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Do the Chaebol Choke Off Innovation?


South Korea's giant family-based conglomerates are thriving, but they may be crushing small companies

Seoul - Song Kyu Heon harbors no illusions about the strength of the chaebol, the family-controlled conglomerates that dominate South Korea's economy. Nonetheless, as chief executive of tech services company Openbase, Song was confident he could beat chaebol -backed rivals to win a multimillion-dollar deal to upgrade the computer systems at a Korean bank. His client roster, after all, includes Citibank (C), LG, heavy equipment maker Doosan, and dozens of other high-profile companies and government ministries. As a longtime contractor with the bank in question, Openbase knew its systems well, and a team of 20 engineers had been preparing a bid for a year. But in October, Song lost the deal to an affiliate of a top chaebol. "There's no such thing as a level playing field here," Song says in his fifth-floor corner office overlooking Tehran-ro, a street that's sometimes called Korea's Silicon Valley.

Song's tale is typical of small and midsize companies in South Korea. While the chaebol unquestionably have fueled the country's growth in recent decades, they're so powerful that they may be hampering innovation and threatening Korea's continued economic success. "With the chaebol's deepening influence hurting fair competition with suppliers and startups, the country risks losing its economic dynamism," worries economist Kim Sang Jo of the Economic Reform Research Institute, an independent policy group.

A DIVERGING ECONOMY

In spite of the worldwide financial crisis, Samsung, Hyundai, LG, and other chaebol have recently reported impressive jumps in sales and profits. But not much of that prosperity has trickled down. While the big companies expand, "the rest of the Korean economy is still struggling," says Maarten Kelder, head of Asia-Pacific at consulting firm Monitor Group.

Korea's reliance on the chaebol is deepening. The top 10 exporters represented 43% of shipments abroad last year, up from 31% in 2001, according to the Korea Development Institute, a state-funded think tank. And the 50 largest companies—most of them chaebol affiliates—accounted for 38% of the country's total output in 2005, up from 30% a decade and a half earlier, the KDI reports. "The chaebol model has served well as a stepping-stone for growth so far, but it is likely to be a stumbling block in the future," says Lee Kye Ahn, a former CEO at Hyundai Motor and now a prominent member of the opposition Democratic Party.

In tech services, for instance, most big conglomerates have subsidiaries that take care of their sister companies. With guaranteed profits from those contracts, these players can afford to undercut the likes of Openbase when competing for work with outside clients. "If not for the huge advantages and influence of the chaebol, Openbase could be a major player," says Baek Seung Gon, vice-president of eBest, a small tech-services player.

"DANGEROUSLY POWERFUL"

The list of the leading IT services companies in South Korea offers ample evidence of chaebol strength. Among the top 10 players, only No. 5, a subsidiary of state utility Korea Electric Power, isn't affiliated with a chaebol. It's the same story in advertising and logistics, with chaebol affiliates dominating the top 10 in both industries. "The chaebol have become so dangerously powerful that you must put a bridle on them," says Lee Dong Gull, a former financial regulatory official who now teaches economics at South Korea's Hallym University.

The reach of the chaebol is such that smaller rivals often work for them as suppliers, so those companies are afraid to speak up. More than a half-dozen executives declined to talk on the record about their relations with the chaebol. And those who agreed to speak were reluctant to give much detail. Openbase, for instance, works as a subcontractor for chaebol tech-services players, so CEO Song is unwilling to name either the bank with which he was trying to get a contract or the rival that beat him.

Other small Korean companies fret about the power of the chaebol. A supplier of interior parts for Hyundai Motor, for instance, says that while the automaker is reporting record earnings, he is barely breaking even. "During fat years the big guys [hog] all the profits," says the supplier's general manager, who asked that his name not be used for fear of retaliation from Hyundai. "They let us get by but never allow us to have a big enough margin to invest in research." Hyundai counters that it treats its suppliers fairly.

Another problem is that the best and brightest university grads want to work for the chaebol—starving startups of talent. Less than 10% of the 4,000 students who graduated this year from Yonsei University in Seoul, for instance, got jobs at small companies. And officials at Yonsei, one of Korea's top three schools, say most of that 10% would have preferred jobs at the chaebol. "I've never thought of seeking a job elsewhere," says Kang Hye Jeong, a 27-year-old marketer at Samsung's handset unit, who says she has visited more than 20 countries in her four years at the electronics giant. "You couldn't expect such global experience at a smaller company."

Given the difficulty of standing up to the chaebol, financing is tough for startups. Brokerage Korea Investment & Securities recently failed to raise a $90 million fund for tech startups, and the main index of Kosdaq, the South Korean equivalent of Nasdaq, has fallen 84% since its peak in March 2000, while the benchmark Kospi index of larger companies has risen 68%.

Korean policymakers acknowledge the need to help the small fry compete with the giants on a more equal footing. Seoul in August earmarked $7.5 billion to finance joint research between universities and smaller companies in new growth areas such as renewable energy. "The policy focus for future growth will be on encouraging competition by liberalizing markets and helping smaller firms create intellectual property," says Noh Dae Lae, deputy minister at the Ministry of Strategy & Finance.

Ultimately, the chaebol may benefit from such initiatives. If the giants squeeze small suppliers so hard that they can't invest in innovation, the chaebol will hurt their own competitiveness, so programs that strengthen smaller companies will likely help South Korea's conglomerates, says Lim Kyung Mook, a researcher at the Korea Development Institute. "The important task is to begin attracting talent and funds to startups," Lim says. "We need a better balance between the conglomerates and smaller companies, a business environment where startups can grow big enough to compete with the big guys."


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