economic environment- key macro economic issues, inflation

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Key Macroeconomic Issues Affecting BusinessStrategy

In the 2001 Annual Report to Shareholders, the CEO ofHewlett-Packard stated:In terms of economic growth and stability, 2001 was one of thetoughest years on record, particularly for the IT [informationtechnology] industry. Triggered in part by the collapse of thehyper inflated dot-com sector, in Q3 of calendar 2001, the U.S.economy softened considerably. A dramatic slowdown inbusiness investment, compounded by the events of September11, tipped the United States into its first recession in a decade.During 2001, the world’s three leading economies slowedsimultaneously for the first time since 1974. The Europeaneconomy stalled, and Japan struggled to fight deflation andrecession. Information technology spending plummeted. Thetelecommunications and manufacturing industries-two of HP’slargest customer sectors-were hit especially hard by the globaleconomic slowdown. These factors had a significant impact onHP’s fiscal 200 1 results.This is an example of the impact of the global economy oncompany profits and operating strategy. Management mustlearn to scan the environment to determine market condition inthe countries where it is either doing business or contemplatingentering the market. We will discuss three key issues in thefollowing pages: economic growth, inflation, and surpluses anddeficits. Then we will follow with a section discussing theunique challenges facing countries in transition from a com-mand to a market economy.

Economic GrowthJust as the world was recovering from the Asian financial crisisof 1997, the dot-com (Internet-based companies) bubble burstin 2000, thus triggering the slowdown in economic growth inthe United States that has filtered throughout the world,particularly in Japan and the euro zone. The terrorist attacks ofSeptember 11 compounded this economic slowdown byeroding consumer and business confidence. The (IMF) listedthe direct impact as one of the impacts of the attacks-that is, thedestruction of life and property and the downturn of specificindustries, such as the airline industry. The U.S. Bureau ofEconomic Analysis puts the figure 7.3 of damages and otherinsurance costs around $21.4 billion. The travel industry,including the airlines, and the insurance industry have lostbillions of dollars and are still on the recovery path. It is highlyprobable that some airlines will either have to merge orcompletely go out of business as a result of the devastatingdownturn in that industry. For example, United Airlines wasunable to meet its debt obligations in December 2002 and wasforced to declare bankruptcy. Economists have a difficult timedistinguishing the long-term effects of 9/ 11 from othereconomic events taking place. It is obvious that some of the

short-term impacts, like a fall in the stock market, a decline inconsumer confidence, and the downturn in the airlines industry,are the results of 9/11. As The Economist states, “TheSeptember 11 attacks killed thousands and irrevocably damagedthe lives of thousands more. But the American economy is toolarge, and resilient, to be thrown off course even by suchshocking and tragic events. It is impossible to quantify exactlythe effects of the attacks. But it seems clear that other factorshave played a bigger role.The corporate scandals in companies like Enron andWorldCom led to a large drop in the U.S. stock market, adevelopment that has spread to international markets. Eco-nomic growth throughout major markets in the world has beenbleak since the beginning of the new century.Companies would like every country in which they are investingor to which they are selling to have a high growth rate in GNIand per capita GNI. If this were the case, even if a company didnot expand its share in each market, it would still be able toincrease revenues at the same pace as the general growth in theeconomy. However, there are significant differences in growthrates worldwide, affecting the degree to which investments in orsales to a country can affect the bottom line of a company. Inaddition, given the stagnation of the global economy in 2001and 2002, companies were forced to compete more aggressively,since their growth had to come from picking up more marketshare instead of relying on a growth in the overall market.How can a manager determine which markets will exhibit solidgrowth in the future so that resources can be committed to thatmarket? The best approach is to look at past history and to tryto forecast the future.The Organization for Economic Cooperation and Develop-ment (OECD) said at yearend 2001 that the global economyhad slipped into its first recession in 20 years. However, itclaimed that worldwide growth was returning but varied byregion. The United States led the recovery with stronger growthafter the end of 2001. The euro area recovered more gradually,with growth still slow in mid-2002. Japan’s recovery was alsoslow, but global demand for exports began to pick up. The restof Asia has shown surprising resilience to the global downturn,with growth in China continuing around 7 percent and growthin the Asia Pacific region strengthening in 2002 as the tech sectorturned up. However, future growth is bound to be unpredict-able and variable by region.As illustrated by McDonald’s in emerging markers, a drop ineconomic growth can have detrimental effects on investment.New investors are hesitant to put money into emergingmarkets, whereas existing investors are forced to cut backoperations and maybe even pull out of the market. Thedeveloping countries with high growth rates are often unstablepolitically or offer other challenges.

LESSON 19ECONOMIC ENVIRONMENT- KEY MACROECONOMIC ISSUES, INFLATION

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Many companies, including Intel, have been hurt by the recentslowdown. Intel’s net income for 2001 fell 70 percent from theprevious year as a result of weak PC sales, a slowdown in theeconomy, and weak consumer confidence. Many companiesbuilt up technology inventory with the boom of the late 1990sbecause they expected continued growth; but when therecession hit, most companies cut technology spending andused up inventory. Although Intel hoped sales would pick upin 2002, they have continued to be low, particu1uly in Europe.The new century, which has tended to be very unstable eco-nomically, is proving to be a huge challenge for managers tryingto determine where to invest. Even the high-income countrieshave proven to be a challenge. However, managers need tocontinue to monitor economic news and to try to predict wherethe growth areas will be in the future. The added dimension ofglobal terrorism and its ability to quickly affect the globaleconomy has forced companies to be much more cautious inpredicting the future and in committing significant resources,especially in unstable areas.

InflationAnother economic factor that management needs to consider isinflation. Inflation means mat prices are going up. The inflationrate is the percentage increase in the change in prices from oneperiod to the next, usually a year. Economists use differenttypes of indices to measure inflation, but the one they use themost is the consumer price index (CPI). The CPI measures afixed basket of goods and compares its price from one periodto the next. A rise in the index results in inflation. Inflationoccurs because aggregate demand is growing faster thanaggregate supply. The demand can occur because of govern-ment spending in which spending is rising faster than the taxrevenues that are used to fund the spending or because ofincreases in the money supply. Inflation affects interest rates,exchange rates, the cost of living, and the general confidence in acountry’s political and economic system.High inflation often results in an increase in interest rates fortwo reasons. The first reason is that interest rates must behigher than inflation so that they can generate a real return oninterest-bearing assets. Otherwise, no one would hold thoseassets. Second, monetary authorities such as the Federal ReserveBank in the United States or the European Central Bank usehigh interest rates to bring down inflation. When interest ratesrise, companies are more hesitant to borrow money, and thistends to slow down economic growth. In addition, consumersare hesitant to incur consumer debt because of the higher costof repayment. As demand falls, prices should stabilize or fall.Inflation is also the most significant factor that influencesexchange rates. Basically, the higher the inflation in a country, themore likely that that country’s currency will fall. Countries withlow inflation should have stable or relatively strong currencies.Inflation also affects the cost of living. As prices rise, consumersfind it more difficult to purchase goods and services unless theirincomes rise the same or faster than inflation. During periodsof rapid inflation (e.g., in Brazil in the early 1990s, wheninflation was rising at a rate of 1 percent per day), consumershave to spend their paychecks as soon as they get them, or theywon’t have enough money to buy goods and services later.

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 backunder control. If governments have to raise interest rates andslow down the economy to slow down inflation, social unrestcould occur. This would also occur if governments controlwages while other prices are spiraling out of control, leading toanimosity in the population.A good example of the impact of inflation on corporatestrategy is Pizza Hut in Brazil in the early 1990s. When inflationwas running wild, no one really knew how to compare prices.Prices were changing daily, and salaries were going up as well, sopeople did not have a good reference point. After the newcurrency was implemented in 1994 and prices stopped rising,people began to compare prices and make more informeddecisions. Consumers began to wonder if the relatively higherprice of a Pizza Hut pizza was worth the price, given localalternatives. In the case of purchases, Pizza Hut used to collectsales immediately (the Stores operated on a cash and carry basis)and delay the payment of supplies. Because Pizza Hut wasconstantly increasing prices, it was generating more than enoughcash flow to pay for supplies once they came due. In effect, itwas paying expenses in one period that were incurred in a priorperiod, and the money it was using was worth less than it wasat the beginning of the period, even though the company hadmore of it to spend. So Pizza Hut was paying for supplies withinflated sales revenues. However, this benefit disappeared onceinflation slowed down. Pizza Hut was forced to control costsbetter and to price more aggressively in order to remaincompetitive. High inflation also creates problems for companiesthat deal in exports. If inflation is going up but the exchangerate is staying the same, the products will gradually becomemore expensive in export markets. For example, assume that aBritish exporter is trying to sell a product to a U.S. distributorfor 100 pounds when the exchange rate is $1.59 per Britishpound. That means the product would cost the U.S. distributor$159.00. If due to inflation in the United Kingdom, the pricewere to rise to 110 pounds, it would now cost $174.90 (110 ´$1.59). At that new price, U.S. consumers might start lookingfor substitutes. However, one would expect the exchange rate toeventually change, causing the British pound to become weaker.If the rate falls to $1.47 per pound, the new dollar cost of theproduct would be $161.70 (110 ´ $1.47), which is only a slightrise over the previous price. If the demand by U.S. consumers isvery sensitive to changes in prices, an increase in prices wouldresult in a fall in demand. So without a change in the exchangerate, inflation in Britain would take a toll on U.S. demand.Through the 1990s and continuing into the present, the worldhas witnessed diminishing inflation. When the 1990s began,inflation was around 4 percent in advanced economies, and 100percent in emerging economies. In emerging economies,inflation decreased to double digits by the mid-1990s and singledigits (around 5 percent) by 2000. In advanced economies,inflation decreased to 2.5 percent by 2000. During the Asianfinancial crisis, inflation rates stayed surprisingly low-except inIndonesia. Russia experienced high inflation rates during itsfinancial crisis of 1998-1999, but it has made strong progress inlowering inflation rates. Inflation is still high in Turkey,


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TVenezuela, Indonesia, and Argentina. Managers need tomonitor trends in inflation to determine how inflation couldaffect their company’s cost structure and competitiveness inworld markets as well as to anticipate possible changes inmonetary policy in response to increases in inflation.

Surpluses and DeficitsOther measures of a country’s economic stability-and potentialas a location for investment-are external and internal surplusesand deficits. Managers need to monitor these balances asindicators of economic strength or weakness. Surpluses rarelyare a problem, but deficits are. An external deficit is when acountry’s cash outflows exceed its inflows. An internal deficit iswhen government expenditures exceed government revenues.The Balance of Payments The balance of payments records acountry’s international transactions. These can be transactionsbetween companies, governments, or individuals. U.S. Interna-tional Transactions 2001,” the balance of payments is dividedinto the current account and the capital and financial account.The current account is comprised of trade in goods and servicesand income from assets abroad and payments on foreign-owned assets in the country. Part of the current account ismerchandise trade balance, or the balance on goods, whichmeasures the country’s merchandise trade deficit or surplus.This can be found on line 71 of the Appendix at the end of thelesson, which is a more detailed version of Merchandiseincludes goods such as automobiles and wheat. A countryderives this balance by subtracting imports from exports. In thecase of the United States, this means subtracting the dollarvalue of its imports from that of its exports. If exports exceedimports, the country has a trade surplus, and if imports exceedexports, the country has a trade deficit. An export is consideredpositive because it results in a payment received from abroad-aninflow of cash. An import is considered negative because itresults in a payment made to a seller abroad-an outflow of cash.For example, the investment and consumption boom of the1990s 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, theUnited States hit a record monthly trade deficit of $35.9 billion.As the deficit continued to climb, the U.S. dollar came underpressure in foreign-exchange markets, and the dollar began tofall. This led to a decline in investor confidence, particularlyamong foreign investors, with expectations that the FederalReserve Bank would raise interest rates. All of this could meana slower economic recovery for the United States.The second component of the current account is services, whichincludes transactions such as travel, passenger fares, and othertransportation, as well as royalties and fees on licensingagreements with foreign customers. Although the populardefinition of the trade balance usually refers just to merchandisetrade, it is probably more accurate to measure the goods andservices trade balance together. For some economies, like thatof the United States, which generates a large percentage of itsGNI from services, the balance on goods and services is a moreaccurate measure than just goods. In 2001, for example, theUnited States had a merchandise trade deficit of $427.165

billion, whereas it had a slightly lower goods and services deficitof $358.290 billion due to a services surplus of $68.875 billion.The third component of the current account is income receipts-payments on assets. This includes items such as receipts fromforeign direct investments abroad. A final category, unilateraltransfers, is typically not a significant component of the currentaccount balance, but it includes government and private reliefgrants and income transferred abroad by guest workers, such asTurkish workers in Germany sending money back to theirfamilies in Turkey. The current account balance is an importantlong run and comprehensive measure of a country’s transac-tions with the rest of the world.The capital account shows transactions in real or financial assetsbetween countries. For example, when the Turtle Bay HiltonHotel on the north shore of Oahu, Hawaii, was sold toJapanese investors, the transaction was recorded as an inflow ofcapital to the United States, which is a positive transaction in thecapital account. Other examples of capital account transactionsinclude foreign direct investments, such as the purchase ofChrysler (United States) by Daimler Benz (Germany); thepurchase and sale of securities, such as the purchase of Brazilianstocks by an American investor; and the purchase of U.S.treasury bonds by a Japanese investor. Also measured infinancial assets are changes in the official reserve assets of acountry, such as gold, special drawing rights and foreigncurrencies.What difference does it make to companies whether a countryhas a current account surplus or deficit? There probably is nodirect effect. However, the events that comprise the balance-of-payments data influence exchange rates and government policy,which, in turn, influence corporate strategy. As a manager ismonitoring the investment climate of a country where thecompany has invested or is considering investing assets, it isimportant to watch for factors that might lead to currencyinstability. One of the problems leading up to the Argentinefinancial crisis was the large current account deficit that itaccumulated throughout the 1990s. This deficit led Argentina’sforeign debt to grow to about one-half of one year’s GDP. Apopular fiscal policy that can be used to combat a growingaccount deficit is to devalue the currency, making exports morepopular to the rest of the world. Argentina was unwilling todevalue its currency, the peso, because Argentine policy kept thepeso pegged to the U.S. dollar. The dollar-and thus, the peso-was very strong at the end of 2001, making Argentine exportsunattractive and imports more appealing. Eventually, therecession and high interest payments on foreign debt took theirtoll, and Argentina defaulted on its $155 billion of foreigndebt. In January 2002, the president of Argentina decided thatthe best course of action would be to let the peso float. ByFebruary 1, 2002, the peso had lost half its value, making itworth only 0.494 U.S. dollars. Foreign companies have lost allinterest in expanding into Argentina until its economic climatestabilizes. By monitoring trends in the balance of payments, amanager can add one more piece of data when deciding whetheror not to do business in a country.


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External Debt Many developing countries-in both the publicand private sector-borrowed heavily abroad during the 1990s tofuel expansion. This external debt can be measured in twoways-as the total amount of the debt and as debt as a percent-age of GDP. The larger these two numbers become, the moreunstable the economies of those countries become. Foreigninvestors need to monitor debt to determine if the governmentwill need to take corrective action to reduce its debt, normally byslowing down economic growth.The most heavily indebted countries in the world in terms oftotal 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 ofthese countries are large in terms of GDP, so debt as a percent-age of GDP was comparatively small. In the case of Brazil,external debt is 40 percent of GDP. However, many Africancountries have external debt in excess of 100 percent of GDP.The plight of the African countries is severe, because the onlyway to get access to foreign capital is to borrow it from interna-tional banks and institutions like the World Bank. They are notable to attract foreign investment because of small marketconditions and political instability, so they must turn to foreigndebt to expand. This is going to make it virtually impossible forthem to payoff their debt. Most of the foreign exchange theyearn 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 countrybecause they felt there was no risk of currency devaluation. Yeteven when the economy started dropping in 1996, investorskept on, pouring money into Argentina believing things wouldpick up, and Argentina kept spending heavily. As noted earlier,in January 2002, Argentina defaulted on its $155 billion inexternal debt, the largest default by any country in history.Internal Debt and Privatization External debt results fromborrowing money abroad. Internal debt results from an excessof government expenditures over revenues. The governmentbudget deficits each year contribute to the overall debt. In thecase of the European Union (EU), the target is to have annualdeficits no greater than 3 percent of GDP and total debt nogreater than 60 percent of GDP. In contrast, India has hadserious problems with its internal debt. The general govern-ment deficit (central and state budget deficit) was estimated in2002 to be 10.25 percent of GDP. Including state-ownedenterprises, the public sector deficit was estimated to haveexceeded 11.7 percent of GDP, and the public sector gross debtwas over 90 percent of GDP.Government internal deficits occur for one of several reasons:The tax system is so poorly run that the government cannotcollect all the revenues it wants to, government programs muchas defense and welfare are too big for revenues to cover, andstate-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 expensecontrol and budget management, as well as improving taxpolicy. Sometimes, however, governments may work hard to

control expenditures but fall short due to a recession, whichreduces the amount of taxes it collects.As countries move to control expenditures and reduce theirbudget deficits, one important strategy to pursue is theprivatization of state-owned enterprises. Privatization reducesdebt by removing the need of the government to subsidize thestate-owned enterprises. When the government owns enter-prises, it often feels an obligation to keep the enterprises a floatto preserve jobs. Once it is free from ownership, the enterprisescan succeed or fail on their own merits.However, privatization is not easy. It is a political as well as aneconomic process, and political objectives do not always resultin the best economic results. Many state-owned enterprises,such as Pemex, the state-owned oil company in Mexico, areconsidered to be the crown jewels of a country, and it is difficultto allow them to be sold off to private investors, especiallyforeign investors. In addition to political objectives are politicalimpediments, such as the obstructive attitudes of existingmanagers and employees of state-owned enterprises. Thus,consider again the example of India cited earlier, in which thedeficits of state-owned enterprises raises raised the overallgovernment debt from 10.25 percent to 11.7 percent of GDPand the stock of government debt from 80 percent to 90percent of GDP.In most countries, the problem with privatization is selling theinefficient, unproductive enterprises-not those that have achance to survive. Where permitted, the privatization processenables foreign companies to pick up assets and gain access tomarkets through acquisition. In Eastern Europe, Latin America,and East Asia, the number of foreign investors purchasingstate-owned enterprises has been increasing, particularly insectors like telecommunications, banking, oil, and gas. Foreignpurchases account for about 76 percent of the total.

Transition to a Market EconomySo far, we’ve been learning about economic systems with theassumption that countries are in one economic system oranother and that they were not in transition from one classifica-tion to another. However, many countries are undergoingtransition from command economies to market economiesbecause of the failure of central planning to generate economicgrowth. The process of transition has made the world ofinternational business very interesting indeed.The breakup of the Berlin Wall and the overthrow of EasternEuropean communist dictatorships in 1989 renewed Westerninterest in doing business in countries throughout EasternEurope as well as in the former Soviet Union that previouslyhad been off limits. These countries were classified as com-mand economies. Most of the command economies are in theprocess of transition to a market economy. Command econo-mies in transition are typically grouped into East Asian (such asChina and Vietnam) and European. Some have shownconsistent economic growth since the transition process began,some have experienced growth reversals, and others haveshown little or no growth.What does transition mean? In general, transition implies:


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TLiberalizing economic activity, prices, and market operations,along with reallocating resources to their most efficient use.Developing indirect, market-oriented instruments for macroeco-nomic stabilization.Achieving effective enterprise management and economicefficiency, usually through privatization.Imposing hard budget constraints, which provide incentives toimprove efficiency. Establishing an institutional and legalframework to secure property rights, the rule of law, andtransparent market-entry regulations.The process of transformation to a market economy differsfrom country to country-no single formula applies to all. Inaddition, the various economies in transition differ greatly intheir commitment to and progress toward transformation intomarket economies.Why do these changes bring renewed Western interest in doingbusiness with economies in transition? The answer is partlypolitical and partly economic. Most economies in transitionexperienced slow economic growth during the Cold War yearsof the 1970s and 1980s. Consequently, the outlook for foreigninvestors who wanted to do business in those countriesseemed bleak. But with the end of the Cold War came the hopethat the governments of these countries would eliminate theirtrade barriers, thus encouraging economic growth and increasedbusiness opportunities. However, there is still significantvolatility in the midst of change. As the Russian economic crisisin 1998 showed, the transition is not smooth. Russia is one ofthe countries in transition that is experiencing extreme volatility.Since the economic crisis, it has achieved macroeconomicstability, but weak institutional and structural systems leavecompanies facing a great deal of risk.

The Process of TransitionThe transition process has provided significant opportunitiesfor MNEs. As the countries in transition have liberalized andopened their doors to the outside world, many foreigncompanies have increased their exports to them. In addition,the privatization process has provided many opportunities forforeign companies to acquire state-owned companies and enterthe market through acquisition.For Russia, the transition to a market economy has beendifficult because the government has been trying simultaneouslyto change the country’s economy and its political system. Theresulting political turmoil is exacerbated by the battle betweenconservatives who are afraid of moving too fast and reformerswho want to install capitalism quickly through privatization andprice decontrol.The Soviet economy was cumbersome, inefficient, and corrupt,but somehow it seemed to work. However, the breakup of thecentral Soviet government and the loss of the relation resultedRussia had with the other 14 Soviet republics and the formerEastern bloc countries has resulted in a contraction of theeconomy every year since 1989. Although government statisticsare not very reliable, it is estimated that the Russian economy bythe end of 1996 was half the size of the economy in 1989,which is a steeper contraction than the Great Depression in theUnited States.

The transition to a market economy in Russia has includedmassive privatization. However, most of the companies endedup in the hands of the former managers under communistrule.The economic crisis in Russia in August 1998 exposed anumber of serious weaknesses. Under the socialist system thatexisted prior to 1989, the economy operated under soft budgetconstraints and hard administrative constraints. The focus wasnot on profits but on meeting the goals established by thestate. Managers knew that they would receive subsidies, loanson easy terms, and a delay in tax payments to make up for adeficit in the bottom line. However, Russian managers wereunder the control of the state and had to behave. They mighthave skimmed some profits for their private gain, but they hadto meet the requirements of the central plan and take care of theworkers. Any shortcomings in these areas were dealt withseverely.Now Russia is trying to adjust to the market economy. Softbudgets have not been done away with entirely, but administra-tive constraints have disappeared. In their place is “old boy”cronyism and corruption. The allegations of corruption, moneylaundering, and capital. Bight by key Russian businesspeople,officials, and family members of high government officialsbecame evident in the aftermath of the crisis of 1998 when theruble was devalued.The economy has also had a difficult time with fiscal andmonetary reform. It has suffered large budget deficits for twomajor reasons. The first is that it was not collecting taxes.Second, the government was having trouble-curtailing spend-ing, two problems which are not unique to countries intransition, as noted in the earlier section on internal deficits.In 1978, China’s government launched reforms designed tomove the Chinese economy away from central planning,government ownership, and import substitution policies (thefavoring of local production over imports) and toward greaterdecentralization and an opening up of the Chinese economy.Since then, the Chinese economy has grown dramatically. From1990 to 1999, the economy grew at an average annual rate of10.7 percent.The Chinese approach to transformation differs significantlyfrom that of the former Soviet Union, since the Chineseleadership is not at all interested in democratic reform. Itcontinues to hold tight to totalitarian political control. Initially,privatization was not an issue, but China has moved toliberalize its economy and allow private investment while notcompletely giving up control of the economy. However, everyyear, the Chinese government loosens the economy a little bitmore. Chinese growth in GDP has exceeded that of theindustrial countries, the world in general, and East Asia and thePacific. However, China’s growth initially was internal ratherthan export-led in contrast to other East Asian countries likeKorea, Japan, and Taiwan. But China struggles with its state-owned enterprises (SOEs). Although the SOEs are becomingless influential in the Chinese economy, they are still huge and asource of concern because of the large numbers of people theyemploy. Most of Chinas government subsidies have shiftedfrom daily necessities to covering enterprise losses, which is the


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same as the soft budget constraints mentioned earlier in theexample of the former Soviet Union. Although China hasborrowed from abroad, it has financed over 75 percent of itsgrowth from domestic sources, but it has some of the largestforeign-exchange reserves in the world to back up current andfuture international borrowing.

Figure 7.3 Reforms and Economic ProgressThere are several reforms that are necessary to achieve economicprogress, but there are also factors that retard economicprogress.Source: Reprinted by permission of the international monetaryfund © International Monetary fund, Finance & Development,June 1999, Volume 36, Number 2.

The Future of TransitionIn its report on economic transition in Eastern Europe and theformer Soviet Union, the World Bank noted that many of thechallenges of the first five years of reform continue. Some ofthe major challenges that the countries in transition will have toresolve are:1. Continued macro stability. The crisis of 1998 helped Russia

achieve basic macroeconomic stability (in terms ofcontrolling inflation), fiscal stability, and a more stableexchange rate. But continued efforts need to be made to keepthese areas in control.

2. Maintaining economic growth. The boost to the Russianeconomy from the devaluation of 1998 and the rise in oilprices has helped spur economic growth, but growth indomestic demand continues to be a challenge. This isdefinitely not a problem in China, where domestic demandhas been especially strong.

3. Continued improvement in institutional and structuralareas. This includes the protection of property rights, thefunctionality of the legal system, the liberalization of newenterprise entry and the reduction of administrative barriersto enterprises, and the development of an effective bankingstructure in which people can have confidence.

4. The solution of social issues, such as poverty, child welfare,and HIVIAIDS.

The challenge facing the Chinese leadership is how to maintaineconomic growth as the country continues to transition to amarket economy while resisting the growing pressures toliberalize politically. The key is the reform of the SO Es.

Although the. Chinese government is supporting them so asnot to have massive unemployment during transition, it ismoving to privatize more of them each year so that it is notburdened with them in the future. In addition, now that Chinahas joined the World Trade Organization (WTO), it must alsoopen up its economy even more, exposing its enterprises toforeign competition.Many of the issues identified earlier are not unique to econo-mies in transition. Within the next 5 to 10 years, as the legacy ofcommunism and a command economy grows fainter, thechallenges of countries in transition will be virtually the same asthose of other developing countries.

Case Study

The Daewoo Group and the Asian Financial CrisisIn 1999, Daewoo Group (www. Daewoo.com) Korea’s secondlargest chaebol, or family-owned conglomerate, collapse under$57 billion in debt and was forced to split into independentcompanies. The Asian financial crisis and its aftermath finallytook its toll on the expansion-minded Daewoo and forcedboth Daewoo and the Korean government to decide how todissolve the chaebol.Kim Woo-Choong started Daewoo in 1967 as a small textilecompany with only five employees and $10,000 in capital. Injust 30 years, Mr. Kim had grown Daewoo into a diversifiedcompany with 250,000 employees worldwide as well as over 30domestic companies and 300 overseas subsidiaries thatgenerated sales of more than $100 billion annually. However,some estimated that Daewoo and its subcontractors employed2.5 million people in Korea. Although Daewoo started intextiles, it quickly moved into other fields, first heavy andchemical industries in the 1970s, and then technology intensiveindustries in the 1980s. By the end of 1999, Daewoo wasorganized into six major divisions:• Trading Division• Heavy Industry and Shipbuilding• Construction and Hotels• Motor Vehicle Division• Electronics and Telecommunications• Finance and ServiceHowever, Daewoo was struggling. Its $50 billion debt was 40percent greater than in 1998, equaling 13 percent of Korea’sentire GDP. A good share of that total, about $10 billion, wasowed to overseas creditors. Its debt-to-equity ratio (total debtdivided by shareholders’ equity) in 1998 was 5 to 1, which washigher than the 4 to 1 average of other large chaebol, but it wassignificantly higher than the U.S. average, which usually isaround 1 to 1 but which rarely climbs above 2 to 1. Of course,there is no way of knowing the true picture of Daewoo’sfinancial information because of the climate of secrecy inKorean companies. In addition, it is possible that Daewoo’sestimated debt might be greatly underestimated because no oneknows whether or not the $50 billion figure7.3 included debtof foreign subsidiaries.How did Daewoo get into such a terrible position, and howmuch did the nature of the Korean economy and the Asianfinancial crisis affect Daewoo?


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TKorean EconomyThe impact of the Asian financial crisis on Korea was partly aresult of the economic system of state intervention adopted byKorea in the mid-1950s. Modeled after the Japanese economicsystem, the Korean authoritarian government targeted exportgrowth as the key for the country’s future. Initially, the govern-ment adopted a strategy of import substitution, and that latergave way to a strategy of “expo,”, or die.” Significant incentiveswere given to exporters, such as access to low-cost money (oftenborrowed abroad in dollars and loaned to companies at below-market interest rates in Korean won), lower corporate incometaxes, tariff exemptions, tax holidays for domestic suppliers ofexport firms, reduced rates on public utilities, and monopolyrights for new export markets. Clearly, the government wantedKorean companies to export.The chaebol, of which the four largest were Hyundai, Daewoo,Samsung, and the LG Group, became the dominant businessinstitutions during the rise in the Korean economy. They wereamong W largest companies in the world and were verydiversified, as can b:: seen by Daewoo’s investment andbusiness choices. They were held together by ownership,management, and family ties. In particular family ties played akey role in controlling the chaebol. Until the 1980s, the banks inKorea provided most of the funding to the chaebol, and theywere owned and controlled by the government. Because of the importance of exporting, the chaebol were alltied to general trading companies. The chaebol received lots ofsupport from the government, and they were also very loyal tothe government, giving rise to charges of corruption.Most chaebol were initially involved in light industry, such astextile production, but the government realized that companiesneeded to shift first to heavy industry and then to technologyindustries. Daewoo transitioned to heavy industry in 1976when the Korean government asked President Kim to acquirean ailing industrial firm rather than let the firm go out ofbusiness and create unemployment.

Asian Financial Crisis and Its Impact On KoreaThe country continued to liberalize, and democracy finally cameinto being in 1988 with the introduction of a new constitutionand the election of Kim Young-Sam, the first democraticpresident in Korea’s, history. The economy also continued togrow at 5 to 8 percent annually during the early to mid- 1990s,led primarily by exports, and the World Bank predicted thatKorea would have the seventh largest economy in the world by2020. However, the Asian financial crisis brought that growth toa halt. After the Thai baht was devalued on July 2, 1997, theKorean won soon followed, and the Korean stock marketcrashed as well. By the end of 1997, the South Korean won -as46.2 percent lower than its predevaluation rate. At the time theCrisis hit. Korea’s external debt was estimated to be $110 billionto S’ 50 billion, 60 percent of it maturing in less than one year.In additional, Korea had another $368 billion of domesticdebt.Korea’s banks had been a tool of state industrial policy, withthe government ordering banks to make loans to certaincompanies even if they were not healthy. Banks borrowedmoney in dollars and lent them to firms in won, shifting the

burden of the foreign exchange from the firms to the banks.Hanbo Steel and Kia Motors went bankrupt, leaving somebanks with huge losses. The Korean won fell in the fall of1997, causing the government to raise interest rates to supportthe won and resulting in more problem loans. Bad loans at thenine largest financial institutions in Korea ranged from 94percent to 376 percent of the banks’ capital, making the bankstechnically insolvent.The chaebol were also very overextended. The top five chaebolwere in an average of 140 different businesses, ranging fromsemiconductor manufacture to shipbuilding to auto manufac-turing. This was happening during a time when most othercompanies in the industrial world were selling off unrelatedbusinesses and focusing on their core competencies. Twenty-fiveof the top 30 chaebol had debt-to-equity ratios of 3 to 1, and10 had ratios of over 5 to 1, as noted earlier. Compare this toToyota Motor of Japan, which had a debt-to-equity ratio in1998 of 0.7 to 1.During this crisis, Korea began to negotiate with the IMF forhelp. The IMF agreed to help, but only if Korea raised interestrates to support its currency, reduced its budget deficits,reformed its banks, restructured the chaebol, improved financialdisclosure, devalued the currency (to stimulate exports evenmore), promoted exports, and restricted imports. In return fora pledge to introduce the reforms, the IMF released funds toKorea to help it payoff its foreign debt and to keep its banksfrom going bankrupt. This in turn brought in more moneyfrom foreign banks that were encouraged by Korea’s pledge toreform itself.One of the IMF’s key areas was banking reform. The IMFencouraged Korea to open up its banking sector to foreigninvestment, hoping that an infusion of foreign bankingexpertise might help the Korean banks make better loans. Ofcourse, foreign banks had made a sizable number of bad loansin Asia as well. In addition, the IMF encouraged the Koreangovernment to pass good bankruptcy laws to allow badcompanies, including banks, to fail. However, the IMF hopedthat Korean banking institutions would merge, forming fewerbut stronger banks. In addition, the IMF encouraged bankingreform in order to cut the links between bankers and politics,tighten supervision and regulation of the banking industry, andimprove accounting and disclosure.

Impact of the Crisis on DaewooWhile the financial crisis was going on, Daewoo’s PresidentKim ignored the warning signs and continued to expand. In1998, a year when the Daewoo Group lost money, it added 14new firms to its existing 275 subsidiaries. While Samsung andLG were cutting back, Daewoo added 40 percent more debt.Finally, Korean President Kim Dae Jung had had enough. Heordered the banks to stop lending to the chaebol until theycame up with and began to execute a plan to sell off businessesand to focus on their core competencies. But that didn’t stopDaewoo. To get access to more money to feed its growth.Daewoo issued corporate bonds, which were purchased byInvestment Trust Companies (lTCs), finance companiesassociated with the chaebol. The ITCs purchased nearly $20billion in corporate bonds.


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In early 1999, Daewoo announced a plan to sell off some of itsbusinesses to comply with government restructuring require-ments before the government took more drastic action, such asnationalization. However, the plans limped along until July1999. At that point with Korea still in a deep recession, Daewooannounced that it would go bankrupt unless its Koreancreditors backed off. It basically could not even service itsinterest payments of $500 million a month. let alone itsprincipal. The government immediately stepped in and frozeDaewoo’s loans until November 1999. This shock rippledthrough Korea, because nobody thought a chaebol would everbe allowed to collapse. That had never happened before, andthe close ties between government and business were such thatit was never expected to happen. The shock of Daewoo’sannouncement negatively affected the corporate bond marketand the ITCs came under pressure because of their hugeexposure 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 fora moratorium on interest payments until March 2000, so theinstability spread to the international markets.

Daewoo’s FutureBy the end of 1999, Daewoo’s President Kim was left with fewoptions to solve Daewoo’s problems. One possibility was todismantle Daewoo and let it have only auto-related businesses.All of the other businesses would be sold off to domestic orforeign investors, and the name would be changed to some-thing other than Daewoo. Another option for President Kimwas to sell some of Daewoo’s auto assets. Ford, DaimlerChrysler, and General Motors showed interest, but sellingDaewoo Motor, the second largest automaker in Korea, wouldbe a big blow to the country.As the Korean economy began to recover in 1999, some feltthat the chaebol should weather the storm and not allowthemselves to be broken up. However, President Kim Dae Junghad mandated that the chaebol get their debt-to-equity ratiosfrom 5 to 1 to 2 to 1 by the end of 1999, and that goal seemedimpossible unless there was a huge infusion of equity capital oreither a write-off of debt through debt restructuring with thebanks or a selling off of debt-laden businesses to others.Under immense pressures caused by the debt and by accu-sations of fraud and embezzlement, President KimWoo-Choong abandoned his company and fled the country.The government separated the Daewoo subsidiaries andworked with creditors to convert the debt to equity, to set upsubsidiaries on debt workout programs, and to look for buyers.After a year of negotiations, General Motors purchased aportion of the $1.2 billion Daewoo Motor in April 2002 for$400 million agreed to keep only three manufacturing plants-two in Korea and one in Vietnam-leaving creditors scramblingto sell its other plants in Eastern Europe, Asia, and the MiddleEast. By mid-2002, the Korean economy was showing promis-ing signs of recovery and reform. In 2001, the economy grew by3 percent and was expected to grow by 5 to 6 percent in 2002.The government has done away with debt-based managementof the large chaebol and is working to dissolve the large

conglomerates to better compete internationally. Of the top-30chaebol that existed prior to the economic crisis, only 14 remain.The improving economy helped General Motors make itsdecision’ to purchase Daewoo Motor, but GM is faced with anew decision: how to market Daewoo cars and reduce the $830million of Daewoo debt Should GM continue selling Daewoocars in the United States and Europe and compete with its ownbrands? Without increasing its debt, will it be able to restoreDaewoo’s 37 percent share of the market in Korea?

Questions

1. How would you describe Korea’s economic system? Whatare the key elements in that system? How would youdescribe the interaction between politics and economics inKorea?

2. Does Korea look like a good place to invest? Why or whynot?

3. What are the key mistakes Kim Woo-Choong made informulating and implementing paewoo’s strategy, and howdid the economic crisis in Korea and in the rest of Asia affectthat strategy?

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

economic environment- key macro economic issues, inflation

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