ICAS Spring Symposium
Institute for Corean-American Studies, Inc.
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Corruption and Government
The Asian economic and financial crisis of 1997 was caused by many factors, some domestic and others external. Domestically, one may mention first of all the excessive government regulation of the economy that has led to the inefficiency and high costs of doing business in Asia, thus making many Asian companies less competitive. In Korea, for example, the so-called "four highs" (high land/factory site cost, high transport cost, high wages, and high interest rates) as compared to those of Korea's major competitor countries had been due mainly to the excessive government regulation that choked the economy through burdensome and inflexible rules and procedures. Other Asian countries such as Japan, Thailand and Malaysia have suffered from similar problems of excessive bureaucratic controls.
Second, the inefficient banking and financial system in Asia misallocated the scarce financial resources, frequently resulting in wasteful investments in real estate or excessive industrial capacity. Credit allocation was manipulated through the symbiotic collusion among politicians, powerful bureaucrats, and businessmen, with the bribery providing the glue in this iron triangle. Bankers' lending decisions were based more on family or political connections than on rational credit appraisals. Excessive reliance on the collaterals for lending decision also stunted the credit evaluation capability of Asian bankers. Third, the rigid labor policy made it almost impossible for Asian companies to lay off surplus workers. Mergers and acquisition could not be used effectively to consolidate businesses due to inflexible labor laws and consequently, foreign direct investments were discouraged.
Finally, corporate governance in Asia had been stuck at a primitive stage for many decades. The minority shareholders had almost no practical ways to inspect the books of their own companies and they could not easily sue the chief executives for their willful mismanagement and gross negligence. The board of directors was composed entirely of internal directors whose careers were at the mercy of powerful company chairmen and CEOs, thus unable to exercise the board's proper supervisory function of performance evaluation and management audit. Interlocking shareholding among many family-owned affiliates and cross-guarantees among them served to enable the company chairmen to exercise absolute management control.
As a result, mis- and/or over-investments have been frequent without thorough investment appraisals and also financed largely through debt financing rather than equity funding. Returns on investments (ROIs) for Asian companies have been very low due to such over- and mis-investment. For example, it was reported that, prior to the 1997 crisis, even though the Korean economy was rather robust in 1996 and the combined accounting profits of the Korean companies listed on the Korea Stock Exchange were over $3 billion in that year, their combined economic value added (EVA) turned out to be negative $3.2 billion. In other words, Korean companies failed to generate the true profits out of their investment capital, thus wasting valuable financial resources of the country. Poor accounting practices and standards in Asia have also led to unreliable financial statements, resulting in the lack of transparency.
Corruption's Impact on Economic Development
Despite some impressive economic growth rates achieved in many Asian countries in recent decades, there has been a growing concern over the widespread corruption in many Asian countries ranging from Indonesia to Korea. Asian corruption has been all the more sinister, as large family-controlled corporations have been able to hide behind opaque accounting standards to collude with government officials in order to gain special business favors in the environment of stultifying government regulations and control. Because of the Asian economic crisis, corruption has attracted renewed interest both among academics and politicians in recent years. In fact, some observers see in the recent Asian economic crisis a silver lining for controlling corruption as the role of corruption in misdirecting capital and masking the results becomes clear. Newly wary foreign investors will be more careful in the future about the local partners that they choose in Asian countries. Recovering Asian economies that need to reattract capital will have to offer more transparency and safeguards than has been the case in the past, especially if they are to beat competitors for scarce investment capital in Latin America and Eastern Europe.
In economics, it is viewed that corruption can occur where rents exist typically as a result of government regulation and public officials have discretion in allocating them. Government restriction and regulation result in rents and rent-seeking behavior, and civil servants provide the necessary licenses or quotas to those businessmen willing to pay bribes.1 Where there is excessive government regulation and controls, corruption tends to be prevalent. It was reported, for example, that about 20 percent of a typical construction project cost in Korea is used to pay bribes, since an average of 44.2 permits or licenses from 7 to 8 different government agencies are required over an average period of three years to receive all the necessary permits there.2 Therefore, corruption increases the business costs and results in the deterioration of competitiveness among private companies. A study shows that the higher the degree of corruption, the more time business managers have to spend with government bureaucrats, thus wasting valuable management time and energy.3
Corruption also leads to misallocation of public investment capital. Ribbon-cutting ceremonies marking the completion of big infrastructure projects such as roads and power plants are often every politician's dream. These occasions present splendid public relations opportunities for high government officials, who are seemingly identified as major contributors to the future growth of the economy. In many Asian countries, however, corrupt officials frequently choose investment projects not on the basis of their intrinsic economic returns but more as an occasion to receive bribes and kickback that these investment projects present. When corruption plays a large role in the selection of investment projects and contractors, often the productivity of capital is reduced and the quality of construction is so poor that they will need continuous repairs and maintenance, imposing a heavy burden on the government budget. Furthermore, corruption tends to encourage over-investments known as "white elephants" in many developing countries.4
International Efforts to Fight Corruption
Corruption is not only a burden to a country's economic development in terms of added business costs and misallocation of scarce investment capital but it also provides an uneven international playing field among many companies competing for international business opportunities. When the United States passed the Foreign Corrupt Practices Act in 1977 barring U.S. firms from paying bribes overseas, it was widely feared that the law would provide an unfair advantage to many Asian and some European firms as they steal contracts away from American firms by paying bribes. For example, business firms in France and many Asian countries are allowed to treat such overseas bribes as business expenses and thus tax-deductible. For years, the United States has urged other countries also to outlaw foreign bribery. In November 1997, the 29 member countries of the Organization for Economic Cooperation and Development completed a treaty that will require all signatories to ban overseas bribery. The OECD Convention on Combating Bribery of Foreign Public Officials was also signed by 5 other non-OECD countries and it is hoped that more countries would sign the Convention later.
The new anti-bribery treaty represents an acknowledgement that corruption is a growing problem and one that hurts almost everyone involved. Honest and competent companies, of course, are injured when they lose contracts that they should have won. But even bribing companies end up inefficiently, spending too much time dealing with public officials and ensuring that the terms of a corrupt transaction are upheld - that the bribee delivers, in other words. In developing countries, corruption may enrich a small group of government and political elite, but it discourages foreign investments and impoverishes the bulk of the population.
Once the treaty goes into effect, every participating country will criminalize bribery of foreign officials. In some ways, however, the treaty does not go as far as the U.S. Foreign Corrupt Practices Act. For example, a number of activities that the U.S. law expressly prohibits are not covered. These include bribes to political parties, political party officials and candidates for office. They also include bribes to state-owned enterprises if the enterprise operates on a "normal commercial basis" without "preferential subsidies or other privileges." Furthermore, foreign corporations would be free from criminal prosecution if their home country does not provide for corporate criminal liability. Authorizing a bribe would be not a crime in countries in which authorization is not illegal unless the bribe is actually carried out. Authorization of a bribe would be a crime, moreover, only if it were part of a conspiracy. Nevertheless, the treaty is a huge first step, and other signatory countries have agreed to discuss extending its reach once this treaty goes into effect.
Regulatory Measures to Improve the Business Transparency: The Case of Korea
The Asian economic crisis has affected Korea especially hard. After almost three decades of rapid economic growth, the Korean real GDP declined by 5.8 percent in 1998 and its unemployment rate increased from an almost full employment level to over 8 percent by early this year. However, if one includes those who are working only for less than a few hours a week and those who stopped searching for new jobs due to the tight labor market, the true unemployed and underemployed are estimated at over 3.5 million people or over 15 percent of the total workforce. Many observers have blamed the rampant corruption in Korea as one of the root causes of the current economic crisis there. Such corruption was possible due to the opaque business practices in Korea. Thus, achievement of the business transparency is considered an urgent task in order to prevent another such crisis.
In early 1998, then President-elect Kim Dae Jung and the heads of the top thirty Korean chaebols reached a five-point accord to promote corporate restructuring and economic modernization in Korea. The accord included among others the measure to improve the transparency of corporate management in Korea by adopting modern accounting standards and by holding corporate management accountable to shareholders by appointing independent outside directors to corporate boards and strengthening shareholder rights. This accord was adopted in response to numerous demands from various parties for the reform of business practices in Korea. Specifically, the International Monetary Fund (IMF) and the World Bank required the Korean government to upgrade accounting standards and disclosure rules to meet international practices as part of their loan conditionality.
In 1998, the Financial Supervisory Commission (FSC) made a thorough review of the existing accounting and auditing systems and, incorporating comments and suggestions of many foreign institutions with keen interests in the Korean economic modernization, adopted several reform measures in order to upgrade the financial accounting standards to the level of international standards. The reform process focused upon three specific areas: (1) revision of financial accounting standards that are primary components of Korean generally accepted accounting principles (GAAP), (2) establishment of modern accounting standards for financial institutions, and (3) establishment of accounting standards for combined financial statements.
The primary goal of the reform was to enhance transparency, credibility and international comparability of Korean accounting standards, employing as benchmarks the International Accounting Standards (IAS) established by the International Accounting Standards Committee. Where the IAS do not exist or are not sufficient to address particular accounting issues of importance to Korean companies, the U.S. accounting standards were used as an alternative benchmark. Employing the IAS or U.S. standards as benchmarks made the revised Korean accounting standards consistent with international best practices. In addition to the corporate financial accounting standards, separate accounting standards for banking, securities, and insurance industries in Korea have been adopted based on international best practices. However, adoption of the so-called combined financial statement standards was unique to Korea due to the special importance of chaebols in the Korean economy.
Standards for the Combined Financial Statements
As in other Western countries, the Korean accounting standards have required firms that have subsidiaries to prepare consolidated financial statements. However, because of the unique chaebol ownership structure in Korea, several consolidated financial statements are issued within the same chaebol. A parent-subsidiary relationship exists when a company as the largest shareholder directly or indirectly owns more than 30% of another company's voting interest. In contrast, an affiliate of a chaebol is any company that operates under the influence of the chaebol owner(s) regardless of the specific corporate ownership structure. Under the existing standards for the consolidated financial statements, an affiliate that is not a subsidiary of another affiliate is excluded from consolidation, even though it is under the common control of the chaebol. As a result, the typical consolidated financial statements are unable to present the whole financial condition of a chaebol in Korea, even though Korean chaebols play a dominant role in the Korean economy. Taking advantage of this gap, Korean chaebols adopted many corrupt business practices through collusion with government and political elite rather than enhancing their genuine management effectiveness.
In order to address these issues, the Korean Congress passed a bill that requires combined financial statements for chaebols for fiscal years starting January 1, 1999. The objective of combined financial statements is to present financial positions, operating results, and cash flows of chaebols as a whole under the assumption that chaebol-affiliated companies constitute a single economic entity. Under the new law, the 30 largest Korean chaebols designated by the Fair Trade Commission are required to issue the audited combined financial statements for all domestic and foreign affiliates that are under the effective control of an individual owner and his/her relatives. The concept of effective control is consistent with the IAS and other international best practices.
The combined financial statements consist of the combined balance sheet, income statement and cash flow statement, prepared under the assumption that chaebol affiliates under the common control constitute a single economic entity. Thus, intra-group balances and intra-group transactions must be eliminated in the preparation of the combined financial statements. The standards also require footnote disclosures of intra-group transactions, including intra-group ownership interests, cross guarantees, cross pledging, intra-group borrowings, and intra-group sales. Separate combined balance sheets and combined income statements need to be disclosed in a footnote for financial affiliates and non-financial affiliates to enhance understandability of the combined financial statements. Further, segmental information by major industries and geographic regions is to be footnoted. Introduction of these uniquely Korean combined financial statements is likely to enhance further the financial transparency of Korean firms.
Concluding Observations and Recommendations
In recent years, there has been growing public recognition and discussion of the problem of corruption, especially in many developing countries including the Asian region. It is also noteworthy that many public officials in developing countries are now willing to discuss openly the challenges of fighting corruption in their countries. In a recent survey of more than 150 high-ranking public officials and key members of civil society from more than 60 developing countries, the respondents ranked corruption as the most severe impediment to economic development and growth in their countries.5 Corruption is also widely blamed as one of the primary root causes of the recent Asian crisis.
Corruption tends to increase the number of less urgent investment projects in developing countries and inflate their costs, both original capital expenditures and subsequent repairs and maintenance expenses. Misallocation of scarce capital and over-investment into 'white elephants" is a serious drain on the economic development of a country. However, the recent Asian economic crisis may be viewed as a silver lining in fighting corruption in many Asian countries, as both the public and private sectors are increasingly determined to introduce major reforms and institutional changes to increase business transparency and institutional reforms. In this sense, the 1997 accord by OECD member countries to fight foreign bribery can serve as a critical milestone in fighting corruption worldwide.
In order to control corruption, Asian countries need to adopt the following policy measures. First, there should be drastic deregulation and liberalization of the economy. Where there is less government regulation, there is less scope for corruption. Simultaneously, a drastic government downsizing is called for with a much smaller civil service force. With the saving in the personnel costs, the salary levels of the civil servants should be made comparable to those in the private sector as in Singapore. Second, strong measures need to be taken to enhance the business transparency and to improve corporate governance in Asia, thereby promoting the competitiveness of Asian business firms through effective management rather than through political patronage. Third, financial sector reforms are critical to allocate scarce capital through market forces than by bribery-influenced political and bureaucratic intervention. Finally, a drastic political reform is essential to lessen the need for politicians to depend upon huge political contributions, often provided in the form of bribery from the business sector.