Matthews Asia Snapshot


New Paradigm for Korea's Growth

Week of August 22, 2014

First, there was “Abenomics” in Japan; now, “Choinomics” in South Korea seeks to bring renewed excitement to the market by way of boosting domestic consumption and household income through increased wages and dividend payouts. As the newly appointed finance minister, Choi Kyung-hwan has touted a policy that is an “about-face” from Korea’s conventional growth formula, which was focused heavily on exports and shunned consumption.

“Choinomics”

 
April’s Sewol ferry disaster, sparked a time of national mourning, and the tragedy led to outcry for numerous government reforms. President Geun Park’s administration responded with a sense of urgency, and implemented numerous consumer-friendly reforms as part of Choinomics. These include tax incentives to increase dividend payouts and wages as well as decrease tax penalties to prevent excessive cash hoarding in the corporate sector. Stringent property lending rules have also been relaxed in an effort to energize the market. These measures have been captured in a supplementary budget designed to boost domestic consumption. Choi’s officials have also proposed a reduction in taxes on dividend income tax for shareholders. The tax reduction would target companies that either pay a higher-than-average dividend or firms that have increased their payouts compared to historical averages. The maximum tax rate for those shareholders would be cut to 25%, from 38%, for high income earners. Other investors may be subject to a progressive rate ranging from 9% to 14%. But these tax cuts are expected to last through the end of 2017. In this way, authorities are using a “carrot and stick” approach, incentivizing companies to essentially increase dividend payouts, while proposing a 10% tax on a portion of unused income (net of salary increases, local capital expenditures, and dividend payouts).

While there is a fair amount of consensus around these policies in Korea, somewhat more controversial are changes to property lending rules. Korea avoided the Global Financial Crisis thanks to stringent property lending rules, limiting loan-to-value amounts to 50% and debt-to-income totals to 30% during the boom period of 2002 to 2007. This policy was implemented a few years before the Global Financial Crisis and was successful in protecting both lenders and borrowers during the crisis. Housing demand is expected to be lackluster these days, especially compared to expectations over stock market performance. Opponents question Choi’s attempt to deregulate the banks, particularly given historically high household leverage, combined with reduced property market return expectations.

Dividends


Korea’s stock market has traded at a discount to its peers largely due to corporate governance concerns. Some of its governance features are exemplary, such as executive pay and mandatory financial statement disclosure requirements. But its chaebol—large, often family-owned conglomerates— continue to be seen as a blemish on Korea’s corporate governance reputation. President Park has vowed to reform the chaebol system, specifically family ownership. For decades, the chaebol system was viewed favorably as the country’s export giants successfully championed global markets. However, the system has been blamed for limiting entrepreneurship given their dominant position in the domestic economy. Choi’s demand for an increased dividend payout should be seen as a baby step toward the country’s corporate governance reform.

Dividends are but one form of capital allocation. As Warren Buffett has famously written, corporate profit can be used for organic growth, inorganic growth, share buybacks or dividends. Dividends can be a great solution if they are more tax efficient, and they generate better returns than other investment options available to management. In the past, Korean companies leveraged generous tax incentives and invested aggressively in research and development and capacity expansion in order to reduce the technological gap that existed between it and more advanced peers, which appears to have been a smart capital allocation strategy. However, since the Global Financial Crisis, many of those companies have been hoarding cash instead of reinvesting it or distributing it to shareholders. With this program, government policy appears to take on the role of an activist investor.

Household Income and Consumption

 
Since his nomination, Choi has promoted the need for improved consumer sentiment and a stronger currency. Because favoring export giants does not necessarily translate into better household income, the average Korean has not been satisfied with this traditional growth formula. Since the Asian Financial Crisis, the balance sheets of most large corporations have vastly improved while household balance sheets have deteriorated. Therefore, even with a pro-business president at the helm, Korea’s new administration has had to embrace a more liberal agenda. The Park administration seeks to discourage corporate cash hoarding while motivating wage increases. This, combined with improved dividend payouts, should provide a boost for households.

A temporary incentive for dividend payouts and wage increases may not move the needle completely, but it is an indication of a paradigm shift in Korea’s growth strategy as represented by Choinomics. This may mark Korea’s first efforts at economic “rebalancing”—moving the emphasis on cyclical companies and externally focused demand-driven exports to more domestically focused, and more stable consumption, driven by household income. More balanced growth that includes both exports, as well as domestic consumption may eventually help Korea’s economy become more resilient and sustainable, thus boosting consumer and investor confidence.

Michael Han, CFA
Portfolio Manager
Matthews Asia

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