Over twelve months to the end of March the KOSPI, South Korea’s main equity index, has risen by almost 13 per cent in US$ terms. Although nothing to sneer at, this lags most of the rest of the region, with Asia’s aggregate returns approximately 18% as measured by the MSCI.
These numbers disguise Korea’s recent performance, however, rising 15% in the first quarter, compared to the region (marginally over 13%) and beaten only by India.
Historically Korea has been a lead indicator for global growth, so is this stronger performance just a sign of rising global expectations following Trump’s inauguration? Potentially, but we believe there is also a chance that it is more a reflection of domestic improvements that have bolstered the country’s potential, and which could continue to do so.
For this to fully succeed change to current ruling structures is required. The current status has been instrumental in South Korea’s incredible success story, as the country evolved from an agricultural nation to an industrial one over the past 50 years, becoming one of very few emerging countries to free itself from the ‘middle-income trap’, lifting per capita gross national income from US$260 in 1970 to over US$27,000 by 2015. In part this is due to companies developing their own internationally competitive products, of which Samsung and Hyundai are the most visible brands.
Much of this development followed a government aided manufacturing model similar to that of Japan. Businesses were supported by the government, often through encouraged lending from the financial sector, and particularly so at times of distress. Industries expanded at times when competitors were struggling, allowing counter-cyclical investments to strengthen their positions ahead of any upturn. Equally it meant that many companies that could have gone bust at times of crisis, instead saw unnatural alliances breathing new life into old assets.
This also led to a small number of powerful families becoming very rich. They were the ones who ran large conglomerates (chaebols, literally ‘money clan’ in Korean) with government blessing. While the system benefited all and there was little complaint as chaebols’ workers’ pay was high and continued to grow, it also meant that the powerful few, the government, and the banks developed significant entangled relationships.
There is a chance that this model might have run its course. The likes of Samsung Electronics now increases its headcount overseas while domestic worker numbers are static and wealth differential is increasing. This has lessened the benefits accruing to the masses, which in turn erodes their support.
And there have been rumblings that something’s afoot for a few years now. Regulatory changes started in 2014, introducing a tax to punish cash-hoarding corporations in 2015, deliberately inducing them to distribute their income or invest it. Although positive, this seemed to have little traction, while South Korea’s dividend yield remained one of the lowest in the region.
A recent political scandal could be the long-needed catalyst for systemic change. In an extraordinary series of events President Park Geun-hye was impeached, effectively removing her from power on 10th March this year. She was accused of giving undue access and influence to an unelected advisor, who in turn is accused of bribery. The constitutional court has upheld legislature’s December impeachment vote with a unanimous 8 judge decision (only 6 were needed) making Park not just the first female president but also the first democratically elected Korean leader to be removed from office.
These events mean that an election is scheduled for 9th May with increasing likelihood of a leftist leaning government, with the two frontrunners both indicating they will reform the chaebol. Further signs exist of a weakening of the conglomerates’ traditional influences with the related bribery and embezzlement charges against one of the most senior Samsung executives, and a separate investigation into members of the powerful family behind Lotte Group’s business empire. Equally importantly, last August Hanjin Shipping was allowed to fail rather than being bailed out by an unlikely suitor, as has often been the case.
As to how far this goes remains to be seen, but one factor to watch will be any change in tax regime for Korean companies and dividends received by shareholders. A current progressive income tax regime for dividends (up to 38%) stifles increased payouts to minorities as significant owners will not want to be taxed for retrieving their wealth.
If there are greater distributions to minority shareholders and an unwinding of some of the conflicting interests it could have a significant impact on equity performance. Bloomberg estimates that the five biggest chaebols account for half of the Kospi, while Korea’s Fair Trade Commission estimates the 10 biggest (of 45) own 27 per cent of all business assets in South Korea. Vested interests on such a scale lower returns for banks (due to poor lending decisions) and for much of the rest of the economy where industrial production has stagnated. For the banks, the economy as a whole and for us, the minority shareholder, both dividends and total returns are likely to improve. We do not expect progress to be sudden, but it could provide a significant longer term fillip for one of Asia’s cheapest equity markets.