A combination of weak global demand, manufacturing overcapacity and currency pressures has been putting an enormous strain on South Korea's traditional growth engine of exports since 2011.
China, faced with its own sagging growth, has engineered a massive "import substitution" cycle, replacing imported goods with locally produced ones as a precursor to becoming a net exporter on a major scale. This strategy of localization was originally the business model of most South Korean exporters. Even successful global brands like Samsung Electronics and Hyundai Motor began their businesses by imitating and replacing Japanese imports, starting from the low end and gradually becoming legitimate competitors.
China's giant state-owned enterprises are now looking to emulate the success of the South Korean chaebol and the Japanese conglomerates before them, which could exacerbate supply and demand imbalances in the Asian manufacturing sector for years to come.
These pressures at the commoditized end of the value chain should lead to better-quality South Korean companies moving higher up, as happened with Japanese companies in response to the emergence of South Korean competition in the 1990s. Unfortunately, since 2012, there have been additional pressures at the top of the manufacturing value chain due to Abenomics, the economic reforms initiated by Japanese Prime Minister Shinzo Abe. Since 2011, the Japanese yen has depreciated 40% against the South Korean won, providing Japanese exporters with pricing power they had not seen since 2007. In essence, many South Korean exporters are being squeezed from both ends of the manufacturing ecosystem.
A NEW ERA Investors will find this outlook very disheartening for the future of South Korean exporters, now under threat from aggressive Chinese moves into their territory. The similarities between Chinese state companies today and South Korean chaebol in the 1990s hint at a major risk to the South Korean export model that has worked so well for two decades. Efforts by Seoul to export its way out of the current predicament will not be effective this time around. This is because its traditional measures of currency intervention, tax cuts and subsidies to conglomerates are being adopted at a much faster pace and on a greater scale by China.
What South Korean policymakers need to promote is structural reform, similar to the "third arrow" of Abenomics. Structural reform of the labor market and overall deregulation will boost entrepreneurs and smaller companies that have been operating under the shadow of the chaebol for decades.
Since the reforms implemented during the Asian economic crisis of 1997-1998, layers of regulation and government intervention have accumulated once again. While global perceptions of South Korea's business sector have been largely shaped by the success of Samsung and Hyundai, other members of South Korea Inc. are lagging far behind these two pacesetters.
Companies that are able to embrace the structural shift from the traditional Asian business model can represent a new era for South Korean companies.
Interestingly, these companies are likely to emerge from South Korea's homegrown sectors, where the traditional customer base is domestic. Cosmetics provides a prime example of how a traditional domestic industry can evolve into a major export business on the back of the emerging consumer class in China and redefine the business models for consumer brands in South Korea.
Cosmetics companies, such as AmorePacific Group and LG Household & Health Care, are providing a ray of hope not only for the future of the consumer sector but for the entire South Korean economy. As China's emerging middle class emulates South Korean consumption patterns, South Korean companies that have been serving domestic customers for years can potentially do the same for millions of mainland Chinese over the coming decades.
Just as Chinese state-run enterprises are using the benchmark of South Korean chaebol of the 1990s and Japanese conglomerates before that for their business models, Chinese consumers are seeking to emulating Korean consumption trends. Already, we are seeing the wild popularity of South Korea's K-pop music and TV dramas driving this cultural following.
During the 1990s, South Korean consumers had a similar appetite for Japanese culture, from TV shows and comics, to food and beverages. With South Korea one of the fastest-growing tourist destinations for mainland Chinese, its consumer brands are getting exposure to a new market that should give them many decades of sustainable growth.
The key challenge for South Korean consumer companies is to move on from a formula that has proved so successful for so long. During the past two decades, the country's economic achievements have been marked by growth and the success of the chaebol's industrial business model -- in particular, the business-to-business model rather than the business-to-consumer approach.
BREAKING THE MOLD There are only a handful of South Korean brands that have successfully made inroads into the B2C model. The most notable examples are Samsung's smartphones and Hyundai's sedans. The global success and recognition of these two brands have helped upgrade the overall perception of South Korea Inc. But other national brands remain entrenched in the B2B model of targeting governments, state companies or multinationals. Not having their own consumer brands will inevitably leave South Korean companies vulnerable to copycat latecomers from China and elsewhere.
As proven by its cosmetics companies however, South Korea can gain an edge over the "fast copy" pursuers in China. The key challenge in making this transition is in embracing the B2C model and creating and maintaining brand loyalty. Learning this relatively new approach will determine the ultimate success of the transition to South Korea Inc. 2.0. In this regard, South Korean consumer companies in the retail, food and beverage, and entertainment segments, such as CJ Group and Orion, already enjoy a head start over traditional export companies.
Another major catalyst for the transition is the proliferation of e-commerce, especially in China, that is allowing smaller companies with good products to break into markets that previously would have required huge investment in distribution and marketing. The success of South Korean cosmetics companies in China is notable in that it relied on distribution channels outside the traditional ones of door-to-door sales, department stores and specialty stores. Instead, we are seeing strong growth in online and duty-free sales, allowing for smaller companies to access China without costly, long-term investments. For many smaller companies outside of chaebol groups, this is an opportunity to compete on a new playing field. The recent successes of South Korean biotech companies illustrate this shift.
Right now the South Korean economy is undergoing a much-needed transition from an economic model that has worked wonderfully for over two decades. Making the change requires vision, risk-taking and good business execution. Improved corporate governance, meanwhile, will be a critical factor in retaining the support from the global investment community.
The need for structural reform at the policy level has been acknowledged since August, as has the necessity of an aggressive response to changing market conditions. There have been glimmers of hope recently, with a flurry of restructuring efforts by some chaebol, led by the Samsung group. These chaebol have been active in mergers and acquisitions and making shareholder-friendly announcements. This could be an early sign of South Korean groups finally recognizing that their current troubles are structural rather than cyclical.
While many companies will undoubtedly be left behind, those that can make the necessary changes will offer massive rewards to both their shareholders and the wider South Korean economy.
Peter S. Kim is a managing director and investment strategist at KDB Daewoo Securities. This article reflects the personal views of the author.