNEs. As the countries in transition have liberalized and opened their doors to the outside world, many foreign companies have increased their exports to them. In addition, the privatization process has provided many opportunities for foreign companies to acquire state-owned companies and enter the market through acquisition. For Russia, the transition to a market economy has been difficult because the government has been trying simultaneously to change the country’s economy and its political system. The resulting political turmoil is exacerbated by the battle between conservatives who are afraid of moving too fast and reformers who want to install capitalism quickly through privatization and price decontrol. The Soviet economy was cumbersome, inefficient, and corrupt, but somehow it seemed to work. However, the breakup of the central Soviet government and the loss of the relation resulted Russia had with the other 14 Soviet republics and the former Eastern bloc countries has resulted in a contraction of the economy every year since 1989. Although government statistics are not very reliable, it is estimated that the Russian economy by the end of 1996 was half the size of the economy in 1989, which is a steeper contraction than the Great Depression in the United States. 11.154

The transition to a market economy in Russia has included massive privatization. However, most of the companies ended up in the hands of the former managers under communist rule. The economic crisis in Russia in August 1998 exposed a number of serious weaknesses. Under the socialist system that existed prior to 1989, the economy operated under soft budget constraints and hard administrative constraints. The focus was not on profits but on meeting the goals established by the state. Managers knew that they would receive subsidies, loans on easy terms, and a delay in tax payments to make up for a deficit in the bottom line. However, Russian managers were under the control of the state and had to behave. They might have skimmed some profits for their private gain, but they had to meet the requirements of the central plan and take care of the workers. Any shortcomings in these areas were dealt with severely. Now Russia is trying to adjust to the market economy. Soft budgets have not been done away with entirely, but administrative constraints have disappeared. In their place is “old boy” cronyism and corruption. The allegations of corruption, money laundering, and capital. Bight by key Russian businesspeople, officials, and family members of high government officials became evident in the aftermath of the crisis of 1998 when the ruble was devalued. The economy has also had a difficult time with fiscal and monetary reform. It has suffered large budget deficits for two major reasons. The first is that it was not collecting taxes. Second, the government was having trouble-curtailing spending, two problems which are not unique to countries in transition, as noted in the earlier section on internal deficits. In 1978, China’s government launched reforms designed to move the Chinese economy away from central planning, government ownership, and import substitution policies (the favoring of local production over imports) and toward greater decentralization and an opening up of the Chinese economy. Since then, the Chinese economy has grown dramatically. From 1990 to 1999, the economy grew at an average annual rate of 10.7 percent. The Chinese approach to transformation differs significantly from that of the former Soviet Union, since the Chinese leadership is not at all interested in democratic reform. It continues to hold tight to totalitarian political control. Initially, privatization was not an issue, but China has moved to liberalize its economy and allow private investment while not completely giving up control of the economy. However, every year, the Chinese government loosens the economy a little bit more. Chinese growth in GDP has exceeded that of the industrial countries, the world in general, and East Asia and the Pacific. However, China’s growth initially was internal rather than export-led in contrast to other East Asian countries like Korea, Japan, and Taiwan. But China struggles with its stateowned enterprises (SOEs). Although the SOEs are becoming less influential in the Chinese economy, they are still huge and a source of concern because of the large numbers of people they employ. Most of Chinas government subsidies have shifted from daily necessities to covering enterprise losses, which is the

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Liberalizing economic activity, prices, and market operations, along with reallocating resources to their most efficient use.

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same as the soft budget constraints mentioned earlier in the example of the former Soviet Union. Although China has borrowed from abroad, it has financed over 75 percent of its growth from domestic sources, but it has some of the largest foreign-exchange reserves in the world to back up current and future international borrowing.

Although the. Chinese government is supporting them so as not to have massive unemployment during transition, it is moving to privatize more of them each year so that it is not burdened with them in the future. In addition, now that China has joined the World Trade Organization (WTO), it must also open up its economy even more, exposing its enterprises to foreign competition. Many of the issues identified earlier are not unique to economies in transition. Within the next 5 to 10 years, as the legacy of communism and a command economy grows fainter, the challenges of countries in transition will be virtually the same as those of other developing countries. Case Study

Figure 7.3 Reforms and Economic Progress There are several reforms that are necessary to achieve economic progress, but there are also factors that retard economic progress. Source: Reprinted by permission of the international monetary fund © International Monetary fund, Finance & Development, June 1999, Volume 36, Number 2. The Future of Transition In its report on economic transition in Eastern Europe and the former Soviet Union, the World Bank noted that many of the challenges of the first five years of reform continue. Some of the major challenges that the countries in transition will have to resolve are:

The Daewoo Group and the Asian Financial Crisis In 1999, Daewoo Group (www. Daewoo.com) Korea’s second largest chaebol, or family-owned conglomerate, collapse under $57 billion in debt and was forced to split into independent companies. The Asian financial crisis and its aftermath finally took its toll on the expansion-minded Daewoo and forced both Daewoo and the Korean government to decide how to dissolve the chaebol. Kim Woo-Choong started Daewoo in 1967 as a small textile company with only five employees and $10,000 in capital. In just 30 years, Mr. Kim had grown Daewoo into a diversified company with 250,000 employees worldwide as well as over 30 domestic companies and 300 overseas subsidiaries that generated sales of more than $100 billion annually. However, some estimated that Daewoo and its subcontractors employed 2.5 million people in Korea. Although Daewoo started in textiles, it quickly moved into other fields, first heavy and chemical industries in the 1970s, and then technology intensive industries in the 1980s. By the end of 1999, Daewoo was organized into six major divisions:

1. Continued macro stability. The crisis of 1998 helped Russia achieve basic macroeconomic stability (in terms of controlling inflation), fiscal stability, and a more stable exchange rate. But continued efforts need to be made to keep these areas in control.

• Trading Division

2. Maintaining economic growth. The boost to the Russian economy from the devaluation of 1998 and the rise in oil prices has helped spur economic growth, but growth in domestic demand continues to be a challenge. This is definitely not a problem in China, where domestic demand has been especially strong. 3. Continued improvement in institutional and structural areas. This includes the protection of property rights, the functionality of the legal system, the liberalization of new enterprise entry and the reduction of administrative barriers to enterprises, and the development of an effective banking structure in which people can have confidence.

• Electronics and Telecommunications

4. The solution of social issues, such as poverty, child welfare, and HIVIAIDS. The challenge facing the Chinese leadership is how to maintain economic growth as the country continues to transition to a market economy while resisting the growing pressures to liberalize politically. The key is the reform of the SO Es.

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• Heavy Industry and Shipbuilding • Construction and Hotels • Motor Vehicle Division • Finance and Service

However, Daewoo was struggling. Its $50 billion debt was 40 percent greater than in 1998, equaling 13 percent of Korea’s entire GDP. A good share of that total, about $10 billion, was owed to overseas creditors. Its debt-to-equity ratio (total debt divided by shareholders’ equity) in 1998 was 5 to 1, which was higher than the 4 to 1 average of other large chaebol, but it was significantly higher than the U.S. average, which usually is around 1 to 1 but which rarely climbs above 2 to 1. Of course, there is no way of knowing the true picture of Daewoo’s financial information because of the climate of secrecy in Korean companies. In addition, it is possible that Daewoo’s estimated debt might be greatly underestimated because no one knows whether or not the $50 billion figure7.3 included debt of foreign subsidiaries. How did Daewoo get into such a terrible position, and how much did the nature of the Korean economy and the Asian financial crisis affect Daewoo?

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The chaebol, of which the four largest were Hyundai, Daewoo, Samsung, and the LG Group, became the dominant business institutions during the rise in the Korean economy. They were among W largest companies in the world and were very diversified, as can b:: seen by Daewoo’s investment and business choices. They were held together by ownership, management, and family ties. In particular family ties played a key role in controlling the chaebol. Until the 1980s, the banks in Korea provided most of the funding to the chaebol, and they were owned and controlled by the government. Because of the importance of exporting, the chaebol were all tied to general trading companies. The chaebol received lots of support from the government, and they were also very loyal to the government, giving rise to charges of corruption. Most chaebol were initially involved in light industry, such as textile production, but the government realized that companies needed to shift first to heavy industry and then to technology industries. Daewoo transitioned to heavy industry in 1976 when the Korean government asked President Kim to acquire an ailing industrial firm rather than let the firm go out of business and create unemployment. Asian Financial Crisis and Its Impact On Korea The country continued to liberalize, and democracy finally came into being in 1988 with the introduction of a new constitution and the election of Kim Young-Sam, the first democratic president in Korea’s, history. The economy also continued to grow at 5 to 8 percent annually during the early to mid- 1990s, led primarily by exports, and the World Bank predicted that Korea would have the seventh largest economy in the world by 2020. However, the Asian financial crisis brought that growth to a halt. After the Thai baht was devalued on July 2, 1997, the Korean won soon followed, and the Korean stock market crashed as well. By the end of 1997, the South Korean won -as 46.2 percent lower than its predevaluation rate. At the time the Crisis hit. Korea’s external debt was estimated to be $110 billion to S’ 50 billion, 60 percent of it maturing in less than one year. In additional, Korea had another $368 billion of domestic debt. Korea’s banks had been a tool of state industrial policy, with the government ordering banks to make loans to certain companies even if they were not healthy. Banks borrowed money in dollars and lent them to firms in won, shifting the 11.154

burden of the foreign exchange from the firms to the banks. Hanbo Steel and Kia Motors went bankrupt, leaving some banks with huge losses. The Korean won fell in the fall of 1997, causing the government to raise interest rates to support the won and resulting in more problem loans. Bad loans at the nine largest financial institutions in Korea ranged from 94 percent to 376 percent of the banks’ capital, making the banks technically insolvent. The chaebol were also very overextended. The top five chaebol were in an average of 140 different businesses, ranging from semiconductor manufacture to shipbuilding to auto manufacturing. This was happening during a time when most other companies in the industrial world were selling off unrelated businesses and focusing on their core competencies. Twenty-five of the top 30 chaebol had debt-to-equity ratios of 3 to 1, and 10 had ratios of over 5 to 1, as noted earlier. Compare this to Toyota Motor of Japan, which had a debt-to-equity ratio in 1998 of 0.7 to 1. During this crisis, Korea began to negotiate with the IMF for help. The IMF agreed to help, but only if Korea raised interest rates to support its currency, reduced its budget deficits, reformed its banks, restructured the chaebol, improved financial disclosure, devalued the currency (to stimulate exports even more), promoted exports, and restricted imports. In return for a pledge to introduce the reforms, the IMF released funds to Korea to help it payoff its foreign debt and to keep its banks from going bankrupt. This in turn brought in more money from foreign banks that were encouraged by Korea’s pledge to reform itself. One of the IMF’s key areas was banking reform. The IMF encouraged Korea to open up its banking sector to foreign investment, hoping that an infusion of foreign banking expertise might help the Korean banks make better loans. Of course, foreign banks had made a sizable number of bad loans in Asia as well. In addition, the IMF encouraged the Korean government to pass good bankruptcy laws to allow bad companies, including banks, to fail. However, the IMF hoped that Korean banking institutions would merge, forming fewer but stronger banks. In addition, the IMF encouraged banking reform in order to cut the links between bankers and politics, tighten supervision and regulation of the banking industry, and improve accounting and disclosure. Impact of the Crisis on Daewoo While the financial crisis was going on, Daewoo’s President Kim ignored the warning signs and continued to expand. In 1998, a year when the Daewoo Group lost money, it added 14 new firms to its existing 275 subsidiaries. While Samsung and LG were cutting back, Daewoo added 40 percent more debt. Finally, Korean President Kim Dae Jung had had enough. He ordered the banks to stop lending to the chaebol until they came up with and began to execute a plan to sell off businesses and to focus on their core competencies. But that didn’t stop Daewoo. To get access to more money to feed its growth. Daewoo issued corporate bonds, which were purchased by Investment Trust Companies (lTCs), finance companies associated with the chaebol. The ITCs purchased nearly $20 billion in corporate bonds.

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INTERNATIONAL BUSINESS MANAGEMENT

Korean Economy The impact of the Asian financial crisis on Korea was partly a result of the economic system of state intervention adopted by Korea in the mid-1950s. Modeled after the Japanese economic system, the Korean authoritarian government targeted export growth as the key for the country’s future. Initially, the government adopted a strategy of import substitution, and that later gave way to a strategy of “expo,”, or die.” Significant incentives were given to exporters, such as access to low-cost money (often borrowed abroad in dollars and loaned to companies at belowmarket interest rates in Korean won), lower corporate income taxes, tariff exemptions, tax holidays for domestic suppliers of export firms, reduced rates on public utilities, and monopoly rights for new export markets. Clearly, the government wanted Korean companies to export.

INTERNATIONAL BUSINESS MANAGEMENT

In early 1999, Daewoo announced a plan to sell off some of its businesses to comply with government restructuring requirements before the government took more drastic action, such as nationalization. However, the plans limped along until July 1999. At that point with Korea still in a deep recession, Daewoo announced that it would go bankrupt unless its Korean creditors backed off. It basically could not even service its interest payments of $500 million a month. let alone its principal. The government immediately stepped in and froze Daewoo’s loans until November 1999. This shock rippled through Korea, because nobody thought a chaebol would ever be allowed to collapse. That had never happened before, and the close ties between government and business were such that it was never expected to happen. The shock of Daewoo’s announcement negatively affected the corporate bond market and the ITCs came under pressure because of their huge exposure to Daewoo. Negotiations in Korea involved 60 banks, some owned by the government, others in the private sector. On September 16, 1999, Daewoo asked its foreign creditors for a moratorium on interest payments until March 2000, so the instability spread to the international markets.

conglomerates to better compete internationally. Of the top-30 chaebol that existed prior to the economic crisis, only 14 remain.

Daewoo’s Future By the end of 1999, Daewoo’s President Kim was left with few options to solve Daewoo’s problems. One possibility was to dismantle Daewoo and let it have only auto-related businesses. All of the other businesses would be sold off to domestic or foreign investors, and the name would be changed to something other than Daewoo. Another option for President Kim was to sell some of Daewoo’s auto assets. Ford, Daimler Chrysler, and General Motors showed interest, but selling Daewoo Motor, the second largest automaker in Korea, would be a big blow to the country.

4. What risks does GM face in taking over Daewoo Motor?

The improving economy helped General Motors make its decision’ to purchase Daewoo Motor, but GM is faced with a new decision: how to market Daewoo cars and reduce the $830 million of Daewoo debt Should GM continue selling Daewoo cars in the United States and Europe and compete with its own brands? Without increasing its debt, will it be able to restore Daewoo’s 37 percent share of the market in Korea? Questions 1. How would you describe Korea’s economic system? What are the key elements in that system? How would you describe the interaction between politics and economics in Korea? 2. Does Korea look like a good place to invest? Why or why not? 3. What are the key mistakes Kim Woo-Choong made in formulating and implementing paewoo’s strategy, and how did the economic crisis in Korea and in the rest of Asia affect that strategy?

As the Korean economy began to recover in 1999, some felt that the chaebol should weather the storm and not allow themselves to be broken up. However, President Kim Dae Jung had mandated that the chaebol get their debt-to-equity ratios from 5 to 1 to 2 to 1 by the end of 1999, and that goal seemed impossible unless there was a huge infusion of equity capital or either a write-off of debt through debt restructuring with the banks or a selling off of debt-laden businesses to others. Under immense pressures caused by the debt and by accusations of fraud and embezzlement, President Kim Woo-Choong abandoned his company and fled the country. The government separated the Daewoo subsidiaries and worked with creditors to convert the debt to equity, to set up subsidiaries on debt workout programs, and to look for buyers. After a year of negotiations, General Motors purchased a portion of the $1.2 billion Daewoo Motor in April 2002 for $400 million agreed to keep only three manufacturing plantstwo in Korea and one in Vietnam-leaving creditors scrambling to sell its other plants in Eastern Europe, Asia, and the Middle East. By mid-2002, the Korean economy was showing promising signs of recovery and reform. In 2001, the economy grew by 3 percent and was expected to grow by 5 to 6 percent in 2002. The government has done away with debt-based management of the large chaebol and is working to dissolve the large

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