Why Are East Asian Business Groups so Common?

It is thought that since the early 1960’s business groups have been a vital asset to the industrialization and economic growth of East Asian Countries. A ‘business group’ is a group of legally independent firms bound together in a formal or informal way. They have shown extreme rapid growth throughout East Asia, and have become a very controversial topic when relating to East Asia’s financial development, often being referred to as “paragons or parasites”. There are many proposed features of business groups, both positive and negative, that have resulted in their rapid formation and substantial growth in Asia.

During East Asia’s early economic development, the main capital markets were undeveloped containing a range of structural weaknesses such as the absence of legal and bank regulations, financial supervision and market supporting institutions. These ‘institutional voids,’ and lack of market infrastructure meant there was high transaction costs and little external investments thus creating high barriers for market entry. There was also a scarce source of advanced technology and little product distribution; as a result, it was difficult for the success and long term survival of independent entrepreneurship in these imperfect markets, often resulting in market failure. The poor market conditions in East Asia led the controlling nature of the Asian government to play an important role in the formation of business groups. For example, there was a large amount of government intervention in Asia where the weak corporate government established a range of restrictive regulations and high taxations and possessed large control over resource allocation.

These bad economic fundamentals, in addition to the government’s neglect of corporate disclosure and poor investment protection, meant capital investment within emerging markets contained a high level of risk and was viewed as unreliable. Business groups were identified as solution to the risk factors associated with market failure and institutional voids, whereby the internalisation of human capital, technology and insurance was seen to enhance a firm’s performance in imperfect markets where the legal and regulatory institutions were of poor quality. There are many “bright sides” related to business groups that have led to their growing popularity in Asia, this growth is represented in Figure.1.,and they have been considered, by growing businesses, as a method to create easier entry into external markets. Figure 1. Table to show the substancial size and economic growth of East Asian Economies from 1980 to 2000.

Business groups posses a range of political and government contacts, and as a result they can be used as a method of solving information and technology imperfections. By joining a business group member firms remain legally independent, but economic and social ties typically unites each group, meaning credible and reliable information about other businesses can be obtained through information transfers and substantial technology can be acquired, which can facilitate a company’s performance and profits, helping support product licensing. This, in addition to their sophisticated capital markets and mature economies, means they can provide soft market infrastructure, being economically important to affiliating firms, by reducing transaction costs and providing access to scarce resources in labour markets, helping to close the productivity- technology gap and restructure declining industries. The growth of Gross domestic products thought to be from business groups is represented in Figure.2.

Figure 2. Table to show growth of Gross domestic products in developing countries from 1960 to 2004, including East Asia.

Within the cross ownership structure of business groups there is efficient business regulations provided by a pool of skilled managers, with significant managerial talent and training. The high degree of managerial control means the performance of companies within the group is closely monitored and there is motivational incentives created to increase business efficiency. A popular hypothesis when relating to business groups is that firms affiliated with groups will be more profitable, due to the main aim of maximizing joint profits and complex linkages, causing managers to identify underperformance and carry out various transactions within the group. This may include the reallocation, channelling of resources, in the form of reinvestment, exchange of profits, loans and lower tax rates. The construction of complex contracts, in addition to assurance of economic and legal institutions for market support, is known as risk sharing and income smothering and is a major advantage in the eyes of affiliated businesses. Through resource channelling, companies are insulated from market pressures and protected from competition so they can survive in external markets.

However, data concerning group affiliation is especially hard to obtain. Business groups in East Asia commonly adopt hierarchical pyramidal structures, within these minority structures there are dominant shareholders, corporate leaders, that possess core control over the group. Family owned groups are not uncommon and complex structuring means shareholders don’t possess full control rights and hold a small fraction of equity claims on a firms cash flow. It is thought that establishment of groups is more popular in East Asia due to structural benefits to controlling owners and the incentive of expropriating minority share holders through tunnelling. The high degree of control, within pyramidal ownership, magnifies the characteristic of control rights beyond cash flows, where corporate owners can gain a company’s control rights through expropriation risk discounts, whereby there is legal protection, in exchange for a company’s rights. This allows for the act of tunnelling, which is a way of directing company assets and future business towards core owners so they can retain control over the country’s corporate sectors with low cash flows.

Tunnelling methods such as providing low interest rates, selling assets, lowering market prices, technology licensing and joint ventures, means dominant share holders can have the direct benefit of using retained earnings for personal gain at a minority shareholders expense, hindering their development in capital markets. Not only this, but growth has been linked to diversification, a consequence of expropriation, and its impact on organisational performance. However, this theory is conflicting because structural characteristics, resulting from family ownership, can decrease the popularity of business groups in terms of outside investors, and complex company linkages can relate to inefficient investment, unreliable accounting and possible inadequate managers through inheritance. The Korean “Chaebol” is an example of a vertically organized pyramidal business group still controlled by a number of founding families. The Chaebol , contains many well known successful companies such as Samsung, LG and Hyundai and consists of centralized ownership, characterised by strong ties with government agencies.

The ownership of banks within the Chaebol is prohibited and it is thought that the role of nationalised banks in channelling of large sources of capital, foreign loans and foreign technology access has been critical to the business group growth. In contrast to the pyramidal Chaebol, the well known Japanese business group, “the Kieretsu” is centred round a core bank and controlled by a group of professional managers. Within the Kieretsu, members own small portions of shares in each other’s companies. The crosslinking vertical structure,( links of manufacturers, distributors and suppliers), and horizontal structure, (business set up around the Japanese bank), of the Kieretsu has been seen as the powerhouse behind industrilaziation in Japan, whereby companies have been sufficiently insulated from competition and market fluxations. The growth and survival of the Kiertsu has been witnessed in East Asia’s poor economic environment, not only during its establishment from the zaibatsu, after world war two, but also after the East Asian Crisis. The 1997 East Asian Crisis and its effects is a controversial topic when relating to the growth of business groups in East Asia.

The East Asian crisis was the financial situation in which a number of East Asian currencies collapsed and many industrial firms became bankrupt. It was thought the Crisis occurred due to East Asia’s bad economic structure, build up of short term debt from foreign exchange and premature market liberalization, which made their economies vulnerable to outside market pressures. However, during the economic stress of the crisis groups did not collapse. Business groups were thought to be less affected by the crisis in terms of investment, due to their ability to reallocate resources internally across firms. Not only this, but political and government links meant access to external funds, making it easier to raise capital after the crisis. It is thought that some business groups potentially grew as a result of the crisis as there was more government control, more leverage and greater disciplines resulting in more investment. Figure.3. shows economies have continued to grown since 1997.

Figure 3. Table representing developing and transition economies in 1980, 1990, 2000 and 2005, in terms of outward FDI stocks.

Overall, I believe it was East Asia’s insufficient market environment and bad economic fundamentals in addition to the pressure of financial performance, that led the structural characteristics of business groups to become a major advantage to outside investors. The “bright sides” of Asian business groups have seemed to outshine the many “dark sides”, in poor economic environments with poor corporate government regulations. Not only this, but in my opinion, the survival of business groups during the East Asian Crisis, due to inter-organisational relations, has also contributed to growth and the common appearance of business groups in East Asia today. I believe Business group popularity in East Asia has led to a global seismic shift of wealth and rise of market; and in the future, this means there could be a shift in power and East Asia could become new leaders in global economy. However, the future of business groups in East Asia is still ambiguous, and it is suggested that following the East Asian crisis groups should be reconfiguring their business structures and adjusting corporate governance systems to regain momentum for further growth. Total word count excluding references and figures:1549.

Bibliography

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