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Facing The Threats And Challenges Of The Korean Economy

Facing The Threats And Challenges Of The Korean Economy. Presentation material. September 7, 2004.

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Facing The Threats And Challenges Of The Korean Economy

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  1. Facing The Threats And Challenges Of The Korean Economy Presentation material September 7, 2004 This report is solely for the use of client personnel. No part of it may be circulated, quoted, or reproduced for distribution outside the client organization without prior written approval from McKinsey & Company. This material was used by McKinsey & Company during an oral presentation; it is not a complete record of the discussion.

  2. KEY MESSAGES • 1. Korea does not appear to be facing a financial crisis similar to 1997 • 2. The economy is however under performing. This will likely continue in the short term… and the medium term if changes are not made • 3. Overcoming the challenges ahead will require concerted efforts of government, corporations and labor

  3. MORE THAN 150 COUNTRIES AROUND THE WORLD HAVE EXPERIENCED FINANCIAL CRISES SINCE 1970 Countries faced with partial financial issue Countries hit by financial crisis Source: IMF; Literature study; McKinsey Analysis

  4. 6 DIFFERENT TYPES OF FINANCIAL CRISIS HAVE OCCURRED • Type 1 • U.S. (Saving and Loan case) • The U.K. (1991) • The U.K (1973) • Sweden (1991) • Denmark (1990) • High • Type 4 • Japan (1990s) • Korea’s 1997 financial crisis • Med. • Development of Financial System • Type 2 • Type 3 • Type 5 • Type 6 • Argentina (1981, 1995) • Brazil (1995, 1999) • Mexico (1995) • Indonesia (1997) • Russia(1997) • Thailand (1997) • Chile (1982) • The Great Depression of the U.S. (1929) • Low • Financial Sector • Financial Sector and Macro Economy • Financial Sector and Real Economy • Financial Sector, Real Economy and Political Sector • Financial Sector, Real Economy, Macro Economy and Political Sector • Fundamental Cause and Seriousness of the Crisis Source: McKinsey analysis

  5. International Money & Capital Flows • Financial system • Real Estate Sector • Real sector LOOKING BACKWARDS THERE ARE 10 INDICATORS WHICH FORETELL OF CRISIS IN EACH SECTOR • Warning signs • Indicator • Value destruction in the real sector • Interest coverage ratio • ROIC<WACC • ICR<2 • Decreased bank profitability • Rapid growth in lending portfolio • Shifting deposits or rapidly rising deposit rates • Excessive nonperforming loans • ROA<1% or Net Interest margin<2% • >20% annually for more than one year • Decrease of deposit level in consecutive 2 quarters • NPL>5% of total bank assets • Inter-bank, money market borrowing rates • Government debt • Overvalued native currencies • Excessively high Inter-bank call interest rate • Public debt as percentage of GDP • FX rate based on purchasing power • Real estate bubbles • Several years of 20% or more annual growth in asset prices Source: McKinsey analysis

  6. IN 1997, CLEAR SIGNS OF POTENTIAL CRISIS WERE VISIBLE THROUGHOUT THE KOREAN ECONOMY • High risk • Moderate risk • Low risk • Level of seriousness • Korea’s situation in 1997 • Warning sign (criteria) Real Sector • ROIC<WACC for most listed companies for 3 years from 1995 • Over 70% of listed companies with ICR <2 • Value destruction in the real sector • Interest coverage ratio • ROA of bank sector continuously below 1% (1994: 0.4%, 1996: 0.3%, 1997: 0.9%) • From 1994 to 1997, total lending increased 60% • Deposit rate increased from 9% in Jan. 1997 to 18% in Jan. 1998 • Total NPL of banking sector was up to 6%, but expected NPL was much higher • Profitability of banks • Rapid growth in lending portfolio • Shifting deposits or rapidly rising deposit rates • Nonperforming loans Financial System International Money & Capital Flows • Call rate (21.6%)>market index (3 year government bond: 14.7%) • Government debt/GDP was comparatively low at 11% to13% • Overvalued by more than 10% • Real estate prices grew by 80% between ‘86 and ‘92 although they stabilized in the 1990s • Interbank, money market borrowing rates • Gov’t debt as percentage of GDP • Overvalued FX rate • Real estate bubbles Real Estate Sector Source: Bloomberg; Banking Industry Association; FSS; MOFE; The Bank of Korea; McKinsey analysis

  7. SERIOUS SIGNS OF AN OVERALL CRISIS ARE NOT APPARENT IN THE KOREAN ECONOMY TODAY • High risk • Moderate risk • Low risk • Level of seriousness • Korea’s situation now • Warning sign (criteria) Real Sector • Value destruction in the real sector • Interest coverage ratio • Value destruction (ROIC<WACC) for listed companies over last 8 years – and the gap is getting wider • ~48% of companies with ICR<2, ~29% with ICR<1 over last 2 yrs Financial System • Profitability of banks • Rapid growth in lending portfolio • Shifting deposits or rapidly rising deposit rates • Nonperforming loans • Banking sector ROA between 0.1% and 0.8% over past 3 years • Growth of household loans reached about 28% CAGR between 2000 and 2004 • Deposits have risen continuously since money crisis; rates are falling since 1998 Q2 • NPL/assets ratio generally stable since the financial crisis however, the ratio began rising in 2003 due to rising delinquency in retail and SME sector International Money & Capital Flows • Interbank, money market borrowing rates • Gov’t debt as percentage of GDP • Overvalued FX rate • Real estate bubbles • Market rate index (5 yr gov’t bond & 3 yr corp. bond) has exceeded the overnight interbank rate since 1998 3Q • Public debt is 19% of GDP in 2003. Still far less than OECD average (78.2%) • Korean won is likely undervalued • Housing sector prices have grown an average 10% p/a for last 3 years. APT in Seoul show around 20% increases Real Estate Sector Source: Bank of Korea, KISLIne; MOFE; Kookmin bank; press clipping

  8. ROIC • WACC* • Sectors with corporate value destruction VALUE DESTRUCTION IN THE REAL ECONOMY IS GETTING WORSE SINCE 1997… Percent, 1990~2003 • Warning signs • Drivers • Overinvestment • Declining relative productivity • IMFCrisis • Value destruction in the real sector • Interest coverage ratio • Profitability of banks • Rapid growth in lending portfolio • Shifting deposits or rapidly rising deposit rates • Nonperforming loans • Interbank, money market borrowing rates • Government debt as percentage of GDP • Overvalued FX rate • Real estate bubbles Note: Average figure of 900 listed companies, excluding financial institutions. Number of subject companies change according to available data. Companies we have analyzed take up 57% of overall economy based on revenue size in 1999. ROIC: (EBIT – tax)/average (Total asset – AP – excessive cash and security – Long term investment – Other asset) * Cost of Equity: Annual average of 5 year market profitability Source: Bloomberg, McKinsey

  9. …BUT THE FINANCIAL SECTOR IS NOW RELATIVELY STABLE KRW trillions, percent • Warning signs • Deposits have risen continuously since monetary crisis and rates are falling as well • Value destruction in the real sector • Interest coverage ratio • Profitability of banks • Rapid growth in lending portfolio • Shifting deposits or rapidly rising deposit rates • Nonperforming loans • Interbank, money market borrowing rates • Government debt as percentage of GDP • Overvalued FX rate • Real estate bubbles • Interest rate* • 17.8 • Total deposits • 4.1 • 1998 • 1999 • 2000 • 2001 • 2002 • 2003 * Based on time deposits Source: The Bank of Korea; MOFE

  10. ADDITIONALLY, NATIONAL DEBT RELATIVE TO OTHER MAJOR COUNTRIES IS REASONABLY LOW AND STABLE Percent, 2003 • Warning signs • Public debt still far less than OECD average • Value destruction in the real sector • Interest coverage ratio • Profitability of banks • Rapid growth in lending portfolio • Shifting deposits or rapidly rising deposit rates • Nonperforming loans • Interbank, money market borrowing rates • Government debt as percentage of GDP • Overvalued FX rate • Real estate bubbles • Government debt* to GDP ratio • OECD average * Government debt is classified based on IMF standard (treasury bond, borrowing, other borrowing activities) Source: MOFE; OECD Economic Outlook (2003.12)

  11. KEY MESSAGES • 1. Korea does not appear to be facing a financial crisis similar to 1997 • 2. The economy is however under performing. This will likely continue in the short term… and the medium term if changes are not made • 3. Overcoming the challenges ahead will require concerted efforts of government, corporations and labor

  12. Booming US economy • Dot com bubble • Consumption-driven growth • Now • 98.6~99.12 • Daewoo scandal • SK Global scandal • 97-12~98.6 • High interest rate, high FX rate • Credit card crisis, • Foundering bond market OVERALL, KOREA IS AT A TURNING POINT TO JOIN THE RANKS OF ADVANCED COUNTRIES • Join the ranks of advanced countries • Restructuring • Mid 2000 • Hyundai scandal • Credit crunch • Early 2000 • System allowing quick acquisitions of corporate bonds • Financial crunch • 1997 • 2003

  13. Domestic demand has been muted due to highly leveraged household balance sheets • Corporate investment has been stalled due to weak business confidence • Exports have been fueling the economy but the linkage between GDP and GDI has weakened • Korea’s dependence on oil and current high oil price may constrain a strong rebound SUMMARY OF CURRENT ECONOMIC OUTLOOK • Since 1994, capital markets’ view of Korea is negative and getting worse

  14. DOMESTIC DEMAND AGGRESSIVE CREDIT WAS EXTENDED TO HOUSEHOLDS AND INDIVIDUALS IN AN ATTEMPT TO DRIVE CONSUMPTION KRW trillion • Credit card usage • Total household debt • Percent • 678 CAGR 70% CAGR 28% • 481 • 237 • Lump sum • Installment • Cash • Advance • Card loans • 2000 • 2001 • 2002 • 2001 • 2002 • 2003 Source: Bank of Korea; Korea Non-Bank Financing Association

  15. 11%p • 54% THIS HAS CAUSED A SHARP RISE IN CREDIT DELINQUENTS AND SHARPLY REDUCED CONSUMPTION AND DOMESTIC DEMAND • Wholesale/retail sales growth index • Credit delinquents trends • Million • Consumers are still shackled by their debt obligations accumulated during the credit boom in 2001-02 • 2000 • 2004. 1Q • Debt repayment ratio* • Percent • 1Q • 2Q • 3Q • 4Q • 1Q • 2Q • 3Q • 4Q • 1Q • 2Q • 2002 • 2003 • 2004 • 2000 • 2004. 1Q * Repayment of debt/disposable income Source: National statistics office; Bank of Korea

  16. INVESTMENT INVESTMENTS HAVE BEEN WEAK FOR THE PAST 6 QUARTERS PRIOR TO 2Q 2004 Investment growth rate under pressure … Companies have negative economic outlook • Investment growth rate (YOY)* • Percent • Business confidence index • 2Q • 4Q • 1Q • 2Q • 3Q • 4Q • 1Q • 2Q • 3Q • 2002 • 2003 • 2004 • 1Q • 2Q • 3Q • 4Q • 1Q • 2Q • 2002 • 2003 • 2003 • 2004 *Indexed to the price of 2000; vs. the corresponding period of last year Source: Korea development bank; Bank of Korea

  17. EXPORTS WHILE EXPORTS ARE THE ONLY PILLAR PROPPING UP KOREA’S ECONOMIC GROWTH… USD billion; YoY growth rate • Growth rate • Total • Export amount • 1Q • 2Q • 3Q • 4Q • 1Q • 2Q • 2003 • 2004 Source: KITA; Bank of Korea

  18. …THE SPILLOVER EFFECTS ON FOREIGN EXCHANGE EARNED AND EMPLOYMENT ARE DIMINISHING 2003 • FX earned by export • Employment generated by export • Percent • Person / USD million • 43 • 67.7% • Share of total exports in capital intensive industries is going up • As a result, there is declining spillover effect in foreign exchange earned and employment • 54.5% • 29 Source: KOTRA; Korea national statistics office; Bank of Korea

  19. GDP GROWTH IS NOT TRANSLATING INTO EQUAL GDI GROWTH KRW trillion • GDP • GDI • 1Q03 • 2Q03 • 3Q03 • 4Q03 • 1Q04 • 2Q04 Source: Bank of Korea

  20. CAPITAL MARKETS’ VIEW KOREAN VALUATIONS LOWER THAN OTHER MARKETS, AND GETTING WORSE OVER TIME Aggregate Market-to-Book ratio IBES - China S&P 500 Europe top 500 Nikkei - Japan HIS – Hong Kong KOSPI - Korea Source: Datastream; McKinsey

  21. IN THE SHORT TERM HIGH OIL PRICES WILL ALSO BE AN IMPEDIMENT TO THE ECONOMY Million barrels daily USD/Bbl, Dubai oil Korea is a the third largest importer of oil * Rising oil prices will impact the economy • USA • Japan • Korea • China • South • Africa • Jan. • Jul. • Jan. • Jul. • Jan • Jul. • Canada • 2002 • 2003 • 2004 * data as of 2002 Source: BP Statistical Review of World Energy (2003); Korea National Oil Corporation; OECD; Bank of Korea

  22. A NUMBER OF FACTORS POINT TO CONTINUED ECONOMIC PRESSURE GOING FORWARD • Export concentration risks • China’s growing competitiveness • Relatively low productivity and unproductive labor relations • Increasing competition for FDI into Korea • Emerging challenge of aging population

  23. EXPORT CONCENTRATION • Share of items in total exports KOREAN EXPORTS ARE INCREASINGLY HIGHLY CONCENTRATED Percent • 100% = • $150.4 billion • $ 123.5 billion • Semiconductor • 9% • 10% Wireless telecom. device • 7% • 10% • 39% • 9% • 45% • Auto • 9% • 7% • Computer • 8% • 7% • Shipbuilding • 7% • 61% • Others • 55% • 2001 • 1H 2004 Source; KITA, literature review

  24. THE MARKETS FOR KOREAN EXPORTS ARE ALSO HIGHLY CONCENTRATED Percent, 2004 • GDP growth (vs. the corresponding period of last year) • Share of exports to each nation • 1H 2004 • 100% = USD 123 bn • China • 25.9% • 2004 1Q • 2Q • US • 22.2% • 8.7% • Japan • 2004 1Q • 2Q • Others • 43.2% • 2004 1Q • 2Q Source: Bank of Korea; Bloomberg, Wall Street Journal

  25. CHINA’S COMPETITIVENESS CHINA’S KEY EXPORT INDUSTRIES ARE BECOMING MORE COMPETITIVE THAN COMPLIMENTARY 2003 • Korea’s key export industries • China’s key export industries • Percentage in Korea’s overall exports • Percentage in China’s overall exports • Rank • Industry • Ratio • Rank • Industry • Ratio • 1 • Electrical machinery, etc. • 28% • 1 • Electrical machinery, etc. • 20% • 2 • Nuclear reactors, machinery, etc • 16% • 2 • Nuclear reactors, machinery, etc • 19% • 3 • Automobile • 12% • 3 • Apparel, clothing accessories • 10% • 4 • Shipbuilding • 6% • 4 • Toys, spots requisites, etc • 6% • 5 • Iron and steel • 5% • 5 • Footwear, headgear, etc • 3% • 6 • 6 • Iron and steel • 3% • Plastics • 5% • 7 • 7 • Mineral fuels/oils, bituminous, etc • 3% • Mineral fuels/oils, bituminous, etc • 4% • 8 • 8 • Organic/Inorganic chemicals • 2% • Organic/Inorganic chemicals • 3% • Man-made filaments • 9 • 9 • Optical, measuring, etc. • 3% • 2% • 10 • 10 • Plastics • 2% • Apparel, clothing accessories • 2% Source: United Nations Statistics

  26. BASED ON ITS COMPETITIVE WAGES AND GROWING CAPABILITIES, CHINA IS BECOMING A FORMIDABLE COMPETITOR • Labor* cost, 2003 • As-is capability gaps with Korea • US$ • Years • KDB • IMD • Shipbuilding • White goods • Automobiles • N/A • TFT/LCD • Mobile handsets • China • Korea * Hourly wages of workers in manufacturing sector Source: IMD World competitiveness annual report; KDB; McKinsey analysis

  27. KOREAN COMPANIES ARE STEPPING UP THEIR INVESTMENTS INTO CHINA USD billions • Korean FDI to China • 2003 Source: Ministry of Commerce, Industry & Energy; Export-Import Bank of Korea

  28. UNPRODUCTIVE LABOR • Korea • Japan • Taiwan • U.S. • Germany • France KOREA’S RELATIVE LABOR PRODUCTIVITY GROWTH IS POOR 2003 • Unit labor costs in manufacturing/ labor productivity growth rate • Labor cost per manufacturing unit (based on local currency) • YoY growth • Wages • Productivity Source: Ministry of Commerce, Industry and Energy, US labor statistics bureau, Euro monitor source, Ministry of Labor

  29. COST OF KOREAN LABOR IS HIGH RELATIVE TO COMPETITOR NATIONS • Hourly labor cost in key competitor countries’ manufacturing sector • USD • Korea • Singapore • Hong Kong • Taiwan • China Source: Ministry of Commerce, Industry and Energy, US labor statistics bureau, Euro monitor source, Ministry of Labor

  30. Korea • Japan • Germany • France • U.S KOREAN LABOR RELATIONS ARE POOR • # of working days lost due to strikes/company shutdown • Productivity of labor management relations • # of working days lost per 1,000 people, 2000~2002 average • Ranking among 60 nations • Country • Score • 1 • Singapore • 2 • Switzerland • 3 • Austria • 5 • Japan • 11 • Taiwan • 21 • The US • 39 • China • 60 • Korea Source: ILO Labors Statistics Yearbook; Bank of Korea; IMD World Competitiveness Report (2004); Ministry of Labor Affairs; McKinsey analysis

  31. THE PERCEPTION OF HOSTILE LABOR UNIONS IS AN OBSTACLE TO INVESTMENT BY FOREIGNERS AND KOREANS • What is the weakest point of Korea as an investment market? • “Hardline trade unions are strapping the promotion of foreign direct investment” - WilliamOberlin, President of Amcham • “One of controversies in the Korean economy is belligerent trade union” – William Pesok, Bloomberg Columnist • “The greatest difference between other countries and Korea is that negotiations to resolve labor disputes are emotional rather than being rational compromise” - Marcos Gomez, Chairman of EU Chamber of Commerce & Industry in Korea • Labor relations • Bureaucratic restrictions • High cost • North Korean nuclear issue Source: MOCIE survey (August 2003), press search

  32. INCREASING COMPETITION FOR FDITO KOREA • Risks from political uncertainty • Labor related restriction • Investment incentives KOREA’S COMPETITIVENESS AS AN INVESTMENT ENVIRONMENT IS LOW On the scale of 10 (figures in brackets show ranking among 60 countries surveyed), 2004 • (44) • Korea • (55) • (41) • (10) • U.S. • (20) • (16) • (17) • Japan • (27) • (44) • (2) • Singapore • (13) • (1) • (12) • Taiwan • (54) • (23) • (8) • China • (47) • (13) Source: IMD world competitiveness yearbook (2004), Korea chamber of commerce & industry

  33. FDIAS A PERCENT OF GDP IS LOW AND DECLINING Percent Foreign direct investment as percent of GDP • Ireland • Singapore • China • Korea* * 2002(E) Source: EIU country index, Global insight, McKinsey analysis

  34. AGING POPULATION 2003 • CAGR • 03-50 • -1.5% • -1.0% • -0.2% • 2.1% IN THE MEDIUM TO LONG TERM KOREA WILL ALSO HAVE TO COME TO GRIPS WITH ITS AGING POPULATION Korean population by age, million persons • Total • Over 55 years old • 25-54 years old • Less than 25 years old Source: KNSO; McKinsey Household Financial Wealth Accumulation Model

  35. BY 2026, TWO PEOPLE WILL NEED TO SUPPORT EACH SENIOR CITIZEN • CONCEPTUAL • Now • Future • Korea in 2003 • 3 economically active people (age 25~54) supporting 1 retired person (age above 55) • Korea in 2013 • Korea in 2026 • Aging trend to accele-rate Source: Korea census, McKinsey analysis

  36. KEY MESSAGES • 1. Korea does not appear to be facing a financial crisis similar to 1997 • 2. The economy is however under performing. This will likely continue in the short term… and the medium term if changes are not made • 3. Overcoming the challenges ahead will require concerted efforts of government, corporations and labor

  37. Government • Labor • Corporations EACH ACTOR IN THE KOREAN ECONOMY WILL NEED TO PLAY A ROLE IN CREATING PROSPERITY FOR THE COUNTRY • Recognize impact of negative reputation • Be creative about win-win solutions • Recognize need for increased productivity • Create conditions to attract more FDI • Labor flexibility • Privatize/restructure • Complete financial sector reforms • Manage Korea PR • Thoughtfully stimulate consumer spending • Invest in and encourage investment in service and hi-tech sectors (cluster/hub) • But, let us focus on what you as corporate leaders need to do…

  38. 6 • 5 • 4 • 1 • 2 • 3 • Stability in external factors • Continuous change • Revenue orientation • Profit orientation • Input driven • Output driven • Tangibles • Intangibles • Hierarchy • Meritocracy • Opacity • Transparency AT A HIGH LEVEL, CORPORATIONS WILL NEED TO SHIFT PARADIGMS IN MINDSETS AND HOW TO MANAGE • Past • Future

  39. Strategic • Operational • Organizational • Employ more rigorous ROIC metrics to ensure only value-creating investments are made • Place multiple bets to generate medium and long-term options (“portfolio of initiatives”) • New business generation • Leverage intangibles • Get the basics right on cost control and operational excellence (current earnings programs) • Focus on building resilience to torpedo shocks (risk management) • Improve transparency and credible corporate governance • Build true performance oriented culture and meritocracy (value-based management) CORPORATIONS SHOULD EMBARK ON SEVERAL CHANGES TO ENSURE LONG-TERM SUSTAINABILITY AND GROWTH

  40. Thank you

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