facing the threats and challenges of the korean economy

Facing The Threats And Challenges Of The Korean Economy

Facing The Threats And Challenges Of The Korean Economy

Presentation materialPresentation material

September 7, 2004September 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

Countries faced with partial financial issue

Countries hit by financial crisis

Source:IMF; Literature study; McKinsey Analysis

MORE THAN 150 COUNTRIES AROUND THE WORLD HAVE EXPERIENCED FINANCIAL CRISES SINCE 1970

4

De

ve

lop

me

nt

of

Fin

an

cia

l S

ys

t em

6 DIFFERENT TYPES OF FINANCIAL CRISIS HAVE OCCURRED

• U.S. (Saving and Loan case)

• The U.K. (1991)

• The U.K (1973)

• Sweden (1991)

• Denmark (1990)

• Japan (1990s)

• Argentina (1981, 1995)

• Brazil (1995, 1999)

• Mexico (1995)

• Thailand (1997)• Chile (1982)• The Great

Depression of the U.S. (1929)

• Indonesia (1997)

• Russia(1997)

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

Type 1

Type 4

Type 2 Type 3 Type 5 Type 6

High

Med.

Low

Fundamental Cause and Seriousness of the Crisis

Korea’s 1997 financial crisis

Source: McKinsey analysis

5

LOOKING BACKWARDS THERE ARE 10 INDICATORS WHICH FORETELL OF CRISIS IN EACH SECTOR

Source: McKinsey analysis

Warning signs

1. Value destruction in the real sector

2. Interest coverage ratioReal sector

Financial system

International Money & Capital Flows

Real Estate Sector

Indicator

• ROIC<WACC

• ICR<2

3. Decreased bank profitability

4. Rapid growth in lending portfolio

5. Shifting deposits or rapidly rising deposit rates

6. Excessive nonperforming loans

7. Inter-bank, money market borrowing rates

8. Government debt

9. Overvalued native currencies

10.Real estate bubbles

• 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

• Several years of 20% or more annual growth in asset prices

• Excessively high Inter-bank call interest rate

• Public debt as percentage of GDP

• FX rate based on purchasing power

6

IN 1997, CLEAR SIGNS OF POTENTIAL CRISIS WERE VISIBLE THROUGHOUT THE KOREAN ECONOMY

Source:Bloomberg; Banking Industry Association; FSS; MOFE; The Bank of Korea; McKinsey analysis

Real SectorReal Sector

Warning sign (criteria)


2. Interest coverage ratio

Financial System

Financial System

International Money &

Capital Flows


Capital Flows

Real Estate Sector

Real Estate Sector

Korea’s situation in 1997

• ROIC<WACC for most listed companies for 3 years from 1995

• Over 70% of listed companies with ICR <2

Level of seriousness

High risk

Moderate risk

Low risk

3.Profitability of banks

4.Rapid growth in lending portfolio

5.Shifting deposits or rapidly rising deposit rates

6.Nonperforming loans

• 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

7. Interbank, money market borrowing rates

8. Gov’t debt as percentage of GDP

9. Overvalued FX rate


• 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

7

Real SectorReal Sector

SERIOUS SIGNS OF AN OVERALL CRISIS ARE NOT APPARENT IN THE KOREAN ECONOMY TODAY

Source:Bank of Korea, KISLIne; MOFE; Kookmin bank; press clipping

Warning sign (criteria)



• 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

Financial System


Capital Flows


Capital Flows

Real Estate Sector

Real Estate Sector

Korea’s situation nowLevel of seriousness

3.Profitability of banks

4.Rapid growth in lending portfolio

5.Shifting deposits or rapidly rising deposit rates

6.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


8.Gov’t debt as percentage of GDP

9.Overvalued FX rate


• 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

High risk

Moderate risk

Low risk

8

8.43

11.811.2

4.16

9.59.49.0

9.1

9.79.2

8.3

10.3

9.110.2

8.5

8.1

8.6

9.6

7.6

9.4

8.8

3.6

7.4

4.8

8.0

5.9

3.6

0

2

4

6

8

10

12

14

1990 92 94 96 98 00 2002

VALUE DESTRUCTION IN THE REAL ECONOMY IS GETTING WORSE SINCE 1997…

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

ROICWACC*Sectors with corporate value destruction

IMFCrisis

Percent, 1990~2003

Warning signs



3. Profitability of banks



6. Nonperforming loans


8. Government debt as percentage of GDP



Drivers• Overinvestment• Declining relative productivity

9

323

405456

512548

252

…BUT THE FINANCIAL SECTOR IS NOW RELATIVELY STABLE

*Based on time deposits

Source:The Bank of Korea; MOFE

KRW trillions, percent

Warning signs











Deposits have risen continuously since monetary crisis and rates are falling as well

1998 1999 2000 2001 2002 2003

17.8

4.1

Interest rate*

Total deposits

10

ADDITIONALLY, NATIONAL DEBT RELATIVE TO OTHER MAJOR COUNTRIES IS REASONABLY LOW AND STABLE

*Government debt is classified based on IMF standard (treasury bond, borrowing, other borrowing activities)

Source:MOFE; OECD Economic Outlook (2003.12)

Percent, 2003

Warning signs











Public debt still far less than OECD average

Government debt* to GDP ratio

19%

53%

63%

78%

155%

OECD average

11

KEY MESSAGES




12

OVERALL, KOREA IS AT A TURNING POINT TO JOIN THE RANKS OF ADVANCED COUNTRIES

Join the ranks of advanced countries

Restructuring

Credit crunch

Financial crunch

1997

Now

98.6~99.12Daewoo scandal

97-12~98.6High interest rate, high FX rate

• Booming US economy

• Dot com bubble• Consumption-driven

growth

SK Global scandal

Credit card crisis,Foundering bond market

Early 2000 System allowing quick acquisitions of corporate bonds

Mid 2000 Hyundai scandal

2003

13

SUMMARY OF CURRENT ECONOMIC OUTLOOK

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

Since 1994, capital markets’ view of Korea is negative and getting worse

14

AGGRESSIVE CREDIT WAS EXTENDED TO HOUSEHOLDS AND INDIVIDUALS IN AN ATTEMPT TO DRIVE CONSUMPTION

Source:Bank of Korea; Korea Non-Bank Financing Association

267

342

439

20022001 2003

CAGR 28%

CAGR 28%

Total household debtCredit card usage

Percent

5 8 8

61

56

53

10

10

11

23

27

28

Card loans

CashAdvance

InstallmentLump sum

481

678

237

2000 2001 2002

CAGR 70%

CAGR 70%

DOMESTIC DEMAND

KRW trillion

15

-5.0

0.0

5.0

10.0

15.0

Wholesale/retail sales growth index

THIS HAS CAUSED A SHARP RISE IN CREDIT DELINQUENTS AND SHARPLY REDUCED CONSUMPTION AND DOMESTIC DEMAND

*Repayment of debt/disposable income

Source: National statistics office; Bank of Korea

Credit delinquents trends

Debt repayment ratio*

2.45

3.77

2000 2004. 1Q

Million

Percent

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q

2002 2003 2004

Consumers are still shackled by their debt obligations accumulated during the credit boom in 2001-02

54%

15

26

2000 2004. 1Q

11%p

16

INVESTMENTS HAVE BEEN WEAK FOR THE PAST 6 QUARTERS PRIOR TO 2Q 2004

7.5

-1.5

1.9

-0.6

-5.0

-2.4

-0.3

6.2

Investment growth rate (YOY)*Percent

2002 20031Q 2Q 3Q 4Q 1Q

*Indexed to the price of 2000; vs. the corresponding period of last yearSource: Korea development bank; Bank of Korea

Investment growth rate under pressure …

Business confidence index

Companies have negative economic outlook

60

80

100

120

2Q 4Q

2002

1Q 2Q 3Q 4Q 1Q 2Q 3Q

2003

2004

2003 2004

INVESTMENT

2Q

17

WHILE EXPORTS ARE THE ONLY PILLAR PROPPING UP KOREA’S ECONOMIC GROWTH…USD billion; YoY growth rate

43.046.1

47.8

56.959.3

64.0

21%

14%16%

26%

38%39%

1Q 2Q 3Q 4Q 1Q 2Q

2003 2004

TotalExport amount

Growth rate

Source: KITA; Bank of Korea

EXPORTS

18

1990 2003

…THE SPILLOVER EFFECTS ON FOREIGN EXCHANGE EARNED AND EMPLOYMENT ARE DIMINISHING

Source: KOTRA; Korea national statistics office; Bank of Korea

FX earned by export

2003

Employment generated by export

Percent Person / USD million

1990 2003

67.7% 43

54.5%

29

• 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

19

GDP GROWTH IS NOT TRANSLATING INTO EQUAL GDI GROWTH

140

150

160

170

180

190

1Q03 2Q03 3Q03 4Q03 1Q04 2Q04

GDP

GDI

Source: Bank of Korea

KRW trillion

20

S&P 500

Europe top 500

KOREAN VALUATIONS LOWER THAN OTHER MARKETS, AND GETTING WORSE OVER TIMEAggregate Market-to-Book ratio

0

1

2

3

4

5

6

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

IBES - China

KOSPI - Korea

HIS – Hong Kong

Nikkei - Japan

Source: Datastream; McKinsey

CAPITAL MARKETS’ VIEW

21

IN THE SHORT TERM HIGH OIL PRICES WILL ALSO BE AN IMPEDIMENT TO THE ECONOMY

0

10

20

30

40

50

2002 2004

Million barrels daily

* data as of 2002

Source: BP Statistical Review of World Energy (2003); Korea National Oil Corporation; OECD; Bank of Korea

2003

Jan. JanJan.Jul. Jul. Jul.

Korea is a the third largest importer of oil * Rising oil prices will impact the economy

5.1

2.0

1.1

1.0

2.8

11.4

Korea

USD/Bbl, Dubai oil

Japan

USA

Canada

China

SouthAfrica

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

KOREAN EXPORTS ARE INCREASINGLY HIGHLY CONCENTRATED

Source; KITA, literature review

100% =

Semiconductor

2001 1H 2004

Wireless telecom. device

Auto

Computer

Shipbuilding

Others

9%

7%

9%

7%

7%

61%

10%

10%

9%

8%

7%

55%

$ 123.5 billion$150.4 billion

39%45%

Percent

Share of items in total exports

EXPORT CONCENTRATION

24

THE MARKETS FOR KOREAN EXPORTS ARE ALSO HIGHLY CONCENTRATEDPercent, 2004

Source:Bank of Korea; Bloomberg, Wall Street Journal

25.9%China

Share of exports to each nation1H 2004

100% = USD 123 bn

US

Japan

Others

22.2%

8.7%

43.2%

GDP growth (vs. the corresponding period of last year)

9.8% 9.6%

2004 1Q 2Q

5.0% 4.8%

2004 1Q 2Q

2004 1Q 2Q

1.6%0.4%

25

China’s key export industries

Percentage in China’s overall exports

Rank Industry Ratio

1 Electrical machinery, etc. 20%

2 Nuclear reactors, machinery, etc 19%

5 Footwear, headgear, etc 3%

6 Iron and steel 3%

9 Optical, measuring, etc. 3%

10 Plastics 2%

Source: United Nations Statistics

CHINA’S KEY EXPORT INDUSTRIES ARE BECOMING MORE COMPETITIVE THAN COMPLIMENTARY

CHINA’S COMPETITIVENESS

Korea’s key export industries

Percentage in Korea’s overall exports

Rank Industry

2 Nuclear reactors, machinery, etc 16%

3 Automobile 12%

4 Shipbuilding 6%

5 Iron and steel 5%

6 Plastics 5%

Man-made filaments 2%

1 Electrical machinery, etc. 28%

Ratio

7 Mineral fuels/oils, bituminous, etc 3%7 Mineral fuels/oils, bituminous, etc 4%

Apparel, clothing accessories 2%

9

10

3 Apparel, clothing accessories 10%

4 Toys, spots requisites, etc 6%

8 Organic/Inorganic chemicals 3% 8 Organic/Inorganic chemicals 2%

2003

26

BASED ON ITS COMPETITIVE WAGES AND GROWING CAPABILITIES, CHINA IS BECOMING A FORMIDABLE COMPETITOR

0.66

9.62

KoreaChina

*Hourly wages of workers in manufacturing sector

Source: IMD World competitiveness annual report; KDB; McKinsey analysis

Labor* cost, 2003

US$

As-is capability gaps with Korea

2.3

2.5

4.5

5.8

7.0Shipbuilding

1.5

3.0

3.0

3.0

White goods

Automobiles

TFT/LCD

Mobile handsets

N/A

Years KDB IMD

27

KOREAN COMPANIES ARE STEPPING UP THEIR INVESTMENTS INTO CHINA

Korean FDI to China

Source:Ministry of Commerce, Industry & Energy; Export-Import Bank of Korea

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1990 1994 1998 20022003

USD billions

28

KOREA’S RELATIVE LABOR PRODUCTIVITY GROWTH IS POORUNPRODUCTIVE LABOR

Unit labor costs in manufacturing/ labor productivity growth rate

Labor cost per manufacturing unit (based on local currency)

YoY growth

8.1

13.2

8.9

-1.4

11.2

8.1

2001 2002 2003

Wages

Productivity

Source:Ministry of Commerce, Industry and Energy, US labor statistics bureau, Euro monitor source, Ministry of Labor

106.6

106.5

102

91.4

89.8

86.5

Korea

Japan

Taiwan

U.S.

Germany

France

2003

29

COST OF KOREAN LABOR IS HIGH RELATIVE TO COMPETITOR NATIONS

Hourly labor cost in key competitor countries’ manufacturing sector

USD

0.66

5.93

5.98

7.48

9.62Korea

Singapore

Hong Kong

Taiwan

China

Source:Ministry of Commerce, Industry and Energy, US labor statistics bureau, Euro monitor source, Ministry of Labor

30

# 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

KOREAN LABOR RELATIONS ARE POOR

56

32

3 1

111

Source:ILO Labors Statistics Yearbook; Bank of Korea; IMD World Competitiveness Report (2004); Ministry of Labor Affairs; McKinsey analysis

Korea Japan GermanyFrance

Ranking among 60 nations Countr

yScore

1 Singapore

2 Switzerland

3 Austria

5 Japan

21 The US

39 China

60 Korea

Taiwan11

8.52

8.45

8.29

7.92

7.62

7.23

6.48

4.00U.S

31

THE PERCEPTION OF HOSTILE LABOR UNIONS IS AN OBSTACLE TO INVESTMENT BY FOREIGNERS AND KOREANS

Source:MOCIE survey (August 2003), press search

What is the weakest point of Korea as an investment market?

• “Hardline trade unions are strapping the promotion of foreign direct investment” - William Oberlin,

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

20%

14%

8%

32%Labor relations

Bureaucratic restrictions

High cost

North Korean nuclear issue

32

KOREA’S COMPETITIVENESS AS AN INVESTMENT ENVIRONMENT IS LOW

Source: IMD world competitiveness yearbook (2004), Korea chamber of commerce & industry

On the scale of 10 (figures in brackets show ranking among 60 countries surveyed), 2004

Labor related restriction

Risks from political uncertainty Investment incentives

Korea

U.S.

Taiwan

China

Japan

Singapore

6.13

4.67

7.14

8.15

8.72

3.75

6.94

6.58

8.29

4.77

6.83

5.29(55)

(20)

(54)

(47)

(27)

(13)

(41)

(16)

(23)

(13)

(44)

(1)

6.69

6.14

7.76

5.62

6.37

3.17 (44)

(10)

(12)

(8)

(17)

(2)

INCREASING COMPETITION FOR FDI TO KOREA

33

FDI AS A PERCENT OF GDP IS LOW AND DECLINING Percent

*2002(E)

Source:EIU country index, Global insight, McKinsey analysis

China

Singapore

Ireland

0

5

10

15

20

25

1996 1997 1998 1999 2000 2001 2002

Korea*

Foreign direct investment as percent of GDP

34

IN THE MEDIUM TO LONG TERM KOREA WILL ALSO HAVE TO COME TO GRIPS WITH ITS AGING POPULATION

0

10

20

30

40

50

60

1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

Over 55 years old

25-54 years old

Less than 25 years old

2003 CAGR03-50

-1.5%

-1.0%

-0.2%

2.1%

Total

Korean population by age, million persons

Source: KNSO; McKinsey Household Financial Wealth Accumulation Model

AGING POPULATION

35

BY 2026, TWO PEOPLE WILL NEED TO SUPPORT EACH SENIOR CITIZEN

Source:Korea census, McKinsey analysis

Future Now

Korea in 2003• 3 economically active

people (age 25~54) supporting 1 retired person (age above 55)

CONCEPTUAL

Korea in 2026

Aging trend to accele-rate

Korea in 2013

36

KEY MESSAGES




37

EACH ACTOR IN THE KOREAN ECONOMY WILL NEED TO PLAY A ROLE IN CREATING PROSPERITY FOR THE COUNTRY

• 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)

• Recognize impact of negative reputation

• Be creative about win-win solutions

• Recognize need for increased productivity

• But, let us focus on what you as corporate leaders need to do…

Government

Labor

Corporations

38

AT A HIGH LEVEL, CORPORATIONS WILL NEED TO SHIFT PARADIGMS IN MINDSETS AND HOW TO MANAGE

Past Future

Stability in external factors

Continuous change

1

Revenue orientation Profit orientation2

Input driven Output driven3

Tangibles Intangibles4

Hierarchy Meritocracy5

Opacity Transparency6

39

CORPORATIONS SHOULD EMBARK ON SEVERAL CHANGES TO ENSURE LONG-TERM SUSTAINABILITY AND GROWTH

Strategic

• 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

Operational

• Get the basics right on cost control and operational excellence (current earnings programs)

• Focus on building resilience to torpedo shocks (risk management)

Organizational

• Improve transparency and credible corporate governance

• Build true performance oriented culture and meritocracy (value-based management)

40

Thank you

facing the threats and challenges of the korean economy

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