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December 26, 2013

Gap Between Two Koreas Widens With Trade Leader Purge, Brokerage Plans

North and South Korea seem to be moving farther apart, both politically and economically.

Although North Korea was embarking on a quest to bring in outside investment and appeared to be strengthening its economic ties with China, news of the execution of Jang Song Thaek, the second most powerful man in North Korea, have called all that into question.

Jang had been North Korea's man in charge when it came to economic relations with China. He had also overseen the special economic zones that were North Korea's declared means of bringing foreign investment into a country that sorely needs outside funds simply to keep its people fed, much less grow its military-starved economy.

But in December, Jang was publicly hauled out of a Politburo meeting and accused of numerous instances of wrongdoing. Put on trial, he was executed immediately after being convicted of charges that included everything from economic corruption and financial mismanagement to planning a coup to seize the government from his nephew by marriage, Kim Jong Un.

The execution was more typical of 1950s North Korea, leading to speculation that instability is brewing in the government and that Jang's purge was a means for Kim to tighten his hold on power. Talk is also surfacing that Jang was too cozy with the Chinese, and that the prospect of Chinese-style economic reforms might have threatened Kim's supremacy. Jang's death certainly has done nothing to improve relations with North Korea's closest business partner, already uneasy over the North's nuclear tests.

Kim should be wary of angering China, considering that, according to the Korean Development Institute in South Korea, 70% of the North's $8.8 billion in international trade last year was made up of coal and timber that flow to Beijing. And, since China is sending in its own China State Grid Corp. and China Railway Construction Group, among others, to build infrastructure in North Korea's Rason free trade zone, Kim may find his actions could cost him dearly.

In a Korea Economic Institute research paper in February of 2012, just a couple of months after Kim Jong Il's death and Kim Jong Un's succession, Andray Abrahamian said of Rason that, despite the special economic zone's relatively ignored existence for 20 years, "amid political transition in North Korea, reform and reorganization has taken place in the SEZ, while at the same time China has included Rason in its ambitious plans to develop its Northeastern province of Jilin. These changes demonstrate Pyongyang’s increasing need to reach out to foreign investors to reinvigorate its economy. They also point toward China’s desire to develop its Northeast region and promote stability while increasing its leverage over North Korea’s economic growth."

"While still unwilling to truly open the economy, it seems apparent that North Korea’s elites are turning to economic development, growth in light industry and trade and investment to define the new era of governance. The creation of investment organs and national laws relating to corporate activity attest to this and coincide with material and legal changes in Rason as well,” according to Abrahamian. That could change, however, in light of Jang's execution, which many Korea-watchers say was intended to send a very clear message.

Kim has said Jang's execution "will not alter trade goals" and the country announced that new enterprise zones will be set up for tourism and investment. But both the execution and the economic sanctions that North Korea faces for nuclear weapons tests could, and likely should, make investors think twice about any potential deals.

In South Korea, meanwhile, the government has set out to create its own "Goldman Sachs" to give it a place in the international securities market. The sale of Woori Investment & Securities Co. represents Seoul's push to reorganize its securities industry and its quest for a world-class investment bank. KB Financial Group Inc., NH Financial Group Inc. and PineStreet Group have all submitted final bids for the $719 million stake in Woori's brokerage unit.

The South Korean government is encouraging industry consolidation, hoping to build larger, more successful firms that can provide more services to a wider range of clients—not just domestically, but internationally. The country's Financial Services Commission has said that, to that end, it would allow brokerage firms that acquire other firms to enter into new businesses. In October, the FSC also began to license some firms to offer bridge loans, margin financing and prime brokerage services to corporate clients.

The move is likely to succeed with the government behind the push, according to John Blank, chief equity strategist at Zacks. The structure of dominant Korean businesses is the chaebol, a business conglomerate peculiar to South Korea that is a global multinational owning a number of different types of businesses under the control of a single chairman.

The chaebol work closely with banks and with the government, which may, according to Blank, direct a particular chaebol to develop a market in a specific product. He said, "The government has a bunch of industry planners, and they [may] say, [for example,] 'We want a bigger TV market' or 'more tractors.' [The industry planners] lay that target out, and then 'encourage' banks to lend to these companies to build up these niches. It's not central planning, but close to it."

As a result, chaebol may be made up of numerous and often unrelated businesses—such as Samsung Group, which has fingers in electronics but also in insurance, shipbuilding and construction, or the Hyundai Group, which is made up of groups that include Hyundai Motors, Hyundai Heavy Industries Group and Hyundai Marine & Fire Insurance, as well as interests in the steel, trade and construction industries. It's not much of a stretch, with such diversity of holdings, for a company to insert itself into the securities industry, and since the chaebol dominate business in South Korea, such an entree could very well result in a dominant firm before too long.

Blank said that the resulting securities firm would be "the Fannie and Freddie version of Goldman Sachs" because the South Korean government will own a stake in the business and "a seat at the table." This "managed conglomerates" system, with such close ties to the government, means that businesses can build monopolies without hindrance. "They are going to get a Goldman Sachs out of this," Blank said.

Korean Goldman Sachs or not, the outlook for Korean banks is not cheery, according to Fitch Ratings. In its 2014 outlook for Asia-Pacific banks, the ratings agency pointed to an "unsupportive regulatory/social/political environment" that "is likely to persist, leading to further contraction in margins and fees," the falling quality of household loans and the continued rise of "already high" household debt. As a result, the sector outlook is negative, and "upside potential is limited."

Other banks are feeling the pain of South Korea's debt quality, with Standard Chartered Plc and Citigroup Inc. seeing their investments in the country costing rather than paying off. Standard Chartered, beat to the punch by Citigroup in 2004 when the latter purchased Koram Bank for $2.4 billion, in 2005 beat out HSBC Inc. to buy up Korea First Bank, paying $3.3 billion for the privilege.

But neither bet is paying off as their purchasers wished, with the South Korean government limiting household lending in an effort to provide relief to consumers mired in debt. Standard Chartered is taking a $1 billion write down on its South Korea business, and Citigroup has seen its net income from South Korea fall 28% YOY from September 2012, with more pain anticipated in 2014. HSBC, for its part, has already said that it plans to gradually shutter its wealth management and retail banking operations in the country.

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