In Search of Angels

As Korea moved through its rapid industrialization and economic development in the second half of the 20th century, small- and medium-sized enterprises (SMEs) found themselves mostly ignored or marginalized as the Korean government funneled resources into the chaebol that have come symbolize corporate Korea. As early as the mid-1970s, the Korean government began to offer systematic financial assistance to SMEs, but it was not until after the Asian Financial Crisis of 1997-1998 that the government launched its most generous policy support for the smallest fish in Korea’s business pond. As Dongsoo Kang of the Korea Development Institute notes, these policies were both an admission that the nation had become too dependent on the fortunes of a few large firms as well as compensation for the earlier sacrifices made by SMEs due to the unbalanced economic growth of the country.

Not surprisingly, SME performance initially accelerated with the help of these programs, but in recent years the Korean government has found itself protecting a large number of uncompetitive businesses – “zombie” firms – from the winds of competition, thus wasting scarce resources that could be allocated elsewhere. Indeed overprotection by the state has become the primary barrier to the development of a truly competitive stable of SMEs in Korea.

To be sure, many aspiring entrepreneurs in Korea face the timeless problem of obtaining the financing necessary to get their product or service off the ground and out the door, a challenge made all the more tricky given the dearth of venture capital funds floating around the country. As the graphic to left (published today as part of a special report on the subject of venture capital in Korea) shows, Korea lags far behind a nation like the United States in terms of angel investments, even when accounting for differences in GDP.

Granted, the United States is exceptional in the success of its venture capital markets, but Korea has cause for concern as it seeks to kickstart its economy for the future. SMEs are at the heart of a capitalist economy and are an essential well-spring of products and practices that trigger what Joseph Schumpeter termed “creative destruction,” the free market’s often untidy way of delivering progress and creating wealth. It’s fair to wonder, then, what will happen to a Korean economy in which SMEs are not a source of this dynamism.

The job of venture capitalist, of course is not for the faint of heart, and it is a role from which private investors often shrink. Banks are reluctant to lend to start-ups and young businesses that lack adequate collateral or whose prospects are simply too risky. In addition, creditors face the problem of differentiating between the financial situation of an SME and that of its owners, who may have, for instance, taken second mortgages on their homes to finance the early activities of the company. Finally, and perhaps most importantly, reluctance to extend financing to SMEs can be especially strong in the case of the most innovative firms, which are, by definition, unproven and thus more of a risk.

In Korea, therefore, the government has stepped in to fill this gap. State support for SMEs has taken a variety of forms, including credit guarantees, direct and indirect loans, credit insurance, and venture funds. There is also batch of non-financial programs aimed at supporting SMEs, including support for research and development, infrastructure, and education and knowledge transfer. One result of state financial support to SMEs has been to reduce the incentives for the private sector to seek out profitable investments among fledgling companies. After all, it is difficult for private banks with budget constraints to profitably compete against with the government’s subsidized loans.

The intention of these programs, of course, was to spur innovation and productivity, but as ever, we must distinguish between intentions and results. As Gunseli Baygan of the OECD wrote in his 2003 report on venture capital in Korea, “the dynamism of venture capital markets is subdued by the extensive government role in all aspects of financing. Government support provided to smaller enterprises tends to protect them from normal business pressures, diminishing competitiveness and innovation.” As a result, Korean SMEs continue to struggle. Instead of recognizing the errors of its excessive intervention, however, the government has stepped in with additional measures – such as prohibiting large firms from operating in certain business sectors – which are sure to further harm the prospects of SMEs.

So why haven’t Korean SMEs become an engine of Schumpeterian creative destruction? As we’ve seen, Korea’s development model created an environment that was biased against their success, built as it was on a system of tightly rigged state-chaebol relations, and the lingering effects of this structure remain evident today. In trying to atone for these historical inequities, however, the Korean government has acted in accordance with the same statist philosophy that created the problem in the first place. Until politicians and bureaucrats realize that they cannot wave their simply wave their baton and orchestrate success, they should not expect the condition of local SMEs to improve.